Category Archives: Macro

Thoughts on the 2020 Berkshire Meeting

Like most value people, I was glued to my TV on Saturday night to the Buffett meeting.

It was one of the best and the most candid Berkshire meetings I have ever watched. Becky Quick did a great job at filtering questions. The questions were all of high substance, without a lot of fluff. There was not an opportunity for people asking “questions” to give 15 minute speeches, for instance.

I also got a real kick out of Buffett’s black-and-white and all-text slide presentation. It’s a sharp departure from what most of us experience in our day jobs.

With a slide deck, how much attention do we pay to presentation? Does any of that style really add any value to the presentation? Probably not. Buffett is a guy who doesn’t care about that sort of thing. He always gets across his point as simply as possible. The rest of us – me included – tend to over-complicate it.

Anyway, Warren Buffett needs to tow a fine line when commenting on markets and the economy. His words can move markets. He was very careful with his words this year, expressing short term caution and long term optimism. He didn’t give an exceptionally candid call on markets.

The last two times Buffett was exceptionally candid about his views on the market were 1999 and 2008. Back in 1999, he gave a famous speech at Sun Valley in which he questioned investor’s expectations and was quite bearish. He called out the internet bubble and overall market extremes. In 2008 and 2009, he took a different point of view and was extremely bullish. In October of 2008, he wrote an opinion piece called “Buy American, I Am” in which he talked about how stocks were cheap and poised for a great future.

This year, Buffett didn’t outright express his bearishness, but I think it was buried in there. If Buffett were outright bearish, he could trigger a crash. I think he’s aware of this. His words expressed caution.

He noted that he hasn’t been buying stocks and sold out of one industry (airlines) completely.

His actions, as opposed to his words, speak volumes. He didn’t back up the truck like a lot of investors did in March. Through his comments about the wide range of probabilities with the virus, I think he was preparing everyone for the fact that the ugliness might not be over for the markets and the economy, which is a sharp contrast to the actual behavior of the markets, which seem to be predicting a swift return to normalcy.

He praised the Fed’s actions to contain the crisis and put Jerome Powell in the same place as Paul Volcker. I agree with him on this point. I think markets are expensive, but I also don’t think that the Fed should let the world burn so I can buy stocks below net current asset value.

With that said, even while praising Powell’s decisive action in ending the crisis, he did take note that today’s unprecedented actions will have long term consequences. I also agree with him there. We are in uncharted territory with monetary policy.

Of course, Buffett also spoke about America’s bright long term future. This was the focus of his initial presentation. Starting off with this speech was a careful move to put his short term caution into context. He expressed his long-term optimism in the future of the country and the prospects for our economy, despite his short term caution about markets and the economy.

Also, Warren talked about how Ben Graham was one of the three smartest people he had ever met. He didn’t mention the other two, but I suspect they are Bill Gates and Charlie Munger.

If you didn’t watch it, I’d recommend checking it out at the below link. Buffett starts in the video at 1:00:33 with his presentation about the long-term future of the country. The really good part – the Q&A – starts at 3:07:20.

I’ve never been to a Berkshire meeting before, but I definitely want to attend in the future.

 

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.

Stocks are Expensive, Volume 1,863

mountains

Every macro valuation metric available shows the same thing: markets are ludicrously expensive.  Stocks are as expensive as they were during the internet bubble.

Every bull has their argument against each macro metric.

One of the better arguments against these metrics is that most of the index is composed of mega tech companies like Amazon, Google, Netflix, and Facebook.

The compounder investors tell us that these companies are growing rapidly and accumulating the market share of smaller companies. As a result, they can grow faster and earn high margins, which justifies higher valuations.

More rational investors agree these stocks are ludicrously valued and will eventually mean revert, but also point out that there are other securities which command more respectable valuations. FANG is not the entire stock market.

For this reason, I took a look at 17 non-tech businesses to get a snapshot at how they have been valued over the last twenty years.

All of these companies are dividend aristocrats. The key criteria for a “dividend aristocrat” is that the company has been around for at least 25 years and has consecutively increased their dividends for the last 25 years.

Naturally, this provides a population of non-tech, high quality companies.

The metric I decided to focus on was EV/Sales.

Here are the 17 companies I looked at and their EV/Sales multiple at different points in time:

aristocrats

Most of these companies are on the expensive end of their history. Even Exxon (during an era of negative oil prices!) is more expensive than it was in 2008 and around the valuation in 2005!

Let’s take a look at the median EV/Sales for this group of stocks:

evsales

The group is 16% more expensive than it was in 2000.

If you thought that 2000 was a bubble, then how is this not a bubble?

They’re 65% higher than they were in 2008, which was the last generational buying opportunity. Most are more expensive than they were in 2016, which wasn’t exactly a cheap market.

It’s also worth noting that the economic outlook was a lot better in 2000, 2005, and 2016 than it is today. Hell, by some metrics, the current outlook is even worse than 2008.

It seems absurd to me that anyone thinks there is “blood in the streets” or that this is the beginning of a wonderful bull market. Bull markets begin from cheap valuations. These are the valuations from which bull markets peak.

It seems equally absurd to me that stocks should be priced like this during a global pandemic when unemployment is near 20%, the highest levels we have seen since the Great Depression.

These companies are all going to be adversely affected by double digit unemployment rates and they’re currently more expensive than they were during some of the best economies of my lifetime.

