Photo Credit: Norman Maddeaux

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February 2017March 2017Comments
Information received since the Federal Open Market Committee met in December indicates that the labor market has continued to strengthen and that economic activity has continued to expand at a moderate pace.Information received since the Federal Open Market Committee met in February indicates that the labor market has continued to strengthen and that economic activity has continued to expand at a moderate pace.No real change.
Job gains remained solid and the unemployment rate stayed near its recent low. Job gains remained solid and the unemployment rate was little changed in recent months. No real change.
Household spending has continued to rise moderately while business fixed investment has remained soft.Household spending has continued to rise moderately while business fixed investment appears to have firmed somewhat.Shades up business fixed investment.
Measures of consumer and business sentiment have improved of late. That sentence lasted for one statement.
Inflation increased in recent quarters but is still below the Committee’s 2 percent longer-run objective.Inflation has increased in recent quarters, moving close to the Committee’s 2 percent longer-run objective; excluding energy and food prices, inflation was little changed and continued to run somewhat below 2 percent. Shades their view of inflation up.

Excluding two categories that have had high though variable inflation rates is bogus. Use a trimmed mean or the median.

Market-based measures of inflation compensation remain low; most 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. What would be a high number, pray tell?  TIPS are showing higher inflation expectations since the last meeting. 5y forward 5y inflation implied from TIPS is near 2.15%, unchanged from February.
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.No change. Any time they mention the “statutory mandate,” it is to excuse bad policy. But don’t blame the Fed, blame Congress.
The Committee expects that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace, labor market conditions will strengthen somewhat further, and inflation will rise to 2 percent over the medium term.The Committee expects that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace, labor market conditions will strengthen somewhat further, and inflation will stabilize around 2 percent over the medium term.No real change.

CPI is at +2.8%, yoy.  Seems to be rising quickly.

Near-term risks to the economic outlook appear roughly balanced. The Committee continues to closely monitor inflation indicators and global economic and financial developments.Near-term risks to the economic outlook appear roughly balanced. The Committee continues to closely monitor inflation indicators and global economic and financial developments.No change.
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 1/2 to 3/4 percent.In view of realized and expected labor market conditions and inflation, the Committee decided to raise the target range for the federal funds rate to 3/4 to 1 percent.Kicks the Fed Funds rate up ¼%.
The stance of monetary policy remains accommodative, thereby supporting some further strengthening in labor market conditions and a 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.Suggests that they are waiting to see 2% inflation for a while before making changes.

They don’t get that policy direction, not position, is what makes policy accommodative or restrictive.  Think of monetary policy as a drug for which a tolerance gets built up.

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.  Gives the FOMC flexibility in decision-making, because they really don’t know what matters, and whether they can truly do anything with monetary policy.
In light of the current shortfall of inflation from 2 percent, the Committee will carefully monitor actual and expected progress toward its inflation goal.The Committee will carefully monitor actual and expected inflation developments relative to its symmetric inflation goal.Now that inflation is 2%, they have to decide how much they are willing to let it run before they tighten with vigor.
The Committee expects that economic conditions will evolve in a manner that will warrant only 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. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.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. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.No change.  Says that they will go slowly, and react to new data.  Big surprises, those.
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, and it anticipates doing so until normalization of the level of the federal funds rate is well under way. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.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, and it anticipates doing so until normalization of the level of the federal funds rate is well under way. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.No change.  Says it will keep reinvesting maturing proceeds of treasury, agency debt and MBS, which blunts any tightening.
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; Jerome H. Powell; and Daniel K. Tarullo.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; Jerome H. Powell; and Daniel K. Tarullo.Large agreement.
 Voting against the action was Neel Kashkari, who preferred at this meeting to maintain the existing target range for the federal funds rate.Kashkari willing to be the lone dove amid rising inflation.  I wonder if he is thinking about systemic issues?

Comments

  • 2% inflation arrives, and the FOMC tightens another notch.
  • They are probably behind the curve.
  • The economy is growing well now, and in general, those who want to work can find work.
  • The change of the FOMC’s view is that inflation is higher. Equities and bonds rise. Commodity prices rise and the dollar weakens.
  • The FOMC says that any future change to policy is contingent on almost everything.

