Category Archives: Macro

A financial health check up for the S&P 500

medical

Debt: The Best Measure of Risk

One of my core beliefs as an investor is that debt is the best measure of risk.

Academic attempts to define risk as the volatility of a stock price are ridiculous. Risk is the possibility of a permanent loss of capital. The risk that a company will go out of business is heightened through the use of leverage.

There is no perfect measure of risk, but I think that debt levels give the clearest signals about the risk of an investment. A company without debt can withstand incredible business problems, while a company in deep debt won’t be able to survive the slightest shake-up.

Debt levels are one of my chief concerns when I purchase a stock.

As a deep value investor, I focus on firms that are going through a tough time in their business or sector. Because they are going through difficulty, it is paramount that balance sheet risk is low. If they have a healthy balance sheet, then they will be able to survive whatever trouble they are mired in.

I try to find the firms that are still profitable and are still in a strong financial position so they can survive the temporary business setback.

Corporate debt at all-time highs!

Due to my views on the subject, I was alarmed when I read several articles indicating that debt is rising to all-time highs within the S&P 500. High leverage levels were one of the driving forces behind the crisis of 2008.

The narrative of the corporate debt scare articles goes like this: (1) the Fed made debt too cheap after the crisis, (2) companies are taking advantage of it and spending it on frivolous activities like buying back shares, (3) corporate debt is now at all-time highs and will trigger a severe credit contraction in the future.

The headlines are usually along the lines of “corporate debt is at all-time highs!”

Well . . . based on inflation alone, corporate debt should regularly hit all-time highs in raw dollar terms. Looking at the total dollar volume of debt issuance doesn’t make a lot of sense.

The Real Story

What, then, is the best way to measure the debt risks to corporate America? Many like interest coverage ratios . . . but I don’t like this, as interest rates can change on a dime for the better or the worse. I look at total debt relative to earnings and assets.

When I assembled the data, I was pleasantly surprised to see that the situation is actually not that bad. Corporate America is financially healthy. Despite record low interest rates, corporate America hasn’t gone on a debt binge. Quite the opposite. They have been deleveraging since the crisis.

debtebitda

debtequity

This suggests that if we do fall into a recession, it won’t be the painful credit crunch we endured in 2008. Even though interest rates are at historic lows, corporate America is not taking the bait.

This also explains why the Fed has been able to keep interest rates near all-time lows. Few companies are actually taking advantage of the low rates.

Financial journalism is in the business of creating sensational click-bait headlines. They aren’t particularly useful. This is why individual investors need to do their own homework and think independently.

I think low corporate debt is also is a major reason that the economy isn’t growing more than 2% even though interest rates are rock bottom.

While it means less growth for the economy, it also means less risk for corporate America. That’s a good thing.

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.

Macro is hard and probably a waste of time

psychics-1026092_960_720

Macro is probably a waste of time, but I can’t help myself

Everywhere I turn in discussions of the stock market, everyone seems to have made a similar conclusion: (1) The stock market is in a bubble, (2) the Federal Reserve created the bubble, (3) When the bubble bursts, we will be faced with financial Armageddon.

The mood among value investors looking at a historically high CAPE ratio is something like this:

I love talking and thinking about Macro, but I suspect it is mostly a fun waste of time and not entirely useful. Peter Lynch offered the following advice about these matters:

Far more money has been lost by investors preparing for corrections or trying to anticipate corrections than has been lost in the corrections themselves.

Nobody can predict interest rates, the future direction of the economy, or the stock market.  Dismiss all such forecasts and concentrate on what’s actually happening to the companies in which you’ve invested.

I think living through 2008 might have polluted everyone’s minds, the same way 1929 poisoned the minds of a generation of investors and made them stay out of the market for life to their own detriment.

Unlike the 2000-02 meltdown, in 2008 there was nowhere to hide. This is because the 2000 collapse was driven by an overvalued stock market falling apart. 2008 was different because it was an economy-wide credit contraction that caused everything to decline.

This left investors with a kind of financial PTSD. As for myself, I had hardly any money at the time, so I wasn’t concerned about my financial assets going down, but I was still consumed by fear.

By day I am an operations nerd for a bank, so I was acutely aware of what was going on. I had very little savings (I was in my mid-20’s and had just started making decent money), a pile of debt and I was mostly worried about basic survival if I lost my job and faced a Depression job market. My main personal lesson from the crisis was about the dangers of being in too much debt and not having sufficient savings. Today I have zero debt and an emergency fund if I lose my job. I sleep better at night.

If anything, this is why the simple low-PE low-debt Graham strategy intuitively appeals to me. Financial problems facing a company or a person are always manageable . . . Unless you’re in heavy debt.

Post-crisis, everyone is consumed with trying to predict the next meltdown after getting burned so badly.

We look at investors who made the right call — people like John Paulson — and are in awe that they made the right call. They knew what was going to happen. We want to be able to predict what is going to happen. We become obsessed with finding tools that will help us prevent losing money.

Post-crisis hindsight also puts the permanent bears in a positive light. They are lauded for getting it right in 2008, but how much money has been lost listening to them since then?

Prediction is Hard

As small investors, I think we may have to just accept the fact that if we want equity-sized returns, we need to take equity-sized risks. A 25% drawdown a couple times a decade is pretty standard. A 50%+ drawdown 3 or 4 times a century is also typical. The average person lives about 80 years, so when they see these events happen a couple of times it looks extraordinary in the context of our lives and permanently affects our thinking. In the grand scheme of things, these events are not uncommon and we should expect them.

