No Free Lunch: Valuation Determines Return

By John Mauldin


Last week, I described the enormous challenges retirees face. One reason for that, aside from insufficient savings, is that markets haven’t delivered the returns many experts said we could plan on.

Back in the late 1990s, we were told that the long-term average return (~10%) was a reasonable long-term assumption—even if the market cooled down from the tech boom. Instead, the S&P 500 index gained about 3% annually since 1999 with total return just over half of the historical average. As a result, Baby Boomers are having to work longer and harder to retire, as well as save more of their income.

Nonetheless, hope still springs eternal for historically average returns. In this week’s letter, longtime friend Ed Easterling joins me as co-author to explore the reasons that so many analysts and product purveyors pitch such hopeful expectations. (Longtime readers will know Ed and I do this periodically.) We’ll show how the long-term average is a longshot bet in almost any market environment. Most of the time, returns over a decade or two are well-above or well-below average.

Most of all, it’s fairly predictable which side of average will occur. This has serious implications, yet there’s a lot that you can do to still achieve investment success. This is also something you will not hear from many in the investment business. “Predicting” less than historical average returns in the future is not exactly a great sales pitch. But as I think Ed and I will demonstrate, it is the most honest and accurate way to talk about potential performance of the future.

Ed founded Crestmont Research in 2001 to research and explain secular stock market cycles. You can find a treasure trove of fabulous charts and articles on cycles and market returns at his www.CrestmontResearch.com website. I’m a big fan of Ed’s work and highly recommend both of his books, especially Unexpected Returns.

No Free Lunch: Return Is Determined by Valuation

By John Mauldin and Ed Easterling

A famous Greek myth involves Orion and Scorpius, whose struggle became eternal after Zeus banished them to opposite fields of the night sky. During winter, Orion hunts in the evening. Yet when summer returns, Scorpius owns the heavens.

The stock market has its own perpetual mythologies. Every investor and financial advisor understands that “past performance is not indicative of future results.” Yet for passive stock portfolios, many embrace century-long averages of stock market performance as a reasonable assumption for future returns.

In reality, the market has periods when Orion finds a bounty of returns, and volatile, low-return periods when Scorpius rules. Investors must know whether the stock market’s season is summer or winter in order to select the best securities and strategies.

Theories and Realities

In 1952, the Journal of Finance published a paper written by Dr. Harry Markowitz titled “Portfolio Selection.” He wrote it while still a graduate student, and it introduced the concepts known today as Modern Portfolio Theory (MPT).

Markowitz likely knew that MPT posed great risk to investors should his magnum opus fall into the wrong hands. He carefully included a warning label in the first paragraph:

The process of selecting a portfolio may be divided into two stages. The first stage starts with observation and experience and ends with beliefs about the future performances of available securities. The second stage starts with the relevant beliefs about future performances and ends with the choice of portfolio. This paper is concerned with the second stage.

Unfortunately, the warning has been largely ignored. Maybe he should have been clearer:

“Do not use MPT without relevant beliefs for future performance!”

The rest of Markowitz’s paper details how risk drives return. He describes how to construct diversified portfolios that optimize returns for a desired level of risk. The level of return, however, is whatever the market delivers. That’s why the precursor stage to MPT is so important. MPT and related models have been used for many decades to build portfolios for individual and institutional investors.

Dr. Eugene Fama later amplified this idea with a paper explaining the Efficient Market Hypothesis. In summary, Fama said markets are extremely efficient at pricing stocks. As a result, after you make numerous assumptions (which basically assume away the real world), investment analysis and selection adds no further value.

Within a few years (1973), professor and economist Burton Malkiel published his literary classic: A Random Walk Down Wall Street. Across its 456 pages, Dr. Malkiel reinforces the message that the stock market follows a random path. As a result, investors are helpless and shouldn’t try to beat it.

Once those three messages went mainstream, the essential ingredients for investor helplessness were in place. Risk drives return. Markets are efficient. Returns are random. Why try? Investors should simply buy and hold. The three professors just needed a bull market to indelibly reinforce the message.

By the time the Great Secular Bull of the 1980s and 1990s ended, index mutual funds had become a highly popular form of stock ownership. Technology then made possible an even more efficient successor: the exchange traded fund (ETF).

Over these decades, millions of investors embraced passive buy-and-hold investing, believing they could simply ride the market and achieve long-term success. Investors and investment professionals became intoxicated rather than alarmed when actual performance greatly exceeded the assumed 10% long-term average return. Surveys in the early 2000s showed investors expecting 15% annual returns for years to come.

That was easy to believe at the time because conditions were perfect. The initially low and progressively rising valuation level of the stock market provided a fertile environment for buy-and-hold. But now we know what happened.

Large segments of the financial industry still believe valuation doesn’t matter. For example, mistaken notions of randomness and consistent long-term returns lead investors to expect the same long-term return from peaks like 2000 and 2007 as they expect from troughs like 2002 and 2009. Clearly, these are instances when theory and reality diverge.

Valuation Matters

Markowitz advised us to use relevant assumptions. To assess relevance and reasonableness, let’s consider a period long enough to smooth short-term fluctuations, yet not so long that an investor loses the opportunity to adjust expectations, lifestyle, savings rate, etc. For most investors, that period is a decade or two. If you are age 55 or over, 20 years starts to sound like the long run.

As previously mentioned, the stock market’s nominal long-term annualized total return has been around 10%. Total return includes capital gains as well as dividends. The century-long 10% average is also close to the average annualized return across all 110 decade-long periods since 1900 (i.e., 1900–1909, 1901–1910, etc.). Yet none of those decades delivered exactly 10%.

To assess the reasonableness of using 10% as an assumption for future annualized returns, a range is more relevant than a single value. If a high percentage of the decades fall near the average, then it would be reasonable to assume that average is relevant and has a reasonable likelihood of occurring. However, if near-average is rare, then such an assumption would be foolish.

To be generous to the analysis, let’s say 8% to 12% represent a near-average range. Although 8% and 12% deliver quite different long-term return results, our purpose here is just to assess credibility.

As shown below, only 21% of the decade-long periods since 1900 delivered annualized total return from the S&P 500 Index between 8% and 12%, and strikingly few were close to the 10% average. Only about one-third of the periods showed a compounded rate over 12%. Almost half of the periods showed less than 8% annual returns!
 


