The David Swensen Asset Allocation


The Yale Model

I have been looking for a good book about asset allocation, and I decided to pick up David Swensen’s book, “Unconventional Success.”

David Swensen should undoubtedly be regarded as a superinvestor. He took over Yale’s endowment in 1985 and achieved a return of 16.1% from 1985 through 2005. This is a considerable achievement, particularly considering the vast sums of capital that Swensen needs to deploy. He achieved these results by focusing extensively on moving away from the heavy allocation to bonds that the Ivy League had before the 1980s. His asset allocation is known as the “Yale Model,” which involves a widely diversified portfolio across asset classes and massive exposure to alternative asset classes, like private equity and venture capital.

“Unconventional Success” is not about how David Swensen achieved these returns for Yale. If it were, I wouldn’t have been as interested in the book considering I don’t run an endowment and never will. The book, instead, is aimed at small investors like myself.

The book is geared towards small investors who want to set up a simple, passive portfolio that will preserve their wealth and give a decent rate of return over the long run. Ben Graham would have called this “defensive investing” back in his day.

The Importance of Asset Allocation

Asset allocation is a critical topic. It is especially crucial for the FIRE crowd. While I admire the superhuman savings rates of FIRE bloggers, I think many of them are making a mistake by putting 100% of their savings in US equities, or an equivalent to VTSAX.

While US equities have been the best asset class over the long run, they are often prone to horrific drawdowns and “lost decades”. While over the long run everything will likely work out, 10 years of flat returns is a long time, especially when you are “retired” and don’t have an income.

Take the 1970s, a flat decade for US stocks. Stocks delivered a .26% real rate of return after inflation with a max drawdown of 40% during the ’73-’74 drawdown. The 2000s is another example. During the 2000s, stocks delivered a nominal return of 1.2% and a real return of -1.21%.

Again, everything worked out. If you had a long time horizon, you made out fine. If you were dollar cost averaging, it wasn’t a big deal. But if you’re retired, it is probably worth having a more diversified asset allocation.

It’s fully expected that elements of a balanced portfolio across asset classes will enter bubbles periodically (REITs in the 2000s, US equities in the 1990s, international developed in the 1980s via Japan), but in a balanced portfolio you won’t have 100% exposure to them. Another important aspect of a balanced portfolio is to have exposure to asset classes that will deliver a return in all economic environments.

US Stocks & US Bonds: The Classic Allocation

This is a blog about value investing and stock selection. That is not what Swensen’s book is about. In fact, Swensen advises strongly against individual investors picking their own stocks and believes that small investors don’t stand a chance. I do it anyway. As Han Solo says, never tell me the odds.

People often come to me for financial advice because they know I’m obsessed with this stuff. My advice is pretty simple: look at the Vanguard life strategy funds, look at the drawdown that happened in 2008, decide which one you could have lived with, keep piling money into it, and try not to look at it for 30 years.

Some mix of stocks and bonds are the standard asset allocation. Stocks supply the long run return, bonds deliver a boring rate of return but provide comfort to psychologically bear with the horrible 50% drawdowns that rear their ugly head every once in awhile. When it feels like all hope is lost, your bond allocation reaches out and says “come with me if you want to live.

Bonds give you the behavioral will to survive significant stock drawdowns. Stocks supply the long-term returns, with gut-wrenching volatility.

This has been the standard investing advice for decades. Swensen thinks that the small investor can do better. He starts by adding in asset classes beyond the standard US equity/bond allocations that dominate most individual portfolios.

The Core Asset Classes

Swensen describes his views on what he calls the “core asset classes” that deserve a place in a portfolio.

US Stocks: Swensen is talking about market cap weighted US equities, of course. No value tilts, trend following, etc. Good old market cap weighted US stocks. Since 1900, US stocks have delivered a 9.37% rate of return. This beats any other big asset class. Those high returns include horrific drawdowns, including a nearly 80% drawdown occurring in 1929-32.

US Treasury Bonds: Swensen is particular about bonds: he’s talking about US government bonds. He is not interested in corporate bonds, which he doesn’t believe deliver a high enough return relative to government bonds to justify their risk.

