I’d say this is getting boring, but it’s pretty fascinating watching the rally run.  Now, this is the seventh time I have done this quarterly analysis.  The first one was for December 2015.  Over that time period, the expected annualized 10-year return went like this, quarter by quarter: 6.10%, 6.74%, 6.30%, 6.01%, 5.02%, 4.79%, and 4.30%.  At the end of June 2017, the figure would have been 4.58%, but the rally since the end of the quarter shaves future returns down to 4.30%.

We are now in the 93rd percentile of valuations.

Wow.

This era will ultimately be remembered as a hot time in the markets, much like 1965-9, 1972, and 1997-2001.

The Internal Logic of this Model

I promised on of my readers that I would provide the equation for this model.  Here it is:

10-year annualized total return = 32.77% – (70.11% * Percentage of total assets held in stocks for the US as a whole)

Now, the logic of this formula stems from the idea that the return on total assets varies linearly with the height of the stock market, and the return on debt (everything else aside from stocks) does not.  After that, the formula is derived from the same formula that we use for the weighted average cost of capital [WACC].  Under those conditions, the total returns of the stock market can be approximated by a linear function of the weight the stocks have in the WACC formula.

Anyway, that’s one way to think of the logic behind this.

The Future?

Now, what are some of the possibilities for the future?

Above you see the nineteen scenarios for where the S&P 500 will be in 10 years, assuming a 2% dividend yield, and looking at the total returns that happen when the model forecasts returns between 3.30% and 5.30%.  The total returns vary from 2.31%/year to 6.50%, and average out to 3.97% total returns.  The bold line above is the 4.30% estimate.

As I have said before, this bodes ill for all collective security schemes that rely on the returns of risky assets to power the payments.  There is no conventional way to achieve returns higher than 5%/year for the next ten years, unless you go for value and foreign markets (maybe both!).

Then again, the simple solution is just to lighten up and let cash build.  Now if we all did that, we couldn’t.  Who would be buying?  But if enough of us did it such that equity valuations declined, there could be a more orderly market retreat.

The attitude of the market on a qualitative basis doesn’t seem nuts to me yet, so I am at maximum cash for ordinary conditions, but I haven’t hedged.  When expected 10-year market returns get to 3%/year, I will likely do that, but for now I hold my stocks.

PS — the first article of this series has been translated into Chinese.  The same website has 48 of my best articles in Chinese, which I find pretty amazing.  Hope you smile at the cartoon version of me. 😉

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Just a note before I begin. My piece called “Where Money Goes to Die” was an abnormal piece for me, and it received abnormal attention.  The responses came in many languages aside from English, including Spanish, Turkish and Russian.  It was interesting to note the level of distortion of my positions among those writing articles.  That was less true of writing responses here.

My main point is this: if something either has no value or can’t be valued, it can’t be an investment.  Speculations that have strong upward price momentum, like penny stocks during a promotion, are dangerous to speculate in.  Howard Marks, Jamie Dimon and Ray Dalio seem to agree with that.  That’s all.

Now for Q&A:

Greetings and salutations.  🙂

Hope all is well with you and the family!

Just have what I believe is a quick question. I already know [my husband’s] answer to this (Vanguard index funds – it his default answer to all things investment), but this is for my Mom, so it is important that she get it right (no wiggle room for losing money in an unstable market), hence my asking you. My Mom inherited money and doesn’t know what to do with it. a quarter of it was already in index funds/mutual funds and she kept it there. The rest came from the sale of real estate in the form of a check. That is the part that she doesn’t know what she should do with. She wanted to stick it in a CD until she saw how low the interest rates are. She works intermittently (handyman kind of work – it is demand-dependent), but doesn’t have any money saved in a retirement account or anything like that, so she needs this money get her though the rest of her life (she is almost 60). What would you recommend? What would you tell [name of my wife] to do if she were in this position? BTW, it is approx $ZZZ, if that makes a difference. Any advice you can give would be very much appreciated!

Vanguard funds are almost always a good choice.  The question here is which Vanguard funds?  To answer that, we have to think about asset allocation.  My thoughts on asset allocation is that it is a marriage of two concepts:

  • When will you need to spend the money? and
  • Where is there the opportunity for good returns?

