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Problems with Constant Compound Interest (6)

Posted on 15 February 2017 by David Merkel

Doctored Photo Credit: Marvin Isidore Macatol || And I say this is heresy!

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My last post produced the following question:

What if your time horizon was 60 years? Would a 5% real return be achievable?

I am answering this as part of an irregular “think deeper” series on the problems of modeling investment over the very long term… the last entry was roughly six years ago. ?It’s a good series of five articles, and this is number six.

On to the question. ?The model forecasts over a ten-year period, and after that returns return to the long run average — about 9.5%/year nominal. ?The naive answer would then be something like this: the model says over a 60-year period you should earn about 8.85%/year, considering that the first ten years, you should earn around 5.63%/year. ?(Nominally, your initial investment will grow to be 161x+ as large.) ? If you think this, you can earn a 5% real return if inflation over the 60 years averages 3.85%/year or less. ?(Multiplying your capital in real terms by 18x+.)

Simple, right?

Now for the problems with this. ?Let’s start with the limits of math. ?No, I’m not going to teach you precalculus, though I have done that for a number of my kids. ?What I am saying is that math reveals, but it also conceals. ?In this case the math assumes that there is only one variable that affects returns for ten years — the proportion of investor asset held in stocks. ?The result basically says that over a ten-year period, mean reversion will happen. ?The proportion of investor asset held in stocks will return to an average level, and returns similar to the historical average will come?thereafter.

Implicitly, this assumes that the return series underlying the regression is the perfectly normal return series, and the future will be just like it, only more so. ?Let me tell you about some special things involved in the history of the last 71 years:

We have not lost a war on our home soil.
We have not had socialism to the destructive levels experienced by China under Mao, the USSR. North Korea, Cuba, etc. ?(Ordinary socialism isn’t so damaging, though there are ethical reasons for not going that way. ?People deserve freedom, not guarantees. ?Note that stock returns in moderate socialist countries have been roughly as high as those in the US. ?See the book Triumph of the Optimists.)
We have continued to have enough children, and they have become moderately productive workers. ?Also, we have welcomed a lot of hard working and creative people to the US.
Technology has continued to improve, and along with it, labor productivity.
Adequate energy to multiply force and distribute knowledge is inexpensively available.
We have not experienced hyperinflation.

There are probably a few things that I have missed. ?This is what I mean when I say the math conceals. ?Every mathematical calculation abstracts quantity away from every other attribute, and considers it to be the only one worth analyzing. ?Qualitative analysis is tougher and more necessary than quantitative analysis — we need it to give meaning to mathematical analyses. ?(What are the limits? ?What is it good for? ?How can I use it? ?How can I use it ethically?)

If you’ve read me long enough, you know that I view economies and financial markets as ecosystems. ?Ecosystems are stable within limits. ?Ecosystems also can only develop so quickly; there may be no limits to growth, but there are limits to the speed of growth in mature economies and financial systems.

Thus the question: will these excellent conditions continue? ?My belief is that mankind never truly changes, and that history teaches us that all governments and most cultures eventually die. ?When they do, most or all economic arrangements tend to break, especially complex ones like financial markets.

But here are three more limits, and they are more local:

Can you really hold for 60 years, reinvesting and never taking a material amount?out?
Will the number investing in the equity markets remain small?
Will stock be offered and retired at ordinary prices?

Most people can’t lock money away for that long without touching it to some degree. ?Some of the assets?may get liquidated because of panic, personal emergency needs, etc. ?Besides, why be a miser? ?Warren Buffett, one of the greatest compounders of all time, might have ended up happier if he had spent less time compounding, and more time on his family. ?It would have been better to take a small?part of it, and use it to make others happy then, and not wait to be the one of the most famous philanthropists of the 21st century before touching it.

Second, returns may be smaller in the future because more pursue them. ?One reason?the rewards for being a capitalist are large on average is that?there are relatively few of them. ?Also, I have sometimes wondered if stock returns will fall when the whole world is employed, and there is no more cheap labor to be had. ?Should that bold scenario ever come to pass, labor would have more bargaining power in aggregate, and profits would likely fall.

Finally, you have to recognize that the equity return statistics are somewhat overstated. ?I’m not sure how much, but I think it is enough to reduce returns by 1%+. ?Equity tends to be offered for initial purchase expensively, and tends to get retired inexpensively. ?Businessmen are rational and tend to go public when stock valuations are high, pay employees in stock when valuations are high, and do stock deals when valuations are high. ?They tend to go private when stock valuations are low, pay employees cash in ordinary times, and do cash?deals when valuations are low.

As a result, though someone that buys and holds the stock index does best, less money is in the index when stocks are low, and a lot more when stocks are high.

Inflation Over 60 Years?

I mentioned the risk of hyperinflation above, but who can tell what inflation will do over 60 years? ?If the market survives, I feel confident that stocks would outperform inflation — but how much is the open question. ?We haven’t paid the price for loose monetary policy yet. ?A 1% rise in inflation tends to cut stock returns by 2% for a year in real terms, but then businesses adjust and pass through higher prices. ?Vice-versa when inflation falls.