Charlie Munger gave this great advice about the subject:

This is the third time Warren and I have seen our holdings in Berkshire Hathway go down, top tick to bottom tick, by 50%.  I think it’s in the nature of long-term shareholding of the normal vicissitudes, of worldly outcomes, of markets that the long-term holder has his quoted value of his stocks go down by say 50%.  In fact, you can argue that if you’re not willing to react with equanimity to a market price decline of 50% two or three times a century you’re not fit to be a common shareholder and you deserve the mediocre result you’re going to get compared to the people who do have the temperament, who can be more philosophical about these market fluctuations.

We can’t invest like 1929 or 2008 are going to occur tomorrow. It’s not a useful long-term strategy for building wealth. We need to accept the fact that we will face those kinds of drawdowns and face the fact that there will be more minor drawdowns frequently (or the 20-25% variety) and don’t give into our emotional need to panic. If we constantly live in fear that a big drawdown is imminent, then we should stay out of the market and won’t earn equity sized returns.

Using valuation tools to time to the market

There are tools to predict future market returns (like the CAPE ratio, the average equity allocation, market-cap-to-GDP, etc.) that give us clues as to where we stand in the cycle, but timing the market using those tools isn’t particularly effective either. I’ve talked about them on this blog.

You can use these tools to predict market returns 10 years out, but it doesn’t tell you if a correction is going to happen tomorrow and they are not particularly useful for timing the market.

The 10-year S&P returns predicted by valuation tools don’t happen in a straight line. My favorite indicator (the average equity allocation), suggests a 10-year rate of return for the S&P 500 of 3.34%. With the 10-year treasury yielding only 2.361%, that actually makes sense. We are likely in store for a decade of low returns across all asset classes. “Low returns over 10 years” does not mean “We are facing Old Testament biblical meltdown.”

(Hell, if we were facing an Old Testament Mad Max kind of situation, what good is your 401(k) going to do you anyway?)

You can use market valuation tools to get a fair understanding of what returns will look like, but it is not a crystal ball. It doesn’t predict if a crash will happen tomorrow or what the road to those returns will look like.

Current valuations are basically where we were around 1973 and 1998. The 10 years after ’73 and ’98 were not particularly good for the indexes . . .  but they were great for value investors, the indexes still delivered a small return, and the world didn’t end. Value stocks had an excellent bull market from 2000-2003 and 1975-1978.

The difference between the two eras is that in 1973-74, value stocks went down with everything else before their bull market in 1975 and in 2000-03 value experienced a bull market during the decline of everything else.

This happened because the 1973-74 event was caused by a real economic shock, while the 2000-03 meltdown was the stock market coming back down from crazy valuations. The 2000-03 collapse was unique in that the market caused the economy to contract, while most meltdowns (like ’73-’74 and ’07-’09) are the economy causing the market to contract. The stock market wasn’t overvalued in 2008, the real estate market was. The decline in real estate caused the economic contraction, which ultimately impacted stocks.

Whether the current situation is like the ’70s or the early 2000s is tough to predict. I suspect that it will be more like the ’70s (value will go down in the bear market with everything else, but then perform nicely). Hopefully I’m wrong and it pans out more like the 2000-03 event. This is discussed in depth in this blog post.

It’s also tempting to short stocks in this environment, but that’s not something I do. You shouldn’t do it, either (unless your name is David Einhorn). Shorting is a dangerous game. For instance, tech shorts in 1999 were correct in their analysis. Even though they were right, most were completely wiped out when tech stocks doubled in 1999. They were ultimately vindicated but, as Keynes warned us, markets can stay irrational longer than you can remain solvent.

It’s tempting to try to time the market with macro valuation tools. I found a great post at Tobias Carlisle’s blog exploring this issue of timing the market using CAPE ratios. You can read the post here and here.  The conclusion is simple: timing the market using valuation tools is a waste of time. He makes the following point:

The Shiller PE is not a particularly useful timing mechanism. This is because valuation is not good at timing the market (really, nothing works–timing the market is a fool’s or genius’s game). Carrying cash does serve to reduce drawdowns.

Japan

Japan in the 1980s is the common comparison among bears to today’s market. There was a similar sentiment among bears in the late ’90s.

In the 1980s, the success of Japanese firms combined with an easy monetary policy caused a massive asset bubble. There was a widespread perception that Japan was going to take over the world.

Easy monetary policy and rising asset prices are where the comparison ends, however. Valuations in late 1980s Japan were genuinely insane. In 1989, the real estate around Japan’s imperial palace was worth more than all the real estate in the entire state of California.

During the 1980s, the Nikkei rose from around 6,600 in 1980 to 38,000 by 1989. Everyone thought that Japan had figured it out: their management was superior, their workers were better, their processes were more efficient. The zeitgeist was captured in the Ron Howard movie “Gung Ho.”

Like all bubbles, the Japanese bubble collapsed. The Nikkei fell from its high of 38,000 in 1989 to 9,000 in 2003. This is the nightmare scenario that the bears fear will happen to the United States stock market.

Valuation puts this in context. Today’s investors fret of a Shiller PE around 30. In Japan circa 1989, the Shiller PE was three times that at 90. Indeed, there is no comparison between US stocks today and Japanese stocks in the 1980s. Valuations today suggest bad returns in the future for US stocks. Valuations in Japan indicated that a complete collapse was inevitable.

Lost from the typical talk of Japan’s lost decade is a discussion of its actual economy. The focus is solely on the markets. Japan’s economy continued to chug along despite the complete meltdown in markets. Its central bank scrambled to contain the collapse, but likely merely prolonged the pain as the market was destined to return to a normal CAPE. Their unemployment rate has never even gone above 6% during the meltdown!

