About jimhemphill

I am Chief Investment Strategist for an investment advisory firm in Radnor, Pennsylvania, just outside of Philadelphia. Our investment approach is globally-diversified, with our research focus on using relative-pricing and relative-yield information in historical context as a guide to optimal asset allocation.

The China Syndrome

Twice within the first week’s trading in 2016, Chinese stock markets were halted by a 7% “circuit breaker” designed to pause trading to allow panic selling to calm. When it became clear that denying investors liquidity for their shares was feeding panic, not calming it, Chinese officials wisely suspended the circuit breaker yesterday, on Thursday, January 7, 2016. Friday, Chinese markets inched higher, and most world markets followed.

China’s market problems immediately spread to the rest of the world. Here in the U.S., we had the worst first four days of trading in a new year since 1950. (Both 2008 and 1991 saw sharper declines, though they took five and six days respectively.) Those first four days alone officially qualify as a market correction for both the Dow and the NASDAQ, though not for the S&P 500.

There are several lessons here:

For years, there has been a disconnect between financial markets and the real economy, driven by monetary stimulus and access to easy credit. Rising stock prices became the self-fulfilling justification for further rises, largely decoupled from economic fundamentals. China’s problems with bad debts and malinvestment have been visible for five years or more, but the Chinese stock market continued to rise, finally peaking in June of 2015 after an astonishing 150% over seven months.

Though the combination of public and private borrowing, combined with cheap and easy money, can drive speculative excesses for shockingly long periods, they cannot do so indefinitely. In China, in Japan, in Brazil and Greece, we see again and again the ultimate consequences of stupid public- and private-sector investments fueled by borrowed funds. (Put another way, both Tom Friedman and Paul Krugman are idiots, though Krugman’s idiocy is fueled by ideology, not genuine stupidity.)

A heavily indebted world awash in cheap money is unable to generate sustained economic growth at a pace sufficient to lift incomes. More debts and more liquidity will not solve a problem caused by the destruction of both financial prudence and the possibility of rational price discovery. Durable prosperity depends on the action of free markets, with capital flowing toward projects with the highest economic returns. Empty, roofless cities in China, a train to nowhere in California, billions diverted to the private pockets of public officials in Brazil–none of these can provide a solution to stagnant global growth, but all can absorb capital, attention, and human creativity that would earn much higher rewards chasing genuine progress.

To return to robust global growth, we need a return to more normal interest rates and a reduction in the size and regulatory scope of government. (Who in the U.S. political system understands this? Certainly Fiorina, probably Paul and Cruz, perhaps Kasich and Rubio. Clinton? Surely not Trump or Sanders.)

Enough economic commentary. What are the implications of China’s meltdown for investment strategy?

For much of the last two years, our portfolio strategy has been defensive while U.S. stock prices (at least through mid-2015) continued to advance, with that advance highly concentrated in speculative tech stocks. We under-performed. Now that markets are falling sharply, our diversified, cash-heavy portfolios are holding value better than stocks in general.

We live in an interconnected global economy. That means there is no safe place to hide, while still earning positive real returns. (In a low-inflation world, you can hide in cash, but it surely will not provide returns sufficient to buy lunch, gas up the car, or put a roof over your head.) Here is the good news: globalization also means we have the ability to flow capital toward areas of genuine economic opportunity, across national borders, and between industries and asset classes.

There is a fundamental difference between 2007 (the market peak before the 2008 financial crisis) and today. Back then, nothing was either absolutely or relatively cheap. Today, there are huge divergences from historical price relationships, particularly between growth and value (value is cheaper than at any time since 1929, with the exceptions of 1998 and 1999), and between U.S. and foreign stocks. (U.S. stocks are more expensive than foreign developed-market stocks by a larger margin than we’ve ever observed, going back to the creation of the MSCI EAFE Index in 1969.)

Our long-term strategy remains the same. Avoid permanent impairment of capital; don’t own stupid, over-priced assets. Own more of those quality assets that are cheap according to robust historical measures. If the market crashes and they get really cheap, buy more.



Trump: Less Than Meets the Eye

“There is no there there.”

                                                                                                Gertrude Stein

Many years ago, Saturday Night Live did a bit called “The Thing that Wouldn’t Leave.” As I recall, John Belushi played the part of the dinner guest who refused to get the hint, hanging around long after his exhausted hosts were clearly ready for bed.

I feel that way about Donald Trump. His persistence atop the polls, despite statements that to me appear radioactive, and debate performances that combine ignorance with bombast, continually confounds my expectations.

So as a citizen, Republican, and conservative, I’m going to take another swing at the noisy excrescence that is The Donald.

A considerable part of Trump’s raison d’etre (reason for being, not just reason for running) is his oft-repeated claim to be smart and rich. “I’m, like, a really smart guy…I’m worth ten billion dollars.”