Right now the 30-year forecast for inflation is around 2.1%/year, but that has bounced around considerably even within a calm environment. ?My estimate of inflation over a 60-year period would be the weakest element of this analysis; you can’t tell what the politicians and central bankers will do, and they aren’t sure themselves.

Summary

Yes, you could earn 5% real returns on your money over a 60-year period… potentially. ?It would take hard work, discipline, cleverness, frugality, and a cast iron stomach for risk. ?You would need to be one of the few doing it. ?It would also require the continued prosperity of the US and global economies. ?We don’t prosper in a vacuum.

Thus in closing I will tell you that yes, you could do it, but there is a large probability of failure. ?Don’t count on buying that grand villa on the Adriatic Sea in your eighties, should you have the strength to enjoy it.

Problems with Constant Compound Interest (5)

Posted on 23 February 2011 by David Merkel

This is a continuation of an irregular series which you can find here.? Maybe if I were more scientific, I would have called it “All Exponential Growth Processes Run Into Constraints and Threats,” or if I were more poetic, “Nothing Lasts Forever — Nothing Grows to the Sky.”

Regardless, simple modeling is the bane of long-duration financial calculations.? I remember talking with some friends who served on a charitable board with me, about some investment grade long bonds (11-30 years) that I had purchased for a life insurance client that yielded 7-9% in late 1999.? They said to me that it was foolish to lock up money for so long in bonds, when you could earn so much more in stocks.? My three comments to them were:

Prohibitive for life insurers to hold equities
At current levels of the market, the yield of these bonds more than compensates for the possibility of capital growth in equities (valuations are stretched)
The risk in the bonds is a lot lower.

And, I said we ought to shift shift our charity’s asset allocation to more bonds, as we were invested past the maximum of our guidelines in equities.? They looked in the rearview mirror and said that we were doing fabulous.? Why change success?

I was outvoted; I was a one-man minority.? There are a lot of people who would have loved to make that change in hindsight, but done is done.? I ended up leaving the board a year later over a related issue.

Now, don’t think that I am advising the same in 2011.? We may be headed for significant inflation or deflation; it is difficult to tell which.? Bonds offer little competition to equities here.? Commodities and cash may be better, but I am reluctant to be too dogmatic.? If the economy turns down again, long Treasuries would be best.

Here’s the difficulty: most people have been trained to think at least one of a few things that are wrong:

That we can use simple models to forecast future outcomes.
That average people are capable of avoiding fear and greed when it comes to investing.
That financial markets are random in the sense that last period’s return has no effect on the returns of future periods.
Over long periods of time, average investors can beat long Treasuries by more than 2%/year.? (Corollary to the idea that the equity premium is 4-6% versus 0-2%/year over high quality bonds.)
That financial markets are expressions of what is going on in the real economy.
That the real economy tends toward stability
That government actions make the real economy more stable

I’m prompted to write this because of two articles that I ran across in the last day: Retiring Boomers Find 401(k) Plans Fall Short, and Stay Out of the ROOM (registration required).

I’ve written about this before in many places, including Ancient and Modern: The Retirement Tripod.? And yet, when I wrote about these issues 20 years ago, one of the things that I tried to point out was that as the demographic bulge retired, it would be difficult for homes and asset markets to throw off the returns necessary, because there would not be enough buyers for the assets/homes.? If a large portion of the population wants to convert assets into a stream of income — guess what?? They are forced sellers, and yields that they will get will be compressed as a result.

In a situation like that, those that are better off, and can delay turning all of their assets into an earnings stream should be disproportionately better off.? As with corporations, so with individuals/families: those with slack assets and flexibility are able to deal with volatility better than those for whom the environment must be stable/favorable for the plan to succeed.

Now, the Wall Street Journal article points at the problems of 401(k) plans.? What they say is true, but the same is true of other types of defined contribution and defined benefit plans.? When assets underperform, and/or investors make bad choices, guess what?? The pain has to be compensated for somehow:

401(k): They will work longer, maybe all of the rest of their lives, and cut back on expenses and dreams.
Non-contributory DC: maybe the employer will ask them to kick in voluntarily, or he might give more.? Also same as 401(k)…
Private sector DB plans: employers may contribute more, or they may terminate them.
Public sector DB plans: Taxes may rise, spending cuts enacted, forced contributions to retiree plans negotiated, plans terminated for a 457 plan, partial plan termination, job cuts, funny accounting practices (worse than the private sphere), brinksmanship over debts, etc.

Note that one of the answers is not “take more risk.”? First, risk and return are virtually uncorrelated in practice.? Only when enough people realize that might risk and return become positively correlated.? Second, there are times to increase and decrease risk exposure.? Typical people won’t want to do that, because of euphoria (the example of my friends above) and panic.? The time to add to high risk assets is when no one wants to touch a high yield bond.? More broadly, always look for asset classes that throw off the best cash flow yields, conservatively estimated, over the next ten-plus years.? Be sure and factor in the likelihood for economic regime changes and capital loss, inflation, deflation, etc.