Bonds will not deliver a substantial rate of return but will protect investors during drawdowns. He also does not recommend owning foreign bonds, as they don’t have the creditworthiness of the United States.

He also recommends that half of an investor’s bond allocation go to TIPS or Treasury inflation-protected securities. TIPS were introduced in 1997 and are bonds that will increase in value if inflation rises. Conversely, they decrease in value if inflation falls. Swensen believes they deserve a place in the portfolio because they will protect against significant equity drawdowns, but they will also help the performance of the portfolio during a time of high inflation like the 1970s. Since 1997, TIPs have delivered a 4.78% rate of return.

Since 1997, we haven’t had a serious inflation problem, so this allocation hasn’t really had its chance to shine.

Meanwhile, the rest of the bond allocation exists primarily to shield the portfolio during drawdowns. The total bond market has delivered a 6.42% rate of return since 1900. They really help during drawdowns. From 1929-32, the total bond market provided a 24% return. During the global financial crisis, the bond market gained 11%.

Of course, that’s the total bond market. Long term US treasuries really shine in drawdowns. In 2008, while every other asset class felt like Britney Spears circa 2007, Vanguard’s long term treasury fund (VUSTX) gained 22%. This occurs because, during a meltdown, investors flock to buy US treasury bonds for safety and the Fed is typically pushing up bond prices to drive down interest rates.

International Developed Equities: Swensen recommends diversifying outside of the United States in developed international equities. Developed meaning that they are no longer growing rapidly and are in a similar position of economic development to the United States. Think of Western Europe & Japan. Since 1976, this asset class delivered a 9.04% rate of return. Like the US market, they are subject to horrific drawdowns.

Emerging Markets Equities: Emerging markets are economies that have recently entered a level of industrial level of development from an agricultural subsistence economy. The ultimate example in recent years is China. Since 1976, emerging markets have delivered a 9.04% rate of return.

Like international developed, they are not entirely correlated with US equities. From 2000 to 2010, a period of time when US equities lost money, they delivered a 10.61% rate of return. Since 2008, they have only achieved a 1.56% rate of return. For this reason, they fit nicely into a portfolio. Historically, they tend to offer high returns when US equities are not performing well.

Much of this has to do with valuations at the start of the decade. US equities were merely much cheaper than emerging markets or developed markets in 2010. Conversely, US equities were ridiculously more expensive than the rest of the world in 2000, which is why they sucked for the decade of the 2000s. The nice thing is that all of the world economies don’t usually enter bubble territory at once.

REITs: REITs, or real estate investment trusts, are companies that own a broad portfolio of income-producing real estate assets. Since 1970, REITs have delivered a 10.99% rate of return. This is another asset class not wholly correlated with US equities that can provide a decent return. Real estate also tends to increase with inflation, which is why Swensen believes REITs deserve a place in a portfolio for their inflation protection.

In particular, they held up well during the tech meltdown. From 2000 through 2002, REITs delivered a 13.78% rate of return while US equities were cut in half. Their worst moment was during the housing crisis when they declined as an asset class by 47%.

REITs also shined during the 1970s inflation, which led to an abysmal return for US equity investors. During the 1970s, REITs delivered an 11.32% rate of return.


The Building Blocks

According to Swensen, the “core asset classes” are the critical building blocks of a portfolio. They will rarely all work at once. An investor will be diversified across asset classes, and the different asset classes will all work their magic at different times.

The bonds exist as protection during stock drawdowns. TIPs have the added benefit of protecting an investor during inflationary periods. Longer termed treasuries will protect the investor during panics or truly horrific deflationary episodes, like 1929-32.

Meanwhile, the rest of the portfolio is divided up into asset classes that should deliver a very high rate of return. The nice thing about the asset classes that Swensen selected is that they don’t all perform well at the same time.

When stocks absolutely sucked during the 2000s and barely beat inflation, REITs and international equities still performed very well. During the 2010s, US stocks did great while international stocks sucked. If we have a repeat of the 1970s, stocks will probably be crushed, but REITs and TIPs will pick up the slack. Ideally, the approach should help an investor avoid “lost decades” like US stocks not delivering any return in the 2000s. You’ll always hate something in your portfolio, but you’ll also probably have something to love in your portfolio.

