Image Credit: Aleph Blog || Has the return on assets for public equities permanently risen? The return on bonds has risen for now.

From the last piece: “At March 31st, 2023, the S&P 500 was priced to return 2.41%/year over the next ten years. Given the rally since then, that return has shrunk to 0.49%/year. Currently the 10-year Treasury yields 3.76%. In investment grade corporates, you could earn more than 5% with considerably lower risk.”

There was an error in that statement, the return had only shrunk to 1.64%/year. A similar adjustment would have to be made to the second graph, which would look more like the graph below.

At June 30th, 2023, the S&P 500 was priced to return 1.65%/year over the next ten years. Given the rally since then, that return has risen to 2.03%/year. Currently the 10-year Treasury yields 4.29% [bond-equivalent yield, add 0.09% to annualize]. In investment grade corporates, you could earn around 6% with considerably lower risk.

Here’s my current outcomes graph:

Image Credit: Aleph Blog || Upside capped, long left tail…

So, on average no price change for 10 years. You just collect your dividends.

There are several ways to get better outcomes from stocks. First, go abroad, there are much better values available in Europe, Japan, and in the emerging markets that respect the rule of law. Second, decouple from the high-tech growth stocks. I’m able to find a lot of stocks in the US with good balance sheets that are small-to-midcap that are cheap relative to growth prospects. Away from the “cool” sectors of the market there are many large-cap stocks with reasonable prices relative to prospects.

That’s all for now. I may blog more, I may not. Business is taking up more of my time. Watch your risks to keep your returns.

Image Credit: Aleph Blog || Has the return on assets for public equities permanently risen?

At March 31st, 2023, the S&P 500 was priced to return 2.41%/year over the next ten years. Given the rally since then, that return has shrunk to 0.49%/year. Currently the 10-year Treasury yields 3.76%. In investment grade corporates, you could earn more than 5% with considerably lower risk.

But, maybe it’s different this time. Yes, I know the danger of the phrase. What if AI increases total productivity of assets and labor by 1%/year on net, permanently? Will companies make more money as they need fewer smart people to do the same amount of intellectual work? Or, will we reach a new equilibrium as the smart people who are laid off start using AI to create totally new businesses, or create even leaner competitor businesses that eat into the profits of those slow to adapt?

Really, I don’t think AI will permanently increase productivity. The system should adjust and things should remain mostly the same.

Image credit: Aleph Blog

The graph above shows what the outcomes have been when the share of investor funds held in equities has been as high as it is now, 49.0%. (Range: 21.9% — 52.7%, average 35.6%) Returns have typically been poor.

So, maybe buy the 10-year investment grade bonds. Inflation is going down, and the US government can’t finance all its debt if rates rise too much. Bonds are a real alternative now.

One last note: the estimated rate of return over the next ten years more than you would ordinarily expect as the data series underlying this model made significant revisions to past data values.

Anyway, be cautious. Bond yields have risen, equity yields (E/P) have fallen. This rally is more speculative than most think… momentum blinds many people to stretched valuations. Unless, we are genuinely in a new era. Which I doubt.

Picture Credit: Aleph Blog || I know this is late, but still, here it is…

At December 31st, 2022, the S&P 500 was priced to return 3.26%/year over the next ten years. Given the rally since then, that return has shrunk to 3.12%/year. Currently the 10-year Treasury yields 3.38%. In investment grade corporates, you could earn more, but… really, who knows?

They say the stock market climbs a wall of worry. We’ve got enough worries to go around.

• Wars. With the superpowers posturing and fighting proxy wars, trade wars, and real wars, it doesn’t take that much for a bigger conflict to emerge. Oh, and are we replacing the stocks of weapons that we have been giving away?
• Plagues. Okay, we’ve been through that recently. Maybe we don’t get that again for a while.
• Famine: Partially due to the Ukraine war, partially due to weather, there are many places in the world facing food scarcity.
• Social Insurance plans facing a crackup. Notice the protests in France from moving the retirement age from 62 to 64? Things like this will happen in many developed countries. And for those of you who don’t remember an old piece of mine on Social Security, there will be a payment event around 2032.
• Around that same time, maybe 20% of US states will have severe events regarding the defined benefit plans for public sector employees.
• With the yield curve inverted, money is getting sucked out of bank deposits and into T-bills, or something like them.
• The Fed does too much. After years of being a “superhero,” trying to create permanent prosperity, they have created an economy that has too much debt. Congress and the President regularly run huge deficits with the tacit support of the Fed. After creating the problem where many bank assets are below par, they offer a one-year program allowing the banks to value the assets at par. Will it only be one year, or will the accounting chicanery become permanent?