At the moment, Trump is in fact quite rich. Probably about one-third as rich as he claims, as discussed here. But almost certainly a billionaire. And surely he must have been pretty darn smart to get there…or perhaps not.

Recently several substantial news organizations have looked at a fairly simple question. How has Trump done as a businessman/investor, compared to how he might have done if he had simply taken the money he inherited from his father, a highly-successful real estate developer, and placed it into an utterly passive investment, a S&P 500 Index Fund?

The answer, pretty clearly, is not very well, as noted and here and here. Long story short, Trump has made about half as much, with all of his Trump-branding of casinos, office buildings, golf courses and condos, as if he had simply taken his inheritance, bought the Vanguard Index 500 mutual fund, and wandered off to spend the next few decades playing golf on a course he did not own.

And this is before adjusting for risk, and for opportunity set. In terms of risk, Trump has used leverage freely. He has swung for the fences, not once but many times. He’s taken enough risk to have his public company, once Trump Casinos and Hotels, more recently Trump Entertainment, go bankrupt four times.

And consider the opportunity set Trump confronted when he got started. Trump’s father put him in charge of a successful New York real estate development company in 1975. New York has, in the years since, floated atop a tidal wave of investment success. The stock market went up more than twenty-fold. When we talk about the richest 1% in the United States, we are talking largely about New York City. Surely there can have been few better places on the planet to have owned and developed real estate. Surely there can have been few better-heeled customers than Wall Street and its moguls. And yet Trump earned returns roughly half as large as those realized by a sensible mail carrier who put his Federal savings plan into a stock index fund.

One of the great ironies of Donald Trump’s life is his own utter lack of irony. It is entirely clear that Trump believes every one of his self-aggrandizing assertions. He believes himself to be the Titan of the age, one of the great businessmen of his time. It simply isn’t true. He is a guy who inherited a pile of money and a single-syllable Anglo-Saxon last name, engaged in a whirlwind of activity, relentlessly promoted his name and brand, and after four decades ended up with a larger pile of money, which he believes wrongly to be the result of his own activity, but which was actually simply the consequence of the swiftly-rising tide that made many others richer still.

Donald Trump was born on third base, re-named it Trump Terrace, and believes he hit a triple. He got thrown out four times trying to steal home. And he proclaims himself, to everyone who will listen (far, far too many of my fellow Republicans) one of the greatest hitters of all time. He is a fraud.

If Trump remains a player in the Republican field, at some point I promise to share what I really think about him.

Prediction vs. Valuation

Two weeks ago we hosted a quarterly investor call, discussing our strategy and our viewpoint on the financial markets. Afterwards we took questions.

The first question we got was, “When will the Fed raise rates and what will happen when they do?”

Our answer was to quote Warren Buffett’s observation: as investors, we are better at valuation than prediction. We can’t know what will happen in the future, no matter how badly we wish to, but even if we could confidently predict a future event, we would still be unable to reliably forecast its effects.

This past week, events demonstrated Buffett’s acumen yet again, and our borrowed wisdom in aping his viewpoint. With many investors publicly worried that the Fed would raise rates, and that the end of free money would hurt the markets, instead the Fed chose to stand pat on rates.

So the market went up, right? No, the market went down, concerned that the Fed’s restraint proved the world economy was in worse shape than we thought. (We are not the first to observe that the Fed is trapped in a Catch-22 of its own making.)

There are two takeaways here. First, forget about predicting. Second, markets that want to go up will interpret most news as bullish, while markets biased toward decline will go down on a similarly broad span of news. Right now the markets see the glass half-empty. Which helps us not at all, since sentiment can swing from greed/bullishness to fear/bearishness with shocking speed and unpredictability.

This leaves us with valuation. U.S. stocks remain very expensive by the long-term measures we find most persuasive, though another week or two of declines would change “very expensive” to merely “quite expensive,” with some limited implications for asset allocation. Foreign stocks are, relatively speaking, unusually, even extraordinarily cheap. That we can act on, never mind the Fed.

’16 No Trump…Please!

“I tremble for my country when I reflect that God is just.”

Thomas Jefferson                    

“The enemy of my enemy is my friend.”

Sanskrit proverb                    

As a Republican, I weep for my party when I contemplate Donald Trump still leading the field of contenders for my party’s Presidential nomination, based on no qualifications other than a willingness to express crude outrage on a small number of hot-button issues.

Trump is no Republican, and no conservative. He has given mostly to Democrats. A few years ago, he declared himself a liberal, and said he was becoming more liberal over time. He is a past supporter of single payer healthcare, is pro-choice…the list goes on. Bill and Hillary Clinton came to Trump’s most recent wedding. Bill urged him to run for President. Indeed, the idea that Trump is actually a Clinton operative in the Republican camp is entirely plausible.