It’s all completely absurd.

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.

Market Update

dessert

The Market

The overall market continues to rally. I think ya’ll are crazy.

Let’s look at where we are today:

  • Market cap/GDP is 132%. This is near the 139% level at the peak of tech bubble in 2000. GDP is also likely to decline significantly this year, so this is likely even higher.
  • Price/sales is 2x. The median since 2001 is 1.48x. This also represents a 20-year period where stocks have been historically expensive. For the entire period from 2003-2017, the market traded below this price/sales ratio.
  • The Shiller PE is currently 26.81. Not quite at internet bubble extremes, but still crazy considering the contraction that is taking place in the real economy. This is where the Shiller PE was before the crash of 1929 and in 2007 before the market fell apart.

Price/sales and market cap/GDP are near internet bubble extremes. This is really crazy.

I remember 1999 and 2000. It was a pretty incredible boom. I remember that it wasn’t about whether or not you could get a job – it was about whether or not you wanted one. The economy was in incredibly awesome condition.

I would not describe the condition of today’s economy as “awesome”.

I expect markets to trade at these kind of valuations when the economy is red-hot and everything is going swimmingly. I don’t expect these kind of valuations during a global pandemic in which unemployment is surging to 20% and we’ve eliminated a decade of job creation in a few weeks.

It’s like we’re selling a house that’s on fire on yesterday’s estimate of value from Zillow.

I think of valuations in terms of expectations. It tells you what the market expects to happen. Right now, the market is predicting a very optimistic future. This likely assumes that stimulus will work and the economy will quickly re-open, with unemployment dropping to 5% or so in short order.

This strikes me as an unrealistic fantasy. An unrealistic fantasy like winning the lottery, or scientists inventing chocolate sundaes that don’t make me gain weight.

It would be one thing to bet on that fantasy if I were being paid for that fantasy with a cheap valuation, but that’s not the case.

The bull case is that reality doesn’t matter and we should buy stocks because the Fed is providing so much stimulus.

Counting on the Fed to prop up an expensive market with deteriorating fundamentals doesn’t strike me as investing. It strikes me as speculation.

Maybe I’m wrong. It wouldn’t be the first time. Most people certainly seem like they disagree with me.

I don’t see why I need to participate in what I think is absolute madness.

I’ll continue to seek out positions where the risk/reward makes sense to me and hold cash if I can’t find these opportunities. Maybe I’ll under-perform. I don’t really care. No one has a gun to my head and is forcing me to participate in what I think is absolute madness. I don’t have a mandate forcing me to be fully invested.

Value

Value investors are pumped.

Unfortunately, I think they’re like a starving man who is presented with a Snickers bar and thinks it’s an all-you-can-eat buffet. We have spent years out in the desert trying to find opportunities in a rich market where growth is rewarded at any price and value has been taken to the woodshed.

We’re jumping for joy at the first semblance of a bargain. I get it.

Of course, I’m talking about deep value investors. The value investors that succeeded in the last five years are those that quote Buffett’s 10x investment in Coke and 5x investment in See’s as a rationale to buy some SaaS company at a P/E of 200.

During economic calamities, we ought to be presented with a 2009-style opportunity. During a moment of total economic metldown the likes of which we haven’t seen in 100 years – we ought to have a 1974 style opportunity.

What we’re getting is a 2000-style opportunity.

I don’t think this is 2000. Value performed well in the early 2000’s because value was cheap and the economy wasn’t so bad. In the early 2000’s, unemployment peaked around 6%. The fact that the economy was doing alright caused value to chug along and deliver returns. Pricey stocks were annihilated because they were priced for the ’90s boom to last for 50 years.

Unemployment is likely to peak above 20%. I think that cyclical value stocks will continue to get killed in that kind of environment.

Random

Goldfrapp – Felt Mountain

 

 

 

The new Dune movie looks awesome.

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.

The value of the market, the value of value, and some soul searching

easter2020

Macro Valuations

I’ve written a lot about how the market is really expensive, no matter which way you slice it.

Meanwhile, we are facing a grim economic reality in which 6 million people are losing their jobs every week and cash flows are evaporating for American companies. Some estimate that unemployment will hit 20% (Great Depression levels) and GDP will take a massive hit, making the Great Recession look like a footnote.

Call me crazy, but I think valuations should be a lot lower in this environment.

My theory about market valuations is simple: the higher they are, the harder they fall.

Valuations don’t matter until we have a recession. When expensive markets run into a recession, they get annihilated. Because we can go for a decade without a recession, that’s a lot of time for valuations to run up to unsustainable levels. It’s also plenty of time for investors to get complacent and think valuations don’t matter. That was the prevailing attitude at the end of the ’90s and it has been the attitude recently.

The history of markets shows that markets move with earnings and cash flows over the long run and then exhibit speculative extremes in the multiples that investors are willing to pay for those earnings and cash flows.

Markets tend to extrapolate the present and assume current conditions will last forever and then get surprised when the environment shifts.

My goal (in my active account, anyway) is to take advantage of these sentiment shifts for individual stocks and the broader market. I want to buy from Mr. Market when he is depressed and sell to him when he is euphoric.

With market cap/GDP presently at 131%, macro valuations suggest that the market will deliver a negative return over the next decade. History suggests this negative return doesn’t happen in a straight line and that there will be a big bull market and a face-ripping bear somewhere in there. I think that the face-ripping bear is happening right now and we’re in the middle of it.

