Introducing the Skinny Tail Mini Investment Fund. My Investor PTSD idea turns out to be a real thing.

Oct 23, 2018 by Gary Gordon


Back on January 31, 2018, in this blog’s previous incarnation as Financial Fables and Facts (ah, those were simpler times.  Pre-Kavanaugh.) I came up with a concept I called “PTSD investing”.  Here’s how I defined it:

“I believe that if a serious economic or financial disturbance occurs, investors exhibit clear signs of PTSD, or post-traumatic stress disorder, that can literally last a decade or more.”

Well, just like Newton and Leibnitz discovering calculus at the same time, while I independently invented PTSD investing, the potent academic team of Julian Kozlowski, Laura Veldkamp and Venky Venkateswaran came up with “The Tail that Wags the Economy: Beliefs and Persistent Stagnation.  OK, they wrote it a year earlier.  But they published it in a National Bureau of Economic Research journal, which let’s face it folks, isn’t exactly People magazine, so their research didn’t reach my eyes.  Fortuitously, economist Robert Shiller cited it in his New York Times column recently, so I got to connect with my economic homies.  Here’s how they explain it (my formatting):

“No one knows the true distribution of shocks in the economy. Consciously or not, we all estimate the distribution using economic data…Tail events are those for which we have little data. Scarce data makes new tail event observations particularly informative. Therefore, tail events trigger larger belief revisions. Furthermore, because it will take many more observations of non-tail events to convince someone that the tail event really is unlikely, changes in tail risk beliefs are particularly persistent.

OK, these guys aren’t exactly Hemingway or Fitzgerald.  And it gets far worse.  For example: 

So I’ll take it from here.  An unusual event is mathematically explained as the tail of a bell curve.  The tails are those 2% (3rd standard deviation) or even 0.1% (4th standard deviation) probabilities of occurring.  We tend to ignore tails, that is until they occur.  Once we do, their trauma leads us to assume a “fat tail”, or a greater probability of happening again than is logical.  But the skinny tail still exists in reality. The investment opportunity of my Skinny Tail Mini Investment Fund lies between our feared “fat tail” and the real “skinny tail”.

But as usual, pictures of real data tell this story better.

The inflation skinny tail tale.

A major economic trauma experienced by Baby Boomers was the Great Inflation of the 1970s and early 1980s.  It sent bond and mortgage yields soaring in order to compensate for the high inflation, as follows:

 

Sources: Department of Labor, Federal Reserve

Inflation began to ebb by 1982, but its trauma remained.  The “real” 10-year Treasury bond yield soared to 9% by 1983, compared to a normal 2½% or so.  And it remained well above normal until about 2000!  Fifteen years.  The Great Inflation was a skinny tail (say a 1% chance) – a rare combination of strong labor unions, OPEC flexing its might, Fed mismanagement, etc.  But for 15 years investors viewed a recurrence of high inflation as a fat tail (say a 20% chance).

This PTSD created an incredible investing opportunity.  As late as November of 1985 you could buy a 30-year Treasury bond with a 10% yield.  Over the ensuing 30 years actual inflation averaged 2.7%, leaving that investor with an astonishing 7.3% real yield.  For 30 years!  Hopefully this convinces you that identifying skinny tails when investors are assuming fat ones is worth the effort.

I’m proposing three thin tail investments at present.  See what you think.

Skinny Tail Mini Investment Fund idea #1: Homebuilders.

Investors clearly haven’t forgotten the housing bust of ’07-’11.  For example, on the front page of this past Saturday’s Wall Street Journal was this headline: “Home-Sales Slump Deepens”.  All for a mere 4% decline in year-over-year existing home sales!  And investors are scared to death of homebuilders right now.  The earnings yields (the P/E ratio flipped) of some major builders, using expected 2019 earnings per share, are:

Lennar: 16%

Pulte: 18%

D.R. Horton: 13%

To put these yields in perspective, both the stock and high-yield bond markets are currently trading at 6%.  Clearly, investors are forecasting substantial and permanent declines in earnings, or a recurring fat tail.  Are they right?  Let’s go to the numbers.  A good measure of the homebuilding market is vacancy rates for the housing stock.  Versus a normal 3.5% vacancy rate, here is a history of the number of excess homes:

 

Source: Census Bureau

The chart shows the tail the tail event during the housing bubble, but at present tail risk is the skinniest it’s been since the 1980s.  So investors are showing a clear case of PTSD.

Skinny Tail Mini Investment Fund idea #2: Private mortgage insurers.

A few months back I recommended the stock of a company named MGIC (Click to read about it if interested).  The company manages home mortgage credit risk.  If investors hate homebuilders, they can’t be too crazy about mortgage insurers, right?  Good guess.  MGIC has a 13% earnings yield and peer Radian clocks in at 14%.  Mortgage credit risk is very largely a function of mortgage lending standards, so let’s check them out:

 

Source: Urban Institute

Once again, you can see tail event, back during the first half of the ‘00’s.  The good old days of subprime and liar loans.  But today tail risk is awfully skinny; subprime is tiny and lenders decided requiring the truth is a good idea.  So why the worried stock valuations?  PTSD.

Skinny Tail Mini Investment Fund idea #3: Airlines.

I recommended airline stocks Delta and American back in the Financial Fables and Facts days during 2017.  I’m bringing them back.  The airlines created investor trauma for several decades by over-competing themselves to serial bankruptcies.  Investors still quake at the thought of airlines increasing capacity, as evidenced by earnings yields of 12% for Delta and 16% for American.

The excess competition took the form of lots of empty seats.  Let’s see where the empty-seat issue stands today:

 

Source: Department of Transportation

Again, the tail event is clear back in 2000.  But airlines have grown quite disciplined, so excess capacity keeps hitting new lows.  As a result, the industry has been able to handle oil price increases by raising ticket prices and other measures.  But the valuations of their stocks show investors are not at all convinced yet.  PTSD. 

 Wrapping up…

  • Investors remain afraid that home sales, mortgage credit and airline excess capacity will return to crisis conditions.
  • Reality is quite different, as evidenced by solid earnings reports this month from homebuilders Lennar and Pulte, mortgage insurer MGIC and airlines United and Delta.
  • The difference between current investor emotion and reality should create a very large investment opportunity.
  • When will fat tail fears abate?  Who knows.  The inflation story says it takes a long time.  But I for one expect the wait to be worth it.
  • To keep it simple, my Skinny Tail Mini Investment Fund consists of Pulte Homes, MGIC and American Airlines.
  • I will give irregular updates on my mini-fund.
  • I own all three, just so you optimists know that I have put my money where my pen is, and you cynics know where I’m coming from.