Most importantly, you can buy all of these asset classes directly through low-cost mutual fund and ETF vehicles. You’re not doing anything fancy with options or hedging. You don’t need to pay excessive fees to someone to do this for you. All of these asset classes are available in most 401(k) lineups, as well.

An added advantage is that these can all be easily managed. A small investor can do this themselves without any help.

DIY Asset Allocation

Swensen recommends that an investor hold no more than 30% of an asset class in their portfolio. This allows the diversification to work. It prevents one asset class from dominating the portfolio. Swensen’s specific recommendations are as follows:

US Stocks – 30%

Foreign Developed Stocks – 15%

Emerging Markets Stocks – 5%

REITs – 20%

US Treasury Bonds – 15%

US Treasury Inflation Protection Securities – 15%

Here is how you can construct this portfolio using simple, low-cost Vanguard ETF’s. You could also do this with mutual funds. My preference is for ETF’s because they maximize your tax benefit. The simplicity is key here: you could rebalance this once a year in your underwear. Investing is one area of life where it actually pays to be a little lazy and not meddle too much.

US Stocks – The Vanguard ETF for US stocks is VTI.  The mutual fund equivalent is VTSAX. Many of the FIRE bloggers recommend putting 100% of your net worth into one of these. Personally, I think that’s fine if you have a long time horizon. However, if you’re already retired, you probably don’t want to be in an asset class that could potentially do nothing for 10+ years and would benefit from diversifying into more asset classes. The expense ratio is a dirt cheap .04%.

International Developed – The Vanguard international developed ETF is VEA. The expense ratio is .07%.

Emerging Markets – The Vanguard emerging markets ETF is VWO. The expense ratio is .14%.

Side note: Alternatively, you could replace the three equity ETF’s above with one ETF – Vanguard Total World Stock Index, VT. This is a market cap weighted index of all stocks in the entire world for an expense ratio of .1%. Currently, the portfolio is 60% in US stocks, 10% emerging markets, and 30% international developed. If this ETF is 50% of your portfolio – you will get right to Swensen’s recommended allocations. 30% of your portfolio will be in US stocks, 15% will be in international developed, and 5% will be in emerging markets. Of course, these allocations won’t remain static and will fluctuate based on the performance of countries within the global portfolio, but it seems like a much easier way to simplify a Swensen portfolio with one equity ETF instead of three.

REITs – The Vanguard real estate ETF is VNQ. The expense ratio is .12%.

TIPs – The Vanguard TIPs fund is VTIP. The expense ratio is .06%.

Treasuries – Swensen doesn’t specifically recommend long-duration treasuries in the book. My preference for long-term treasuries is merely because they will do the best when the markets fall apart, which is the whole reason they’re in a portfolio. Vanguard doesn’t have an ETF for long duration treasuries, but they do have a mutual fund, VUSTX. The expense ratio is .2% on the investor shares. iShares has an ETF for long duration Treasuries, TLT. The expense ratio on that is .15%. If you want to follow Swensen’s advice and own treasuries of all durations, there is also an iShares product called GOVT.

Backtesting Swensen

How have Swensen’s allocations performed over time?

Since 1985, when the data is available for his recommended mix of asset classes (the TIPs returns are made up from 1985 through 1997 based on inflation rates), the Swensen portfolio has returned 9.77%. After inflation, 6.99%. $10,000 invested in the Swensen allocation in 1985 would be worth $238,007.

The worst year for the portfolio was 2008, in which it lost 26.58%. The total US stock market lost 37% during that period, and REITs were cut in half, while a 60/40 portfolio lost 20%. Before the global financial crisis, the worst year for the Swensen portfolio was a loss of only 6.92%. This occurred during the early 2000s meltdown when US-only equity investors saw their portfolio cut in half.

The portfolio really shined during the 2000s, when US stocks did nothing. The portfolio achieved a return of 6.88% from 2000 to 2010, or 4.34% after inflation.

