the FT: America’s reading problem

I like Gillian Tett, the US managing editor for the Financial Times.  It’s partly because she has a PhD in Anthropology, partly because she has a wide breadth of interests that allow her to write much more interesting columns than the average journalist.

Her latest is about “America’s Reading Problem,” an article that contains the results of Department of Education research documenting the fact that ” 14 per cent of the adult population (or 32 million people) cannot read properly, while 21 per cent read below a level required in the fifth grade. And 19 per cent of high-school graduates cannot read.”

Hartnell College, a community college in Salinas, CA has a powerpoint online that contains a more detailed version of the same information.

Ms. Tett points out that this reading deficit, which has persisted in the US for a long time, tends to reinforce the distinction between haves and have-nots.

I have two thoughts:

–if government economic policy is reliant totally on monetary measures and not on education reform, no wonder 0% interest rates + quantitative easing for a long time have been necessary to  provide the (low skill) jobs that will shrink the unemployment rate.  Imagine what those jobs must be like.  It also seems to me very likely that higher rates will make jobs for the illiterate disappear very quickly.

–I’ve been unable to find the original government source document referred to, although the results are in the Tett article and in many others that pop up through an online search.   The only Department of Education report I can find says simply that literacy rates in the US are similar to those elsewhere in the OECD.

How odd.

I normally search government websites several times a week, so that’s maybe a thousand instances.  This is the first time something like this has happened.


a reply to a reader comment

I spent a lot of time over the weekend thinking about how to reply to a comment from an astute regular reader about my post on Friday.

Here it is (edited slightly):

Thanks for your comment, Chris.

I agree completely with most of what you say. I think the US stayed with easy money for far too long.  As you point out, we’ll find out how damaging the speculative excess this has spawned has been as rates begin to rise. At the same time, the internet has changed the dynamics of ownership of physical assets. The aging of the population plus the unwillingness/inability of homeowners to use the equity in their houses to fund current spending will also be drags on consumption in the US. And, despite our warts, we’ve come out of the big recession in better shape than the rest of the developed world. So we now face a complex, slow-growth world with lots of challenges for stock and bond markets.

As to mining commodities, though, I continue to think that they exist in their own boom-bust worlds whose main feature is that participants will add capacity, even though history has shown that this will destroy pricing, so long as they have positive cash flow and can get bank loans. Oil and gas are a little more complicated, but let’s ignore that. The ensuing slumps can last a decade or more. It’s the odd nature of these industries that they produce more when prices decline rather than less. I regard the current weakness in the prices of mining commodities as resulting from industry weirdness rather than a recession-induced falloff in demand.

Of course, this is an optimistic viewpoint and I’m an optimist, so I could easily be wrong.

Does it make a difference whether oil and iron ore price declines are harbingers of general economic weakness or are just playing out a new day in their Groundhog Day existences?

I think it does.

If I’m correct, then mining weakness–and the “lost decade” it seems to predict for countries radically dependent on mineral production, although important, is one of many entries to the list of transformational issues facing today’s world. That list includes:

–Millennials vs. Baby Boomers
–China’s emergence as the world’s biggest economy
–the disruptive power of the internet
–political reaction to the failure of the governments of the US, EU and Japan to enact appropriate fiscal policy, defending entrenched special interests (many of them on the wrong side of change) instead.

In the world I envision for 2016, stocks will go basically sideways.  It will be hard to make money by owning them, but with careful selection it’s possible.

If, on the other hand, if you’re right that mining commodity price weakness foreshadows global economic contraction that just hasn’t hit mainstream indicators yet, then my take is much too positive. Cash will be the best place to be.

oil …again

After a long period of the stock market thinking that lower oil prices are a good thing (for all sectors except Energy), the market now appears to have adopted the opposite view.

Over the past short while, when the spot price, a mere shadow of its June 2014 self, moves down, so too does the S&P 500.  Economically sensitive stocks get clunked more than the average equity.   And vice versa.

To me, this seems so obviously wrong   …and yet it’s happening.

This wouldn’t be the first time that the market got a crazy idea into its head and ran with it for a while.  Remember in 2009 when a number of prominent hedge fund managers proclaimed that the Fed’s decision to lower interest rates would quickly cause runaway inflation and that the only protection against this government folly was to stockpile gold?

Here we are six years later, with still no inflation to speak of.  Gold had an amazing two-year run, which had nothing to do with the Fed, and everything to do with demand for the yellow metal in India and China.  The gold price has since lost 40% of its value as new mine supplies have come into the market and as domestic developments in Indian and China have lessened their ardor for money-like stuff they can bury in the backyard.

It’s tempting to think that the reversal of view about oil is only occurring because most big market participants have closed their books for the year and are drinking egg nog on the sidelines.  But I think it’s a dangerous habit to cultivate–the idea that I’m right, the market’s wrong and it will soon come to its senses.  The reality is that I’m wrong maybe 40% of the time.  Also, it could be that soon is the operative word.