It took nearly 20 years for Japan to go from a Shiller PE of 90 to a more normal Shiller PE of 15. Markets are worth what they’re worth and they will eventually fall to normal levels of valuation. That’s what happened in Japan. Very little changed in their real economy, it just took a long time to work off their crazy 1989 valuations.

Value in Japan

Even if the US is in a Japanese style asset bubble (even though it is nowhere near those levels), I was curious how a value strategy performed in Japan during their asset meltdown if this were the future for the United States.

It’s encouraging that value-oriented strategies actually performed very well during the Japanese market collapse. In James Montier’s epic The Little Note That Beats the Markethe observed that Joel Greenblatt’s magic formula returned 18.1% from 1993 to 2005 in Japan. EBIT/EV alone returned an excellent 14.5%.

This suggests that as long as you stick to a value framework, even in a market that is in long-term decline, a value strategy should hold up over a long stretch of time.

Conclusions

My apologies if this post is a bit of a mess, but it summarizes many of the things that have been on my mind lately.  To summarize my conclusions:

  • It is probably best for most investors to not obsess over macroeconomics. The smartest people in the world are playing that game . . . and they’re bad at it. We cannot do any better.
  • Market valuation tools are useful for predicting returns over the next decade but aren’t particularly helpful in predicting short-term market moves.
  • The United States is not in a Fed-induced, Japanese-style asset bubble. Our market is high, but a definite return is still likely over the next 10 years.
  • Even if we were in a Japanese style asset bubble (which we’re not), a disciplined value-oriented strategy should still perform very well in the United States.
  • 50% drawdowns 3-4 times a century and 25% corrections are standard. They’re the cost of earning equity returns. If equities went up by their historical 8% average every year in a straight line, they would eventually stop delivering those returns. If you can’t handle corrections of that magnitude, you shouldn’t invest in stocks.

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.

 

 

Going Global with Value Investing

global

Holding Cash in a Euphoric Market

I have a problem. 26% of my portfolio is in cash. I hate cash. It earns nothing. My preference is to be fully invested at all times. I prefer not to try to time the market.

But . . . I am frightened by the valuations present in the U.S. market right now. I don’t believe in market timing, but with a Shiller CAPE around 30, average equity allocation at 42% (probably higher now), and market cap to GDP at 132% . . . it definitely feels like the market is primed for a fall. Usually, value stocks tumble with everything else (except for the early 2000s).

This conflicts with my belief that investors shouldn’t time the market. If you own cheap stocks, it shouldn’t matter what the general market is doing, they will eventually realize their intrinsic value. The CAPE ratio or any valuation metric for that matter isn’t entirely predictive. Just because stocks are expensive now doesn’t mean that the market is necessarily going to crash. Valuations may even be justified if interest rates stay low. That seems like wishful thinking, but we’ve gone through long stretches before where interest rates stay very low (as they did in the 1930s and 1940s). You just don’t know. No one has a crystal ball.

Whether it is stocks or companies, all that you can do is put the probabilities in your favor.  Expensive stocks and markets can get more expensive. Cheap stocks and markets can go down. As a group, though, this is unlikely. Buying cheap stacks the odds in your favor.

International Net-Net Investing

The prudent course seems to me to expand outside of the United States for diversification. It is also a way to make sure I am not overly correlated with the US market. The most tempting way to do this is to buy net-nets in foreign countries.

Net-net investing involves buying companies at sub-liquidation values. In the most basic form, you take all current assets and subtract all liabilities to arrive at the net current asset value (NCAV). No value is given to long term assets like plant, property, and equipment which might be more difficult to sell. Graham advocated buying a net-net at 2/3 of the NCAV value and then selling when it reaches full value (thus securing a 50% gain). Graham remarked about net-nets: “I consider it a foolproof method of systematic investment . . . not on the basis of individual results but in terms of the expectable group outcome.”

Studies show that net-net investing is the best way to earn the highest returns. Buffett’s best returns were when he was investing in net-nets in the 1950s and 1960s. Joel Greenblatt created his original “magic formula” with a net-net strategy in 1981. He devised a strategy of buying net-nets with low P/E’s and demonstrated that you could earn 40% returns.  The period he studied was after the market crash of 1973-74. Those net-net opportunities were eliminated during the bull market of the 1980s and 1990s, which is why he didn’t stick to that strategy. Net-net investing is also hard for professionals investing a lot of money, as the stocks usually have extremely low market caps. It’s only something individuals like me can pursue who are dealing with relatively small sums of money.

Those net-net opportunities were eliminated during the bull market of the 1980s and 1990s, which is why he didn’t stick to that strategy. Net-net investing is also hard for professionals investing a lot of money (i.e., over $10 million or so), as the stocks usually have extremely low market caps. It’s only something that individuals like me can pursue who are dealing with relatively small sums of money.

The strategy I pursue during frothy bull markets is Graham’s low P/E strategy that he devised in the 1970s. Graham demonstrated that this strategy delivers 15% rates of return over the long run. 15% returns are incredible but not nearly as exciting as what you can make investing in net-nets which amp up returns to the 20% level. I look at other value factors (price to sales, EBIT-Enterprise Value, relative valuation), but I try to stick to Graham’s rules (low debt to equity ratio and an earnings yield that doubles corporate bond yields).

While Graham’s P/E strategy is my base during bull markets, I look at other value factors (price to sales, EBIT-Enterprise Value, relative valuation). I like to see multiple signals that a stock is cheap but I try to stick to Graham’s rules (low debt to equity ratio and an earnings yield that doubles corporate bond yields).