Right now, the markets are rallying because investors are realizing that the Fed won’t allow the system to collapse (I agree with this). They also think that the Fed they can engineer a quick and rapid recovery and pepper over rich valuations (I don’t agree agree with this).

Everyone seems to be getting very bulled up and cocky.

I think they are making a mistake.

It’s also possible that I’m making a mistake, so I decided to take a look at some additional data to figure out if that’s the case.

Value Investing Vs. The Market

Value purists would say that I shouldn’t pay attention to all of this nonsense.

They would argue that I’m not investing in the market. I’m investing in individual businesses. I’m not investing in the stock market, I’m investing in individual value stocks.

Unfortunately, it is impossible to assemble a group of 20-30 stocks that are not correlated with the market. Whether I like it or not, my stock portfolio is correlated with the market. The market matters.

To get around this and be less correlated with the market, I could concentrate in 5-8 of my “best ideas.”

I think this is a path that can cause permanent impairments of capital. A blow up in one or two positions can endanger the entire portfolio.

I’m also skeptical that I really have any “best ideas.” The best ideas of the best investors in history often blow up.

This is why diversification is the path I’ve chosen and I think 20-30 stocks is the best way to prevent portfolio blow ups while still offering the opportunity for outperformance.

The disadvantage of diversification is that I am more correlated with the market’s returns.

The Value of Value

With all of that said, I am worried that my focus on the valuation of the overall market is blinding me to the bargains within the deep value universe.

For this reason, I decided to take a look at the absolute valuation of the cheapo segment of the market. To do this, I used Ken French’s free data available on his website.

I restricted the data to the post-1990 universe. I’m considering the post-1990 period to be the modern era in which valuation multiples have been elevated.

I’m not expecting to be able to buy stocks at 1980 single digit CAPE valuations, for instance.

Let’s start by looking at cash flow/price.

Cash Flow/Price

cashcheap

At the end of 2019, the value segment of the market was close to its mean.

Not particularly exciting.

VBR (the Vanguard small value ETF) is down about 30% year to date, so I’d estimate that this is probably close to 20% now from 15% at year end 2019. That’s really encouraging, as it implies that the value segment of the market is close to its 2009 and early 2000’s levels. Those high levels will probably set the stage for tremendous performance in the upcoming years.

Interestingly, value was very expensive for most of the 2010’s. I think this is the key factor in value’s under-performance in the last decade. Value was expensive versus its long-run mean.

cashexpensive

Meanwhile, in compounder-bro-land, the market is more expensive than it was during the internet bubble. No surprise there.

Something interesting to note: this glamorous segment of the market was cheap in 2010 and the early 1990’s, likely setting up the excellent performance for glamour in the 1990’s and the 2010’s.

Book to Market

In most environments, last year’s cash flows are a good proxy for what’s happening next year.

In Quantitative Value, Wes Grey and Toby Carlisle found that trailing-twelve-month earnings work better than normalizing them. It’s a very surprising result, but it suggests that last year’s earnings tend to be a good proxy for next year’s.

Of course, we are not in a normal environment. Many businesses are seizing up and revenues are collapsing with economic lockdowns in place. This makes this current environment unlike any recession we have experienced since World War II.

For this reason, I think book value is useful in this kind of environment. When earnings disappear, different metrics of value are useful even though earnings-based metrics work better in the backtests.

booktomarketcheap1990

From this perspective, the value segment of the market was very cheap relative to its mean in the early 1990’s, the early 2000’s, and 2009. This makes sense, as those periods coincided with tremendous performance for value.

Like cash flow to price, this was also expensive through most of the 2010’s, explaining value’s woes during the last decade.

By this metric, at the end of 2019, value stocks were expensive.

With VBR down 30%, I estimate this is probably up to 190%. That is pretty good. It’s not as cheap as it was in 2009 or the early 2000’s, but it’s getting there.

expensive

Meanwhile, in compounder-bro-land, the market was more expensive at the end of 2019 than it was during the internet bubble.

Interestingly, it’s also evident that this segment of the market was cheap at the dawn of the 2010’s. This likely drove the tremendous performance of this segment of the market for the last decade.

Considering that QQQ is flat year to date, this segment of the market likely still beyond internet bubble extremes.

Good luck, compounder bros. I think you’re going to need it.

Soul Searching

Looking at this data, it suggests to me that I might be too cautious right now.

While the broader market is overvalued, the value segment of the market is approaching levels of cheapness last experienced in 2009.

On the other hand, this can get a lot cheaper, especially if the broader market tanks. This is particularly true considering that cash flows are about to disappear for a lot of businesses.

I could be allowing my emotions to blind me, which is a classic behavioral investing mistake. I am concerned about losing my job, for instance. I have a sizable emergency fund, but the idea of losing my job still worries me and can be clouding my thinking.

Earlier this year, I was contemplating selling my house and moving in search of another opportunity.

Now, I worry if I will be able to sell my house at a decent value. What job opportunities will even exist with the economy in lockdown?

Emotional stress might be interfering with my ability to see things clearly.

When I launched my blog, my hope was that I could build a portfolio of net-net’s when the next bear market arrived. During the boom, I’d stick to low price-to-earnings stocks and then shift my focus to net-net’s and negative enterprise value stocks.

