Tag Archives: investment returns

Productivity: What It Is & Why It Matters

The Kansas City Federal Reserve posted the Twitter comment and graph below highlighting a very important economic theme. Although productivity is a basic building block of economic analysis, it is one that few economists and even fewer investors seem to appreciate.

The Kansas City Fed’s tweet is 100% correct in that wages are stagnating in large part due to low productivity growth. As the second chart shows, it is not only wages. The post financial-crisis economic expansion, despite being within months of a record for duration, is by far the weakest since WWII.

Productivity growth over the last 350+ years is what allowed America to grow from a colonial outpost into the world’s largest and most prosperous economic power. Productivity is the chief long-term driver of corporate profitability and economic growth. Productivity drives investment returns whether we recognize it or not.

Despite its foundational importance to the economy, productivity is not well understood. There is no greater proof than the hordes of Ivy League trained PhD’s at the Federal Reserve who have promoted extremely easy monetary policy for decades. It is this policy which has sacrificed productivity at the altar of consumption and short-term economic gains.

For more on the interaction between monetary policy and economic growth please read Wicksell’s Elegant Model.

What Drives Economic Activity

Economic growth is a direct function of productivity which measures the amount of leverage an economy can generate from its two primary inputs, labor and capital. Without productivity, an economy is solely reliant on the two inputs. Due to the limited nature of both labor and capital, they cannot be depended upon to produce durable economic growth over long periods of time.

Leveraging labor and capital, or becoming more productive, provides the dynamism to an economy. Unfortunately, productivity requires work, time, and sacrifice. It’s a function of countless factors including innovation, education, government policies, and financial incentives.


Labor, or human capital, is largely a function of the demographic makeup of an economy and its employees’ skillset and knowledge base. In the short run, increasing labor productivity is difficult. Realizing changes to skills training and education take time but they do have meaningful effect. Similarly, changes in birth rate patterns require decades to influence an economy.

Within the labor force, the biggest trend affecting current and future economic activity, both domestic and globally, is the so called “silver tsunami”, or the aging of the baby boomers. This outsized cohort of the population, ages 55 to 73 are beginning to retire at ever greater rates. As this occurs, they tend to consume less, rely more on financial support from the rest of the population, and withdraw valuable skills and knowledge from the workforce. The vast number of people in this demographic cohort makes this occurrence more economically damaging than usual. As an example, the old age dependency ratio, which measures the ratio of people aged greater than 65 to the working population ages 18-64, is expected to nearly double by the year 2035 (Census Bureau).

While the implications of changes in demographics and the workforce composition are numerous, they only require one vital point of emphasis: the significant economic contributions attributable to the baby boomers from the last 30+ years will diminish from here forward. As they contribute less, they will also require a higher allotment of financial support, becoming more dependent on younger workers.

Finally, immigration is also an important component in the labor force equation. Changes in immigration policies and laws are easier to amend to foster more immediate growth but political dynamics argue that pro-immigration policies and laws are not likely within the next few years.


Capital includes natural, man-made and financial resources. Over the past 30+ years, the U.S. economy benefited from significant capital growth, in particular debt. The growth in debt outstanding, a big component of capital, is shown broken out by sector in the graph below. The increase is stark when compared to the relatively modest level of economic activity that accompanied it (black line).

This divergence in debt and economic growth is a result of many consecutive years of borrowing funds for consumptive purposes and the misallocation of capital, both of which are largely unproductive endeavors. In hindsight we know these actions were unproductive as highlighted by the steadily rising ratio of debt to GDP shown above. The graph below tells the same story in a different manner, plotting the amount of debt required to generate $1 of economic growth. Simply, if debt were used for productive activities, economic growth would have risen faster than debt outstanding.Data Courtesy: Bloomberg, St. louis Federal Reserve

Data Courtesy: Bloomberg, St. Louis Federal Reserve


Since 1980, the long term average growth rate of productivity has stagnated in a range of 0 to 2% annually, a sharp decline from the 30 years following WWII when productivity growth averaged 4 to 6%. While there is no exact measure of productivity, total factor productivity (TFP) is considered one of the best measures. Data for TFP can found at the San Francisco Federal Reserve- (http://www.frbsf.org/economic-research/indicators-data/total-factor-productivity-tfp/)

The graph below plots a simple index we created based on total factor productivity (TFP) versus the ten year average growth rate of TFP. The TFP index line is separated into green and red segments to highlight that change in the trend of productivity growth rate that occurred in the early 1970’s. The green dotted line extrapolates the trend of the pre-1972 era forward.