I may be a little cranky at this point, but I remain fascinated at politicians and policymakers in DC who engage in magical thinking. There is a great advantage to have the world’s reserve currency, but it is not unlimited. At some point, the notional credit line will be exceeded. If/when there is a tipping point, it will be ugly.

Let me show you one more graph regarding possible future outcomes for the S&P 500 in early 2023:

The above graph assumes a 2% dividend on the S&P 500, and uses prior market periods +/- 1% in terms of expected returns. There is a long left tail, but not as long as the Great Depression, which of course can never happen again, right?

Valuations are still extended. We are still in the 95th percentile as far as this model is concerned. You might do better with value stocks, foreign, emerging market, and small stocks, but this is still an awkward time to be long the winners of the last bull phase of the market.

One final note: 80% of my total net worth, and 95% of my liquid net worth are invested in the strategies in which my clients are invested. I still maintain a posture of 70% invested in risk assets and 30% in safe assets. To me, it is a happy medium balancing risk and return.

Also, I know I haven’t been writing much, but I plan on writing more. That said, time is short for me.

Picture Credit: Aleph Blog || I know this is late, but still, here it is…

At September 30th, 2022, the S&P 500 was priced to return 4.14%/year over the next ten years. Given the rally since then, that return has shrunk to 3.20%/year. Does that sound attractive? It is lower than the yield on the 10-year T-note, and lower than current inflation (which is falling like a stone, don’t tell the geniuses at the FOMC).

And you could be adventurous, as I was when I was a corporate bond manager (2001-2003) buying long single-A and BBB/Baa bonds. Even at 10 year maturities, you can get well over 5% for sound credits.

The stock market needs to fall around 20% to be at parity with lower-rated investment grade bonds. This is not pleasant news, but given the media drumbeat of:

Stocks always beat bonds! Stocks always beat bonds! Stocks always beat bonds! Stocks always beat bonds! Stocks always beat bonds!

It needs to be said that it is not always true. It wasn’t true in the 2000s decade. It wasn’t true in the Great Depression.

I’m keeping this short this evening. The US corporate bond market is still more attractive than the US stock market. If the S&P 500 drops below 3100, with no changes in interest rates, then the stock market will be a better buy.

So be ready for the stock market to fall further after the Fed stops tightening, when the recession ensues, and buy stocks amid the panic.

PS — when the tech giants are firing people, that is a sign that they are no longer growth stocks.

Graph Credit: Aleph Blog || How do you feel about 3.00%/year nominal returns over the next 10 years? That’s less yield than the 10-year T-note

Stocks always beat bonds. Stocks always beat bonds. Stocks always beat bonds. Stocks always beat bonds.

Quite a mantra. And for those with a long time horizon, this is true. What I am telling you this evening is if you want that to work for you, your time horizon should be greater than ten years. With the ten-year T-note yielding 3.41%, the S&P 500 at 3946 indicates likely nominal returns of 3.00%/year over the next ten years. Though the bond market has had a lousy year, many of the times I wrote about this over the last few years, the S&P 500 had return expectations in line with a 10-year single-A corporate bond. When the market indicates returns lower than a 10-year T-note, it is still quite expensive (95th percentile).

As the end of December 2021 was near the recent highs, so the end of June 2022 was near the recent lows, projecting a nominal 3.32%/year return for the S&P 500 over the next ten years. The weak rally of the last eleven weeks has reduced future returns to 3.00%.

So what to do? For me, not much. I have always kept my asset allocation around 70% risky, 30% safe. I am near that now, and don’t feel the need to panic. I like the stocks that I own for me and my clients. We are up this year. All that said, I haven’t had a good year prior to this since 2013. Versus the broad market, my performance has been poor as value has lagged, and I am more value-y than most value managers.

The histogram above attempts to show scenarios when likely returns per year were within 1% of where they are now. Positive returns are expected with a considerable left tail.

So What Might Happen?