Good asset allocation marries the time horizon of an investor to the forecasts for future returns, conservatively stated, and considers what could go wrong.? At present, investment opportunities are average-ish.? I would be wary of stretching for yield here, or raising my risk exposure in equities.? Stick with high quality.

And, for those that are retired, I would be wary of taking too much into income.? I have a simple formula for how much one could take from an endowment at maximum:

10 Year Treasury Yield
Plus a credit spread — 2% if spreads are sky-high, 1% if they are good, 0.5% if they are tight.
less losses and fees of 0.5% — higher if investment expenses are over 0.25%.

Not very scientific, but I think it is realistic.? At a 3.5% 10-yr T-note yield, that puts me at a 4% maximum withdrawal rate, given a 1% credit spread.? This attempts to marry withdrawals to alternative uses for capital in the market.? You may withdraw more when opportunities are high, and less when they are low.? (But who can be flexible enough to have a maximum spending policy that varies over time?)

Now some of the advanced models that calculate odds of retiring successfully are a step in the right direction, but they also need to reflect demographics, time-correlation of returns, regime-shifting returns/economics, etc.? Things don’t move randomly in markets; that doesn’t mean I know which way things are going, but it does mean I should be cautious unless the market is offering me a fat pitch to hit.

These statements apply to governments as well, and their financial security programs.? In aggregate, investments can’t outgrow growth in GDP by much, unless labor takes a progressively lower share of national income.? (And who knows, but that the pressure on union DB plans to earn high returns might lead to takeovers/layoffs in private firms…)? The real economy and the financial economy are one over the long haul, but can drift apart considerably in the intermediate-term.

In summary, any long promise/analysis/plan made must reflect the realities that I mention here.? We’ve spent years on the illusions generated by assuming high returns off of financial assets.? Now with the first Baby Boomers trying to retire, the reality has arrived — sorry, not everyone in a large birth cohort can retire comfortably.? Wish it could be otherwise, but the economy as a whole can’t generate enough to make that proposition work.

I don’t intend that this series have more parts, but if one strikes me, I will write again.

Problems with Constant Compound Interest (4) (and more)

Posted on 24 November 2009 by David Merkel

At the meeting of the eight bloggers and the US Treasury, one of the differences was whether the recovery was real or not.? The Treasury officials pointed to the financial markets, and the bloggers pointed at the real economy (unemployment and capacity utilization).

With T-bills near/below zero, I feel it is reasonable to trot out an old piece of mine about the last recession.? But I will quote most of it here:

I posted this on RealMoney on 5/6/2005, when everyone was screaming for the FOMC to stop raising rates because the ?auto companies were?dying.?

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On Oct. 2, 2002, one week before the market was going to turn, the gloom was so thick you could cut it with a knife. What would blow up next?

A lot of heavily indebted companies are feeling weak, and the prices for their debt reflected it. I thought we were getting near a turning point; at least, I hoped so. But I knew what I was doing for lunch; I was going to the Baltimore Security Analysts? Society meeting to listen to the head of the Richmond Fed, Al Broaddus, speak.

It was a very optimistic presentation, one that gave the picture that the Fed was in control, and don?t worry, we?ll pull the economy out of the ditch. When the Q&A time came up, I got to ask the second-to-last question. (For those with a Bloomberg terminal, you can hear Broaddus?s full response, but not my question, because I was in the back of the room.) My question (going from memory) went something like this:

I recognize that current Fed policy is stimulating the economy, but it seems to have impact in only the healthy areas of the economy, where credit spreads are tight, and stimulus really isn?t needed. It seems the Fed policy has almost no impact in areas where credit spreads are wide, and these are the places that need the stimulus. Is it possible for the Fed to provide stimulus to the areas of the economy that need it, and not to those that don?t?

It was a dumb question, one that I knew the answer to, but I was trying to make a point. All the liquidity in the world doesn?t matter if the areas that you want to stimulate have impaired balance sheets. He gave a good response, the only surviving portion of it I pulled off of Bloomberg: ?There are very definite limits to what the Federal Reserve can do to affect the detailed spectrum of interest rates,? Broaddus said. People shouldn?t ?expect too much from monetary policy? to steer the economy, he said.

When I got back to the office, I had a surprise. Treasury bonds had rallied fairly strongly, though corporates were weak as ever and stocks had fallen further. Then I checked the bond news to see what was up. Bloomberg had flashed a one-line alert that read something like, ?Broaddus says don?t expect too much from monetary policy.? Taken out of context, Broaddus?s answer to my question had led to a small flight-to-safety move. Wonderful, not. Around the office, the team joked, ?Next time you talk to a Fed Governor, let us know, so we can make some money off it??