TIPs didn’t exist in the 1970s, but substituting Swensen’s bond allocation for intermediate-term treasuries, the Swensen portfolio would have delivered an 8.26% rate of return and a small return of .41% over inflation. This is during a period where double-digit inflation led to losses across nearly every asset class. Moreover, the Swensen portfolio did this when bonds were crushed due to rising interest rates. The fact that it kept up with inflation at all is impressive. If TIPs existed back then, I would guess that the portfolio would have done even better.

Since the book was published in 2005, the portfolio has continued to do well. It has returned 6.68% or 4.56% after inflation.

Other Considerations

Taxes – Avoiding taxes is a significant consideration for most. The bond and REIT allocations will generate most of their return via dividends, not capital appreciation. If you hold them in a taxable account, you will have to pay taxes on the payments every year. To avoid this, you might want to consider carrying them in a non-taxable account like an IRA or 401(k).

Other asset allocations – Swensen’s allocations aren’t the holy grail of passive investing. There are other alternatives. Meb Faber and Eric Richardson cover a lot of interesting allocations in The Ivy Portfolio. Meb even has an ETF that covers his recommended asset allocation, which he dubs the global asset allocation, GAA. Another great book on the subject is DIY Financial Advisor from the great people at Alpha Architect.

Tweaking it – If you’re like me, you like to test and tweak things yourself. For instance, my preference is to gear my passive equity allocations towards value. US small cap value is the best performing asset class of all time. Since 1927, small-cap value has delivered a 10.93% rate of return. Why not gear more of my portfolio towards that? Or, you might want to set aside some of your portfolio to buy a portfolio of value stocks, like I did. If that’s not your bag, maybe you want to try trend following and momentum, even though I think that’s hocus pocus and nonsense.

There are some great resources available to experiment with your own allocation. One great resource is Portfolio Charts, a helpful visual resource where you can analyze different asset allocations from the Vanguard Three-Fund Portfolio to the classic 60-40, and it includes an analysis of the Swensen allocation. The author also maintains an excellent blog discussing asset allocation.

If you want to get deeper than that and experiment with more asset allocations, there is this resource at the Bogleheads forum. This is what I used to generate the return data listed through the blog post. You can experiment in that Excel spreadsheet with all different kinds of allocations.


There is no holy grail to investing. If you’re looking for a simple, low cost, easy to implement portfolio that doesn’t require a lot of work – the Swensen portfolio is a great place to go. Odds are, you’ll avoid “lost decades” and will preserve your capital over a long period.

As I stated before, 100% US equities might work for the FIRE bloggers, but I really think more of them should consider a more diversified asset allocation. They can’t afford lost decades, after all.

If you’re crazy like me, you also like picking your own stocks or pursuing a pure quant based approach like the Magic Formula or Acquier’s Multiple. Personally, I explicitly set aside this account that I track on the blog to buy and sell shares. My 401(k) and taxable account are in more of a diversified asset allocation like Swensen’s. My equity allocations are (obviously) geared towards value.

The bottom line is that you have to find what works for you. Good luck on your journey.


This wouldn’t be one of my blog posts if I didn’t throw in something completely random. This is pretty funny.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

2018: A Year In Review


My Portfolio

This has not been a good year for my portfolio. I am below where I started, and I am down 16.4% for the year.

This is the second year in a row in which I have underperformed the S&P 500. This is certainly disheartening. The last two years for me have made a strong case for shutting up and putting money in an index fund, but I’m not ready to give up just yet. More on this later.


This quarter, I purchased a number of new positions. You can read the write-ups below.

Most of these companies are statistically cheap on the basis of earnings, cash flows, enterprise multiples, and sales. All have a strong financial position with low debt/equity ratios, good Z-scores, good Piotroski F-Scores. From a quantitative perspective, they’re all in the right neighborhood.

One position, Amtech, was purchased for the asset value. Amtech is selling below net current asset value and near cash. This is high quality for a net-net, considering that the company actually has earnings and positive cash flow. Most net-net’s tend to be terrifying perpetual money losers.