What a difference a quarter makes!  As I said one quarter ago:

Are you ready to earn 6%/year until 9/30/2026?  The data from the Federal Reserve comes out with some delay.  If I had it instantly at the close of the third quarter, I would have said 6.37% — but with the run-up in prices since then, the returns decline to 6.01%/year.

So now I say:

Are you ready to earn 5%/year until 12/31/2026?  The data from the Federal Reserve comes out with some delay.  If I had it instantly at the close of the fourth quarter, I would have said 5.57% — but with the run-up in prices since then, the returns decline to 5.02%/year.

A one percent drop is pretty significant.  It stems from one main factor, though — investors are allocating a larger percentage of their total net worth to stocks.  The amount in stocks moved from 38.00% to 38.75%, and is probably higher now.  Remember that these figures come out with a 10-week delay.

Remember that the measure in question covers both public and private equities, and is market value to the extent that it can be, and “fair value” where it can’t.  Bonds and most other assets tend to be a little easier to estimate.

So what does it mean for the ratio to move up from 38.00% to 38.75%?  Well, it can mean that equities have appreciated, which they have.  But corporations buy back stock, pay dividends, get acquired for cash which reduces the amount of stock outstanding, and places more cash in the hands of investors.  More cash in the hands of investors means more buying power, and that gets used by many long-term institutional investors who have fixed mandates to follow.  Gotta buy more if you hit the low end of your equity allocation.

And the opposite is true if new money gets put into businesses, whether through private equity, Public IPOs, etc.  One of the reasons this ratio went so high in 1998-2001 was the high rate of business formation.  People placed more money at risk as they thought they could strike it rich in the Dot-Com bubble.  The same was true of the Go-Go era in the late 1960s.

Remember here, that average returns are around 9.5%/year historically.  To be at 5.02% places us in the 88th percentile of valuations.  Also note that I will hedge what I can if expected 10-year returns get down to 3%/year, which corresponds to a ratio of 42.4% in stocks, and the 95th percentile of valuations.  (Note, all figures in this piece are nominal, not inflation-adjusted.)  At that level, past 10-year returns in the equity markets have been less than 1%, and in the short-to-intermediate run, quite poor.)

You can also note that short-term and 10-year Treasury yields have risen, lowering the valuation advantage versus cash and bonds.

I have a few more small things to add.  Here’s an article from the Wall Street Journal: Individual Investors Wade In as Stocks Soar.  The money shot:

The investors’ positioning suggests burgeoning optimism, with TD Ameritrade clients increasing their net exposure to stocks in February, buying bank shares and popular stocks such as Amazon.com Inc. and sending the retail brokerage’s Investor Movement Index to a fresh high in data going back to 2010. The index tracks investors’ exposure to stocks and bonds to gauge their sentiment.

“People went toe in the water, knee in the water and now many are probably above the waist for the first time,” said JJ Kinahan, chief market strategist at TD Ameritrade.

This is sad to say, but it is rare for a rally to end before the “dumb money” shows up in size.  Running a small asset management shop like I do, at times like this I suggest to clients that they might want more bonds (with me that’s short and high quality now), but few do that.  Asset allocation is the choice of my clients, not me.  That said, most of my clients are long-term investors like me, for which I give them kudos.

Then there is this piece over at Bloomberg.com called: Wall Street’s Buzz Over ‘Great Leader’ Trump Gives Shiller Dot-Com Deja Vu.  I want to see the next data point in this analysis, which won’t be available by mid-June, but I do think a lot of the rally can be chalked up to willingness to take more risk.

I do think that most people and corporations think that they will have a more profitable time under Trump rather than Obama.  That said, a lot of the advantage gets erased by a higher cost of debt capital, which is partly driven by the Fed, and partly by a potentially humongous deficit.  As I have said before though, politicians are typically limited in what they can do.  (And the few unlimited ones are typically destructive.)