Data Courtesy: San Francisco Federal Reserve

The graph below plots 10 year average productivity growth (black line) against the ratio of total U.S. credit outstanding to GDP (green line).

The stagnation of productivity growth started in the early 1970’s. To be precise it was the result, in part, of the removal of the gold standard and the resulting freedom the Fed was granted to foster more debt. For more information on this please read our article: The Fifteenth of August.  The graph above reinforces the message from the other debt related graphs – over the last 30 years the economy has relied more upon debt growth and less on productivity to generate economic activity.Data Courtesy: Bloomberg, St. Louis and San Francisco Federal Reserve

Demoting Productivity

Government deficit spending is sold to the public as economically beneficial. However, the simple fact that government debt as a ratio of GDP has continually grown, tells you this is a lie. Further, there is not just a financial cost to running deficits but an opportunity cost that is underappreciated or ignored altogether. The capital misallocated towards the government was not employed for ventures that may have resulted in economically beneficial productivity gains.

The government is not solely to blame. The Federal Reserve has used monetary policy to prod economic growth and deprive the economy of full economic recessions that clean up mal-investment. They have bailed out the largest enablers of unproductive debt. Their policies encourage public and private debt expansion, much of which has been unproductive as shown in this article.

We the people, also play a role. We drive bigger cars and live in bigger houses for example. We tend to spend more lavishly than generations past. Too much of this unproductive consumption is done with borrowed money and not savings. While these luxuries are nice, the economic benefits are very short-term in nature and come at the expense of the long-term benefits of more productive investment.


Given the finite ability to service debt outstanding and aforementioned demographic challenges, future economic growth, if we are to have it, will need to be based largely on gains in productivity. Current economic circumstances serve as both a wet blanket on economic growth and are clearly weighing on productivity by diverting capital away from productive uses in order to service that debt. Ill-conceived policies that impose an over-reliance on debt and demographics have largely run their course.

The change required will be neither easy nor painless but it is necessary.  Policy-makers will either need to become immediately responsive and take action to address these issues or discipline will be imposed by other involuntary means.

This is not just an economics story. Importantly, as investors in assets whose value and cash flows are dependent on these economic forces, we urge caution when the valuation of those assets is high as it is today amid such a challenging economic backdrop.

Wait for the Fat Pitch : Buy and Hold vs Active Management

Ted Williams described in his book, ‘The Science of Hitting,’ that the most important thing – for a hitter – is to wait for the right pitch. And that’s exactly the philosophy I have about investing – wait for the right pitch, and wait for the right deal. And it will come… It’s the key to investing.” – Warren Buffett

Many investment managers tempt investors with historical returns by using them as indicators of future return expectations. Unfortunately, even if they are clairvoyant, a buy and hold strategy based on a “known” long term return is likely not in a client’s best interest. Buy and hold strategies that are solely focused on a long-term total return fail to consider the current state of valuations, the risk reward profile, and therefore the path of returns the market may take between now and the future. Importantly, they also ignore investor circumstances and whether he or she is a young worker in savings mode or a retiree who must draw living expenses from their account.

Even with a “known” return, it may be comforting to think one can buy and hold without any reservations. The reality is that, in many circumstances, such a strategy leaves a lot to be desired. On the path between today and tomorrow, there will inevitably be periods where returns are well above original expectations accompanied by a lower level of risk. There will also be periods where returns are lower than expected and the risk is greater.

This paper is theoretical in nature, but the simple message underlying the article is, as stated in the opening quote, you do not have to swing at every pitch. Patience rewards the prudent.

Destination vs Path

Let’s take a time machine back to January 1st 2005. Given that we are coming from the future, we know the following facts about the S&P 500:

  • January 1, 2005 price: 1181.41
  • 2015 Cyclically-adjusted P/E (CAPE): 26.49
  • Earnings growth 2005-2015: 7.68%
  • Dividend yield 2005-2015: 2.04%:
  • Dec 31, 2015 price: 1524.53
  • Annualized total return 2005-2015: 7.59%

In 2005, most investors would have considered the prospect of a 7.59% annualized return as favorable on a nominal basis as well as in comparison to U.S. ten-year Treasury notes, which yielded 4.22% at the time. Armed with that information, we guess that many investors would elect to buy and hold and earn 7.59%.

