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The Case Against 100% US Stock Indexing

liberty

Why not buy a US market cap weighted index and forget about it?

In my post on gold, I catalogued all of my disagreements with the perma-bears. In this post, I am going to talk about my disagreements with the perma-bulls who advocate owning nearly 100% US stock market cap weighted indexes.

100% US stocks is the preferred asset allocation of most FIRE bloggers. It’s the mantra repeated often in the financial independence blogosphere. Warren Buffett recommends a similar allocation, 90% US stocks and 10% treasuries.

I don’t think this is the optimal approach. I think investors should embrace stabilizing asset classes, global diversification, and moving away from market cap weighting.

USA: The Place to Be

I love the United States of America. I don’t find Lee Greenwood cheesy. I particularly love small towns in America. The traditional town square, modest homes with an America flag flapping in the breeze, the churches, the little communities. I listen to Ronald Reagan’s “shining city on a hill” speech and I find it inspiring.

Perhaps my perception is a fantasy about a world that doesn’t really exist anymore. Perhaps I’ve had pro-America propaganda fed into my brain since birth. Whatever.

Perhaps I’m blinded by patriotism and have been indoctrinated, but I think there is more to it than that. I don’t think it’s an accident that the United States became the world’s top superpower in the 20th century. I don’t think it’s just because of abundant natural resources and two oceans protecting us from invasion.

The United States has one of the best economic systems in the world. Our founders crafted a document that created a framework which was pretty hard to screw up. It has a number of safeguards built into it that maintain a certain economic and political framework that is very hard to untangle.

The testament to that framework is the results. There isn’t any country on Earth with standards of living that are as high and widespread as ours. The US ranks 10th in per capita income throughout the world, but that’s across 327 million people. Countries with higher levels of per capita income (like Switzerland, Luxembourg, Qatar), have much smaller populations.

For all of the complaining about our very legitimate problems, this is still the best place on Earth. Unequal distribution of wealth? At least we have wealth to distribute. Keep in mind that an income of $32,400 – a very average income in the United States – places a person in the top 1% of incomes globally. An average American lives better than 99% of the human beings on Earth. Keep in mind that half of the planet lives on less than $5.50 per day.

We have it pretty good, problems aside. Not only that, but for all of the whining about our infrastructure, it’s some of the finest in the world. When was the last time you had to drive on a dirt road? Or pay off a police officer because the country is completely corrupt?

The magnificence of this country seems entirely lost in our political conversation. We tend to dwell on our problems, rather than our strengths and how good we have it.

The Extraordinary Performance of US Markets

The long term performance of our capital markets reflects the soundness of the American economic model. Since 1871, the US has delivered a 9.07% nominal return, 6.87% real. There isn’t a country that comes close over a long enough time frame.

Since 1970, US stocks have crushed it. US stocks have delivered a 10.57% real return since 1970, or 6.41% real. The rest of the world delivered a 8.65% return, or 4.65% real.

returns

Since 2010, international investing has been an outright disaster. US stocks delivered a real return of 11.49% and the rest of the world delivered 3.32%. For perspective, the US bond market has returned 3.68% since 2010. This decade, you would have been better off buying a total bond market fund instead of buying international stocks.

2010

The US is indeed a wonderful economy. US investors never had to worry about the markets going to zero, which happened to other countries in the 20th century. Corporate governance is also strong. While there are the occasional frauds, we can reliably believe that companies will stay on the up and up. Those who stray will be prosecuted. The SEC will limit most, but not all, frauds.

We also have the largest military in the world, which helps play a role in protecting the interests of US markets. There is something to be said for having fleets of aircraft carriers, drones, and nuclear weapons looking out for our interests.

A US stock investor is investing in the best performing stock market in the world. Not only that, but they’re investing in some of the best and most profitable companies in the world. Berkshire Hathaway. Google. Amazon.

The US is also diversified, with representation in every economic sector and industry. This compares favorably to other countries, which are often concentrated in a single industry or sector. Take Australia, for instance, which is concentrated in financials and natural resources.

Meanwhile, compared to alternative asset classes, like bonds, US stocks have dramatically outperformed.

bonds

An investor looking at all of this data comes to a simple conclusion: why own anything else besides US stocks? They outperform every other asset class and they outperform the rest of the world. There are clear reasons behind this. There is an equity risk premium, a theory which postulates that US stocks outperform because they’re more volatile. Meanwhile, there are plenty of political reasons to think that the US stock market will continue to outperform.

A US index investor invests in all of the publicly traded companies in the country. Some will be extraordinary winners, some will be extraordinary losers. A 100% US index investor can also expect to pay low fees, and fees can be a massive drag on returns.

Buy an index fund and you’ll own your own piece of corporate America, which is always working overtime to deliver a return for you, the shareholder. There are ups and downs, but the market always recovers.

So, why not simply invest in 100% US stocks and call it a day?

Going International

While international stocks haven’t performed as well as US stocks, they can help an investor smooth out their returns during periods of time when US stocks are doing poorly.

I think this is due primarily to the unique relationship between the US dollar and the performance of the US stock market. US dollar strength tends to coincide with strong periods for US stocks.

usd

Notice the periods of time when USD is strengthening vs. other currencies: the late ’90s, the mid ’80s, the 2010’s. They’re all periods of time when US stocks are doing awesome.

Notice the periods of time when the dollar was weakening: the 1970’s, the 2000’s, the late ’80s. These were all periods of time when international stocks outperformed US stocks. Currency movements are a big part of this out-performance. It’s the interaction of the dollar with global currencies that provides an important diversification benefit.

This is best revealed when looking at returns from a decade-by-decade perspective.

decade

As you can see, international stocks tend to outperform during bad decades for US stocks. I might be wrong about my thesis about this (that it is related to currency movements), but the facts remain. International stocks can help even out returns and provide a more consistent return.

Political Risk: Millennials, The Allure of Socialism, & Political Diversification

I think international stocks also provide protection against the US embracing bad political policies. While the Constitution is strong and prevents politicians (and voters) from screwing up a good thing, it isn’t guaranteed.

Consider that 70% of Millennials say they’d vote for a socialist. Granted, this is a survey and the results are suspect,  but it largely jives with my conversations with people of my age cohort and younger.

The reality is that socialism is a guaranteed disaster and fails everywhere it’s tried in the world.

I suspect that Millennials aren’t really socialists. They are largely blinded because they have been surrounded by the fruits of capitalism their entire lives and take it for granted. It’s like the way a fish views water: it’s just the way things are. It’s hard for a fish to imagine being taken to the surface and drowning. Fully stocked grocery stores, utilities that work, a persistently growing economy, persistently improving consumer technology. That’s just the way life is from their perspective. The reality is that it is the fruit of our economic system.

With that said, I understand where Millennial socialists are coming from.

I suspect that Millennials really want to move away from a boom and bust economy. I graduated from grad school in 2006 and experienced sheer terror in 2008. I worked for a bank and was worried it was going under.

I watched people all around me pack up boxes and wonder for their future. Many of them were older and had a lot of debt. A bulk of their income went to their mortgages, as a lifetime of lifestyle creep bit them in the behind.