Shiller’s position is driven at least partly by the weak CAPE model, and the rest by his interpretation of current events.  I don’t make much out of policy uncertainty indices, which are too new.  The VIX is low, but hey, it usually is when the market is near new highs.  Bull markets run on complacency.  Bear markets plunge on revealed credit risk threatening economic weakness.

One place I will agree with Shiller:

What Shiller will say now is that he’s refrained from adding to his own U.S. stock positions, emphasizing overseas markets instead.

That is what I am doing.  Where I part ways with Shiller for now is that I am not pressing the panic button.  Valuations are high, but not so high that I want to hedge or sell.

That’s all for now.  This series of posts generates more questions than most, so feel free to ask away in the comments section, or send me an email.  I will try to answer the best questions.

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Late edit: changed bolded statement above from third to fourth quarter.

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I wrote this to summarize my thoughts from a chat session that I was able to participate in at Thompson Reuters Global Markets Forum yesterday.  It was wider ranging than this, but was a very enjoyable time.  Thanks to Manoj Rawal for inviting me.

On the Pursuit of Economic Growth

I think one of the conceits of the modern era is the degree of trust we place in governments.  We want them to do everything for us.  The truth is that their power is limited.  Even if we delegate more power to them, that doesn’t mean the power can/will be used by the government for the purposes intended.

The government is composed of people with their own goals.  It’s not much different than shareholders delegating power of the corporation to a board of directors, who collectively oversee management, should they care to do so.  Often delegated power gets misdirected for the ends of the power- and money-hungry.

Who watches the watchers?  It is one reason why we have “rule of law” in many republics – there is law that governs the government, if we have the will to maintain that.  It differs from “rule by law” which exists more commonly on Earth – laws exist so that the rulers can maintain their rule over those they rule – of which China is an excellent example.  Freedom that is good for the interests of the Communist Party is allowed to exist, but not other freedoms.  There are no rights that are God-given, not subject to the dictates of governments.

Sorry for the digression – my main point is that even the most powerful governments get bogged down, and can’t do nearly what people imagine they can do.  It is akin to what Peter Drucker said on management, that where managers proliferate, it takes progressive more people to manage all of the people – you might actually be able to get more done with fewer people.

Governments face another constraint – because people think the government can stimulate the economy, we have had governments stretch past their budgetary limits, borrow a lot of money, and make long-dated promises that they can’t keep.  This is not just a US phenomenon.  This is happening globally.  It is rare, possibly even non-existent to find countries that run balanced budgets, have sound monetary policy, and haven’t overpromised on entitlements.

As such, there isn’t that much that governments can do in terms of discretionary spending.  Even when they do allocate money, most projects of any significance don’t produce immediate results, but take years to start and more years to complete.  China may be able to run roughshod over its citizens, but where rule of law exists, there is necessary delay for most projects.  Obama or Trump can long for “shovel ready” projects.  They don’t exist, at least not many of them exist that are sizable.

As such, when I look at the plans of Donald Trump, I don’t give them a lot of weight in investment decisions that I make.  The same goes for any US or foreign leader, central banker, or whatever.  Short of starting a war, the amount of truly impactful things he can do is limited, especially for overly indebted governments.

What does matter then?  I think culture matters a lot.  Here are some questions to think about:

  • What priority do we place on taking risk?
  • How do you balance the competing needs of creditors and debtors?
  • How easy is it to start a business?
  • How do we feel about people using natural resources for profit?
  • How predictable is government policy, so that people can make long-term plans, and not worry about whether they will be able to see those plans to their fruition or not?
  • Does the culture protect private property?
  • Do we encourage men and women to marry, start families, and raise intelligent children?
  • Do we encourage charitable endeavors, so that effective help can be given to those who genuinely want to escape poverty? (rather than perpetuate it through continual handouts?)
  • How much do we play favorites across and within industries?
  • To what degree do we force uneconomic growth objectives through tax incentives, such as owning a home, rather than renting?
  • How much are we willing to allow technology to eliminate jobs, such that labor is directed away from simple tasks to tasks of higher complexity?

It is my opinion that those are the greater drivers of economic growth, and that the government can do little to foster growth, aside from having simple long-term policies, and letting us get on with being productive.