Let’s add a few more facts to the story. In January 2005, market valuations as measured by CAPE were at 26.59, which was a premium of 67% to the average (15.93) up to that time using data since 1900. In 2005, investors knew that if prices reverted to valuation means over the course of the ensuing ten year period, with earnings and dividends constant, the total return over the entire period would be -0.21%. Such a return compares poorly to the 4.22% annualized, risk-free returns offered by the ten-year U.S. Treasury note in 2005.

As it turned out, CAPE valuations did revert to their mean and even slightly below by March 2009. However, they expanded afterwards and by 2015 closed at levels nearly identical to 2005. The variation in the multiples investors were willing to pay for earnings (CAPE) factored largely into returns from 2005 to 2015. As a result, the actual path of annual returns was quite different from the straight line 7.59% many were expecting.

For anyone who was fully invested, and like today many were, that volatility imposed terrific stress. Furthermore, because of the reversion to the mean, there were opportunities to grow wealth at a faster rate than 7.59%, but it required having some cash on hand in order to take advantage of those opportunities.

The following graph compares the expected price of the S&P 500, assuming a market return of 7.59% every year for the ten-year period, to actual prices. Despite the same final price, note the wide price differences that occurred over the period. These divergences represented opportunities to change your investment posture, to increase or reduce risk, and better your realized total returns.

The following illustration adds bars to the graph above to highlight the expected returns in 2005 and the revised annual expectations in each ensuing year.

With the benefit of hindsight, we know an investor did not need to settle for the 7.59% guaranteed 10-year annualized return in 2005. In 2009, the expected return until 2015 would be more than double the original 7.59%.

Let’s consider an alternative way an investor might have invested over the ten year period.

The following table and graph compares a hypothetical, actively-managed portfolio versus a rigid buy and hold portfolio. The active investor, in our example, used a more conservative allocation when equity valuations were high. Conversely, when valuations normalized, the investor takes more risk by reallocating to a predominately equity-oriented portfolio.

As shown in the graph above, the actual dollar returns of the active versus buy and hold portfolios differed from the dotted straight line expected return. The table above the graph shows that the active portfolio beat the buy and hold portfolio by approximately 1.50% a year, and importantly, did so while taking less risk. The Sharpe ratio in the table, measuring returns as a percentage of risk, clearly favors the active approach.

The premise here is illustrative, and we urge you not to take the data too literally. We could have made the active allocations look a lot better by reducing equities to zero before the financial crisis, or we could have made them worse by not increasing the allocation to equites in the post-crisis era. The point of this exercise is not to play Monday morning quarterback, but to provide a simple example of how a more thoughtful active approach can use valuations to reduce risk and increase returns.   

The Path for the Next Ten Years

In Stocks versus Bonds: What to own over the next decade, we showed that under three optimistic scenarios in which valuations remain historically rich but mean revert to a still high level, (CAPE 24.80 = +1 standard deviation from the mean) annualized equity returns are likely to range from 0.71% to 4.62%. Under what we deem to be an average scenario, investors with a ten-year holding period should weak total returns. As such, a buy and hold strategy currently provides poor return expectations when compared to historical equity returns.

Given that the odds favor CAPE regressing towards its mean, or possibly below it, within the next ten years, logic and reason argue that better opportunities likely lie ahead. Why not take the conservative approach today when valuations stand at historically high levels?  Doing so may allow you the opportunity to swing at the fat pitch tomorrow.

By some measures, as shown below, equity valuations are at levels never witnessed in the modern era. Whether “this time is different” or valuations are sharply out of line and will correct, is up for debate. We simply urge you to consider that there are potential future opportunities that can only be seized by exhibiting caution today.


The point being made here is essential; risk management is generous. Based on the past 100 years of market data, there is no evidence that long-term returns are penalized by taking a defensive investment posture at high valuations. Investors today do not need to buy and hold stocks and remain heavily invested when expected returns are paltry. The historical record, though imprecise, affords an excellent map for navigating and managing risk.

Patience is an investor’s friend, and time has a habit of delivering better opportunities to those inclined to exercise it.  Each investor can determine his own “strike zone” and is well-served to exercise patience until a fat pitch comes along.

