The Great Yield Famine
Over 150 years ago due to blight the potato crop failed in Ireland, causing starvation and triggering a wave of emigration of about 1 million people. The price of this staple rose dramatically. When the famine struck in Ireland, it affected rich and poor alike. High prices of all foodstuffs caused better-off consumers to trade down to potatoes, increasing demand.
Economists have debated ever since whether the potato is an example of a rare phenomenon known as a “Giffen good,” something for which demand rises rather than falls as its price goes up. It’s a little counterintuitive, because you need certain conditions for the Giffen condition to hold. Generally, the good in question has to be essential to most budgets, but substitutes must exist. Regardless whether Giffen goods are as mythical as unicorns, the phrase does capture meaning that resonates, particularly in today’s mixed-up economic and financial environment, which is the topic we wish to highlight.
In the present, thanks to forceful intervention of central banks, we are in the midst of a famine of another sort. Interest rates are at record lows, about as low as ever seen since the Irish potato famine, in fact. In this Great Yield Famine, savers seem to be exhibiting Giffen behavior, demanding more of yield-producing assets when they are priced at record highs. Well-heeled owners of stocks have preferred bond funds, whose inflows have recently topped already excessive levels sustained for several years. Still, within the stock market, the latest craze is to seek the “safety” of dividend paying stocks, when ironically, like bonds, they offer some of the skinniest yields on record.
This brings us to the question of risk. Common sense says that if an asset has been going down recently, it must by definition have been risky. Fair enough, but this logic implies that if a security is going up, it is not risky. Alternatively, one could compare securities to a benchmark. In the quant world, this has typically addressed through something known as “value-at-risk,” or VAR. Although it sounds intimidating, it’s basically a way to summarize and characterize historical price movement. This measure attempts to make a definitive statement that if prices are as volatile as in the past, then over a certain timeframe the probability that a predefined loss threshold could be attained might be surmised. While the concept is pretty nifty and mathematically sophisticated, it skirts the subject of sorting out what will be risky in the future versus what was risky in the past, despite great effort by software vendors to promote the ability of these models to do so.
It is in the financial industry’s interest to act as if risk can be tamed. But when one digs down for answers, one finds that despite visible confidence that it can be, august policymakers such as the Basel Committee on Banking Supervision have determined otherwise. Findings surveyed by this commission last January and published in Risk magazine show that VAR and even its most obvious successor are “of limited use during periods of market stress,” and might even “work as a systematic amplifier of boom and bust cycles.” If a stock or bond was volatile historically, or moved in tandem with the broader market, its behavior might change, going through phases that no longer fit with past models.
Advisors periodically review risk, obviously a legitimate exercise. But it can also be a powerful marketing tool. Customers would willingly transfer risky assets to another advisor in exchange for “safe” ones, particularly if the safe assets are going up, and the risky ones are going down. Moreover, they are likely to respond best to a simplistic approach. But is this best for the client? Is risk being controlled, or possibly could it be magnified by these actions, as the research above supposes?
Before 2009-2012, the last time the stock market ascended sharply over several years was the internet bubble, which ended in 2000. In that period of time, value stocks performed miserably, leaving their shareholders feeling like they were left behind at the station. Interestingly, once the bubble was pricked and deflated, value stocks were the stars, and capital rushed into that style of investing. In the present cycle, value might perform well again, which would tend not to favor growth managers such as us here at Gaineswood. However, we believe our hybrid approach to growth investing may thrive should the present day worm turn, and for those willing to consider asset allocation, we think risk might be addressed through fundamental and historical overlays. An interesting “Tiles of Styles” chart depicting the situation is available here.
Today, thanks to the blight of central bank intervention, we are amid the great yield famine. An unfortunate side effect is that not only are prices of bonds dear, this is also the case for a variety of substitutes, just as it was for foodstuffs in Ireland over 150 years ago. Three possible exceptions are cash holdings, funds that can short stocks, and precious metals equities. These options have been sought out for fundamental reasons by investors who wanted to play defense despite hearing the bulls’ hooves thundering from behind. Ironically, now due to the dismal performance of these asset classes, investors unfortunate enough to still be positioned this way find some of these strategies dubbed as risky when measured by either the simple loss aversion method or the more sophisticated value at risk methodology.
What statistical characterizations can lack is a historical or a fundamental perspective. For example, certain steady large multinational stocks can and should be seen as less risky, due to the nature of their franchises. But that doesn’t mean they couldn’t be out of favor for years due to valuation or cost inflation, and thus be risky in the future. More pointedly, precious metals stocks are notorious for being volatile to the downside at certain parts of a cycle, and then like a chameleon becoming the antidote to market risk and exhibiting negative correlation at other periods of time. In the middle of what may be the high point of a yield famine, they suddenly became pariahs. They are prime candidates for investor capitulation.
So what would you do in the midst of a great famine? Would you stock up on costly potatoes and hunker down, or would you bravely immigrate to a new world of opportunity?