As such, I don’t see a lot going on right now that should promote higher growth.  Note that high growth is not necessary for a strong stock market, but it is necessary if you want to see ordinary laborers benefit in society.

This post may fall into the “Dog bites Man” bucket, but I will see if I can’t shed a little more light on the phenomenon.  Here’s the question: “When do we see new highs in the stock market most often?”  The punchline: “After a recent new high.”

The red squares above show the probability of hitting a new high so many days after a new high.  The black line near it is a best fit power curve.  The blue diamonds above show the probability of hitting a new high so many days after not hitting a new high.  The green triangles above show the ratio of those two probabilities, matching up against the right vertical axis. The black line near it is a best fit power curve.

As time goes to infinity, both probabilities converge to the same number, which is presently estimated to be 6.8%, the odds that we would hit a new high on any day between 1951 and 2015.  Here’s the table that corresponds to the above graph:

Probability of a new high afterDays after no new highDays after new highProbability Ratio
1st day3.1%57.3%18.29
2nd day4.2%43.3%10.39
3rd day4.6%36.7%7.90
4th day4.8%33.8%6.99
5th day5.1%30.0%5.87
6th day5.2%28.2%5.37
7th day5.5%24.2%4.36
8th day5.7%22.5%3.97
9th day5.6%23.4%4.18
10th day5.6%22.6%4.00
11-155.9%19.0%3.22
16-206.0%17.2%2.86
21-306.1%16.4%2.71
31-406.2%14.5%2.35
41-506.2%15.2%2.47
51-606.3%14.2%2.28
61-756.3%13.9%2.21
76-906.3%13.6%2.16
91-1056.3%12.8%2.02
106-1206.4%12.5%1.96
121-1406.4%12.0%1.87
141-1606.5%11.3%1.75
161-1806.4%11.5%1.79
181-200 days6.4%11.8%1.84

 

E.g., as you go down the table the probability 43.3% represents the probability that you get a new high on the second day after a new high.

Here’s an intuitive way to think about it: if you are not at a new high, you are further away from a new high than if you were at a new high recently.  Thus with time the daily probability of hitting a new high gets higher.  If you were at a new high recently, you daily odds of hitting a new high are quite high, but fall over time, because the odds of drifting lower at some point increase.  Valuation is a weak daily force, but a strong ultimate force.

That said, the odds of hitting new highs a long time away from a new high are significantly higher than the odds of hitting a new high where there has been no new high for the same amount of time.

Closing Thoughts

I could segment the data another way, and this could be clearer: If you are x% away from a new high, what is the odds you will hit a new high n days from now?  As x gets bigger, so will the numbers for n.  Be that as it may, when you have had new highs recently, you tend to have more of them.  New highs clump together.

The same is true of periods with no new highs — they tend to clump together and persist even more.

Valuation and momentum are hidden variables here — momentum aids persistence, and valuation is gravity, eventually causing markets that don’t fairly price likely future cash flows to revert to pricing that is more normal.  Valuation is powerful, but takes a long while to act, often waiting for a credit cycle to do its work.  Momentum works in the short-run, propelling markets to heights and depths that we can only reach from human mimickry.

That’s all.

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Onto the next rule:

“We pay disclosed compensation.  We pay undisclosed compensation.  We don’t pay both disclosed compensation and undisclosed compensation.”

I didn’t originate this rule, and I am not sure who did.  I learned it at Provident Mutual from the Senior Executives of Pension Division when I worked there in the mid-’90s.  There is a broader rule behind it that I will get to in a moment, but first I want to explain this.

There are many efforts in business, particularly in sales, where some want to hide what they are truly making, so that they can make an above average income off of the unsuspecting.  At the Pension Division of Provident Mutual, the sales chain worked like this: our representatives would try to sell our investment products to pension plans, both municipal and corporate.  We preferred going direct if we could, but often there would be some fellow who had ingratiated himself with the plan sponsor, perhaps by providing other services to the pension plan, and he would become a gateway to the pension plan.  His recommendation would play a large role in whether we made the sale or not.