I would much rather invest in net-nets than the low P/E strategy, as the returns are better, it is easier to calculate intrinsic value, and it is easier to determine the appropriate selling point (you sell when the stock hits the net current asset value). Unfortunately, in the United States, there aren’t enough net-nets available to make it viable. Net-net returns are higher than any other strategy, but a net-net is also more likely to go bankrupt than a normal company, so diversification is paramount. When Graham bought net-nets for his partnership, he would buy them in bulk. I read once that he would own nearly 100 net-nets at any given time.

We live in a different world. To put it in perspective, there are about 9 net-nets in the United States right now. Of these 9 choices, they aren’t of the best quality and most of them can only be bought on OTC exchanges.

Net-nets become available in bulk in the United States during market meltdowns like 2008 and 2009. There were also a lot of them in the early 2000s during the tech crash. During both periods, net-nets performed exceptionally well.

There are quality net-nets available internationally, but the problem I have with buying them is that I don’t trust my ability to read foreign financial statements or research companies. I can’t go into Edgar and read an annual report for a Korean net-net, for instance.

I don’t even know where I can run reliable screens to hone in on the right opportunities. Unforeseen tax consequences would also plague me by investing in individual foreign stocks. While I wouldn’t owe US taxes because this is an IRA account, I would still owe taxes in the foreign countries on any gains. For those reasons, I am not keen on buying individual stocks outside of the United States.

Another reason I prefer buying individual companies in the United States is the SEC. I’m happy that the SEC is active in the US market. The SEC misses quite a bit, but it’s still better than what exists internationally.

For all of these reasons, I don’t want to buy international net-nets even though I think the returns are probably substantial and it would allow me to diversify outside of the frothy United States market.

I will shift to net-nets when they are available in bulk quantities (as they were in 2008 and 2009) during the next market meltdown and I can buy at least 10 quality choices. Unfortunately, that’s not an option in the current market.

A Possible International Solution

Thinking about the issue, I thought of something I once heard of listening to a Meb Faber speech from 2014 at Google. He discussed a really interesting idea: applying Robert Shiller’s CAPE ratio internationally.

Meb Faber has done a great research (available on his website) about this topic. He has empirically demonstrated that countries with a low CAPE tend to deliver higher returns (as a group) compared to those markets with higher valuations. Just like individual companies with low valuation metrics, this occurs as a group and it’s not an iron clad rule of prediction.

The CAPE ratio isn’t the best valuation metric for a market, but it’s good enough and it’s readily available for most markets.

This brings me to a possible solution: buying international indexes via ETFs for countries posting low CAPE ratios. This would allow me to avoid the tax consequences of international investing in individual stocks, remain consistent with a value approach, and provide adequate diversification. I will also be able to lower my correlation with the US market in a manner consistent with a value template.

I found a decent list of countries by CAPE ratio. The cheapest market in the world right now is Russia. The reasons for Russia’s low valuation is obvious. Oil has been crushed in recent years and Russia’s economy is very oil dependent. They are also under international heat and sanctions. For these reasons, Russia has a CAPE ratio of 4.93. Russia is hated by international investors. Of course, that is music to my ears: the best investments are the ones that everyone hates.

If it’s not behaviorally difficult to buy, it’s not really a bargain.

To give some perspective on how low Russia’s CAPE ratio is — there were only a handful of times that the US has a CAPE ratio that low — the early 1920s, the early 1930s, World War II, the early 1950s, the early 1980s. All of these were exceptional times to buy stocks. Even in March of 2009, the CAPE ratio for the US market only went down to 15.

In the early 1920s, early 1930s and the early 1980s – people hated stocks, which made them the best times to buy them.

Business Week ran a cover in 1979 called “the death of equities”. This was right before the greatest bull market in history from 1982-2000, which took the Dow from below 1,000 to over 10,000. The reason people hated stocks in the early 1930s is obvious. In the early 1920s, people in the United States hated stocks because the country suffered a severe but short Depression, which everyone forgets about because it is overshadowed by the Great one in the 1930s.

It’s true for individual companies and it’s true for entire markets: buy them when everyone hates them, sell them when everyone loves them.

Possible Investments

I haven’t decided if I’m willing to pull the trigger on this idea just yet, but I am curious to hear anyone’s thoughts.

I was considering putting 10% of my portfolio into two of the below ETFs:

iShares MSCI Brazil Index (Ticker: EWZ).  Brazil currently has a CAPE ratio of 10.4.

iShares MSCI Russia Capped ETF (Ticker: ERUS).  Russia currently has a CAPE ratio of 4.9.

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.

Is the Bubble About to Burst?

bubble

Q4 2016 Data

In an earlier post I referenced an excellent market valuation model that I found at the Philosophical Economics blog. To sum it up: the model projects the next 10 years of market returns by using the average investor allocation to equities. The theory is that most bull markets are fueled by rising valuations as investors move money from other asset classes into stocks. The model tells you how much “fuel” is out there to push equities higher.

The Q4 2016 number recently became available over at Fred. The current average equity allocation at the end of the year was 41.279%. Let’s plug this into the equation I referenced in my earlier blog post on this topic:

Expected 10 year rate of return = (-.8 * Average Equity Allocation)+37.5

(-.8 * 41.279) + 37.5 = 4.48%

We can therefore expect the market to deliver a 4.48% rate of return over the next ten years. Not particularly exciting, but not the end of the world either.

Market Timing

Most hedge fund letters this year emphasized how market valuations are at historic highs and take a cautionary approach to stocks. I agree with their spirit because I think everyone should always approach the market with caution. If someone cannot handle losing half of their money, then they have no business in the stock market. A drop of that magnitude can happen at any time no matter where valuations stand. That short-term risk is the very reason that stocks outperform other asset classes over the long-term.

