Tag Archives: Michael Lebowitz

Economics on Gilligan’s Island

Famed economist Henry Hazlitt wrote the economics classic, Economics in One Lesson: The Shortest and Surest Way to Understand Basic Economics. The book is quite popular and has sold well over one million copies. While the content is brilliant, what makes it distinctive is the simple clarity he uses to explain complex economic concepts.

We try our best to follow in Hazlitt’s footsteps and explain economics without the complexity and jargon so often used by trained economists. One of our techniques is to bring an economic concept to its most basic level so that it’s easily understood by all readers. While at 720Global, we produced an animated video, The Animated Virtuous Cycle, which allows a ten-year-old to understand the complex economic topic of productivity.

In this paper, we lead with a few instances where we have taken Hazlitt’s approach to better explain economic concepts. Following those excerpts, we use Gilligan’s Island as a means of illustrating productivity and its importance for the health of an economy and the prosperity of its people.

As a refinement of our recent article, Productivity: What it is and Why it Matters, we hope this approach allows more readers to grasp the importance of productivity growth. Falling productivity growth helps to explain the link between many of the mounting economic and social troubles we face. Equally important, from an investor’s perspective, productivity growth is the driver of current and future cash flows for almost every investment imaginable. 

If you want to skip to our simple primer on productivity, go to the section entitled “Gilligan’s Island”.

Greetings From Stiltsville

The following excerpt came from our article, Greetings From Stiltsville: Deficit Spending is not a Free Lunch. We created the fictitious island of Stiltsville to demonstrate why GDP is a poor measure of economic growth.  

Imagine an island called Stiltsville, where a person’s value is based solely on their height. In order to increase their value, people living on the island used to wear platform shoes. A person wearing six-inch platform shoes would suddenly be more valuable than a person of similar height who wore normal footwear. Eventually, platform shoes were replaced by stilts, three-foot stilts were be replaced by six-foot stilts, and so on. People eventually rose to be the height of giraffes. The main point is that, on an island where height is valued above all else, people will try to game the situation to their advantage by increasing their height by any means available.

People from other lands would look at the people of Stiltsville and recognize their obsession with height greatly distorts their perception of value.  They would also likely conclude that distorted perceptions result in actual distortions in productivity, because:

  • People waste time and money thinking about how to increase their height, and
  • Walking around in platform shoes or stilts does not necessarily increase a person’s productivity, and instead most likely impairs it

Now imagine a world in which the health of an economy is perceived to be based on one metric; Gross Domestic Product (GDP). GDP is simply the total amount of spending in an economy. GDP, as currently measured, does not distinguish between “good” spending and “bad” spending. GDP does not distinguish between consumption spending and investment spending. GDP also does not distinguish whether spending is generated by existing wealth, by going into debt temporarily, or by going into debt permanently. In this world, every dollar spent on education or new means of production, is counted the same as every dollar spent on epic bachelor parties and video games. 

This world, the world of GDP accounting, is the world we live in. More spending today than occurred yesterday is considered economic growth. Growth, regardless of how it happens or at what cost, is highly sought after by politicians, economists and central bankers.

The Fallacy of Macroeconomics

In our RIA Pro article, The Fallacy of Macroeconomics, we show why the current mindset governing what constitutes economic growth is deeply flawed. In this article, we swapped Stiltsville for Glenn Villeneuve, a real person living off the grid in a remote part of Alaska.

To help you appreciate the benefit of creating value through production, we elicit the National Geographic Channel’s Life Below Zero. The documentary tracks the lives of several people that live largely independent, “off-the-grid”, in the wilds of Alaska. Of particular interest is Glenn Villeneuve, who does not appear to rely on help from the outside world, nor many of the innovations of modern society, including electricity and power tools. Assessing Glenn’s daily activities, we better illustrate the measurement of a personal economy. While this example does not represent the norm, it does provide a microcosm of a simple economy to allow us to contrast the circumstances of Villeneuve with the fallacy of an economic perspective focused on consumption.

A typical day for Glenn involves some of the following activities in which he produces goods: hunting, trapping, fishing, sourcing water, and chopping lumber. Other parts of his day are spent consuming prior production such as eating, drinking, sleeping, and warming up by a fire. The first set of activities involves productive endeavors that add economic value. The second set of activities involves consuming the value he created. Note that there is also an intermediate stage in which the value he created is stored (saved) for future consumption.

Throughout the show, Glenn consistently extols efficiency or the benefits of using the least amount of energy and the most amount of ingenuity to add value to his camp. After watching an episode or two, a viewer quickly realizes that without this supply side mindset Glenn would quickly exhaust his resources and become a victim of the harsh Alaskan climate.

Most of our days are quite different than Glenn’s, but nevertheless they are filled with similar pursuits. We sit at a desk providing legal services, picking grapes from a vine, building houses and millions of others jobs in which we create value. While most of us do not “eat what we kill” and consume the value we create directly, we earn the value in the form of currency. As a store of that value, currency then affords us a medium of exchange for something we need or want when it suits us.

Just as portrayed in Glenn’s example, the harder we work and the more innovative and productive we are, the more value we create. It is in this straightforward incentive that the prosperity of a populace grows and scarcity is diminished.

The Fed’s Mandate to Pick your Pocket

In a recent article entitled, The Fed’s Mandate to Pick your Pocket, we used the analogy of three people stranded on a deserted island to explain inflation.

Inflation is everywhere and always a monetary phenomenon.” – Milton Friedman

This oft-cited quote from the renowned American economist Milton Friedman suggests something important about inflation. What he implies is that inflation is a function of money, but what exactly does that mean?

To better appreciate this thought, let’s use a simple example of three people stranded on a deserted island. One person has two bottles of water, and she is willing to sell one of the bottles to the highest bidder. Of the two desperate bidders, one finds a lonely one-dollar bill in his pocket and is the highest bidder. But just before the transaction is completed, the other person finds a twenty-dollar bill buried in his backpack. Suddenly, the bottle of water that was about to sell for one-dollar now sells for twenty dollars. Nothing about the bottle of water changed. What changed was the money available among the people on the island.

As we discussed in What Turkey Can Teach Us About Gold, most people think inflation is caused by rising prices, but rising prices are only a symptom of inflation. As the deserted island example illustrates, inflation is caused by too much money sloshing around the economy in relation to goods and services. What we experience is goods and services going up in price, but inflation is actually the value of our money going down.

Gilligan’s Island

Having traveled to Stiltsville, The Brooks Range of Alaska and a deserted island, we now bring you to Gilligan’s Island. This widely popular 1960’s television sitcom portrayed the island home of seven castaways.  Despite the comic ventures of the half-witted first mate, Gilligan, and the rest of the castaways, the setting provides a nice canvas to illustrate how a nation’s prosperity can only permanently grow with the help of productivity.

As we stated in, Productivity: What it is and Why it Matters“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.”

Given the three factors that create prosperity – labor, capital, and productivity – we discuss how the three elements of economic growth can be employed on Gilligan’s Island and the benefits and drawbacks of each. We greatly simplify this analysis by assuming that the only product the castaways produce are coconuts. Further, the coconuts can be sold to Robinson Crusoe Island (RC Island), and as a result the castaways on Gilligan’s Island can buy whatever goods they desire. 

Labor

While there are many facets to labor such as education, training, work ethic and incentives, the biggest factor is demographics. Demographics describe the composition of a population. On Gilligan’s Island, all seven inhabitants, even the socialite Mrs. Howell, are capable of picking coconuts for long hours each day. Given this construct, there are two ways the island can increase its economic production; work more hours and/or have babies.

If each person were to increase their daily workload by two more hours, they would pick more coconuts and exchange them for more money and other goods. This would certainly make them more prosperous. However, picking hours are limited by what is physically possible and the number of hours of daylight. At some point, their ability to work more reaches a limit. 

The other way to increase the island’s economic activity is to have babies that will eventually work. If, for instance, the population were to double to 14, then we might assume the coconut production would also eventually double and therefore economic activity would double. That is true, but the level of activity and prosperity per person would remain the same.

In both examples, there is a limit to the number of people that can fit on the island and the number of hours that can be worked. While additional hours and babies can increase economic activity and prosperity, both have a definitive maximum.

Capital

Capital includes natural, man-made and financial resources.” The capital in our example is coconut trees and coconuts. In our most basic example, the only other potential source of capital is borrowing money from RC island.

Thurston Howell III, the once prominent millionaire, has devised a way to buy more stuff than is possible through daily coconut picking activities. He approaches RC island and asks to borrow money. RC island agrees and lends the Islanders money which is then spent.

Now, in addition to what they can buy from their coconut sales, they have the additional purchasing power of debt. This method makes Gilligan’s Island seemingly more prosperous, but only temporarily. In the future, they will not be able to borrow any more money and must use their income from coconut sales to pay back the debt. The buying power gained from the debt will be paid back in the future plus interest. Credit can raise the level of consumption, but it is temporary and limited.

Productivity

Fortunately, Gilligan’s Island has the Professor. The resident genius realized the ultimate bounds of borrowing, working more hours and having babies. All three tactics could certainly provide more but were limited and flawed. He knew that capital, either saved or borrowed, and a little ingenuity could be used to permanently increase the number of coconuts they pick without requiring more hours of work or more people.

The Professor suggested they cut one month’s intake of caviar to buy ladders. The ladders allow them to get up and down the trees quicker and produce more coconuts in less time. Also, he suggested they borrow money to buy genetically modified coconut trees that produce five times as many coconuts as the trees currently on the island. By doing so, each trip up the tree would yield five more coconuts than before. The debt would have to be paid back with interest, but the extra revenue would more than offset the extra expense. They could also use their savings or debt to buy tools that could be used to make many different products from the coconuts. These products would generate more revenue per coconut.

This illustration demonstrates how productivity acts as leverage to get more out of labor and capital and expand the prosperity of an island and, for that matter, a nation.  

Summary

The concepts presented here are grossly simplified, but they apply to our modern, multifaceted economy every bit as much as they do to Gilligan’s Island. As a nation, we can keeping gaming GDP growth with largely unproductive debt or we can save and invest more. It is easier to borrow and spend, but it offers only a short-term means of raising consumption. It is not a permanent, long-term solution. Saving and investing comes with a temporary, short-term cost but the long -term benefits more than outweigh that sacrifice.

This lesson applies to the economy and the generation of demand for the products and services that drive the revenue and profits available to investors. It also applies to the value of individual investments themselves. With this precious of understanding of productivity and its value we should be asking if the companies we invest in are using capital to wisely invest in their future or are they using it for other less-productive purposes? This is not a binary question in most cases as most companies do both, however we all but guarantee that, over the long run, companies focused on investments where productivity growth trumps short-term profits will benefit at the expense of companies focused elsewhere.

For related research on this important concept we recommend reading The Death of the Virtuous Cycle and watching our short video The Animated Virtuous Cycle.

There are countless ways to evaluate equities, and they all have glaring flaws. Equity valuation is not a science with predictive formulas. It is subjective, and the formulas themselves and the interpretation of the results rely on an estimate of what the future holds.

Some models use historical data under the assumption that the current trend will be predictive of the future while others use forecasts that differ from the past. It is a rare occasion that the past neatly maps out the future or, for that matter, that anyone accurately predicts the future. No model represents the holy grail of investing, but understanding their inputs and outputs can reveal a lot about relative valuations and the sentiment of a market. As investors, we need to take into account all types of valuation techniques and their assumptions, especially those that may not confirm our current investment thesis.

Differences between various valuation models allows one to construct a bearish or bullish outlook simply by choosing the model that produces the appropriate outcome. Recently, Price to Forward Earnings (P/fE) has been flashing a buy signal and has been used by many investors as evidence that stocks are cheap. At the same time, as shown below, most other traditional valuation models are pointing to a market that is anywhere from 65% to 95% overvalued. What gives?

Choosing E?

Price to earnings is one of the most popular forms of equity valuation. It is a logical approach given that earnings, the profits available after all expenses, are ultimately what investors are buying. The basic price to earnings ratio (P/E) simply tells us what multiple the market is paying for profits. For instance, a P/E of 20 means investors are willing to pay 20 times the current level of earnings to own shares of the company. Theoretically, in this case, if a company’s earnings are flat for eternity, the investor will earn a 5% (1/20) annual return. If future earnings exceed current earnings, the return will be greater than 5%, and the return will be less than 5% if the opposite is true about earnings..

To provide a framework allowing for the comparison of current P/E valuations to prior valuations or valuations between other stocks or indexes, the E (earnings) in the ratio can be historical, recent or forecasted.  

Our preferred method, Cyclically Adjusted Price to Earnings (CAPE), compares today’s price versus inflation-adjusted earnings over the preceding ten year period. If you believe that future earnings growth will follow the longer term trend of years past, this valuation tool provides a dependable relative valuation metric.  

(Use Code: BEAR MARKET for a 30-day free trial)

The most commonly used P/E is based on earnings from the trailing twelve months (TTM). The reason we are not as comfortable with this approach is that, at times, one year earnings periods can differ markedly from prior periods due to one-off events. For instance, earnings over the last 12 months are considerably higher than the previous few years due to the corporate tax cut. As a result, TTM P/E is lower, but does that make stocks cheaper? That is not a trick question and can be answered yes or no depending on other factors. Regardless of your preference, both TTM and CAPE P/E ratios use earnings data that has occurred in the past.

Another popular way to calculate P/E uses estimates of forward earnings for the next 12 months. Theoretically, this approach is the best of the three methods. When you are buying a stock or an index, it is the earnings in the future that matter, not those in the past.

While the price to forward earnings (P/fE) ratio seems like the smartest approach, it is much harder to use as predicting earnings can be very difficult. In fact, the point at which one needs to be most vigilant about avoiding overpriced equities often is the time when misplaced confidence is highest in equities. Of greater concern, most investors rely on forward earnings forecasts from Wall Street. While Wall Street banks may employ the best analysts and have access to knowledge that you and I do not, they are biased. To put it bluntly, Wall Street banks and brokers make money by selling stocks.

This opinion is not cynical, this is how the world works. McDonald’s, for instance, is always quick to point out the health benefits of their salads, but have they ever tried to dissuade customers from ordering a Big Mac, jumbo fries and a large Coke? In fact, they entice customers to order that exact “super-size” combination through pricing deals.

Data Supporting our Cynicism

Given that Wall Street is in the business of selling stocks, they tend to be optimistic. The graph below points this out by showing the difference between forecasted earnings and the true earnings that were released 12 months after the forecasts. The gray-shaded area plots the percentage difference.

Note the following:

  • On average, forward earnings expectations are 16.5% higher than actual earnings
  • During the last three recessions, forward earnings were 50% greater than actual earnings
  • Forward earnings are greater than actual earnings 85% of the time

The ebbs and flows of earnings from quarter to quarter and year to year graphically hide some of the perpetual optimism. The next graph uses the historical earnings trend line (dotted blue) from the graph above to compare to forward estimates. This modification of the first graph allows us to compare more reliable earnings trends to forecasts.

As shown, forward forecasts have been consistently overly optimistic since 1994 except for the 2008/09 recession. While the reliability of optimism is worth stressing, the level of current optimism, represented by the gray shaded area showing the percentage difference, indicates that current forward earnings estimates are the highest they have been compared to the longer term earnings trend over this 25-year period.

Current P/fE

The graph below charts P/fE. As shown, the current P/fE level is below the average of the last 28 years and, dare we say, cheap.

Given this set of information, stating that stocks are cheap on the basis of forward earnings and P/fE alone is foolish. The graph below contrasts current P/fE with various one-year earnings forecasts. To help pick one of the horizontal lines associated with different annual earnings growth rates consider:

  • 2012-2017 earnings grew at 4.67%
  • 2018 grew at 21.77%
  • 2019 expected to grow at 20% (1.56 vs 1.30)

We should also note that growth associated with the tax cuts have a one-year shelf life. While earnings may be higher as companies pay fewer taxes, the growth rate of those earnings should revert towards trend levels as they are married to economic activity.

As shown, forward P/fE is only as good as the forecast. Even if earnings grow at 15% in 2019, which would be impressive, the ratio goes from below to above average. In more pessimistic scenarios, such as a reversion to the longer-term trend growth or a mild recession, the ratio becomes very expensive. Traditionally, this is what happens as the economy moves in to a recession but Wall Street analysts are slow to react.

Summary

  • The growth benefits of the tax cut are not recurring
  • Will buybacks continue to boost EPS?
  • Revenue growth has been running 4%, can corporate profit margins keep expanding?
  • Forecasted earnings are overly optimistic 85% of the time
  • Forecasted earnings have never predicted a recession or a big drop in earnings
  • In the event no recession emerges, then wage pressures are likely to negatively impact earnings and margins

Instead of restating our thoughts on the current “value” exposed by P/fE, we leave you with a simple thought and graph. At current levels, price to forecasted earnings are as “cheap” as they were in November 2007. Oddly enough, the National Bureau of Economic Research (NBER), which is responsible for identifying the dates when U.S. recessions begin and end, mark December 2007 as the beginning of the Great Recession. That was not a good time to own “cheap” stocks.

Gradual inflation has a numbing effect. It impoverishes the lower and middle class, but they don’t notice.”—Andrew Bosomworth, PIMCO Germany, as quoted in Der Spiegel

Media reports and political candidates have been stressing the rising wealth and income inequality gaps in the United States. They do so to advance their agendas, but the problem is real and they are justified in raising it. At the same time, both groups are largely overlooking an important piece of the puzzle in the way they talk about it. To properly diagnose this important problem, we need to understand the role the Federal Reserve plays in managing economic growth and how it contributes to these rising imbalances. This article examines the Federal Reserve’s monetary policy objectives and their stated inflation goals to help you better appreciate the role they play in this troubling and growing problem.  

Populism on the Rise

The political success of Donald Trump, Bernie Sanders and more recently Alexandra Ocasio-Cortez leave scant doubt that populism is on the rise. Voters from both parties are demanding change and going to extremes to achieve it. Much of what is taking place is rooted in the emergence of the greatest wealth inequality gap since the roaring ’20s.

Over the last twenty years, the “1%” have been able to accumulate wealth at an ever-increasing rate. According to the Economic Policy Institute, the top 1% take home 21% of all income in the United States, the largest share since 1928. The graph below, while slightly dated, shows the drastic change in income trends that have occurred over the last 35 years.

Graph Courtesy: New York Times – One Broken Economy, in One Simple Chart

This grab for riches by the few is coming at the expense of the many. There are a variety of social, political and economic factors driving the growing discrepancy, but there is one critical factor that is being ignored.

Enter the Federal Reserve

The Federal Reserve Act, as amended in 1977, contains three mandates dictating the management of monetary policy. They are 1) maximize employment, 2) maintain stable prices, and 3) keep long-term interest rates moderate.

These broadly-worded objectives afford the Federal Reserve great latitude in interpreting the Act. Among these, the Fed’s mandate for stable prices is worth a closer look. The Fed interprets “stable prices” as a consistent rate of price increases or inflation. Per the Federal Reserve Bank of Chicago, “The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for Personal Consumption Expenditures (PCE), is most consistent over the longer run with the Federal Reserve’s statutory mandate.” 

Understanding why the wealth gap has exploded in recent years requires an appreciation for how this small but consistent rate of inflation harms the poor and middle class while simultaneously enriching the already wealthy.

Wealth is defined as that which is left after consumption and the accumulated results of those savings over time.

With that in mind consider inflation from the standpoint of those living paycheck to paycheck. These citizens are often paid on a bi-weekly basis and spend all of their income throughout the following two weeks. In an inflationary state, one’s purchasing power or the amount of goods and services that can be purchased per dollar declines as time progresses. Said differently, the value of work already completed declines over time.  While the erosion of purchasing power is imperceptible in a low inflation environment, it is real and reduces what little wealth this class of workers earned. Endured over years, it has adverse effects on household wealth.

Now let’s focus on the wealthy. A large portion of their earnings are saved and invested, not predominately used to pay rent or put food on the table. While the value of their wealth is also subject to inflation, they offset the negative effects of inflation and increase real wealth by investing in ways that take advantage of rising inflation. Further, the Fed’s historically low-interest-rate policy, which supports 2% inflation, allows the more efficient use of financial leverage to increase wealth.

Some may counter that daily laborers living week to week get pay raises that offset inflation. That may be true, but it also assumes inflation is measured correctly. The Fed relies upon the Consumer Price Index (CPI) and Personal Consumption Expenditures (PCE) metrics as gauges of inflation. While widely accepted, we all have firsthand experience of the rapid rise in the cost of health care, higher education, rents, and many other essential goods and services that suggests far greater inflation than the Fed’s 2% objective. The truth is that inflation is not measurable with any real accuracy.

John Williams, of Shadow Stats, calculates inflation based on the methods used by the Bureau of Labor Statistics in 1980. Currently, his calculation has CPI running at 9.9% per year, much higher than the latest 2.2% CPI reported. The difference between Williams’ calculation and the BLS’ reported figure is caused by the numerous adjustments the BLS has made to the CPI calculation over the years which has reduced reported inflation. Economists argue that the BLS adjustments provide better accuracy. Maybe, but the record level of wealth inequality and public dissatisfaction offers hard evidence to the contrary. Disagreements notwithstanding, the loss of wealth due to inflation, whether at 2% or 10%, is punishing for those spending everything as it limits their ability to save and accumulate wealth.

Economic growth as measured by Gross Domestic Production (GDP) is the holy grail of all measures of economic advancement. Rising GDP in a debt-based economy depends on credit growth which explains why inflation is so important to policy-makers. The logical conclusion is that the Fed’s primary purpose for running a consistent rate of inflation is to foster credit growth. The growth of credit benefits those who have collateral to borrow against, employ leverage and invest. Again, it is the wealthy that benefit from this. For everyone else, it is a merciless master that makes it difficult if not impossible to maintain one’s standard of living.

The more of one’s wealth that is used for consumption, the more one is subject to the ills of inflation. Additionally, this circumstance also drives a negative feedback loop in that inflation also quietly incents people to consume since goods and services will be more expensive tomorrow than they are today.

While we illustrate the extremes in this article, one can envision how the middle class, which increasingly spend the majority of their wages on consumption and invest little or nothing, also fall into the inflation trap.

Summary

The central banking scheme of supporting economic growth through increasing levels of debt only makes sense if “growth at all cost” uniformly benefits all citizens, but it does not. There is a big difference between growth and prosperity. Furthermore, an inflationary policy that aims to minimize the burden of debt while at the same time aggravating the growth of those burdens is taking a serious toll on global economic and social stability.

As we are finding, the United States is not immune to these disruptions.  The source of these problems are accumulating and compounding as a result of the public’s failure to understand why it is happening. This will ultimately lead to further policy-making errors. Until the Fed’s policies are publicly discussed, re-examined and ultimately reconsidered, the problems will not resolve themselves.

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

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

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

Productivity

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.

Summary

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.

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.

Summary

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.