For the stocks I purchased for earnings, a common concern for them is that their underlying businesses are at a “cyclical peak”. I don’t believe we are going to have a recession in the next year, which is why I am comfortable purchasing them. I’ll explain more on my views of the macro landscape later in this post.


Below is a list of all of my sells this year:


Previously, I tried to hold stocks for at least a year before selling them unless the stock was up significantly.

I loosened that rule up this year to give myself an escape hatch if the fundamentals deteriorate. For me, the biggest red flag is an actual loss at the top of the income statement. This helped me get out of two value traps early: Big Five Sporting Goods and Francesca’s Holding. I managed to exit Big Five with an 8.27% gain, which is incredible considering that the stock is down 62% for the year. Getting out of Francesca’s early was another great move, as it is down 87% for the year.

I try not to get married to positions. I think it’s important to keep an eye on the fundamentals of the companies I own. If the fundamental change, I should revisit my opinion.

International Indexing

This year, I also abandoned my “international indexing” strategy, which I pursued because of the poor opportunity set in the US combined with my poor skills in researching individual foreign companies.

The debacle in Turkey exposed this as a bad idea for me.

In order to stick with a position, I need to understand it. I don’t know anything about the situation in Turkey other than the market was cheap. That’s not a good thesis that will give me enough confidence to hold through a horrific drawdown.

I decided in the fall that this account should focus on my original mission when I set aside this money and started this blog. I set out originally when I launched this blog to hold individual positions in companies that I’ve researched. That’s what I am sticking with.

Misery Loves Company

This has been a difficult year for systematic value investing. As they say, misery loves company. Value investing has had a terrible year and my portfolio is not an outlier. Here are some examples:

  • The Russell 2000 value index is down 15.3%.
  • The Vanguard small-cap value ETF (VBR) is down 14.8%.
  • QVAL, the quantitative value ETF from Alpha Architect, is down 19.69%.
  • Validea’s 20-stock Ben Graham screen is down 15%. The 10-stock various is down 23%.
  • AAII hasn’t updated it yet, but as of November 30th the value screens did not have a good year. I suspect that when they update for December, the results will be a lot worse. As of 11/30, the Ben Graham “enterprising investor” screen (probably the closest proxy to what I’m doing) was down 15.5%. Their low price-to-free cash flow screen was down 12.5%. The high F-score screen was down 17%. Notably, the magic formula held up nicely this year. They show that screen with a gain of 7%.

The current situation could go many different ways, as is always the case in markets.

Traditionally, value stocks sell off before the rest of the market before a major calamity. They tend to be canaries in the coal mine. This was certainly the case in 2007. This is because value stocks are cyclically sensitive and, at the end of the expansion, they are the most vulnerable to a decline. This is also why they tend to rip in the early years of expansion, like 2003 and 2009. Everyone thought they were utterly doomed, but the world doesn’t end the way everyone was expecting. Stocks that had the biggest clouds hanging over them tend to perform exceptionally well once the weather improves.

The critical question, then, is: are we at the end of the economic expansion? Are we at the end of this cycle of economic development, or is the recent market sell-off one of Mr. Market’s typical bouts of insanity?

For possible answers, I turn to history.

Mr. Market’s meaningless temper tantrums

The market is replete with the corrections of the 10-30% magnitude that don’t reflect any reality in the real economy.

The most famous example of this is the crash of 1987, which had hardly any impact on the real economy. Mr. Market went into euphoric overdrive in the first half of 1987 (probably cocaine-fueled), with the market rising 22% from January 1st through the August peak. It then suffered a 33.7% peak to trough decline from August 1987 through December.

People are obsessed with another 1987 style crash happening again. Whenever the market has a nice run, Twitter is replete with comparisons of the chart to a stock chart of 1987.

I find this amusing. We should be so lucky. The 1987 crash had zero impact on the real economy and turned out to be an incredible buying opportunity. During the crash, Buffett’s friends (people like Bill Ruane and Walter Schloss) were at their annual conclave in Williamsburg, Virginia. They saw the panic for what it was and went to the phones to buy stocks.

Buffett used the crash to buy one of his most famous investments: his large allocation to Coca-Cola, which would set Berkshire’s returns into overdrive in the 1990s.