If I were an alarmist, I would agree with some of the hedge fund letters and say: “The market hasn’t traded at these valuations since 2007! Get to the chopper!” This implies that we are on the brink of another historic meltdown in stocks. This is the prognostication that is often heard about stocks today. I think it is misleading.

Valuation simply predicts the magnitude of future returns over the long run. Higher valuations mean lower returns and lower valuations mean higher returns. That’s it. It does not predict what the market will do over the next 12 months. It does not mean that if you wait long enough, you’ll have an opportunity to buy when valuations are at more attractive levels. Anything can happen in the next year. There could be an oil embargo. A war could break out. Terrorists could strike. Our politicians could cause another crazy showdown that imperils the economy. Trump-o-nomics might actually work. Maybe it won’t. No one really knows and anyone who proclaims otherwise is lying.

It is tempting to look at market valuations as a tool to time the market. Wouldn’t it be great to sell in 2007 and buy in 2009? Get in when the market is depressed and get out when valuations rise and the market looks like it is due for a correction? My view is that market valuations should not be used as a market timing tool. When it comes to timing the market, I think Peter Lynch put it best when he said:

“Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.” – Peter Lynch

This is great advice. Today’s market valuations may be at 2007 levels — but they were also around these levels in 2004 (S&P 500 up 8.99%), 1968 (up 7.32%), 1997 (up 25.72%) or 1963 (up 17.51%). It makes little sense to try to time the market based on valuation or refuse to participate simply because the market isn’t offering the kind of compelling bargains that it presented in 2009. The question is: is this 2007 or 1997?

Stopped clocks are always right twice a day. This is how I feel about the permanent bears. They certainly called it in 2008, but did they call the turnaround? How many of them have been predicting disaster for the last decade and have been proven wrong year after year? There is bound to be another meltdown at some point in the future, but there is no way to predict when that will happen. The wait can be long. While you wait, more money can be lost through unrealized gains than is lost in the actual correction. 2017 may be the year for a major market meltdown of and the end of the bull market. Perhaps. Taking the advice of the permanent bears will help you avoid it, but how much more money was lost listening to their advice since 2009? It doesn’t make sense to refuse to participate in the market simply because the market isn’t offering compelling valuations.

Valuation in a Vacuum

Stock market valuation doesn’t occur in a vacuum. One should always compare the expected returns in stocks against the expected returns in other asset classes. My view is that the best asset to compare stocks to is AAA corporate bonds. The way to think about stocks is as corporate bonds with variable yields. The question isn’t “is the market overvalued?” The question is “Do current earnings yields justify the risk of owning stocks when compared to the returns on safer asset classes?”

This is why interest rates drive the stock market.

“Interest rates act on asset values like gravity acts on physical matter.” – Warren Buffett

Below is a historical perspective of market valuation compared to the interest rates on corporate bonds. The expected 10 year S&P 500 return is derived from the equation described earlier in this post.

Year Expected 10 Year S&P 500 Return AAA Corporate Bond Yield Equity Risk Premium
2017 4.48% 3.05% 1.43%
2012 9.38% 3.85% 5.53%
2007 5.06% 5.33% -0.27%
2002 4.33% 6.55% -2.22%
1997 7.86% 7.42% 0.44%
1992 14.43% 8.20% 6.23%
1987 14.37% 8.36% 6.01%
1982 19.24% 14.23% 5.01%
1977 15.03% 7.96% 7.07%
1972 5.22% 7.19% -1.97%
1967 4.41% 5.20% -0.79%
1962 5.66% 4.42% 1.24%
1957 9.81% 3.77% 6.04%
AVERAGE 2.60%

Historical

As you can see, there are times when the market adequately compensates investors for the risk of owning stocks and there are times when it does not. It is also evident that there is a strong correlation between interest rates and future market returns. Higher interest rates mean that stocks need to deliver higher earnings yields, something that is usually achieved by a market correction that depresses P/E ratios and boosts earnings yields.

From this perspective, the market isn’t wildly overvalued. The current market valuation is largely in line with historical norms based on where interest rates are today.

That is the right way to think about stocks. It is folly to think “valuations are too high, therefore I will not participate because a correction is imminent.” That is short-term prognostication and it is typically wrong. No one knows what will happen over the next year and market valuations won’t provide the answer.

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.

Your Politics and Your Portfolio Do Not Mix

election

Your Political Opinions are Emotional

Political opinions are powerful forces. Usually, they are more influenced by emotions and passion than they are by facts. The enemy of good investing is human emotion. Human emotion fueled the internet bubble. Human emotion drove people to buy homes they couldn’t afford (it’s the American dream!). Human emotion took the Nasdaq to 5,000 in 2000 and took the stock market to a 15 year low in the spring on 2009. Most investors underperform because of their emotions.  They pile into stocks when they are overvalued and exit when they are at their most appealing level. Winning at investing isn’t about smarts, it’s about mastery of your emotions. If the market were made up of people like Spock, then Mr. Market wouldn’t be able to act so crazy. Fortunately the market is made up of people who are the opposite.

Making the Wrong Call

The emotional impact of politics is one of the key reasons it should be excluded from investment decisions. Case in point: I am sympathetic to a small government perspective. After the election of Barack Obama and a completely Democratic congress in 2008 during a financial crisis while the Federal Reserve was increasing the money supply like Weimar Germany, it was tempting for people of my orientation to think that the country was about to turn into a hyperinflationary socialist state. At this time it was more tempting than ever to shout “sell” from the rooftops.