Naturally, he wanted a commission.  That’s where the rule came in, and from what I remember at the time, many companies similar to us did not play by the rule.  When the sale was made, the client would see a breakdown of what he was going to be charged.  If we were paying disclosed compensation to the “gatekeeper,” we would point it out and mention that that was *all* the gatekeeper was making.  If the compensation was not disclosed, the client would see the bottom line total charge, and he would have to evaluate if that was good or bad deal for plan participants.

Our logic was this: the plan sponsor would have to analyze the total cost anyway for a bundled service against other possible bundled and unbundled services.  We would bundle or unbundle, depending on what the gatekeeper and client wanted.  If either wanted everything spelled out we would do it. If neither wanted it spelled out, we would only provide the bottom line.

What we would never do is provide a breakdown that was incomplete, hiding the amount that the gatekeeper was truly earning, such that client would see the disclosed compensation, and think that it was the entire compensation of the gatekeeper.

We were the smallest player in the industry as far as life insurers went, but we were more profitable than our peers, and growing faster also.  Our business retention was better because compensation surprises did not rise up to bite us, among other reasons.

Here’s the broader rule:

“Don’t be a Pig.”

Some of us had a saying in the Pension Division, “We’re the good guys.  We are trying to save the world for a gross margin of 0.25%/year on assets, plus postage and handling.”  Given that what we did had almost no capital requirements, that was pretty good.

Most scandals over pricing involve some type of hiding.  Consider the pricing of pharmaceuticals.  Given the opaqueness is difficult to tell who is making what.  Here is another article on the same topic from the past week.

In situations like this, it is better to take the high road, and make make your pricing more transparent than your competitors, if not totally transparent.  In this world where so much data is shared, it is only a matter of time before someone connects the dots on what is hidden.  Or, one farsighted competitor (usually the low cost provider) decides to lay it bare, and begins winning business, cutting into your margins.

I’ll give you an example from my own industry.  My fees may not be the lowest, but they are totally transparent.  The only money I make comes from a simple assets under management fee.  I don’t take soft dollars.  I make money off of asset management that is aligned with what I myself own.  (50%+ of my total assets and 80%+ of my liquid assets are invested exactly the same as my clients.)

Why should I muck that up to make a pittance more?  It’s a nice model; one that is easy to defend to the regulators, and explain to clients.

We probably would not have the fuss over the fiduciary rule if total and prominent disclosure of fees were done.  That said, how would the brokers have lived under total transparency?  How would life insurance salesmen live?  They would still live, but there would be fewer of them, and they would probably provide more services to justify their compensation.

Even as a bond trader, I learned not to overpress my edge.  I did not want to do “one amazing trade,” leaving the other side wounded.  I wanted a stream of “pretty good” trades.  An occasional tip to a broker that did not know what he was doing would make a “friend for life,” which on Wall Street could last at least a month!

You only get one reputation.  As Buffett said to the Subcommittee on Telecommunications and Finance of the Energy and Commerce Committee of the U.S. House of Representatives back in 1991 regarding Salomon Brothers:

I want the right words and I want the full range of internal controls. But I also have asked every Salomon employee to be his or her own compliance officer. After they first obey all rules, I then want employees to ask themselves whether they are willing to have any contemplated act appear the next day on the front page of their local paper, to be read by their spouses, children, and friends, with the reporting done by an informed and critical reporter. If they follow this test, they need not fear my other message to them: Lose money for the firm, and I will be understanding; lose a shred of reputation for the firm, and I will be ruthless.

This is a smell test much like the Golden Rule.  As Jesus said, “Therefore, whatever you want men to do to you, do also to them, for this is the Law and the Prophets.” (Matthew 7:12)

That said, Buffett’s rule has more immediate teeth (if the CEO means it, and Buffett did), and will probably get more people to comply than God who only threatens the Last Judgment, which seems so far away.  But I digress.

Many industries today are having their pricing increasingly disclosed by everything that is revealed on the Internet.  In many cases, clients are asking for a greater justification of what is charged, or, are looking to do price and quality comparison where they could not do so previously, because they did not have the data.

