October 2016 CPI

When the October CPI numbers were released on Thursday, I thought it was curious how little attention they received on Bloomberg radio during my drive to work. Maybe because it was a report that came in exactly as expected, I thought. After collecting the data and doing a little bit of analysis, I’m not so sure.

Let’s start with the basics. The year over year change in the Consumer Price Index for October 2016 was 1.64%. The ten-year annualized change is 1.979%. These numbers are close enough to the Federal Reserve’s own 2% target that interest rates should be much closer to normal*. A rate hike in December is more than fully justified. Two rate hikes next year is below the minimum threshold — I would prefer to see four.

Inflationary pressures have been slowly building since May 2015. They peaked in May 2016 and have slowly been moving lower. For October, increases in inflation are seen in Housing, Apparel, Transportation, and Medical Care. Dropping off the list is Recreation and Other. In both cases, the rate of inflation is slowing. Food & Beverage and Education & Communication are in deflation. For the category of Food & Beverage, it has been in deflation for two consecutive months. This is the first for Education & Communication.

For the month of October, 69% of the index is seeing increasing inflation, 22% of the index is seeing deflation, and the remaining 9% is seeing a slowing rate of inflation. The sub-index that is experiencing increasing inflation has a year-over-year rate of 2.34%. This sub-index is on a four-month stretch where the rate is increasing at an increasing rate (from 0.95% to the current 2.34%).

The slowing inflation rate sub-index is slowing at a higher rate (0.06% last month to 0.98%). The deflation sub-index is also increasing from -0.60% to -0.28%.

What this tells me is inflationary pressures already exist in all three sub-indexes of the overall index. The Federal Reserve is still behind the curve and getting further behind.

* I know I have mentioned the concept of what constitutes normal for interest rates is elusive, but something close to 3% is justifiable.

Personal Income

I’ve started looking at a new economic series — real disposable personal income. Because the new Trump administration is likely to push through some significant tax policy changes, I want to start tracking this measure. I chose disposable because it is personal income less taxes. No other expenses are included.

The key point of following disposable income versus total income is to follow the combined affects of income increases and tax decreases. I really don’t care where the change comes from. I’m starting to follow this series now to establish a baseline.

Data comes from the Bureau of Economic Analysis at the end of each month. Thus, the month of September 2016 just became available two weeks ago. The one-year rate of change is 2.1% which is down from 3.3% in September 2015. The ten-year rate of change is 3.6% down from 4.1% in September 2015.

There are plenty of rumors regarding president-elect Trump’s campaign promises. Since we do not have a 2017 fiscal budget, the potential for another continuing resolution into January is possible. There is a possible path for the new administration to work with Congress to push through a reconciliation version of the 2017 budget that would include the tax promises from the campaign. This would hit the goal of getting it done within the first 100 days of the administration.

When I read that, I knew it was time to start watching this series. There could be some dramatic changes to disposable income coming in just a few short months.

Joining Lend Academy

Lend Academy is an interesting website where investors in Lending Club and Prosper get together and discuss issues. From my time on the Lending Club investor section the the forum, I have been impressed by the detail and sophistication of the analysis that has been presented. These people do not seem to be casual investors, but they are very serious about their investment and what they expect to achieve.

I recently received my October 2016 statement and walked through the XIRR calculation for the month. It was remarkable how few purchases I made during the month. It was especially so since nothing showed up on the screen during the last two weeks. I have two loans that have a status of “In Grace Period” and two loans that have a status of “Late”. Still, 92% of my loans by dollar amount have a status of “Current”.

The number of loans that have moved into a non-Current status has been the subject of a few posts on the Lend Academy forum. Some are speculating this could be the precursor of a recession. Others wonder if stacking is becoming more common (stacking is a situation where borrowers obtain money from multiple sites and either don’t pay at all or immediately go onto a payment plan). I don’t have an opinion on either, but I do worry about the resilience of borrowers if a slowdown in the economy is coming.

I opened my account in July. The XIRR calculation did not work well in the opening month so I discarded the result. For the month of October 2016, my XIRR is 4.80%. This is above August’s result but below September’s result. I do like this result since I am only 45% invested. If I was 100% invested in similar grades, I would have expected to see an approximate return of 9.60%. That would have been well above my target rate of 8%.

With the slowdown in the secondary market, I do not have much confidence in returns for November being much higher. With the grade composition likely being stable, the majority of the increase in returns will need to come from a higher investment percentage. That means continuing to purchase from the secondary market.

I did have a very curious situation arise during the month. On the first of November, I downloaded the notes from 2013 and ran a statistical analysis on the status of several characteristics of the loans. With the characteristic of “Purpose”, no individual item was statistically better than others. “Credit Card Refinancing” has been a stand out every month since I started in July. There have also been others that showed significant differences, but this is the first month where all of the “Purpose” types showed the statistically same outcomes.

It is far too early to consider using 2014 data. I just ran a test and 54% of the grade A loans are still open. That’s simply far too many to know the final percentage that will be Paid Off versus Charged Off.

I am certain there will be many more posts on the changes occurring in the Lending Club portfolio. Most of the knowledge I have about it will come from Lend Academy. The company will be releasing their quarterly results on Monday. With the stock price hovering around $5, I am hoping there will be good news. That price is a cut off point for some funds to invest. Maybe the price will go up and I can set aside immediate concerns about the financial viability of the company.

Portfolio Risk Management

I have become interested in determining risk lately. I have a large textbook on Risk Management that I may try to break into. I’m not sure what is in it and I have a doubt that I will find much useful since I’m not interested in determining risk based on prior data.