Selling in late 2008 would have been a terrible mistake. It is a mistake made by many right wingers who loaded up on gold as they prepared for financial Armageddon. Since 2009, the S&P 500 is up 155%.  Gold is only up about 15%.  In 2009, the immediate year after the collapse, the S&P rose 28%.

Let’s examine another scenario. Let’s say you were someone of a more liberal orientation when Ronald Reagan was elected is in 1980. Many of the leading (liberal) economists of the time predicted that Reagan’s policies would be a complete failure.  They predicted that his fiscal policies would stoke instead of quell inflation. The Reagan years saw a 144% increase in the S&P 500.

The bottom line is that while you may try to convince yourself that your politics are hard grounded in facts and are as immutable as the laws of nature, you simply can’t use your political beliefs as a useful metric to predict future market returns. Your politics are grounded in emotion and for that reason they shouldn’t guide your investment thinking.

Does it Even Matter Who the President Is?

Nor do I think politics even matter that much to the economy. The popular news creates the impression that politics is the only thing that influences the economy, but the truth is that it doesn’t really matter all that much. American businesses are going to try to sell more products and be more productive no matter who is President.

My guess is that if Al Gore won the 2000 election, Alan Greenspan would have still cut interest rates in the wake of the internet bubble, homeowners would have still levered up, and the housing collapse was inevitable. Similarly, was Bill Clinton responsible for the surpluses and prosperity of the late 1990s, or was it simply a surge of computer-driven productivity gains that would have happened anyway?  The President and their party receive the credit for booms and the punishment for busts in the public’s mind, but their actual real world influence is limited.

Also, the United States political system is set up to resist radical change.  That may be frustrating when the President can’t implement their desired mix of policies, but it is a good thing for the health of the economy.  The Constitution is designed to derail radical change and it works most of the time.

Productivity

The Federal Reserve plays a more important role than the President in the direction of the economy. The Fed’s influence is still limited, though.  The Fed can only influence the short-term gyrations of the economy and the inflation rate. They can’t impact the long-run trend of the economy because the long-run trend is driven by productivity. Despite the attempts of policy makers to influence productivity, I doubt that public policy can have any impact at all on productivity rates.

Productivity seems to be driven more by the forces of capitalism and the abilities of managers than it is by policy.  I doubt that laws can make a country more productive any more than a law can change the weight on my bathroom scale.  Productivity is the true driver of economic performance and it appears to be out of the hands of policy makers.  That’s probably a good thing.

capture

Source: United States Department of Labor.  Productivity does not seem to care who the President is.

Right now we’re in a productivity slump and everyone is losing their minds over it. I think this productivity slump is much like the slump that occurred in the 1970s: it’s temporary. Much like the boom in productivity from 1995 to 2005 was also temporary. Productivity appears to be stubbornly mean reverting. It has a tendency to revert to its 2% long term trend and there is little we can do to change it.

There was a belief in the late 1990s that information technology had permanently increased the productivity rate.  That’s what the “New Economy” talk and hyper optimistic federal government budget projections were driven by.  It wasn’t permanent and productivity is reverting to the mean.  Similarly, the worry now is that the productivity slump is a sign of permanent stagnation in the US economy.  That’s probably just as wrong as the 1990s optimism was.  At some point in the next 10 years when productivity starts surging due to mean reversion, we’ll hear that we are in a new economic era of higher productivity driven by artificial intelligence, social media, cloud computing, 3-D printers, etc.  Then it will revert to the mean and everyone will start wondering if we are in a permanent slump again.

There is very little that politicians do to change desire of individuals and businesses to earn more money, which is really the driving force behind productivity.

Ignore It

The lesson of history seems to be that the safest long term bet is to leave your politics at home when making investment decisions.  There is a human tendency to believe that if there are people you disagree with in power, then the world must be headed to hell in a handbasket.  If there are people that you agree with in power, then there is a tendency to believe that manna will begin to come down from the heavens.  It’s your emotions talking and emotions are the enemy of capital gains.

Besides, your political beliefs should be deeply held as a result of moral conviction.  They shouldn’t be formulated based on the impact that a policy will have on the S&P 500.  They’re for the voting booth, not your portfolio.

PLEASE NOTE: The information provided on this site is not financial advice and I am not a financial professional. I am an amateur and the purpose of this site is to simply monitor my successes and failures.  Full disclosure: my current holdings.

Bruce Greenwald on Globalization

This is a fascinating and thought provoking video with Bruce Greenwald on globalization and the future of the economy.

PLEASE NOTE: The information provided on this site is not financial advice and I am not a financial professional. I am an amateur and the purpose of this site is to simply monitor my successes and failures.

 

Are Markets Efficient?

1mg9bcfgo6

My high school interest in the stock market led me to major in Finance in college.  Hoping to learn juicy insights into beating the stock market, I was instead taught the efficient market hypothesis, or EMH.  The efficient market hypothesis states that markets are largely efficient at assessing risk and dishing out returns.  Over time, equities perform better than other asset classes because equities are riskier than other asset classes.  Returns are a compensation for risk.  Basically, business students pay a lot of money to learn that they don’t have a chance against an index fund.  Fortunately, I went to a state college for this advice.

Eugene Fama and Kenneth French, the architects of EMH, performed research which showed that value investing delivers higher rates of return but attributed this to the increased riskiness of value investing.  Value investors disagree and contend that their approach actually reduces risk because they demand a margin of safety from their investments.