 
With almost 80% of the decade-long periods not near-average, using 10% as a relevant assumption for the next decade or two is a long-shot bet. For investors patient enough to evaluate twenty-year periods, the incidence of near-average values between 8% and 12% increases to 35%. Thus, the odds-on bet—at least two-thirds of the time—is to assume nowhere close to 10%.

Taking the analysis of decade-long periods a step further, let’s explore the effect of relative valuation on returns. Stock market valuation is most often measured with the price/earnings ratio (P/E).

Across the 110 decade-long periods, total return for the S&P 500 Index ranged from an annualized loss of almost -2% to an annualized gain of just under 20%. Even a ten-year period wasn’t enough to ensure a gain. Four of the decade-long periods delivered losses, and even more when inflation is taken into account.

The next chart divides the series into five quintiles, each with twenty-two of the decades. The first quintile includes the twenty-two periods with the lowest starting value for P/E. The second quintile has the next lowest set and the fifth quintile includes the decades starting with the highest P/E values.


 
The graph and table present the average value for P/E in each of the quintiles as well as the corresponding average annualized total return. As the market’s valuation level rises, the level of return realized from the stock market declines.

For example, the average P/E for the lowest twenty-two decades is 8.5 and the average compounded annualized return is 13.5%. The average P/E across the highest twenty-two periods is 26.9, with return averaging 4.8%. As beginning P/E rises, the subsequent return slides.

There is some variation and occasional outliers within these quintiles. For example, some periods start with high valuation and end with even higher valuation (e.g., 1995). In other instances (e.g., 1974), relatively low valuation was even lower ten years later. Bull market and bear market cycles run for various lengths. But when assessed in the aggregate, the relationship of valuation and subsequent return is strong. A higher valuation is strongly associated with diminished returns over the next 10­–20 years.

This is intriguing because the results are counterintuitive. It raises a question about whether either or both of the extremes might be predictable. Is there a way to know at the start of the ten-year period whether it’s likely to deliver above-average or below-average returns?

The quintiles provide a hint to the underlying cause, but don’t provide all of the answers. It also doesn’t address whether the relationship of valuation and return is simple correlation or is causal. These answers and insights could significantly impact an investor’s decision about the most appropriate investment approach. It would even provide buy-and-hold investors with a better expectation for their likely outcome.
 

Malkiel was right about the stock market being random, but only in the short term. The day-to-day fluctuations are responses to new information and changing investor psychology. These daily adjustments are part of the process that Fama described in his theory about market efficiency.

Both men, however, were mistaken about timing. Malkiel asserted that even long-term returns walk randomly. He seems to have thought that something random in the short run must be even harder to predict over the long run.

Ironically, the short term is burdened with noise that the longer term filters out. Benjamin Graham, the father of value investing, described this dynamic with the metaphor: “In the short run, the market is a voting machine. But in the long run, it is a weighing machine.”

Likewise, Fama assumed that market efficiency worked at the speed of a trade. In reality, there’s a lot of information and different views about the same information to process into market prices. Market efficiency is an extended process; it’s not an immediate event. Individual stock analysis and selection are part of this efficiency process.

Stock market return is more than a single number tucked in front of a percent sign. Three components underly stock market return: earnings growth rate, dividend yield, and the change in valuation level over the period (i.e., P/E).
 


 
Earnings growth pairs with valuation change to drive capital gains or losses. If the market’s P/E remains constant, the index will rise or fall equal to changes in aggregate earnings. Likewise, if earnings don’t change, the index will increase or decrease with changes in P/E. Dividend yield is the proverbial icing on the cake that completes total return.

Above, we made a compelling case for the relationship between P/E and return. The primary determinant of whether a decade ends in the pink or green bar is the change in P/E over the respective period. P/E tends to fluctuate in a bounded range generally between 10 and 25, yet rarely below 8 or above 30.

As basic as it may sound, returns tend to be higher when P/E starts low. Likewise, losses are more likely when P/E starts high. Therefore, almost all of the periods in the below-average pink bar started with P/E above the historical average. Similarly, almost all of the periods in the above-average green bar started with a relatively low P/E.

Most importantly, changes in P/E over longer-term periods are not random. Although in the short run, investor psychology and current events push P/E above or below its fair value, the change in valuation level over the long term is driven by financial principles.

Valuation rises and falls to adjust the general level of return from stocks, which fluctuates in response to changes in the inflation rate. For example, when inflation rises, financial securities respond with lower valuation to compensate for the costly effects of inflation.

Most financial assets, especially stocks, rise toward their highest relative value (and lowest expected return) when the inflation rate is low and stable. Bond prices rise as yields fall in response to declining inflation. Stocks, as perpetual securities, react positively to low inflation. Therefore, the P/E cycle is primarily a response to the inflation cycle. Over the long run, P/E is driven by fundamentals, not by randomness.

* * * * * * *

John here to close: P/E is even more powerful than its multiplier effect on earnings. But we’ll need to save that discussion until next week. It will lead us into a talk about market valuation (fairly priced or overvalued), implications for predicting returns (yes, it is possible), and a few thoughts on investment approach. You won’t want to miss it. I’ll have more surprising and insightful charts from Ed and Crestmont Research.

New York, Cleveland, Austin, and Dallas

Shane and I are in Cleveland as I finish this letter. We’ll fly to New York for the weekend to see a Broadway show and meet with friends, then a business meeting on Monday morning and back to Cleveland.

Dr. Rockwood removed the cataract from my left eye on Wednesday, liked what he saw the next day, and scheduled surgery for my right eye next Wednesday. I will be in Austin and Dallas the first week of April for investor meetings that I am told are already full. Then we will fly back to Puerto Rico until the end of the month, where Chicago seems to be appearing on my calendar.

We mentioned Harry Markowitz and Burt Malkiel. I have met both separately and together on more than a few occasions, primarily at Robb Arnott’s invitation. They are delightful people and deserve the accolades they have had. Harry is 91 and although moving slower, his mind is as wicked sharp as ever. It still fills me with awe to remember him lecturing me as I challenged a particular point of MPT at a conference in Florida at least 15 years ago. He drew quadratic equations in the air (I swear this is true) to explain my obvious lack of understanding. I am not sure what he said because I was simply awestruck as he was drawing those quadratic equations in reverse so that I could see them. I was so overwhelmed with even the concept of doing that, I completely lost track of what he was saying. My life has been blessed to get to meet so many people like Harry. I have learned a lot from our walks and quiet conversations overlooking pleasant venues.

Back in the real world, I have been told to avoid strenuous activity while my new eyes get settled. Which means more reading and walking. Have a great week and spend some time with friends.