The people who are trying to predict the next crash of 1987 are missing the point. You can’t predict things like the crash of 1987. The trick is to identify the opportunities created by these events by buying new opportunities with a prudently calculated margin of safety.

Even indexers were fine in the crash of 1987 as long as they didn’t succumb to panic selling. Amid all of the “carnage” of 1987, the S&P 500 returned 5.25% that year. In 1988, the index returned 16.61%. In 1989, it returned 31.69%. It was a non-event, but market commentators are still obsessed with it.

Who suffered from the 1987 decline? Speculators. People who were leveraged. People who bought financial derivatives and exotic financial products. People who bought concentrated positions in speculative names. People who bought concentrated positions on margin. In other words: they’re the same people that always lose money over the long run and people who deserve to lose money over the long run.

Investors, in contrast to speculators, made out just fine in 1987. In modern parlance, these are the kind of people who thought they could predict volatility and went long in XIV. Alternatively, these are the kind of people who thought they could predict the price movement of cryptocurrency – i.e., a financial product best suited for anonymously buying heroin. Because blockchain is going to alter Western Civilization or something. Speculators always lose, and they’re always surprised when they lose. It’s so strange to me how people keep flocking to speculation like blood-sucking mosquitoes to a bug zapper.

What are some other instances of market downturns that didn’t reflect or predict anything in the real economy? In 1961-62 the market suffered a 28% drawdown. In the summer of 1998, the S&P suffered a 19% drawdown. ’83-’84 – 14% drawdown. 2011 – 19.4%. 1967 – 22%. 1975 – 14%. You get the idea. These things happen all the time.

Here is a young Warren Buffett talking about the 1962 hiccup. It sounds pretty familiar.




What particularly amuses me is how people are always trying to develop explanations for why these things happened. The 1987 crash is the most studied crash of all time with extensive media coverage. There still isn’t any consensus on what caused it. Some blame “portfolio insurance”. Others blame the Plaza Accords. Others still contend that the 1980s stock boom was a speculative bubble and the bubble never ended. They think the Fed has just been bailing out markets for 30 years and all of the gains since 1987 have been illusory.

Trying to predict and explain these things is a fool’s errand, unless you think you’re the next Taleb or Paul Tudor Jones (you’re not). I usually laugh at the commentators with impressive credentials and expensive suits who go on cable and explain why this stuff happened. Well, sir, if you look at the 200-day moving average, put this over the 50 day moving average, and if you look at the uptick in volume, and compare this to steel prices, and then take a look at these Bollinger Bands, and then look at the M2 supply’s impact on bond outflows, and compare this to the put/call ratio . . . blah, blah, blah

They might as well be astrologers. They might as well be ripping apart chicken guts and trying to predict tomorrow’s lottery numbers. Of course, this really shouldn’t be a surprise coming from the Wall Street elite. This stuff isn’t above them. They’re not all rational. These are people who buy healing crystals, after all.

The people who try to predict Mr. Market’s moods are like dutiful scientists following around someone at a bar after 15 tequila shots and trying to explain all of their behavior, trying to develop some rhyme or reason to it. “Hmmmm, very interesting, she is projectile vomiting after singing Sweet Caroline. Perhaps there is a correlation between vomit and Neil Diamond.”

I suppose much of it has to do with the rise of the efficient markets theory. If markets are efficient and they reflect all available information, then Mr. Market’s temper tantrums must actually mean something.

From their perspective, it can’t be my simple explanation: people are crazy and stuff happens. It can’t be that Ben Graham got it right in the 1930s and that much of financial theory since then has been a big waste of time.

Mr. Market gets it right (sort of)

Occasionally, Mr. Market gets it right and the carnage is tied to real turmoil in the real economy that will cause a real impact on the fundamentals.

Sort of, anyway. Even when Mr. Market gets it right, he overreacts. Mr. Market usually believes every bad recession is the end of Western civilization and the market suffers a 50% drawdown that would not be justified if markets were truly efficient. This is evidenced by the fact that the market normally snaps back by 50-100% in a year or two after the bloodbath.