My view here is that the Fed will overshoot in tightening, leading the stock market to new lows in this bear market. Ray Dalio has said something like this. Looking at the ’70s or the Great Financial Crisis are not what I would look at. My best analogy here is the dot-com bubble.

I remember from that era how many people said that Fed policy was irrelevant to growth stocks. When the yield curve inverts, those who finance long assets with short-term debt blow up. During the dot-com bubble, that was mostly tech firms. The banks were mostly not affected. That is true today, as the banks are in good shape.

So expect:

• The yield curve to get more inverted
• Stocks to fall, especially growth stocks
• Real GDP will decline
• Commodities will suffer
• The Fed will panic, and loosen in 2023

That’s all for now. I have been going through a hard period in my life, thus I have not been posting much.

Image credit: All images belong to Aleph Blog

Well, finally the bear market… at 3/31/2002 the S&P 500 was priced to return a trice less than zero in nominal terms. After the pasting the market received today, that figure is 3.57%/year nominal (not adjusted for inflation). You would likely be better off in an ETF of 10-year single-A rated bonds yielding 4.7% — both for safety and return.

I will admit that my recent experiment buying TLT has been a flop. I added to the position today. My view is that the long end of the curve is getting resistant to the belly of the curve, and thus the curve is turning into the “cap” formation, where the middle of the curve is higher than the short and long ends. This is a rare situation. Usually, the long end rallies in situations like this. The only situation more rare than this is the “cup” formation where the middle of the curve is lower than the short and long ends.

I will have to update my my old post of “Goes Down Double-Speed.” We’ve been through three cycles since then — bear, bull, and now bear again. People get surprised by the ferocity of bear markets, but they shouldn’t be. People get shocked at losing money on paper, and thus the selloffs happen more rapidly. Bull markets face skepticism, and so they are slow.

What are the possibilities given where the market is now? When the market is expecting 3.57% nominal, give or take one percent, what tends to happen?

The Fed cares about things in this order:

• Preserve their own necks
• Preserve the banks, and things like them
• Fight inflation
• Fund the US Government
• Promote nominal GDP growth, though they will call it reducing labor unemployment. The Fed really doesn’t care about labor unemployment, or inequality. They are a bourgeois institution that cares about themselves and their patrons — those who are rich.

I know this post is “all over the map.” My apologies. That said, we in a very unusual situation featuring high debt, high current inflation (that won’t last), war, plague, and supply-chain issues. How this exactly works out is a mystery, especially to me — but I am giving you my best guess here, for whatever it is worth. It’s worth than double what you paid for it! 😉

Full disclosure: long TLT for clients and me

Image credit: All images belong to Aleph Blog

This should be a brief post. At the end of 2021, the S&P 500 was poised to nominally return -1.53%/year over the next 10 years. As of the close yesterday, that figure was 0.73%/year.

The only period compares with this valuation-wise is the dot-com bubble. We are near dot-com level valuations, in the 98th percentile. And if you view the 10-year returns from the worst time of the dot-com bubble to now, you can see that the results they obtained are worse than what I forecast here.

Of course, a lot of what will happen in nominal terms will rely on the actions of the Fed. Will the Fed:

• Allow a real recession to clear away dud assets that are on life support from low rates? (Collapsing the current stock/junk bubble.. they would never do this unless their hands were tied.)
• Risk the 1994 scenario where the compressed coupon stack in the Residential Mortgage Backed Securities [RMBS] market begins a self-reinforcing interest rate rise cycle on the long end as mortgage rates rise, prepayments drop, mortgage durations extend, leading to bond managers selling RMBS and long bonds with abandon to bring their duration risk down. The Fed chases the yield curve up, and the stock and housing markets both fall. The Fed chokes on their policy, and gives up tightening to save both markets.
• Or, if not the 1994 scenario, does the Fed dare to stop tightening before the yield curve inverts, and just wait for a flat curve to do its work? (Nah, that would be smart. The Fed always inverts the curve to prove their manliness, and blows some part of the market up in the process.)
• Or do they just accept financial repression, and punish savers to benefit wage earners (Will it really work? Dubious.), as the Fed keeps their policy rate low.

I posed those scenarios to Tom Barkin, President of the Richmond Fed when he came to speak to the CFA Institute at Baltimore last week. He gave answers that were either evasive, or he didn’t get it.