Whether in financial product prices, healthcare prices, or other places where pricing has been bundled and secretive, the ability to hide is diminishing.  For those who do hide their pricing, I will offer you one final selfish argument as to why you should change: given present trends, in the long-run, you are fighting a losing battle.  Better to earn less per sale with happier clients, than to rip off clients now, and lose then forever, together with your reputation.

 

I was reading through The Wall Street Journal’s Daily Shot column, done by the estimable @SoberLook, and saw the following graph and text:

The S&P 500 move this year is completely outside the historical seasonal trends.

Graph Credit: Deutsche Bank via @SoberLook at The Wall Street Journal

Averages reveal, but they also conceal.  When I look at a graph like this, I know that any given year is highly likely to look different than an average of years.  So, no surprise that the returns on the S&P 500 are different than the averages of the prior 11 or 19 years.

But how has the S&P 500 fared versus the last 68 years?  At present this year is 20th out of 68, which is good, but not great or average.  But look at the graph at the top of this article: up until the close of the 25th trading day of the year (February 7th) the market had performance very much like a median year.  All of the higher performance has come out of the last nine days.  (For fun, it is the ninth best out of 68 for that time of year; even that is not top decile.)

I can tell you something easy: you can have a lot of different occurrences over nine days in the market.  The distribution of returns would be quite wide.  Therefore, don’t get too excited about the returns so far this year — they aren’t that abnormal.  You can be concerned as you like about valuation levels — they are high.  But 2017 at present is a “high side of normal” year compared to past price performance.

And, if you want to be concerned about a melt-up, it is this kind of low positive momentum that tends to persist, at least for a while.  Trading behavior isn’t nuts, even if valuations are somewhat steamy.

I’m around 83% invested in equity accounts, so I am conservative, but I’m not thinking of hedging yet.  Let the rally run.

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I am a fiduciary in my work that I do for my clients. I am also the largest investor in my own strategies, promising to keep a minimum of 80% of my liquid net worth in my strategies, and 50% of my total net worth in them (including my house, etc.).

I believe in eating my own cooking.  I also believe in treating my clients well.  I’ve treated part of this in an earlier post called It’s Their Money, where I describe how I try to give exiting clients a pleasant time on the way out.  For existing clients, I will also help them with situations where others are managing the money at no charge, no payment from another party, and no request that I manage any of those assets.  I do that because I want them to be treated well by me, and I know that getting good advice is hard.  As I wrote in a prior article The Problem of Small Accounts:

We all want financial advice.  Good advice.  And we want it for free.  That’s why we come to the Aleph Blog, where advice is regularly dispensed, and at no cost.

But… I can’t be personal, and give you advice that is tailored to your situation.  And in my writing here, much as I try to be highly honest, I am not acting as a fiduciary, even though I still make my writings hold to such a standard.

Ugh.  Here’s the problem.  Good advice costs money.  Really good advice costs a lot of money, and is worth it, if you have enough money to spread the cost over.

But when you have a small account, you have a problem in getting advice.  There is no way for someone who is fiduciary (like me) to make money addressing your concerns.  That is why I have a high minimum for investing: $100,000.  With that, I can spend time on clients, even helping them with assets from which I make no money.

What extra things have I done for clients over time?  I have:

  • Analyzed asset allocations.
  • Analyzed the performance of other managers.
  • Advised on changing jobs, negotiating salary, etc.
  • Explained the good and bad points of certain insurance companies and their policies, and suggested alternatives.
  • Analyzed chunky assets that they own elsewhere, aiding them in whether they keep, sell, or sell part of the asset.
  • Analyzed a variety of funky and normal investment strategies.
  • Advised on buying a building, and future business plans.
  • Told a client he was better off reinvesting the slack funds in his business that needed financing, rather than borrow and invest the funds with me.
  • Told a client to stop sending me money, and pay down his mortgage.  (He has since resumed sending money, but he is now debt-free.)

I take the fiduciary side of this seriously, and will tell clients that want to put a lot of their money in my stock strategy that they need less risk, and should put funds in my bond strategy, where I earn less.

I’ve got a lot already.  I don’t need to feather my nest at the expense of the best interests of my clients.