I was lucky enough to keep my job, but the experience shook me to the core. At the time, I was working 60-70 hours a week with no overtime. I wasn’t working like that to become the CEO of the company. I was working that way to ensure I’d stay off the lay off list because I knew that there weren’t any other jobs for the taking.

The whole experience lit a fire under me. Get the hell out of debt. Develop a bullet proof savings war chest in case I ever lose my job. I never wanted to experience that kind of desperation ever again.

Meanwhile, other Millennials graduated into that economy facing similar prospects. Many of them were in a worse situation due to student loan debt. I was lucky enough to get through college with academic scholarships, but I still had debt at the time and felt similar levels of desperation.

Facing that kind of economy in debt is enough to drive a person to think that the US economic system is broken. The fact that Millennials struggle to reach important milestones – like owning a home – further exacerbates this reality. Owning a home and having a stable job are important elements to making people feel that the “system” works. The fact that Millennials feel shortchanged in both regards makes it clear why they think the system is broken.

It’s all further exacerbated by the expectations that were instilled in Millennials when they were young. Growing up in the ’90s, we were surrounded by prosperity that we assumed was “normal” and would last forever. We walked into a storm with insanely inflated expectations of ourselves and the future.

The feeling of inadequacy is made worse by the fact that, thanks to the internet, we’re constantly exposed to our peers who are doing “better” than us. They are probably fronting to make themselves look better on social media, but it’s easier for a Millennial to feel like they’re falling behind when we look at the picture-perfect lives of our peers on social media.

If you look at your “successful” peers on social media, you see picture perfect families with nice homes and smiling children. No one is posting about the troubles they have paying the daycare bill, or the fight they had with their spouse the other night. They might have a beautiful home, but they’re actually house poor and have little disposable income after they pay the mortgage. They’re not going to post when they were passed over for a promotion at work. No one posts about the bad things in their lives. It’s all smiling faces and a front. It’s easy to look at that and feel like you’ve been left behind.

Anyway, while I completely understand where Millennials are coming from in thinking that the system is broken, they are still completely wrong in their politics. They’re especially wrong because they fail to realize how fortunate they are to simply be born in America. As mentioned earlier, simply being lucky enough to be born in America virtually guarantees you’re going to be in the top 1% of incomes globally.

Even if they don’t really want socialism (I suspect they just want a stronger welfare state, less debt, and an economy that isn’t so boom and bust), I think they are voting for people that do actually want socialism and want to undo the entire system that made our way of life possible.

Warts and all, it’s still the best system in the world. Blowing it up isn’t going to make life any better.

This is another reason to own international stocks. If the US does something insane like go socialist, the rest of the world won’t. Just like every company in an index doesn’t succeed, every country in the world doesn’t always succeed. Own all of the countries and you get some important diversification in case something in one country goes wrong.

If you’re going to own a lot of different companies, why not own a lot of different countries for the same reason?

Owning international stocks isn’t just about creating more consistent returns. It’s also about diversifying political risk against the possibility that the US economic system – which has worked so well for so long – could be upended by bad politics and an angry electorate.

I hope the US remain the premier world economy. I think it probably will stay at the top. But what if I’m wrong? That’s why I own international stocks. If the US goes down the wrong path, I don’t think that the entire world will follow. Diversification among countries is just as important as diversification among companies.

Bonds aren’t a waste of time

I wrote about owning bonds in my post, are bonds for losers?

While stocks are virtually guaranteed to outperform bonds over the long term, bonds can help contain drawdowns. Most people underestimate their capacity for financial pain and bonds can help limit that pain.

On the surface, going 100% stocks is the way to go. Since 1871, stocks have offered a real return of 6.87%. Bonds offered a return of 2.51%. 60/40 offered a 5.54% return. Why not go for the higher returns and just go all-in on US stocks?

The drawback of owning 100% stocks is that they can undergo truly horrific drawdowns that can take years to recover from. US stocks were flat in real terms from 2000-2012. 12 years of sideways markets is rough. From 1964 to 1981 (17 years), US stocks only delivered a real return of 1.32% from 1929 to 1948 (19 years).

Can your long term investing plan sustain multiple decades of flat real returns?

It’s easy to look at a long term chart of US stocks, or a long-term CAGR, and brush off these drawdowns. Living through them is a completely different matter.

In the early 2000s, US stocks suffered a 44% drawdown. From 2007-2009, stocks suffered a 50% drawdown. Imagine you had a 100% stock portfolio. Also, imagine you had a significant amount of money saved up, like $500,000. A 50% loss is $250,000. That’s a decent house in most parts of the country. Would you have been able to “stay the course” in the face of those kinds of losses? I think most people are kidding themselves if they think they will behave rationally in those situations.

For most people, I think the answer is no. Just imagine what it’s like to experience these kind of drawdowns:

EPhLPwhX4AAUr2N

These kind of severe drawdowns can make a person behave irrationally. A big part of the problem is that these drawdowns aren’t just numbers on a brokerage statement. Markets are reacting to very real and very bad circumstances in the real world.

After a nasty drawdown, it’s easy to get caught up in the mentality that the economy is ending and something is fundamentally wrong.

In 1929-32, it looked like the US was unraveling at the seams. We went from the ’20s, a time in which anything seemed possible (imagine starting a decade without plumbing or electricity and ending it with a stock market boom), to soup lines and hobo villages.

In the 1973-74, there was a widespread feeling that the post-World-War II prosperity was unraveling. The country was running out of oil. The decade prior was a political horror show: the assassinations of JFK, Martin Luther King, Robert Kennedy. Protests in the streets. Dead students at Kent State. We lost a war for the first time in history and lost 50,000 of our young men. Our President was unmasked as a corrupt man who resigned from office instead of face impeachment. Double digit inflation further eroded our standards of living. They called it malaise and it was a widespread feeling that America’s best days were behind us.

The early 2000’s debacle was marked by a feeling that the ’90s was nothing but a bubble economy and we were now going to pay a price. The turn of the millennium and the late ’90s was associated with extraordinary optimism about the future. We had a glorious party and now we were hungover. Add to that the experience of 9/11, this feeling became particularly palpable.

We all remember 2008, but at that moment, it felt like the entire economic system was falling apart.

During a serious stock drawdown, you get the general feeling that the world is falling apart. Stock aren’t drawing down for no reason. They’re drawing down for reasons of psychology that go beyond CAGR’s and numbers on a brokerage statement. Serious drawdowns are caused by a cultural mood. The mood is going to affect the psychology of an investor.

Moments like these also increase the odds of personal struggles, like the potential loss of a job or a house, which further add to the stress of the situation.

It’s easy to see why most investors won’t behave rationally during these situations. In many cases, they’re going to wind up selling their stocks are the worst possible moment when stocks are bottoming. Bear markets start with a feeling of uneasiness towards the boom, they intensify with a general feeling of malaise, and they capitulate when the situation feels utterly hopeless. Of course, the moments when everyone feels hopeless that are the best times to buy stocks.

drawdown10k

I own bonds to smooth out the ride and keep myself behaving correctly. My age might suggest that it’s not a good idea, but I know that I won’t “stay the course” if my 401(k) balance drops 50% and I’m worried about losing my job. While most financial planners would say I’m not aggressive enough (the 401-k website usually gives me the yellow light because my investments are “too conservative”), I want to limit my drawdowns and I know bonds are the best way to accomplish that.