There were net-net’s two weeks ago, but many of those bargains have since disappeared.

Is it possible that the opportunity to buy net-net’s emerged and disappeared in two weeks?

Maybe.

My gut tells me this is not the case and I will have an opportunity to purchase a portfolio of 20-30 high quality net-net’s and negative enterprise value stocks, but this French data makes me second guess that.

During this meltdown, I’ve been tempted to simply throw everything into my asset allocation which is down only 7.9% year to date. This allocation doesn’t try to predict the future and has caused me no stress.

If this market truly has passed me by and I’m wrong about everything, then I need to do some serious soul searching and re-evaluate my approach.

For now, I’m not ready to give up on my active account just yet. I do think there will be an opportunity to buy net-net’s and negative enterprise value stocks at some point during this bear market.

If not, I may need to simply pursue my asset allocation strategy and stop trying to pick stocks and predict the future.

It could also make more sense to focus more on arenas of the market where I can have more of an advantage, such as dark stocks and international net-net’s.

With that said, I don’t think I’m wrong, even though I’m open to that possibility.

I think it’s a bit of a fantasy to think we’ll have a 1987-style decline and 1988-style bounceback. After all, during 1987 and 1988, it was a time in which the economy was booming and we didn’t have a recession. Mr. Market was just being crazy. We faced a similar outcome at the end of 2018 and throughout 2019, another period in which we didn’t have a recession. Mr. Market was just being crazy.

This does not strike me as a comparable situation.

We’ll have to see, I guess.

This is a hard game, indeed.

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.

What the Perma-Bulls and Perma-Bears Get Wrong

thoughts

Perma Bulls and Perma Bears

Right now, it feels like the financial world is divided into two camps:

  1. “End the Fed” Perma Bears: They think that the Fed engineered a series of asset bubbles and is responsible for the subsequent crash of those asset bubbles. We just had a big asset bubble and this bubble is now collapsing. The Fed is an unholy abomination that does more harm than good. “Fiat” is a cursed word. The perma bear view of monetary policy is best channeled by this Onion article. The old ones like gold. The young ones like Bitcoin. They both think stocks are terrible to own.
  2. “Always Buy Stocks” Perma Bulls: They think that the market is mostly efficient and the Fed helps the market avert crises and is a positive force. Buy an index fund and stop obsessing over the Fed, they say. Earnings will increase over time, stocks will pay dividends, and it’s best to just ignore the noise, buy-and-hold. They like to advertise that they don’t bother with macro forecasting and focus on the long term trajectory of stocks.

The two camps disagree with each other pretty intensely. Perma bulls look at most perma bears as either idiots or charlatans. Perma bears look at perma bulls as naive fee-hungry AUM gatherers.

I disagree with both camps about a lot of things and I agree with them about a lot of things.

I think they both have valid points. I also think there are things that they’re wrong about.

Ideology

I value flexibility.

I occasionally find myself dragged into a dogma or a point of view. I think it’s really important to fight that tendency.

This is a pretty good quote from Charlie Munger on the subject:

“Another thing I think should be avoided is extremely intense ideology, because it cabbages up one’s mind. You’ve seen that. You see a lot of it on TV, you know preachers for instance, they’ve all got different ideas about theology and a lot of them have minds that are made of cabbage.

But that can happen with political ideology. And if you’re young it’s easy to drift into loyalties and when you announce that you’re a loyal member and you start shouting the orthodox ideology out what you’re doing is pounding it in, pounding it in, and you’re gradually ruining your mind. So you want to be very careful with this ideology. It’s a big danger.”

As someone who has had my own dalliances with intense ideology, I can completely relate to this.

Once I develop a worldview, it is very easy for me to be trapped by that worldview, particularly when I only absorb content from sources that I agree with.

I have my biases and so does everyone else.

I don’t think there is a silver bullet to avoid hot-blooded emotional biases completely, but I think it’s important to always consider how I might be wrong.

Perma Bulls and Perma Bears would probably benefit from a similar approach. I’m usually perplexed by the iron-willed certitude that they’re right. Ya’ll really never have doubts that you might be wrong?

What I think the perma bulls are right about

1. Markets are efficient over the long run

Bulls often point out that markets, over the long run, reflect economic reality. Over the long run, they are mostly efficient.

They are mostly correct.

Markets, over the long run, are going to reflect economic reality. This is even true during the last 10 years: the era of quantitative easing and zero percent interest policy.

Perma-bears argue that this boom has been all smoke-and-mirrors and doesn’t have anything to do with what’s happening in the real economy.

Well, what’s a pretty good proxy for what’s going on in the real world?

I think truck tonnage is a pretty good example. Truck tonnage closely tracks actual stock market performance.

trucksrussell3k

It seems like stocks mostly track what’s happening in the real, physical, economy.

Over the long run, the S&P 500 closely tracks the earnings growth of the companies within the S&P 500. This includes the boom of the last 10 years that the perma-bears think is utterly nonsensical Fed manipulation.

Earnings grow over time. This does provide an upward trajectory to the market over time.

Peter Lynch sums this up pretty well in this clip:

2. The Fed does a decent job

Cullen Roche had a great tweet thread the other day, in which he examined the role of the Fed in the nation’s economy.

To sum up the tweet thread, the role of the Federal Reserve is to serve as a clearing system between banks and ensure that the system continues to function correctly.

