Of Risk and Returns

When you hear pundits say this or that, most pundits are wrong most of the time, especially those that call for extraordinary action. In the long run, stock markets go up because the fundamentals of the companies tend to get better. The product gets improved, the quality gets improved, the quantity gets improved, and ultimately the company gets improved. Sure, some companies are in their death throes, but there are more companies that are in the growth part of their life cycles. On balance this works out. We are not contingent on the world being a happy place as investors.

Usually, when we talk with clients, we don’t say things like “at the first sign of trouble, we cut and run.” Generally, we say something like “risk and return are related, you can’t have one without the other. When risks appear to be the greatest, that is usually when opportunity is the greatest.”

We invest for the long-term because that is the correct time horizon to keep in mind. Stuff comes up from time to time to focus our attention on the immediate, but those times pass, usually with an opportunity to invest for the long-term at a short-term mispricing. So why is it that every time one of these little glitches comes along, we all act like this is the one time that our thoughtful preparation and consistent story should be ignored?

It would be great if whenever the stock market is down 3% or so in a day our phone would ring and it would be advisors calling to tell us that more clients are putting more money into their accounts. No, it is always asking what we can tell clients to keep them from running for the hills. Oh well, human nature being what it is, we will probably never get that other call.

All our teaching, all our efforts at setting client expectations and all our communications are forgotten once those red numbers start filling up the screen. People are largely incapable of seeing something like what happened in Japan last week and not getting scared. It is one of the tenets of behavioral finance that people are instinctual creatures, better prepared to stumble upon a sleeping lion than figure out if we’re at risk from a default by some corporation or a wiggle at some nuclear reactor. Our reaction will be irrational in many cases, predicated on innate fears not facts.

Let’s have a little quiz, just one question. How many people died at the Three Mile Island nuclear accident? Here are the possible answers: a few, not very many, lots or none.

The correct answer is none, though evidently one man died of a heart attack in the rush to relocate to a ‘safer’ location (didn’t work for him, did it?).

So far in Japan, thousands of people are known to have died and thousands more are presumed dead from the tsunami that followed the earthquake way last Friday. So far, five workers have been killed at the nuclear reactor, and many more people have been hurt by explosions that were largely contained by the containment structure. Yet, much of the world wants to take a huge step backward from nuclear power but no one is suggesting we stop using water. Our crude guess is that more people die in backyard swimming pool accidents every year than are killed by radiation poisoning, but we are willing to curtail using nuclear power but we have a right to have a killing machine in our own back yards. (Don’t get me started on trampolines.)

There is no real reason to believe that the Fukushima Daiichi plant represents the same sort of risk that Russia’s Chernobyl nuclear plant did back in 1986. The situation is more akin to Three Mile Island in 1979. The biggest difference is that Chernobyl was built on a totally different reactor model than Three Mile Island or Fukushima. Chernobyl used a graphite system of cooling where the uranium rods would descend into a large block of graphite for cooling rather than be kept in cement and cooled by water. For those in the know, graphite is just another name for carbon and when that plant melted-down, the graphite burned and spewed radioactive soot over a wide area. Also, Chernobyl had no containment structure to contain any radiation release. Once the accident there started, it was able to spread quickly beyond the initial core to surrounding structures. Three Mile Island had a containment structure and only minimal amounts of radioactive steam escaped that plant. Fukushima likewise has a containment structure and though those containment structures have evidently suffered some damage from explosions from hydrogen boiling out of the cooling water and combusting, they still are keeping the radiation contained.

Among the greatest killers in modern society are automobiles. We will guarantee that if as many people died in nuclear reactor accidents annually as die in car accidents, even we wouldn’t support nuclear power. But, they don’t. As a society, we are content to suffer the tens of thousands of deaths each year for the freedom to hop in the old jalopy and head out on the highway. Some seemingly would be content to sit in the darkness each night to save us from the occasional radiation poisoning from nuclear power.