“You load sixteen tons, what do you get?
Another day older and deeper in debt
Saint Peter don’t you call me ’cause I can’t go
I owe my soul to the company store” 
– Sixteen Tons by Tennessee Ernie Ford

Shortly following Donald Trump’s election victory we penned a piece entitled Hoover’s Folly. In light of Trump’s introduction of tariffs on steel and other selected imports, we thought it wise to recap some of the key points made in that article and provide additional guidance.

While the media seems to treat Trump’s recent demands for tariffs as a hollow negotiating stance, investors are best advised to pay attention. At stake are not just more favorable trade terms on a few select products and possibly manufacturing jobs but the platform on which the global economic regime has operated for the last 50 years. So far it is unclear whether Trump’s rising intensity is political rhetoric or seriously foretelling actions that will bring meaningful change to the way the global economy works. Either as a direct result of policy and/or uncharacteristic retaliation to strong words, abrupt changes to trade, and therefore the role of the U.S. Dollar as the world’s reserve currency, has the potential to generate major shocks in the financial markets.

Hoover’s Folly

The following paragraphs are selected from Hoover’s Folly to provide a background.

In 1930, Herbert Hoover signed the Smoot-Hawley Tariff Act into law. As the world entered the early phases of the Great Depression, the measure was intended to protect American jobs and farmers. Ignoring warnings from global trade partners, the new law placed tariffs on goods imported into the U.S. which resulted in retaliatory tariffs on U.S. goods exported to other countries. By 1934, U.S. imports and exports were reduced by more than 50% and many Great Depression scholars have blamed the tariffs for playing a substantial role in amplifying the scope and duration of the Great Depression. The United States paid a steep price for trying to protect its workforce through short-sighted political expedience.

Although it remains unclear which approach the Trump trade team will take, much less what they will accomplish, we are quite certain they will make waves. The U.S. equity markets have been bullish on the outlook for the new administration given its business-friendly posture toward tax and regulatory reform, but they have turned a blind eye toward possible negative side effects of any of his plans. Global trade and supply chain interdependencies have been a tailwind for corporate earnings for decades. Abrupt changes in those dynamics represent a meaningful shift in the trajectory of global growth, and the equity markets will eventually be required to deal with the uncertainties that will accompany those changes.  

From an investment standpoint, this would have many effects. First, commodities priced in dollars would likely benefit, especially precious metals. Secondly, without the need to hold as many U.S. dollars in reserve, foreign nations might sell their Treasury securities holdings. Further adding pressure to U.S. Treasury securities and all fixed income securities, a weakening dollar is inflationary on the margin, which brings consideration of the Federal Reserve and monetary policy into play.

The Other Side of the Story

The President recently tweeted the following:

Regardless of political affiliation, most Americans agree with President Trump that international trade should be conducted on fair terms. The problem with assessing whether or not “trade wars are good” is that one must understand the other side of the story.

Persistent trade imbalances are the manifestation of explicit global trade agreements that have been around for decades and have historically received broad bi-partisan support. Those policies were sponsored by U.S. leaders under the guise of “free trade” from the North American Free Trade Agreement (NAFTA) to ushering China in to the World Trade Organization (WTO). During that time, American politicians and corporations did not just rollover and accept unfair trade terms; there was clearly something in it for them. They knew that in exchange for unequal trade terms and mounting trade deficits came an implicit arrangement that the countries which export goods to the U.S. would also fund that consumption. Said differently, foreign countries sold America their goods on credit. That construct enabled U.S. corporations, the chief lobbyists in favor of such agreements, to establish foreign production facilities in cheap labor markets for the sale of goods back into the United States.

The following bullet points show how making imports into the U.S. easier, via tariffs and trade pacts, has played out.

  • Bi-partisan support for easing multi-lateral trade agreements, especially with China
  • One-way tariffs or producer subsidies that favor foreign producers were generally not challenged
  • Those agreements, tariffs, and subsidies enable foreign competitors to employ cheap labor to make goods at prices that undercut U.S. producers
  • U.S. corporations moved production overseas to take advantage of cheap labor
  • Cheaper goods are then sold back to U.S. consumers creating a trade deficit
  • U.S. dollars received by foreign producers are used to buy U.S. Treasuries and other dollar-based corporate and securitized individuals liabilities
  • Foreign demand for U.S. Treasuries and other bonds lower U.S. interest rates
  • Lower U.S. interest rates encourage consumption and debt accumulation
  • U.S. economic growth increasingly centered on ever-increasing debt loads and declining interest rates to facilitate servicing the debt

Trade Deficits and Debt

These trade agreements subordinated traditional forms of production and manufacturing to the exporting of U.S. dollars. America relinquished its role as the world’s leading manufacturer in exchange for cheaper imported goods and services from other countries. The profits of U.S.-based manufacturing companies were enhanced with cheaper foreign labor, but the wages of U.S. employees were impaired, and jobs in the manufacturing sector were exported to foreign lands. This had the effect of hollowing out America’s industrial base while at the same time stoking foreign appetite for U.S. debt as they received U.S. dollars and sought to invest them. In return, debt-driven consumption soared in the U.S.

The trade deficit, also known as the current account balance, measures the net flow of goods and services in and out of a country. The graph below shows the correlation between the cumulative deterioration of the U.S. current account balance and manufacturing jobs.

Data Courtesy: St. Louis Federal Reserve (NIPA)

Since 1983, there have only been two quarters in which the current account balance was positive. During the most recent economic expansion, the current account balance has averaged -$443 billion per year.

To further appreciate the ramifications of the reigning economic regime, consider that China gained full acceptance into the World Trade Organization (WTO) in 2001. The trade agreements that accompanied WTO status and allowed China easier access to U.S. markets have resulted in an approximate quintupling of the amount of exports from China to the U.S.  Similarly, there has been a concurrent increase in the amount of credit that China has extended the U.S. government through their purchase of U.S. Treasury securities as shown below.

Data Courtesy: St. Louis Federal Reserve and U.S. Treasury Department

The Company Store

To further understand why the current economic regime is tricky to change, one must consider that the debts of years past have not been paid off. As such the U.S. Treasury regularly issues new debt that is used to pay for older debt that is maturing while at the same time issuing even more debt to fund current period deficits. Therefore, the important topic not being discussed is the United States’ (in)ability to reduce reliance on foreign funding that has proven essential in supporting the accumulated debt of consumption from years past.

Trump’s ideas are far more complicated than simply leveling the trade playing field and reviving our industrial base. If the United States decides to equalize terms of trade, then we are redefining long-held agreements introduced and reinforced by previous administrations.  In breaking with that tradition of “we give you dollars, you give us cheap goods (cars, toys, lawnmowers, steel, etc.), we will most certainly also need to source alternative demand for our debt. In reality, new buyers will emerge but that likely implies an unfavorable adjustment to interest rates. The graph below compares the amount of U.S. Treasury debt that is funded abroad and the total amount of publicly traded U.S. debt. Consider further, foreigners have large holdings of U.S. corporate and securitized individual debt as well. (Importantly, also note that in recent years the Fed has bought over $2 trillion of Treasury securities through quantitative easing (QE), more than making up for the recent slowdown in foreign buying.)

Data Courtesy: St. Louis Federal Reserve

The bottom line is that, if Trump decides to put new tariffs on foreign goods, we must presume that foreign creditors will not be as generous lending money to the U.S. Accordingly, higher interest rates will be needed to attract new sources of capital. The problem, as we have discussed in numerous articles, is that higher interest rates put a severe burden on economic growth in a highly leveraged economy. In Hoover’s Folly we stated: Further adding pressure to U.S. Treasury securities and all fixed income securities, a weakening dollar is inflationary on the margin, which brings consideration of the Federal Reserve and monetary policy into play.

It seems plausible that a trade war would result in potentially controversial intervention from the Federal Reserve. The economic cost of higher interest rates would likely be too high a price for the Fed to sit idly by and watch. Such policy would be controversial because it would further blur the lines between monetary and fiscal policy and potentially jeopardize the already tenuous independent status of the Fed.

Importantly, this is not purely a problem for the U.S. Still the world’s reserve currency, the global economy is dependent upon U.S. dollars and needs them to transact. Any disruption in economic activity as a result of rising U.S. interest rates, the risk-free benchmark for the entire world, would most certainly go viral. That said, for the godless Communist regimes of China and Russia, a moral barometer is not just absent, it is illegal. Game theory, considering those circumstances and actors, becomes infinitely more complex.

Summary

Investors concerned about the ramifications of a potential trade war should consider how higher interest rates would affect their portfolios. Further, given that the Fed would likely step in at some point if higher interest rates were meaningfully affecting the economy, they should also consider how QE or some other form of intervention might affect asset prices. While QE has a recent history of being supportive of asset prices, can we assume that to be true going forward?  The efficacy of Fed actions will be more closely scrutinized if, for example, the dollar is substantially weaker and/or inflation higher.

There will be serious ramifications to changing a global trade regime that has been in place for several decades. It seems unlikely that Trump’s global trade proposals, if pursued and enacted, will result in more balanced trade without further aggravating problems for the U.S. fiscal circumstance.  So far, the market response has been fidgety at worst and investors seem to be looking past these risks. The optimism is admirable but optimism is a poor substitute for prudence.

In closing, the summary from Hoover’s Folly a year ago remains valid:

It is premature to make investment decisions based on rhetoric and threats. It is also possible that much of this bluster could simply be the opening bid in what is a peaceful renegotiation of global trade agreements. To the extent that global growth and trade has been the beneficiary of years of asymmetries at the expense of the United States, then change is overdue. Our hope is that the Trump administration can impose the discipline of smart business with the tact of shrewd diplomacy to affect these changes in an orderly manner. Regardless, we must pay close attention to trade conflicts and their consequences can escalate quickly. 

Imagine a world with two investment options, apples and oranges. Investors are best served to reduce their holdings of apples and to replace them with oranges when demand for apples drives the price too high. The simple logic in this example is applicable across the full spectrum of economics, and it holds every bit as true in today’s complex world of investing. The question every investor should have is, “When does the price of “apples” make “oranges” the preferred holding”? Most of the time, answering that question is not easy. Occasionally however, the evidence becomes too obvious to ignore.

Replace apples and oranges with stocks and bonds and you have defined the majority of investors’ asset allocation schematic. Unlike our fruit example, the allocation decision between stocks and bonds, is based on many factors other than the price of those two assets relative to each other. Among them, recent performance and momentum tend to be a big influence in both raging bull markets and gut-wrenching bear markets. In both extremes, valuations tend to take a back seat despite historical data providing ample evidence that equity valuations alone should drive allocation decision.

Current equity valuations and nearly 150 years of data leave no doubt that investors are best served to ignore yesterday’s stock market momentum and gains and should be shifting to bonds, as we will demonstrate.

Valuations

How often do you hear someone touting a stock because its share price is low, or advising you to sell because the price is too high? This nonsense does not come from just Uber drivers and novice investors; it is the primary programming line-up of the main-stream business media.  The share price on its own is meaningless. However, the stock price times the number of shares outstanding provides the market capitalization (market cap) or the dollar value of the company. Inexplicably, market cap is a number you rarely hear from those giving stock tips.

Market cap allows investors to take the aforementioned corporate worth and compare it to earnings, cash flow, revenues and a host of other fundamental data to provide a logical valuation platform for comparison to other investment options.

While we use a slew of different valuation techniques, we tend to prefer the Cyclically-Adjusted Price-to-Earnings (CAPE) Ratio as devised by Nobel Prize winning economist and Yale professor Robert Shiller. The ratio adjusts for inflation and as importantly, uses ten years of earnings data to derive a price to earnings ratio that encompasses business cycles. Shiller’s approach eliminates short-term noise that tends to make the more popular one-year trailing price-to-earnings ratio erratic and potentially misleading.

Currently, the CAPE on the S&P 500 is 33.41. Looking back as far as 1871, today’s valuation has only been exceeded by a brief period in the late 1990’s. To help link return expectations and CAPE valuations we plot below every historical monthly instance of CAPE to the respective forward ten-year returns. Each of the 1,525 dots represents the intersection of CAPE and the ten year total return that followed since 1871.

Data Courtesy: Robert Shiller

Apples or Oranges

While the analysis is telling, investors should compare the returns versus those from a ten-year U.S. Treasury note to determine whether the returns on stocks adequately compensated investors for the additional risk.

The graph below shows the returns above minus the prevailing ten-year U.S. Treasury note.  Essentially, the graph shows the excess or shortfall of the returns provided by stocks versus those of ten-year Treasury Notes in the ten years following each monthly CAPE instance. Negative returns indicate the 10-year Treasury yield exceeded the 10-year total return on stocks.

Data Courtesy: Robert Shiller

To better highlight the data and put a finer point on current prospects, consider the bar chart below.

Data Courtesy: Robert Shiller

The chart above aggregates the data from the prior chart into ranges of CAPE as shown on the x-axis. It also displays the mean, maximum and minimum of the excess ten year returns of stocks at the various CAPE ranges. This information can be used to create expectations for future performance given a stated CAPE.

With the current CAPE at 33.41 as circled, investors should expect an annualized excess return for ten years of -2.04%. Based on historical data which includes 32 full business cycles dating back to 1871, the best excess return experienced for all instances of CAPE over 30 is 0.39%. Over this 147 year period, there have been 57 monthly instances in which the CAPE was above 30. Only four of these instances provided an excess return over Treasuries and the average was a paltry twenty basis points or 0.20%.

Call us cynical, but the prospect of equity market excess returns  for the next ten years measuring in the fractions of a percent is not nearly enough compensation for the distinct possibility of underperforming a risk-free asset for ten years.

Summary

History, analytical rigor and logic all argue in favor of shifting one’s allocations away from stocks. Investors have no doubt become accustomed to the easy gains provided by equity markets over the past ten years, and old habits are hard to break but we know valuations to be mean-reverting. Given current extremes, this comparison offers compelling evidence that compounding wealth most effectively depends on breaking that habit.

The Federal Reserve (Fed) has increased the Fed Funds rate by 125 basis points or 1.25% since 2015, which had little effect on bonds until recently. Of late, however, yields on longer-maturity bonds have begun to rise, contributing to anxiety in the equity markets.

The current narrative from Wall Street and the media is that higher wages, better economic growth and a weaker dollar are stoking inflation. These forces are producing higher interest rates, which negatively affects corporate earnings and economic growth and thus causes concern for equity investors. We think there is a thick irony that, in our over-leveraged economy, economic growth is harming economic growth.

Despite the obvious irony of the conclusion, the popular narrative has some merits. Fortunately, the financial markets provide a simple way to isolate how much of the recent increase in longer-term bond yields is due to growth-induced inflation expectations. Once inflation is accounted for, we shine a light on other factors that are playing a role in making bond and equity investors nervous.

Given the importance of interest rates on economic growth and stock prices, understanding the supply and demand for interest rates, as laid out in this article, will provide benefits for those willing to explore beyond the headlines.

Nominal vs. Real

Since September of 2017, the yield on the five-year U.S. Treasury note has risen 90 basis points while the ten-year U.S. Treasury note has increased 75 basis points. At the same time, inflation, as measured by annual changes in CPI, declined slightly from 2.20% to 2.10%. Recent inflation data, while important in understanding potential trends, is by definition historical. As such, forecasts and expectations for inflation over the remaining life of any bond are much more relevant.

Treasury Inflation Protected Securities (TIPS) are a unique type of bond that compensates investors for changes in inflation. In addition to paying a stated coupon, TIPS also pay holders an incremental coupon equal to the rate of inflation for a given period. In technical parlance, TIPS provide a guaranteed real (after inflation) return. Non-TIPS, on the other hand, provide a nominal (before inflation) return. The real returns on bonds without the inflation protection component are subject to erosion by future rates of inflation. To gauge the market’s expectations for inflation, we can simply subtract the yield of TIPS from that of a comparable maturity nominal bond.

During the same six month period mentioned above, yields on five and ten-year TIPS increased 30 basis points. As shown below, this means that 60 basis points of the 90 basis point increase in the five-year note and 45 basis points of the 75 basis point increase in the ten-year note are a result of non-inflationary factors. The graphs below highlights the recent period in which five and ten-year yields rose at a faster pace than inflation expectations.

Data Courtesy: St. Louis Federal Reserve

Data Courtesy: St. Louis Federal Reserve

By isolating the widening gap between nominal and real yields on Treasury notes of similar maturities, we establish that there are other factors besides inflation that account for about two-thirds of the recent march higher in yields. Below, we summarize the potential culprits affecting both the supply and demand for U.S. Treasury debt offerings, which should help uncover the factors other than inflation that are driving yields higher.

Supply Factors

The most obvious influence driving yields higher, in our opinion, is the prospect of larger Federal deficits in the coming years. The tax reform package boosts the deficit over the next ten years by an estimated $1.5 trillion, and the recent two-year continuing resolution (CR) for government spending adds an additional $300 billion of debt to the U.S. Treasury’s ledger. We remind you these are in addition to Congressional Budget Office (CBO) forecasts for sharply increasing deficits due to social security and other previously promised entitlements.

As if deficit spending approaching that of the financial crisis of 2008 is not shameful enough, the administration’s latest budget proposal is even more daunting. Based on the proposed budget, if we optimistically assume that the current economic expansion can last for ten more years without a recession and that GDP can grow by about 1.50% more than that of the last decade, then the deficit will grow by “only” approximately $8 trillion by 2027. Keep in mind; debt outstanding tends to grow by a larger amount than stated deficits due to accounting gimmicks used by the Treasury. Before including Trump’s budget proposal, the trajectory of Federal debt outstanding is forecast by the Office of Management and Budget (OMB) to increase by $1.1 trillion on average in each of the next five years.

To put that into context with the nation’s ability to pay off the debt, the economy has grown by approximately $500 billion a year on average over the last three years. Federal tax receipts as a percentage of GDP over the last three years have declined from 11.5% to 11.1%. If the economy grows $500 billion, we should expect an additional $55 billion of tax revenue. These numbers emphasize the extent to which elected officials from both parties have radicalized the budget process and the acute state of fiscal irresponsibility now in play.

Don’t dismiss the magnitude of $20 Trillion in U.S. debt and it projected growth rate. It is larger than the debts of the next four largest debtor nations combined. 

Demand Factors

“Deficits don’t matter.” This frequently quoted statement leads many to believe that our nation’s debts will always be funded by willing and able creditors. To their point, rapidly increasing federal debt levels of the last thirty years have been easily funded and at increasingly lower interest rates.

To better gauge whether we can expect said support to fund the increase in projected debt issuance, we analyze the two largest holders of publically traded Treasury securities, foreign investors and the Federal Reserve.

Foreign investors hold 43% of all publically held Treasury securities outstanding, commonly referred to as “marketable debt held by the public.” China and Japan top the list, with each holding over $1 trillion of Treasury debt. The graph below compares foreign holdings of U.S. Treasury debt and the entire stock of public U.S. Treasury debt.

Data Courtesy: St. Louis Federal Reserve

Will foreign buyers continue to grow their holdings by over $400 billion each year?

To help answer that question, consider:

  • Over the last year, foreign holders have purchased approximately 5% of new debt compared to a range of 40-60% since the recession of 2008.
  • Since 2015, foreign holders have increased their Treasury security holdings by $151 billion while $1.591 trillion of new Treasury debt has been issued.
  • Since 2015, Japan has reduced holdings of US. Treasuries by 12% or $141 billion.
  • Since 2015 China has reduced holdings of US. Treasuries by 4% or $52 billion.

The second largest holder of U.S. Treasuries is the Federal Reserve. Quantitative Easing (QE) was a major part of the Feds economic stimulus and bailout program of the 2008/09 financial crisis and continues to this day. QE is essentially the act of printing money to purchase debt securities from the market. According to the Federal Reserve Bank of St. Louis, Fed holdings of U.S. Treasury securities rose from $474 billion in March 2009 to a peak of $2.40 trillion in December 2014, an increase of 416%. That balance was held stable through the end of 2017. To put that into context, as of September 2017, mutual funds, pension funds, and insurance companies held a combined $2.47 trillion of Treasury debt.

As we discussed in the Fed Giveth (LINK), the Fed has recently begun reducing the size of their balance sheet, and therefore its holdings of Treasury securities are slowly shrinking. They began in late 2017 by reducing the amount of Treasuries held by $6 billion per month and will increase the pace by $6 billion every three months until they reach $30 billion per month. This schedule, if reliable, implies that the Fed will reduce their Treasury holdings by $225 billion in 2018 and $351 billion in 2019. In this way, the reduction in Federal Reserve holdings is an incremental supply of Treasury securities to the market. And when the supply of bonds increases, yields should rise.

The absence of the Fed as large Treasury holders and the reductions in holdings and new purchases of Treasuries by China and Japan should have similar effects on yields, although the magnitudes may be different. So, rising yields are not just about inflation, whether realized or expected, it is also about the changes taking place in supply and demand simultaneously.

Summary

Vice President Dick Cheney was quoted in 2002 as saying “deficits don’t matter.” With the staggering accumulated deficits of the past few years, we are about to test Cheney’s theory. The powerful economic environment of the 1980’s and 1990’s allowed for the accumulation of federal, corporate and personal debt. In this millennium, the growth of debt accelerated, but the tailwinds supporting economic growth have weakened substantially.

Just because we were easily able to fund deficits of years past does not mean we should be so naïve as to think it will be easy going forward. As described above, the circumstances we face today are far more challenging than those of past years. The confluence of these events argues that investors should prepare for a new paradigm and not get caught flatfooted trusting in outdated narratives.

We leave you with a bit of wisdom from investment guru Bob Farrell, Former Chief Stock Market Analyst Merrill Lynch

“In the early stages of a new secular paradigm, therefore, most are conditioned to hear only the short-term noise they have been conditioned to respond to by the prior existing condition.  Moreover, in a shift of long-term significance, the markets will be adapting to a new set of rules while most market participants will be still playing by the old rules.”

Most investors, knowingly or not, rely on long-only, passive strategies. They may shift holdings between stocks, bonds, and cash at various intervals, but generally, their portfolio returns mimic those of well-known stock and bond indices.

A recent graph from Goldman Sachs, as shown below, serves as a prescient reminder that this popular portfolio strategy may be worth reconsidering in the current environment.

The graph shows bull and bear market periods based on a portfolio comprised of 60% equities and 40% bonds. This graph uniquely allows the reader to simultaneously visualize both returns and the duration of the respective bullish or bearish periods.  Focusing on the current bullish period, here are two important takeaways that investors must consider:

  • The current bull market in stocks and bonds is 8.7 years old and only about five months shorter than the longest bullish period since at least 1900. That period, the “roaring twenties” preceded the Great Depression.
  • Total returns for the current recovery are the third highest over the past 118 years, eclipsing both 2008 and 1999, which both resulted in significant (over 50%) drawdowns.

This chart should give investors pause. While it does not necessarily imply the bottom will fall out as it did in the 1930’s, or even 1999 and 2008, it does suggest that asset markets are historically stretched when measured in both return and the duration. Over the coming years, it is highly likely that a sizeable portion of those returns will be lost.