Before the Fed, busts were always horrifying. This is because any contraction in the US economy turned into a banking crisis, which made everything worse than it needed to be.

The Fed prevents this from happening.

From Cullen’s thread:

boomsbustsfed

As the above chart shows, the Federal Reserve largely succeeded in reducing the volatility of the economy. Now that the Fed intervenes when the turds hit the fan and prevents the banking system from falling apart, recessions are a lot less severe than they used to be.

The Fed was created out of the panic of 1907. JPMorgan stepped in and saved the system. Realizing that we couldn’t rely on one man to save the system forever (JPMorgan wasn’t an immortal Highlander, as far as I know), we needed an institution to prevent these panics from raging out of control.

(Side note: I love at the center of the 1907 panic was the “Knickerbocker Trust.” Is there a more old-timey name for a financial institution?)

Another reason that the booms and busts are less severe is the fact that the Fed generates inflation.

Perma bears hate inflation and usually cite inflation as the reason that we should end the Fed and tear the whole system down.

The reality is that a little inflation isn’t a bad thing. In fact, it’s a wonderful thing. One of the reason that those 19th century recessions were so severe is because when recessions arrived, prices usually declined. This means that everyone was incentivized to delay purchases, hoping for cheaper prices later. This magnified the decline further, creating a deflationary spiral.

Does $1 need to buy the same amount of goods from one year to another? Why? What’s the point? If wages and financial assets increase with the rate of inflation, what does it matter if cash stuffed in a mattress can buy the same goods that they could in 1955?

Even though the Fed existed in the 1930’s, they didn’t intervene appropriately. They let banks fail and it was their job to make sure that the system didn’t collapse. They allowed the money supply to shrink, making the deflation worse.

They had a role and they abdicated it.

No one explains this better than Milton Friedman:

In other words, by abdicating their role, the Federal Reserve allowed what would have been a very severe recession to mutate into the Great Depression. If they stepped in and did their job, they could have saved the system. Instead, by allowing the money supply to shrink and banks to fail, they made the problem worse.

It’s also worth noting that the Great Depression was exacerbated by the gold standard, which prevented us from expanding the money supply in a manner that was necessary.

There is a reason we ended the gold standard: it never worked particularly well. It also broke down in the early 1970’s, when 40 years of an artificially suppressed gold prices started to lead to problems with the US treasury.

What the perma bears are right about

1. Markets enter bubbles

Efficient market theorists will outright deny the existence of bubbles. In fact, they did a good job of bullying everyone from using the term until the early 2000’s after the internet bubble shook out. After the financial crisis, we went to another extreme and started calling everything a bubble.

Eugene Fama, for instance, claims that there wasn’t really an internet bubble. Or, more specifically, that it was impossible to identify the bubble until after the prices collapsed.

This is obviously wrong. Many people predicted there was a bubble.James O’Shaughnessy is one example.

There are often very obvious extreme bubbles. Japan in the late 1980’s is one example, which John Templeton correctly identified. The internet bubble is another. Bitcoin in 2017 was another very obvious bubble. Housing was another bubble, which was predicted by a number of people, including Michael Burry.

The wild swings in the multiple that investors are willing to pay for stocks is a sign that markets are not perfectly efficient and don’t always carefully estimate the present value of future cash flows.

The below is from the data on Shiller’s website:

shiller

Does this look like a market that is always rationally calculating the present value of future cash flows, or one that often gyrates between bouts of extreme greed and despair?

The change in multiples reflects that bubbles happen. They aren’t a figment of people’s imagination.

In fact, at extremes, bubbles are predictable. They do happen from time to time and they are possible to identify before prices collapse.

The market in the late 2010’s entered bubble territory. By pretty much every metric available, the market in the late 2010’s was at an extreme of valuation.

2. The Fed makes mistakes and contributes to bubbles

Does the Fed contribute to the cyclical nature of the US economy? Does the Fed contribute to bubbles? Does the Fed make mistakes?

Yes, yes, and yes.

While the Fed does a very good job at containing the effects of panics and ensuring that the system doesn’t go off the rails, they do make mistakes. This isn’t because they are evil. It’s because they are humans. Humans have biases, make errors, and get things wrong.

The Fed probably contributed to the bubble of the 1920’s.

They let the party go on too long and let things rage out of control in the late 1920’s. They should have taken the punch bowl away. Like a 20 year old managing risk at a frat party, they spiked the jungle juice with more Everclear instead of letting things calm down. Then, in 1929, someone called the cops and the fun was over.

The Fed also contributed to the inflation of the 1970’s.

Richard Nixon was dead set on winning his 1972 election and did everything possible to ensure victory. While he was having his cronies break into hotels to help make this happen, he also put pressure on Arthur Burns to ease monetary policy.

We were already experiencing the early stages of inflation, but Nixon wanted to win and didn’t care. He did not want the Fed to apply the brakes. He wanted a booming economy by the time that the election came around. Arthur Burns complied. The economy was doing well once election day came and Nixon won in a 49 state landslide.

Inflation then grew out of control and the Fed started raising rates to deal with it. Then, as if delivered by fate, we faced an oil crisis at the same time. The economy plunged into the horrible recession of 1973-74.

Scrambling to end the recession, the Fed started easing again. They never really got the inflation under control, but ending the terrible recession was a bigger concern.

The recession ended, but the inflation came back.