Your mom is the same age as my wife.  A major difference between the two of them is that your mom doesn’t have a lot of investable assets, and my wife does.  We have to be more careful with your mom.  If your mom is only going to draw on these assets in retirement, say at age 67, and will draw them down over the rest of her life, say until age 87, then the horizon she is investing over is long, and should have stocks and longer-term bonds for investments.

But there is a problem here.  Drawing on an earlier article of mine, investors today face a big problem:

The biggest problem for investors is low future returns.  Bonds have low rates of returns, and equities have high valuations.  You’ll see more about equity valuations in my next post.

This is a real problem for those wanting to fund retirements.  Stocks are priced to return around 4%/year over the next ten years, and investment-grade longer bonds are around 3%.  There are some pockets of better opportunity and so I suggest the following:

  • Invest more in foreign and emerging market stocks.  The rest of the world is cheaper than the US.  Particularly in an era where the US is trying to decouple from the rest of the world, foreign stocks may provide better returns than US stocks for a while.
  • Invest your US stocks in a traditional “value” style.  Admittedly, this is not popular now, as value has underperformed for a record eight years versus growth investing.  The value/growth cycle will turn, as it did back in 2000, and it will give your mom better returns over the next ten years.
  • Split your bond allocation into two components: long US high-quality bonds (Treasuries and Investment Grade corporates), and very short bonds or a money market fund.  The long bonds are there as a deflation hedge, and the short bonds are there for liquidity.  If the market falls precipitously, the liquidity is there for future investments.

I would split the investments 25%, 35%, 20%, 20% in the order that I listed them, or something near that.  Try to sell your mom on the idea of setting the asset allocation, and not sweating the short-term results.  Revisit the strategy every three years or so, and rebalance annually.  If assets are needed prematurely, liquidate the assets that have done relatively well, and are above their target weights.

I know you love your mom, but the amount of assets isn’t that big.  It will be a help to her, but it ultimately will be a supplement to Social Security for her.  Her children, including you and your dear husband may ultimately prove to be a greater help for her than the assets, especially if the markets don’t do well.  The asset allocation I gave you is a balance of offense and defense in an otherwise poor environment.  The above advice also mirrors what I am doing for my own assets, and the assets of my clients, though I am not using Vanguard.