A 100% stock investor might simply throw in the towel completely. This is what many of them do.

When the losses are cushioned with something like a 60/40 approach, it is easier to stay the course and not give up.

The Drawbacks of Market Cap Weighting

The index fund is an extraordinary creation. It allows everyday investors like myself to access the public markets for a low fee. Fees are a tremendous drag on returns.

As far as I’m concerned, a monument should be built to Jack Bogle for creating such an amazing product for every day investors, who were previously swindled out of commissions and paid extraordinary fees to access public markets.

The theory behind market cap weighted indexes is intuitive and easy to understand. Active investors are making bets against each other, trying to outperform each other. This is a zero sum game: for every winning trade, there is someone on the other side making the wrong decision. This is why most active investors underperform. Only some of them can be winners. Add fees to the equation and it becomes even more difficult to outperform.

So, why not simply own the market cap weighted index and get the average rate of return?

There is one problem with this approach: nearly every strategy that moves away from market cap weighting outperforms over the long-run.

  1. Fundamentally weighted indexes outperform.
  2. Equally weighted indexes outperform.
  3. The 30 stocks in the Dow Jones Industrial Average outperforms market cap weighted US stocks.
  4. Completely random 30 stock portfolios outperform the market.
  5. Low volatility strategies outperform, while also containing drawdowns.
  6. Nearly every AAII stock screener outperforms the market.

Finally, all the research and data shows that a pivot towards smaller, cheaper stocks outperforms over the long run.

equities

Small value is the best performing asset class since 1972. However, it notably under-performed during the bull markets of the 2010’s and the 1990’s.

Large cap growth – one of the worst performing long term strategies – also dramatically outperformed in both the 2010’s and the 1990’s bull markets.

Why do non market cap weighted strategies outperform over the long haul and under-perform during bull markets?

I think all of these strategies (equal weight, small size, value, fundamental weight, random portfolios) outperform because they pivot away from the coolest stocks. The coolest, biggest, stocks – the leaders of a bull market – are systematically avoided by all of these strategies. This causes all of these strategies to under-perform in a rip-roaring bull market, which are led by those large cap growth stocks. Meanwhile, non market-cap-weighted strategies also avoid the inevitable horrific decline in these bull market leaders. Over the long run, they outperform.

I think value, in particular, outperforms because it is systematically buying cheap stocks and selling when they get expensive. I talk about that in this post.

Meanwhile, a market cap weighted index is going to buy more of the largest, coolest, stocks as they go up.

As a value investor, I think that the opposite strategy is the best approach.

The ’90s bubble is a good example. In 2000, the market was concentrated in a handful of bubble names. This drove your returns during the bull and made them worse during the bear. If you avoided the leaders of the ’90s bull during the early 2000’s meltdown, then you dramatically improved your long term returns.

For an extreme example of this kind of behavior, look to Japan. James Montier demonstrated that the magic formula delivered a 16.5% rate of return during Japan’s meltdown in the ’90s and 2000’s. The magic formula outperformed because it avoided the biggest stocks in that market and pivoted towards value. This likely caused the strategy to under-perform during Japan’s long bull market. Even in a market that overall was doing poorly, pivoting away from market cap weighting made it possible to earn a high rate of return.

Meanwhile, if every strategy outperforms market cap weighting, then why do most active managers under-perform?

I think the answer is simple: those active managers have the same biases of the index itself. They are going to pile into the same outperforming stocks that the index is piling into it. This is for career reasons. The best performing stocks are safe to own. If you own them and succeed, you’re a genius. If you own them and fail, well, you’re with everyone else.

Active managers and institutional investors aren’t the smart money. They are most of the money and, therefore, most of the market. They’re subject to the same behavioral flaws and biases as everyone else. They discard under-performing strategies, they get excited about whatever is hot at the moment.

It’s also driven by FOMO. Most of them will probably load up on these stocks in an even more extreme way than the index itself. Not only that, but the size of most institutional investors, makes them pivot towards large caps out of of necessity.

Conclusion

I don’t think owning 100% market cap weighted US stocks is the optimal approach.

I think diversification adds a lot to a portfolio. Adding bonds can limit drawdowns. Adding international stocks helps diversify political and currency risks and leads to more consistent returns.

Pivoting away from market cap weighting limits returns during bull markets, but leads to long term out-performance by systematically avoiding the most exciting large cap names.

While indexing in 100% US stocks is likely to do fine over the long run, I think a more balanced portfolio with pivots towards value is a more optimal approach.

Of course, this depends on your perspective. Portfolios are personal. I’m someone who doesn’t experience FOMO. If other investors are outperforming me, I don’t really care. If it drives you absolutely crazy to underperform, then market cap weighting might be for you. If you don’t believe value is a factor likely to persist, you might want to own more market cap weighted indexes.

You do you, but you should go into an investment strategy with a full understanding of the risks and potential rewards.

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.

Podcast on Asset Allocation

microphone

Trey Henninger graciously had me on his podcast again to discuss my approach to an ETF asset allocation that helps me sleep at night.  You can listen here.

If you would like to read about my approach, you can click here.

Also, please note that this was before my change of heart on gold vs. TIPS, which you can read about here.

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.

UFS (Domtar)

I sold my position in Domtar due to their announcement that they would report a top line operating loss.

63 shares @ $36.35. My cash-equivalent position (I count the NEAR ETF as cash) is currently 26.9% of my portfolio.

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.

My thoughts on perma-bears and gold

gold

I’ve always hated gold

I have always been against owning gold.

Why did I think gold was a terrible investment? A huge reason for my gold aversion is the influence of Warren Buffett’s writings on my life and thinking. Here is what Warren has to say on the asset:

“It gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.”

In his 2011 letter, Buffett addressed the issue more in-depth:

“The second major category of investments involves assets that will never produce anything, but that are purchased in the buyer’s hope that someone else – who also knows that the assets will be forever unproductive – will pay more for them in the future. Tulips, of all things, briefly became a favorite of such buyers in the 17th century.

This type of investment requires an expanding pool of buyers, who, in turn, are enticed because they believe the buying pool will expand still further. Owners are not inspired by what the asset itself can produce – it will remain lifeless forever – but rather by the belief that others will desire it even more avidly in the future. The major asset in this category is gold, currently a huge favorite of investors who fear almost all other assets, especially paper money (of whose value, as noted, they are right to be fearful). Gold, however, has two significant shortcomings, being neither of much use nor procreative.

True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production.

Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end. What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade, that belief has proved correct. Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis. As ‘bandwagon’ investors join any party, they create their own truth — for awhile.”

To sum it up: gold has no calculable margin of safety. It produces no cash flow. The return derives from what someone else is willing to pay. It therefore ought to be categorized as speculation and not as investment.

Of course, my main aversion to gold has been my attitude towards the people who embrace it the most: the perma-bears.

The Perma Bear View of the World

Who are the perma-bears?

Perma-bears think that the Fed is an utterly corrupt institution and that they are going to lead the world to ruin. The world economy, in their view, is a debt soaked Ponzi scheme that is sure to unravel. Anyone who owns stocks or bets on a positive outcome for humanity’s future is a damned fool.