Your thinking returns will be below-average in the next 10 years analyst,

 


Angela Merkel, Donald Trump and a broken alliance
 
Weakening ties between US and Europe mainly benefit China and Russia
 
Philip Stephens
 


Here in the grand ballroom of Munich’s Bayerischer Hof was a moment for Europeans to feel good about themselves. Angela Merkel’s broadside against Donald Trump’s US administration in defence of the liberal international order unlocked a cascade of pent-up frustration. Mike Pence, who followed the German chancellor to the podium on Saturday, must have had his headphones turned off. America’s allies, the US vice-president intoned, should do as they were told.

That this exchange took place at the Munich Security Conference, for 50 years a spiritual home of Atlanticism, tells you something about the state of a relationship that not so long ago celebrated the victory over Soviet communism. Europeans have been inclined to downplay the impact of Mr Trump’s presidency on the Nato alliance. But enough is enough.

In this case, “enough” for Ms Merkel included Mr Trump’s unilateral decisions to pull American troops out Afghanistan and Syria, to withdraw from the treaty prohibiting the deployment of intermediate range nuclear weapons, and to threaten Europe for not falling into line with US sanctions against Iran. Each has a vital bearing on European security; all were taken by the White House without reference to, or discussion with, partners.

Add Mr Trump’s absurd threat to declare that European (he means German) auto exports are a danger to US national security and you can see why an energised, almost emotional, Ms Merkel received a standing ovation — and why a wooden Mr Pence was met with near silence.

The winners in Munich were Russia and China. Sergei Lavrov, the hard-bitten Russian foreign minister, rarely allows himself a smile. He struggled to suppress his satisfaction. If Russian president Vladimir Putin has one overarching strategic goal, it is to drive a wedge between Europeans and Americans. Let us Europeans run our common home, Mr Lavrov offers. What he means, of course, is that with the Americans gone Moscow can take charge.

Beijing also sees an opportunity. Yang Jiechi, the Communist party’s foreign affairs chief, put China firmly on Ms Merkel’s side, lauding the role of global rules and institutions in facing challenges such as nuclear proliferation and climate change. Mr Yang paid homage to multilateralism almost as often as Mr Pence praised Mr Trump.

Europeans have concerns about Beijing’s push westwards through its Belt and Road Initiative and about the lead China’s Huawei has taken in producing next generation communications technology. But does the continent, Mr Yang asked, really want to put itself at the mercy of US technological hegemony?

There are still those who believe that things can again be as they used to be. Mr Trump has, at most, six more years in the White House and, with a little luck, only two. The Democrats, newly in charge of the House of Representatives, sent a sizeable delegation to Munich carrying the message that Washington still has Atlanticists. Optimists point to a gap between Mr Trump’s rhetoric and US policy on the ground. He derides Nato; the Pentagon has sent more US troops to eastern Europe to counter the threat from Russian revisionism.

True enough. But the reality-is-not-as-bad-as-the-rhetoric school ignores the hollowing out of an alliance once grounded in shared principles and values as well as common defence. Nato’s founding charter starts with a commitment to democracy, freedom and the rule of law. These are not values that much interest Mr Trump. The US president has made plain his preference for authoritarian strong men over champions of a liberal international order. The rule of law scarcely looms large in his worldview.

The corrosive impact of this on European public opinion shows up in surveys showing the collapse of trust in American leadership. How can Germany make the case for Atlanticism, Berlin diplomats fret, when a sizeable proportion of the country’s voters would rather put their faith in Mr Putin than in the president of the US.

The weakening of the alliance predates Mr Trump. For all his grand rhetoric, former US president Barack Obama waited until the end of his second term to show much interest in refurbishing ties with Europe. The absence at this year’s gathering of the late senator John McCain spoke soberly to the passing of the generation of American politicians and policymakers for whom Atlanticism was mother’s milk. But take away the commonality of values and the very foundations crack.

The hard geopolitical truth is that both sides still need each other. Ms Merkel may talk about Europe taking on more responsibility for its own security affairs, but there is little evidence she is ready to persuade a pacifist Germany to turn that way. French president Emmanuel Macron has tried to force the pace. Ms Merkel has slowed it.

As for the US, Mr Trump may not understand this but the shifts in global power make Europe a more rather than a less important ally. This is not a continent that Washington can afford to cede to its rivals. What has been lost is the warmth that comes with the idea of a shared endeavour and the trust that allows space for valid disagreements. In a world destined to be shaped by coldly transactional alliances, Europeans and Americans are both losers.


Up and Down Wall Street 

The Federal Reserve Faces a Reckoning

By Randall W. Forsyth 

Federal Reserve Chairman Jerome Powell.
Federal Reserve Chairman Jerome Powell. Photograph by Andrew Harrer/Bloomberg


The Federal Open Market Committee won’t make any changes in its policy interest rates this coming week. It may disclose plans to wind down its program of reducing the size of its balance sheet. But these policy decisions will be made against the backdrop of a developing debate of the basic functions of monetary policy not seen in more than a generation.

As for the basic headlines, the Federal Reserve’s policy-setting panel is certain to leave its federal-funds target range unchanged at 2.25%-2.50% at the conclusion of its two-day meeting.

At the same time, the FOMC will also release its latest Summary of Economic Projections, which will include the members’ guesses on where the fed-funds rate will end 2019. Those are depicted in the “dot plot” graph, which gets the most market attention.

A lot has changed since the last set of FOMC forecasts released after the Dec. 18-19 meeting, when the Fed raised the funds target by one-quarter percentage point and the dot plot indicated a median forecast of three more hikes. Just days later, in early January, Fed Chairman Jerome Powell pivoted sharply to indicate that the monetary authorities would be “patient” in raising rates further and would be flexible in reducing its holdings of Treasury and agency mortgage-backed securities.

That reversal spurred the sharp rebound in equity and other risky assets that erased much of those markets’ fourth-quarter swoon, reflecting the new dovish tilt by the Fed. And by Friday, the fed-funds futures were pricing in nearly a 37% probability of a rate cut by next January, according to the CME FedWatch site.

Powell will be quizzed Wednesday afternoon on the FOMC statement and other decisions in the postmeeting press conference. His comments might provide more guidance on future rate moves, but his interview on 60 Minutes last Sunday shows that, after some earlier clear pronouncements on policy, he has mastered the ability of his predecessors to say little or nothing if it suits him.