Issue of the Week

More on our nuclear future –

Did you know that radiation exposure is calculated several ways? We’re used to speaking in rads, or units of radiation. That is kind of old fashioned. Sieverts (named for Swedish physicist Rolf Sievert) are the usual units of radiation we will hear about in coming days and weeks as we get more information on the Tokyo Electric Power plant that is quickly being rendered less dangerous in northern Japan.

A dose of 10 sieverts will usually kill someone by giving them radiation sickness and they will either die quickly by having their digestive tract cease functioning or their lungs collapsing or more slowly via some cancer or other. A smaller dose of a couple of sieverts won’t incapacitate someone but will make them sick and generally some cancer will follow, though not all the time. 30 sieverts will kill you within minutes. (One sievert will exert one Joule of energy on one kilogram of matter times a weighting factor which we couldn’t understand from the description in Wikipedia.)

An analogy would be to fire, if you were to walk into a 1500 degree furnace (and in this case it matters little whether it is Fahrenheit or centigrade) you would die almost instantaneously. A 200 degree (Fahrenheit) wall, on the far side of the fireplace from the fire would cause you lots of damage if you stayed there long enough. 140 degree (Fahrenheit) water will scald you, but not do much more damage than that. Room temperature, roughly 70 degrees Fahrenheit, won’t cause you any harm to speak of, except your ice cream will eventually melt. It’s the same thing with radiation, a little won’t necessarily cause any material harm, a lot will kill you.

Over the course of just living, you will get exposed to maybe 1 or 2 sieverts of radiation over the course of a year from having the sun shining on your face or walking through a forest with lots of decaying leaves all around you. This is analogous to room temperature, a little heat all the time. If you got that 1 or 2 sieverts in an hour, you’d get mild radiation sickness. We live in an eradiated world, you cannot escape natural radiation. You get it every time you turn around.

The typical US nuclear energy worker is allowed to get exposure to 50 millisieverts (each millisieverts is one one-thousandth of a sievert) of radiation in a 24 hour period. That is about as much as we’d get from a couple of chest X-rays, if we got them daily. Of course we don’t get X-rayed daily. Note the person giving the chest X-ray leaves the room while this is going on. The 50 millisieverts could come all at once or slowly over time and build up. Both have their issues, but slowly is almost always better than quickly.

A dose of 50 millisieverts has been shown not to cause cancer and nuclear workers who don’t get exposed to doses of radiation higher than that don’t seem to get cancer at higher rates than anyone else. A lot of people who have never seen or heard of nuclear power still get cancer.

In Japan, the allowed dose of daily radiation is double the US limit or 100 millisieverts. At the Fukushima Daiichi plant, that level has been temporarily raised to 250 millisieverts so technicians can work longer shifts in higher radiation so maybe they can stop this thing from actually melting down. Having to replace workers every time they got to 100 millisieverts was making it tough to get any work done. Workers would hit their 100 millisieverts in just a few minutes and have to be replaced. Allowing several chest X-rays back to back may keep all of us from getting a lot more radiation than maybe we were expecting.

Fukushima Daiichi has been rotating guys through the plant so that none will get lethal doses of radiation, but there are only so many guys who kind of know what they are doing when it comes to these reactors, so these are the guys the rest of us are counting on to fix this. These guys are real heroes, wish them luck.

Economic News

Producer prices rose 1.6% in February due largely to the impact of food and fuel prices. Over the last 12 months, producer prices have risen 5.6%. Can anyone spell inflation? Core prices rose a much smaller 0.2% and are up 1.8% in the past 12 months. The headline number was far above what Wall Street expected, let along what ought to be comfortable to investors. The rise in food prices was the largest since 1974. Energy price increases added substantially to the total.

Housing starts fell 22.5% in February to the lowest level since April 2009, right at the bottom of the recession. A big piece of this drop was dictated by the high number of starts in January that were trying to beat some regulations that went into effect at the end of that month. With recent data indicating that home prices are again falling, there is little incentive for builders to be aggressive in starting new units, but the constant conundrum of having too many housing units in many places but too few in some other places explains why starts to fall to zero.