They’ve been saying this for a long time, and they are almost always wrong. However, like a stopped clock, perma-bears are occasionally right whenever we have a recession and a nasty bear market, which reliably happens once every 15 years or so.

Gold is the only asset that is beloved by perma-bears (Although, Millennial Fed hating perma bears seem to be embracing crypto).

Perma-bears hate the stock market because they think stocks are in a big bubble pumped up by the Federal Reserve. They hate bonds because they do not believe that they are truly “risk-free” assets, and the Fed has pushed yields to unusually low levels. Bonds are also in a bubble.

Stocks are in a bubble. Bonds are in a bubble. In their view, everything is in a bubble, except gold.

They also see the Federal Government’s deficits as a severe problem. They think that the US is ultimately going to deal with the debt by inflating the currency or straight up defaulting on the debt in an apocalyptic scenario that is sure to imperil the global economy.

The ultimate perma-bear book is The Creature from Jeckyl Island, which argues that the Federal Reserve is a monstrous creation that is eroding the liberty and money of Americans. It’s worth a read to get insight into the history of the Federal Reserve and the deep seated hatred of it.

You’ll often see these perma-bear types quite angry that inflation exists at all. Before the Fed, they argue, dollars were a store of value. You didn’t have to worry about the slow drip of 2% inflation eroding your wealth over time.

Since 1913, the value of a dollar has been eroded by 96% due to inflation. This usually gets the perma-bears very angry, as if the only asset allocation is cash stuffed into a mattress.

Perma-bears have always hated the Fed, but they really hated Alan Greenspan. The perma-bear goldbug crowd saw Greenspan as a dangerous departure from the already maligned Federal Reserve of yore.

After the crash of 1987, they were incensed that Greenspan “bailed out” the stock market by cutting interest rates and intervening to ensure that liquidity was available. In this view, the Greenspan era was the beginning of the end, taking us down to a path of Fed manipulation leading the United States and the US dollar towards a great reckoning. In their view, Greenspan’s 1987 cutting of interest rates in response to the stock market crash was the original sin that started it all and led us down a path to ruin. They further believe that his softening of interest rates in the mid-90’s furthered the problem and contributed to the dot com bubble. Then, taking interest rates to 1% in the mid-2000s blew up the real estate bubble.

Some take it back further, and blame Nixon for ending the gold standard, creating fiat currency, which they believe will ruin the world economy. This is despite the fact that the world economy has thrived for the last 50 years since we ended price controls and dollar pegs to gold.

Then, along came Bernanke and Yellen, who really broke the brains of the perma-bears. Bernanke and Yellen, in their view, continued the insanity by pushing Washington to bail out the banks and then undergoing successive rounds of quantitative easing, creating the “everything bubble” that is sure to destroy the global economy.

The perma-bears really had their day in the sun in the wake of the GFC, when the world was ripe to their message. They thought that quantitative easing was going to cause hyperinflation. All of this money printing was sure to wreck the world.

The trouble is: the hyperinflation never came. In fact, the 2010s was a decade with some of the most mild inflation since World War II. Ironically, this was during the most aggressive expansion of monetary policy since World War II.

inflation

The perma-bears will say all of this is nonsense. They say that the inflation is here and that the CPI is a sham statistic. They point to healthcare prices and student tuition as evidence of Fed induced inflation. They also argue that the inflation may not be happening in consumer prices, but that it is being swept up into asset inflation. They believe that the housing bubble was a perfect example of this: the Fed pumped up a big bubble in real estate even though the CPI didn’t rise in a meaningful way.

My Disagreements with the Perma Bears

Listening to the perma-bears has been a recipe for investment disaster.

They have been calling for the end of our financial system since Richard Nixon ended the gold standard, and the world economy keeps chugging along. Occasionally, gold has its day in the sun (the 2000s, the 1970s), but typically financial assets like bonds and stocks that actually generate cash flows do better over time.

I also think that the CPI is legit and I think inflation remains depressed for another reason outside of shadow statistics and asset inflation: money velocity is at generational lows.

The best explanation of the relationship between monetary policy and inflation is the equation MV = PQ, and velocity is a critical component of that inflation. Velocity has remained depressed since the GFC, which is why inflation has remained subdued even while the money spigots have been open.

The segments of the economy that are undergoing inflation (healthcare & education) are being inflated for reasons that have nothing to do with the Fed. The Fed didn’t make the decision to back student loans with taxpayer & deficit financed money, flooding the sector with cheap debt. The Fed also didn’t create the perverse incentive system around medical pricing, in which no one directly pays for anything, the Federal government floods the sector with taxpayer & deficit financed money, and prices predictably rage out of control.

Neither healthcare or education inflation have anything to do with the Fed.

m2 velocity

I also disagree with the perma-bear Fed hatred.

Looking at the history of recessions in the United States, recessions were more frequent and more severe before the Federal Reserve was created than after. I think this is due to a simple factor: inflation. By creating a mostly constant rate of inflation, recessions did not coincide with deflation after the Fed’s creation.

Before the Fed, price levels would shrink during recessions and rise during booms. Deflation makes recessions particularly nasty. With falling prices, consumers and businesses hold off on purchases, hoping that prices will be lower in the future. This then extends and deepens the downturn. At no time was this more apparent during the Great Depression itself.

My views on the Great Depression are informed by the work of Milton Friedman. This is pretty good explanation of what happened during the Great Depression from Milton’s point of view:

If you want to learn more about Milton Friedman’s views, he wrote two excellent books for non-economists summarizing his views:

Free to Choose

Capitalism and Freedom

Both books had a big influence on my thinking. I read them at an impressionable age in high school. For years, I could never get a coherent explanation of what caused the Great Depression. I remember asking a teacher: “What caused the Great Depression?” She told me: “The crash of 1929.” I replied: “We had a crash in 1987, why didn’t that cause a Great Depression?” No one could give me a satisfactory explanation and I’m pretty sure that the teacher thought I was an a-hole.

It wasn’t until I read Milton Friedman that I found an explanation that made any sense.

In Milton’s view, the Fed caused the Great Depression. The Fed fueled a boom during the 1920’s, but then did very little to contain the bust. They were also handicapped by the gold standard itself. They let banks fail. Their decisions and failures led to a shrinking of the monetary supply. They turned what would have been a nasty recession into a decade long Depression.

Imagine that in 2008, instead of trying to contain the collapse, the Fed let all the banks fail and let the money supply contract. This nightmare scenario is exactly what happened during the early 1930’s, and turned what would have been a nasty recession into a decade long Great Depression.

In many ways, the Fed’s handling of the 2008 crisis is the opposite of the way that the Depression was handled. If it weren’t for Bernanke’s decisive action, we likely would have had a decade very similar to the 1930’s. A decade of stagnation, 25% unemployment, soup lines, etc.

We complain about the Great Recession, but it was truly a cake walk compared to the economic horrors of the Great Depression. Charlie Munger summarizes it pretty well here:

“And of course, most of my schooling was in the Great Depression, but that means I’m one of the very few people that’s still alive who deeply remembers the Great Depression. That’s been very helpful to me. It was so extreme that people like you have just no idea what the hell was like. 