PS ? ?Before Broaddus answered, he said something to the effect of: ?I?m glad the media is not here, because they always misunderstand the ability of the Fed to change things.? ?A surprise to the Bloomberg, Baltimore Sun, and at least one other journalist who were there.

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And now to the present application:

Why are commodities rising amid surplus conditions in storage?? Why is it reasonable to take over corporations when it is not reasonable to expand organically?? We are in a position where yields on short? Treasuries are nonexistent, investment grade and junk yields are low for corporates, and equities are rallying, but there is little growth, or some shrinkage in productive capacity.? Why?

The liquidity offered by the Fed is being used by speculators for financial positions, levering up relatively safe positions, rather than speculating on areas that are underwater, like housing and commercial real estate.? This is consistent with prior experience.? When the Fed does not allow a significant recession to occur, one proportionate to the amount of bad loans made, but comes to the rescue to reflate, what gets reflated is the healthy parts of the economy that absorb additional leverage, not the part that is impaired because they can’t benefit from low rates.? They have too much debt already relative to the true value of their assets.

That is why a booming stock market does not portend a good economy.? Banks aren’t lending to fund new growth.? They are lending to collapse capacity through takeovers.? ROE is rising from shrinking the equity base, not by increasing sales and profits.

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There is another current application:

Why do we buy commodities as investments?? Is it that we fear inflation in the short or long run?? Is it that it is a proxy for future prices for consumption in retirement, so we are hedging the future price level in a dirty way?

Think about it.? How do you transfer present resources to the future?? Most consumable goods can’t be stored, or require significant cost for storage.? Services can’t be stored; elderly people can’t store up health care.

Storage occurs through building up productive capacity that will be wanted by other at a later date, such that they will want to trade current goods and services for your productive capacity.? Storage also occurs by purchasing goods that do keep their value, and then trading them for goods and services you need when the time come to consume.

That is how one preserves value over time, and it is not easy.? It will be even harder if there are such disruptions to the economy that markets that are virtual do not survive.? (I.e. paper promises are exchanged, but their is significant failure to deliver at maturity.)

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In an environment where the government is playing such a large role in the economy, it is difficult to see how one can invest for the long term — when we are twisted between deflation and inflation, rational calculations are circumscribed, and simple judgments, such as buying out a competitor and shrinking the overall balance sheet are made.? In one sense, that is the rational thing.? Less capacity is needed.? But unemployment will rise.

That’s sad, but wage rates may be too high for some to be employed, given the lack of demand.? I view this as true in aggregate, but people that are aggressive in seeking employment are able to do much better.? I have seen it.? Even in a bad market, those that strive intelligently get hired.

Problems with Constant Compound Interest (3)

Posted on 16 June 2009 by David Merkel

This post should end the series, at least for now.? Tonight I want to talk about the limits to compounding growth.? Drawing from an old article of mine freely available at TSCM, I quote? the following regarding talking to management teams:

What single constraint on the profitable growth of your enterprise would you eliminate if you could?

Companies tend to grow very rapidly until they run into something that constrains their growth. Common constraints are:

insufficient demand at current prices
insufficient talent for some critical labor resource at current prices
insufficient supply from some critical resource supplier at current prices (the “commodity” in question could be iron ore, unionized labor contracts, etc.)
insufficient fixed capital (e.g., “We would refine more oil if we could, but our refineries are already running at 102% of rated capacity. We would build another refinery if we could, but we’re just not sure we could get the permits. Even if we could get the permits, we wonder if long-term pricing would make it profitable.”)
insufficient financial capital (e.g., “We’re opening new stores as fast as we can, but we don’t feel that it is prudent to borrow more at present, and raising equity would dilute current shareholders.”)

There are more, but you get the idea.

Again, the intelligent analyst has a reasonable idea of the answer before he asks the question. Part of the exercise is testing how businesslike management is, with the opportunity to learn something new in terms of the difficulties that a management team faces in raising profits.

As with biological processes, when there are unlimited resources, and no predators, growth of populations is exponential.? But there are limits to business and investment profits because of competition for customers or suppliers, and good untried ideas are scarce.? Once a company has saturated its markets, it needs a new highly successful product to keep the growth up. Perhaps international expansion will work, or maybe not?? Are there new marketing channels, alternative uses, etc?

Trying to maintain a consistently high return on equity [ROE] over a long period of time is a fools bargain and I’ll use an anecdote from a company I know well, AIG.? I was pricing a new annuity product for AIG, and I noticed the pattern for the ROE of the product was not linear — it fell through the surrender charge period, and then jumped to a high level after the surrender charge period was over.

I scratched my head, and said “How can I make a decision off of that?”? I decided to create a new measure called constant return on equity [CROE], where I adjusted for capital employed, and calculated the internal rate of return of the free cash flows.? I.e., what were we earning on capital, on average over the life of the product.

I took it to my higher-ups, hoping they would be pleased, and one said, “You don’t get it!? You don’t argue with Moses!? The commandment around here is a 15% return on average equity after-tax!? I don’t care about your new measure!? Does it give us a 15% return on average equity or not?!”