Over the last six years, around half of my clients have availed themselves of this help.  If you’ve read Aleph Blog for awhile, you know that I have analyzed a wide number of things.  Helping my clients also sharpens me for understanding the market as a whole, because issues come into focus when the situation of a family makes them concrete.

So informally, I am more than an “investments only” RIA [Registered Investment Advisor], but I only earn money off of my investment fees, and no other way.  Personally, I think that other “investments only” RIAs would mutually benefit their clients if they did this as well — it would help them understand the struggles that they go through, and inform their view of the economy.

Thus I say to my competitors: do you want to justify your fees?  This is a way to do it; perhaps you should consider it.

Postscript

Having some people in an “investment only” shop that understand the basic questions that most clients face also has some crossover advantages when it comes to understanding financial companies, and different places that institutional money gets managed.  It gives you a better idea of the investment ecosystem that you live and work in.

In general, I don’t like books on personnel management.  That’s mostly because good management techniques are mostly obvious, and there are typically a lot of good strategies that are somewhat different, and most of them will work, if applied with a little common sense.  Pick one.  Apply it.  Be consistent.  Get feedback.  Adjust.  Repeat.

No one has the “holy grail.”  That is true of this book also.  What I appreciate about “The Difference” is its emphasis on creating a good culture.  I’ve worked in companies with good cultures, bad cultures and mixed cultures.  What Subir Chowdhury gets right is the key difference is attitude, and it flows from the top.

Some firms fail because employees are afraid to tell the truth.  That was true within areas of AIG when I worked for it.  Do you want a culture based on truth?  Be honest, ask for it from your bosses, and expect it from your subordinates.  Don’t punish anyone for telling the truth; instead reward it.

Some firms fail because of a lack of emphasis on quality.  The need for short-term profits outweighs quality products and services.  Low quality is a cancer — it can spread from employee relationships to products, services, accounting, vendor relations, marketing, etc.  Cultural change is needed, starting at the top.  If management doesn’t put quality ahead of short term profits, quality will not characterize a company.  Management has to lead efforts on quality by example, instructions, and rewards.  Employees won’t care about quality if management doesn’t care about them, and reward them for stopping bad quality even if it slows production.

The book takes an approach like this, only much better than I can.  It provides a cutesy acronym to summarize the approach for creating a great corporate culture, which to me trivializes ideas, but aids memory for others.

The author peppers the book with his experiences in his life  and work, from youth to the present.  I found those to be a mixed bag.  Like most people, a lot of it sounds like he is tooting his own horn repeatedly.  Many of them are quite instructive, a few aren’t.  I particularly found his example of giving to beggars to be weak.  Yes, the poorest need money, but what they need more is relationships.  The poorest lose relationships due to disease, accidents, substance abuse, selfishness on the part of their family and their own selfishness, an attitude of blaming the world around rather than look at their own failures, and more.

Giving them money does not break the problem; it often feeds the problem.  Creating relationships for them can allow them to reboot their lives, if they want to live a new life.  Don’t get me wrong; I’m no great shakes here.  I just know that the poorest need radical personal change if they ever want to escape their poverty.  Money won’t make the difference necessary most of the time.

That last rant aside, I liked the book and would recommend it.  It’s kind of expensive for its size, but maybe you want a short book that you can read in 1-2 hours.  You’ll get enough to make you think, and maybe make a difference.  It’s “good enough” to help you, but not outstanding.

Quibbles

Already mentioned.

Summary / Who Would Benefit from this Book

You may not need another management book.  If you need something short to motivate a need for corporate and personal change, this could be the book for you.  If you want to buy it, you can buy it here: The Difference: When Good Enough Isn’t Enough.

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.

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.