I don’t have  PhD.  I don’t have a Nobel Prize. I’m just a working stiff with a blog and a brokerage account.  My analysis is lacking in sophisticated mathematical modeling, but I agree with the value crowd based on common sense.  Just look at the price ranges from the last year of a few large and stable American companies:

Apple: $118.69 to $89.47 – 24.62% difference

American Express: $75.74 to $50.27 – 33.63% difference

Caterpillar Inc: $56.36 to $97.40 – 43.47% difference

I find it difficult to believe that the underlying value of these business experienced such a wild fluctuation in the last calendar year.

One could also look to the entire market as a whole.  Look at the performance of the S&P 500 over the last 26 years:

1990 – 2000: Up 318.42%

2000-2003: Down 27.66%

2003-2007: Up 47.26%

2008-2010: Down 19.88%

2010-2016: Up 90.43%

Did the actual underlying economic output of the United States experience such wild swings over that time period, as the markets seemed to believe?

Here is the total economic output of the United States since 1990:

U.S. Bureau of Economic Analysis, Gross Domestic Product [GDP], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/GDP, December 31, 2016.

capture

It certainly doesn’t look like the actual economy of the United States experienced anywhere near the wild volatility that the United States markets experienced from 1990 to 2016.

I don’t believe that the markets are efficient.  It seems to me that Ben Graham’s characterization of Mr. Market, the crazy manic depressive shouting prices for businesses based on his mood, is closer to reality than the efficient market popularized by EMH.

I believe that astute investors can find mispriced stocks.  Fortunately, most of the investing community believes in EMH because this is what is written in Finance textbooks.  This a good thing.  The more people that believe that markets are efficient, the less competition there will be for value investors.

PLEASE NOTE: The information provided on this site is not financial advice and I am not a financial professional. I am an amateur and the purpose of this site is to simply monitor my successes and failures.

 

 

Projecting Market Returns

pexels-photo-127642

Market prognosticators frequently opine in the direction of the markets based on public policy, what Millennials are doing, whether Euro will do this and the Yen will do that, who won the Super Bowl, if it is an election year, etc.  They have no idea what they are talking about.

The more accurate forecast models take a hard look at value.

Shiller P/E

One method is the Shriller P/E.  It was designed by Yale economist Robert Shiller.

Looking at the market in terms of the current P/E can be misleading depending on where we are in the business cycle.  For instance, during a recession, earnings plummet and P/E ratios rise even though the market may be undervalued.   During a boom, earnings are temporarily inflated, which can cause the market to appear cheap when it may in fact be quite expensive.  Shiller accounted for this by comparing price to average earnings over the last 10 years, accounting for the impact of economic gyrations.

Gurufocus maintains a nice  tracker of the Shiller P/E here.

Market Capitalization as Percentage of GDP

A better method is looking at the market in terms of its value in relation to GDP.  Buffett popularized this method in a 1999 article in Fortune.  Buffett was able to use market valuation as a percent of GDP to assess market values.  He assessed the market correctly at the time and declared the market to be overvalued.

The methodology is easy to understand.  The market derives its value from earnings and US companies can only earn what the US economy can actually produce.

Gurufocus maintains a tracker for this metric here.

A Better Method

The GDP method is more accurate than the Shiller PE, but it is still an imprecise instrument.  For instance, the GDP model predicts a range of returns over the next 10 years of +4.6% to -8.2%.

Recently I came across a market valuation model that was even more compelling at the Philosophical Economics blog.  This model instead looks at the average equity allocation.  The idea is that during a bull market, valuations increase as investors move their money from other asset classes into stocks.  As the equity allocation increases, the market runs out of fuel for higher valuations and future returns are diminished.

The key reason this makes sense is the relationship between interest rates and returns.  As interest rates rise, it seems natural that investors would decrease their equity allocation and put more of their funds towards bonds.  If bonds are dishing out high rates of return for little risk, why take the risk of owning equities?  This is precisely what happened in the 1970s and early 1980s, when interest rates soared and equities were punished.  It also set the stage for an extraordinary period from 1982 to 2000, in which declining interest rates from historic highs fueled one of the greatest bull markets in history.

Interestingly, as Buffett pointed out in the earlier referenced 1999 article, earnings and economic growth were actually less in the 1980s and 1990s than they were in the 1960s and 1970s.  The only difference between the two periods is the direction of interest rates.

The model can actually be plugged into a simple equation:

Expected 10 year rate of return = (-.8 * Average Equity Allocation)+37.5

Looking at the most recent data, the current average equity allocation is 40%.  Plug this into the equation and we get the following result: (-.8 * 40) + 37.5 = 5.5% expected 10 year rate of return

The metric is tracked here and is updated quarterly.  If the equity allocation were to rise to 45%, that implies that the next ten years will deliver a paltry 1.5% return.  That would hardly seem sufficient compensation for the volatility risk in equities.

So What?

Generally I like to remain agnostic about the market and focus on bargain stocks.  However, my 401(k) plan is dedicated to index funds and I think it makes sense to look at market valuations.  An overvalued market combined with an overheating economy is certainly cause for concern and something investors should remain cognizant of.

tumblr_mztrt5j8jz1sfie3io1_1280

They heard that the average equity allocation went down in the most recent quarter

The model described in this post should reduce your fears when the market drops.  A market drop simply means that future returns are going to be higher.  Drops in the market are cause for celebration, as you can now buy stocks that will deliver a higher rate of return.  I would certainly buy more if the market were to plunge 50% tomorrow.  I’d also probably start scrounging whatever cash I had on hand and piling into the market.

PLEASE NOTE: The information provided on this site is not financial advice and I am not a financial professional. I am an amateur and the purpose of this site is to simply monitor my successes and failures.

