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Oil, MBS, Putin and Safety Nets

The following is a lightly edited version of a letter sent to FutureSafe clients on March 10 2020. It is reproduced here in the hope that it might be helpful and of interest to the broader investing community. Please note that the information contained herein might be outdated. As always, please consult your advisor or an investment professional before making any investment decisions. This information is provided purely for educational and informational purposes, and please remember that all investments carry risk which might cause you to lose some or all of your investment.

Hi All,

I promised you last week that I would send you a nerdy update on how Safety Net Investing works.

This is it.

However, it crossed my mind that if you were following the market earlier today, you might also be looking for a simple “Here’s what’s up with the market”, so I’ll start with that and roll into Safety Net investing from there.

Market Update Please?

OK. As I write this on Monday night, tomorrow’s (Tuesday) futures are pointing to a strong open. However, today (Monday) was a pretty big drop by any standards. The S&P 500 lost around 225 points, the largest one-day point drop in its history. That sounds pretty awful, but perhaps it would make you feel better to know that as a percentage it fell around 7.6%. That is also pretty awful, but it doesn’t even crack the top 10 worst days by percentage drop.

Since you asked (in your head): it was the 17th largest one-day percentage drop in the S&P 500’s history.

And this happened because ???

General punditry suggests that the markets were already nervous about the economic effects of people being spooked by the corona virus, but then Saudi Crown Prince Mohammad Bin Salman Al Saud aka “MBS” and Russia’s Vladimir Putin had something of a date-gone-wrong, which caused oil prices to tailspin.

Say What? Did you really say Putin and MBS?

Yup. Here’s how it unfolded: It was beginning to look like corona virus concerns might cause a drop in demand for oil. Economists like to call this a “demand shock”, which would drive oil prices lower. Lower oil prices would have meant lower oil income for Saudi Arabia and Russia.

Neither MBS nor Putin like the idea of lower oil income. So, MBS and Putin had a get together, where each tried to persuade the other to produce less oil. The game plan was to try and neutralize the Demand Shock in an attempt to prevent oil prices from going lower.

Considering the (rumored) egos involved, that went as well as you might imagine.

It appears that in a royal hissy fit (fit for a prince?) MBS made his “I’ll show you” move. Stunningly, he said that not only was he not going to decrease production, he was actually going to increase oil production.

Economists call this a “supply shock” – which, just like a “demand shock”, also drives prices lower. The combination of the supply shock and the demand shock – which some economists cleverly call a “double shock” – completely tanked oil prices.

Take a look at this chart from Bloomberg:

oil crashes

The only time we’ve seen a bigger crash in oil prices was January 1991 – when Saddam Hussain invaded Kuwait!

I’m not terribly upset if MBS and Putin suffer due to lower oil prices. Aren’t low oil prices good news for the rest of us?

Lower oil prices might be good news at the gas pump, but it was terrible news for oil companies. These oil companies also tend to borrow a lot of money …

… which contributed to the concern that some of these oil companies would go bankrupt …
… which totally tanked the high-yield bond market …
… which in turn means that banks that loaned money to them might be in trouble and …
… you can see the whole domino effect argument.

By the time all this unfolded over the weekend and Sunday night, European stock markets were down around 7% to 10% and US Markets followed this morning.

(Aside: In what seems like an unfortunate choice of words these days, economists use the word contagion to describe this cross-market carry over effect.)

So, stock markets tanked. Anything else?

Yes. The 10 Year US Treasury (that I first told you about last week) dropped even further, to a historic low of just about 0.30% and perhaps even more shocking, the 30 Year US Treasury also dropped to below 1%. This is the first time in history that all US Treasury interest rates, regardless of how long, are all below 1%.

Now just think about that: what would motivate someone to lock up their funds with the US Government for 30 years, for less than 1% a year in return? 

Yet, people did, presumably out of pessimism and fear.

OK, so how does this affect my Safety Net?

Right, so when the Fed decides to drop interest rates, the amount of interest you can reliably earn on your money decreases. To see why this is important, I need to take a step back and walk you through how Safety Net Investing, or more accurately, Goal Based Safety Net Investing works.

OK, fine. If you must.

The very first step in Safety Net Investing is for you, the investor, to pick a number that you do not want your account value to go below on a certain target date. You can think of this as your “nightmare number” or a bright orange line that you do not want your account to end up below, when that target date rolls around.

Gimme an example.

For instance, you might say “I really do NOT want to have less then $100K in that account on Dec 31 2025”. That is your Safety Net –  or more specifically, a Safety Net Level of $100K and a Target Date of Dec 31 2025.

Got it. Go on.