Inflation didn’t stop until Paul Volcker stepped in and engineered a recession in the early 1980’s to break the back of inflation. This is the recession we probably should have had in the early 1970’s, but Nixon and Arthur Burns didn’t have the political will to do it. Volcker and Reagan had the backbone that Burns and Nixon lacked.

The Fed typically contributes to the cyclical nature of the US economy. I think that the yield curve predicts recessions and booms because it’s a good proxy for how tight or loose monetary policy. They overshoot in both directions.

The Fed usually overshoots when they are raising rates, triggering a recession. Meanwhile, they can leave rates too low for too long, contributing to asset bubbles and inflation.

My Views

The bulls have points and the bears have points.

I agree with the bears that the Fed makes mistakes, but I also agree with the bulls that the Fed, for the most part, reduces the severity of booms and busts in the US economy.

Even though they make mistakes, they should also get credit for correcting those mistakes. Yes, the Fed was helmed by Arthur Burns and generated inflation. But doesn’t the Fed get any credit for Paul Volcker ending it?

I think that the 2008 recession could have turned into another Great Depression, but an aggressive policy response prevented that from happening. At the same time, I also think that the Fed contributed to the housing bubble.

I agree with the bears that markets enter bubbles, but I don’t think that the Fed is the sole cause of it.

Bubbles have been happening throughout the history of civilization, with or without a Federal Reserve. The South Sea Bubble and Tulipmania happened without a central bank, after all.

Bubbles happen because humans set prices in markets and humans are emotional beings.

Usually, bubbles start with a kernel of truth like:

1. 1999: The internet is going to the change the world. The companies that embrace the internet are going to dominate our future.

2. 2004: Real estate is a rock solid investment. It only occasionally declines violently. It’s less volatile than the stock market. You can apply leverage to it and generate income.

3. 1988: Japan is outperforming the United States. The country has a highly educated population and they have created an excellent and efficient business model.

4. 2017: Blockchain is a transformative technology.

5. 1980: Gold is a good hedge against inflation.

People take those kernels of truth and go too far with it.

Have you ever gone too far with a good thing? I certainly have! Markets  do the same thing.

Does the Fed contribute to these bubbles? Does the Fed contribute to booms and busts? Of course, but they’re not the sole actor here. In fact, they’re probably not the dominant actor.

Our limbic system is probably more to blame for the internet and housing bubbles than Alan Greenspan.

Bubbles are a feature, not a bug, of financial markets. This is because fear, greed, euphoria, and despair are features of the human condition.

Markets are increasingly dominated by computers and algorithms, but that doesn’t stop the fact that the money belongs to human beings and human beings are intensely emotional. This is particularly true when it applies to money that they have suffered to earn.

The perma bears argue that the Fed is both the arsonist and the fire department, channeling the plot of Backdraft.

I’d argue that it’s an institution that has mostly done good for the country and occasionally makes mistakes because they’re controlled by human beings and nobody is perfect.

Today’s Market

I think that we had a bubble at the end of the 2010’s and it is unwinding now. On this front, I agree with the bears.

I think the Fed probably made a mistake and waited too long to start raising rates. By 2013-14, the financial crisis was over and it was probably time to start tightening. The low rates led to mal-investment. The low rates probably contributed to the fracking boom, for instance.

I also think that the Fed is responding as it should to the current crisis, agreeing with the bulls.

The Fed is responding to the crisis aggressively, which is what they should be doing when faced with the worst recession in the last 90 years. They are throwing the kitchen sink at a brutal problem. They are doing everything they can to prevent the system from collapsing.

This is exactly what they should be doing!

However, I don’t think that the Fed is an all powerful wizard. For this reason, I don’t think that the Fed can prevent this bubble from unwinding, any more than the Japanese could prevent their market from eventually falling to a fair value.

(And yes, I know that the Japanese bubble was far more extreme than anything we experienced in the late 2010’s. I’m simply using this as an example that central banks aren’t all-powerful and mighty.)

It’s probably best to not be “perma” anything. I try to objectively look at the situation tactically and not through the lens of an ideology. There are times to be bullish about stocks and times to be bearish.

Random

My favorite Pink Floyd song from an album that doesn’t get any respect.

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.

Quick Note

TAIL

I bought TAIL yesterday. I basically bought this as a hedge against the stocks that I still own that I can’t bring myself to sell. This helps me stay somewhat market neutral during this bear market.

I’m not taking an outright short position on the market. Yet, anyway. Still struggling with whether I want to actually do that.

Deep Value

The good news is that the deep value universe of stocks in the Russell 3K with an EV/EBIT multiple under 5 is now over 200 stocks, which is the best environment we have seen since the financial crisis.

Under normal circumstances, I would be a buyer. I just don’t think markets bottom when a recession is only just beginning.

deepvalue

Market Valuations

Other good news, after yesterday’s decline, market cap/GDP is now down to 110%. This isn’t cheap, but better than where we were. There are a range of outcomes from here depending on where valuations are 10 years from now:

Market cap/GDP = 40% = -6.3% CAGR

80% = 1.7%

120% = 6.7%

The outcome is largely unknowable. Future valuations strongly depend on what interest rates are 10 years from now.

I think you could make a strong case for both outcomes: interest rates will be lower as we emulate the Japan example, which suggests valuations can be higher.