It was really there was just nobody had any money the rich people didn’t have any money. People would come and beg for a meal at the door, and we had a hobo jungle not very far from my grandfather’s house. I was forbidden to walk through a good amount, so I walked through it all the time.  

And I was safer in that hobo jungle the depths of the 30s when people are starving, practically, than I am walking around my own neighborhood now in Los Angeles at night. The world has changed on that. You’d think the crime would be less [now], but the crime was pretty low in those days.”

My grandfather grew up during the Great Depression, and I would often listen to his stories about how bad things were. It left quite the impression and I never forgot it. It was a time that was so rough that I don’t think most people today can even imagine it.

I think that the Fed and Bernanke helped us avoid the 1930’s fate. We could have wound up with 1/4 of the population unemployed. I also think that 21st century hobo-jungles would be more crime ridden than the 1930’s alternatives. Imagine the 1930’s hobo jungles with meth addicts and tents. That’s what a 21st century Great Depression would be like.

The perma-bears seem to think that the Fed should have let this all happen. In their view, we deserved a Depression as some kind of Calvinist atonement for the booms of the 1990’s and 2000’s.

I think that’s crazy.

In fact, I’m not so sure that the Fed caused the real estate bubble, which has been accepted as a truth by most people. For instance, did the Fed pass the Community Reinvestment Act, which effectively created the subprime real estate market? Did the Fed repeal Glass Steagall? Did the Fed create CDO’s? Did the Fed create the immoral collusion between the banks and rating agencies? Did the Fed create the post-internet bubble narrative that real estate was safe and stocks were insane? Did the Fed take Wall Street’s investment banks public, removing the strong risk management controls that existed during the partnership era?

Sure, 1% interest rates might have sprinkled some lighter fluid on an already raging bonfire of greed and mismanagement, but I don’t think the Fed caused the problem. It was a bubble that was brewing for decades for a lot of reasons.

The Fed certainly has made a lot of mistakes throughout their existence. They let the 1920’s bubble rage out of control. They failed to contain the effects of the bust. They were too loose with monetary policy in the 1960’s and 1970’s and caused massive inflation. They also deserve credit: Volcker and Greenspan both created an idyllic period during the Great Moderation, an era of low inflation and infrequent recessions.

The Fed tends to be the cure to and the cause of most recessions. They tend to tighten too much at the end of an expansion, causing the recession. They tend to loosen too much, leading to inflation and imbalances in the economy. Despite this, I think on the whole they have been a positive influence, and I think the history of US recessions confirms this.

Nor do I think bubbles are caused by the Fed. Bubbles are caused by human nature. The Fed might push it along, but there isn’t any government policy that will stop bubbles. People will always get excited about new narratives and that will always cause bubbles. Bubbles are a feature of the human race. We had bubbles before the Fed was ever created and we’ll have bubbles until the end of civilization.

Gold’s Terrible Track Record

Not only do I have disagreements with the perma-bear messengers of doom, but the data agrees more with Warren Buffett’s assessment of the asset class than Ron Swanson’s: gold is an asset with no margin of safety and no cash flows. It’s simply a bunch of volatile price action.

Ron Swanson: my favorite gold bug

Since 1980, for instance, we can compare the performance of both financial assets in simple terms. Since 1980, stocks have delivered a 11.38% rate of return, turning $10,000 into $746,067. Meanwhile, $10,000 invested in gold delivered only a 2.59% return, turning $10,000 into $27,757.

This even obscures the story a bit. While gold delivered a positive return over this 40 year period, all of the return was captured in one time period: an epic move from the lows in 2000 to a high in 2012. Around the time that gold coins began to be sold on Fox News aggressively, the gold market peaked.

Meanwhile, shortly after Paul Volcker decimated inflation in the early 1980s, gold went through a 61% draw-down from 1980 through 1999 while stocks ripped into an extraordinary bull market.

The greatest period of time for the gold market was the 1970’s. During the 1970’s, when inflation ravaged every other financial asset, gold delivered a 28% CAGR and turned $10,000 into $163,717.

What caused gold’s ascent during the 1970’s? Inflation is one key cause. Another is Nixon’s end to the gold standard in the early 1970’s. Until the Nixon shock, gold could be converted to dollars at a pre-determined price. This effectively amounted to price controls imposed by the federal government. When the link was severed and gold was allowed to float freely, the price skyrocketed after being unnaturally suppressed for decades.

These events also finally made the dollar into a fiat currency, a concept which has melted the brains of so many interested in permanent bearishness. For Boomer perma-bears, many have embraced the goldbug mantra. Crypto-fanatics are the Millennial’s answer to the perma-bear, a group that is equally maddened by the concept of fiat currencies.

So, in additon to the solid arguments or Warren Buffett, the fact that I don’t believe gold has any margin of safety, and my dismissive attitude towards the arguments of perma-bears and anti-fiat cranks, I’ve dismissed gold.

Rethinking My Position

While I haven’t changed my fundamental point of view about gold and perma-bears, I have been re-thinking my aversion to owning gold in a portfolio.

While gold on its own may be a bad asset to hold, that doesn’t mean that it can’t work effectively in a portfolio with other assets as a risk management tool.

One of the really nice things about gold is that it tends to do well when stocks are doing poorly. In addition to the 1970’s and 2000’s, gold also did very well during the worst years of the Great Depression, rising from $20.78 to $35 from 1929 through 1934. When the world looked like it was ending during those dark times, people began to hoard onto physical gold as a way to deal with the calamity.

The effect that gold hoarding had on gold-backed USD led FDR to implement Executive Order 6102. The order effectively outlawed the “hoarding” of gold and forced people to exchange their gold for a low price of $20.67. This was later amended via the Gold Reserve Act of 1934, which changed the convertibility of the gold price to $35. This was effectively a devaluing of the US dollar and was used to alleviate the effects of the Great Depression.

This arrangement and system of price controls was further solidified by the Bretton Woods agreement, which pegged all currencies to the dollar and pegged the dollar to gold at a conversion rate of $35. This amounted to government controls on the price of gold. When Nixon finally lifted those price controls and eliminated the convertibility of dollars to gold, the gold price raged out of control.

Anyway, to make a long story short: gold does really well when stocks are doing poorly. This means it may deserve a place in a portfolio. Gold’s best decades were during the 1930’s, the 1970’s and the 2000’s, which were the worst decades to own stocks.

Much of the price action in gold has been driven by the legal maneuvering of the US government, but there seems to be an innate tendency of investors to flock to the safety of “hard assets” when the world looks like it is going to hell.

These characteristics makes gold an interesting component to a portfolio.

Gold In a Portfolio

Let’s say that the price action of gold in the 1930s was a fluke because the government used gold as a way to manage the value the dollar. The price action in the ’30s was a fluke caused by the Depression and Roosevelt’s efforts to contain it. The price action of the ’70s was due to the final lifting of decades of price controls on gold.

That’s why I think 1980 is a decent starting point to think about the price of the gold. Since 1980, gold has performed terribly, as discussed earlier in the blog.

However, in a portfolio, it adds some benefits, mainly due to the fact that it is so uncorrelated with US stocks and does well during bad periods for US stocks.

