Photo Credit: New America || Could only drive through the rear-view mirror

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

This is the time of year where lots of stray forecasts get given.  I got tired enough of it, that I had to turn off my favorite radio station, Bloomberg Radio, after hearing too many of them.  I recommend that you ignore forecasts, and even the average of them.  I’ll give you some reasons why:

  • Most forecasters don’t have a good method for generating their forecasts.  Most of them represent the present plus their long-term bullishness or bearishness.  They might be right in the long-run.  The long-run is easier to forecast, in my opinion, because a lot of noise cancels out.
  • Most forecasters have no serious money on the line regarding what they are forecasting.  Aside from loss of reputation, there is no real loss to being wrong.  Even the reputational loss issue is a weak one, because Wall Street generally has no memory.  Why?  Enough things get predicted that pundits can point to something that they got right, at least in some years.  Memories are short on Wall Street, anyway.
  • The few big players that make public forecasts have already bought in to their theses, and only have limited power to continue buying their ideas, particularly if they are wrong.  This is particularly true in hedge funds, and leveraged financial firms.
  • Forecasts are bad at turning points, and average forecasts by nature abhor turning points.  That’s when you would need a forecast the most, when conditions are going to change.  If a forecast presumes “sunny weather” on an ordinary basis it’s not much of a forecast.
  • Most forecasters only think about income statements.  Most of the limits stem from balance sheets proving insufficient, or cash flows inverting, and staying that way for a while.
  • Most forecasts also presume good responses from policymakers, and even when they are right, they tend to be slow.
  • Forecasts almost always presume stability of external systems that the system that holds the forecasted variable is only a part of.  Not that anyone is going to forecast a war between major powers (at present), or a cataclysm greater than the influenza epidemic of 1918 (1-2% of people die), but are users of a forecast going to wholeheartedly believe it, such that if a significant disaster does strike, they are totally bereft?  When is the last time we had a trade war or a payments crisis?  Globalization and the greater division of labor is wonderful, but what happens if it goes backward, or a major nation like France faces a scenario like the PIIGS did?

I leave aside the “surprises”-type documents, which are an interesting parlor game, but have their own excuses built-in.

My advice for you is simple.  Be ready for both bad and good times.  You can’t tell what is going to happen.  Valuations are stretched but not nuts, which justifies a neutral risk posture.  Keep dry powder for adverse situations.

And, from David at the Aleph Blog, have a happy 2017.

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

If I had to suggest two attitudinal adjustments for the average retail investor, I would encourage patience and a little courage.  Why these two?

Patience is needed for a wide variety of reasons.  There is almost never a need to act quickly.  If a few days matters to a decision, such that you feel that you have to act NOW, you’re probably playing the wrong game.  Of course don’t dawdle when you know what you need to do, but don’t let markets, relatives or salesmen push you around.

One example of that hit me recently when I realized that I had acquired 0.1% of the market cap of a microcap stock.  It rarely if ever trades, so it took three weeks to patiently source that many shares by waiting patiently on the bid price of the market.  The amount I have gotten already has exceeded my expectations, but I’m still bidding for more, quietly.

I’m usually pretty patient in trading, which means occasionally some trades won’t get done.  That’s okay, there are usually multiple opportunities, and alternative stocks to buy if you can’t get one of the stocks that you want at the price that you want.

Patience is also useful when the market is rising or falling quickly.  Many people will get tempted to greed or fear, but someone who is patient and has his emotions under control can wait and then make a more rational decision without concern.

Patience is also needed for just maintaining an asset allocation over a long time.  Remember, you don’t make money while you buy and sell, you make money while you wait.  For average investors, those that are patient do best.

That is why some courage is also needed.  Many investments will lose money for a time.  I would estimate that 2/3rds of the stocks that I currently hold have been at a unrealized capital loss for over a month of time at some point at minimum.  At present, almost all are at unrealized capital gains.  So much for the bull market.