At times like this, I go through this mental checklist:

  1.  How dependent is my portfolio on this one idea?  The riskiest situation is one where my holdings end up being an all-or-nothing bet on a falling oil price being good, without my realizing it.
  2. How likely is it that, contrary to my view, the market turns out to be right?
  3. If I wanted to rearrange my holdings to neutralize the effect of lower oil–meaning, in this case, becoming more defensive–how would I do it?  Would these changes make any difference to my performance expectations?  If not, why don’t I make them?
  4. If I were managing professionally, I’d ask if I should do some of this in any event, to guard against falling behind my peers (and ultimately getting fired–even worse, maintaining a portfolio that would pay off spectacularly for my replacement).

Most often, when I go through this process I find something in my portfolio that I don’t like and change it.  Invariably the move improves my performance.  But most often it has nothing to do with my original worry.

As to the market’s current fixation on oil, I have three thoughts:

–for now I’m content with what I hold and hope to ride out the craziness,

–I think this latest market kerfluffle brings us closer to the day when we’ll want to add oil exposure, and

–downward pressure on the market in December will translate into somewhat higher returns in 2016.


a footnote to yesterday’s post

Yesterday I wrote about the Third Avenue Focused Credit fund, which shut itself down amid a tsunami of redemptions.  (The SEC has since blessed its liquidation plan, by the way.)

Several thoughts:

–Typically, institutional clients abhor their managers keeping cash reserves.  Their idea is that they do the asset allocation, which they consider the brainy part of the business, and leave the details to the managers they hire.  They don’t want managers upsetting their asset allocation plans by holding more than a tiny amount of cash.  On the other hand, they want the ability to withdraw their funds instantly that the mutual fund/ETF form gives them.  Given that the majority of the shares of the Focused Credit fund were “institutional,” this may have been part of the fund’s problem.  In hindsight, the institutions should have had separate accounts to hold their money in.  On the other hand, it’s hard to turn down the cash that clients are pleading with you to take.

–One secret to investing is to ride your winners and cut your losers.  There’s a tendency for investors of all stripes to do the opposite.  Sometimes they even sell some of their good securities to buy more of their losers.  Don’t ask me why.  My only answer is that no one likes to admit he’s made a mistake.

In particular, when a fund sees redemptions coming, I think it must sell assets across the board, with particular attention to offloading the least liquid, most losery holdings it has.  Otherwise the fund ends up making itself less and less liquid.  If brokers figure out what’s going on, which they will surely do pretty quickly, or if another fund begins to sell, these less liquid holdings may become unsalable, except at crazy low prices.  (All a broker has to do is look at your latest SEC filings or your own marketing materials to learn in detail what you own.)

–Another secret to investing, especially applicable to value investing, is to buy low. Its corollary is to sell high. Both are much harder to do than most suspect.  In fact, stock market participants typically do the opposite.  Some fund managers will even use the flow of money into their funds (or lack of it) as a contrary indicator.  They adopt a bearish stance when they’re flooded with cash and become more bullish as the buy high/sell low crowd starts to leave.  Maybe you can’t hold cash, but you can hold some highly liquid, if boring, positions.

my takeaway

I don’t know the people at Third Avenue and have no idea how they handle management of their portfolios in general or how they dealt with redemptions at the Focused Credit fund.  Even if the managers did everything by the book, my guess is that the withdrawals were so overwhelmingly large that closing the fund was the only option.

The Focused Credit demise came during a period of economic expansion.  Yes, natural resources junk bonds have been in trouble, but the general economy isn’t.  I wonder what would happen to junk bond funds in an economic downturn?





Third Avenue Focused Credit Fund

a decision to liquidate

Last week the Third Avenue Focused Credit Fund (TFC), a junk bond fund managed by well-known value investor Third Avenue Management, decided to cease normal operations and liquidate itself.

The fund had lost about two-thirds of the assets it had at its high point to a combination of market losses and investor redemptions.  TFC apparently had reached the point where it determined it could only sell further holdings at big price concessions.

Rather than do so, the directors of the fund opted to stop honoring redemption requests, distribute all its cash on hand to shareholders and put the remaining fund assets into a liquidation trust.  Third Avenue is in the process of issuing shares in this trust to TFC shareholders, who will receive the proceeds of liquidation sales as and when they happen.

How did this happen?

According to the New York Timesthe lead portfolio manager of TFC was telling investors that everything was fine two months ago.

I’ve looked at the SEC filings for TFC since mid-2014.  Three things jump out at me (remember, though, I’m a stock guy, not a junk bond person):

–there’s no undue concentration in any industry or sector area (I’d suspected there might be)

–the percentage of assets classified as “level 3,” meaning basically that they’re being valued by a theoretical model rather than a daily market price, went from negligible in mid-2014 to about 20% of assets in September 2015.  I don’t know whether this came about through a change in portfolio strategy (which would strike me as odd) or whether it’s the result of liquidity drying up in the bonds TFC held.

–net assets were about $2 billion on September 30th.  According to the NYT, they had shrunk to $790 million ten weeks later.  That implies an avalanche of redemptions.

What caused the massive outflow?

Who knows.  My only observation is that the majority of shares were “institutional,” which typically means each holder had at least $500,000 worth of shares.  Maybe a small number of them represented a large chunk of the fund’s assets and they all decided to allocate away from TFC during their year-end planning.