It’s also possible interest rates will be higher. I think that’s the likely outcome, as our demographic situation is different than Japan and I think money velocity will likely pick up as Millennials enter their peak earnings years. It’s also quite possible that, thanks to quarantines, we’ll have a baby boom in 9 months which is also bullish for the long term prospects of the economy.

In any case, we have to look at the range of outcomes. The base case is 1.7%, which isn’t really too exciting compared to the risk of owning equities.

Recession

Markets don’t bottom at the beginning of a recession when unemployment is low.

Of course, there isn’t anything normal about what’s going on right now. This was a violent move down, and for all I know the market could make an equally violent move up when this is all resolved.

I turn to valuations and history for guidance. In the last two recessionary drawdowns, market cap/GDP got down to 75% in 2003 and 57% in 2009. That means this likely really isn’t over until we get down to at least 80%.

The yield curve is currently un-inverted. That’s good news. I’m unusual among cranky market bears in that I want the Fed to ease and try to stop this recession aggressively and think they’re doing the right thing by throwing the kitchen sink at this. I also think that the federal government needs to pursue hardcore fiscal stimulus to end this.

yield

Markets don’t bottom when the yield curve just starts to un-invert. They bottom when we have a large spread between the 3-month and 10-year. That’s a pretty good indicator that an economic boom and turnaround is in our future. We aren’t there yet.

Buuuut . . . at least we’re starting to get there and are headed in the right direction.

More good news is that the vaccine is being tested. Let’s make sure this works and roll it out and defeat this thing.

Stay safe and healthy. Hug your people. Well, those you’re safely quarantined with. 🙂

Random

Electric Youth is great.

 

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.

I’m out

dark

Selling

I sold a lot of stocks this week. I sold most of my stocks this week. I’m now up to 79.5% cash and bonds in this portfolio. This is obviously a wildly bearish perspective for markets and the economy.

One perspective on this: I’m panic selling and I’m not taking a long term perspective.

People of this persuasion would probably say: value investors should buy when there is blood in the streets! Isn’t there blood in the streets right now?

I don’t think so. I think we are only at the beginning of a truly horrific period for the markets and the economy and I am accumulating cash to take advantage of the bottom, which we are nowhere near.

I don’t think we’re anywhere close to the end of this. This is not capitulation. My Twitter feed is still full of people talking about buying the dip. The BTFD mantra isn’t slowing down.

That is not the mentality you see at the bottom of the market.

With all of this said, yes, I’m timing the market. Yes, I know you’re not supposed to time the market. Yes, I know you’re not supposed to pay attention to macro.

Yes, this is speculation. But you know what? Picking individual stocks is speculation. I created this account for active bets. I have other accounts for my balanced asset allocations. This account is for active bets. Right now, I’m making an active bet that this is only the beginning of a massive drawdown and value stocks are not going to be a place to hide.

I’m also nearly certain I’m right about this and I’m acting accordingly. This is only the beginning of the horror show that is about to unfold. I even sold my “cash equivalent” ETF because I’m concerned about the corporate debt market, which that ETF has exposure to.

I might look like a fool for doing this by the time all is said and done, but I think this is a prudent course of action based on where we are.

Recession

Back in December 2018, I was bullish. The reason was pretty simple: I knew we were not going to have a recession and there were a lot of cheap stocks.

Going into this year, I was bearish. The yield curve had already inverted, which reliably predicts recessions 1-2 years out. The world economy was already showing signs of slowing down, and manufacturing was already in a recession.

In the recession, my expectation was that stocks would fall 50%. I thought that my 30% cash allocation would give me a decent cushion when that happened. I also assumed that throughout 2020, I would have the opportunity to gradually exit positions and build up that cash position. There was nothing gradual about this decline.

While everyone loves the buy-and-hold mantra and Warren Buffett also extols it, I think it’s a common mantra at the end of a bull market that is typically bad advice.

Buffett has a quote which people like to repeat: “Be fearful when others are greedy, and greedy when others are fearful.”

Well, to be fearful when others are greedy, you actually need to sell. To be greedy when others are fearful, you actually need to have cash on hand to take advantage of the bargains. This advice is incompatible with buy-and-hold.

The reaction to the Coronavirus is going to make a recession that was already underway even worse. This isn’t going to be a standard recession. This is going to be much worse than recent experiences. This is unlike anything we’ve experienced since the Depression.

Around me, closures are being announced all over. Malls are closed. Sports are cancelled. Airports are dead. Even among the places that aren’t closed, people are avoiding them.

Think about what is going on right now. Global trade and global supply chains are slowing. People are beginning to quarantine themselves. That means they’re not going to restaurants and bars. What happens to the people who depend on tip income at restaurants and bars, for instance? What happens to the businesses where they spend money? How about people who work at airports? Movie theaters? Daycares?

Right now, we are suspending large chunks of the economic machine.

Now, think about all of the leveraged firms that are out there. How are they going to handle the slightest hiccup in their cash flows? Will they be able to keep making payments on their debt? Or will this force them over the edge? Now, what happens to all of the people who worked for those leveraged firms? Where do those people spend money? How about the partners that these firms had? Everyone’s spending is someone else’s income.

In 2008, the peak to trough decline in GDP was only 2.24%. Think about the impact that a 2.24% reduction in GDP had on markets and the economy. With the situation that’s currently unfolding, I’m betting the decline in GDP is going to be a hell of a lot worse than 2.24%.

Valuation

The thing about valuation: it doesn’t matter until something goes wrong.