Let’s look at a really crazy portfolio: 50% US stocks, 50% gold. The two assets together interact with each other in a beautiful way, reducing volatility and drawdowns. Here is the result since 1980:

portfolios

On its own, gold is a terrible thing to own. It had a horrible 61% drawdown over a 20 year period. It delivered only a 2.59% CAGR over four decades.

However, if you add it into a 50/50 portfolio with stocks, and you get a pretty decent portfolio. Volatility is reduced. Max drawdowns are reduced. It then delivers a decent rate of return of 7.66%.

Looking at my own asset allocation, I’ve compared what would happened if I replaced my 20% allocation to TIPS with a 20% allocation to gold. It significantly improves the results.

vsggold

Not only does it improve the results of the portfolio, but I believe that it reduces the risks. Currently, 40% of my portfolio is tied up in treasuries. Treasuries, particularly long term treasuries, are the best asset to own in a portfolio when markets are in trouble.

But – does it make sense to have 40% of my money in one asset class?

What if the perma-bears are right, even temporarily? What if rounds of quantitative easing cause hyperinflation? For instance, what if all of this money creation over the last decade has created a forest of dried out wood? If money velocity picks up, that could cause a forest fire of hyperinflation.

What if US government bonds are not a truly safe haven asset? Looking at the balance sheet of the US federal government, I certainly think there is a danger. Does it make sense to have 40% of my money invested in something tied to the solvency of a spendthrift government that has no plans to implement any discipline?

I think gold can be an effective way to hedge against these risks. If these risks turn out to be nothing, then 80% of my portfolio is geared towards a “normal” view of the world and I’ll do okay. Gold has historically kept up with inflation and risen during periods of strife, so they will work effectively in a portfolio. If we do have an economic disaster – gold should do extraordinarily well and 20% of my portfolio will further help me sleep at night.

It seems logical that people will continue to flock to gold as a safe haven when the global economy is in turmoil. If the perma-bears are right and the Fed unleashes hyperinflation, it’s difficult to imagine how gold wouldn’t do well in that environment. If the perma-bears are right and the US government deficit finally blows up, then it’s difficult to imagine how gold wouldn’t do well. It’s also hard to imagine why gold wouldn’t be a stabilizing force in the event of a sharp reduction in stock prices.

Conclusion

I think I have been wrong about my aversion to gold. I think I confused my disagreement with the messengers to an aversion to the entire asset class, which is effective at reducing risk and volatility within a portfolio.

I think gold can function well in a portfolio. It can also help an investor sleep at night, knowing that they will hold something that will retain value even in nightmare scenarios like hyperinflation, a Communist take over, or the global economy going to hell. It can provide piece of mind and it can help diversify a portfolio, reduce volatility, and reduce risk.

Random

This is a fun song.

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.

2019: A Year In Review

returns

Performance

After miserably under-performing in 2017 and 2018, I had a somewhat decent year and slightly exceeded the performance of the S&P 500. For an outline of my complete strategy, you can click here.

I launched this blog and set aside this chunk of my IRA in late 2016. It has been a fun ride.

I wanted to use this account to systemically follow my own version of Ben Graham’s “Simple Way” strategy and keep a live trading journal.

I also figured I’d buy net-net’s when they were available. There haven’t been many that I could find in the last few years, with the exception of Amtech (which I took one free 50% puff from), and Pendrell (which I roughly broke even on). I’m anxiously awaiting a time in which I can buy a lot of cigar butts. For now, I’m buying Simple Way stocks: low debt/equity, low P/E’s, low enterprise multiples.

Every trade has been recorded when it happens on this blog and I’ve also posted my rationales for when I buy a new position.

I thought this blog would be something different. Most of the investing blogs I found included a lot of talk about discipline, about how to find the companies, and even had write ups for new positions.

Few of the investing blogs out there showed a real person’s portfolio. Few showed when they buy,  when they sell, and show the outcome. I wanted this to be a live trading journal with all the failures and all of the successes, for all to see. I wanted to show the real, long, lonely, grind of active value investing for a normal person. I wanted this to be something different.

When I set out to do this, I wrote: “A key thing to keep in mind is that while these methods succeed over the long haul, there are periods of time when they do not work. I hope this blog will help me remain disciplined and focused on my own value investment journey.”

The last three years have certainly been a test of my discipline and that of most deep value investors. For deep value investors, this has been a particularly grueling slog.

For many, it has been tempting to stray. There are plenty of “value” investors who went out and bought a bunch of compounders with 200 P/E’s and cited See’s Candy and some Munger mental models as the reason for the style drift.

“Hey, even Buffett paid up for a good business! That’s why I’m buying Amazon and Facebook!”

“Yea dude, you’re just like Buffett in the ’70s. He really threw caution to the wind when he bought See’s at a P/E of 5 and less than sales . . . but hey, it wasn’t a net-net.”

They have been rewarded for their style drift. Over the long haul, I think they’re going to suffer the same fate as those who bought the Nifty 50 in the early ’70s and tech stocks in the late ’90s, but we shall see.

I digress. This year’s performance is an outcome that pleases me. It wasn’t much out-performance, but hey, a win is a win.

Value’s Underperformance Continues

pain

Clubber Lang explains deep value investing

My performance this year has been especially pleasing because 2019 was another year when value under-performed the broader market.

My style is closely aligned with small cap value, and here is how this year’s small cap ETF’s performed:

VBR (Vanguard Small-Cap Value) – Up 22.77%

SLYV (SPDR S&P 600 Small-Cap ETF) – Up 24.26%

They didn’t do badly. Over 20% returns are excellent. Unfortunately, in relative terms, they didn’t do as well as the S&P.

Looking at the universe of stocks with an EV/EBIT multiple under 5 in the Russell 3,000, they are currently up a measly 12.7%.

The total return of the EV/EBIT<5 universe doesn’t even tell the whole story. In early March, this group was up over 20% after a massive rally. The rally then fell apart completely, and the group suffered a face-ripping 24% drawdown. The market gods made us feel hope, and then punched us in the gut.

Earlier this year, the under-performance was even worse than 1999. It rebounded a bit at the end of the year, but it’s still a staggering level of under-performance. Deep value is suffering its worst slog since the late ’90s, and 2019 year was quite similar to 1999.

cheapobucket

So, while I matched the performance of the S&P 500, I outperformed most value strategies. Why was this the case?

The reason, I think, is that I had a high turnover at the right time. We’re all taught by Buffett that high turnover is wrong, but it helped me this year. When positions reached a decent value, I sold them. With the massive rally this year, that happened a lot sooner than I originally anticipated. I was usually right (Gap) but I got out of some stocks way too early (I’m looking at you, UFPI).

I also finally exited my long suffering Gamestop position once their private equity dreams were dashed. I got out at $11.45, which looks like it was a good move, as the stock is now down to $6.08.

I’m also the guy who bought Gamestop (twice!) at an average price of $24, but I take consolation that it could have been worse.

Here are all of the positions I sold this year:

closedyearend

Yes, that’s a lot of turnover. It’s very un-Berkshire.

I’ve long wondered if I’m adding anything to a value strategy with my stock picking and trading. This year, at least, it looks like it paid off. I avoided a significant drawdown for value and still enjoyed the Q1 and Q4 rallies.

I’ve held a significant amount of cash this year, after being all-in and 100% invested when the opportunity was rich a year ago.