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I recently received two sets of questions from readers. Here we go:

David,

I am a one-time financial professional now running a modest “home office” operation in the GHI area.  I have been reading your blog posts for a couple years now, and genuinely appreciate your efforts to bring accessible, thoughtful, and modestly stated insights to a space too often lacking all three characteristics.  If I didn’t enjoy your financial posts so much, I’d request that you bring your approach to the political arena – but that’s a different discussion altogether…

I am writing today with two questions about your work on the elegant market valuation approach you’ve credited to @Jesse_Livermore.   I apologize in advance for any naivety evidenced by my lack of statistical background…

  1. I noticed that you constructed a “homemade” total return index – perhaps to get you data back to the 1950s.  Do you see any issue using SPXTR index (I see data back to 1986)?  The 10yr return r-squared appears to be above .91 vs. investor allocation variable since that date.
  2. The most current Fed/FRED data is from Q32016.  It appears that the Q42016 data will be released early March (including perhaps “re-available” data sets for each of required components http://research.stlouisfed.org/fred2/graph/?g=qis ).  While I appreciate that the metric is not necessarily intended as a short-term market timing device, I am curious whether you have any interim device(s) you use to estimate data – especially as the latest data approaches 6 months in age & the market has moved significantly?

I appreciate your thoughts & especially your continued posts…

JJJ

These questions are about the Estimating Future Stock Returns posts.  On question 1, I am pulling the data from Shiller’s data.  I don’t have a better data feed, but that should be the S&P 500 data, or pretty near it.  It goes all the way back to the start of the Z.1 series, and I would rather keep things consistent, then try to fuse two similar series.

As for question 2, Making adjustments for time elapsed from the end of the quarter is important, because the estimate is stale by 70-165 days or so.  I treat it like a 10-year zero coupon bond and look at the return since the end of the quarter.  I could be more exact than this, adjusting for the exact period and dividends, but the surprise from the unknown change in investor behavior which is larger than any of the adjustment simplifications.  I take the return since the end of the last reported quarter and divide by ten, and subtract it from my ten year return estimate.  Simple, understandable, and usable, particularly when the adjustment only has to wait for 3 more months to be refreshed.

PS — don’t suggest that I write on politics.  I annoy too many people with my comments on that already. 😉

Now for the next question:

I have a quick question. If an investor told you they wanted a 3% real return (i.e., return after inflation) on their investments, do you consider that conservative? Average? Aggressive? I was looking at some data and it seems on the conservative side.

EEE

Perhaps this should go in the “dirty secrets” bin.  Many analyses get done using real return statistics.  I think those are bogus, because inflation and investment returns are weakly related when it comes to risk assets like stocks and any other investment with business risk, even in the long run.  Cash and high-quality bonds are different.  So are precious metals and commodities as a whole.  Individual commodities that are not precious metals have returns that are weakly related to inflation.  Their returns depend more on their individual pricing cycle than on inflation.

I’m happier projecting inflation and real bond returns, and after that, projecting the nominal returns using my models.  I typically do scenarios rather than simulation models because the simulations are too opaque, and I am skeptical that the historical relationships of the past are all that useful without careful handling.

Let’s answer this question to a first approximation, though.  Start with the 10-year breakeven inflation rate which is around 2.0%.  Add to that a 10-year average life modification of the Barclays’ Aggregate, which I estimate would yield about 3.0%.  Then go the the stock model, which at 9/30/16 projected 6.37%/yr returns.  The market is up 7.4% since then in price terms.  Divide by ten and subtract, and we now project 5.6%/year returns.

So, stocks forecast 3.6% “real” returns, and bonds 1.0%/year returns over the next 10 years.  To earn a 3% real return, you would have to invest 77% in stocks and 23% in 10-year high-quality bonds.  That’s aggressive, but potentially achievable.  The 3% real return is a point estimate — there is a lot of noise around it.  Inflation can change sharply upward, or there could be a market panic near the end of the 10-year period.  You might also need the money in the midst of a drawdown.  There are many ways that a base scenario could go wrong.

You might say that using stocks and bonds only is too simple.  I do that because I don’t trust return most risk and return estimates for more complex models, especially the correlation matrices.  I know of three organizations that I think have good models — T. Rowe Price, Research Affiliates, and GMO.  They look at asset returns like I do — asking what the non-speculative returns would be off of the underlying assets and starting there.  I.e. if you bought and held them w/reinvestment of their cash flows, how much would the return be after ten years?

Earning 3% real returns is possible, and not that absurd, but it is a little on the high side unless you like holding 77% in stocks and 23% in 10-year high-quality bonds, and can bear with the volatility.

That’s all for now.