What serious students of monetary policy are most interested to hear is how the Fed’s thinking on its aims and approaches might be evolving. Despite the U.S. central bank’s having virtually met its dual mandate of maximum employment with price stability—with February unemployment at 3.8% and its main inflation measure running just below its 2% annual target through January—there remains widespread dissatisfaction with the economy and how many are faring in it. And that’s a decade after the Great Financial Crisis and the extraordinary monetary measures enacted to stimulate a recovery.

Danielle DiMartino Booth, a former adviser to the Dallas Fed president and publisher of the Money Strong newsletter, wrote in a Bloomberg opinion piece this past week that while the loose policies of the Fed and other central banks have boosted asset prices, the inflation in prices of stocks and other assets have benefited their owners, primarily the well-off, and worsened wealth inequality.

“If the ‘wealth effect’ used to justify a generation of quantitative easing hasn’t kicked in yet, trickling down to those who need it most, it’s past time the Fed acknowledged its failings and opened the door to a new policy framework,” she concludes.

Martin Wolf, the Financial Times’ economics writer, contended this past week that “monetary policy has run its course,” having done all it can to fight secular stagnation, the state of persistent inadequate demand hypothesized by Lawrence Summers, the former head of the National Economic Council under President Barack Obama and Treasury secretary under President Bill Clinton.

Persistently low interest rates aren’t artificially depressed by central banks but by the low level of real rates needed by the economy, Wolf continues. But those low rates, even below zero, fail to boost the economy mired in a “balance sheet recession,” as Nomura economist Richard Koo hypothesizes, which leads companies and households to pare debt rather than borrow and spend. As Koo was quoted saying in this column in 2016, negative interest rates seem “an act of desperation born out of despair over the inability of quantitative easing and inflation targeting to produce the desired results.”

Three years later, the total amount of negative-yielding bonds hit $10.2 trillion, JPMorgan reported this past week, the highest amount since December 2017. Others argue the expansion of debt encouraged by low interest rates now exerts a drag on the economy, as companies and households have to pay off those obligations rather than expand. General Electric(ticker: GE), an extreme example, has had to prioritize shoring up its balance sheet over growth.

With monetary policy having reached this apparent cul-de-sac, Wolf contends fiscal measures are needed to counter insufficient demand. Taken a step further, this argument extends to adopting Modern Monetary Theory, which essentially argues a nation that can borrow in its own currency isn’t limited by the size of the debt. If inflation heats up, fiscal policy can be tightened. Powell dismissed MMT as “just wrong” in recent congressional testimony, an opinion shared by the overwhelming majority of mainstream economists, even as it gains adherents on the left.  
Some critics on the right, meanwhile, argue the Fed simply has been too tight after its nine rate boosts since late 2015 and the contraction of its balance sheet from a peak of $4.4 trillion in October 2017 to $3.9 trillion currently. A Wall Street Journal op-ed this past week trotted out the idea of targeting commodities to guide monetary policy, a notion that goes back to early 20th century Swedish economist Knut Wicksell. The recent weakness of commodity prices suggests policy is too tight, the authors contend.

The Fed targets overall inflation rather than commodities, which play a small role in the 21st-century economy. The Fed’s problem has been that it has consistently undershot its 2% target, which is the opposite of central banks’ traditional inability to maintain stable prices. One change under consideration is for the Fed to make up past shortfalls by letting inflation catch up on the high side. Central bankers contend persistently too-low inflation makes it harder for them to fight recessions. Critics counter that 2% inflation means that a dollar loses half of its purchasing power over about 36 years, which is not price stability.


These and other policy ideas are under a review by the Fed under its vice chairman, Richard Clarida, which is supposed to scrutinize the central bank’s strategy, tools, and communications policies. The results, which are due later this year, will be of more than academic interest.

Forty years ago this October, the Fed embarked on a major, single-minded policy assault on double-digit inflation, even at the cost of severe, back-to-back recessions. Now, it would appear the focus of the debate under way is directed at maintaining the economic expansion that, despite being on the way to be the longest on record, has been more successful in boosting asset values than household income.


Will the Federal Reserve provide clarity on its bond holdings?

FT Reporters




Will the Federal Reserve provide clarity on its bond holdings?

Investors and economists are supremely confident that the US central bank will leave policy unchanged at this week’s monetary policy meeting, but there will still be plenty to digest — not least details of the Fed’s plans for its multitrillion-dollar balance sheet.

The Fed Funds market indicates that not only is there virtually zero chance of policymakers raising interest rates this week, it is now pointing to an extended pause from the central bank and a more than a 25 per cent chance that it cuts rates by the end of the year.

There will therefore be plenty of attention to the Fed’s revised economic forecasts. Although the central bank’s rate setters on the Federal Open Market Committee have sounded a cautious tone lately, several have stressed that they still plan to raise rates at least once more this year.



The greatest attention is likely to fall on any details offered on the Fed’s balance sheet which was swelled to a peak of $4.5tn through various quantitative easing programmes in the wake of the financial crisis.


But since 2017 the central bank has been shedding the bonds it acquired, deflating the size of its balance sheet to just under $4tn. However, the pace at which the Fed is offloading the debt it bought was one of the factors behind last year’s turbulence in financial markets, and Fed chair Jay Powell said last month that an announcement on its future balance sheet would come “fairly soon”.

That led economists to predict that a more detailed road map for “quantitative tightening” could come at this week’s meeting. But just how far it will trim has remained unclear, and whether it will slow its selling as it approaches the end point. On Wednesday, more clarity is likely to come. Robin Wigglesworth

Will UK government bonds wake up?

Their current snooze is certainly sparking curiosity. Gilts investors are clearly aware that the UK is trapped in a chaotic process of leaving the EU — an event with deep and broad implications for all UK markets, chiefly sterling but bonds and equities too. And yet the market is not really moving.

Robert Stheeman, who runs the UK’s Debt Management Office, noted to Reuters this week that “the market is currently quiet and relatively benign”. Ructions in the bond market have “rarely been noticeable”, he added.

In part, this reflects the same paralysis that is keeping sterling nervous but still within a tight range; without any certainty on how Brexit will pan out, investors are loath to jump in either direction.

In addition, the question ‘what would gilts do in a no-deal Brexit?’ is not straightforward.

For sterling, it is simple: the harder the Brexit, the larger the fall. For gilts, all things being equal, the “fear trade” from a deal-free divorce would almost certainly send bond prices flying and hammering yields down, particularly on the assumption that the Bank of England would respond with substantial stimulus.