July 2017September 2017Comments
Information received since the Federal Open Market Committee met in June indicates that the labor market has continued to strengthen and that economic activity has been rising moderately so far this year.Information received since the Federal Open Market Committee met in July indicates that the labor market has continued to strengthen and that economic activity has been rising moderately so far this year.No change.  Feels like GDP is slowing, though.
Job gains have been solid, on average, since the beginning of the year, and the unemployment rate has declined.Job gains have remained solid in recent months, and the unemployment rate has stayed low.Shades labor conditions down, as improvement has seemingly stopped.
Household spending and business fixed investment have continued to expand. Household spending has been expanding at a moderate rate, and growth in business fixed investment has picked up in recent quarters. Shades business fixed investment up.  Does that matter as much in an intangible economy?
On a 12-month basis, overall inflation and the measure excluding food and energy prices have declined and are running below 2 percent.On a 12-month basis, overall inflation and the measure excluding food and energy prices have declined this year and are running below 2 percent.Small change of timing.  It’s not much below 2%…
Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations are little changed, on balance.Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations are little changed, on balance.No change
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.The Dual Mandate is the perfect shield to hide behind.  The Fed can be wrong, but it can never be blamed.
The Committee continues to expect that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace, and labor market conditions will strengthen somewhat further. Inflation on a 12-month basis is expected to remain somewhat below 2 percent in the near term but to stabilize around the Committee’s 2 percent objective over the medium term.Hurricanes Harvey, Irma, and Maria have devastated many communities, inflicting severe hardship. Storm-related disruptions and rebuilding will affect economic activity in the near term, but past experience suggests that the storms are unlikely to materially alter the course of the national economy over the medium term. Consequently, the Committee continues to expect that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace, and labor market conditions will strengthen somewhat further. Higher prices for gasoline and some other items in the aftermath of the hurricanes will likely boost inflation temporarily; apart from that effect, inflation on a 12-month basis is expected to remain somewhat below 2 percent in the near term but to stabilize around the Committee’s 2 percent objective over the medium term.Mentions the transitory effects of hurricanes.  Aside from that, they think they are on track.
Near-term risks to the economic outlook appear roughly balanced, but the Committee is monitoring inflation developments closely.Near-term risks to the economic outlook appear roughly balanced, but the Committee is monitoring inflation developments closely.No change.  Note the unbalanced language, though – they are only monitoring inflation closely.
In view of realized and expected labor market conditions and inflation, the Committee decided to maintain the target range for the federal funds rate at 1 to 1-1/4 percent.In view of realized and expected labor market conditions and inflation, the Committee decided to maintain the target range for the federal funds rate at 1 to 1-1/4 percent.No change.
The stance of monetary policy remains accommodative, thereby supporting some further strengthening in labor market conditions and a sustained return to 2 percent inflation.The stance of monetary policy remains accommodative, thereby supporting some further strengthening in labor market conditions and a sustained return to 2 percent inflation.No change, but monetary policy is no longer accommodative.  The short end of the forward curve continues to rise, and the curve flattens.
In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation.In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation.No change
This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.No change.  If you don’t know what will drive decision-making, i.e., it could be anything, just say that.
The Committee will carefully monitor actual and expected inflation developments relative to its symmetric inflation goal.The Committee will carefully monitor actual and expected inflation developments relative to its symmetric inflation goal.No change. Symmetric: we can’t let inflation get too low, because we don’t regulate banks properly.
The Committee expects that economic conditions will evolve in a manner that will warrant gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run.The Committee expects that economic conditions will evolve in a manner that will warrant gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run.No change
However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.No change
For the time being, the Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction.Deleted; QE is over (for now).
The Committee expects to begin implementing its balance sheet normalization program relatively soon, provided that the economy evolves broadly as anticipated; this program is described in the June 2017 Addendum to the Committee’s Policy Normalization Principles and Plans.In October, the Committee will initiate the balance sheet normalization program described in the June 2017 Addendum to the Committee’s Policy Normalization Principles and Plans.Promises the very slow end of QE, as they may start to let securities mature.
Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Charles L. Evans; Stanley Fischer; Patrick Harker; Robert S. Kaplan; Neel Kashkari; and Jerome H. Powell.Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Charles L. Evans; Stanley Fischer; Patrick Harker; Robert S. Kaplan; Neel Kashkari; and Jerome H. Powell.No dissents; it’s relatively easy to agree with doing nothing.

 

Comments

  • Labor conditions can’t get much better. GDP is meandering.
  • The yield curve is flattening, with short rates rising more than long rates.
  • Stocks, bonds and gold fall a little. Though the statement doesn’t say it, many conclude that tightening will continue.
  • I think the Fed is too optimistic about the economy. I also think that they won’t get far into letting securities mature before they resume reinvestment.

I feel like the skunk at the party here. I have no argument with the authors, per se. They came up with their concept and executed it adequately. No one else that I know of has done a book of their notes from Berkshire Hathaway annual meetings, in this case extending over 30 years.

But the bar for writing Buffett books is low, because they sell so well.  Many marginal concepts get written about that aren’t as good as simply reading the writings of Buffett and Munger themselves.  This is true of this volume in two ways. 1) It is notes, not a transcript.  Notes aren’t as good; if I want Buffett, I want him unfiltered, unless the person has a significant interpretation of an aspect of Buffett that is consistent with what Buffett has said, but brings a lot more to the table.  This doesn’t bring much more to the table.

2) Buffett and Munger are at their best when they are prepared.  What I found interesting going through the book was how many things Buffett and Munger got wrong hazarding guesses on the future.  Some were in areas of expertise, most weren’t.  The annual meeting is a lot less valuable than the things that Buffett and Munger have prepared for people to read or hear.

So, I got partway through the book, found it tedious, and scanned the rest to see if it was similar.  It was, so I set the book aside.

Thus, I fault the publisher for this book.  You are much better off reading Buffett and Munger directly, and you can do it for free.