Modern Portfolio Theory posited that risk was based on the average return of a stock versus an index. While this is a simplification of the term beta, it does indicate that risk is solely based on past data. Since I have turned into an income investor, there is much more risk in a dividend getting cut affecting the stock price than prior movements in the price.

I mention this because I have watched one of my holdings, Bristol-Myers Squibb, suffer two major price hits in the past three months. With a beta of 0.72, the price should move less than the S&P 500 index. Because of these two price shocks, the beta will move higher. This is equivalent to rating the stock a Sell after these two price moves.

This is in fact what the service I am paying for has done with an email announcement that BMY is now rated a Hold. The service recently went through a portfolio management change and this was the first selection. Now anyone can get something wrong on the first day, but I do not like the rating change after a large price drop. This actually indicates to me there isn’t much confidence in the stock recovering anytime soon and I will be stuck with, at best, dead money.

For now, I think it is time to put the service on probation. I have my own valuation techniques, both home grown and professionally designed, that I can use to overlay opinions generated by the service. This is definitely not something I am pleased about. The whole point of having a service is to automate part of the portfolio creation process. Now that can’t be done without intervention. At what point do I then declare the service isn’t providing what I want? Something to ponder.

Loan Purchases Stall

We have reached the end of September and I had three days this week where no loans for sale on the secondary market reached my trading criteria. I’ve had one day per week where this happened, but three out of five is remarkable. It was an uneven week since I did purchase ten loans total during the other days. It is quite notable how many minimum loans are for sale (original purchase price was $25). I now have a large quantity of loans, but not a large amount of principle tied up.

I frequently do an analysis of how loans are performing. I worry about sudden changes in risk so I download the current state of every loan made and look at the risk profile for various parameters of the person requesting the loan. The results have been reasonably stable. Maybe you can extrapolate that and make an assertion the economy is doing well, but that isn’t where I want to go. Instead, I want to mention that I haven’t changed my buying profile. In other words, I won’t change the characteristics I look for just because I can’t find anything with my current criteria for sale or that I could possibly conclude the aggregate consumer is doing well. I stick with what I know because part of setting an acceptable risk profile is not changing it. The economy turns in cycles and not taking on excessive risk as the economy turns is the prudent action.

Instead of talking about the economy, I would like to mention I do not like where the Federal Reserve is turning. Chairperson Janet Yellen mentioned in a speech on Thursday the Fed may begin purchasing corporate bonds. She mentioned this in the context of noting the Fed is running out of government bonds to purchase within their original buy criteria. This is not where the Fed should be going. During the meeting at Jackson Hole, there was much talk about negative interest rates. This is also not a place where the Fed should be going.

It is beginning to reach the point where I need to be more vocal in my opposition to what the Fed is doing. We have gone past financial repression and are getting dangerously close to re-making markets and industries. When the Fed begins purchasing corporate bonds, they are explicitly saying who they want to succeed in the marketplace. When they set interest rates below zero, they are crippling banks, insurance companies, and pension funds. The institution is beginning to wield an out sized amount of power within the marketplace.

I was an avid believer in what the Federal Reserve did during the 1990s and 2000s. I have begun to switch to an opponent of everything they are doing. At this point of the cycle in the economy, they should be selling the $2.5 trillion in bonds they hold on their balance sheet (the size of the balance sheet should normalize back to where it was before the crisis which is 90% less than where it is now). For years the Fed followed the Taylor rule which says rates should be around 3%. Even if some economists are correct when they claim the Taylor rule is broken, LIBOR rates are at 0.90%, far above the Fed’s target of 0.25%. There needs to be a change in the way the marketplace functions and it needs to begin with a radical change in Federal Reserve behavior.

Portfolio Construction

The second part of the Lending Club analysis involves what I already own. My goal for the portfolio is to own a duration laddered portfolio with a geometric weight on grades. That’s a serious mouthful so let me describe each part.

Since I am only investing in 36 month loans, the loans I expect to own have a duration of 36 months to one month. I would prefer to own an equal amount for each month on the duration ladder. That sounds simple enough but these loans pay down principal like any other loan which means it will take exact accounting to validate the purchase.

Weighting based on grades is more complex. The charge off rate increases as the grade gets lower. This is expected and validates the grade. I want to minimize my exposure to loans that will default (be charged off) and that means holding a larger amount in the higher grades. In looking at the 2012 – 2013 loans, the charge off rate versus grade approaches a line. There is an academic realm of consumer behavioral expectations that I would like to explore regarding credit, but this is designed to be about me.

If I were to accept a normal amount of risk, I would weight linearly along the grade scale. However, I am not willing to accept a normal amount of risk due to my age and retirement horizon. Thus, I have decided to use a geometric scale to establish a weighting pattern. The result is a weighting pattern where the highest grade has a target weight 19 times higher than the weight of the lowest grade.

So my routine becomes a simple pattern of downloading the loans for sale, filtering based on my criteria, sorting by the highest discount rate, and determining if the note would fit into my portfolio. Given the bandwidth I have access to, this should take less than five minutes each day.

As an aside, I am a little concerned about the amount of effort I will have to put into this, specifically on the accounting side. Each time a note posts a payment, I’ll need to markdown the principal that is paid. The purpose is to keep the amount available for each duration period accurate. At first I thought there would be only 36 loans — one for each duration period. Then I realized as principal is paid down, I can go into the secondary market and purchase smaller loans to back fill that period. Suddenly, the number of loans I would be owning became a number large and unknowable.

I think I should be able to keep track weekly and it should take less than an hour, but that will depend on whether there is seven loans with payments or seventeen. I really want to only do this weekly. It will match up with the weekly work I perform on the equity side of the portfolio. This will be an interesting experience as I continue learning about peer to peer lending.