There will be a lot of people who try to scare investors.  Some mean well; some don’t — they are just trying to sell you on their services.  A little courage pays here.  Remember that the investors that buy and hold almost always do better than traders — and this is true of all mutual funds including ETFs.

And now for something completely different

I wrote these three pieces at unpopular times:

If indeed you bought and held from February of 2009, you did quite well.  Even from March of 2012 you did well.

But what of now?  How will you do in the future if you buy-and-hold now?  I can tell you two things:

  • Better than most of those that trade, and
  • Likely not as well as in 2009 or 2012.  In 2009, we were staring at 16%+/yr returns over the next ten years, and people were scared to death.  In 2012, it was 8.5%/year for the next ten years.  Now it’s around 6%.

If you were to say to me, I don’t think 6%/yr is worth playing for, you would get an ambivalent answer from me.  I would tell you that I am staying in, but that you should do what you are comfortable doing, if you can avoid future panic and greed.

Though the rewards are likely lower now than previously, you still have a decent number of players that don’t believe the rally, and probably have not had a lot of exposure to the market for a while.  The psychology of most people lends itself toward self-justification.  If they have missed much of the rally, they are likely to pooh-pooh it now.  Only a rare person would switch now, though if you saw a lot of people switching to bull mode, then it would be time to worry, and maybe, lighten up.

Personally, I don’t see it, and together with my other studies, it leads me to hold on.  And guess what, that could be wrong, at least in the short-run.  But when you take into account the odds of making two correct timing trades — out now, in later, and the cost of the taxes on my taxable account, the incentives for reducing equity exposure now look poor.

Back to the Beginning

That’s why you need patience and some courage.  Those will steady you through the hard times.  Hard times will come, and I can’t tell you when.  If you want to sell a little now, go ahead, and leave it in a fund that is safe.  Then set up a googlebot to track both “buy-and-hold” and “dead.”  When you begin to get a lot of pings, invest the money again.

But for most of us, we will be best off maintaining a constant risk posture, because it is too hard to time the market, especially after taxes.  So, be patient and little courageous.

PS — I don’t say be a LOT courageous, because I’ve seen guys make significant errors taking large chances.  Remember, moderate risk wins in the end.

Idea Credit: Philosophical Economics Blog || I get implementation credit, which is less…

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

My last post on this generated some good questions.  I’m going to answer them here, because this model deserves a better explanation.  Before I start, I should say that in order to understand the model, you need to read the first two articles in the series, which are here:

If you are curious about the model, the information is there.  It includes links to the main article at Economic Philosopher’s blog ( @jesselivermore on Twitter).

On to the questions:

Is this nominal or real return? Where can I find your original blog post explaining how you calculate future returns? Similar charts using Shiller PE, total market cap to gdp, q-ratio etc. all seem to imply much lower future returns.

This is a nominal return.  In my opinion, returns and inflation should be forecast separately, because they have little to do with each other.  Real interest rates have a large impact on equity prices, inflation has a small impact that varies by sector.

This model also forecasts returns for the next ten years.  If I had it do forecasts over shorter horizons, the forecasts would be lower, and less precise.  The lower precision comes from the greater ease of forecasting an average than a single year.  It would be lower because the model has successively less power in forecasting each successive year — and that should make sense, as the further you get away from the current data, the less impact the data have.  Once you get past year ten, other factors dominate that this model does not account for — factors reflecting the long-term productivity of capital.

I can’t fully explain why this model is giving higher return levels, but I can tell you how the models are different:

  • This model focuses in investor behavior — how much are investors investing in stocks versus everything else.  It doesn’t explicitly consider valuation.
  • The Shiller PE isn’t a well-thought-out model for many reasons.  16 years ago I wrote an email to Ken Fisher where I listed a dozen flaws, some small and some large.  That e-mail is lost, sadly.  That said, let me be as fair as I can be — it attempts to compare the S&P 500 to trailing 10-year average earnings.  SInce using a single year would be unsteady, the averaging is a way to compare a outdated smoothed income statement figure to the value of the index.  Think of it as price-to-smoothed-earnings.
  • Market Cap to GDP does a sort of mismatch, and makes the assumption that public firms are representative of all firms.  It also assumes that total payments to all factors are what matter for equities, rather than profits only.  Think of it as a mismatched price-to-sales ratio.
  • Q-ratio compares the market value of equities and debt to the book value of the same.  The original idea was to compare to replacement value, but book value is what is available.  The question is whether it would be cheaper to buy or build the corporations.  If it is cheaper to build, stocks are overvalued.  Vice-versa if they are cheaper to buy.  The grand challenge here is that book value may not represent replacement cost, and increasingly so because intellectual capital is an increasing part of the value of firms, and that is mostly not on the balance sheet.  Think of a glorified Economic Value to Book Capital ratio.

What are the return drivers for your model? Do you assume mean reversion in (a) multiples and (b) margins?

Again, this model does not explicitly consider valuations or profitability.  It is based off of the subjective judgments of people allocating their portfolios to equities or anything else.  Of course, when the underlying ratio is high, it implies that people are attributing high valuations to equities relative to other assets, and vice-versa.  But the estimate is implicit.

So…I’m wondering what the difference is between your algorithm for future returns and John Hussman’s algorithm for future returns. For history, up to the 10 year ago point, the two graphs look quite similar. However, for recent years within the 10-year span, the diverge quite substantially in absolute terms (although the shape of the “curves” look quite similar). It appears that John’s algorithm takes into account the rise in the market during the 2005-2008 timeframe, and yours does not (as you stated, all else remaining the same, the higher the market is at any given point, the lower the expected future returns that can be for an economy). That results in shifting your expected future returns up by around 5% per year compared to his! That leads to remarkably different conclusions for the future.

Perhaps you have another blog post explaining your prediction algorithm that I have not seen. John has explained (and defended) his algorithm extensively. In absence of some explanation of the differences, I think that John’s is more credible at this point. See virtually any of his weekly posts for his chart, but the most recent should be at http://www.hussmanfunds.com/wmc/wmc161212e.png (DJM: the article in question is here.)

I’d love to meet and talk with John Hussman.  I have met some members of his small staff, and he lives about six miles from my house.  (PS — Even more, I would like to meet @jesselivermore).  The Baltimore CFA Society asked him to come speak to us a number of times, but we have been turned down.

Now, I’m not fully cognizant of everything he has written on the topic, but the particular method he is using now was first published on 5/18/2015.  There is an article critiquing aspects of Dr. Hussman’s methods from Economic Philosopher.  You can read EP for yourself, but I gain one significant thing from reading this — this isn’t Hussman’s first model on the topic.  This means the current model has benefit of hindsight bias as he acted to modify the model to correct inadequacies.  We sometimes call it a specification search.  Try out a number of models and adjust until you get one that fits well.  This doesn’t mean his model is wrong, but that the odds of it forecasting well in the future are lower because each model adjustment effectively relies on less data as the model gets “tuned” to eliminate past inaccuracies.  Dr. Hussman has good reasons to adjust his models, because they have generally been too bearish, at least recently.

I don’t have much problem with his underlying theory, which looks like a modified version of Price-to-sales.  It should be more comparable to the market cap to GDP model.

This model, to the best of my knowledge, has not been tweaked.  It is still running on its first pass through the data.  As such, I would give it more credibility.

There is another reason I would give it more credibility.  You don’t have the same sort of tomfoolery going on now as was present during the dot-com bubble.  There are some speculative enterprises today, yes, but they don’t make up as much of the total market capitalization.

All that said, this model does not tell you that the market can’t fall in 2017.  It certainly could.  But what it does tell you versus valuations in 1999-2000 is that if we do get a bear market, it likely wouldn’t be as severe, and would likely come back faster.  This is not unique to this model, though.  This is true for all of the models mentioned in this article.