The graph above fails to factor in one consideration that may make the next correction different from the last four. During the last four recessions and related equity market corrections, a balanced portfolio (60/40) benefited greatly from gains in fixed income assets. The graph below compares total returns during those periods of a portfolio that is 100% invested in the S&P 500 versus one that is allocated to the S&P 500 and U.S. 10 year Treasury notes in a 60:40 ratio.

As shown, the addition of bonds and reduction of equities resulted in positive returns during the recessions of 1981 and 1991. During the last two recessions, bonds helped to cut the portfolio’s losses in half.

Looking forward, an important question we must consider is will bonds help minimize losses as they have done in the past. In the prior two recessions, the ten year U.S. Treasury note yields were greater than 4% and nearly double those of today. The significance is that a higher yield provides more room for yields to decline and thus bond prices to increase. Further, the higher yield provides more coupon income to help offset equity losses.

Investors relying on gains on bond holdings to offset losses on stock holdings should consider that while bonds may produce gains, said gains are likely more limited than at any time in the past.

What’s an Investor to do?

Given the historical precedence, we think it is appropriate for investors to consider alternative wealth management strategies. Below, we describe a few strategies that are not dependent upon positive stock and bond market direction to generate positive returns.

Global macro – By far the most complex and difficult of strategies, managers use a fundamental assessment of global economic dynamics to establish long or short positions in every asset class available to them.

Deep value – This strategy seeks to limit investments to those securities that are heavily discounted and/or extremely out of favor and thus appear to have very limited downside risk. This strategy tends to have longer holding periods than most.

Option strategy – Managers employing this strategy predominately engage in the exchange-traded options market (put/calls) and/or over-the-counter options (swaptions). At times, options are combined with long or short positions in the underlying securities to create the desired profile.

Event-drivenThis is a strategy focused on identifying specific catalysts related to a company, a sector or an economy and positioning for the ultimate realization of that event.

Arbitrage – In this approach, managers look for pricing anomalies among related instruments and seek to extract risk-free profits by being long or short those instruments at the same time.

Volatility –  Now viewed as an asset class like stocks, bonds and commodities, this strategy uses long or short positions and options to produce returns through low (and rising) or high (and falling) price swings in those instruments.

Long/Short – Predominantly used by managers in the equity markets to pair a long position in one stock against a short position in another with the intent of limiting market risk while taking advantage of perceived richness and cheapness in selected securities.

Trend Following – This strategy is generally a technical approach which relies upon the momentum of price action in a security or an index to generate profits. Managers use long or short positions as a trend establishes itself, then take profits and reverse positions as the trend weakens or reverses.

Fund of Funds – Firms with expertise in identifying talented investment managers look to diversify investment dollars among many managers and strategies, including some of the strategies listed above.

The strategies listed above represent a subset of strategies commonly used by those seeking returns that are not highly correlated with market returns. Like any strategy, those summarized above tend to cycle through periods where they are effective and times when they are less so. Thus, like any strategy, timing is important.

The overly simplistic approach of buy-and-hold fails to acknowledge that given a deep enough correction, most investors will eventually react by selling to stop the mental anguish. This usually occurs very near the worst possible time – at the bottom. To continually build wealth through good and bad markets, investors require a diverse, alternative set of strategic tools. Further, traditional bond/stock strategies of yesterday had the benefit of a cushion provided by fixed income assets. Given the low level of rates, we must question the validity of relying on bonds to hedge a portfolio in the next turndown.

By ignoring history and shunning alternative strategies, investors will, in time, lose much of the wealth they have accumulated over the prior years. Compounding wealth does not require keeping up with high-flying markets in good times, it demands prudent decision-making to avoid large losses when markets sour.


It is important to stress that the strategies detailed above are typically beyond the scope of amateurs and do contain substantial risks of loss. We highly recommend speaking with a knowledgeable investment manager, and conducting extensive due diligence, before investing in such strategies.

Last Friday, Gross Domestic Product (GDP or the domestic economic growth rate) for the fourth quarter of 2017 was released. Despite being 0.3% short of expectations at 2.6% annual growth, it nonetheless produced enthusiasm as witnessed by the S&P 500 which jumped 25 points.  One of the reasons for the optimism following the release was a strong showing of the consumer which notched 2.80% growth in real personal consumption. The consumer, representing about 70% of GDP, is the single most important factor driving economic growth and therefore we owe it to ourselves to better understand what drove that growth. This knowledge, in turn, allows us to better assess its durability.

There are three core means which govern the ability of individuals to spend. The most obvious is income and wages earned. To help gauge the effect of changes in income we rely on disposable income, or the amount of money left to spend after accounting for required expenses. Real disposable personal income in the fourth quarter, the same quarter for which GDP data was released, grew at a 1.80% year over year rate. While other indicators of wage growth are slightly higher, we must consider that payroll gains are not evenly distributed throughout the economy. In fact as shown below 80% of workers continue to see flat to declining growth in their wages.

While this may have accounted for some of the growth in consumption we need to consider the two other means of spending over which consumers have control, savings and credit card debt.

Savings: Last month the savings rate in the United States registered one of the lowest levels ever recorded in the past 70 years. In fact, the only time it was lower was in a brief period occurring right before the 2008/09 recession. At a rate of 2.6%, consumers are spending 97.4% of disposable income. The graph below shows how this compares historically.

As shown above, the savings rate is less than half of that which occurred since the 2008/09 recession and well below prior periods.

There are two ways to think about the record low level of savings. Optimistically, we can claim that consumers are confident about future job prospects and wage growth and therefore feel as though they do not need to save. More realistically, we can assume that consumers are in a bind and are reducing their savings to make ends meet. More recently, the higher price of education and health coverage are likely culprits for pushing consumers to skimp on savings.

Credit Card Debt: In addition to reducing savings to meet basic needs or even splurge for extra goods, one can also use credit card debt. Confirming our suspicion about savings, a recent sharp increase in revolving credit (credit card debt) is likely another sign consumers are having trouble maintaining their standard of living. Over the last four quarters revolving credit growth has increased at just under 6% annually which is almost twice as fast as disposable income. Further, the 6% credit card growth rate is about three times faster than that of the years following the recession of 2008/09.

Adjusted GDP

While the GDP data represents actual consumption, we again ask if it is sustainable. In the case of the last few quarters, in particular, we must answer that question based on the ability for savings to decline further and credit card usage to remain high. As such, we normalized GDP based on the savings rates and credit card usage growth of the post-recession era. In our opinion, this gives us a realistic reading of what GDP would be like without the benefits of sharply reduced savings rates and unsustainable usage of credit cards.

Savings: If we recalculate the amount of consumption that would have occurred had the savings rate remained at the post-recession savings rate of 5.50%, we compute that $281 billion of savings was sacrificed over the last four quarters.

Credit Cards: The amount of revolving debt has been increasing at 6% annually over the last four quarters which is double the rate of income, or the ability to pay for the debt. If we assume instead a more normal 3% usage growth rate, which is in line with income growth, we estimate that additional credit accounted for $20 billion of spending above and beyond what is sustainable.

Over the last four quarters, real GDP rose by $421 billion, resulting in a 2.60% annual increase. If we adjust consumption to more normal levels of spending and credit usage, the increase in GDP is a mere 0.71%, hardly robust.

Summary

Can savings decline further and credit increase more? The answer is yes, but to do so savings would hit all-time lows and the rate of credit growth would greatly exceed the rate of income growth. Despite the hype of post-tax reform corporate bonuses, wages and salaries continue to muddle along at a very uninspiring rate.  This data further tells the story of an indebted consumer that is being forced to spend more income on non-discretionary items such as rent, education, healthcare and energy and in response is using credit and savings to fund those purchases.

This story will get interesting when the first-quarter 2018 GDP is released and the hangover from the holiday season reveals itself. The revisions to growth are likely to be confounding and broadly rationalized away by stock-friendly analysts. While monthly data has yet to give us any meaningful indications, we suspect personal consumption for the current quarter, and likely many ahead, will be weak.

In the past month, two well-known and highly respected money managers have made confident assertions about the markets. Their comments would lead one to believe that the future path of the market in the coming months is known. Sadly, many investors put blind faith in the words of high-profile, accomplished professionals and do little homework of their own. While we certainly respect the background, knowledge, and success of these and many other professionals, we take exception with their latest bit of advice.

Before the election In November 2016, were there investment professionals that claimed a Donald Trump victory would drive equity prices significantly higher? Although we are certain there were a (very) few, they certainly were not publicly discussing it, and the broad consensus was overwhelmingly negative.  In March of 2009, which professional investors were pounding the table claiming that the next decade would produce some of the greatest market returns in history? Again, while some may have thought valuations were fair at the time, few if any were raging bulls.

The two instances are not unique. More often than not, investor expectations fail to accurately anticipate the future reality. This is not solely about amateur individual investors, as it equally applies to the best and brightest. Despite the urge to heed the sage advice of the “pros”, we must always remain objective, especially when everyone seems so certain about what will happen next.

The Known Future

The current message from Wall Street analysts, media gurus and most investors is that stock prices will undoubtedly go up for the foreseeable future.  Unbridled optimism about corporate earnings offer one point of fundamental justification for such views, but in large part these forecasts are predominantly based on the simple extrapolation of prior price trends. In late January 2018, a few esteemed Wall Street analysists actually raised their year-end S&P 500 price forecast from what it was only weeks prior. Although rationalized by stronger estimates of earnings expectations and an improving economic prognosis, the fact that January’s market rally has the S&P 500 already approaching their year-end forecast also played a meaningful role.

Basing future expectations on the most recent price activity is a great method of forecasting returns, until the trend changes. Wall Street analysts are not the only ones convinced the recent trend will continue in the months ahead. The graph below shows that expectations for stock price increases are now higher than at any time since at least 1987.

This second table from Ronnie Stoeferle at Incrementum provides a broad gauge of the excessive bullishness in the markets.

While there are a slew of technical reasons to suspect the recent market dip may be a speed bump on the way to higher prices, there are some serious fundamental warnings along with geopolitical concerns that argue downside risks are being grossly ignored. We would avoid using the word certainty to describe a market or economic forecast, and given the juxtaposition of risks and excessive valuations, relying on the certainty of others is not a prudent way to build wealth.

Ray Dalio

The following quotes came from a recent interview with Ray Dalio:

  • “We are in this Goldilocks period right now. Inflation isn’t a problem. Growth is good, everything is pretty good with a big jolt of stimulation coming from changes in tax ”
  • “There is a lot of cash on the sidelines. … We’re going to be inundated with cash,” … “If you’re holding cash, you’re going to feel pretty stupid.”
  • Finally, he said he expects to see “a market blow-off” despite the economy being in the last legs of the economic growth cycle.

What could go wrong? Ray Dalio, the billionaire founder of the world’s largest hedge fund, warns us that taking a conservative posture will make you “feel pretty stupid.”

There are four problems with these comments. First of all, does Ray Dalio really believes there is “cash on the sidelines”?  For every buyer there is a seller. The concept of “money on the sidelines” does not hold in a free market economy. This is one of Lance Robert’s 7 Myths of Investing.

7-Myths Of Investing

Second, neither he nor anyone else knows what the future holds and for every buyer there is a seller. Third, even if we presume him to be correct concerning the market, will he let you know when it’s time to sell stocks and hold cash?  Keep in mind that wealth is compounded most effectively by not chasing markets higher but by avoiding large losses. Finally, Mr. Dalio almost certainly has hedges in place so that, even if he is wrong, his portfolio will have some cushion. Again, although we respect his insight and he may well be correct, it is concerning to hear a person of such influence potentially mislead investors into thinking the future is certain and worse mocking those taking precautionary measures.

Jeremy Grantham

Mr. Grantham, also a very successful investment manager, has made similar comments as to how this bull market ends.

  • “I recognize on one hand that this is one of the highest-priced markets in U.S. history. On the other hand, as a historian of the great equity bubbles, I also recognize that we are currently showing signs of entering the blow-off or melt-up phase of this very long bull ”
  • “A melt-up or end-phase of a bubble within the next six months to two years is likely, i.e., over 50%.”

Mr. Grantham has a perfect track record this millennium of calling out the equity bubbles of 2000 and 2008 well in advance. Further, he has stated unequivocally that equity valuations are excessive and investors should expect flat to negative returns over the longer term. Currently, his firm GMO is forecasting annualized inflation-adjusted returns of -4.4% for U.S. large-cap stocks over the next seven years. Despite the prospects of negative returns and wealth losses, he feels confident influencing others to chase a “melt-up” bubble that may last from six months to two years.

Dalio/Grantham Wisdom

Both highly successful investors and thought leaders are telling the story of tenable market risks but then tempting investors with the possibility of a grand finale worth chasing.

No one knows how this current bull market will end. Dalio and Grantham may be correct, and it may end with a melt-up, blow-off rally for the ages.  On the other hand, it may have ended last week with the blow-off rally having occurred over the last year.

To put a historical perspective on how this market may top, the following charts compare the death of the NASDAQ 100 bull market in 2000 and the end to the S&P 500 bull market in 2007.

As shown, the topping of the last two bull markets took vastly different paths. Whether a blow-off rally as seen in the late 1990s, the one advocated by Grantham and Dalio, is the right call or a more frustrating rounded top of 2008 is the answer, we do not know. Left for consideration is whether the 37% rally since Trump’s election was the blow-off top and, if so, has it reached its apex?

Summary

While market geniuses in their right, Dalio and Grantham’s ideas about how this ends have zero certitude. If their minds change, we will almost assuredly be the last to know. Although a cynical premise, could they be propping the market up with talk of a magnificent rally so they can reduce their own risk? There is abundant evidence this occurred in 2007 as the mortgage meltdown progressed, albeit with different protagonists.  So, we think it is a fair question to ask in this instance.

Given current valuations, the risks are significant, and if history is any indication, we can be assured that this bull-run will end sooner rather than later. This is not a message encouraging you to ignore the thoughts of Dalio, Grantham or other successful investors. Rather we remind you that you are solely responsible for the risks you take. Being a good fiduciary and worthy steward of wealth mandates that we understand the risks as highlighted by Dalio and Grantham and avoid being influenced by the consensus groupthink that often has an ulterior motive. We all know how that ends.

We leave you with the S&P 500 price projections from Wall Street’s best and brightest in 2008.

The following article emphasizes that the perceived economic prosperity of recent decades is largely the result of political expediency. Those in charge of monetary policy have repetitively failed to act in the best interests of the public in an effort to either avoid criticism or preserve their individual status. While often ignored, this dynamic is crucial to understand to form longer term expectations for asset prices.

“I’m making records, my fans they can’t wait

They write me letters, tell me I’m great” – Joe Walsh

The modern day printing of digital dollars from thin air, literally from nothing, brings to mind a Latin phrase “ex nihilo, nihil fit” which means out of nothing, nothing comes. If that statement is true, and a moment of reflection surely produces the logical conclusion that it is true, then what do central bankers hope to accomplish by means of conjuring currency from, well, nothing? What does it further say about setting interest rates at less than nothing? If nothing can come from nothing then there is no solution in the idea that by printing dollars and inflating asset prices you can create something (a durable organic recovery). Although the net result for the economy will be nothing, the net result of those actions for individuals appears to be a redistribution of wealth in the economy. In the end, it becomes clear that the purpose of and reason for the exercise is not the good of the general public but rather advocacy of large financial institutions, political expediency and hubris. If that were not the case, then why would the Federal Reserve need to hire a veteran lobbyist (former Enron and Clinton administration employee) in navigating the use of their powers in the months following the financial crisis?

Hilltop Houses and Fifteen Cars

There is something god-like in the idea of creating something out of nothing – especially money – which fits with the progression of status among Federal Reserve (Fed) members. The idea that their stature and judgement is beyond reproach has been in play for some time.

Alan Greenspan: The absurd notion of central bankers as rock stars was popularized by Alan Greenspan. He achieved celebrity status by advancing in ways never before seen, the interventionism of the Federal Reserve. Some of his handiwork includes engineering a rapid recovery of the stock market following the Black Monday crash in 1987, the notoriety of uttering the term “irrational exuberance” in 1996, the front man on the cover of Time magazine as a member of “The Committee to Save the World”, having his name on a key market term – The Greenspan Put, and of course having a book published about him by the iconic Washington Post reporter and author Bob Woodward well before his tenure as Fed chief ended.  These are things now to which every Fed Chairman aspires – indeed, to which every central banker aspires.

Ben Bernanke: So desperate to follow suit after he stepped down as Fed Chairman in 2014, he could not wait for someone to write his story so he penned his own in the self-aggrandizing “Courage to Act”. In addition to well-paid fees for public appearances, his desperation for notoriety also extends to consulting for some of the most powerful hedge funds as well as blogging his perspectives from time-to-time. The legacy he is desperately trying to shape seems similar to the gilded stature Greenspan crafted for himself.

Janet Yellen: In her time as the Chairman, Yellen was the beneficiary of much good fortune and did nothing to make waves (or right the ship). As the New York Times reports, given her tenure presiding over a “plummeting unemployment rate and consistently low inflation, Ms. Yellen became a pop culture phenomenon.” Such hyperbole used to lobby for Janet Yellen’s rock star status is derisory. The health of the organic economy is contrived by the over-use of debt. The disparity between the rich and poor has never been wider as Yellen assisted in hollowing out the middle class by adhering to a “saver-punishing” low-rate policy. Trickle down policy of boosting asset prices is surely benefitting the wealthy but to the detriment of society.  By myopically targeting traditional measures of inflation, she took latitude to continue crisis policies to print money and is complicit in the on-going accumulation of debt. The likelihood is that the failure to normalize monetary policy years ago has sown the seeds of the next crisis. Like Bernanke, how her role is cemented in history as one of those who are “great” among central bankers too will be determined by time and economic outcome.

Jerome Powell: Will the latest chairman of the Fed, Jerome Powell, have the courage to act? Vilified in the late 1970’s and early 1980’s for raising interest rates and temporarily choking off economic activity, Fed Chairman Paul Volcker had the character to sacrifice his own popularity and accept the short-term consequences in exchange for dramatic long-term economic benefits. He did it because arresting inflation was in the best interest of the country. Mr. Powell has a choice to make. He can do what’s best for the country or he too can aim to become a “pop culture phenomenon” and keep the charade going but he cannot do both.  Time will tell.

…Before the Fall

The modern day desire for individual notoriety and legacy among central bankers belies the purpose of the role they play in shaping the business cycle. Their influence on the trajectory of the economy should be so subtle as to scarcely be perceived. As was the case with McCabe, Martin and Burns, few should recognize their names. The incongruence of this passion among the power-elite who manage the printing presses of the world’s largest economies is akin to the contrast between pride and humility. Anyone who thinks themselves qualified to manage the monetary policy of the complex system of a major economy lacks requisite humility and is too deceived by pride to be thus qualified. A proud man is always looking down on things and people and, of course, as long as you are looking down, you cannot see that which is larger – the best interests of people or democracy


Comparing current equity valuations to prior valuation peaks such as those of 2008, 1999 or any other period is commonplace, but remains an essential way of assessing current market prospects and potential risks. Currently, seven of the eight traditional valuation techniques shown by Goldman Sachs below are in the upper strata of recent history.

The graph above, courtesy Goldman Sachs, is from August 2017. Since that time it is highly likely that all of those valuation levels have risen further.

In Second to None, published March 1, 2017, we opined that simply assessing valuation techniques, as shown above, is a great starting place for investors to gauge the present status of valuations. We added that it is equally important to normalize different periods of time to make their valuations comparable based on the level of economic growth which directly supports corporate profits. The result of our analysis shows that the current level of Cyclically Adjusted Price to Earnings (CAPE) is well above the levels of every other market peak, including 1999 and 1929. Essentially, investors are willing to pay more for each unit of economic growth today than at any time in modern history.

In this article, we update the data to reflect the current GDP adjusted CAPE and take it a step further to include the cyclical nature of corporate profit margins. When both adjustments are factored in, we gain a unique perspective that demonstrates the extent to which today’s valuations are, quite literally, off the charts.

GDP Trends

While the economy cycles from recession to growth and back, the long term economic growth trend, or secular GDP, has trended lower for the better part of the last 30 years. The graphs below show the cyclical short-term nature of economic growth (left) as well as the longer term trend (right).

Data Courtesy: St. Louis Federal Reserve (FRED)

There are a number of reasons for the long-term, downward growth trend about which we have written extensively. In a nutshell, the following are the three largest factors accounting for the deteriorating trend in growth:

  • Debt – The amount of federal, corporate and individual debt has consistently risen at a pace faster than economic growth. As such, many debtors are unable to borrow further to keep spending. Others are hampered by interest payments which crowd out spending. The Federal Reserve has used extraordinary policies to force interest rates to historic lows to counter the debt burden, but their actions have only bought time and incentivized even more debt. The debt problem, which we call the Lowest Common Denominator, has only worsened.
  • Demographics – Over the last 30 years, baby boomers provided a driving force for economic growth. As this outsized generation nears retirement, they will spend less and, in many instances, become a burden on the taxpayers that support them through social security and other entitlements. Additionally, slowing population growth and tightened restrictions on immigration are reducing the number of workers and consumers that can contribute to economic growth.
  • Productivity – Partially as a result of years of poor economic, fiscal and monetary policy that dis-incentivized long-term investment in favor of consumption, the rate of productivity growth, the lifeline of economic growth is nearing zero.

It is primarily these three reasons and their longer-term projections that make us nearly certain that secular economic growth will continue to weaken in the years ahead. That does not mean there will not be periods of stronger growth. However, given that few of our nation’s leaders truly understand what drives sustainable economic growth and even fewer have the courage required to reverse the trends, we see little reason to expect change.

Given our assumption that long-term economic trends are likely to persist, we believe it is necessary to use economic growth to normalize current equity valuations to compare them to prior periods.  The following graph is an updated version of the one shown in Second to None.  It plots CAPE divided by the trailing ten-year growth rate of nominal GDP.

Data Courtesy: St. Louis Federal Reserve (FRED) and Robert Shiller

Note that the graph above and all of the graphs normalizing CAPE in this article, unlike the one presented in Second to None, are scaled by multiples of the average on the y-axis instead of the calculated number. The rationale being that the purpose of the analysis is not to provide a concrete numerical data point, but a comparative measure that allows one to relate valuations over many different economic environments. As an example the current reading is 2.86, meaning market valuations using this measure are 2.86 times higher than the average since 1956.

The two potential arguments against this type of analysis are likely from those that disagree with our longer-term growth forecast or those that agree with us but believe that we should exclude data from the financial crisis of 2008 as it was far from the norm.

For those that think economic growth will be better than the trend of the last thirty years, you should be aware that a ten-year growth rate of 8.21% is required to bring the adjusted valuation to its long-term mean. Such a ten-year growth rate has not been witnessed since 1987 and is nearly 2% greater than the average over the last 70 years.