I sold positions when they moved to my estimate of their intrinsic value, or when my thesis fell apart (Gamestop), or when the companies started to undergo significant operational slip-ups. My selling intensified after the yield curve inversion, as I thought the likelihood of a recession was higher. Market sell off’s then occured over developments in the trade war (not recession concerns), but I avoided some big drawdowns even though my rationale was wrong.

After being nearly 50% cash earlier this year, I gradually bought and scaled into positions that I thought were cheap.

This quarter, I purchased five new positions. The positions and corresponding write-ups are below:

  1. Movado
  2. National General Holdings
  3. Prudential
  4. Principal Financial Group
  5. RMR Group

A Tale of Two Decembers (Macro Stuff)

If you don’t care about my Macro views, you can skip this section

This December and last December are opposite images of each other.

The best way to represent this is CNN’s Fear and Greed index.

feargreed

Right now, the index is at 93, indicating “extreme greed.” A year ago, we were a level of 12, or “extreme fear.”

Mr. Market is one crazy lunatic.

bigtrouble

What changed fundamentally to cause this emotional swing? Nothing. The only difference is the price action and how everyone feels after a great year for stocks.

Last year, I was bullish. Cheap stocks were plentiful. On Christmas Eve 2018, I felt like Santa gave me an early Christmas present, as there were nearly 100 stocks in the Russell 3k with an EV/EBIT multiple under 5. It was the best opportunity set we’ve had in 5 years. Meanwhile, the yield curve was not inverted (it had only flattened, and only longer-dated maturities were inverted), so I knew that the odds of a recession in the next year were minimal. It seemed to me to be a great time to go long, and that’s what I did. At the end of last year, I was 100% invested and quite excited.

Right now, I’m quite bearish. The 3-month and 10-year yield curve have inverted this year. Meanwhile, bargains are less plentiful.

I believe that the yield curve is a proxy for how tight or loose monetary policy is, which is why the yield curve is a forward-looking indicator for the economy. The eggheads say that the yield curve doesn’t matter, and this time is different – but those are the same lines we heard after the last two inversions. I’ll take the easy rule that works every time over the expert opinions of the eggheads.

The yield curve inverted after four years of the Fed tightening monetary policy.

yieldcurve

The eggheads assure us that this is nothing to worry about.

The Fed was raising rates for four years and finally reversed course this summer. They then started cutting the balance sheet in early 2018.

My view that the Fed was too restrictive is perplexing for many involved, especially the Fed haters who believe that the Fed was too loose with policy. After all, how can the Fed be too restrictive when interest rates are so historically low?

The yield curve tells a different story. The yield curve indicates that monetary policy was too restrictive. It seems insane, but one also needs to look at the velocity of money, an important and often ignored component of the overall monetary picture, best expressed by the classical equation, MV=PQ.

When velocity is low – as it has been since the GFC – seemingly low interest rates can still be restrictive.

velocity

Money velocity plummeted after the GFC and never recovered. This is why I think an ultra-accommodating monetary policy didn’t cause hyperinflation as everyone feared (myself included) and the fears were best expressed by this 2010 viral cartoon.

I think that four years of monetary tightening were restrictive and baked a recession into the cake.

Shortly after the Fed inverted the yield curve, the Fed started cutting rates over the summer. In September, they began to increase the size of the balance sheet again. The Fed is now in a loosening mode, which markets have interpreted as a bullish signal.

The discussion around the yield curve is quite funny. Historically, a yield curve inversion predicts a recession roughly a year or two ahead of time. The attitude of most market participants is ridiculously short term and seems to be “the yield curve inverted, and the market went up for a few months. Therefore, it’s nothing to worry about.”

I think this year’s Fed easing is too little, too late. The markets are rallying just because the Fed is loosening policy, and investors believe we will avoid a recession. The yield curve has un-inverted and is steepening, implying that monetary policy is now accommodative. Unfortunately, I think that the Fed shifted to accommodation too late in the game.

This is what usually happens. The Fed always begins loosening policy before the recession arrives, and it is always too little, too late.

In the last cycle, the Fed began cutting rates in the summer of 2007. By the end of 2007, after multiple rate cuts, the yield curve steepened. Markets hit their peak in the fall of 2007. As we now know, we were not out of the woods in late 2007. We were only at the beginning of the pain.

During the tech boom, the same thing happened. The Fed started to cut rates at the end of 2000 and un-inverted the yield curve. We still had a recession in 2001, with the stagnation that lingered into 2003.

There is always a lag between a shift in monetary policy and the impact on the real economy. The Fed began loosening policy in mid-2007. The economy didn’t start to rebound until mid-2009. The Fed started tightening its policy back in 2004, and the recession didn’t start until the end of 2007.

There is always a lag between monetary policy and its impact on the real economy.

I think the same outcome is likely this time. We haven’t seen the full impact of the tightening that occurred from 2015 through 2019. Similarly, we probably won’t know the effect of the recent loosening of policy for a couple of years.

The length of a yield curve inversion also correlates to the length of a recession. The last yield curve inversion lasted from mid-2006 to late-2007. The recession lasted from December 2007 to the summer of 2009.

This inversion lasted for five months, from May through October this year. The length of the inversion implies we’re in store for a roughly 6-month recession. I think this means we’ll have a relatively mild recession. It will be a recession that is more like the early ’90s and early 2000s recession than it is going to be like the last, big, bad, 2008 debacle.

To summarize: I think we’re going to have a recession. I also don’t think it’s going to be as bad as 2008.

The Bigger They Are, The Harder They Fall (More Macro)

Again, skip if you don’t care about my opinion on Macro stuff.

Unfortunately, a “mild recession” doesn’t necessarily mean we’re going to have a mild bear market. The early 2000s recession (in which unemployment only peaked at 6.2%) led to a 44% drawdown in the market.

The extent of a big drawdown tends to be a combination of the severity of the recession and the extent of the overvaluation. That’s why a frothy market can drawdown severely when faced with minor economic turbulence.

In other words, the bigger they are, the harder they fall.

Before the 2000 drawdown, the market represented 146% of GDP. The massive overvaluation at the time is why such a minor recession was able to cause such a significant stock drawdown. It’s sort of like how a bubblicious stock can completely disintegrate when reality is only slightly off from the market’s lofty expectations.

Compare this to the early ’90s recession. The early ’90s recession was relatively minor, similar to the early 2000s. The increases in unemployment during the early ’90s recession were nearly identical to the early 2000s event. However, unlike the 44% drawdown in the early 2000s, in the early 1990s, the market only suffered a 16% drawdown. Why was the drawdown so minimal? Simple: valuations weren’t as high in the early ’90s. The market cap to GDP was only about 59%.

In contrast to the minor events of the early ’90s and early 2000s, the 2008 recession was the most severe recession since World War II. The market was frothy, but it wasn’t quite at 2000 bubble levels. We suffered a 50% drawdown. The 2008 drawdown happened because of the severity of what was happening in the real economy. It was not entirely a response to overvaluation in the stock market, which is what happened in the early 2000s.

I think that if we had the 2008 recession at 2000 valuations, then the early 2000s meltdown would have been much more severe. We likely would have gone into a 60% or 80% drawdown, rivaling the Great Depression. We lucked out in the early 2000s by having a relatively minor recession.