Stock returns are probabilistic and mean-reverting (in a healthy economy with no war on your home soil, etc.).  The returns for any given year are difficult to predict, and not tightly related to valuation, but the returns over a long period of time are easier to predict, and are affected by valuation more strongly.  Why?  The correction has to happen sometime, and the most likely year is next year when valuations are high, but the probability of it happening in the 2017 are maybe 30-40%, not 80-100%.

If you’ve read me for a long time, you will know I almost always lean bearish.  The objective is to become intelligent in the estimation of likely returns and odds.  This model is just one of ones that I use, but I think it is the best one that I have.  As such, if you look the model now, we should be Teddy Bears, not full-fledged Grizzlies.

That is my defense of the model for now.  I am open to new data and interpretations, so once again feel free to leave comments.

As such, if you look the model now, we should be Teddy Bears, not full-fledged Grizzly Bears. Click To Tweet

Idea Credit: Philosophical Economics Blog || I get implementation credit, which is less… 😉

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

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.

That puts us in the 82nd percentile of valuations, which isn’t low, but isn’t the nosebleed levels last seen in the dot-com era.  There are many talking about how high valuations are, but investors have not responded in frenzy mode yet, where they overallocate stocks relative to bonds and other investments.

Think of it this way: as more people invest in equities, returns go up to those who owned previously, but go down for the new buyers.  The businesses themselves throw off a certain rate of return evaluated at replacement cost, but when the price paid is far above replacement cost the return drops considerably even as the cash flows from the businesses do not change at all.

For me to get to a level where I would hedge my returns, we would be talking about considerably higher levels where the market is discounting future returns of 3%/year — we don’t have that type of investor behavior yet.

One final note: sometimes I like to pick on the concept of Dow 36,000 because the authors didn’t get the concept of risk premia, or, margin of safety.  They assumed the market could be priced to no margin of safety, and with high growth.  That said, the model does offer a speculative prediction of Dow 36,000.  It just happens to come around the year 2030.

Until next time, when we will actually have some estimates of post-election behavior… happy investing and remember margin of safety.

Are you ready to earn 6%/year until 9/30/2026? Click To Tweet

Photo Credit: ajehals || Pensions are promises. Sadly, promises are often broken. Choose your promiser with care…

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

If you want a full view of what I am writing about today, look at this article from The Post and Courier, “South Carolina’s looming pension crisis.”  I want to give you some perspective on this, so that you can understand better what went wrong, and what is likely to go wrong in the future.

Before I start, remember that the rich get richer, and the poor poorer even among states.  Unlike what many will tell you though, it is not any conspiracy.  It happens for very natural reasons that are endemic in human behavior.  The so-called experts in this story are not truly experts, but sourcerer’s apprentices who know a few tricks, but don’t truly understand pensions and investing.  And from what little I can tell from here, they still haven’t learned.  I would fire them all, and replace all of the boards in question, and turn the politicians who are responsible out of office.  Let the people of South Carolina figure out what they must do here — I’m a foreigner to them, but they might want to hear my opinion.

Let’s start here with:

Central Error 1: Chasing the Markets

Credit: The Courier and Post

Much as inexperienced individuals did, the South Carolina Retirement System Investment Commission [SCRSIC] chased the markets in an effort to earn returns when they seemed easy to get in hindsight.  As the article said:

It used to be different, before the high-octane investment strategies began. South Carolina’s pension plans were considered 99 percent funded in 1999, and on track to pay all promised benefits for decades to come.

That was the year the pension funds started investing in stocks, in hopes of pulling in even more income. A change to the state constitution and action by the General Assembly allowed those investments. In the previous five years, U.S. stock prices had nearly tripled.

Prior to that time, the pension funds were largely invested in bonds and cash, which actually yielded something back then.  If the pension funds were invested in bonds that were long, the returns might not have been so bad versus stocks.  But in the late ’90s the market went up aggressively, and the money looked easy, and it was easy, partly due to loose monetary policy, and a mania in technology and internet stocks.