For those that think excluding 2008 is appropriate, we calculated a seven-year CAPE divided by seven-year growth. While the current level using this time frame is not as egregious, it is two times that of the average over the last 70 years and only slightly lower than the peak established in the year 2000.  We remind those in this camp that the current economic expansion has lasted 103 months, almost twice the average since 1945. The longest expansion during this period was 120 months. No one knows when a correction will come, but we are clearly in the later stages of the cycle unless one assumes that the laws of mean reversion have been permanently suspended for both valuations and economic cycles.

Margins are Cyclical

Corporate profit margins, or the difference between sales and net profits, are considered one of the most cyclical fundamental measures that exist. The reason is that, when margins are high in certain industries, new entrants are lured to those industries by the higher margins. Conversely, when margins are low, companies exit those industries and those remaining companies can increase margins. The graph below shows the cyclical nature of corporate margins since 1948.

Data Courtesy: St. Louis Federal Reserve (FRED)

When margins are higher or lower than average, it makes sense to assume they will revert to the mean over time. Therefore, the rationale and logic for normalizing CAPE based on current margins and its historical tendency, provides a valuation level, as shown below, that is comparable to other periods.

Data Courtesy: St. Louis Federal Reserve (FRED) and Robert Shiller

Note that in the first graph showing historical margins that margins over the last 70 years appear to have broken the cyclical pattern and have stayed well above the average for an extended period. Many stock promoters believe this is a reflection of a “new normal” and cheer such a feat. They may be correct, but you might also want to consider that if margins have risen to a new level and are not cyclical anymore, the age-old incentives that drive business decisions in a free market economy no longer exist.  If that is the case, we may also want to consider that capitalism may be broken. If capitalism is in fact eroding, do you really want to pay a high premium for stocks? To help answer that question, we suggest a quick review of the gross economic inefficiencies of those nations where capitalism is not employed.

Comparative CAPE

We believe that durable longer-term economic trends and profit margins should be used to normalize CAPE and again make it comparable to prior periods. The graph below presents CAPE adjusted for both.

Data Courtesy: St. Louis Federal Reserve (FRED) and Robert Shiller

The graph above highlights that valuations using this measure dwarf any prior valuation peak since at least the 1950’s. At over 350% above the mean, stock investors are currently paying significantly more for a unit of economic growth than at any time in the last 70 years. To extend the analysis, we estimated the adjusted CAPE level of 1929, as shown on the graph, and come to the same conclusion.

Summary

Most astute investors know that stock valuations are at or near historical highs. Even these investors, however, may be unaware that today’s valuations, when adjusted for the level of economic growth and heightened profit margins, defy comparison with any prior period since the Great Depression. The simple fact is that investors are paying over three times the average and almost twice as much as the prior peak for a dollar of economic growth. Furthermore, it is happening at a time when we are clearly late in the economic cycle and the outlook for growth, even if one is optimistic, is well below that required to justify such a level.  

Fundamental valuations are a great means of understanding the potential value or lack thereof in a market or individual stock. However, it is a poor short-term trading tool. There is no doubt that, in time, valuations will revert to the norm. This can occur via sharp earnings increases or slower earnings growth accompanied by years of price stagnation. It can also transpire, as it has in the past, with a sharp drawdown in equity prices. Regardless of how you think this resolves itself, we hope this valuation technique provides another helpful tool for assessing the proper risk and reward tradeoff offered by markets currently.

Today’s equity market valuations have only been eclipsed by those of 1929, and 1999.”

In March of 2017, we examined traditional equity valuations in a new light to help better compare today’s valuations versus those of past business cycles. In particular, we adjusted the popular price-to-earnings (P/E) ratio for economic growth trends. The logic backing the analysis is that investors should be willing to pay a larger premium if economic growth is strong, and therefore corporate earnings are higher, and vice versa if economic growth is comparatively weak. The premise is similar to the popular price-to-earnings growth (PEG) ratio commonly used by equity investors. While P/E assesses the value of a stock on the basis of trailing earnings, PEG is more forward-looking using the expected growth of earnings. Essentially, the ratio tells us how much a current investor is willing to pay for a unit of expected earnings.

This re-publication of Second to None is intended to revisit a variety of key points as a base of understanding for an upcoming article. Given the extent to which markets have moved over the past several months, updating this analysis is timely. Further, the upcoming article will broaden the discussion to include a second important driver of corporate earnings and therefore provide fresh perspectives on valuations. We are confident you will find it compelling, so stay tuned.


Given the continuing equity market rally and multiple expansion, the quote above from prior articles, had to be modified slightly but meaningfully. As of today, the S&P 500 Cyclically Adjusted Price to Earnings ratio (CAPE) is on par with 1929. It has only been surpassed in the late 1990’s tech boom.

A simple comparison of P/E or other valuation metrics from one period to another is not necessarily reasonable as discussed in Great Expectations. That approach is too one-dimensional.   This article elaborates on that concept and is used to compare current valuations and those of 1999 to their respective fundamental factors.  The approach highlights that, even though current valuation measures are not as extreme as in 1999, today’s economic underpinnings are not as robust as they were then. Such perspective allows for a unique quantification, a comparison of valuations and economic activity, to show that today’s P/E ratio might be more overvalued than those observed in 1999.

Secular GDP Trends

Equity valuations are a mathematical reflection of a claim on the future cash flows of a corporation. When one evaluates a stock, earnings potential is compared to the price at which the stock is offered. In most cases, investors are willing to pay a multiple of a company’s future earnings stream. When the prospects for earnings growth are high, the multiple tends to be larger than when growth prospects are diminished.

To forecast earnings growth for a company, one needs to do an in-depth analysis of the corporation, the economy and the markets in which it operates. However, evaluating earnings growth for an index comprising many companies, such as the S&P 500, is a relatively straight-forward task.

Corporate earnings are a byproduct of economic activity. Earnings growth can differ from economic growth for periods of time, but in the long run aggregate earnings growth and GDP growth are highly correlated.  The two graphs below offer an illustration of the durability of this relationship. The graph on the left plots three-year average GDP growth and its trend since 1952, while the graph on the right highlights the correlation of GDP to corporate profits.

Data Courtesy: St. Louis Federal Reserve (FRED), Bureau of Economic Analysis (BEA) and Bloomberg

Given the declining trend of GDP and the correlation of earnings to GDP, it is fair to deduce that GDP and earnings growth trends were healthier in the late 1990’s than they are today. More specifically, the following table details key economic and financial data comparing the two periods.

Data Courtesy: St. Louis Federal Reserve (FRED), and Robert Shiller http://www.econ.yale.edu/~shiller/data.htm

As shown, economic growth in the late 1990’s was more than double that of today, and the expected trend for economic growth was also more encouraging than today. Trailing three- five- and ten-year annual earnings growth rates contrast the current stagnant economic growth versus the robust growth of the 90’s. Additionally, various measures of debt have ballooned to levels that are constricting economic growth and productivity. Historically low interest rates are reflective of the current state of economic stagnation.

The graph below charts price-to-earnings (CAPE) divided by the secular GDP growth (ten-year average), allowing for a proper comparison of valuations to fundamentals.

Data Courtesy: Robert Shiller http://www.econ.yale.edu/~shiller/data.htm

The current ratio of CAPE to GDP growth of 19.77 has far surpassed the 1999 peak and all points back to at least 1950. At the current level, it is over three times the average for the last 66 years.  Further, based on data going back to 1900, the only time today’s ratio was eclipsed was in 1933. Due to the Great Depression, GDP at that time for the preceding ten years was close to zero. So, despite a significantly deflated P/E multiple, the ratio of CAPE to GDP was extreme. Looking forward, if we assume a generous 3% GDP growth rate, CAPE needs to fall to 18.71 or 35% from current levels to reach its long term average versus GDP growth.

Summary

Equity valuations of 1999, as proven after the fact, were grossly elevated. However, when considered against a backdrop of economic factors, those valuations seem relatively tame versus today. Some will likely argue with this analysis and claim that Donald Trump’s pro-growth agenda will invigorate the outlook for the economy and corporate earnings. While that is a possibility, that argument is highly speculative as such policies face numerous headwinds along the path to implementation.

Economic, demographic and productivity trends all portend stagnation. The amount of debt that needs to be serviced stands at overwhelming levels and is growing by the day. Policies that rely on more debt to fuel economic growth are likely not the answer. Until the disciplines of the Virtuous Cycle are understood and followed, we hold little hope that substantial economic growth can be sustained for any meaningful period. Given such a stagnant economic outlook, there is little justification for paying such a historically steep premium for what could likely be feeble earnings growth for years to come.

Consider the following:

  1. The current U.S. economic expansion has lasted 103 months and counting. Based on data since 1945 covering 11 business cycles, the average is 58 months and the longest was 120 months (1991-2001).
  2. The unemployment rate is at 4.1%, the lowest level since January 2001.
  3. For the first time on record, the S&P 500 produced positive total returns in each month of last year.
  4. The S&P CoreLogic Case-Shiller 20-City Home Price Index is at 203.84, the highest level since December 2006 and less than 3 points shy of the all-time high seen at the peak of the housing bubble in July 2006.
  5. Small Business Optimism is at the highest level since September 1983 and the Michigan Current Consumer Sentiment gauge is at 17-year highs.
  6. Recent corporate earnings growth is strong at 9-10% and running above the historical average (6%).
  7. Tax reform legislation reduces taxes for corporations from a statutory rate of 39% to 21%.
  8. The current U.S. Consumer Price Index is 2.1% and 1.8% excluding-food and energy.
  9. The Federal Reserve is planning to adhere to a gradual series of rate hikes and balance sheet reduction over the coming year.
  10. The market currently expects 2 to 3, 25 basis point rate hikes in 2018, which would bring the Fed Funds rate to just over 2.00%.
  11. The Federal Reserve loses 44 years of policy-making experience with the departures of Yellen, Fischer, Dudley and Lockhart.
  12. Geopolitical risks are more extensive than any year in recent memory. Problems include instability in Sub-Saharan Africa, Southern Asia and the United Kingdom as well as friction between the U.S. and North Korea, Iran, Mexico and China.

After what we observed in 2017, another year of complacency measured by record low volatility and high valuations cannot be ruled out. That said, mean reversion remains part of the natural order and every day that elapses brings us another day closer to the eventuality of a regime shift. Changes in monetary policy, fiscal policy and Fed leadership have historically been quite volatile for markets, although the term of Janet Yellen was an exception. Also, according to Eurasia Group’s Ian Bremmer, “The markets don’t recognize it. They’re hitting records on a regular basis. The global economy feels pretty good, but geopolitically we are in the midst of a deep recession.” Heightened geopolitical risks have the potential to stir up the volatility pot and markets are not priced for any of those probabilities.

Markets have remained remarkably stable despite numerous geopolitical concerns throughout the past year. Based on the information provided above, it appears as though markets may be underpricing expectations for interest rate moves given the obvious dynamics between global growth, low rates, swollen balance sheets and market valuations. Yet the paradigm of the Fed as inflation fighters has long since passed, and the concern now remains defending against the evil windmills of deflation. The new Federal Open Market Committee (FOMC) will try to remain vigilant, but any unexpected uptick in inflation may spook them into moving back toward their natural inclination as inflation fighters. Given the shifting winds of Fed policy from easier to less easy, the markets’ failure to acknowledge the risks of a quicker tightening pace and the sensitivities of the debt-bloated economy to higher interest rates, our concerns remain in the arena of some difficult changes occurring sooner rather than later.

The same divergent dynamic exists on the geopolitical side of the equation. Often characterized as exogenous risks, they can be especially combustible when markets become as complacent as they apparently are today. The important message for investors is to remain vigilant about assessing risks and avoid being lulled into the groupthink trap. This is especially true as the consensus perspective becomes increasingly one-sided. Risks and consensus have both reached extremes and should be given proper consideration.

Cause when life looks like easy street, there is danger at your door.”  – Grateful Dead

The New England Patriots are the winningest professional football team of the new millennia. While we could post a long list of reasons for their success, there is one that stands above the rest. In a recent interview, Patriots quarterback Tom Brady stated that they start each year with one goal; win the Super Bowl. Unlike many other teams, the Patriots do not settle for a better record than last year or improved statistics. Their single-minded goal is absolute and crystal clear to everyone on the team. It provides a framework and benchmark to help them coach, manage and play for success.

Interestingly, when most individuals, and many institutions for that matter, think about their investment goals, they have hopes of achieving Super Bowl like returns. Despite their well-intentioned ambitions, they manage their portfolios based on benchmarks that are not relevant to their goals. In this paper, we introduce a simple investment benchmark that simplifies the tracking process toward goals which if achieved, provide certitude that one’s long-term objectives will be met.

The S&P 500

Almost all investors benchmark their returns, manage their assets and ultimately measure their success based on the value of a stock, bond or blended index(s). The most common investor benchmark is the S&P 500, a measure of the return of 500 large-cap domestic stocks.

Our belief is that the performance of the S&P 500 and your retirement goals are unrelated. The typical counter-argument claims that the S&P 500 tends to be well correlated with economic growth and is a valid benchmark for individual portfolio performance and wealth. While that theory can be easily challenged over the past decade the question remains: Is economic growth a more valid benchmark than achieving a desired retirement goal?  Additionally, there are long periods like today where the divergence between stock prices and underlying economic fundamentals are grossly askew. These variances result in long periods when stock market performance can vary greatly from economic activity.

Even if we have a very long investment time frame and are willing to ignore the large variances between price and valuation, there is a much bigger problem to examine. Consider the following question: If you are promised a consistent annualized return of 10% from today until your retirement, will that allow you to meet your retirement goals?

Inflation and Purchasing Power

Regardless of your answer, we are willing to bet that most people perform a similar analysis. Compound current wealth by 10% annually to arrive at a future portfolio value and then determine if that is enough for the retirement need in mind. Simple enough, but this calculus fails to consider an issue of vital importance. What if inflation were to run at an 11% annual rate from today until your retirement date?  Your portfolio value will have increased nicely by retirement, but your wealth in real terms, measured by your purchasing power, will be less than it is today. Now, suppose you were offered annual returns equal to the annual rate of inflation (the consumer price index or CPI) plus 3%.

Based on 2017 CPI of approximately 2% for a total return of approximately 5% compared to almost 20% for the S&P 500, we venture to say that many readers would be reluctant to accept such an “unsexy” proposition. Whether a premium of 3% is the right number for you is up for debate, but what is not debatable is that a return based on inflation, regardless of the performance of popular indexes, is a much more effective determinant of future wealth and purchasing power.

To show why this concept is so important, consider the situation of an investor with plans to retire in 25 years. Our investor has $600,000 to invest and believes that he will need $1,500,000 based on today’s purchasing power, to allow him to live comfortably for the remainder of his life. To achieve this goal, he must seek an annualized return of at least 4.50%. As a point of reference, the total return of the S&P 500 is 6.60% over the past 100 years. At first blush our investor, given his relatively long time frame until retirement, might think the odds are good that the S&P 500 will allow him to achieve his retirement goal. However, his failure to factor in inflation causes his calculations to be incorrect. Since 1917, inflation has averaged 3.09%. The S&P 500 total return since 1917 including the effect of inflation is only 3.51%. The odds are not in his favor, and his oversight may ultimately leave him in a difficult situation.

The graph below shows the resulting 25 year total returns based on each monthly starting point since 1917. The red line shows our investor’s goal of 4.50%. Keep in mind that since the graph requires 25 years of data, the last data point on the graph is December 1992.

Over the time frame illustrated, the investor was subjected to anxiety-inducing random high and lows relative to his target return. His portfolio performance is a flag in the wind at the mercy of the volatility of the equity markets.

Instead of rolling the dice like an investor managing and benchmarking towards the S&P 500, why not manage your portfolio based on an index that will properly target a dollar amount of purchasing power in the future? In our prior example, achieving a benchmark of the annual rate of CPI plus 4.50% would allow our investor to retire with at least $1,500,000 in today’s purchasing power.

Inflation based indexing

Unlike benchmarking to a popularly traded equity or bond index using ETFs and mutual funds, managing to an inflation-linked benchmark is more difficult. It requires an outcome-oriented approach that considers fundamentals and technical analysis across a wide range of asset classes. At times, alternative strategies might be necessary or prudent. Further, and maybe most importantly, one must check one’s ego at the door, as returns can vary widely from those of one’s neighbors. The challenge of this approach explains why most individuals and investment professionals do not subscribe to it. It is far easier to succeed or fail with the crowd than to take an unconventional path that demands rigor.

The reward for using the proper index and successfully matching or exceeding it is certitude. The CPI-plus benchmark approach described here is far more honest and durable in its ability to compound wealth and show definitive progress. It is deliberate and does not hand over control of the outcome to the whim of the market. It also requires an investor to avoid the hype and distractions that continually surround the day-to-day movements of the stock market.

Summary 

We understand the difficulty in achieving one’s financial goals, especially in today’s unique environment of low-interest rates and high stock market valuations. Why compound the difficulty by managing your wealth to the random volatility of an index or benchmark that is different from your goals? Matching the performance of the S&P 500 is cheap and easy for a reason. It is also irrelevant to compounding wealth as it ignores important aspects of the wealth management process such as avoiding large and wealth-debilitating drawdowns.

Meeting your goals requires a logical and deliberate strategy guided by a set of rules that few investors understand. There is a reason many investors and retirees are failing to meet their goals. Using a reliable but different approach will help ensure that you don’t end up as one of them.

The following outlook provides our investment thoughts for the coming year. We did not include specific recommended asset allocation weightings for the major asset classes, as they will be part of Real Investment Advice premium services.  If you would like to receive pre-launch information on our new services just send us your email address.

Market Fundamentals

The confluence of improving synchronous economic global growth and hyper-inflating asset markets is urging central bankers to pause extraordinary policies and, in many cases, begin reversing them. While not obvious to most, monetary policy error has been in play since quantitative easing commenced in 2009, but the consequences will not appear until future central bank actions to raise interest rates and reduce their balance sheets affects commerce. The yield curve, credit spreads, and financial conditions can provide indications of when this may occur.

Market Fundamentals Commentary

Record highs in stocks, near-record lows in bond yields and historically tight credit spreads present significant challenges for investors. Economic data has improved, but many fundamental economic gauges remain soft relative to pre-crisis averages and inconsistent with asset price levels and valuations. Most investors do not seem at all concerned as money continues to move into risky asset classes, a classic sign of a bubble. While a defensive posture seems prudent, the technical picture remains supportive of further gains. One should respect the momentum behind these moves for the foreseeable future but be mindful that liquidity can evaporate quickly.

The primary investment theme remains “buy the dip.” That approach has worked amazingly well, a testament to the sustained strength of markets. Thanks in no small part to gradualism from the Fed on interest rate and balance sheet normalization, the blind assumption is that the favorable trajectory of risk assets can be endlessly extrapolated into the future.

There is a distinct difference between taking a defensive posture and a negative one. Remaining full-bore aggressively long at this juncture is a speculative endeavor akin to letting our kids play in the median of a busy highway. Proper care and stewardship of wealth means being protective and forward-looking to avoid large losses.

“The peer pressure and career risk of bolstering one’s defenses in a Pamplona-style bull run are palatable, but wealth is most effectively compounded by avoiding large losses not chasing returns with the irrationally exuberant. Many investors and others are stumbling confidently forward playing the role of the genius in a bull market.  The prudent manager worries about the trifles of liquidity at a time when it is so plentiful it seems unreasonable to worry.  Liquidity comes at a cost, but excess liquidity in times of crisis offers both priceless protection and clear-headed decision-making opportunities that are rare indeed.” –Liquidity Defined 12/14/2017 –The Unseen

Outlier scenario – The market is far more sensitive to changes in interest rates than currently perceived. If the Fed continues to increase the Fed Funds rate and reduce their balance sheet in response to low unemployment and moderate levels of inflation, economic activity will decline. The result is a recession that initiates the unwinding of leverage accumulated in the system compounded by and revealing many layers of hidden risks.

Federal Reserve Outlook

The Fed gets new leadership early in the year in Jerome Powell, but he appears to be using the same playbook as Janet Yellen.

  • Yield curve flattening
  • Financial conditions will eventually become less favorable
  • U.S. dollar stable at the low end of a 3-year range and supportive of future Fed policy

Federal Reserve Commentary

Given his time as a Fed board member and non-controversial positions on policy, Fed Chair nominee Jerome Powell should have no trouble being confirmed. He echoes many of Janet Yellen’s perspectives, and his demonstrated comportment is similar to that of the post-GFC era Chairmen. In the near-term, such a status quo transition is constructive for risk markets. However, the lengthy duration of the current economic cycle and the lofty valuations present when Powell assumes command make it hard to argue that the current environment is stable.

Outlier scenario – The inability of the Fed to effectively respond to a weaker economy due to elevated levels of inflation and/or a dramatically weaker U.S. dollar alters market expectations about the Fed “put” that has been in place for the past 30 years.

Bond Markets

Yield curve flatter as Fed interest rate hikes continue but inflation remains tame/below target

  • Debt levels continue to weigh on economic growth and inflation dynamics
  • Growing debt due to fiscal policy/tax cuts heightens concerns
  • Shortage of quality collateral and rate differential keeps long-term interest rates low

Bond Markets Commentary

U.S. Treasury yields are bi-polar. Short maturity yields are rising with Fed rate hikes while long-maturity yields are stable to lower. This dynamic produces a flattening of the yield curve revealing short-term optimism and long-term doubt. On an absolute basis, yields remain very low. The 2-year Treasury yield is 1.82% while the 10-year yield is 2.40%. The 2s-10s yield curve spread resides at the lowest level (0.58%) since the financial crisis of 2008.

Investors looking for income in the safety of the Treasury market will die of thirst long before achieving their targets. Accordingly, many investors are reaching for additional yield in riskier categories, namely high yield credit and dividend-paying stocks. This game has been going on for a long time. Despite the relative yield enhancement those alternatives offer, the question of whether or not an investor is appropriately rewarded for taking that risk still exists.

Non-investment grade, or “junk” bond, yields range from 4% to 10%, depending on the company and sector, with the overall average yield at about 5.75%. A bond is relegated to junk status precisely because of the elevated risk of default. At current market yields, junk bonds pose an inordinate threat of record low recovery value and terminal realized yield. Using the average yield for junk bonds of 5.75%, an average default rate of 5% and a generous recovery rate of 50%, a high yield debt portfolio is mathematically identical to a risk-free asset with a yield of 3.25%. That amounts to a risk-adjusted premium of only 0.85% over 10-year Treasuries (3.25 – 2.40). A yield pickup of less than 1% is hardly compelling, especially when one considers the downside from current valuation levels is immense.

Investors who think they get a nice yield boost from owning high yield debt are not considering the risk-adjusted outcomes. The risk-adjusted premium over Treasuries should be at least 200 to 300 basis points. Fixed income portfolio allocations should reside predominantly in the defensive havens of high-quality sovereign, well selected municipal and investment-grade corporate bonds. We recommend no allocation to junk.