Consumer prices rose 0.5% in February. Food and energy prices were mainly to blame for the change. But, the core index, which ignores food and fuel prices, rose 0.2%. In the past 2 months, inflation at the retail level has risen 2.1%, with the core up 1.1%. The Federal Reserve has been generally unfazed by inflation so far this cycle and this seems like the direction they will continue to follow. They point to slack in the economy and labor markets as the reason they aren’t especially worried about inflationary pressures

Leading indicators rose for the eighth month in a row, this time by 0.8%. Eight of the ten indicators rose last month. This is supposed to indicate that the US economy will expand for the next six months. The coincident index, which follows the same four economic barometers used to date economic cycles, rose by 0.2%. This show that the US economy continues to grow, take that bearish prognosticators.

Weekly Stuff


Let’s take a second or two to revisit “carry trades.” In a carry trade, a speculator is willing to bet that a very low interest rate will allow them to use huge leverage to bet on volatile assets. Japanese short-term interest rates approach zero and so we think that defines them as being low. At the same time, the Japanese central bank, the Bank of Japan, has tried to make the yen stable at least if not a declining currency in hopes of stimulating Japanese exports, the life-blood of their economy. So, it seemed a pretty safe bet that speculators could borrow trillions upon trillions of yen, use those yen to buy commodities or common stocks or emerging market bonds and show enormous returns by taking the pedestrian returns from the assets and leveraging them up many fold.

That worked pretty well until the yen began to rise in value. All of a sudden, the essentially free credit that Japan had offered became exceedingly expensive. So, commodities, stocks, emerging market bonds and other speculative assets were sold to repay those trillions and trillions of yen before the value of the yen rose even further. The result was that the yen rose even more, triggering more sales of commodities, more purchases of yen and more rounds of this madness.

That probably explains the inexplicable rise in the yen as lots of people needed yen to pay-down their margin loans. This neatly explains the drop in commodities well beyond what a slower Japan would likely indicate and also the drop in other volatile asset classes that aren’t directly impacted by the Japanese crises. Will someone please stop this madness?

Most stock markets fell again last week. The exceptions were interesting, Brazil, Canada, Korea among the markets we monitor were gainers. Two of those are commodity-rich nations who benefit from higher prices on what they produce. The other is a direct competitor with Japan and benefits from both the Japanese rebuilding outlook but also from sales of products Japan might not be able to deliver in the immediate future. Look for the list of gainers to be a lot longer next week as many of the world’s troubles seem to slacken at the same time.

US stock markets struggled but succumbed to the negative bias. Still, US markets fared better than most. The old safe haven trade may not be what it used to be, but it is still a small element that benefits the US.

It was a good week to be in bonds of most stripes. US Treasury bonds gained nicely, dragging most other high-grade bonds with them. High yield bonds did slip a little. Most foreign developed markets, including Japan saw a similar gain in their bonds. It was another week with emerging market bonds getting sold, likely due to the carry trade described above.

Real estate securities were generally lower on the week. It was sort of confusing with mixed signals from financials and mixed news on the economic front. After the gains in both US and global REIT markets over the past year, a little correction is overdue.

Commodity markets were wracked with news bond good and bad last week. The being of broader hostilities in Libya got energy markets moving higher. But, most grains, industrial metals and softs were weaker on the outlook for softer economic growth. Precious metals were generally softer despite a weaker dollar and all the uproar globally. Gold barely managed a rise even with the dollar drop, so gold in most currencies fell.

We saw the first day of spring this weekend and the biggest full moon we are going to see for several years. Some have argued that the close approach of the moon to the Earth might have had something to do with the Tohuko Earthquake. A rival theory argues that a series of earthquakes around the edges of the Pacific Ocean in the past year-plus indicates that a large quake should occur in the Northeast Pacific (i.e. off-shore Oregon or in California) soon to balance all the forces that caused the other three quakes (in Chile early last year, in New Zealand in February and Japan in March).

Have a great week.

Karl Schroeder, RFC, CSA
Investment Advisor Representative

Schroeder Financial Services, Inc.