I’ve seen stuff like this happen before

In most of the instances I’ve observed, however, the fund is part of a large asset management group–a brokerage firm or a bank–that steps in and buys the illiquid assets at the fund’s carrying value, thus providing money to meet redemptions.  Third Avenue is apparently not big enough to do so.


Not many.

Past junk bond crises have shown that this asset class is much less liquid than one might think.  Also, if things turn ugly it’s probably better to own shares in a fund with a deep-pocketed parent.






oil: confusing correlation and causation

This is about the current state of the oil market.

The fact that two things occur together (correlation) does not always mean that one causes the other.

For example, every morning the rooster crows and the sun comes up.  But killing the rooster won’t plunge the world into eternal darkness.

Birds fly south and winter begins: birds fly north and winter ends.  Same story.


Some commentators are arguing that the sharp decline in the price of oil is a harbinger of recession, using the argument that low prices and recession are very often linked.  I don’t think this is correct.

The causal connection between lower demand and price works something like this:

When aggregate global demand begins to contract, sellers of end products see their businesses begin to slow down.  They may cut their prices to sell stuff they have on hand and they certainly begin to shrink their inventories to a level that matches the lower demand they are experiencing.  They do so by cutting back new orders sharply.  Middlemen do the same.  This process typically hits producers with a very sharp decrease in new orders.  Producers respond in the only way they can, by cutting prices.

In the case of oil today, none of this is true.  Yes, prices are only a third of what they were eighteen months ago.  But aggregate demand is steadily rising.  So too world inventories.  The majority of oil producers are increasing their output, as well.

What’s happening with oil is that years of very high prices established a pricing umbrella that encouraged new entrants (shale oil), previously uneconomical, to invest tons of money and enter the business.

Established producers, meaning OPEC, have started a massive price war to force the new guys into bankruptcy.  The producers are learning the basic, but bitter, lesson that it’s much easier to keep new entrants out (by keeping prices low) than it is to deal with them once they have invested in plant and equipment and have begun production.

Shaping a Portfolio for 2016: dealing with oil

Energy stocks now make up about 7% of the market capitalization of the S&P 500.  That’s not much.  They make up about 14% of the junk bond universe, however.  And they’re a huge chunk of emerging markets.  To my mind, it’s the spillover effect from these latter two areas where the price of energy may have an effect on the stock market.

forecasting earnings

I think it’s impossible to know what the earnings of oil and gas stocks will be for 2016.

If an exploration company spends $10 million to find 1 million barrels of oil, oil and gas accounting rules call for it to expense $10 of finding costs every time it produces a barrel.  On top of that, it expenses the out of pocket costs of extraction.

A complication:  suppose the extraction costs exceed the selling price of the oil.  If so, the oil company won’t produce any.  It won’t have revenue, but it won’t have a loss on its income statement, either.

If, however, the oil company decides the field is permanently impaired, it could write part of all of the cost of the field off at the end of this year.  That would allow it to show an accounting profit on output from that field in 2016.

This kind of housecleaning has already begun with Royal Dutch Shell, which has written off a number of high cost projects.

To the extent that the industry as a whole has large, non-recurring writeoffs this December, 2016 earnings will look better than we now think.  We won’t know this for a while, however.

reported earnings probably don’t matter that much

It seems to me that the stocks are no longer trading on reported earnings, but on the spot price of oil and gas instead.

It strikes me, too, that we’re now entering some sort of capitulation phase with oil and gas stocks, where panicky investors tend to throw the baby out with the bathwater.  This phase could last a considerable amount of time, especially if energy prices continue to slide during what is supposed to be the strongest season for demand.  So there’s plenty of scope for near-term bad news.

We’ll know that the capitulation is over only when the stocks stop reacting negatively to oil/gas price declines.

the energy sector is now a small part of the S&P 500

At today’s size, it would take a 15% fall in the Energy sector to clip one percentage point off the return on the S&P 500.  One could argue that in this sense, oil and gas no longer have a large bearing on the fate of the index.

one worry

It seems very clear to me that the current decline in energy prices is similar to what happened during 1982-86.  That is, a period of very high prices leads to the creation of supply overcapacity that causes the price to subsequently plunge.

I don’t think there are wider macroeconomic implications.   It’s all about the microeconomics of benefit to oil consumers and hurt to oil producers.  For the S&P 500, that ends up being a net plus.  For emerging markets, especially for OPEC, it’s a net minus.

I find it hard to follow the logic of the argument that if very high oil prices are bad for the world economy, then low ones are also bad.  Yet that’s what I’m beginning to read and hear in the financial media.  It’s taking the form of a claim that the price decline is not being caused by oversupply–which it clearly is–but by a recessionary falloff in demand.  The low oil price, these commentators say, is the first evidence that the world is entering a business cycle decline.

If investors in general begin to believe this, we could talk ourselves into a period of stock market weakness.

For long-term investors, this shouldn’t have any effect on investment strategy.  For more trading oriented, a stock market selloff based on false premises could provide a buying opportunity.  When?  My guess is as we enter the seasonal energy lull early next year.