Outlier scenario – Rising debt levels, inflation and global concerns over future monetary policy causes interest rates to rise as marginal buyers (Japan, China, Saudi Arabia, etc.) turn to sellers to reduce U.S. debt and U.S. dollar exposure. A disorderly rise in interest rates creates sudden distress and defaults in credit markets.

Stock markets

Markets remain supported as financial conditions are historically ultra-easy, despite the recent interest rate hikes

  • Valuations are stretched to extremes
  • Investors are conditioned to such valuations and insensitive to history
  • Momentum and lack of viable investment options helps the market retain a bid
  • Problems emerge when higher short-term rates have a constricting economic effect

Stock Market Commentary

There are several measures used to justify current valuations, but they sound similar to those used in the dot-com Tech bubble. The relationships between valuation and fundamentals, on which cash flows are ultimately based, are grossly dislocated. Markets may well move higher, but to advocate a full allocation to equities under current circumstances ignores warnings of bubbles past. Stock market cap-to-GDP, price-to-sales, margin balances, cyclically-adjusted price-to-earnings ratios (CAPE), and others argue convincingly that the stock market is either near historic valuations or well through them. Owning well-selected, single-name companies because they are fundamentally cheap, not relatively cheap, makes sense.  Otherwise, limiting general equity allocation exposures is prudent until reasonable opportunities return. We suggest setting stop losses and/or options strategies to help limit downside risk and retain any additional upside.

Outlier scenario – Realization and acknowledgment that valuations are high and concern over future returns sparks initial selling as the market begins to collapse under its own weight. This sets off a broad exodus out of risky assets for similar reasons.

FX

Currencies remain the pressure release valve for money printing and monetary malfeasance.

  • GBP at risk to weaken further as Brexit talks continue to languish
  • Growth in Europe, slow policy response by ECB and political turmoil in Germany point to a weaker Euro
  • US dollar stable/stronger in response to GBP and EUR

FX Commentary

The precedent set since the financial crisis suggests one wants to steer away from currencies likely to be devalued for purposes of supporting and manipulating asset prices. The problem with that plan is that all developed world economies are guilty of money-printing schemes. Further, it seems inevitable that they will most likely take this short cut once again should problems re-emerge. The most dominant and liquid currencies are those most susceptible to active and intentional devaluation.

Europe’s banking system, though improving, still has significant exposures to possible defaults and therefore the potential for bank failures and government bailouts. Australia and Canada have rather large housing market bubbles that probably will not escape punishment in the next downturn. China remains both a communist regime and a pretender on the stage of free markets. The United States has somehow developed a sick pride in unconventional monetary policies and, given the U.S. dollar’s reserve currency status, will be called upon to conjure liquidity in times of distress. Given that the safest currencies tend to reside in stable nations with strong economies, it is not difficult to see why the U.S. dollar has historically been a safe-haven currency.  While muscle-memory argues that the dollar retains safe-haven status in the next crisis, other factors may come in to play and upend much of what has historically held true. Other durable alternatives include the Singapore dollar, the Norwegian krone and the Polish zloty.  Finally, the immutable status of gold as money is indisputable, despite decades of efforts from central bankers to discredit its durability. Warren Buffet was wrong to classify gold as an asset as it is the ultimate alternate currency. Given the proclivity of central bankers to print digital dollars, insurance in the form of gold and gold miners warrants consideration in a portfolio.

The Bitcoin hype is a speculative phenomenon but one well-timed as it further reflects the lack of trust in central bankers. We do not consider Bitcoin or any other crypto-currency as a replacement for gold, but we are not averse to reasonable alternatives to traditional fiat currencies.

Outlier scenario – The Federal Reserve’s willingness to print money to bailout banks following the last financial crisis raises concerns going forward about U.S. dollar stability. Those reservations cause traditional sponsors of the U.S. dollar financed economy (China, Japan, Saudi Arabia) to reduce their dollar holdings thus inciting volatility and resulting in a precipitous decline in the world’s reserve currency.

Commodities

Comparative weakness in commodities and strength in equities is signaling a rare long-term buying opportunity.

  • Gold, crude oil, and copper among other key hard and soft commodities that have been relatively cheap for some time
  • Natural resources not only reflect value but act as a sound hedge against central bank interventionism
  • China’s debt growth, excess capacity, and property bubble raise concerns, putting pressure on Australia, Latin America, and Near-term commodity upside limited

Commodities Commentary

The extent to which crude oil and energy companies have languished since the 2014 peak in crude prices suggests there are opportunities in the stocks and/or bonds of those companies. That said, there is no way around doing the appropriate work to find those opportunities. Energy-related Exchange-Traded Funds (ETFs) tend to include a lot of speculative companies unfit for a defensive stance, which makes it difficult to take a generalized ETF approach. If the Fed does what they do best (print money), then natural resource companies now trading at a relative discount to other sectors of the economy stand to be terrific value plays into the future. There is certainly a risk, but the downside should be limited for the equities and bonds of good, undervalued companies.

Broadly, commodities are currently at a unique value point relative to stocks. A portfolio allocation overweight in resource companies may present some volatility but should be a good long-term position to have and add to as the economic cycle progresses.

Further, commodities provide a hedge against inflation. While not on the horizon, inflation could force central banks to halt money printing policies with severe effects for asset markets driven by those same policies. Investments in the resource/commodity sector can take the form of good equity selections or, even better, discounted bonds of companies offering above average yields to reinforce durable contracted cash flow returns.

Outlier scenario – Similar to gold, in the event of a suddenly unfolding crisis, the demand for natural resources surges as uncertainty about financial assets and central bank responses cause many to use hard and soft commodities as an alternative source of safe haven.

Emerging Markets (EM)

Dependent on trade-based commerce, EMs benefiting from synchronous global growth.

  • Durability of export-led growth key to outlook
  • EM countries are hurt by US dollar strength
  • Rising short-term interest rates in the US and issues emanating from China will begin to expose a variety of EM imbalances

Emerging Markets Commentary:

Emerging market economies tend to be inherently volatile, unstable and marred by crises. Although those risks remain in play, select emerging market countries may offer comparative stability and excellent return opportunities in the next year. An improving trend in emerging market performance fully developed in 2017, and a continuation of this trend has sound historical precedence. That said, there is still plenty of risk and uncertainty especially within the context of a broad global destabilization. A portfolio allocation to EM stocks through funds tracking the MSCI Emerging Markets Index should offer a return boost if we are to have another year of low volatility. On the other hand, if 2018 proves to be turbulent, this exposure will certainly detract from returns. Dollar strength tends to play a big role in EM returns. Any sustained U.S. dollar strength, especially if accompanied by a global economic downturn, is a strong signal to exit these positions. Portfolio weighting is important, and accordingly, a modest level properly sizes the exposure relative to uncertainties.

Outlier scenario – With developed stock and bond markets fully valued due to central bank intervention, the emerging markets become a value option not found in many other categories. Fundamentals and momentum align to spur a historic rally relative to developed markets, but vigilance is important.

The Federal Reserve raised the Federal Funds rate on December 13, 2017, marking the fifth increase over the last two years.  Even with interest rates remaining at historically low levels, the Fed’s actions are resulting in greater interest expense for short-term and floating rate borrowers. The effect of this was evident in last week’s Producer Price Inflation (PPI) report from the Bureau of Labor Statistics (BLS). Within the report was the following commentary:

About half of the November rise in the index for final demand services can be traced to prices for loan services (partial), which increased 3.1 percent.”

While there are many ways in which higher interest rates affect economic activity, the focus of this article is the effect on the consumer.  With personal consumption representing about 70% of economic activity, higher interest rates can be a cost or a benefit depending on whether you are a borrower or a saver. For borrowers, as the interest expense of new and existing loans rises, some consumption is typically sacrificed as a higher percentage of budgets are allocated to meeting interest expense.  On the flip side, for those with savings, higher interest rates generate more wealth and thus provide a marginal boost to consumption as they have more money to spend.

This article focuses on borrowers and savers to show how the current interest rate cycle is squeezing consumers. Said differently, the rising cost of borrowing is dwarfing the benefit of saving.

Borrowers

As mentioned but worth repeating, personal consumption accounts for the bulk of economic activity. To gauge how higher interest rates might affect individuals’ spending, we classify personal debt into the following five categories: mortgages, home equity lines, auto loans, student loans and credit card debt. The following table shows the amount of debt outstanding in each category and estimates the percentage of each loan type that has fixed interest rates and floating interest rates.

Distinguishing between fixed and floating interest rates is important, as borrowers using fixed-rate loans are largely unaffected by higher interest rates. Accordingly, we focus this analysis on floating rate debt as those borrowers and consumers will see immediate increases in their interest expenses every time the Fed raises rates.

Based on the table, approximately $2.8 trillion of consumer loans outstanding are floating rate. We calculate that every 25 basis point (0.25%) interest rate hike by the Fed will increase interest expense higher by $7 billion annually for these consumers.  Since December 2015, when the Fed began to hike interest rates, the Fed Funds rate and other interest rates to which consumer debt is frequently indexed are about 125 basis points higher. Thus on an annual basis, the additional cost of borrowing is approximately $35 billion. Looking forward, if the Fed raises rates three times in 2018 as they currently forecast, the annual interest expense will increase by another $21 billion to bring the total to $56 billion per year.

The graph below charts Fed Funds, 3-month LIBOR, and average credit card rates to show the nearly perfect correlation between Fed actions and short-term borrowing rates. 3-month LIBOR is the index most frequently used to determine floating rate interest rates.

Data Courtesy: St. Louis Federal Reserve (FRED)

Savers

To do a complete analysis of the effect of higher rates on consumption, we must look beyond the increased interest costs, as quantified above, and also consider the benefits of higher interest rates to savers. According to the Fed, personal savings equals $471 billion. The increase in interest rates should reward savers, which will help offset the economic burden related to the increase in interest expense.

Interestingly, what should happen and what has happened are two different stories. The truth of the situation is that individual savers have barely benefited from higher rates as banks and financial intermediaries are not passing on higher rates to savers. The chart below provided by WalletHub and Wolfstreet.com compares the change in the Fed funds rates and credit card interest rates to instruments of savings. Please note the table does not include the most recent increase in rates on December 13, 2017.

To confirm the data in the chart, we searched for other sources of savings rate data. Data from the FDIC reports that bank savings rates, 3-month CD’s, money market accounts and interest checking rates have increased by 0, 3, 1, and 0 basis points respectively since the Fed began raising rates two years ago.

Based on the graph and the data above, it is fair to say that borrowers have benefited by less than ten basis points (0.10%) on average despite 125 basis points (1.25%) of interest rate increases. Based on total savings of $471 billion, we can approximate the benefit to borrowers is a mere $600 million.

Summary

Consumers are being squeezed. Debt linked to short-term interest rates is rising lockstep with the Federal Funds rate while savings rates remain stubbornly low. While the dollar amounts are not massive, the transmission mechanism of the Fed’s rate hikes is acting like a tightening vice that will result in less consumption and slower economic growth.

One of the key takeaways from the Fed’s action during and following the financial crisis of 2008 has been a prolonged and intentional effort aimed at crushing savers. Near zero percent savings rates is part of the Fed’s strategy to incentive savers to move out of the security of cash and invest in riskier assets and/or consume. Even today, despite the rise in interest rates, banks accept the benefits of higher rates imposed on borrowers while refusing to adjust rates for savers. As one of the primary regulators of the financial system, the Fed could encourage a change in that behavior, but to date, no such influence has even been mentioned. Interestingly, the savings rates that banks earn on deposits at the Fed has increased lockstep with Fed Funds.

After nearly a decade of imposing its unique brand of price controls over the cost of money, the Fed admittedly is not willing to do that which is in the best interest of the general public and continues to adhere to policies that favor their primary constituents, the big banks and major corporations.

Real Investment Advice is pleased to share with you the first of what will be many articles from Peter Cook, CFA. Peter has worked as a leader in the global investment industry for almost 30 years.  He is an expert in how business cycles interact with financial market cycles, and has applied that expertise across asset classes in both traditional and alternative portfolio management.

Main Ideas:

  1. A traditional portfolio of stocks and bonds (i.e., what almost all investors are invested in) is extremely overvalued compared to historical norms.
  2. A strategy of investing in ETFs for the stock portion of a portfolio reduces the long-run cost of investing, but does not reduce the risk of a major loss during a bear market for stocks. A cost reduction strategy is different than a risk management strategy.
  3. The benefit of diversification achieved by investing in bonds depends on the level of interest rates. If interest rates are low (high), diversification benefits will be reduced (increased).  Today, interest rates are low, so the benefit of diversification is low.

Have you ever been asked to name your favorite song of all-time?  Children have a way of asking impossible questions like that.  Answering that question is impossible because a favorite song depends on the mood, the timing, and the events surrounding the time you heard it.  Some are favorites for the melody or the performer and others because of the associated memories.  The older you get and the more memories you have, the harder it is to identify only one favorite.  The unsatisfying answer for my son when he asks about my favorite song is that many can be my favorite, for different reasons at different times.

By analogy, in the investment world it should be impossible to find a single favorite chart of data that is clearly more important than others.   But the analogy doesn’t hold, because the most important chart in the investment world is shown below.  The following pages are devoted to explaining why.

Specifically, the chart shows the valuation of the largest 15 developed market stock and bond markets compared to all valuation levels in the past 200 years.  When the blue line is low, a portfolio of stocks are bonds is cheap compared to history.  When the blue line is high, a portfolio of stocks and bonds is expensive compared to history.

Most investment portfolios are composed of stocks and bonds because the outstanding amount of stocks and bonds dwarfs the amount of other available investment opportunities.  That’s true whether you are an individual with a 401(k) plan or a pension fund which invests billions of dollars.

That reality translates, in a practical sense, to some basic potential portfolio strategies.  The most common traditional portfolio contains a 60/40 split of stocks and bonds.   Some investors will adjust the ratio based on their age and income requirements.  More sophisticated investors will add private equity, commodities, or real estate to their portfolios to take advantage of specific investment opportunities.  But in almost all cases, stocks and bonds comprise the overwhelming majority of a portfolio.

Why does that matter?  Because the chart above shows that the valuation of a portfolio of stocks and bonds today is higher than it has ever been in the past 200+ years.   That is, a portfolio of stocks and bonds is more expensive than at any time in the past 200+ years.

But instead of recognizing the risk the chart poses, investors are much more likely to be swayed into a sense of safety by the two hottest concepts in finance; index investing and diversification.  While index investing and diversification are excellent investment concepts most of the time, they can offer a misleading sense of security some of the time.  The chart’s message is that we are at a “some of the time” point in history today.

Index Investing to the Rescue?

Considering the benefits of index investing, John Bogle, who for decades has popularized index investing as the head of Vanguard Funds, was quoted in 2011 as saying….

“My rule — and it’s good only about 99% of the time, so I have to be careful here — when these crises come along, the best rule you can possible follow is not ‘Don’t stand there, do something,’ but  ‘Don’t do something, stand there!’

In this case, Bogle was extolling the virtue of building a stock portfolio and staying invested for the long-term, regardless of short-term fluctuations.  But what happens during the 1% of the time Bogle referred to?  Can index investing save an investor from the peril of an extremely expensive portfolio?  The short answer is no.  Index investing can indeed reduce the cost of investing in stocks and bonds compared to investing in mutual funds or with a financial advisor, probably by ½-1% or so per annum.  That insight has made Bogle a very wealthy man.

The good news is that if index investing can save an investor ½-1% per year, a portfolio would be worth 5-10% more over 5-10 years.   Of course, during those 5-10 years, the investor must decipher the meaning of economic, political, and financial trends and how to adjust a stock and bond portfolio accordingly.  In a world of accelerating technological change, that is no small task.  Adding to the noise, there are almost as many opinions on markets as there are commentators, which can confuse any investor.  Regardless of these nuances, people who rely on indexes to grow their portfolios are making a bet that financial advice is not worth its price.

But the bad news is that an investor can build a portfolio of stock and bond indices, which guarantees they receive a “market return,” while being completely unaware that the portfolio is being built at the highest valuation in history.   Unfortunately, the “market return” includes stock market bear phases that occur every 5 years or so, in which the stock market loses 40-50% of its value.  With stocks and bonds as expensive as they currently are, it is conceivable that a bear market could produce losses greater than 40-50%.

For example, in the case of extreme valuations for technology stocks in 2000, the Nasdaq lost 80% in the following three years.  In the case of extreme real estate valuations in 2008, many bank and real-estate investments lost 100% of their value over two years.  Are stocks perceived as “can’t miss” today, just like technology and real estate stocks were back then?

The main point is that saving ½-1% per year in cost for advice could become miniscule compared to the potential for catastrophic losses by achieving the “market return” after a period of extreme overvaluation.  This point is not just theoretical.  In fact, the broad S&P 500 index lost 50% or more twice in the past 20 years; first in 2000-2003 and again in 2007-2009.  To demonstrate the danger of building a portfolio of stock indexes when valuations are extremely high, the chart below shows how a composite of global stock market index valuations have fluctuated over the past 200 years.

Focusing on the right side of the chart, the three peaks are the peaks in stock market index valuation that occurred in 2000 (internet bubble), 2007 (real estate bubble), and today (insert your own description).  In all three cases, stock valuations were in the 90% zone, which are similar to the peak last reached in 1929. In other words, stocks in 2000, 2007, and today are more expensive than they have been for 90% of the time over the past 200 years.   After the peaks in valuation in 2000 and 2007, broad stock market indices suffered multi-year declines, creating the possibility of a repeat in the current environment.

Locking in the market return by investing in a stock market index exposes an investor to the same severe losses any other stock market investor experiences.  Many of today’s investors remember what it felt like when their stock portfolios were cut in half by 2003 and 2009, but seem oblivious to that risk today.  In summary, building an indexed portfolio of stocks is an exercise in cost reduction but certainly not an exercise in risk management.

Diversification to the Rescue?

“Aha!” says the person familiar with the benefits of portfolio diversification, “that’s why I diversify my portfolio with stocks AND bonds.  Bonds always go up when stocks decline.  Plus, it is impossible to time the market. I invest in stocks because they always go up in the long run, and I diversify with bonds, just in case something bad happens to stocks in the short run.”

The good news is that bonds tended to rise in price in the past during bear markets in stocks, which provides some badly-needed upside when stocks are experiencing severe downside risk.   In the most recent example, a portfolio of long-term government bonds rose 30% during the bear market in stocks from 2007-2009. Unfortunately, investors do not typically invest their bond portfolios solely in long-term government bonds, so only a small portion of investors achieved big gains in bonds to offset their stock market losses.

The bad news is that simple mathematics can demonstrate there is a limit to how much bonds can rise in price.  One reason that long-term bonds could generate 30% gains in 2007-2009 is that interest rates began that period at 6% in the US and fell to 2-3%.  In addition, that portfolio of long-term bonds paid interest of 6% per annum, further increasing the total return on a bond portfolio during a prolonged bear market in stocks.

Today US long-term interest rates are at 2-3%, leaving little room for bond prices to appreciate further. In Europe and Japan, interest rates are near zero or even negative, leaving no room for bond prices to appreciate further.  How low are interest rates compared to historical norms? The chart below gives us the answer.  Composite interest rates for 15 developed bond markets have never been lower in the past 200 years.

The chart above demonstrates the limited upside for bond prices in the future, based on actual 2017 prices and yields.  An investor who buys bonds to diversify in case of a downturn in the stock market is really betting on bonds becoming even more overvalued relative to their historical norms.  While there is no law stipulating that bonds can’t become even more expensive, future price gains during a bear market in stocks will be limited, and almost cannot come anywhere near the 30% achieved by long-term government bonds during 2007-2009.  The main point is that the benefits of diversifying a stock portfolio with bonds are reduced when bond yields are already very low.

Investor Behavior to the Rescue?

Unfortunately, there is more potentially bad news when investing in stocks or bonds that are extremely expensive.  Data shows most investors didn’t heed their own advice of investing for the long-term when confronted with losses during 2007-2009, or for that matter any other bear market of the past century.  When a multi-year destruction of portfolio value occurs, at some point most investors discover their point of maximum financial pain/loss and sell the stock portfolios that have created the pain/loss.  It is impossible to “buy low, sell high” when you are “selling low.”

One reason for this behavior is that other forms of pain are occurring simultaneous to stock market losses, which are associated with economic recessions.  During recessions, a business might be in jeopardy, or a job might become much less secure.  Investors, when considering those sources of financial risk, are in fact much less diversified from a stock market decline than they think.  The main point is that any diversification program should not only consider the historical interaction between stock and bond prices; it should also consider the potential for a loss of employment income during a period in which stock prices decline.

Conclusions

At the risk of oversimplification, the most important chart in the investing world is the chart shown below, because it shows that investment portfolios of stocks and bonds are more highly valued today than at any time in history.  That fact alone should force an investor to reduce expectations for returns on a portfolio of stocks and bonds, including the possibility of negative returns over a time-horizon of 5-10 years.

For investors who think they can avoid significant losses by using ETFs to reduce the cost of stock market investing and who diversify by buying bonds to cushion the risk of stock market losses, the following should be considered:

  • Almost all portfolios are comprised primarily of stocks and bonds, so almost all investors in 2017 are holding portfolios at extremely high valuations. Your portfolio is probably just as risky as anyone else’s portfolio.
  • Investing in portfolios at extremely high valuations increases the probability of future losses if/when valuations eventually revert to the normal levels. Valuations might continue to rise to even more extreme levels, but that is a low-probability bet.
  • An index strategy is undertaken to reduce the costs of achieving the future’s “market return,” but achieving a “market return” at a reduced cost is not the same thing as a reducing the risk of a significant decline in stock market indices.
  • Bonds are typically used to diversify a portfolio from the risk of a severe stock market decline. But the benefit of diversification is reduced when interest rates are extremely low, as they are today.
  • The concept of diversification should be expanded to consider that a loss of employment or ownership income is likely to coincide with a period in which stocks are declining.

All of the graphs courtesy of Deutsche Bank

Recently we received the following question from a subscriber:

“If a correction in the stock or bond markets comes, the Central Banks will buy stocks with printed money, like the Japanese Central Bank, etc. Will there ever be a shakeout of the garbage and junk in the system? I am losing all confidence.” –Ron H.

Questions like Ron’s that suggest the decay of capitalism and free markets should raise concerns for anyone’s market thesis, bullish, bearish or agnostic. What stops a central bank from manipulating asset prices? When do they cross a line from marginal manipulation to absolute price control? Unfortunately, there are no concrete answers to these questions, but there are clues.

Global central banks’ post-financial crisis monetary policies have collectively been more aggressive than anything witnessed in modern financial history. Over the last ten years, the six largest central banks have printed unprecedented amounts of money to purchase approximately $14 trillion of financial assets as shown below. Before the financial crisis of 2008, the only central bank printing money of any consequence was the Peoples Bank of China (PBoC).