Quibbles

Already stated.  Again, I don’t fault the authors.

Summary / Who Would Benefit from this Book

You are much better off reading Buffett and Munger directly, and you can do it for free.  If you want a feel for the annual Berkshire Hathaway meetings over time, it might be worth purchasing, but I don’t think that is a desirable goal.  If you still want to buy it, you can buy it here: University of Berkshire Hathaway.

Full disclosure: The publisher kind of pushed a free copy on me, after I commented that there are too many marginal Buffett books out there.

If you enter Amazon through my site, and you buy anything, including books, I get a small commission. This is my main source of blog revenue. I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip. Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book. Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website. Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites. Whether you buy at Amazon directly or enter via my site, your prices don’t change.

Full disclosure: long BRK-B

Joel Tillinghast, one of the best mutual fund managers, runs the money in Fidelity’s Low-Priced Stock Fund.  It has one of the best long-term records among stock funds over the 28 years that he has managed it.

The author gives you a recipe for how to pick good stocks, but he doesn’t give you a machine that produces them.  In a style that is clever and discursive, he summarizes his main ideas at the beginning and end of the book, and explains the ideas in the middle of the book.  The ideas are simple, but learning to apply them will take a lifetime.

Here are the five ideas as written in the beginning (page 3):

  1. Make decisions rationally

  2. Invest in what we know (did I mention Peter Lynch wrote the foreword to the book?)

  3. Worth with honest and trustworthy managers

  4. Avoid businesses prone to obsolescence and financial ruin, and 

  5. Value stocks properly

At this point, some will say “You haven’t really given us anything!  These ideas are too big to be useful!”  I was surprised, though, to see that the same five points at the end of the book said more (page 276).  Ready?

  1. Be clear about your motives, and don’t allow emotions to guide your financial decisions

  2. Recognize that some things can’t be understood and that you don’t understand others.  Focus on those that you understand best.

  3. Invest with people who are honest and trustworthy, and are doing something unique and valuable.

  4. Favor businesses that will not be destroyed by changing times, commoditization, or excessive debt.

  5. Above all, always look for investments that are worth a great deal more than you are paying for them.

That says more, and I think the reason they are different is that when you read through the five sections of the book, he unpacks his initial statements and becomes more definite.

Much of the book can be summarized under the idea of “margin of safety.”  This is a type of value investing.  When he analyzes value, it is like a simplified version of reverse discounted cash flows.  He tries to figure out in a broad way what an investment might return in terms price paid for the investment and what “owner earnings,” that is, free cash flow, it will generate on a conservative basis.

One aspect of the conservatism that I found insightful is that he assumes that the terminal value of an investment is zero. (page 150)  In my opinion, that is very smart, because that is the area where most discounted cash flow analyses go wrong.  When the difference between the weighted average growth rate of free cash flow and the discount rate is small, the terminal value gets really big relative to the value of the cash lows prior to the terminal value.  In short, assumptions like that say that the distant future is all that matters.  That’s a tough assumption in a world where companies and industries can become obsolete.

Even though I described aspects of a mathematical calculation here, what I did was very much like the book.  There are no equations; everything is described verbally, even the math.  Note: that is a good exercise to see whether you understand what the math really means.  (If more people on Wall Street did that, we might not have had the financial crisis.  Just sayin’.)

One more fun thing about the book is that he goes trough his own experiences with a wide variety of controversial stocks from the past and his experiences with them.  His conservatism kept him a great number of errors that tripped up other celebrated managers.

I learned a lot from this book, and I enjoyed the writing style as well.  He clearly put a lot of effort into it; many people will benefit from his insights.

Quibbles

His methods are a lot like mine, and he clearly put a lot of thought into this book.  That said, he doesn’t understand insurance companies as well as he thinks (I’m an actuary by training).  There are a number of small errors there, but not enough to ruin a really good book.

Summary / Who Would Benefit from this Book

I highly recommend this book.  This is a book that will benefit investors with moderate to high experience most. For those with less experience, it may help you, but some of the concepts require background knowledge.  If you want to buy it, you can buy it here: Big Money Thinks Small: Biases, Blind Spots, and Smarter Investing.