Think about your typical highly valued stock. It has an absurd expectations embedded into it. As long as it continues to meet those expectations, then valuation doesn’t matter.

Of course, as a rule of nature, s*** happens. Eventually, there will be a hiccup or whiff of bad news. The stock craters. It is a phenomenon that repeats over and over again. It surprises market participants again and again.

The entire US stock market is the equivalent of a richly valued stock right now.

We’ve been lucky for the last 10 years. No s*** has happened. No recession. We had a near default in 2011, but it didn’t happen and we didn’t have a recession. We had an oil decline in 2015, which was bad for the oil industry, but good for everyone else. No recession. This is why valuations haven’t mattered and bears have become a punchline among the investing commentary class.

Now, we’re going into a storm. The s*** is hitting the fan. And we’re going into this at absolutely absurd valuations.

Recently, on a market cap/GDP perspective, we exceeded the highs of the tech bubble. The stock market was valued at 150% of GDP.  We were at 140% in 2000. We’re at 125% now.

To put this into perspective, at the lows in the early 2000’s bear market, we got down to 75% of GDP. That is 40% down from here.

And what happened during the recession of the early 2000s? Unemployment peaked at only 6%. To put this into perspective: unemployment was 6% in 2014 when we felt like the economy was booming. In the early 2000’s, we barely had a decline in GDP. The overvaluation in the market meant that an extremely mild recession was enough to send markets into a 45% peak-to-trough decline.

In 2008, the market was not as expensive. We were at 110% of GDP. The valuation fell to 57% of GDP. If we fell to this level from here, it means markets fall by another 54%. Hello, S&P 1,250.

2008 was an intense recession. However, as I mentioned earlier, that was only a 2.24% decline in GDP. Unemployment peaked at 10%. The fact that the market wasn’t as expensive as it was in 2000 probably cushioned that drawdown.

The extent of a serious drawdown is a combination of the overvaluation of the market and the severity of the recession. We were lucky that the early 2000’s recession was a mild one. I’ll bet that if we went into the 2008 recession at 2000 valuations, we would have seen a 60-80% decline in the market.

This time, we went into this drawdown already ahead of the 2000 era valuations. Meanwhile, we are likely going to get a recession that is even worse than 2008. This is a recipe for a horrific decline in the markets.

Value’s Place in This

I own a bunch of stocks with a margin of safety, right? If I already own stocks with margin of safety, then why should I care about the broader market? Why sell when I know the stock is worth more than that?

Well, the fact of the matter is that value almost always goes down with the broader market, sometimes by more. When markets drawdown, they bring everything else down with it. Serious drawdowns happen during recessions.

red

In every big drawdown, the US stock market has managed to drag small value down with it. This even happened in the early 2000’s. Value did well over this period, but in the middle of it, it still experienced a 31.28% drawdown.

Margins of safety don’t offer protection in recession. The margins of safety get bigger as the bear markets grind on.

Another part of the problem is that my margin of safety is based on EBIT and earnings. One of the drawbacks of this approach is that EBIT evaporates into a poof of smoke during a serious recession. Goodbye, margin of safety.

Looking Forward

Eventually, of course, I think this market will bottom. There will be fiscal stimulus. There will be monetary stimulus. There will be pent up demand from months of quarantines.

This will eventually be a stock picking bonanza, just like 1974 or 2009.

I just don’t think we’re there yet.

What if I’m wrong?

Well, that’s why I own a passive account that’s balanced between asset classes that should do well in multiple economic environments (this portfolio has 40% in treasuries and gold) and it is where I don’t try to predict the future.

If I’m wrong, I’ll have too much cash and I’ll continue lagging the S&P 500. No news there.

If I’m wrong, you can all laugh at how stupid I was to sell good businesses at bargain prices.

Frankly, I hope that happens, because I don’t want a recession or decline of this magnitude to happen. It’s going to be bad news for a lot of people who don’t deserve this. I’ll take absolutely zero pleasure in seeing this happen.

But . . . every fiber of my being tells me that I’m not wrong. I haven’t decided if I want to make an outright bearish bet on something like SH, but don’t be surprised if you see that trade soon.

I am positioning myself accordingly and trusting my instincts and my analysis.

Random

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.

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 100% US stock market cap weighted indexes and letting it ride.

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. So, I’m sympathetic to the tendency to have massive home country bias and let investments ride on America Inc.

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. For all of the whining about corruption, we’re one of the least corrupt places on Earth. 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. There are also all of the advantages that I’ve described above.

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.

Meanwhile, look at 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 only see the good stuff. No one is posting about the troubles they have paying the daycare bill, or the fight they had with their spouse the other night. No one is going to post that they are 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 good things. It’s easy to look at that and feel like you’ve been left behind. It’s also important to realize that it’s not the full picture and everyone is struggling with something. No one’s life is perfect, despite what they portray on social media.

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.

I think bonds are worth owning for their ability to cushion drawdowns. I think 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%. Another flat period is 1929 to 1948, which lasted 19 years.

Can your long term investing plan sustain multiple decades of flat real returns? It is really easy to look at the last decade of returns and assume it will go on forever. I assure you, it will not. Stocks have gone through long stretches of poor returns in the past and they will again in the future.

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.

There are, of course, other diversifiers that can help cushion drawdowns and provide diversification. I covered much of this in my post on gold.

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.

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.