At last week’s debate, Trump explicitly refused to support the Republican Party’s nominee for President, should it prove to be someone other than himself. This Pat Buchanan-like move would normally be instantly disqualifying for any Republican. After all, this is the party whose nomination process almost always settles on the guy (must it always be a guy?) whose “turn” it is to carry the banner. Thus weak candidates like Bob Dole, John McCain, and Mitt Romney periodically escort the party to defeat for the highest office.

Given his poor qualifications as a Republican, and add in that Trump is unqualified by experience, ability, and temperament to hold the office of President regardless of party, why is he still leading the field among likely Republican voters?

Pretty clearly, the answer is a growing groundswell of rage at the political and media establishment, who regardless of party appear to collude in preventing certain obvious issues from making their way into the public square. For a certain narrow and angry segment of Republican voters, it appears that if Trump is rude to people they dislike (any politician, any media figure including able and dispassionate journalists like Megyn Kelly and Chris Wallace), he must be on their side.

Trump’s sudden prominence echoes a similar personality, regrettably also Republican, who emerged briefly from obscurity more than a half-century ago. From 1950 to 1954, Wisconsin Senator Joseph McCarthy led a crusade against Communists and homosexuals in American government. He started with a speech claiming possession of a list of Communists in the State Department.

McCarthy struck a nerve in an American public fearful the Washington establishment was not taking seriously the threat from communists within the government. The threat from Communism was real, as evidenced by the spying of Alger Hiss and others, but the real threat was in no sense clarified or mitigated by McCarthy’s irresponsible accusations. Indeed, because McCarthy was such a crass and vindictive bully, he left many convinced that anti-Communism was per se an indefensible position. Crafting a rational response to a real issue of public policy was made profoundly more challenging by McCarthy’s tactics. (There was no legitimate issue of public policy behind McCarthy’s persecution of gays. None. The man was just a bully.)

McCarthy was finally undone by his own bluster and lack of evidence. It all came to an end in June of 1954, at the Army-McCarthy hearings, when Army counsel Joseph Welch interrupted the blowhard Senator’s attack on one of Welch’s junior legal colleagues to ask, “Have you no sense of decency, sir, at long last? Have you left no sense of decency?”

The question answered itself. That was the beginning of the end of McCarthy’s reign of terror. He disappeared from the public eye, and drank himself to death within three years.

We know already about Trump’s sense of decency. He has none. How long will it take before he vanishes, and what damage will he do to my party and our country in the meantime?

How’s My Crystal Ball?

Prediction is dangerous, especially when it involves the future.”

Yogi Berra                                   

Greece appears to be moving steadily toward implementation of the brutal terms imposed by the troika (EU, ECB, and IMF) as conditions for the provision of more liquidity to Greek banks and a new ESM loan to the government. There can always be further twists and turns to the Greek tragedy, but we’ve come far enough to assess the accuracy of my prior predictions in this blog. By my count, I got one of my three predictions mostly wrong, and a second correct in principle but wrong on magnitude. Here’s my scoring:

1) Who’s on First? I thought Greece’s new Syriza leadership (Prime Minister Tsipras and Finance Minister Varoufakis) entirely misunderstood the strength of their negotiating position. When you are going hat-in-hand to someone to whom you have previously lied when borrowing money, in order to borrow more money you simply must have in order to survive, you cannot possibly expect to dictate terms. Germany’s Angela Merkel was the key player on the other side, and she was never going to make any deal that would leave her constituents paying indefinitely for Greeks to enjoy better public-sector benefits than they themselves received. Score this one correct.

2) Outside looking in. I predicted that Greek hubris and miscalculation would place them outside the Euro by midsummer. I missed this one on two grounds. First, I underestimated the utter determination of much of the Eurozone to keep Greece in, despite the endless provocations of Tsipras and company. Second, I did not anticipate the ultimate complete surrender to austerity by Tsipras. While we can’t entirely discount the possibility of Tsipras and company snatching even-worse-defeat from the jaws of defeat, I score this one wrong.

3) Buy on the cannons. My final prediction was that significant market dislocation attendant on a Grexit would provide a buying opportunity for European equities, followed by a strong rally. I’ll score this one both semi-correct and unresolved. European markets declined but did not crash, making a low on July 8, then rallied a bit more than 6%. We’ll have to wait and see where European stocks go in the coming years, compared to U.S. equities.

There is one poorly understood aspect of the Greek drama I got substantially correct. The central problem for Europe was keeping Greece within the Euro while simultaneously discouraging the growth of anti-austerity parties in other Eurozone nations. Greece’s comprehensive failure to improve its position by electing a radical-Left government has been noted in other countries, such as Spain, where anti-austerity party Podemos has been losing support.