But at the same time, the risk of inflation, fuelled by a plunge in the pound, would hurt gilts. In addition, some fund managers suspect that the government would find a way to smooth the blow with fiscal stimulus — another likely drag for the bond market.

Taken together, it is therefore hard to see how benchmark 10-year government bond yields can shift meaningfully from their current level of 1.19 per cent. A no-deal Brexit, which few in financial markets seriously expect, may be the only way to find out. Katie Martin

What is driving down the Hong Kong dollar?

A sliding Hong Kong dollar is again forcing the territory’s central bank to intervene in the currency markets, for the first time since August. The Hong Kong Monetary Authority has bought up $692m worth of Hong Kong dollars over the last week after the currency hit the lower limit of a trading band that dates back to 2005.

But this time it may also be China’s stock market rally — in addition to the US Federal Reserve — piling downward pressure on Hong Kong’s currency.

Even though the territory’s de facto central bank has raised its overnight lending rate in lockstep with the Fed, this has had little impact on the broader cost of borrowing thanks to the ample liquidity sloshing around in Hong Kong’s banking system. A gap of almost one percentage point between three-month Hibor, Hong Kong’s interbank lending rate, and US equivalent Libor, has prompted investors to sell lower-yielding Hong Kong dollars for the higher-yielding US dollars.

But now another seller of the Hong Kong dollar has entered the scene. Ronald Man, North Asia rates and foreign exchange strategist at BofA Merrill Lynch, said Hong Kong-based investors were selling Hong Kong dollars as they purchased renminbi to invest in China’s rocketing stock market.

Mr Man said the institutional investors who helped drive the weakness in the Hong Kong dollar last year “are probably very close to being at their limit, whereas more of the depreciation process here on in will be driven by the equities investors”.

Neither he nor any other analysts are worried about the viability of the Hong Kong dollar’s peg, though, as the latest interventions still left HKMA with HK$71bn to marshal in defence of Hong Kong’s currency if needed. Hudson Lockett

5G - The Future Is About To Arrive

Mark J. Grant



Summary


•The new 5G network promises blazing speeds, massive throughput capability, and ultra-low latencies and makes "the existing communication model obsolete."

•This is critically important to understand for investors.

•I still do not believe that many people and institutions know just how important this new technology is going to be in a wide variety of sectors.


Let me be explicitly clear. The new 5G network that is most assuredly beaming itself our way makes "the existing communication model obsolete." This is critically important to understand for investors.

The 5th generation of cellular connectivity promises blazing speeds, massive throughput capability, and ultra-low latencies. While I have written about subject before, I still do not believe that many people and institutions know just how important this new technology is going to be in a wide variety of sectors.

5G is going to have a huge positive impact on most major phone carriers, as the major carriers all plan to launch 5G this year. As they will become the provider of streaming services for everything from data, to TV content, to games, it is my opinion that they will eventually replace the cable and internet connections as there will be no need, any longer, to use those services. There will be a router in your house, or office, that will supply "everything." Also, virtually every phone will have to be replaced by the new 5G phones which will be a giant boon for the mobile telephone makers and their suppliers, in my opinion.

President Trump recently stated,

I want 5G, and even 6G, technology in the United States as soon as possible. It is far more powerful, faster, and smarter than the current standard. American companies must step up their efforts, or get left behind… I want the United States to win through competition, not by blocking out currently more advanced technologies. We must always be the leader in everything we do, especially when it comes to the very exciting world of technology!

In a statement the CTIA, the trade association representing the U.S. wireless communications industry, appreciated the support from the President.


We share the President's commitment to leading the world in next-generation 5G wireless.
Thanks to the innovation, hard work and investment of America's wireless industry, the first commercial 5G deployments are happening now, in communities across the country.

5G, and its connectivity to the "Internet of Things," has the capability to create more efficient industries such as connected cars, and smarter cities which are all components of the "Internet of Things" equation. The uses for the military are inestimable as military installations can be instantaneously controlled from hundreds of miles away. Cameras on military and commercial aircraft will be able to see and diagnose issues in "real-time," allowing for much safer experiences.

The global population is set to reach 9.6 billion people by 2050. In the "Internet of Things" 5G based smart farming, a new system will be built for monitoring the crop field with the help of sensors (light, humidity, temperature, soil moisture, etc.) and automating the irrigation system.

The farmers can monitor the field conditions from anywhere. The "Internet of Things" based smart farming is highly efficient when compared with what is available now.

One of the major telephone service providers has announced multiple partnerships focused on an enhanced 5G healthcare experience. Perhaps the biggest announcement was the partnership with Chicago based Rush University Medical Center. Together, they're working to bring the first standards-based, 5G-enabled hospital to the United States.

Incorporating 5G technology into the healthcare space will ultimately bring faster speeds and lower latency which are critical to the mission-critical nature of hospital care and they support the abundance of innovative technologies Rush is currently deploying throughout its system.

Dr. Shafiq Rab of Rush stated,

High-speed, low-latency 5G technology will help enable care to be delivered virtually anywhere at any time. The technology will enhance access to care, even from long distances, while also helping to decrease costs and improve efficiency. Imagine sometime in the not too distant future, for example, a doctor performing a virtual visit with a patient while downloading an entire MRI scan within seconds. The cutting-edge applications we're implementing need a fast, reliable network to support them.

The numbers are staggering for growth of 5G. IDC forecasts 5G connections to rise at an annual average rate of 315.7% from 2019-2022. They also project 5G mobile subscriptions to expand by 322.2% during this same time period.

Next consider the car and truck companies. The vehicles will be able to communicate with each other in almost virtual time because the latency is so quick. A human being is unlikely to be part of this equation and the safety factor on the new 5G cars and trucks will make travelling much safer, which should speed up people and companies buying and leasing these new cars and trucks. The vehicles will be able to "sense" each other and avoid collusions and also avoid obstacles as the use of very detailed maps, constantly changing in "Real Time," will become available.

Then there will be the monitoring of devices. Water meters, electric meters, locks for your offices, garage door openers, inventory in a store and a whole host of the "internet of things" can be monitored in virtually "Real Time." The savings to many types of companies, such as utility companies, and retail stores, is likely to be substantial.

The 5G network, because of the speed, also requires more antennas at closer distances. That means that the tower companies, along with the chip makers, will benefit along with the makers of the antenna equipment. This will just be a huge boon for these companies, in my estimation.