Here’s the real problem.  It’s okay to invest in only bonds. It’s okay to invest in bonds and stocks in a fixed proportion.  It’s okay even to invest only in stocks.  Whatever you do, keep the same policy over the long haul, and don’t adjust it.  Also, the more nonguaranteed your investments become (anything but high quality bonds), the larger your provision against bear markets must become.

And, when you start a new policy, do what is not greedy.  1999-2000 was the right time to buy long bonds and sell stocks, and I did that for a small trust that I managed at the time.  It looked dumb on current performance, but if you look at investing as a business asking what level of surplus cash flows the underlying investments will throw off, it was an easy choice, because bonds were offering a much higher future yield than stocks.  But the natural tendency is to chase returns, because most people don’t think, they imitate.  And that was true for the SCRSIC, bigtime.

Central Error 2: Bad Data

The above quote said that “South Carolina’s pension plans were considered 99 percent funded in 1999.”  That was during an era when government accounting standards were weak.  The standards are still weak, but they are stronger than they were.  South Carolina was NOT 99% funded in 1999 — I don’t know what the right answer would have been, but it would have been considerably lower, like 80% or so.

Central Error 3: Unintelligent Diversification into “Alternatives”

In 2009, I had the fun of writing a small report for CALPERS.  One of my main points was that they allocated money to alternative investments too late.  With all new classes of investments the best deals get done early, and as more money flows into the new class returns surge because the flood of buyers drives prices up.  Pricing is relatively undifferentiated, because experience is early, and there have been few failures.  After significant failures happen, differentiation occurs, and players realize that there are sponsors with genuine skill, and “also rans.”  Those with genuine skill also limit the amount of money they manage, because they know that good-returning ideas are hard to come by.

The second aspect of this foolishness comes from the consultants who use historical statistics and put them into brain-dead mean-variance models which spit out an asset allocation.  Good asset allocation work comes from analyzing what economic return the underlying business activities will throw off, and adjusting for risk qualitatively.  Then allocate funds assuming they will never be able to trade something once bought.  Maybe you will be able to trade, but never assume there will be future liquidity.

The article kvetches about the expenses, which are bad, but the strategy is worse.  The returns from all of the non-standard investments were poor, and so was their timing — why invest in something not geared much to stock returns when the market is at low valuations?  This is the same as the timing problem in point one.

Alternatives might make sense at market peaks, or providing liquidity in distressed situations, but for the most part they are as saturated now as public market investments, but with more expenses and less liquidity.

Central Error 4: Caring about 7.5% rather than doing your best

Part of the justification for buying the alternatives rather than stocks and bonds is that you have more of a chance of beating the target return of the plan, which in this case was 7.5%/yr.  Far better to go for the best risk-adjusted return, and tell the State of South Carolina to pony up to meet the promises that their forbears made.  That brings us to:

Central Error 5: Foolish politicians who would not allocate more money to pensions, and who gave pension increases rather than wage hikes

The biggest error belongs to the politicians and bureaucrats who voted for and negotiated higher pension promises instead of higher wages.  The cowards wanted to hand over an economic benefit without raising taxes, because the rise in pension benefits does not have any immediate cash outlay if one can bend the will of the actuary to assume that there will be even higher investment earnings in the future to make up the additional benefits.

[Which brings me to a related pet peeve.  The original framers of the pension accounting rules assumed that everyone would be angels, and so they left a lot of flexibility in the accounting rules to encourage the creation of defined benefit plans, expecting that men of good will would go out of their way to fund them fully and soon.

The last 30 years have taught us that plan sponsors are nothing like angels, playing for their own advantage, with the IRS doing its bit to keep corporate plans from being fully funded so that taxes will be higher.  It would have been far better to not let defined benefit plans assume any rate of return greater than the rate on Treasuries that would mimic their liability profile, and require immediate relatively quick funding of deficits.  Then if plans outperform Treasuries, they can reduce their contributions by that much.]

Error 5 is likely the biggest error, and will lead to most of the tax increases of the future in many states and municipalities.