This person did not care for nuances, but I tried to explain the ROE pattern, and how this measure averaged it out.? It did not fly.? As many have commented, AIG was not a place that prized actuaries, particularly ones with principles.

As it was AIG found ways to keep its ROE high:

Exotic markets.
Be in every country.
Be in every market in the US.
Play sharp with reinsurers.
Increase leverage
Press the accounting hard, including finite reinsurance and other distortions of accounting.
Treat credit default swap premiums as “found money.”
Take on additional credit risk, like subprime lending inside the life companies through securities lending.

In the end, it was a mess, and destroyed what could have been a really good company.? Now, it won’t pay back the government in full, much less provide anything to its shareholders, common and preferred.

Even a company that is clever about acquisitions, like Assurant, where they do little tuck-in acquisitions and grow them organically, will eventually fall prey to the limits of their own growth.? That won’t happen for a while there, but for any company, it is something to watch.? Consistently high growth requires consistently increasing innovation, and that is really hard to do as the assets grow.

If True of Companies, More True of Governments

This is not only true of companies, but even nations.? After a long boom period, state and federal governments stopped treating growth in asset values as a birthright, granting them a seemingly unlimited stream of taxes from capital gains, property, and transfer taxes.? They took it a step further, borrowing in the present because they knew they would have more taxes later.? The states, most of which had to run a balanced budget, cheated in a different way — they didn’t lay aside enough cash for their pension and retiree healthcare promises.? The Federal government did both — borrowing and underfunding, because tomorrow will always be better than today.

Over a long enough period of time, things will be better in the future, absent plague, famine, rampant socialism, or war on your home soil.? But when a government makes long-dated promises, the future has to be better by a certain amount, and if not, there will be trouble. That’s why an economic downturn is so costly now, the dogs are behind the rabbit already, running backwards while the rabbit moves forwards makes it that much harder to catch up.

I’ve often said that observed economic relationships stop working when people start relying on them, or, start borrowing against them.? The system shifts in order to eliminate the “free lunch” that many thought was available.

A Final Note

Hedge funds and other aggressive investment vehicles should take note.? Just as it is impossible for corporations to compound their high profits for many decades, it is impossible to do the same as an investor.? Size catches up with you.? It’s a lot easier to manage a smaller amount — there are only so many opportunities and inefficiencies, and even fewer when you have to do so in size, like Mr. Buffett has to do.

“No tree grows to the sky.”? Wise words worth taking to heart.? Investment, Corporate, and Economic systems have limits in the intermediate-term.? Wise investors respect those limits, and look for growth in medium-sized and smaller institutions, not the growth heroes of the past, which are behemoths now.

As for governments, be skeptical of the ability of governments to “do it all,” being a savior for every problem.? Their resources are more limited than most would think. Also, look at the retreat in housing prices, because the retreat there is a display of what is happening? to tax revenues… the dearth will last as long.

Full disclosure: long AIZ

Problems with Constant Compound Interest (2)

Posted on 11 June 200911 June 2009 by David Merkel

I had many good comments on part 1 of this series.? One was particularly good that focused on the economy as a whole, and how the promises made by the government were unlikely to be fulfilled with Social Security and Medicare.? Our government attempts to finance programs on the cheap by relying on future growth, which does not always happen.? They move up spending rapidly if growth is large, and small if growth is negative.? In either case, the government grows as a fraction of the economy.

But let me consider asset allocation projections.? It is really difficult to consider average projections of asset returns, whether in real or nominal terms.? Asset returns vary considerably, and the number of years from which average returns are calculated are few relative to the volatility of returns.

We have created an industry of asset allocators, many of which have allocated off of foolish long-term historical assumptions, as if the past were prologue.? Even if they use stochastic models, the central tendency is critical.? What do they assume they can earn over long-dated investment grade debt?? The higher that margin is, the more they lead people astray.? Stocks win in the long run, but maybe by 1-2%, not 4-6%.

Consider defined benefit pension funds — after all, it is the same problem.? What is the right long term rate to assume for asset performance?? Alas there is no good answer, and with private DB plans continuing to terminate because of underfunding, the answer is less than clear.

Scoundrels use the mechanism of discounting to their own ends — they make future obligations seem smaller than they should be, magnifying profits, and minimizing capital needs.? Cash flows are inexorable, though.? There are few ways to avoid the promises from pensions.

Investors, be aware.? Realize that long term investment assumptions are probably liberal.? Also realize that long term assets and liabilities that rely on those assumptions have liberal valuations as well.? After all, who wants to under-report income when the accounting is squishy?

Now, for my readers, what have I missed?

Problems with Constant Compound Interest

Posted on 4 June 20094 June 2009 by David Merkel

This piece is an experiment.? I’m not exactly sure how this will turn out by the time I am done, so if at the end you think I blew it, please break it to me gently.

People in general don’t get compound interest, or exponential processes generally.? It is not as if they are pessimistic, they are not numerate? enough to apply the rule of 72.? (Rule of 72: For interest rates between 3 and 24%, the time it takes to double the money is approximately 72 divided by the interest rate, expressed as a whole number.)