The FCC estimates that there will be 4 trillion MHZ-Pops which is compared to the 230 billion that are in existence at this time. HIS forecasts that the 5G equipment market will grow 321.3% from 2018-2022.

You might think that the new 5G technologies are far off so that nothing needs to be done now.

I beg to differ. Keysight commissioned Dimensional Research to conduct the survey on which its state of 5G report is based, which included responses from more than 350 senior technology leaders and strategists from service providers and technology companies. Fifty-four percent of respondents said that they had already begun their 5G development, and 16% said they already had 5G partially deployed. Thirty-one percent of respondents said that they planned to deploy 5G within the next 12 months, with an additional 13% saying that deployment would come within the next 12-24 months.

The first mobile phone call took place on April 3, 1973. This was almost 46 years ago. The technology advanced slowly, slowly from one generation to the next. 5G is not an evolution, in my opinion, but a revolution, because of the huge increase in speed which allows for modern day miracles. "Real Time" has finally arrived.

I suggest investors take some "Real Time" now to size up both the opportunities and the pitfalls. If not, they will be making decisions in the past, as the future will have already materialized.


The Cold War in Tech Is Real and Investors Can’t Ignore It

By Reshma Kapadia

The Cold War in Tech Is Real and Investors Can’t Ignore It
 

Cisco Systems, an early Silicon Valley success story, has become one of the nation’s top tech exporters. Today, roughly half of the networking giant’s sales come from outside the U.S. As foreign countries sought to catch up with U.S. connectivity, Cisco helped plug them in.

But a wave of nationalist thinking has put Cisco (ticker: CSCO)—and most of its peers—in an uncomfortable position. Earlier this month, Cisco CEO Chuck Robbins described the current climate as “one of the more complex macro, geopolitical environments that I think we’ve seen in quite a while with all the different moving parts.”

It’s likely to get worse.

While investors are cheering indications of progress being made toward a resolution of trade issues between China and the U.S., the battle for tech supremacy between the two global superpowers shows few signs of abating. Even as the White House was negotiating on trade with Beijing, it was also contemplating a U.S. ban of telecommunications equipment from Chinese companies like Huawei Technologies, essentially China’s version of Cisco. As President Donald Trump was tweeting about the importance of 5G on Thursday, Secretary of State Mike Pompeo was pushing U.S. allies to ditch Huawei.

This is a fight that is not going to end anytime soon. For years, U.S. officials have worried about Chinese equipment being used to infiltrate U.S. networks and businesses for possible espionage and theft of intellectual property. Even a resolution of the trade war won’t quell those fears.

“The perception is that too much of the information- and communication-technology supply chain is centered on China,” says Paul Triolo, who focuses on global technology policy issues for risk consulting firm Eurasia Group. “If we are in a conflict and using infrastructure built by China, they could theoretically hit a button and shut off everything.”

“After 30 years of saying companies should optimize supply chains and move some abroad, now we are saying it’s a security concern,” he says. “Adjusting to that is jarring.”

WELCOME TO THE NEW COLD WAR IN TECH.

For a short period last year, the Trump administration banned U.S. exports to Chinese telecom equipment maker ZTE(763.Hong Kong). Unable to get crucial components from U.S. suppliers, ZTE’s production was crippled, and its stock fell 40%.

The move had collateral damage, including U.S. optical networking company Acacia Communications(ACIA), whose own stock fell 35% in the days after the ban. Ultimately, President Trump reversed the ban and fined ZTE $1 billion instead.

Last August, Australia banned Huawei gear from its 5G networks. In January, the Australian wireless and internet company TPG Telecom(TPM.Australia) scrapped its plan to build a new mobile network, citing the ban. TPG shares are down 29% since late August.


For investors, these are early previews of the dangers to tech companies as their parent nations are pulled between the U.S. and China. Consider that Flex(FLEX), Broadcom(AVGO), Qualcomm(QCOM), Micron Technology(MU), Intel(INTC), and Qorvo(QRVO) each sold Huawei more than $90 million of equipment in 2017, the last full year of data, according to Gavekal Research analyst Dan Wang. All of those sales could be imperiled by a Huawei export ban that has been discussed by the Trump administration. For investors, a ban is a greater risk than the cyclical slowdown already weighing on the chip industry.

At the same time, China is no longer content to be the world’s factory for low-cost goods, pushing its own homegrown companies to challenge the global positions of established tech leaders. For China, technology is central to its ambitions to be a global power, a topic that goes well beyond trade agreements.

Western Europe is already caught in the middle. Ostensible U.S. allies are being pressured by the Trump administration to take a tough line with privately held Huawei. European telecom operators, however, have spent years buying Huawei gear. Vodafone, a top United Kingdom telecom provider, has temporarily banned Huawei from the most critical parts of its network. But both Germany and the U.K. are leaning against an outright ban, The Wall Street Journal has reported.

The U.S., meanwhile, has stepped up its crackdown. In December, at the request of the U.S., Canada arrested Huawei Chief Financial Officer Meng Wanzhou on charges of bank and wire fraud. The company has repeatedly denied those charges as well as spying allegations. Huawei did not respond to requests for comment.

Huawei has become a major player in the telecom space by undercutting rivals like Cisco and Nokia(NOK). The Shenzhen-based company’s revenue has risen to an estimated $109 billion last year from $18 billion in 2008.

“We have experienced price-focused competition from competitors in Asia, especially from China, and we anticipate this will continue,” Cisco warned in its latest annual report.

Congress has introduced bipartisan bills to ban the sale of U.S. chips and components to Huawei and other Chinese telecom companies breaking the law or violating sanctions. Lawmakers finding common ground on the issue illustrates the magnitude of the threat, which has been complicated by U.S. companies turning to China’s 1.4 billion consumers for growth.

Lately, however, U.S. companies have felt the pain of more-insular Chinese consumers, who have been encouraged to buy local goods. China weakness was the focus of Apple’s rare revenue warning earlier this year.

Mergers are another likely casualty, as the U.S. and China each add new reviews of cross-border deals. Last year, the Trump administration blocked chip maker Broadcom, then based in Singapore, from buying Qualcomm because of its Chinese connections. Qualcomm dropped its own bid for NXP Semiconductors (NXPI) of the Netherlands last year after China’s review board, the State Administration for Market Regulation, dragged its feet. In its latest annual report, Qualcomm warned that “future acquisitions may now be more difficult, complex, or expensive to the extent that our reputation for our ability to consummate acquisitions has been harmed.”