Anyway, this is an awkward market situation, but the one thing that is clear to me is that investors should be at the lower end of risk for their asset allocation.

PS — As for me, I am living with value stocks, small stocks, and international stocks. Very little in the S&P 500 here.

Image credit: All images belong to Aleph Blog

This should be a brief post. At the end of the third quarter, the S&P 500 was poised to nominally return -0.64%/year over the next 10 years. As of the close today, that figure was -1.83%/year, slightly more than the -1.84%/year at the record high last Friday.

The only period compares with this valuation-wise is the dot-com bubble. We are above dot-com level valuations. And if you view the 10-year returns from the worst time of the dot-com bubble to now, you can see that the results they obtained are milder than what I forecast here.

Of course, a lot of what will happen in nominal terms will rely on the actions of the Fed. Will the Fed:

• Allow a real recession to clear away dud assets that are on life support from low rates? (Collapsing the current asset bubble)
• Change the terms of monetary policy, and start directly monetizing US Treasury debt? (Risking high inflation)
• Continue to dither with financial repression, leaving rates low, not caring about moderate inflation, with real growth zero-like. (Zombie economy — this is the most likely outcome for now)

In some ways the markets are playing around with something I call “the last arbitrage.” Bonds versus Stocks. The concept of TINA (There is no alternative [to stocks]) relies on the idea that the Fed will be the lapdog of the equity markets. If stocks are high, the Fed is happy. Phrased another way, if the Fed maximizes wealth inequality, it is happy.

And the Fed will be happy. They live to employ thousands of macroeconomists who would have a hard time finding real employment. These economists live to corrupt our understanding f the macroeconomy, justifying the actions of the Fed. The Fed just wants to scrape enough seigniorage to pay the staff, and keep Congress and the Administration mollified. All taken out of the hides of those who save.

So with the last arbitrage… interest rates have to stay low to keep the stock market high, even if it means slow growth, and moderate and growing inflation. The likely change promulgated by the Fed today, raising the short rate by 0.75% in 2022 will likely flatten the yield curve, leading to a crisis of some sort, and push them back into QE and near-zero short rates. The stock market will have a pullback and a rally, but what of inflation? How will people act when there is no way to save for the short-run, without inflation eating away value?

Brave new world. The Fed is stuck, and we are stuck with them. Gold does nothing, and would be a kinder mistress than the Fed. Better to live within strict limits, than the folly of an elastic currency. But as is true with all things in America, we are going to have to learn this the hard way.

PS — As for me, I am living with value stocks, small stocks, and international stocks. Very little in the S&P 500 here.

Image Credit: All images courtesy of Aleph Blog || Lookout below!

I’ll keep this brief, as I’ve said it so many times before. This market is on borrowed time. The only comparable period for this market is from the fourth quarter of 1999 to the third quarter of 2000 — the dot-com bubble, which was another period of speculation fueled by loose monetary policy. Here’s a picture of what price returns were like from that era over the next ten years (but with a 2% dividend yield).

And we are touching the sky at present. Though at the end of the quarter, the S&P 500 was priced to return -0.91%/year over the next ten years, at present that value is -1.41%/year. None of these figures are adjusted for inflation. At the recent high of 4,536.95 on September 2nd, the expected return was -1.73%/year for the next ten years. This graph shows how we are touching the sky:

The actual line is touching the maximum line. The future line gives an idea of how valuations could normalize over ten years.

The Dow 36,000 crowd will get their day in the sun, maybe even this year, or it might not happen until 2035. But even if it hits the level, it’s unlikely that it will stay above that level for most of the rest of the next 10 years.

I’ll close with a quote from something I wrote recently:

And I think even as the market falls, value should do well, as it did in 2000-2001. This piece from Bob Arnott at Research Affiliates makes a good case for it.

So play it safe; it’s a messy speculative world out there. It wouldn’t take much for it to turn ugly.

Image Credit: Aleph Blog || The model fits the data well

I don’t plan on doing this often, but I got a number of good responses on the last article, and I want to answer them in a more complete way, rather than doing it in the comments, where they for practical purposes never get read.