The central banks’ goals, in general, are threefold:

  • Expand the money supply allowing for the further proliferation of debt, which has sadly become the lifeline of most developed economies.
  • Drive financial asset prices higher to create a wealth effect. This myth is premised on the belief that higher financial asset prices result in greater economic growth as wealth is spread to the masses.
    • “And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”Ben Bernanke Editorial Washington Post 11/4/2010.
  • Lastly, generate inflation, to help lessen the burden of debt.

QE has forced interest rates downward and lowered interest expenses for all debtors. Simultaneously, it boosted the amount of outstanding debt. The net effect is that the global debt burden has grown on a nominal basis and as a percentage of economic growth since 2008. The debt burden has become even more burdensome.

The wealth effect is putting riches in the hands of a small minority of the population, with negligible benefits, if any, flowing to the majority of the population. Bernanke’s version of the virtuous circle, as highlighted above, is far from virtuous unless you are in the upper five to ten percent of households by wealth.  To understand how a real economic virtuous circle works, we recommend you read our article The Death of the Virtuous Cycle and watch The Animated Virtuous Cycle.

Inflation has been low since 2008 and deflation continues to be a chief concern of most central bankers. Because QE, in all cases, was focused on financial asset prices and not the prices of everyday goods and services, the inflation they aimlessly seek has not occurred.

To summarize our views, largely ineffective monetary policies are providing few economic benefits. They are increasing the debt burden and furthering socially destabilizing trends. Worse, these policies are packed with consequences that lie dormant and have yet to emerge. One of our concerns, which is being heralded as a positive, is the massive distortions in financial asset prices worldwide. Consider a few of these facts below and whether they are sustainable:

  • U.S. yields have been among the lowest ever on record dating back to 1776
  • U.S. equity valuations have risen to levels rarely observed and from this perch have always been followed by massive losses
  • Over $9 trillion in sovereign bonds yields in many European countries and Japan have negative current yields
  • European junk-grade debt now trades at yields lower than U.S. Treasuries
  • Veolia, a French BBB rated company, recently issued a 3-year bond at a yield of -.026%.
  • Italian 3-year government bonds yield -0.337%, despite the 3rd highest debt to GDP ratio of all developed nations (132%)
  • Argentina, which has defaulted 6 times in the past 100 years, issued a $2.75 billion 100-year bond paying a paltry 8% interest
  • The BOJ owns over 75% of all Japanese ETFs
  • The Swiss National Bank owns 19.2 million shares of Apple, or 3% of total shares outstanding, and $84 billion in aggregate of U.S. stocks

Yes, Ron, the central bankers have clearly crossed the line between free markets and government controlled markets. To answer your question about the “shakeout,” we must wait until the inevitable day comes and asset prices are in free-fall. When this occurs, we will learn the full extent of their support and how far they have crossed the line. We like to think the central bankers are willing to endure the short-term pain of such a situation and allow the natural cycle of economies and asset prices to run their course. The reality, however, is that the pattern of their actions in the post-financial crisis era argue that they are unlikely to relinquish their grip. To the extent that authority and power is extended to the Fed through the U.S. Congress, it does not seem likely for career politicians to urge action that may be painful in the short-term but highly beneficial in the long-term.

This premonition was supported by recent statements from the October 2017 Federal Reserve minutes and appointed Fed Chairman Jerome Powell respectively. Fed Minutes:

“In light of elevated asset valuations and low financial market volatility, several participants expressed concerns about a potential buildup of financial imbalances,” further “They worried that a sharp reversal in asset prices could have damaging effects on the economy.” Jerome Powell, in prepared remarks to Congress stated: “(the Fed) will respond with force to threats to the nation’s stability.”

Putting two and two together, one can quickly figure out that falling asset prices and the “damaging effects” they will inflict on the economy will not be tolerated by the Fed. 

Ron, while we cannot answer your question with certainty, we are relatively confident the Fed and other central banks’ influence on markets will only increase in time as they continue to perpetuate the debt and economic problems they helped create. Naturally, the next question for consideration is to what extent markets may be bigger than the Fed? That is an article for another day.

We love reader questions. Please submit them to us and we will be happy to respond.

The term “priced in” is a phrase used frequently by Wall Street and the financial media. This expression is used to describe how much the price of stock or a market has accounted for an anticipated event. For example, consider a pharmaceutical stock that has risen 50% over the last few days on the prospects of getting regulatory approval for a new drug. If the collective “market” deems that the stock should increase a total of 100% if the drug is approved, then we can say the “market” has “priced in” a 50% chance the drug will be approved.

The term “market”, as used above, is vague. It is meant to represent the consensus view. Importantly to investors, it represents potential opportunity when an investor has a view that differs from the consensus.  If you were 100% certain the drug in the prior example would be approved, you could make a 50% gain on the stock if proven correct.

This article is a follow-up to one published November 29, 2017, Corporate Tax Cuts – The Seen and the Unseen. In that piece, we provided an analysis of the proposed corporate tax reduction that lies within the pending tax reform bill. We pointed out that, while investors appear focused on the benefits to corporations, they are grossly negligent ignoring the negative economic effects that higher individual taxes will have on consumption (70% of GDP) and the adverse influence of an additional $1.5 trillion deficit.

In this piece, we consider how the consensus is quantifying the positive effect the tax bill should have on stocks. Specifically, we discuss what is “priced in” to the market. This example, unlike that of the drug maker, is not black and white. However, by explaining how market projections are created, we offer guidance on how much the market has priced in for corporate tax cuts. This in turn offers investors a non-market opinion on what the corporate tax cut is worth and a basis to take appropriate actions.

To be clear, our view of the implications of this legislation are likely negative to GDP and therefore corporate earnings. That said, we also want to understand how the consensus views the proposal in order to form an opinion about how the market may trade. In due time the consequences of poorly constructed tax reform will appear but in the meantime, 720Global does not set the market price, the consensus does.

Corporate Tax Cuts

Since at least 1947, historical data has provided sufficient evidence to show that corporate tax reductions, subsidized by federal deficits and individual taxpayers, have resulted in slowing GDP growth. Accordingly, we believe that the current proposal will follow the path of prior tax reductions and result in weaker economic growth and ultimately lower corporate earnings than would have occurred without the legislation.

While our opinion, as stated above and detailed in the previously referenced article, differs widely from the “market”, we thought it might be helpful to provide a framework using the logic of most investors to value the corporate tax reduction.  The following paragraph from the article reviews our findings.

Based on this simple analysis thus far, it is easy to understand why equity investors are giddy over a sizeable reduction in the corporate tax rate. If the statutory rate is reduced to 20% as proposed, and the effective rate remains 10% lower, the amount of money corporations pay in taxes will be reduced sharply. Based solely on this assumption, corporate after-tax profits, in year one alone should increase by almost $200 billion, while federal corporate tax receipts will be reduced by the same amount. Such a boost in corporate earnings would increase the forecasted internal rate of return (IRR) on the S&P 500 by approximately .90%. Holding everything else constant, this equates to a price increase of 285 points for the S&P 500 or an 11% gain from today’s level.

We recently read an article in which the Swiss investment firm UBS claims “Stocks could surge 25% if the Republican tax bill passes.” Given the juxtaposition between the paragraph above and the UBS forecast, we wanted to walk you through the math and let you judge for yourself what investors think the tax cut is worth.

Valuation Math

The graph below compares corporate earnings with a tax cut (green line) to one without the cut (red line).  As a reminder, corporate earnings will be affected by the changes in the effective tax rate not the statutory rate. As such, we base our analysis on an expected decrease in the effective tax rate from the current level of 22% to 10%, and assume earnings in both cases grow at 5% a year.

The present value of the difference between the two lines above is the likely approach that most investors are using to price the value added from the tax plan. In turn, the present value figure of that differential yields a dollar premium that can then be added to the current price of the S&P 500 to arrive at an expected price after the tax cut. Based purely on the earnings shown in the graph, an investor looking to receive those cash flows would be indifferent between paying the current price for current earnings and paying the current price plus $285 per share or 2925 for the earnings benefiting from the tax cuts. The current price of the S&P 500 is 2640. Thus, investors that believe the tax cut will reduce the effective tax rate by 12% should expect the S&P 500 to increase by approximately 11%.

In order to validate our findings above, we take a different approach and quantify how the change in earnings would affect the price to earnings ratio (P/E). Currently, the one year trailing earnings for the S&P 500 are $107 per share and the P/E is 24.63. If earnings increased by 12% due to tax cuts, the P/E would decline to 21.99. If the market were to price in the increased earnings under the assumption that valuations are unchanged, the price of the S&P 500 would need to increase 12% to bring P/E back to its current level. This different approach delivers a very similar result.

Starting Line

Thus far, the analysis seems relatively straight forward, however there is another major concern when gauging how much of the tax bill is priced in to the market. We need to ask, “When did the market begin to price in the benefits of tax relief for corporations?”  Obviously it is impossible to pinpoint a date, but we selected three possibilities to show why this matters. The table below uses the night before the Presidential election, the date Congress began debating tax reform and the current date. The current price of 2640 allows us determine how much the S&P 500 has priced in.

As shown above, those that believe the tax deal has not been priced in and its passage will increase corporate valuations by 12% ought to expect a full adjustment in the price of the index from current levels. On the flip side, those that similarly believe the tax bill will boost valuations but believe this has been known by the market since the day Donald Trump was elected might expect a decline of 9.59%. They would argue the market has priced in a corporate tax reduction and then some. Another option is that in addition to tax cuts, the market is giving some consideration to other Trump policies that may be beneficial to the market such as regulatory reform. Although we try to isolate and quantify the effects of tax cuts, there are clearly many other dynamics in play.

Summary

UBS believes stocks are worth 25% more than current levels if proposed tax cuts become law. While we do not know how they arrived at such a large number, we can use our analysis above to solve for possible answers. Based on the framework of our analysis, it is likely that UBS thinks corporations will reap the entire 12% tax benefit and corporate earnings will grow 1.25% faster due to broad economic benefits stemming from the bill. Their assumption also implies that none of the 25% is priced in. In other words, the true gains due to the tax bill are likely even higher.

UBS clearly presumes the tax cut will benefit the corporate bottom line due to a decreased tax burden and will also spur economic growth. As we discussed in the aforementioned article, there is no precedent for such a claim. History does not support UBS’s case, nor does common sense. We also remind you that UBS makes money selling stocks. Despite spurious math, as a for-profit financial institution, their interests are well-served by pitching the idea of a big post-tax cut rally.

If you believe like we do that the benefits to corporate earnings are being grossly overestimated by the consensus you are at a distinct advantage. This does not mean you must sell all stocks and short the market immediately. It does however require you to proceed with caution, for when reality catches up with the consensus, market valuations could be at risk.

To reiterate a point we made in the prior article:

Given the historical evidence regarding the implications of corporate tax cuts, we are left questioning the so-called “Trump bump.” We argue that a market rally based on that premise is incoherent, and the market should be discounting prices and valuations due to the tax cuts not inflating them.”

Since Donald Trump was elected President, the S&P 500 has rallied over 21% or nearly 500 points. In our opinion, a good portion of the gain is attributable to his promise, as well as congressional efforts, to reform the tax code. In particular, the proposed sharp reduction in the corporate tax rate has the equity market’s attention. At first blush, the simple logic driving equity investors appears reasonable. Appearances, however, can be deceiving, and history is littered with failed investors that banked on a faulty thesis. As such, instead of tripping head first into that same category, we decided to assume nothing and look at the proposed reduction in the corporate tax rate and historical data to better understand how the legislation might affect the economy and corporate earnings.

Corporate Tax Rates

The graph below highlights the statutory and effective corporate tax rates since 1947.

Data Courtesy: St. Louis Federal Reserve (FRED)/ BEA (NIPA tables)

The statutory tax rate is the legally mandated rate at which corporate profits are taxed. As shown above, the rate has been consistent over the last 75 years except for one significant change as a result of the Tax Reform Act of 1986.

The effective corporate tax rate is the actual tax rate companies’ pay. One can think of the statutory rate as similar to the MSRP sticker price on a new car. It provides guidance on cost but consumers always pay something less. The effective tax rate, like the “discounted” price one pays for a car, is the actual percentage of profits that corporations remitted to the government. This rate is calculated by dividing a company’s tax payments by their pre-tax profit. Deductions of all sorts reduce the pre-tax profit, thus creating a difference between the statutory and effective tax base and therefore the amount paid. For purposes of this article, we aggregate corporate tax receipts and corporate profits to calculate an effective rate for all corporations.

From 1947 to 1986 the statutory corporate tax rate was 49% and the effective tax rate averaged 36.4% for a difference of 12.6%. From 1987 to present, after the statutory tax rate was reduced to 39%, the effective rate has averaged 28.1%, 10.9% lower than the statutory rate.

Based on this simple analysis thus far, it is easy to understand why equity investors are giddy over a sizeable reduction in the corporate tax rate. If the statutory rate is reduced to 20% as proposed, and the effective rate remains 10% lower, the amount of money corporations pay in taxes will be reduced sharply. Based solely on this assumption, corporate after-tax profits, in year one alone, should increase by almost $200 billion while federal corporate tax receipts will be reduced by the same amount. Such a boost in corporate earnings would increase the forecasted internal rate of return (IRR) on the S&P 500 by approximately .90%.  Holding everything else constant this equates to a price increase of 285 points for the S&P 500 or an 11% gain from today’s level. It is impossible to assess how much of the gain since the election is due to tax reform expectations and how much is due to other factors, but we wager a good portion of it has been based on the promise of tax reform.

History

While the math and logic above seem sound, we can turn to historical data to understand the relationship between taxes and economic growth and profits. In doing this, we can better forecast the actual effects that lower corporate taxes might have on economic growth and corporate profits.

The graph below compares the effective corporate tax rate to the running three-year average GDP growth rate. The dotted trend lines smooth the data to allow for a clearer comparison.

Data Courtesy: St. Louis Federal Reserve (FRED)/ BEA (NIPA tables)

As is clearly observable, GDP has trended lower at a very similar pace as the effective corporate tax rate. The graph below puts the data in a scatter plot format to evaluate the statistical relationship between corporate tax rates and economic growth rates.

Data Courtesy: St. Louis Federal Reserve (FRED)/ BEA (NIPA tables)

The R² shown above (.3552), a statistical measure of correlation, is far from perfect, but there is a reason to believe that lower effective tax rates may partially explain the weakening trend in GDP growth.  Based on statistical regression, every 1% decrease in the effective tax rate should diminish GDP growth by 0.12%. 

The President, his economic team, and lawmakers are selling the tax bill with claims that a reduction in corporate taxes will boost economic growth. Based on data from the last 75 years, that has never been the case. In fact, the average annualized GDP growth rate in the five years before the major statutory tax reduction in 1986 was 3.90%. In the five years following the tax cut, the average annualized growth was reduced by more than half to 1.93%.

Next, we show a scatter plot comparing effective tax rates to corporate profits.

Data Courtesy: St. Louis Federal Reserve (FRED)/ BEA (NIPA tables)

As measured by a R² of .051, the graph above shows that over the last 75 years, there has been no measurable relationship between effective corporate tax rates and corporate profit growth.

Who Pays

The historical evidence above tells a different story than the bill of goods being sold to citizens and investors.  Corporate tax rates are positively correlated with economic growth which means that lower corporate tax rates equate to slower economic growth. Further, there is strong evidence that corporate profits are largely unaffected by tax rates.

Investors buying based on the benefits of the tax proposal appear shortsighted. They value the benefits of corporate tax cuts, but they are grossly negligent in recognizing how the tax cuts will be funded.  

The tax bill, as it is currently proposed, will increase the deficit by $1.5 trillion over ten years. As such, the government will borrow an additional $1.5 trillion on top of current projections of approximately $1 trillion per year.

When the government borrows money to fund a fiscal deficit they effectively crowd out investment that could have funded the real economy. Said differently, the money required to fund the government’s deficit cannot be invested in the pursuit of innovation, improving workers skills, or other investments that pay economic dividends in the future. As we have discussed on numerous occasions, productivity growth drives economic growth over the longer term. Therefore, a lack productivity growth slows economic growth and ultimately weighs on corporate earnings.

A second consideration is that the long-term trend lower in the effective corporate tax has also been funded in part with personal tax receipts. In 1947, total personal taxes receipts were about twice that of corporate tax receipts. Currently, they are about four times larger. The current tax reform bill continues this trend as individuals in aggregate will pay more in taxes.

As personal taxes increase, consumers who account for approximately 70% of economic activity, have less money to spend.

Summary

As is often the case in economics and investing, there is a “seen” and an “unseen.” The “seen” is widely visible and, right or wrong, generally represents a consensus agreement about reality. The “unseen,” while equally important, largely goes under-appreciated. In time, it is the “unseen” that will affect economic growth rates and corporate earnings. It is the “unseen” that investors must grasp if they are to be successful. In this case, the “unseen” is the massive federal deficit. Its burden on the economy prevents traditional forms of stimulus from having their desired effects.

Given the historical evidence regarding the implications of corporate tax cuts, we are left questioning the so-called “Trump bump.” We would argue that a market rally based on that premise is incoherent, and the market should be discounting prices and valuations due to the tax cuts not inflating them. 

“Before long, we will all begin to find out the extent to which Brexit is a gentle stroll along a smooth path to a land of cake and consumption.” – Mark Carney, Bank of England Governor

In 1939, the British Government, through the Ministry of Information, produced a series of morale-boosting posters which were hung in public places throughout the British Isles. Faced with German air raids and the imminent threat of invasion, the slogans were aimed at helping the British public brave the testing times that lay ahead. The most enduring of these slogans simply read:

 “Keep Calm and Carry On.”

Ironically, it was the only one of the series that was never actually displayed in public as it was reserved for a German invasion that never transpired. Today, the British Government may wish to summon a fresh propaganda strategy to address a new threat on the horizon, that of the eventuality of Brexit.

The Kingdom Divided

The United Kingdom (UK) is in the process of negotiating out of all policies that, since 1972, formally tied it to the economic dynamics of the broader western European community. Since the unthinkable Brexit vote passage in June 2016, the unthinkable has now become the undoable. The negotiations, policy discussions, logistical considerations and legal wrangling are becoming increasingly problematic as they affect every industry in the UK from trade and finance to hazardous materials, produce, air travel and even Formula 1 racing.

The worst case scenario of a disorderly or “hard” Brexit, whereby no deal is reached by the March 2019 deadline, is the most extreme for investors along the spectrum of potential outcomes. A deadlock, which is unfortunately the most likely scenario, would result in tariffs on trade between the UK and the European Union (EU). Such an outcome would result in a rapid deterioration of British economic prospects, job losses and the migration of talent and businesses out of the country. Even before the path of Brexit is known, a number of large companies with UK operations, including Barclays Bank, Diageo, Goldman Sachs, and Microsoft, are discussing plans to move or are already actively moving personnel out of Britain. Although less pronounced, the impact of a “hard” Brexit on the EU would not be positive either.

The least damaging Brexit outcome minimizes costs and disruption to business and takes the form of agreement around many of the key issues, most notably the principle of the freedom of movement of labor. The current progression of events and negotiations suggests such an agreement is unlikely. The outcome of negotiations between the UK and the EU will be determined by politics, with the UK seeking to protect its interests while the EU and its 27 member states negotiate to protect their own.

To highlight the complexities involved, the challenges associated with reaching agreements, and why a hard Brexit seems most likely, consider the following:

  • Offering an early indication of the challenges ahead, German Prime Minister Angela Merkel stated that she wants the “divorce arrangement” to be agreed on before terms of the future relationship are negotiated. The UK has expressed a desire for these negotiations to run concurrently
  • A withdrawal agreement (once achieved) would need to be ratified by the UK
  • A withdrawal agreement would have to be approved by the European Parliament
  • A withdrawal agreement would have to be approved by 20 of the 27 member states
  • The 20 approving states must make up at least 65% of the population of the EU or an ex-UK population of 290 million people
  • If the deal on the future relationship impacts policy areas for which specific EU member states are primarily responsible, then the agreement would have to be approved by all the national parliaments of the 27 member states

The summary above shows that the unprecedented amount of coordination and negotiation required within the 27 member states and between the EU Commission, the EU Council and the EU Parliament, to say nothing of the UK.

The “do nothing and see what happens” stance taken by the British and the EU would likely deliver a unique brand of instability but one for which there is a precedent.

The last time we observed an economic event unfold in this way, investment firm Lehman Brothers disappeared along with several trillion dollars of global net worth. Although the Lehman bankruptcy was much more abrupt and less predictable, a hard Brexit seems likely to similarly roil global markets. The “no deal” exit option, which is the path currently being followed, threatens to upend the intricate and endlessly interconnected system of global financial arbitrage. Markets are complacent and seem to have resigned themselves to the conclusion that since no consequences have yet emerged, then they are not likely.

Lehman Goes Down

In late 2007 and early 2008, as U.S. national housing prices were falling, it was becoming evident that the financial sector was in serious trouble. By March of 2008, Bear Stearns was sold to JP Morgan for $2 per share in a Fed-arranged transaction to stave off bankruptcy. Bear Stearns stock traded at $28/share two days before the transaction and as high as $172 per share in January 2007. Even as evidence of problems grew throughout the summer of 2008, investors remained complacent. After the Bear Stearns failure, the S&P 500 rallied by over 14% through mid-May and was still up over 3% by the end of August following the government seizure of Fannie Mae and Freddie Mac. While investors were paying little attention, the solvency of many large financial entities was becoming more questionable. Having been denied a Federal Reserve backstop, Lehman failed on September 15, 2008 and an important link in the global financial system suddenly disappeared. The consequences would ultimately prove to be severe.

On September 16, 2008, the first trading day after Lehman Brothers filed for bankruptcy, the S&P 500 index closed at 1192. On September 25, just 10-days later, it closed 1.43% higher at 1209. The market, in short time, would eventually collapse and bottom at 666 in six short months. Investors’ inability to see the bankruptcy coming followed by an inability to recognize the consequences of Lehman’s failure seems eerily familiar as it relates to the current status of Brexit negotiations.

If all efforts to navigate through Brexit requirements are as complicated and difficult as currently portrayed, then what are we to expect regarding adverse consequences when the day of reckoning arrives? Is it unfair to suspect that the disruptions are likely to be severe or potentially even historic? After all, we are not talking about the proper dissolution of an imprudently leveraged financial institution; this is a G10 country! The parallel we are trying to draw here is not one of bankruptcy, it is one of disruptions.

As it relates to Brexit, Dr. Andreas Dombret, member of the executive board of the Deutsche Bundesbank, said this in a February 2017 speech to the Bank of International Settlements –

“So while economic policy will of course be an important topic during negotiations, we should not count on economic sanity being the main guiding principle. And that means we also have to factor in the possibility that the UK will leave the bloc in 2019 without an exit package, let alone the sweeping trade accord it is seeking. The fact that this scenario would most probably hurt economic activity considerably on both sides of the Channel will not necessarily prevent it from happening.”