China’s investments in the U.S. fell to less than $5 billion last year from $46 billion in 2016, according to Rhodium Group.

The Cold War in Tech Is Real and Investors Can’t Ignore It
Illustration by Edel Rodriguez


The shifting dynamic is a costly distraction, at best, as tech companies come up with contingencies and look to shift production out of China. But the real worry is that as the U.S. and China try to protect their own interests, they may take down the entire tech ecosystem along with all of the innovation it produces.

Wall Street’s tech analysts can’t model for an end to innovation. But that doesn’t mean investors should dismiss the risk.

“It’s absolutely something we have to think about in terms of the assumptions we are making about revenue and margins,” says Steve Smigie, senior investment analyst for GQG Partners, which oversees nearly $19 billion.

Take Huawei. If the company is hit with an export ban similar to the one imposed on ZTE, Wang of Gavekal Research says the company would be unlikely to survive. While a collapse might be seen by U.S. officials as a cold war victory, it would reverberate throughout the global economy. Huawei has six times the sales of ZTE, and its gear is used in 170 countries.

While the tech cold war remains largely theoretical, Barron’s spoke to policy watchers, fund managers, and industry analysts to come up with a basket of stocks already feeling effects from the tech battle.

THE HARDEST HIT: CHIP STOCKS

Semiconductor chips are the brains for just about anything with an on-and-off switch. Chips also happen to be the Achilles’ heel for China, making them a major battleground in a tech cold war. Despite several pushes in past decades to create its own semiconductor industry, China makes just 30% of the chips it needs, according to a report by Deloitte.

Chip stocks had a rough fourth quarter last year, hit by concerns about tariffs and a cyclical downturn. The PHLX Semiconductor Index has rebounded 17% to start the year.

The threat of export restrictions, however, still looms over the industry. “It has made it extremely hard to have conviction on a lot of these names,” says John Vinh, an analyst with KeyBanc Capital Markets, who has a Sector Weight on much of the industry he covers. “The ban on ZTE had a ripple effect through the chip industry. A ban against Huawei would have a much more significant impact. I would be cautious on any trade deal. China still has issues that we wouldn’t be out of the woods on, even if there is a resolution.”


THE MOST TO LOSE: MICRON TECHNOLOGY

Micron, the No. 1 memory chip maker in the U.S., is one of Huawei’s suppliers and would be in the crosshairs of any export ban. Even absent a ban, Micron will struggle as China tries to reduce its reliance on U.S. suppliers.

Analysts estimate that China is at least five years away from chip independence, but it is having initial luck on lower-end chips, like the flash memory used in smartphones. Since the focus is on building self-reliance, not necessarily profitability, China’s chip push could spell pricing-related trouble for entrenched rivals like South Korean giants Samsung Electronics(005930.Korea) and SK Hynix(000660.Korea), and U.S.-based Micron. Micron is less diversified than Samsung and could also lose out if China begins to favor Asian suppliers to hedge its bets. Micron declined to comment on China’s chip initiatives.

The company has publicly told investors that competition always exists and that the China threat is nothing new. In its annual filing, however, Micron includes the following risk: “The threat of increasing competition as a result of significant investment in the semiconductor industry by the Chinese government and various state-owned or affiliated entities that is intended to advance China’s stated national policy objectives. In addition, the Chinese government may restrict us from participating in the China market or may prevent us from competing effectively with Chinese companies.”

While Micron benefits from long-term trends around artificial intelligence and autonomous cars, Goldman Sachs chip analyst Mark Delaney recently warned in a note that memory pricing broadly could deteriorate another 20% or more in the first quarter, with further declines in the second quarter. He recently cut his 2019 earnings estimate by 14%, to $6.27 a share. At a recent $43, Micron is already one of the cheapest stocks in the S&P 500 index based on next year’s consensus earnings estimates. But the U.S.-China dynamic makes even this cheap stock a risky bet.

WELL POSITIONED: HUAWEI’S COMPETITION

Huawei has spent several years challenging the established network infrastructure players like Cisco, Nokia, Ericsson(ERIC), Ciena(CIEN), and Juniper Networks(JNPR). Any move away from Huawei, therefore, would benefit these companies.

Their routing and switching gear sit in the core of telecom networks where traffic is aggregated—the very area that intelligence experts fear could be targeted by Chinese spyware.

“We believe over a third of the mobile infrastructure and software market that IHS values at $47 billion in 2019 presents a battleground along with the nearly $15 billion routing and optical markets,” Raymond James analyst Simon Leopold wrote to clients last month.

Cisco is the safe play and would be a winner if the Trump administration follows through on an executive order banning Huawei from U.S. 5G networks. Huawei products are already limited in the U.S., but a ban could spur European allies to take similar steps, and their networks use Huawei.
Cisco has an additional advantage over its rivals. The company only gets about 3% of its sales from China, making it less vulnerable to retaliation—something the company is familiar with. In 2015, China blacklisted Cisco, along with several other U.S. companies, from its government-approved purchase lists, after revelations by Edward Snowden that the U.S. National Security Agency had intercepted Cisco routers to install surveillance tools.

The catch for Cisco is that its diverse business—a quarter of its sales come from selling routers and switches to service providers—limits the impact from any share gains from Huawei. Nokia, Ericsson, Ciena, and Juniper are more exposed to the category. Leopold estimates that Nokia could see share gains worth about $740 million, or 2.5 to three percentage points of incremental sales growth.

THE NEUTRAL PARTY: TAIWAN SEMICONDUCTOR MANUFACTURING

If there is a Switzerland in this technology cold war, it is Taiwan Semiconductor Manufacturing(TSM), the world’s largest semiconductor manufacturer. The company’s knack for speedy innovation and ability to help companies modify their designs to improve their chips has made it a go-to manufacturer for a who’s who of technology, from U.S. companies such as Apple(AAPL) and Qualcomm to their Asian rivals like Huawei and MediaTek.

Taiwan Semi is roughly five times the size of its next closest rival, privately held GlobalFoundries, putting the company in a rare safe position in the tech cold war—and making it an attractive option for investors. “This is an asset that is critical for both the U.S. and China and not in the hands of either,” says Bhavtosh Vajpayee, an analyst on the $39 billion Oppenheimer Developing Markets fund, which owns Taiwan Semiconductor.