The ’73-’74 drawdown is one example of an authentic event. The S&P 500 suffered a peak-to-trough decline of 48%. Oil drove the economic funk. With US oil production peaking in the 1970s, the US economy became more reliant on oil imported from OPEC nations. When OPEC colluded to restrict supply in response to US support for Israel, oil skyrocketed. This caused a severe and brutal recession in the United States.

The 2008 event was tied to real economic activity, as we’re all aware of and I don’t need to repeat. Banks were failing and it felt like the system was falling apart.

How about 2000? Many cite the 2000-02 market as one long bear market. I divide it up into stages. The initial fall in 2000 was simply Mr. Market throwing a temper tantrum. There was no catalyst. In 2000, people suddenly realized that it was crazy to pay 100x earnings for Cisco, even though it was a great company. They realized it was insane to pay 10x sales for IPOs of dot com companies that didn’t make any money. It was simply a mood wearing off.

Side note: Cisco was the first stock I ever bought. I sold it after I read “The Intelligent Investor” and realized it was crazy to own it.

In 2001, however, the deflation in the stock market along with 9/11 began to have a real impact on the economy, which triggered the more serious sell off of 2002 and early 2003.

What is this thing – a meaningless temper tantrum or something real?

The key question is whether or not the recent decline is merely Mr. Market panicking or if he is predicting real damage in the US economy.

To answer that, we should ask what distinguishes speculative panics from real events.

The most significant difference between a real event and speculative BS is that there is no consensus explanation for speculative panics. There are plenty of scapegoats for the crash of 1987, the “flash crash” of 2011, but no consistent broadly accepted explanation. In contrast, there is no doubt what caused the market declines of 1981-82, 1973-74, 1990, 2008.

Is there any consensus on what caused the recent collapse? Not really. Speculation abounds: the market is concerned about trade wars, the Fed hiking interest rates, hedge funds are “de-risking.” There isn’t any consensus. There isn’t a clear bogeyman. That leads me to believe that the market is not accurately predicting any carnage in the real economy within the upcoming year.

I also doubt we’re entering a recession for the following reasons:

1) The yield curve hasn’t inverted. While some rates briefly inverted this year, there is a lot of noise in the shorter end of the curve (under 5 years). The inversion that accurately predicts recessions, the 2 year versus 10 year, has not inverted. It’s also worth noting that the inversion usually happens a year or two before the recession begins in earnest. The fact that it hasn’t happened at all leads me to believe that rates are not yet high enough to push the economy into a recession.


2) There has been no discernible change in the unemployment trend. October 2018 marked an all-time low in the unemployment rate. The unemployment rate usually begins to tick upward before the onset of a recession. The unemployment rate started to rise in the first half of 2007, months before the beginning of a bear market or the start of the recession in December 2007. The unemployment rate also began to rise in the fall of 2000, the summer of 1990, and the fall of 1981. I would expect the unemployment rate to begin tipping upward if a recession was imminent.


broader unemployment

3) Household leverage is healthy. Think about what causes a recession. Typically, it is driven by monetary policy. In a boom, interest rates are cut and households accumulate debt, which drives the expansion. In the later stages of a boom, the Fed increases interest rates. The higher debt burden plus the higher interest rates restrict the cash flow of households. As they cut back to deal with the stress on cash flows, this pushes the economy into a recession. Currently, household debt payments as a percentage of disposable income are near all-time lows, despite the recent increases in interest rates.


4) There isn’t any sign of a slip in broad economic indicators. In fact, most of them are at all-time highs. Here are a couple: truck tonnage and industrial production.



The Opportunity For Value Investors

In the last couple of years, I have been concerned about rich equity valuations. I invested anyway in the best bargains I could find. I invest for the market that exists, not the one that I wish for. I wish every year could offer up 2009-style bargains. I also wish pizza, cookies, and ice cream didn’t cause me to gain weight. Unfortunately, my wishes are not reality.

With that said, the recent sell-off has helped the situation. It’s not 2009 cheap, but it’s a much better situation than it has been in a long time. The Shiller P/E is down to 27.69, which is hardly cheap but is better than it has been in a few years. The latest data isn’t available, but I’m sure that the average investor allocation to equities has also declined, which is also good news for future returns.

