Category Archives: Macro

Is the Bubble About to Burst?

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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

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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.

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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?

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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.

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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

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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.

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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

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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.