Taiwan itself is trying to maintain a similar neutral position. The island is to chips what Saudi Arabia is to oil. Taiwan accounts for about 60% of global capacity to make customized chips, like those used for AI or cameras in smartphones. But it’s impossible to ignore Taiwan’s precarious political position. Self-governed, it relies on the U.S. for military protection, but its economy relies on China—which considers it a province.

The natural question: Could China force Taiwan Semiconductor to cut off the U.S. or start a boycott? The company has been preparing for multiple crisis scenarios for years and has diversified its business to protect against things like a boycott, says Alberto Fassinotti, a portfolio manager for emerging market equities at global investment manager Rock Creek Group. Taiwan Semiconductor did not respond to a request for comment.

Analysts say any attempt by China to cut the U.S. off from accessing Taiwan and its chips would be challenged by the U.S., possibly turning a cold war into a hot one and upending all types of investment theses.

Taiwan Semi is a top holding for many global fund managers. The company’s strong balance sheet and 2.7% dividend yield offer investor protection, but those looking to buy may want to wait. Earnings estimates may still be too rosy, given the confluence of pressures facing the broader chip industry. Currently trading at 18 times forward earnings, the stock becomes more attractive below its historical average of 15 times, fund managers say.

CHINA’S INNOVATORS: THE BATS

Baidu(BIDU), Alibaba Group Holding(BABA), and Tencent Holdings(700.Hong Kong) dominate every aspect of the internet in China and drive much of the nation’s innovation. The companies have made aggressive pushes into digital payments, AI, and autonomous vehicles. But their reach extends well beyond China.

The companies have invested billions of dollars globally. Tencent is one of the world’s most active and aggressive tech investors, with stakes in Snap(SNAP), Activision Blizzard(ATVI), Tesla(TSLA), and Spotify Technology(SPOT).

Baidu, Alibaba, and Tencent also are China’s ticket to becoming a more dominant technology player, which makes them attractive investments in the tech cold war. The BATs together also hold stakes in more than half of China’s 124 unicorns, (startups valued at more than $1 billion), according to a report by Deloitte.

“The Chinese government is very aware that if it wants to reach its goals, they need these companies to invest,” says Brian Bandsma, a manager on the Vontobel Emerging Markets strategy that oversees $15.7 billion and owns Tencent and Alibaba. “And companies helping China achieve its objectives will have more flexibility, allowing these companies to go into ancillary businesses with little competition and shielding investors from regulatory risk.”

The companies are still grappling with their own challenges—China’s economic slowdown is denting Alibaba’s sales, increased investment and marketing are pressuring Baidu’s margins, and regulations around gaming loom over Tencent’s stock. Those challenges are now reflected in the stocks. The three companies lost a total of $229 billion in market value last year, and each trades below its five-year price/earnings ratio. They may be China’s—and investors’—best hope for remaining part of the global tech landscape.


Buttonwood

Why private equity appeals

It offers investors smoother returns, and a way around debt constraints



JOHN MCGAHERN’S novel, “That They May Face the Rising Sun”, is set in a remote corner of Ireland. There is a lake, a church, two bars and not much else. Gossip is prized but in short supply. Much of it is concerns John Quinn, a womaniser who has buried two wives and is looking for a third. His quest takes him to Knock, a shrine to the Virgin Mary, which has become a place to find a partner. Like many pilgrims, John Quinn is outwardly pious. But his mind is fixed on earthly matters.

The masking of intent may also be true of visitors to the temple of private equity. On the surface, investors in such funds might hope to harvest a reward—an “illiquidity premium”—for locking up their money for five to ten years. That allows private-equity funds time to turn sluggish businesses into world-beaters. The pitch is seductive. Capital has flooded in as readily as pilgrims flock to the shrine at Knock.

Perhaps, though, private equity’s pilgrims are really after something else. These institutional investors may face limitations on how much they can borrow. Private equity offers a way round such constraints: it is liberal in its use of debt to juice up returns. And that is not all. The value of privately held assets are not assessed all that often. That is a plus for those who, for ignoble reasons, would like not to be told how volatile their investments are.

This is a conclusion of a new paper from AQR Capital Management. Its authors look at the returns on private-equity purchases (“buy-outs”) of American businesses. They find that, after fees, private equity outperformed the S&P 500 index of large companies by an average of 2.3% a year between 1986 and 2017. That is quite the winning margin. But on closer examination, it looks less impressive. Buy-out targets tend to be small firms that are going cheap—that is, they have a low purchase price relative to their underlying earnings. An investor would have achieved higher returns from a basket of small-capitalisation “value” stocks than by putting his money in private equity.

The edge that private equity had over large listed stocks seems also to have dulled. In the past decade returns have been no better than the S&P 500. This may be because more capital is chasing buy-out targets. Private-equity funds once purchased businesses that were much cheaper than S&P 500 firms, says AQR. But the gap in valuations has closed.

Why are pension funds still so keen to push money into private equity? A tenet of textbook finance is that investors can build a portfolio that fits their preferences by choosing the right mix of equities, the risky asset, and cash, the risk-free asset. Nervous types might keep most of their assets in cash. At the other extreme, a risk-loving investor may wish to borrow (ie, have a negative cash holding) so that stockholdings exceed 100% of his capital. An investor with a limited ability to borrow can instead turn to private equity. Its funds take on $1-2 of debt for every $1 of equity.

The AQR authors point to another appeal. Illiquid assets, such as private-equity holdings, are not revalued in line with the price of publicly traded companies—“marked to market”—all that often. A common practice is to rely on self-appraisals. These tend not to reflect the day-to-day fluctuations in the price of listed firms. All this makes for artificially smooth returns.

Such smoothing has several advantages. When stock prices fall, the value of private-equity funds appears to fall less sharply. A mixed portfolio of public and private equity will look less volatile than a pure portfolio of listed stocks. The true riskiness of private equity would only become apparent in a prolonged bear market. Otherwise, it appears to offer diversification, albeit of a specious kind.

Some investors are forced to sell stocks (to “de-risk”) when prices fall, to comply with solvency rules. In such cases a bit of returns-smoothing is helpful, as a rigid marking to market would oblige investors to sell stocks at rock-bottom prices. That said, capital tends to flood into private equity when markets are booming. A lot of buy-outs will then be at peak prices.

The best private-equity funds are skilful investors. But the discretion they all have over how they report returns makes it hard for investors to judge who the best are. One study finds that half of funds claimed to be in the top quartile. Still, smoothed returns and leverage may be what investors are really after. Like lovelorn pilgrims to Knock, they will treat any other reward as a bonus.