This year we crossed an important milestone. The market cap to GDP exceeded the previous bubble in 2000. In 2000, we peaked at 146% of GDP. The market currently trades at 153% of GDP.

The same is true on a price/sales basis. The market is the most expensive it has been in history. The S&P 500 currently trades at 235% of sales. At the peak of the 2000 bubble, we were at 180%.

Another great metric is the average investor allocation to equities. Currently, that’s not quite at 2000 levels, but it’s still pretty high. Keep in mind that this chart ends in Q3. It’s probably higher now, probably around 44%.

Using the equation I described in an earlier blog post, the current investor allocation to equities suggests a 2.3% real return for US Stocks over the next decade. If history is any guide, that’s a 2.3% real return that will probably have a 50% drawdown somewhere in there.

For US stocks, the 2020s is not going be anything like the 2010s.

average

Earnings-based metrics look a little better. The TTM P/E is about 24. The CAPE ratio is 31.

Of course, the problem with earnings-based metrics for macro valuations is that they are based on a cycle where profit margins have been exceptionally high. Margins are likely to mean revert. Margins have also been boosted by leverage. Forward P/E’s don’t look insane, but forward P/E’s are a notoriously unreliable indicator.

margins

Profit margins have remained high over the last decade. Bulls will say that this is a new era. I think that this is likely to return to historical norms.

There are plenty of people who say, “this is a bubble, but it’s not as bad as the late ’90s.” They usually cite the fact that this bubble hasn’t included a bunch of money-losing dot com IPO’s. To which I say: so what? We’ve had similar insanity in initial coin offerings and money-losing venture capital moonshots. Last time we had Pets.com. This time, we have WeWork, Theranos, and fake electronic currency. No bubble is exactly the same, but they’re all bubbles and they all end in tears.

What Does This Mean for Value?

In the early 2000s, value stocks did well, while the broader market went down. If we’re lucky, the same will happen again.

Unfortunately, we probably are not that lucky. Once the broader market goes down, value stocks usually go down with it. The outperformance often happens in the early stages of an economic recovery. It’s also possible that value stocks will decline by less than the broader market.

I think value investors are in store for a significant drawdown, just like index investors likely are. We’ll just have to wait and see.

I’m preparing for this situation by holding onto cash when I can’t find bargains, rather than making an outright bet that we’re going to have a recession by going short or buying a massive amount of long-term treasury bond ETF’s.

Earlier this year, I purchased CDs that matured in December and yielded 2% on average. When they all matured this month, the market was even pricier than it was before that, which was disappointing.

Cash is King

Fortunately, a positive development occurred before my bank CD’s matured in December. My broker eliminated commissions.

The elimination of commissions made cash equivalent short term bond ETF’s more appealing to me. Before commissions were eliminated, it seemed foolish to buy a cash ETF for a commission, and then gradually exit the position and pay a new commission each time. That was almost certain to eat into even the paltry interest that I was receiving.

The commissions would eat into any interest I earned on the cash. With the elimination of these commissions, cash ETF’s are now a viable option for me. The removal of commissions is why I purchased NEAR, a cash ETF from iShares, with a TTM yield of 2.6%.

Currently, I am 20% cash. My approach to this environment is simple: I’ll buy cheap stocks when I find them and I’ll hold cash when I can’t. Hopefully, I’ll still get solid exposure to the value factor and limit my drawdown in the next recession.

Random

In 2019, I wrote some blog posts that I am pleased with, including:

Here is some random ’80s:

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.

RMR Group (RMR)

winter

Key Statistics

Enterprise Value = $634.49 million

Operating Income = $205.54 million

EV/Operating Income = 3.08x

Earnings Yield = 10%

Price/Revenue = 1.04x

Debt/Equity = 0%

Free Cash Flow/EV = 27%

The Company

RMR Group is a property management company. They manage properties for REIT’s and and other real estate companies. They have been operating since 1986 (under a different name – REIT Management & Research) and manage properties in 48 states throughout the continental US.

Four of RMR’s REIT clients are: Industrial Logistics Property Trust (ILPT), Office Properties Income Trust (OPI), Senior Housing Property Trust (SNH), and Service Properties Trust (SVC). ILPT manages industrial & logistics properties, SNH manages elder care facilities (a growth industry based on US demographic makeup), SVC manages hotels.

Other clients include Travel Centers of America, a company with $6 billion in revenue operating truck stops throughout the United States. Five Star Senior Living is another client which operates elder care facilities.

My Take

The nice thing about all of RMR’s clients is that they are unlikely to be disrupted. The elder population is growing in the United States and they are all going to need medical care and housing, no matter what happens to the US economy. Truck stops and industrial parks might decline with an economic downturn, but they aren’t going away. Office properties are probably the most prone to disruption with the expansion of remote work, but that’s not going away entirely.

Not only are RMR’s clients unlikely to be disrupted, but RMR has *20-year contracts* in place to manage them. I believe a 20 year contract can be categorized as a moat. The key base management fee that they earn is .5%, which is based on market cap plus the value of the real estate. On top of that, RMR earns an incentive fee which is tied to the 3-year stock performance of the companies that it services. The management fee is steady and isn’t going anywhere. Meanwhile, when the stocks of the underlying REITs outperform, RMR earns an incentive fee on top of that.

Quantitatively, this is as good as it gets and it checks all of my boxes. It’s selling at an EV multiple of 3x, a 27% free cash flow yield, and at annual sales. The operating cash flow is $198 million, which compares favorably to the enterprise value of $635 million.

They post high returns on capital. The return on equity is 28%, and that appears to be sustainable based on the consistency of the management fees.

The balance sheet is in impeccable shape. Out of the current $46 price, $22.20 is cash. They have zero long term debt. The Altman Z-Score is 6.4, which implies a zero chance of bankruptcy.

The base case is that RMR itself has 20-year contracts in place with their key clients and they will continue to earn the base management fee. The potential upside is that the stocks of the managed companies wind up outperforming. In this situation, RMR earns more incentive fees.

The stock is currently cheap due to concerns about the REITs that it manages. The REITs have a lot of debt. OPI has a debt/equity ratio of 164%, SNH is 127%, SVC is 180%, ILPT is 97%. A few of these companies lost money in the last year and the stocks underperformed. Leverage isn’t uncommon in the REIT industry and cash flows are fairly predictable, so I am not overly concerned.Meanwhile, much of RMR’s earnings are tied up in the performance of these stocks. When those stocks underperform, it weighs down RMR with it.

Something else that probably weighs down the stock is the control of a single individual, Adam Portnoy, who controls a majority of the company’s voting stock. Not only does Adam Portnoy have total control over the company, he also serves as managing director and CEO. Investors can look at this in two ways: you have an owner-operator committed to increasing the stock price as much as possible, or you have an owner-operator who has more power than shareholders. The concerns likely weigh on the stock.

RMR has only been trading since 2015, but it is at a discount to its history and its competitors. It is currently the cheapest it has ever been. As recently as 2018, the stock traded at 3.5x sales and it currently trades at 1x sales.

Overall, this looks to me like a compelling bargain with a predictable business. The potential upside far outweighs the downside, which I think is further limited by the company’s strong balance sheet.

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.