Safety Net investing is based on a super elegant idea: That you invest your money by intelligently splitting it across two buckets. The first bucket is a Performance Seeking Bucket (e.g. the stock market) and the second is a Safety Bucket (e.g. “US Treasuries”). The Performance Bucket offers the prospect of higher returns, but also a higher likelihood of losing money. The Safety Bucket is a lot more boring, offering lower returns, but if you use U.S. Treasuries (which we do), they can be pretty much risk-free.

The clever part of Goal Based Safety Net Investing is this:

Goal Based Safety Net Investing allocates your money between the Performance Seeking Bucket and Safety Bucket in such a way that the account value at any point in time plus the potential interest you could get from Treasuries (on or before the target date), is greater than your Safety Net Level.

That sentence has too many syllables and it hurts my head. Can you draw me a picture?

OK, here you go (disclaimer: this is just an educational illustration – your investments may not go up and down as in this diagram, and could lose money) :

Image

Try to think of this as the tale of two lines.

The first line is your account value over time plus the potential interest that you can get from the Safety Bucket (e.g. from U.S. Treasuries). Call this line the “green line” (green, because this is the money you can more or less count on at any given point in time).

The second line is your “nightmare number” for the account … the Safety Net line – the number that you do not want your account to end up below at the target date. It’s one flat “danger” line that you want to be safely above.

Call this the “orange line” (orange, because if you’re close, there is a danger you might go below it by the target date).

The primary goal of Safety Net Investing is to try and make sure our account value plus any potential interest (aka “green line”) stays as far above above the safety net level (aka “orange line”) as possible, and to minimize the risk that the green crosses below the orange line.

So how do you do that?

Plot twist: It’s not really about the lines. It’s all about the gap between the lines.

If there is a large gap between your green line (your account value+potential interest) and your orange line (your safety net level), that suggests that you’re in good shape. You’ve got room to take risk because the likelihood that you will end up with your account value below the safety net level is small. The technical term for this gap between the account level+potential interest line and safety net lines is “risk budget” or more colloquially, “cushion”.

If you have a lot of cushion, you can invest a larger proportion in the Performance Seeking Bucket and less in the Safety Bucket.

However, if you don’t have much cushion, you’re going to have to allocate less to the Performance Seeking Bucket and more to the Safety Bucket. 

Got it. Nice drawing!

Thanks. That was my wife, Sheena. I can’t draw.

Back to my Safety Net, please?

Notice that the potential interest you can earn changes as interest rates change.

Now think about what happened over the past few weeks. First, the stock market fell, taking your account value down with it. Second, treasury yields fell, which means that the interest your account can earn also went down.

This is a double whammy!

Any good news?

Yup. And this is subtle. When yields fall (as they did last week), it turns out that the prices of Treasury bonds actually go up. So, you could have seen an increase in value for the part of the account in the Safety Bucket, which increases your account value and the risk budget!

This is why the Safety Bucket is technically called the Goal Hedging Portfolio by academics, because it has the effect of hedging your bets when yields fall.

Summary please?

When yields fall, as they did last week, your Safety Bucket increases in value, and contributes towards increasing your risk budget.

However, when yields fall, the interest bearing capacity of your account decreases, which contributes towards decreasing your risk budget.

This push-pull is balanced by clever math within the Investment Engine so as to try and weaken or even neutralize some of the effect of yield fluctuations on the Safety Bucket. This is called Integrated Interest Rate Risk Management and is automatically managed by the Investment Engine.

Cool. So, what should I expect with my account?

This week is when we perform our usual quarterly rebalancing. This means depending on where your Safety Net is set, our investment engine will recompute the green and orange lines for each account, calculate the new risk budget and reallocate across the Performance and Safety buckets.

Since lower interest rates as well as lower stock prices has driven your green line lower, your risk budget is likely lower. The Investment Engine will do its math and reallocate between Stocks and Treasury Bonds based on your Safety Net to try and minimize the risk of ending below your Safety Net – i.e. of the green line going below the orange line. (Of course, there is always a possibility, however small, that the engine might fail and you might end up below your Safety Net on the Target Date.)

This means that if your account is low on risk budget, we might need to sell some of your stocks and buy bonds. This is because we treat your Safety Net as a mandate to us and we want to minimize the risk that you end up below your safety net level if the market were to fall further.

Remember that you can always change your Safety Net levels anytime you need to.

Apologies for the long tutorial, but it’s important to us that we explain to you not just of what we do, but how we do it.

I would love to hear from you about whether this was useful, too long, too complicated, too boring or anything else. If you found this hard to follow along, let us know. We’d be happy to do a little video.

As always, call or email me at any time if you have any questions or concerns!

-Vijay  

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Vijay Vaidyanathan, PhD

CEO, Optimal Asset Management Inc.