The drawdown has produced an ample number of cheap stocks, which is great news for value investors. The high number of cheap stocks is unprecedented for a healthy economy.

In December of 2016, there were only 47 stocks in the Russell 3,000 with an EV/EBIT multiple under 5. In December 2017, the count was down to 40. There are now 90 of these stocks, which is historically very high. Such a high number of cheap stocks bodes well for value. In past years when there have been more than 80 of these, as a group, these cheap stocks have delivered an average annual return of 32%.

The year 2000, in particular, was an incredible year for the relative performance of this group. This group of stocks with an EV/EBIT multiple below 5 delivered a 28.35% return compared to a loss of 9.1% in the S&P 500. This was extraordinary out-performance. The good times made the careers of a number of value investors who were new to the game and weren’t already tarnished by the under-performance of value in the ’90s, like David Einhorn.

Everyone knows that value has under-performed for a decade and this is similar to the late 1990s. The thinking goes that this under-performance will lead to another period like the 2000s when value stocks crushed expensive stocks. For the last few years, I wanted to believe that this situation was bound to mean revert soon. The main factor that made me doubt this reversion to the mean was the low number of cheap stocks that were available.

What made value roar in the early 2000s? The ’90s bubble led to a plethora of bargains in the small-cap value universe. The depth of these bargains led to an incredible performance in the early 2000s. Looking at the dearth of cheap names in 2016-2018, my concern was that even though value had under-performed recently, I didn’t see the quantity of bargains that I knew existed circa 2000.

The recent sell-off has changed that dynamic. There were 101 stocks with an EV/EBIT multiple under 5 back in 2000. Now, there are 90. A week ago, there were 108.

This leads me to believe that we are entering a situation very similar to 2000. Just like 2000, the economy is fundamentally healthy and not in a recession. A recession would negatively impact all stocks, not merely the pricey growth-oriented names. Meanwhile, there are a massive number of bargains to choose from.

Despite my under-performance in the last two years, I am now more optimistic than ever.

I think we will see substantial out-performance for value and I think my portfolio of diversified value names should perform well. Value stocks are no longer merely cheap on a relative basis; they are cheap on an absolute basis as well.

Moreover, the sentiment that the value factor is played out and over-farmed is more widely accepted than ever before. You even see this in the behavior of so-called “value” investors. Value investors in recent years have thrown away the old metrics and adopted a “can’t beat ’em, join ’em” philosophy. “Value” guys are out there pitching Facebook, Amazon, and the like. Usually, the pitch involves wildly overoptimistic metrics plugged into a DCF model along with talk of “moats”. Excellent value investors like David Einhorn are treated like out of touch dinosaurs.

Everything feels right to me. The time for value is now, and I am wildly excited for the upcoming year in a way that I wasn’t previously.


  • I read a number of good books this year. Chief among these is Margin of Safety by Seth Klarman. I wrote a blog post about it here. Saudi America was another great read, which I wrote about here. Here are a few other standouts I read this year:
    • Seinfeldia. If you are a Seinfeld and Curb Your Enthusiasm fan like myself, this book is a must read. It’s all about the birth of Seinfeld and the history of the show, with an inside scoop on all of the details of production.
    • Keeping at It. This was Paul Volcker’s autobiography. It was an amazing read about my favorite Fed chairman. You’ll come away with a sense of how hard economic policy is. Everything Paul Volcker did now seems so clear, but at the time it was extraordinarily hard and uncertain.
    • Brat Pack America: A Love Letter to ’80s Teen Movies. I grew up on a steady diet of movies from my favorite decade, the 1980s. This was an in depth homage to all of them. The author clearly has a deep love of the decade and the movies and music it produced. It shines through in this book. He ties each movie into larger cultural trends which were happening at the moment. He also interviews many of the creators of these movies and visits the real life locations in which they happened. Highly recommended.
  • I found myself watching Star Trek III a lot this year. It is such an underrated movie in the wake of Star Trek II. This is the ending and it should be heart warming to every nerd out there.

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