Thanks for sharing your estimates and work on the average investor equity allocation. I recently wrote an email to you asking if you have done similar studies for other countries. I read that while the US has 45% the UK is at 10% average equity allocation. Have you seen if the average equity allocation can be applicable model for other countries or you reckon everything moves together with the S&P? The Hang Seng for example gained after the dot com bubble and was not flat to down in 10 years. Peak was 7 years later… this could be an opportunity to outperform if you are selective because while you are saying avoid large cap growth names it is worth noting that the US has outperformed the world last 10 years since Osama died and the USD has been the strongest currency. It may be the case of avoid US stocks here and be aggressive in Australia which has value oriented index and has been flat since GFC.

https://alephblog.com/2021/06/18/estimating-future-stock-returns-march-2021-update/#comment-39991

I haven’t run into any other nation where there is sufficient data to do what I am doing here. Remember, the data from the Fed’s Z.1 report include estimates of the value of private assets. I can’t believe the 10% number for the UK. That has to be wrong… it is probably not counting private assets, and may only be counting direct holdings by individuals and not those of institutions.

Is this CAPE forward returns, or the money-flow based model?

Also, how do you think about the fact that CAPE Excess spread is still positive?

Thanks.

https://alephblog.com/2021/06/18/estimating-future-stock-returns-march-2021-update/#comment-39992

Neither. This is the asset share model, not the CAPE, which less accurate than this model. I have no idea regarding the CAPE Excess spread. I don’t pay attention to that.

The asset share model measures the percentage of assets held by Americans in stocks. The highest figure ever is 52.3%, the lowest is 21.8%. When the value is high, future returns are low, and vice-versa. We are over 51% at present.

The bailouts always favor the rich. As I am sure you know, people like Charlie Munger have basically said that the peasants should shut up and be grateful because if the rich hadn’t been bailed out (bailouts are ongoing), the peasants would have had an even worse outcome.

Sheila Bair had a plan to go into these financial firms and do a few things: 1. protect depositors 2. fire management 3. re-open by selling to a healthy firm. She was laughed out of the room, and resigned (around 2008).

Never forget that all the rich folks you see on CNBC, even Warren Buffet, were bailed out. I wasn’t. Luckily I had taken action to retain most of my gains, so I did pretty well. These people that are supposed to be so much smarter than the rest of us? Probably not so much. They are just in the right club.

https://alephblog.com/2021/06/18/estimating-future-stock-returns-march-2021-update/#comment-39993

Charlie Munger is a bright guy, but he’s wrong here. Anyone reading Aleph Blog during the Financial Crisis knows that I did not favor the bailouts, and that I would not have minded another depression. That’s an unpopular view, but it would have punished the rich for borrowing too much. It would have leveled the playing field, and things would have normalized within ten years.

People forget the the promiscuous monetary policy of the Fed set us up for both crises 1929 and 2008. It’s setting us up for another one now. BTW, Buffett did not get bailed out. He didn’t need it with his fortress balance sheet.

You’ve persuaded me. How do I persuade my young?

https://alephblog.com/2021/06/18/estimating-future-stock-returns-march-2021-update/#comment-39994

That’s a tough question. I raised eight children, who all got to listen to me for a long time. Only three out of eight ended up doing well in their finances. (Two are stay-at-home moms who married the right guys. Note: the good ones marry early. Those who purposely delay marriage typically have troubles.) Four are marginal, and one is a total failure. Did I expect better? Yes. but once the arrow leaves the string, you can’t influence it any more.

One of the smartest guys I know said to me, “Once they become adults, don’t say anything, but pray for them a lot.” I think he is correct, though if a teachable moment comes, seize it.

I think most people have to pay “market tuition.” Losses teach investors a lot, and do much good, so long as the investor does not give up. Those that give up will likely never learn.

The children of mine that are succeeding ask my advice. Now, you could tell your kids about Aleph Blog, but they might find me boring.

Given the extreme valuations of the market and exuberant behavior by average investors, I wonder if even deep value stocks and funds will provide a reasonable return going forward. What worked back in 2000 – 2010 may not work this time around. I currently like Aegis Value (AVALX) which is heavily invested in resource stocks including precious metal miners. Manager is a deep value investor with portfolio currently having a P/B of 0.8 and average stock market cap < $800M. This fund outperformed during the 2000 to 2010 bear market but does lag during times when growth stocks are in vogue. Currently looking for other deep value funds to protect capital over the next 10 years. Just wish T. Rowe Price Capital Appreciation was still open. I’m thinking maybe a good balanced fund from Dodge & Cox or Oakmark might be a worthy holding at this point.

https://alephblog.com/2021/06/18/estimating-future-stock-returns-march-2021-update/#comment-39995

Those are credible investments, and seem reasonable to me. There is still a huge valuation gap between growth and value stocks. I am not worried about value here.