But there is a greater problem, and it applies to the bright as well as the dull.? People don’t understand the limitations of compound interest.

Let me begin with a story: I started my career at Pacific Standard Life, a little life insurer based in Davis, California.? The universal life policieswere crediting 11-12% interest, and annuities were in the 9-10% region.? It was fueled by junk bonds.? One of my first projects was to set the factors that would give us GAAP reserves for the universal life products.? To do this, I was told to project UL account values ahead at 11-12% interest for the life of the policies.

That rate of interest doubles policy account values every six or so years.? What economic environment would it imply to sustain such a rate of interest?

High inflation, or
High opportunities, because there is little competition.

The former was a possibility, the latter not.? As it was, inflation was receding, and 1986 was the nadir for the 80s.

People buying policies would see these tremendous returns illustrated, and would buy, because they saw an easy retirement in sight.? Alas, constant compound growth rarely happens in economics.? Policyholders ended up very disappointed; Pacific Standard went insolvent in 1989, and the rump was sold off to The Hartford.

Where do we often see constant compound growth modeled in finance?

Asset allocation models, including simple illustrations done by financial planners
Life insurance sales and accounting
Defined benefit pension accounting
Long-dated debt obligations
Simple stock price models, like the Gordon Model, and all of its dividend discount model cousins.
Social finance systems, like public pensions and healthcare.

There are likely many more.? Whenever we talk about long-dated financial obligations, whether assets or liabilities, we need something simple to aid us in decision-making, because the more variables that we toss in, the harder it is for us to make reasonable comparisons.? We need to reduce calculations to single variables of yield, present values, or future retirement incomes.? Our frail minds need simple answers to aid us.

I’m not being a pure critic here, because I need simple answers also.? Knowing the yield of a long debt obligation has some value, though if that yield is high, one should ask what the is likelihood of realizing the value of? the debt.? Similarly, it would be useful to know how likely it is that one would receive a certain income in retirement.

I’m going to hit the publish button now, and pick this up in a day or so.? Until then.

Separate Processes

Posted on 18 December 2021 by David Merkel

Photo Credit: atramos || Inflation isn’t the most organized phenomenon, and investors often all want to be on the same side of the boat…

I have a very irregular series called, “Problems with Constant Compound Interest.” Part of the idea of that series is that it is difficult to assure growth in capital in any sort of constant way. The simple models of the CFPs, and even actuaries that assume constant or near constant growth are ultimately doomed to fail if they try to exceed growth in nominal GDP by more than 2%/year.

Because of the oddities in the current market environment, current interest rates and inflation have decoupled. They are separate processes. We all want to build value in real (inflation-adjusted) terms, but how do you do that in an environment where price to free cash flow multiples are sky high, nominal interest rates are low, and the prices of most commodities are high as well (leaving aside gold as an oddity). Mindless stock bulls talk of TINA [There Is No Alternative (to buying stocks)], as if there is no limit to how high stock prices can go when interest rates are low. I want to tell you about TIN. There Is Nothing (worth buying). This is the nature of financial repression.

If you invest in short bonds, you get gouged by current inflation. If you buy long bonds, you run the risk that the Fed might start monetizing Treasury debt directly, and inflation really runs. With stocks you run the risk of any hiccup in the global economy (when is the omega variant coming so that we can move on to Hebrew letters?) can derail the market, particularly if it leads to higher interest rates.

The Fed has gotten its wish and is forcing an asset bubble on the US to aid growth, however fitfully. All of the relationships of the present to the future are out of whack, because interest rates are too low. But if intermediate interest rates rose to the level of nominal GDP growth, we would see deficits grow even more rapidly as the US government would refinance at higher rates. The Fed is stuck in a doom loop of its own design ever since Alan Greenspan got the great idea to cut short recessions too soon. That has led us into a liquidity trap designed by the Fed.

As I said to one of my clients this week (a bright man), “If you are not bewildered, you are not thinking.” About the only idea I can think of for investing at present is the intersection of high quality and low-ish valuations. As it says in Ecclesiastes 11:2 “Give a serving to seven, and also to eight, For you do not know what evil will be on the earth.” Diversify among safe-ish investments, with a few cyclicals that will do well if things run hot, and stable businesses, if things do not.

That’s all.

Limits

Posted on 26 December 2019 by David Merkel

Photo Credit: David Lofink || Most things in life have limits, the challenge is knowing where they are

I was at a conference a month ago, and I found myself disagreeing with a presenter who worked for a second tier ETF provider. The topic was something like “Ten trends in asset management for the next ten years.” The thought that ran through my mind was “Every existing trendy idea will continue. These ideas never run into resistance or capacity limits. If some is good, more is better. Typical linear thinking.”

Most permanent trends follow a logistic curve. Some people call it an S-curve. As a trend progresses, there are more people who see the trend, but fewer new people to hop onto the trend. It looks like exponential growth initially, but stops because as Alexander the Great said, “There are no more worlds left to conquer.”