Understanding the Economy

A few years ago, hedge fund manager Ray Dalio provided a very useful template for understanding the economy.  The video is above and I think it is incredibly useful as a template for understanding where we are in the economic cycle.  I encourage everyone to watch the video.  I think you will find it enlightening.

To sum up Ray’s thesis: debt drives the economic cycle.  Without debt, the economy can only grow as fast as productivity.  It is debt that drives booms and recessions.  Debt allows the economy to grow beyond the productivity rate, which hovers around 2% in the long run.  When debt levels become too high and begin to restrain cash flows, households and business restrict spending and this causes the economy to contract.

2008 and 2% Growth

The Dalio template explains what happened in 2008 and the aftermath.

In the short term (5-10 year) business cycle, borrowing increases.  As borrowing increases, cash flows because increasingly tightened.  When the cash flows tighten enough, a recession occurs.  The Federal Reserve responds by lowering borrowing costs, restoring borrowing and creating a new economic boom.  Throughout these booms and busts, debts continuously increase.  In 2008, we approached the end of a long term (80 year) debt cycle, in which debts became so high and interest rates were already so low that the conventional monetary tools no longer worked.  This was the beginning of a decade of deleveraging, in which businesses and households shied away from debt after such a tumultuous experience.  During such a time in which new debts cannot drive the economy, the best that the economy can do is grow at its productivity rate.

There has been a lot of head scratching in the last decade about why the economy can’t grow faster than 2%.  Dalio’s template explains it.  It has nothing to do with taxes, regulation, culture, etc. It is caused by the deleveraging. Without debt, the economy can’t grow faster than the productivity rate, which averages around 2%.

Deleveraging

capture

The data  supports the thesis that businesses and households are deleveraging.  The S&P 500 debt to equity ratio fell to its lowest level in 30 years.  Households went through a similar deleveraging process, as documented in the chart above.  Households now have the lowest debt payments as a percentage of disposable income that they have had since the early 1980s.  Incomes have increased, households cleaned up their debt levels and interest rates have died. Every business and every household that had a lot of debt in 2008 went through hell in the recession. The memory has not been lost. 0% interest rates and quantitative easing weren’t enough to spur borrowing, causing a lot of confusion among economists and policy makers. The cause ought to be obvious: no one wants to get burned again because the memories are fresh.

This has been bad for economic growth since the crisis, but I think it improves the long term prospects of the US economy.  Economist Hyman Minsky theorized that stability is destabilizing, because stable times encourage increasingly reckless lending and borrowing. We experienced this truth in 2008. If Minsky is right about stability, then the opposite must be true for instability. Instability is stabilizing.  Less debt means a lower likelihood of a 2008 economic shock. A more healthy attitude about debt and borrowing might prevent a wild economic boom, but the lack of such boom times also prevents catastrophic economic shocks.

We went through a similar experience in 1929, the last time we reached the end of a long term debt cycle. The difference between 1929 and 2008 was the response of the Federal Reserve. The Fed responded disastrously in 1929. The Fed turned an economic panic and recession triggered by a deleveraging into a Great Depression, as Milton Friedman proved. This time, it appears that in 2008 the Fed responded appropriately. That is why we have been able to go through a relatively tranquil deleveraging, in which debts decreased and the economy grew in a limited capacity at its productivity rate.

Turnings

I was fascinated by Dalio’s template of the long-term 80 year debt cycle because it matches perfectly with William Strauss and Neil Howe’s generational theory. The theory describes history in terms of 80-100 year cycles. The cycle of history also seems to match Dalio’s observations about the long-term debt cycle, in which debts continuously accumulate throughout the ups and downs of a long term cycle and then culminate in a period of deleveraging, lasting roughly a decade. Check out Strauss and Howe’s excellent book if you want to understand the debt cycle in a better historical context.

Strauss and Howe also discuss a high that follows a crisis (deleveraging). When the delveraging is over, a roughly 20 year period of financial tranquility follows. Yes, there are recessions and the normal stock market bull and bear markets, but nothing of the magnitude of a 1929 or 2008. Instability is stabilizing and everyone making the decisions has fresh memories of the deleveraging. This prevents corporate managers from acting like the reckless managers of the 1990s/2000s or the 1920s.

The last decade has usually been described as a slow growth period of malaise. I think this misses the mark. The seeds have been planted for a future sustainable economic boom because the paring down of debts and the memories of the crisis lowers the likelihood of an economic shock. The Fed’s actions – far from being reckless as is typically described – were exactly the monetary medicine that the economy needed. This was the medicine that Fed failed to deliver in the early 1930s. The deleveraging was inevitable in the 1930s, but we didn’t need to have a Depression. We could have had a period like the decade we just experienced.

So What?

How do I use this template to influence investment decisions?  Generally, I am agnostic when it comes to the macro economy. As long as I have a diversified portfolio of cheap stocks that are financially healthy, I should outperform the market over long stretches of time.  The market will rise over time as long as the economy continues to expand.  The slow and steady expansion of the economy is its natural impulse, as people are always looking for more productive ways to produce goods and services and the population will continuously expand.

With that said, I think it is important for investors to remain cognizant of our position in the debt cycle. For instance, if debt service ratios are approaching new highs, a recession is likely to happen soon. In that environment, it makes sense to steer clear of heavily leveraged firms or firms that are heavily cyclical. If debt levels are combined with high market valuations, avoidance of market indexes may be prudent.

I hope you find the Dalio template as insightful and useful as I do.

PLEASE NOTE: The information provided on this site is not financial advice and I am not a financial professional. I am an amateur and the purpose of this site is to simply monitor my successes and failures.