Weak Treasury Auction-Markets Are Efficient


Weak treasury auction is giving some people pause today.  Is inflation coming?  Is the US government going to go broke anytime soon?  No and no.

Are the Chinese buying our debt? Sure they are. They may have cut back, but they still are buying.

I think the weak auction has more to do with risk/reward and math than anything else.  If you had $100,000 today, do you invest in ten year treasuries at 2.66%, or do you take a shot on the equity market with historical long term returns of 8%?

Sure, equities are riskier.  You could lose your entire investment.  However, if you invest in a passive fund that replicates the S+P 500, you won’t lose your nest egg.  Put it away for a long time and don’t look at it.

Yesterday, I attended a lunch at the Booth School at the University of Chicago and listened to Dean Zmijewski interview Professor Gene Fama.  Fama is the father of modern portfolio theory.  He hypothesized efficient markets in 1962.  No one had disproved his theory yet.  He should be getting a Nobel Prize in Economics next year if the committee has any sense at all.

Fama had some great points, with some very insightful commentary.  First, he said the market has not had any “bubbles”.  Markets are efficient.  A great question he asked, “Did anyone predict the bubble?”.  If no one could predict the height of the bubble, and no one predicted the pop of the bubble, then the market had to be efficient.  Certainly, some people predicted the end of the bubble.  But they are a small fraction of the total population of the world.  Even on Wall Street, where the market savants lie, very few took the opposite side and made millions on the bubble.  They are chronicled in the book, The Big Short.

Professor Fama also had a couple of interesting things to say about government debt. How do we pay it off? Well there are a few ways. One is cut spending and grow the economy. However the debt load is so big that this is only one part of the equation. The other is via immigration. We can allow the countries that have dollars to repatriate them through their citizens moving here and spending them. The third is inflate the dollar. Hmmm. Don’t think either party will get strongly behind any of those.

Fama also had interesting things to say about the distribution of stock market returns when it came to active and passive management of funds.  On his blog, he talks about it under, “Luck versus Skill in Mutual Fund Performance”.  I’d urge you to read the entire essay, but here are some of the finer points.

“Thus, even before expenses, the overall portfolio of active mutual funds shows no evidence that active managers can enhance returns. After costs, fund investors in aggregate simply lose the fees and expenses imposed on them.”

Essentially, if you use an active manager, you believe that it’s a zero sum game. Successful managers are profiting off of others stupidity.

“The regression says that the aggregate mutual fund portfolio has almost full exposure to the market portfolio (a 0.96 dose, which is close to 1.0), but almost no exposure to the size and value/growth returns (0.07 and -0.03, which are close to zero). Moreover, the market alone captures 99% of the variance of month-by-month aggregate fund returns.

In short, the combined portfolio of all active mutual funds is close to the cap-weighted market portfolio, but with a return weighed down by the high fees and expenses of actively managed funds.”

There is much more there. But, the conclusion is that you cannot beat the market unless you have information that the market doesn’t know. I think they call that inside trading in a lot of instances! You get to wear the orange jump suit if you get caught.

To get really geeky, Fama was asked about the way the distribution appeared. Some bell curves look differently than others. The shape of the bell curve sometimes can tell you something about the data. In this case, there were “fat tails”. The bell looked more like the letter “T” than anything else. This also proves Fama’s point on efficient markets.

Fama also talked about some of the programs put in place by the current administration. Not surprisingly as a classical economist, he was against virtually all of them. What was more important though was what he had to say about muni bonds. There is a 100% certainty that many of them will default in the next ten years. The government obligations with a smaller tax base will overwhelm the system. Bankruptcy is the only option. At that point, society will have a choice-and it’s not going to be pretty. The populace that pays taxes and receives no government help will have to decide if they are going to allow politicians to bail out the government. Politicians, no matter their political stripe always bail out governments.

The bond auction today will make hearts flutter. But we have had bad auctions in the past. While Obama and the Democrats plans are absolutely terrifying for the financial future of the country, there is an election in November. Hopefully we have learned our lesson.