Even then, not every trend goes as far as promoters would think, and sometimes trends reverse. Not everyone cares for a given investment idea, product or service. Some give it up after they have tried it.

These are reasons why I wrote the Problems with Constant Compound Interest series. No tree grows to the sky. Time and chance happen to all men. Thousand year floods happen every 50 years or so, and in clumps. We know a lot less than we think we do when it comes to quantitative finance. Without a doubt, the math is correct — trouble is, it applies to a world a lot more boring than this one.

I have said that the ES portion of ESG is a fad. Yet, it has seemingly been well-accepted, and has supposedly provided excess returns. Some of the historical returns may just be backtest bias. But the realized returns could stem from the voting machine aspect of the market. Those getting there first following ESG analyses pushed up prices. The weighing machine comes later, and if the cash flow yields are insufficient, the excess returns will vaporize.

In this environment, I see three very potent limits that affect the markets. The first one is negative interest rates. There is no good evidence that negative interest rates stimulate economic growth. Ask those in nations with negative interest rates how much it has helped their stock markets. Negative interest rates help the most creditworthy (who don’t borrow much), and governments (which are known for reducing the marginal productivity of capital).

It is more likely that negative rates lead people to save more because they won’t earn anything on their money — ergo, saving acts in an ancient mold — it’s just storage, as I said on my piece On Negative Interest Rates.

Negative interest rates are a good example of what happens you ignore limits — it doesn’t lead to prosperity. It inhibits capital formation.

Another limit is that stock prices have a harder time climbing as they draw closer to the boundary where they discount zero returns for the next ten years. That level for the S&P 500 is around 3840 at present. To match the all time low for future returns, that level would be 4250 at present.

Here’s another few limits to consider. We have a record amount of debt rated BBB. We also have a record amount of debt rated below BBB. Nonfinancial corporations have been the biggest borrowers as far as private entities go since the financial crisis. In 2008, nonfinancial corporations were one of the few areas of strength that the bond markets had.

One rule of thumb that bond managers use if they are unconstrained is that the area of the bond market that will have the worst returns is the one that has grown the most during the most recent bull part of the cycle. To the extent that it is possible, I think it is wise to upgrade corporate creditworthiness now… and that applies to bonds AND stocks.

Of course, the other place where the debt has grown is governments. The financial crisis led them to substitute public for private debt in an effort to stimulate their economies. The question that I wonder about, and still do not have a good answer for is what will happen in a fiat money world to overleveraged governments.

Everything depends on the policies that they pursue. Will the deflate — favoring the rich, or inflate, favoring the poor? No one knows for sure, though the odds should favor the rich over the poor. There is the unfounded bias that the Fed botched it in the Great Depression, but that is the bias of the poor versus the rich. The rich want to see the debt claims honored, and don’t care what happens to anyone else. The Fed did what the rich wanted in the Great Depression. Should you expect anything different now? I don’t.

As such, the limits of government stimulus are becoming evident. The economic recovery since the financial crisis is long and shallow. The rich benefit a lot, and wages hardly rise. Additional debt does not benefit the economy much at all. We should be skeptical of politicians who want to borrow more, which means all of them.

One of the greatest limits that exists is that of defined benefit pension plans vainly trying to outperform the rate that their risky assets are expected to earn. They are way above the level expected for the next ten years, which is less than 3%. Watch the crisis unfold over the next 15 years.

Finally, consider the continued speculation that shorts equity volatility. You would think that after the disaster that happened in 2018 that shorting volatility would have been abandoned, but no. The short volatility trade is back, bigger and badder than ever. Watch out for when it blows up.

Summary

Be ready for the market decline when it comes. It may begin with a blowout with equity volatility, but continue with a retreat from risky stocks that offer low prospective returns.

How Much Should I Spend?

Posted on 18 October 2019 by David Merkel

Photo Credit: 401(K) 2012 || As that great moral philosopher George Harrison once sang: “It’s gonna take a lotta money, a whole lot of spending money…”

Here is a comment from a reader on my last post:

Hello David. Fellow actuary here. I usually love your posts. I disagree with this one. Or at least I disagree with the title. ?How much (or how little) should I spend?? may have matched the content better.
I?d love to read your thoughts on ?When have I saved enough so that I may now outspend my income?? Perhaps you have written such a post but I don?t recall it.
Thanks for your great content!
https://alephblog.com/2019/10/16/how-much-should-i-save/#comment-37283

Yeah, I get it. Here are four posts that describe my view on spending money:

Build the Buffer
On a Letter From A Younger Friend
Problems with Constant Compound Interest (6)
Don?t be a Miser in Retirement (Or Ever) [This is the most comprehensive one]

My main idea is encouraging spending that supports the well-being of the household in the long-run. I am trying to encourage a balanced point of view, which is the hardest thing to do. For many people it is easier to convince them to do just one simple thing than try to balance two or more unaligned goals.