Rhyming

On June 23, 2016, the day before the Brexit vote, the FTSE 100 closed at 6338. After a few hours of turbulence following the surprising results, the FTSE recovered and by the end of that month was up 2.6%. Today, the index is up 17.5% from the pre-Brexit close. The escalating risks of a hard exit from the EU clearly are not priced into the risky equity markets of Great Britain.

Data Courtesy: Bloomberg

Conversely, what has not recovered is the currency of the United Kingdom (chart below). The British Pound Sterling (GBP) closed at 1.4877 per U.S. dollar on June 23, 2016, and dropped by 15 points (-10%) to 1.33 by the end of the month following the Brexit vote. Over the past several months the pound has fallen to as low as 1.20 but more recently it has recovered to 1.33 on higher inflation readings and hawkish monetary policy language from Bank of England (BoE) governor Mark Carney. Despite following through on his recent threats to hike interest rates, the pound has begun to again trend lower.

Data Courtesy: Bloomberg

Carney has voiced concern over Brexit-induced inflation by saying that if global integration in recent decades suppressed price growth then the reduced openness to foreign markets and workers due to Brexit should result in higher inflation. This creates a potential problem for the BoE as a disorderly exit from the EU hurts the economy while at the same time inducing inflation. Such a stagflation dynamic would impair the BoE’s ability to engage in meaningful monetary stimulus of the sort global financial markets have become accustomed since the financial crisis. If the central bankers lose control of inflation, QE becomes worthless.

Some astute observers of the currency markets and BoE pronouncements argue that Carney’s threat of rate hikes are aimed at halting the deterioration of value in the pound and preventing a total collapse of the currency. That theory is speculative but plausible when analyzing the chart. Either way, whether the pound’s general weakness is driven by inflation concerns or the rising risks associated with a hard Brexit, the implications are stark.

What is equally evident, as shown below, is the laissez-faire attitude of the FTSE as opposed to the caution and reality being priced in by the currency markets. In Lehman’s case, the stock market was similarly complacent while the ten year Treasury yield dropped by nearly 2.00% from June 2007 to March 2008 (from a yield of 5.25% to 3.25%) on growing economic concerns and a flight-to-quality bid.

Data Courtesy: Bloomberg

A Familiar Problem

As discussed above, the Bank of England may find itself in a predicament where it is constrained from undertaking extreme measures due to inflation concerns or even being forced to tighten monetary policy despite an economic slowdown. Those actions would normally serve to support the pound. Further, if the prospect of a hard Brexit continues to take shape, capital flight out of the UK may overwhelm traditional factors. In efforts to prevent the disorderly movement of capital out of the country, the BoE may be required to hike interest rates substantially. Unlike the resistance of equity markets to bad news, the currency markets are more inclined, due to their size and much higher trading volume, to fairly reflect the dynamics of the economy and the central bank in a reasonable time frame.

Our perspective is not to presume a worst case scenario but to at least entertain and strategize for the range of possibilities. Equity markets, both in the UK and throughout the world, transfixed by the shell game of global central bankers’ interventionism, are clearly not properly assessing the probabilities and implications of a hard Brexit.

All things considered, the pound has rallied back to the high end of its post-Brexit range which seems to suggest the best outcome has been incorporated. If forced to act against inflation, the Bank of England will be hiking rates against a stagnant economy and a poor economic outlook.  This may provide support for the pound in the short term but it will certainly hurt an already anemic economy in the midst of Brexit uncertainty.

Summary

Timing markets is a fool’s errand. Technical and fundamental analysis allows for an assessment of the asymmetry of risks and potential rewards, but the degree of central bank interventionism is not quantifiable. With that premise in mind, we can evaluate different asset classes and their adherence to fundamentals while allowing a margin of error for the possibility of monetary intervention. After all, if central banks print money to inflate asset prices to create a wealth effect, some other asset should reveal the negative effects of conjuring currency in a fiat regime – namely the currency itself. In the short term, it may appear as though rising asset prices create new wealth, but over time, the reality is that the currency adjustments off-set some or all of the asset inflation.

Investors should take the time, while it is available, to consider the gravity of the disruptions a hard Brexit portends and look beyond high flying UK stocks to the more telling movement of the British pound. Like with Lehman and the global financial system in 2008, stocks may initially be blind to the obvious. Although decidedly not under the threats present during World War II, the British Government and the EU lack the leadership of that day and will likely need more than central banker propaganda to weather the economic storm ahead.

Keep calm and carry on, indeed.

If someone told you that the President of the United States in 2028 would be a Democrat and a woman from the state of New York, could you guess who it might be? We highly doubt it. In 1998, ten years before being elected president, Barack Obama had just been re-elected to the Illinois State Senate and was on no one’s radar as a Presidential candidate. In fact, had you been told at that time an African-American Democrat from Illinois would be president in 2008, it’s likely you would have assumed that two-time democratic presidential nominee Jesse Jackson would be the 44th President. In 1990, George W. Bush had just bought the Texas Rangers baseball club and was still four years from becoming Governor of Texas. In 1983, Bill Clinton was ten years out of law school and serving his second term as Governor of Arkansas. We could keep going down the line of presidents, and you would realize that even armed with some key details about the future, it would be extremely difficult to predict who a future president might be.

Stock investing is a little different. If you know the future level of three simple data points, you can calculate to the penny the price of any stock or index in the future and the exact holding period return. This precise prediction will hold up regardless of wars, economic activity, natural disasters, UFO landings or any other event you can dream up.

Unfortunately, those three data points are not readily available but can be inferred using historical trends, future expectations and logic to project them. With projections in hand, we can develop a range of price and return expectations for an index or an individual stock. In this paper, we provide an array of projections based on those factors and provide return expectations for the S&P 500 for the next ten years.

Factor 1: Dividends

Dividends are an important and often overlooked component of stock returns. To emphasize this point, an investor guaranteed a 3% dividend yield based on the current price, receives a 30% gain (non-compounded) in ten years. In other words, the investor has at least a 30% cushion to guard against price declines over a ten-year period.  That is what Warren Buffett refers to as a “moat,” and it is a wonderful benefit of investing in dividend-paying stocks.

The scatter plot graphed below compares the S&P 500 dividend yield to the Ten-year U.S. Treasury Note yield since 1980.  This historic backdrop helps project the S&P 500 dividend yield for the next ten years.

Data Courtesy: St. Louis Federal Reserve (FRED)

From 1980-1999, Treasury yields and dividend yields behaved alike. The trend line above, covering these years, has a statistically significant R-squared of 0.84 (84% of the move in dividend yields can be explained by moves in the 10-year yield). Since the year 2000, that relationship has all but disappeared. The R-squared for the post-financial crisis era is a meaningless .02.

Around the year 2000, dividend yields appear to have hit a floor ranging from 1-2%, despite a continued decline in Treasury yields. The reason for this is that many companies want to entice investors with higher dividend yields. As such, they raised dividends to keep the dividend yield relatively attractive. Had the regression of the 1980-1999 era held, dividend yields would be below 1% given current Treasury yields.

The graph above makes forecasting the future dividend yield relatively easy. As long as Ten-year U.S. Treasury yields stay below 5-6%, we expect dividend yields will range from 1-2%. Accordingly, we simplify this analysis and assume an optimistic 2% dividend yield for the next ten years.

Dividend Yield – Base/Optimistic/Pessimistic = 2%

Factor 2: Earnings

Over the long-term, earnings are well correlated to economic growth. Our ten-year analysis easily qualifies as long-term. Over shorter periods, there can be sharp variations due to a variety of influences such as regulatory policies and tax policies all of which influence profit margins. To arrive at reasonable expectations for earnings growth, we first consider economic growth. The following chart plots the declining trend in GDP growth since 1980.  Given the burden of debt, weak productivity growth and the obvious headwinds from demographics, we think it is likely the trend lower continues.

Data Courtesy: St. Louis Federal Reserve (FRED)

Next, we consider S&P 500 earnings growth rates. Earnings growth over the last three years, ten years and since 1980 are as follows: 3.18%, 4.38%, and 5.93% respectively. Given the economic and earnings trends, we believe a 3% future earnings growth rate for the next ten years is fair, 5% is optimistic, and 1% is pessimistic.

Earnings Growth – Base/Optimistic/Pessimistic = 3.00%/5.00%/1.00%

Factor 3: Valuations

Robert Shiller’s Cyclically Adjusted Price-to-Earnings ratio (CAPE) is our preferred method of valuation as it averages earnings over ten year periods. In doing so, it avoids short-term volatility of earnings and provides a more consistent baseline reflective of a company’s or indexes true earnings potential.  Currently, the CAPE of the S&P 500 sits in rare territory, as shown below. In fact, outside of the late 1990’s tech boom, there were only two months since 1881 when the Shiller CAPE was higher than today’s level – August and September of 1929.

CAPE has a history of extending well above and below its mean. Importantly, it also reverts to its mean after these long stretches of time. It does not seem unreasonable to expect that, over the next ten years, it will again revert to its mean since 1920 of 17.29. An optimistic scenario for 2028 is a CAPE reading of one standard deviation above the mean at 24.77. The pessimistic case is, likewise, one standard deviation below the mean at 9.70. Further, as shown below, we also present an outlook assuming CAPE stays at its current level of 31.21.

The graph below shows CAPE and the three forecasts along with the current level.

Data Courtesy: Robert Shiller http://www.econ.yale.edu/~shiller/data.htm

CAPE – Base/Optimistic/Pessimistic = 17.29/24.80/9.70

What does 2028 hold in store?

The following graph and table explore the range of outcomes that are possible given the scenarios outlined above. To help put context around the wide range of expected returns, we calculated an equity-equivalent price of the 10-year U.S. Treasury Note and added it to the graph as a black dotted line. Investors can use the line to weigh the risk and rewards of the S&P 500 versus the option to purchase a relatively risk-free U.S. Treasury Note. The table below the graph serves as a legend and reveals more information about the forecasts. The color shading on the table affords a sense of whether the respective scenario will produce a positive or negative return as compared to the U.S. Treasury Note. The far right column on the table indicates the percentage of observations since 1881 that CAPE has been higher than the respective scenarios.

Data Courtesy: Robert Shiller http://www.econ.yale.edu/~shiller/data.htm and 720Global/Real Investment Advice

As shown in the graph and table above, only scenarios 8 through 12 have a higher return than the ten year U.S. Treasury Note. Of those, three of the five assume that CAPE stays at current levels. Scenario 8, shaded yellow, has a negligible positive return differential.

Summary

The bottom line is that, unless one has a very optimistic view on earnings growth and expects valuations to remain elevated beyond what historical precedent argues is reasonable, the upside is limited, and the downside is troubling. The odds favor that a risk-free investment in a 10-year Treasury note will provide a better return through 2028 with less volatility. With current 10-year note yields at roughly 2.25%, that should emphasize the use of the term “troubling.”

The lines in the graph above are smooth, giving the appearance of identical returns each period. Markets do not work that way. These projections do not consider the path taken to achieve the expected total return and they most certainly will not be smooth. The best case scenario, and the one least likely to occur is for volatility to remain low. This would generate the most orderly path. Given that the post-crisis VIX (equity market volatility index) has averaged 17.7, current single-digit levels are an aberration and it does not seem unreasonable to expect more volatility in the future.

Even if one of the scenarios plays out exactly as we describe, the path to that outcome would be very choppy. For instance, if the worst case scenario played out, an investor may lose 60-80% of value in a matter of one or two years. However they would most likely have better than expected annual returns in the years following.

In a follow up to this article we will take this thought a step further and discuss the so-called path of returns. We show you the expected and actual path of returns from 2005 to 2015 and argue that an investor armed with the three factors, and a little discipline, may have generated much better returns than those earned by investors using a buy and hold approach.

Real Investment Advice is pleased to introduce J. Brett Freeze, CFA, founder of Global Technical Analysis. Going forward on a monthly basis we will be providing you their valuable S&P 500 Valuation Chart Book. This unique analysis provides an invaluable long term perspective of equity valuations. 

If you are interested in learning more about their services, please connect with them.

Introduction

We believe that the chief determinant of future total returns is the relative valuation of the index at the time of purchase.  We measure valuation using the Price/Peak Earnings multiple as advocated by Dr. John Hussman.  We believe the main benefit of using peak earnings is the inherent conservatism it affords: not subject to analyst estimates, not subject to the short-term ebbs and flows of business, and not subject to short-term accounting distortions.  Annualized total returns can be calculated over a horizon period for given scenarios of multiple expansion or contraction.

Our analysis highlights expansion/contraction to the minimum, mean, average, and maximum multiples (our data-set begins in January 1900) .  The baseline assumptions for nominal growth and horizon period are 6% and 10 years, respectively.  We also provide graphical analysis of how predicted returns compare to actual returns historically.

We provide sensitivity analysis to our baseline assumptions.  The first sensitivity table, ceterus paribus, shows how future returns are impacted by changing the horizon period.  The second sensitivity table, ceterus paribus, shows how future returns are impacted by changing the growth assumption.

We also include the following information: duration, over(under)-valuation, inflation adjusted price/10-year real earnings, dividend yield, option-implied volatility, skew, realized volatility, historical relationships between inflation and p/e multiples, and historical relationship between p/e multiples and realized returns.

Our analysis is not intended to forecast the short-term direction of the SP500 Index.  The purpose of our analysis is to identify the relative valuation and inherent risk offered by the index currently.

Predicted Returns

Predicted Return: Sensitivity Analysis

Price to Peak Earnings

As of 10/31/2017:  Price/Peak Earnings 23.6

To get at the significance of the P/E, you have to start by understanding that stocks are not a claim to earnings anyway.  Stocks are a claim to a future stream of free cash flows – the cash that can actually be delivered to shareholders over time after all other obligations have been satisfied, including the provision for future growth.  Knowing this already tells us a lot.  For example, price/earnings ratios based on operating earnings are inherently misleading, since that “earnings” figure does not deduct interest owed to bondholders nor taxes owed to the government.   This isn’t to say that P/E ratios are useless, but it’s important for the “E” chosen by an investor to have a reasonably stable relationship to what matters, which is the long-term stream of free cash flows.  For that reason, our favored earnings measure for market valuation (though it can’t be used for individual stocks) is “peak earnings” – the highest level of net earnings achieved to date.  (Excerpted from Dr. John Hussman)

Duration

As of 10/31/2017:  Duration 53.5 years

In the case of equities, duration measures the percentage change in stock prices in response to a 1% change in the long-term return that stocks are priced to deliver. So we have a basic financial planning concept.  If a buy-and-hold investor with no particular view about market conditions or future returns wishes to have a fairly predictable amount of wealth at some future date, that investor should hold a portfolio with a duration that is roughly equal to the investment horizon.  (Excerpted from Dr. John Hussman)

Valuation

As of 10/31/2017:  Overvalued by 107.2%

Inflation Adjusted PE

As of 10/31/2017:  Real Price to 10-Year Real Earnings 31.1x

Dividend Yield

As of 10/31/2017: Dividend Yield 1.87%

Option Implied Volatility

VIX measures 30-day expected volatility of the S&P 500 Index.  The components of VIX are near- and next-term put and call options, usually in the first and second SPX contract months.   “Near-term” options must have at least one week to expiration; a requirement intended to minimize pricing anomalies that might occur close to expiration.

As of 10/31/2017:  10-Day EMA 10.44

Option Skew

The CBOE SKEW Index (“SKEW”) is an index derived from the price of S&P 500 tail risk.   The price of S&P 500 tail risk is calculated from the prices of S&P 500 out-of-the-money options. SKEW typically ranges from 100 to 150.   A SKEW value of 100 means that the perceived distribution of S&P 500 log-returns is normal, and the probability of outlier returns is therefore negligible.   As SKEW rises above 100, the left tail of the S&P 500 distribution acquires more weight, and the probabilities of outlier returns become more significant.

As of 10/31/2017:  10-Day EMA 137.64

Realized Volatility

As of 10/31/2017:  6.34%

Inflation and PE Multiples

Lower levels of inflation are rewarded with higher earnings multiples.

Higher levels of inflation are punished with lower earnings multiples.

Inflation and PE Multiples

Lower levels of volatility are rewarded with higher earnings multiples.

Higher levels of volatility are punished with lower earnings multiples.

PE Multiples and Realized Returns

Lower valuations are rewarded with higher realized returns.

Higher valuations are punished with lower realized returns.

As of 10/31/2017:  Price to Peak Earnings 23.6x  Average: 12.6x

In Something Wicked This Way Comes, we provided an in-depth look at how stock repurchases are distorting McDonald’s (MCD) earnings per share and making the company look more profitable than it truly is. When such financial wizardry is considered alongside the growing popularity of passive investment strategies and overall sense of market euphoria, we have a better appreciation for why MCD trades at a valuation higher than fundamentals suggest would be appropriate.

We thought it would be helpful to extend this analysis to the entire S&P 500 to see if we can uncover other companies demonstrating fundamental and valuation divergences similar to MCD.

Who Else?

Similar to the MCD analysis, we evaluated changes in fundamentals, equity price and valuation data over the last five years for most companies that comprise the S&P 500. The data below, summarizing our broad findings, is based on 475 of the 505, S&P 500 companies. 30 companies were omitted from the analysis due to insufficient data.

  • 141 companies, or about 30% of the S&P 500, had annualized five-year sales growth rates of 1% or less.

Of these 141 companies:

  • The average stock price gain over the five year period was +68%.
  • 106 of the companies had a stock price increase of 25% or more that was concurrent with falling revenue.
  • The average number of shares outstanding declined by 2%. This data point is misleading as many energy companies within this group issued shares to bolster capital when the price of oil declined sharply in 2014/2015.
  • The average amount of debt outstanding increased 70%
  • The valuation ratio of market capitalization to sales increased 73%.

The table below isolates companies which had five year revenue declines of greater than 10%, price increases greater than 20%, declines in shares outstanding and increased debt outstanding.

Data Courtesy: Bloomberg

The company-specific data and the averages for this group highlight the extreme divergences that exist between poor fundamental data and current price and valuation. The list of companies showing these characteristics extend well beyond what we show here, these are just the most egregious examples.

In the table below, we highlight a few other larger, well-known companies. While these companies did not match all of the criteria for the table above, they do have price and valuation changes that are inconsistent with their revenue growth.

Data Courtesy: Bloomberg

A few comments about the tables above:

  1. Note that all of the companies are large firms from a wide range of industries and thus well represented in many passive indexes.
  2. Despite flat to negative revenue growth for at least five years, they have all experienced respectable price and valuation increases.
  3. In most cases, the companies have increased their debt outstanding while decreasing shares outstanding. It is likely the debt in many of these companies is being used to some degree to repurchase stock.
  4. For the most part, the companies are mature and therefore likely have low to mid single-digit revenue and earnings growth prospects.

Disclaimer: The analysis performed on the companies listed was not as extensive as that from the prior article on MCD. Some of these companies may have new products or promising innovation that justifies their price and valuation increases despite the poor fundamentals. However, we believe the MCD problem is at play in most of these companies.

Summary

There are good companies with bad stocks and bad stocks of good companies. What we lay out here is not an indictment of specific companies but a reality check on stock valuations. This analysis highlights a host of companies that appear to have prices that are well above a fair fundamental value. This does not mean the prices of these companies cannot continue to rise and further defy financial gravity. It does mean that, over time, these companies must either grow revenue and earnings at significantly faster rates than they have or their share prices will fall as their valuations likely revert to historical norms.

The popularity of passive investing and unawareness of the effects of buybacks are complicit in boosting the price of many undeserving companies to eye-watering valuations. We suspect passive strategies will continue to attract a larger than normal percentage of investment dollars as long as these blind momentum strategies work. Given the tremendous financial incentives to executives we think stock buybacks will continue as well. That said, valuations will reach a tipping point and the masking of fundamental weakness will be exposed. When this occurs, those managers and investors employing active approaches will greatly outperform those with passive strategies.

720Global and Real Investment Advice (RIA) have been collaborating to bring investors unique market insight for two years. On October 9th, 720Global and RIA officially became partners in these efforts. As such, we want to help RIA readers appreciate 720Global’s economic and investment perspective.

Since 2015, 720Global has written nearly 100 articles, produced an important video and participated in a multitude of other events such as conferences and podcasts. While our articles span a wide range of topics, they all adhere to a core set of themes. To maintain consistency in our logic and avoid too much focus on any one topic, we track a “family tree of articles.” At the top of the tree are four “granddaddy” themes. These are major categories under which almost any topic we seek to explore will fit. The offspring of the major themes, so to speak, are core articles used to describe important concepts related to the theme. Progressively moving down the tree, articles tend to focus on a smaller subset of the theme. More granular, these articles may focus on a specific company, news event or a specific economic data point. In amalgamation, the articles provide a comprehensive understanding of the theme and offer examples, trading ideas, and introduce related concepts. This helps readers become more knowledgeable and apply critical thinking on the road to becoming informed investors.

The paragraphs below briefly describe the core (“granddaddy”) themes. At the end of each paragraph are sample articles and links. For a list and summary of every article 720Global has written, please contact us at mplebow@720global.com.

Theme 1 – Economics

Economics attempts to describe and quantify the production, distribution, and consumption of goods and services. Understanding economic data, trends and forces are of utmost importance to properly evaluate almost every type of investment. Economics is frequently sold to the public as a complex and sophisticated science, one best left for Ph.D.’s to study, describe and manage. We disagree. Economics is simply the study of human behavior and decision making. Our core economics articles distill the “science” to its basic foundations and deconstruct common myths. In some articles, we review traditional economic approaches to help readers understand the economy as presented, often erroneously, by the financial media, Wall Street, and the government.

Articles we’ve written on economics and economic principals include:

The Death of the Virtuous Cycle

Animated Virtuous Cycle

Lowest Common Denominator: Debt

The Illusion of Prosperity

Theme 2 – Portfolio Management and Investment Strategy

Articles about this theme address all investment classes, including specific advice for some asset classes as well as actionable investment ideas.

We never forget that investment management is a series of processes and beliefs used to preserve and compound wealth. Throughout history, markets repeatedly teach the durability of cycles and that periods of superior returns are followed by periods of subpar returns and vice versa. Changes in trend can happen when least expected and result in wealth-destroying losses or wealth-enhancing opportunities for investors. Accordingly, we believe a patient, conservative posture in times like today, when valuations portend future losses, is just as important as aggressiveness when value is presented. Wealth is built over the long term by adhering to a game plan, even if it is not the popular strategy. We subscribe to the motto:

Risk is not a number. Risk is simply overpaying for an asset.”

Articles we’ve written on portfolio management and investment strategy include:

A Shot of Absolute: Fortifying a Traditional Investment Portfolio

Limiting Losses

Protecting Your Blind Side

Something Wicked This Way Comes – Analysis of McDonalds

A Peak Above All Others

Theme 3 – Monetary and Fiscal Policy

Central banks and governments, both domestic and foreign, are increasingly playing a larger role in “steering” economic activity. While this interventionism can have positive economic effects and promote their immediate objectives, these actions have consequences. In many cases, the costs of poor policy accumulate over time. Unfortunately, few are able to recognize the potential pitfalls as focus always seems to be on the near-term benefits. We frequently discuss fiscal and monetary policy to help our readers see the potential benefits and understand the potential consequences that lie ahead.