A quick aside. One of Warren Buffett’s fundamental principles of investing is that we are much better at understanding today’s values than we are at predicting tomorrow’s outcomes. In this respect, it is worth pointing out that my commentary on Europe’s crisis is intended to provide context for understanding our investment strategy, which remains entirely driven by relative prices and relative yields, and not by predictions–mine or anyone else’s.

Greece: Game Over, or Game On?

On Sunday, Greek voters stunned Europe by voting in overwhelming numbers to reject the final offer from Greece’s creditors on the terms of a possible new rescue package. That package had in any case already been withdrawn, making the Greek plebiscite equal parts historic and incomprehensible, especially given the expressed desire of most Greeks to remain in the Eurozone, even as they cast a vote that European leaders explicitly defined as a vote to leave.

The results of the vote gave Greek Prime Minister Tsipras and Finance Minister Varoufakis what they said they needed–a powerful mandate from the Greek electorate to negotiate from a position of strength, based upon a clear national rejection of future austerity. To make things even more confusing, Varoufakis had threatened to resign if Greece voted to accept the creditor’s expired plan. So once Greeks rejected that plan, Varoufakis…resigned.

For months, European finance ministers were treated to lectures from Varoufakis, an academic economist and expert on game theory. At one point, the Greek Finance Minister commented, “If only the other side had a competent game theorist, they would already have accepted our position.” In his understanding of the “game” being played, Greece held all the cards, despite having fraudulently qualified for Euro membership, failed to fully implement two prior reform agreements, and with the Greek banking system on life support and operating on strict capital controls.

Over the next week or two, we’ll see if Varoufakis was visionary or delusional during all of those contentious months of unproductive negotiation. My own belief remains that there is no prosperous future in an ever-larger public sector, a less flexible labor market, and amid endemic corruption. Maybe I am wrong.

My read remains that, unless France can persuade Germany to agree to never-ending subsidies for Greece, the problem for Europe’s leaders will shift from how to keep Greece in the Eurozone to how to manage its exit. Will they be able to avoid a failed state within continental Europe? Let the games continue.

The Greek Tragedy: Final Act?

As it has been for more than a century, Greece is a financial mess. Last weekend, negotiations broke down between Greek Prime Minister Alex Tsipras and the “troika” of the European Union, European Central Bank, and the International Monetary Fund. (EU, ECB, IMF from this point forward.)  There will be no third bailout for Greece, at least not until the results of Sunday’s Greek referendum are in.

This past Monday, June 29, world stock markets fell sharply. The S&P 500 Stock Index was down 2.1%, erasing all year-to-date gains. This was the biggest decline since April of 2014. On Tuesday evening, Greece officially defaulted on a 1.6 billion Euro loan owed to the IMF.

We have watched the Greek situation carefully for years, and have written about it several times, most recently here. There are two dimensions to this latest chapter in the Greek tragedy.

The first is the human dimension. A Greek exit from the Euro (and probably from the EU as well) is likely to have profound and even catastrophic human costs. The Greek people, most of them hard-working and honest, will suffer greatly. Within a year or two, Greece is likely to be the world’s only formerly developed nation. We may see in Greece a level of poverty, suffering, and social breakdown not seen in Europe in peacetime since the grim decades of the 1920s and 1930s.

The second dimension is financial. How will the Greek drama impact the finances of U.S. investors? This is a very different picture. In the medium term, we expect a “Grexit” from the Eurozone to be a net positive for investors, for several reasons:

  • The risk of a systemic breakdown, like the 2008-2009 financial panic, is low. When the Greek crisis emerged in 2009, European banks had dangerous exposure to Greek loans, and a default could have triggered a collapse of Europe’s financial sector. Those big bank debts have been written down and recycled to European governments. If Greece defaults, it will cost European taxpayers billions, but we see little risk of contagion.
  • Monday’s market action was not unusual. Historically, declines of 2% or more happen several times a year. (Back in 2008-2009, they often happened several times a week.) Here in the later stages of a long, long bull market, periodic downside surprises are inevitable. What has been unusual is the very low volatility of markets since 2013. Expect a bumpier ride, but don’t worry about it.
  • Absent Greece, the investment outlook for Europe looks much more positive. With plenty of bad news already “priced in,” the unanticipated outcome is one where a Greek exit is largely an economic non-event for the rest of Europe. (Remember that Greece’s peak GDP was less than 3% of the Eurozone as a whole.)

Overall, our expectation remains largely unchanged. We expect the departure of Greece from the Eurozone to be an extended, messy process, very much a “Grexident” rather than a clean and surgical separation. But while markets may be volatile, we think any sharp downside break will represent a buying opportunity.