That is why the “stoplight rule” is so useful. It is minimal, but balances saving and spending. Imagine telling a friend to enjoy life, but not too much, such that he compromises the future. The stoplight rule is a real help.

People have a hard time expanding their time horizons. It is easiest to live for the present, and hardest to live for retirement. The good of the present is tangible, whereas the good of the future is intangible.

I do not favor excessive savings. It usually leads to a trail of tears in relationships. God wants life to be enjoyed, because it honors the way he provides for us. God is not a miser; we should not be misers either.

As I said in the post Don?t be a Miser in Retirement (Or Ever):

The author of?the?book that I most recently reviewed, Carlos Sera,?gave one of his sayings on page 97 of his book:

?There is a fine line between over-saving and under-living.?
That particular story dealt with a couple that had been especially frugal, and after not earning all that much, at retirement had $6 million. ?They had a traditional marriage, and the husband handled the money entirely. ?He worked until 72, retired due to incapacity, and on the day of his retirement, he handed his wife a check for $3 million.
She thought it was a joke, so for fun she tried to cash the check. ?To her surprise, the check cleared. ?Then came the bigger surprise ? her amazement gave way to anger! ?All the years of self-denial, and they were this well-off! ?There were so many things she denied herself along the way, and now both of them were too old to truly enjoy their riches.
There?s more to the story? the point the author goes for is mostly abut how husbands and wives should learn to cooperate on the shared tasks of household economic management, so that both are on the same page, and they can be agreed on goals and methods.
I agree with that, and would add that the best approach on spending versus saving is what I would call a conservative version of the ?middle way.? ?Make sure that you are provident, but balance that with contentment and a happy enjoyment of what you have. ?Life is meant to be lived.
Yes, it is good to be prudent and frugal, but not to the point where you amass a lot of assets and never enjoy them.
https://alephblog.com/2015/11/03/dont-be-a-miser-in-retirement-or-ever/

I sometimes say in certain charitable contributions “What is the point of money if I can’t enjoy it being spent to a good purpose?”

Yes. There are some tiny-minded people who believe that “the one with the most toys at death wins.” These are people who want to delude themselves that selfishness is what is right, which is ridiculous.

If you are well off, God does not want you to be a miser. First, he wants you to honor Him. After that, he wants you to take care of your charitable obligations to society. After that, he wants you to enjoy what you have.

And that’s what I do, Lord helping me. I am sparing on optional items, but I take care of my home, the church, and other opportunities for charity that are in front of me. After that I relax, because I wait for other needs to be big enough to deal with.

The Best of the Aleph Blog, Part 41

Posted on 22 August 2018 by David Merkel

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In my view, these were my best posts written between February 2017 and April 2017:

Problems with Constant Compound Interest (6)

It is very difficult to get a high real rate of return over a long time.? This article peels apart the math, and brings out the quantitative factors that play a role in the analysis.

Yield = Poison (3)

When the yield premiums for taking most forms of additional risk are too low, it’s time to take much less risk, and reduce yield considerably.

Streaking Into the Record Books?

Remember the streak of days where the market did not go down by 1% or more?? It ended and did not set a record, but it was a top 10 long streak.

We Get New Highs More Frequently After New Highs

Dog bites man, but I have never seen an analysis like this done before.

Everyone Needs Good Advice

On the value of having someone financially smart to whom you can ask questions

Two Questions on Returns

Clarifying the return series that I use for my forecasts of future stock market returns, and is it likely for an investor to earn a 3% real return over a long horizon?

The Permanent Portfolio

I give a significant analysis of Harry Browne’s idea.? Yes, it works.

Four Simple Investment Strategies That Work

Indexing
Buy-and-hold
Permanent Portfolio
Bond Ladders

Operating vs Financial Cash Flows

Do ETFs affect the valuations of individual stocks, or the market as a whole?

The Rules, Part LXIII

(This rule applies to salesmen) ?We pay disclosed compensation. ?We pay undisclosed compensation. ?We don?t pay both?disclosed compensation?and undisclosed compensation.?

Steeling Themselves For Pension Benefit Cuts

On the?Kline-Miller Multiemployer Pension Reform Act of 2014, and its impact on pension benefits in multiemployer plans that are VERY underfunded.

Because of underfunding, there will be more cuts. ?Depend on that happening for the worst funds, and at least run through the risk analysis of what you would do if your pension benefit were cut by 20% for a municipal plan, or to the PBGC limit for a corporate plan. ?Why? ?Because it could happen.

On the Pursuit of Economic Growth

On why cultural values play a large role in economic growth, but governments generally don’t.? (Hint: Stimulus is a dumb idea.)

The Financial Report of the United States Government 2016

This is an underrated report from the US Government, but even it is forced to downplay how the situation is for Social Security and Medicare.? Things aren’t getting better, and time is running short.? The next time I write about this is when the 2018 report comes out.? Until then remember my more recent piece?Notes from an Unwelcome Future, Part 1.