Full disclosure: The publisher asked me if I wanted a free copy and I assented.

If you enter Amazon through my site, and you buy anything, including books, I get a small commission. This is my main source of blog revenue. I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip. Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book. Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website. Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites. Whether you buy at Amazon directly or enter via my site, your prices don’t change.

==============

It is often a wise thing to look around and see where people are doing that is nuts.  Often it is obvious in advance.  In the past, the two most obvious were the dot-com bubble and the housing bubble.  Today, we have two unrelated pockets of nuttiness, neither of which is as big: cryptocurrencies and shorting volatility.

I have often said that that lure of free money brings out the worst economic behavior in people.  That goes double when people see others who they deem less competent than themselves seemingly making lots of money when they are not.

I’ve written about Bitcoin before.  It has three main weaknesses:

  • No intrinsic value — can’t be used of themselves to produce something else.
  • Cannot be used to settle all debts, public and private
  • Less secure than insured bank deposits

In an economic world where everything is relative in a sense — things only have value because people want them, some might argue that cryptocurrencies have value because some people want them.  That’s fine, sort of.  But how many people, and are there alternative uses that transcend exchange?  Even in exchange, how legally broad is the economic net for required exchangability?  Only legal tender satisfies that.

That there may be some scarcity value for some cryptocurrencies puts them in the same class as some Beanie Babies.  At least the Beanie Babies have the alternative use for kids to play with, even though it ruins the collectibility.  (We actually had a moderately rare one, but didn’t know it and our kids happily played with it.  Isn’t that wonderful?  How much is the happiness of a kid worth?)

I commented in my Bitcoin article that it was like Penny Stocks, and that’s even more true with all of the promoters touting their own little cryptocurrencies.  The promoters get the benefit, and those who speculate early in the boom, and the losers are those fools who get there late.

There’s a decent public policy argument for delisting penny stocks with no real business behind them; things that are worth nothing are the easiest things to spin tales about.  Remember that absurd is like infinity.  If any positive value is absurd, so is the value at two, five, ten, and one hundred times that level.

The same idea applies to cryptocurrencies; a good argument could be made that they all should be made illegal.  (Give China a little credit for starting to limit them.)  It’s almost like we let any promoter set up his own Madoff-like scheme, and sell them to speculators.  Remember, Madoff never raked off that much… but it was a negative-sum game.  Those that exited early did well at the expense of those that bought in later.

Ultimately, most of the cryptocurrencies will go out at zero.  Don’t say I didn’t warn you.

Shorting Volatility

This one is not as bad, at least if you don’t apply leverage.  Many people don’t get volatility, both applied and actual.  It spikes during panics, and reverts to a low level when things are calm.  It seems to mean-revert, but the mean is unknown, and varies considerably across different time periods.

It is like the credit cycle in many ways.  There are two ways to get killed playing credit.  One is to speculate that defaults are going to happen and overdo going short credit during the bull phase.  The other is to be a foolish yield-seeker going into the bear phase.

So it is for people waiting for volatility to spike — they die the death of one thousand cuts.  Then there are those that are short volatility because it pays off when volatility is low.  When the spike happens, many will skinned; most won’t recover what they put in.

It is tough to time the market, whether it is equity, equity volatility, or credit.  Doesn’t matter much if you are a professional or amateur.  That said, it is far better to play with simpler and cleaner investments, and adjust your risk posture between 0-100% equities, rather than cross-hedge with equity volatility products.

Again, this is one where people are very used to selling every spike in volatility.  It has been a winning strategy so far.  Remember that when enough people do that, the system changes, and it means in a real crisis, volatility will go higher than ever before, and stay higher longer.  The markets abhor free riders, and disasters tend to occur in such a way that the most dumb money gets gored.

Again, when the big volatility spike hits, remember, I warned you.  Also, for those playing long on volatility and buying protection on credit default — this has been a long credit cycle, and may go longer.  Do you have enough wherewithal to survive a longer bull phase?

To all, I wish you well in investing.  Just remember that new asset classes that have never been through a “failure cycle” tend to produce the greatest amounts of panic when they finally fail.  And, all asset classes eventually go through failure.