There are ways to get shares of funds that are closed, but you might have to pay a premium to get them.

Any thoughts about the attractiveness of local-currency (or hard) emerging sovereign bonds at this point in time?

https://alephblog.com/2021/06/18/estimating-future-stock-returns-march-2021-update/#comment-39996

If the Fed is moving to tighten, or even taper, these are not good ideas. I lost money in those asset classes after Bernanke uttered “taper.” Emerging market debt typically does not do well when the Fed is tightening policy.

IMO valuations will go higher than the last tech bubble. Trend over time has been bubbles getting bigger and valuations getting higher. Accommodative FED, low interest rates will support the market and technology which is truly changing the world will cause euphoria in investors and the market. We have a ways to go before the top is in, IMO.

I work in the tech industry (software for years, now in IT), and I see the world moving to the cloud in droves. I see the SAAS companies growing 30-100%+ per year in revenue. Yes they are 20-50x sales valuations, but when you are growing that fast and your growth is accelerating every quarter, and it’s obvious the entire world is going to be using your product in the near future, what is the proper value? All I can do is buy on pullbacks, and wait for euphoria signals like the 90s (CNBC on the tv at the country club instead of ESPN, stuff like that). When I start seeing that stuff, I’ll sell some on pops, and then trail the rest with a moving average to get me out after the bubble pops.

David I believe you are a very smart guy, and a very good investor. As with most good value investors, they are early. Just my opinion.

https://alephblog.com/2021/06/18/estimating-future-stock-returns-march-2021-update/#comment-39997

I think you are a good investor as well, but you fish in a different pool than I do. Yes, I know value investors are early. When I worked for a value-oriented hedge fund, I was the the “black sheep” that looked at momentum and tried to coax my associates out of short positions that looked doomed.

I am not as sanguine as you, but you know that. The model that I use implies that there are limits to how high or low equity valuations can get. We are near that top now. The dot-com bubble was worse then the bubble before the financial crisis as far as the equity markets go, though the financial crisis was more severe for the economy as a whole, as it affected the banks.

On a macroeconomic basis, my concern is that the Fed will run into a zugzwang situation where they have to choose from two bad options. Personally, I think they will choose to deflate, but really, who knows? They tend to favor the unlevered rich, and not the working poor.

Dumb question but when you say the expected returns are under 1% are you simply just doing an inverse of the current S&P PE ratio, which is around 44?

https://alephblog.com/2021/06/18/estimating-future-stock-returns-march-2021-update/#comment-39998

That’s not a dumb question. No, that’s not what I am doing. I am using the asset share model. The asset share model measures the percentage of assets held by Americans in stocks. The highest figure ever is 52.3%, the lowest is 21.8%. When the value is high, future returns are low, and vice-versa. We are over 51% at present.

Using what the asset share for stocks was in the past, I run a regression to calculate how sensitive 10-year returns on the S&P 500 are to the asset share of stocks. Then I use that equation to forecast future performance. At present the model is forecasting returns of -0.91%/year over the next ten years, not adjusted for inflation.

To those asking how David calculates this, the model is here:

https://alephblog.com/2016/04/16/estimating-future-stock-returns-follow-up/

https://alephblog.com/2021/06/18/estimating-future-stock-returns-march-2021-update/#comment-40000

Thank you for saying that. And hey, you got comment 40,000. Well done.

Now that said, I should add one thing. Roughly one year ago, I figured out how to more accurately estimate the values between the quarterly data that the Fed puts out. I ran some regressions to estimate how much money goes into stocks and everything else, independent of returns on the asset classes. It has made the model work better over the last two years.

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

At Aleph Blog, I try to say what I think is true, whether it is popular or not. I think we are in a precarious place at present and am reducing risk. I don’t think there is much upside in this environment, aside from some safe and boring value stocks, and those only maybe — but that is where my money is, along with 30% in very short fixed income.