Articles we’ve written on monetary and fiscal policy include:

The Fed’s Definition of Price Stability is Likely Different From Yours

Clarity or Confusion

Chasing the Dragon 

The Fifteenth of August

Theme 4 – Behavioral Finance

At their core, economic activity and financial market fluctuations are driven by individuals pursuing their own interests and the whims of human decision making. At times, decision making is rational, as assumed by most economic and market models. Other times, as history repeatedly shows, humans make irrational decisions. Maintaining a view on the mindset of investors, policy makers and the population can provide a distinct advantage. By recognizing what seems plausible or unrealistic about economic activity, one can ascertain which investments may do well or poorly.

Articles we’ve written on behavioral finance include:

Perception versus Reality

Bubbles and Elevators

Play the Game to Win

Our core purpose is to enhance our client’s ability to preserve and generate real wealth by identifying, understanding and applying basic truths and coherent logic to the global economic and financial system. 720Global’s articles provide unique insight and candor that is often lacking in financial research.

Please do not hesitate to email us with any questions or comments. 

As Halloween nears, kids are choosing costumes to transform themselves into witches, baseball players and anything else they can imagine. In the spirit of Halloween, we thought it might be an appropriate time to describe the most popular costume on Wall Street, one which many companies have been donning and fooling investors with terrific success.

Having gained over 65% in the last two years, the stock of McDonald’s Corporation (MCD) recently caught our attention. Given the sharp price increase for what is thought of as a low growth company, we assumed their new line of healthier menu items, mobile app ordering, and restaurant modernization must be having a positive effect on sales. Upon a deeper analysis of MCD’s financial data, we were quite stunned to learn that has not been the case. Utility-like in its economic growth, MCD is relying on stock buybacks and the popularity of passive investment styles to provide temporary costume as a high-flying growth company.

Stock Buybacks

We have written six articles on stock buybacks to date. While each discussed different themes including valuations, executive motivations, and corporate governance, they all arrived at the same conclusion; buybacks may boost the stock price in the short run but in the majority of cases they harm shareholder value in the long run. Data on MCD provides support for our conclusion.

Since 2012, MCD’s revenue has declined by nearly 12% while its earnings per share (EPS) rose 17%. This discrepancy might lead one to conclude that MCD’s management has greatly improved operating efficiency and introduced massive cost-cutting measures. Not so. Similar to revenue, GAAP net income has declined almost 8% over the same period, which rules out the possibilities mentioned above.

To understand how earnings-per-share (EPS) can increase at a double-digit rate, while revenue and net income similarly decline and profit margins remain relatively flat, one must consider the effect of share buybacks. Currently, MCD has about 20% fewer shares outstanding than they did five years ago. The reduction in shares accounts for the warped EPS. As noted earlier, EPS is up 17% since 2012. When adjusted for the decline in shares, EPS declined 7%. Given the 12% decline in revenue and 8% drop in net income, this adjusted 7% decline in EPS makes more sense. MCD currently trades at a trailing twelve-month price to earnings ratio (P/E) of 25. If we use the adjusted EPS figure instead of the stated EPS, the P/E rises to 30, which is simply breathtaking for a company that is shrinking. It must also be noted that, since 2012, shareholder equity, or the difference between assets and liabilities, has gone from positive $15.2 billion to negative $2 billion. A summary of key financial data is shown later in this article.

In addition to adjusting MCD’s earnings for buybacks, investors should also consider that to accomplish this financial wizardry, MCD relied on a 112% increase in their debt. Since 2012, MCD spent an estimated $23 billion on share buybacks. During the same period, debt increased by approximately $16 billion. Instead of repurchasing shares, MCD could have used debt and cash flow to expand into new markets, increase productivity and efficiency of its restaurants or purchase higher growth competitors. MCD executives instead manipulated EPS and ultimately the stock price. To their good fortune (quite literally), the Board of Directors and shareholders appear well-deceived by the costume of a healthy and profitable company. Over the last three years, as shown below, compensation for the top three executives has soared.

Source: MCD 2017 proxy statement (LINK)

The following table compares MCD’s fundamental data and buyback adjusted data from 2012 to their last reported earnings statement.

Data Source: Bloomberg and MCD Investor Relations

The graph below compares the sharp increase in the price of MCD to the decline in revenue over the last five years.

Data Courtesy: Bloomberg

Passive Influence

The share price of MCD has also benefited from the substantial increase in the use of passive investment strategies.

Active managers carefully evaluate fundamental trends and growth prospects of potential investments. They typically sell those investments which appear rich and overvalued while buying assets which they deem cheap or undervalued. When there is a proper balance among investing styles in a market, active investors act as a policeman of sorts, providing checks and balances on valuations and price discovery. Would an active investor buy into a fast food company with minimal growth prospects and rapidly rising debt, at a valuation well above that of the general market and long-term averages? Likely no, unless they knew of a greater fool willing to buy it at a higher price.

On the other hand, passive managers focus almost entirely on indexes and are typically less informed about the underlying stocks they are indirectly buying. They are indiscriminate in the deployment of capital allocating to match their index usually on the basis of market capitalization. Such a myopic style rewards those indexes exhibiting strong momentum. When investors buy indexes, the stocks comprising the index, good and bad, rise in unison. Would a passive investor buy into a fast food company with minimal growth prospects and rapidly rising debt at a valuation well above that of the general market and long-term averages? Yes, they have no choice because they manage to an index that includes that company.

When the marginal investors in a market are largely passive in nature, active managers are not able to effectively police valuations, and their influence is diminished. During such periods, indexes and their underlying stocks rise, regardless of the economic and earnings environment.  As the saying goes “a rising tide lifts all boats,” even those that are less seaworthy, such as MCD.

Summary

We warn investors that, when the day after Halloween occurs for MCD and other stocks trading well above fair value, investors might find a rotten apple in their portfolio and not the chocolatey goodness they imagined.

Buybacks will continue to occur as long as executives reap the short-term benefits, stock prices rise, money is cheap, and investors remain clueless about the long-term harm buybacks inflict on value. We suspect passive strategies will also garner a larger than normal percentage of investment dollars as long as these blind momentum strategies work. That said, valuations will reach a tipping point and the masking of fundamental weakness will be exposed.

Building wealth on faulty underpinnings is a strategy ultimately destined for failure. We urge investors to understand what they are buying and not be mesmerized by past gains or what the “market” is doing. Simply, when a stock rises above fair valuations, future returns are sacrificed.

 

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The most fundamental basis for economics is human decision-making. Satisfying needs and wants creates demand. Engaging in a vocation to provide a good or service of value to others generates supply. The intersection of the two is a market.

This week we introduce the unique insight of Mark McElroy. Mark is a friend of 720Global who often provides valuable input on our article concepts, their structure and occasionally challenges their validity. Now, with some minor arm-twisting, he challenges the status quo of economics – the profession, the pedigrees and their intentions. 

In Saying It Slowly Doesn’t Help, he doesn’t challenge the PhD economists so much as he takes the rest of us to task. If human decisions are the basis for economics then aren’t we all obligated to be economists at some level? His casual but intentional arms-length observer status poses the question: why is economics so difficult?

Saying It Slowly Doesn’t Help

“The quality of ideas seems to play a minor role in mass movement leadership. What counts is the arrogant gesture, the complete disregard of the opinion of others, the singlehanded defiance of the world.”Eric Hoffer, The True Believer

To communicate about economics is to describe the mirror as if it were a commodity. Economics is a tricky subject. It schemes and dodges—just try to sneak up on a mirror. For all the numbers, parentheses, red and black, boxes and columns, economics is mostly narrative. The digits and bytes of the trade are stand-ins for our resources or assets that are stand-ins for our fears, hopes, memories, hungers and regrets.  Economics is the overly eager attempt to hold at arms-length what we don’t want to see up close. Quantifying the narrative is like measuring a joke. But, it must be done.  It should be done.  Honestly, it needs to be done because no one is alone.

If such twaddle seems impractical, you’re in large company. I get it. That doesn’t necessarily mean you should be off the hook for thinking practically (critically) regarding how we talk about ourselves, our resources, and our guiding principles–economics.  Our collective want for information about economics is huge. Really huge. Cable, Twitter, whatever offers a 24/7 stream of info about economics to more and more people.  Evidently being in a flood doesn’t make one a hydrologist (that was weak, I apologize).  For all the volume of economic info/data available, one would expect we could be fairly proficient in discussing/communicating the basics of economics. Given the rise of six year financing plans for Toyota Corollas, I’m gonna go out on a limb and call BS on the notion that we know how to talk about it effectively. Clearly. Honestly.

If you fancy yourself an economist (and everyone should), it may be of comfort to realize economists are not the only ones in this “we have much to say and struggle to be understood” syndrome.  Scientists find themselves there, too. Scientists are studying themselves and the scientific assumptions regarding how to communicate about science. Tired of being picked last for kickball in the public square, scientists are aiming their magnified gaze upon themselves and are coming around to a counter-intuitive notion.  The more scientists try to correct and inform the public discourse, the less impact they have.  Saying it (you know, smart stuff) with more detail and credentials not only doesn’t work, it makes things worse. Tim Requarth in Slate wrote it like this:

[T]he way most scientists think about science communication—that just explaining the real science better will help—is plain wrong. In fact, it’s so wrong that it may have the opposite effect of what they’re trying to achieve.

I think he meant this:

[T]he way most scientists economists think about science economic communication—that just explaining the real science economics better will help—is plain wrong. In fact, it’s so wrong that it may have the opposite effect of what they’re trying to achieve.

Okay, he clearly did not mean that, but it would have been great if he did. Go read his article in full and play this parlor game. Every time you see “science” or some version of it, replace it with “economics” or some version of it.  It pretty much holds up.

Economics should be natural for us to communicate, but it isn’t. Who doesn’t know what a mirror looks like?  Economics is discussed ad nauseam as if it were an elusive concept that only a few have glimpsed (yep, just like Bigfoot) when it should be as natural as falling off a bike. Why is that?

I have a guess. Something as simple and natural as discussing the priorities and principles around which we value and exchange our assets has been made complex, confusing, and somehow has justified cable news panels with snooty people using phrases I can’t spell (of which there are many)—all this is the handiwork of a cottage industry (institution) committed to sustaining the confusion for profit, prestige, or because they miss satisfaction of taking names in third grade.


SIDEBAR: I am in a sustained lover’s quarrel with an institution that now spans 30+ years. Institutions of all flavors are the same in that their original spark, purpose or mission always becomes overwhelmed by its desire for self-perpetuation. To be clear, when I refer to the cottage industry proliferating the confusion regarding economics as an “institution,” it is meant as no compliment. If you have finished watching the paint dry and are intrigued by the whole institution thing, check out the work of Eric Hoffer, The True Believer: Thoughts on the Nature of Mass Movements.  SIDEBAR CLOSED


If economics remains confusing for me (as is religion and healthcare), I am less likely to experience contentment (or faith or health). Admittedly, though, the institutions that keep economics (and other matters) an ivory tower topic have a willing accomplice in me.  It is a co-dependence. Somewhere deep down I need as a way coping for that topic to be at arms-length.  At arms-length, I can see economics as a collection of digits, theories, and fractional transactions en masse. I am then spared the need to contemplate the basics of economics: stewardship, community, contentment, and charity.

Honestly, it needs to be done because no one is alone.

Mark McElroy, PhD @B40MKM is a writer, farmer, and management consultant with leadership roles in nonprofit and technology/information companies.

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The following article was published for premium subscribers of 720Global’s The Unseen on July 28, 2017. 720Global is sharing it exclusively with readers of Real Investment Advice.  Despite being two months “seasoned”, the rationale for hedging equity market exposures are even more relevant today. For more information on The Unseen please contact info@720global.com.

Protecting your Blind Side

The price of protecting quarterbacks was driven by the same forces that drove the price of other kinds of insurance: it rose with the value of the asset insured, with the risk posed to that asset.”  -Michael Lewis, The Blind Side

Counter-intuitively, that is often not the case in the capital markets. The more asset valuations and risk rise, the more implied volatility tends to drop and therefore the cost of insuring financial assets typically fall. As the S&P 500 index nears the sumptuously round number of 2500 and valuations surpass levels preceding the Great Depression, the price of options to protect investors is deeply discounted.  Provide valuable insight

The lead quote from Michael Lewis is in reference to NFL Hall of Famer Lawrence Taylor, otherwise known as LT, a defensive end for the New York Giants. LT was an exceptional player who not only threatened an opposing team’s offensive prowess but more importantly, the health of their quarterback. The Blind Side, by Michael Lewis, documented how teams were forced to pay dearly for insurance against this threat. The insurance came in the form of soaring salaries for strong left tackles who protect right handed quarterbacks from the so called “blind side” from which players like LT were attacking. The sacrifices teams made to shield their most valuable asset, the quarterback, limited the salaries that could be spent on players to boost their offensive fire power. LT taught general managers an important lesson -protecting your most important asset is vital in the quest for success.

Growing your wealth through good times and preserving it in bad times are the key objectives of wealth management. At times when the markets present “LT”-like threats, prudence argues for both a conservative posture and protection of assets.

While many investors continue to ignore the lopsided risk/return proposition offered by the equity markets, we cannot. Sitting on one’s hands and avoiding the equity market is certainly an option and one which we believe might look better over time than most analysts think. That said, it is not always a viable option for many professional and individual investors. Some investors have a mandate to remain invested in various asset classes to minimum required levels. In other cases, investors need to earn acceptable returns to help themselves or their clients adhere to their financial goals. Accordingly, the question we address in this article is how an investor can run with the bulls and take measures to avoid the horns of a major correction.

Risk vs. Reward

There are two divergent facts that make investing in today’s market extremely difficult.

  1. The market trend by every measure is clearly Any novice technician with a ruler projected at 45 degrees can see the trend and extrapolate ad infinitum.
  2. Markets are extremely overvalued. Intellectually honest market analysts know that returns produced in valuation circumstances like those observed today have always been short-lived when the inevitable correction finally arrives.

In The Deck is Stacked we presented a graph that showed expected five-year average returns and the maximum drawdowns corresponding with varying levels of Cyclically-Adjusted Price-to-Earnings (CAPE) ratios since 1958. We alter the aforementioned graph, as shown below, to incorporate the odds of a 20% drawdown occurring within the next five years.

Over the next five years we should expect the following:

  1. Annualized returns of -.34% (green line)
  2. A drawdown of 27.10% from current levels (red line)
  3. 76% odds of a 20% or greater correction (yellow bars)

In a recent article, 13D Research raised an excellent point quoting Steve Bregman of Horizon Kinetics:

There is no factor in the algorithm for valuation. No analyst at the ETF organizer—or at the Pension Fund that might be investing—is concerned about it; it’s not in the job description. There is, really, no price discovery. And if there’s no price discovery, is there really a market?”

If, as Bregman states, the market is awash with investors, traders and algorithmic robots that do not care about fundamentals or value, is there any reason to think the market cannot continue to ignore fundamentals and run higher? While such a condition can easily endure and propel prices to even loftier valuations, the precedent of prior bubbles dictates this does not end well. At some point, the reality of economic fundamentals which underlie prices reassert themselves. Accordingly, in the following section, we present a few hedging strategies that allow one to profit if the market keeps charging ahead and at the same time limit losses and/or profit if financial gravity reasserts itself.

Options

There are an infinite number of options strategies that one can deploy to serve all kinds of purposes. Even when narrowing down the list to purely hedging strategies one is left with an enormous number of possibilities. In this section, we discuss three strategies that involve hedging exposure to the S&P 500. The purpose is to give you a sense of the financial cost, opportunity cost, and loss mitigation benefits that can be attained via options.

Option details in the examples below are based on pricing as of July 24, 2017.

Elementary Put Hedge

This first option strategy is the simplest option hedge one can employ. A put provides its holder a right to sell a security at a given price. For instance, if you own the S&P 500 ETF (SPY) at a price of 100 and want to limit your downside to -10% you can buy a put with a strike price of 90. If SPY drops below 90, the value of the put will rise in line, dollar-for-dollar with the loss on SPY, thus nullifying net losses beyond 10%. Devising a similar strategy to manage a basket of stocks, ETF’s or mutual funds is more complicated but similar.

To help visualize what a return spectrum might look like on a portfolio hedged in this manner consider a simple scenario in which one owns the S&P 500 (SPY) and hedges with SPY options.  The following assumptions are used:

  • Own 400 shares of SPY at a price of $246.80 per share at the cost of $98,720.
  • The holding period is 1
  • Purchase SPY put options with a strike price of $230, expiration of 9/21/2018 and a cost of $9.15 per share and total cost of $915 per option. (Each option is equal to 100 shares)

The graph below provides the return profile of the long SPY position (black) and three hedged portfolios for a given range of SPY prices. The example provides three different hedging options to show what under-hedged (2 options), perfectly-hedged (4 options) and over-hedged (8 options) outcomes might look like.

Note the breakeven point (yellow circle) on the hedged portfolios occurs if SPY were to decline 10% to $221 per share. The cost of the options in percentage terms is shown on the right side of the breakeven point. It is the difference in returns between the black line and the dotted lines. Conversely, the benefit of the options strategies appears in the percentage return differentials to the left of the breakeven point. (Additional cost/benefit analysis of these strategies is shown further in the article) In this example, we assume the options are held to the expiration date. Changes in other factors such as time to expiration, rising or falling volatility, and intrinsic value will produce results that do not correspond perfectly with the results above at any point in time other than at the expiration date.

Collar

The elementary option strategy was straightforward as it only involved buying a one-year put option. Like the first strategy, a collar entails holding a security and buying a put to hedge the downside risk. However, to reduce the cost of the put option a collar trade requires one to also sell (write) a call option. A call option entitles the buyer/owner to purchase the security at the agreed upon strike price and the seller/writer of the option to sell it to them at the agreed upon strike price. Because the investor is selling/writing an option, he is receiving payment for selling the option. Incorporating the call option sale in a collar strategy reduces the net cost of the hedge but at the expense of upside returns.

To help visualize what the return spectrum might look like with a collared portfolio that owns the S&P 500 (SPY) and hedges with SPY options, consider the following assumptions:

  • Own 400 shares of SPY at a price of $246.80 per share at the cost of $98,720.
  • The holding period is 1
  • Purchase SPY put options with a strike price of $230, expiration of 9/21/2018 at the cost of $9.15 per share and total cost of $3,660. (Each option is equal to 100 shares)
  • Sell/write SPY call options with a strike price of $270, expiration of 9/21/2018 at the cost of $3.75 per share and total benefit of $1,550.

As diagramed below, a collar strategy literally puts a collar or limit around gains and losses.

Writing the call option reduces the net hedging cost by $1,550, limits losses to 9% but caps the ability to profit if the market increases at 7.21%.

Bloomberg created an index that replicates a collar strategy. Bloomberg’s collar index (CLL) assumes that an investor holds the stocks in the S&P 500 index and concurrently buys 3-month S&P 500 put options to protect against market declines and sells 1-month S&P 500 call options to help finance the cost of the puts. As options expire new options are purchased. The percentage returns of the S&P 500 and CLL indexes from 2007 and 2008 are graphed below.

Data Courtesy: Bloomberg

Note that the CLL and SPY returns were well correlated until the latter part of 2008. At this point, when volatility spiked and the markets headed sharply lower, the benefits of the collar were visible.

**Bloomberg assumes a different collar structure than we modeled and described above.

Sptiznagel’s Tail Strategy

Mark Spitznagel is a highly successful hedge fund manager and the author of a book we highly recommend called “The Dao of Capital.” Spitznagel uses Austrian school economic principles and extensive historical data to describe his unique perspectives on investing. In pages 244-248 of the book, he presents an options strategy that served him well in periods like today when valuations foreshadowed significant changes in market risk. The goal of the strategy is not to hedge against small or even moderate losses, as in the first two examples, but to protect and profit from severe tail risk that can destroy wealth like the recent experiences of 2000 and 2008.

Sptiznagel’s strategy hedges a market long position with put options expiring in two months. On a monthly basis, he sells the put options and buys new options expiring in two months. The strike price on his options are 30% below current prices. To replicate his strategy and compare it to the ones above we assume the following:

  • Own 400 shares of SPY at a price of $246.80 per share at the cost of $98,720.
  • The holding period is 1
  • Purchase 82 SPY put options (equivalent to .50% of the portfolio value) with a strike price of $175 (30% out of the money), expiration of 9/15/2017 (2 months) at a cost of $.06 per share and total cost of $492. (Each option is equal to 100 shares)
  • For purposes of this example, new options are purchased when the current options mature every two months (Spitznagel sells and buys new options on a monthly basis).
  • We also assume this hedge was already in place for a year resulting in an accrued trade cost of $2,952 (6 *$492) to date.

The graph below highlights the cost benefit analysis.

The strategy graphed above looks appealing given the dazzling reward potential, but we stress that the breakeven point on the trade is approximately 30% lower than current prices. While the cost difference to the right of the breakeven point looks relatively small, the axis’s on the graph have a wide range of prices and returns which visually minimizes the approximate 6% annual cost. Similar strategies can be developed whereby one gives up some gains in a severe drawdown in exchange for a lower cost profile.

Cost/Benefit Table

The tables below compare the strategies detailed above to give a sense of returns and a cost/benefit analysis across a wide range of SPY returns.

The option strategies in this article are designed for the initial stages of a decline. Pricing of options can rise rapidly as volatility, a key component of options prices, increases. The data shown above could be vastly different in a distressed market environment. These options strategies and many others can be customized to meet investor’s needs.

Summary

We insure our cars, houses, health and our lives. Why is the idea of hedging ones wealth rarely considered especially considering the cost of that protection actually falls as the market becomes more vulnerable? Given current market valuations along with a 76% chance of a 20%+ drawdown, we urge clients to consider implementing a defensive strategy of insuring your portfolio.  Although option strategies compress returns, they serve to “defend the perimeter” in the event of a severe market correction. These strategies and many others like them yield peace of mind and the ability to respond clinically in the event of turmoil as opposed to reacting emotionally.

The rather simple examples in this article were created to give you a sample of the costs and benefits of hedging. When devising a hedging strategy, it often helps to draw a picture of an ideal but realistic return spectrum. From that point, a spreadsheet model can be used to try to create the desired return profile using available options.

In addition to options strategies, there are other means of hedging a long portfolio such as structured notes, volatility funds, and short funds. Portfolio construction is also an important natural means of mitigating exposure to losses. While the topic for future Unseen articles, they are ideas worth exploring and comparing to options strategies.  Hedging and options analysis is a complex field limited only by imagination and market liquidity. If you have questions, feel free to reach out to us to explore these or other ideas that may be better suited for you.

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