It’s Okay To Hold Some Cash

The great sage and baseball legend, Yogi Berra, once said:

“It’s tough to make predictions – especially about the future.”

But financial planning is all about contemplating how much money will result from a particular savings rate combined with an assumed rate of return. It’s also about arriving at a reasonable spending rate given an amount of money and an assumed rate of return. In other words, plugging in a rate of return is unavoidable when doing financial planning. Perhaps financial planners should use a range of assumptions, but some assumption must be made.

The good news is that bond returns stand in defiance to Berra’s dictum; they aren’t too difficult to forecast. For high quality bonds, returns are basically close to the yield-to-maturity. Stock returns are harder, but there are ways to make a decent estimate. The Shiller PE has a good record of forecasting future 10-year stock returns. It’s not perfect; low starting valuations can sometimes lead to low returns, and vice versa. But it does a decent job. And the further away the metric gets from its long-term average in one direction or another, the more confident one can be that future returns will be abnormally high or low depending on the direction in which it has veered from its average. Currently, the Shiller PE of US stocks is over 30, and its long term average is under 17. That means it’s unlikely that future returns will be robust.

The following graph shows end-of-April return expectations for various asset classes released by Newport Beach, CA-based Research Affiliates. One will almost certainly have to venture overseas to capture higher returns. And those likely posed for the highest returns – emerging markets stocks – come with an extra dose of volatility. Along the way, there will be problems caused by foreign currency exposure too, though Research Affiliates thinks foreign currency exposure will likely deliver some return.

Hope for a correction? Move some money to cash?

Given this return forecast, investors will have to contemplate saving more and working longer. But investors who continue to save should also hope for a market downturn. As perverse as that sounds, we are in a low-future-return environment because returns have been so good lately. We have basically eaten all the future returns over the past few years. And nothing will set up financial markets to deliver robust returns again like a correction. That’s why the Boston-based firm Grantham, Mayo, van Otterloo (GMO), which views the world similarly, though perhaps a bit more pessimistically, to Research Affiliates has said that securities prices staying at high levels represents “hell,” while a correction would represent investment “purgatory.” If prices stay high, and there are no deep corrections or bear markets, there will be little opportunity to invest capital at high rates of return for a very long time.

Investors who aren’t saving anymore should hold some extra cash in anticipation of purgatory. If we get purgatory (a correction) instead of hell (consistently high prices without correction), the cash will allow you to invest at lower prices andva higher prospective return. How much extra cash? Consider around 202%. The Wells Fargo Absolute Return fund (WARAX) is run by GMO, and 81% of its assets are in the GMO Implementation fund (GIMFX). Around 6% of the Implementation fund is in cash and another 16% of the fund is in U.S. Treasuries with maturities of 1-3 years, according to Morningstar. So more than 20% of the Implementation fund – and nearly 20% of the Absolute Return fund — is in Treasuries of 3 years or less or cash.

Around 52% of the Implementation fund is in stocks, most of them foreign stocks. So around 40% of the Absolute Return fund is in stocks. (The other holdings of the Absolute Return fund are not invested in stocks as far as I can tell.)

If you normally have something like a balanced portfolio with 50% or 60% stock exposure, it’s fine to take that exposure down to 40% right now. There is no question that this is a hard game to play. The cheaper prices you’re waiting for as you sit in short-term Treasuries or cash, with roughly one-third of your money that would otherwise be in stocks, may not materialize. After all, as Berra said, “It’s tough to make predictions.” Or the lower prices may materialize only after your patience has expired, and you’ve bought back into stocks at higher prices just before they’re poised to drop.

These adverse outcomes are real possibilities. But the buy-and-hold, strictly balanced allocation (60% stocks/ 40% bonds) also isn’t easy now for those who (legitimately) fear a 30+ Shiller PE. That’s why it’s arguably reasonable to move some of your stock allocation into cash and/or short-term Treasuries, but not the whole thing. And sitting in cash hasn’t been this easy for a decade or more, now that money markets are yielding over 1% and instruments like PIMCO’s Enhanced Short Maturity Active ETF (MINT) are yielding over 2%. Those yields at least act as a little bit of air conditioning if investment hell persists and prices never correct while you sit in cash with some of your capital.