Central Error 6: Insufficient Investment Expertise

Those in charge of making the investment decisions proved themselves to be as bad as amateurs, and worse.  As one of my brighter friends at RealMoney, Howard Simons, used to say (something like), “On Wall Street, to those that are expert, we give them super-advanced tools that they can use to destroy themselves.”   The trustees of SCRSIC received those tools and allowed themselves to be swayed by those who said these magic strategies will work, possibly without doing any analysis to challenge the strategies that would enrich many third parties.  Always distrust those receiving commissions.

Central Error 7: Intergenerational Equity of Employee Contributions

The last problem is that the wrong people will bear the brunt of the problems created.  Those that received the benefit of services from those expecting pensions will not be the prime taxpayers to pay those pensions.  Rather, it will be their children paying for the sins of the parents who voted foolish people into office who voted for the good of current taxpayers, and against the good of future taxpayers.  Thank you, Silent Generation and Baby Boomers, you really sank things for Generation X, the Millennials, and those who will follow.

Conclusion

Could this have been done worse?  Well, there is Illinois and Kentucky.  Puerto Rico also.  Many cities are in similar straits — Chicago, Detroit, Dallas, and more.

Take note of the situation in your state and city, and if the problem is big enough, you might consider moving sooner rather than later.  Those that move soonest will do best selling at higher real estate prices, and not suffer the soaring taxes and likely diminution of city services.  Don’t kid yourself by thinking that everyone will stay there, that there will be a bailout, etc.  Maybe clever ways will be found to default on pensions (often constitutionally guaranteed, but politicians don’t always honor Constitutions) and municipal obligations.

Forewarned is forearmed.  South Carolina is a harbinger of future problems, in their case made worse by opportunists who sold the idea of high-yielding investments to trustees that proved to be a bunch of rubes.  But the high returns were only needed because of the overly high promises made to state employees, and the unwillingness to levy taxes sufficient to fund them.

Seven central errors committed by the South Carolina Retirement System and politicians Click To Tweet

Photo Credit: Jessica Lucia

Photo Credit: Jessica Lucia || That kid was like me… always carrying and reading a lot of books.

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

If you knew me when I was young, you might not have liked me much.  I was the know-it-all who talked a lot in the classroom, but was quieter outside of it.  I loved learning.  I mostly liked my teachers.  I liked and I didn’t like my fellow students.  If the option of being home schooled had been offered to me, I would have jumped at it in an instant, because then I could learn with no one slowing me down, and no kids picking on me.

I read a lot. A LOT.  Even when young I spent my time on the adult side of the library.  The librarians typically liked me, and helped me find stuff.

I became curious about investing for two reasons. 1) my mother did it, and it was difficult not to bump into it.  She would watch Wall Street Week, and often, I would watch it with her.  2) Relatives gave me gifts of stock, and my Mom taught me where to look up the price in the newspaper.

Now, if you knew the stocks that they gave me, you would wonder at how I still retained interest.  The two were the conglomerate Litton Industries, and the home electronics company Magnavox.  Magnavox was bought out by Philips in 1974 for a price that was 25% of the original cost basis of my shares.  We did worse on Litton.  Bought in the mid-to-late ’60s and sold in the mid-’70s for a 80%+ loss.  Don’t blame my mother for any of this, though.  She rarely bought highfliers, and told me that she would have picked different stocks.  Gifts are gifts, and I didn’t need the money as a kid, so it didn’t bother me much.

At the library, sometimes I would look through some of the research volumes that were there for stocks.  There are a few things that stuck with me from that era.

1) All bonds traded at discounts.  It’s not that I understood it well, but I remember looking at bond guides, and noted that none of the bonds traded over $100 — and not surprisingly, they all had low coupons.

In those days, some people owned individual bonds for income.  I remember my Grandma on my mother’s side talking about how little one of her bonds paid in interest, given that inflation was perking up in the 1970s.  Though I didn’t hear it in that era, bonds were sometimes called “certificates of confiscation” by professionals  in the mid-to-late ’70s.  My Grandpa on my father’s side thought he was clever investing in short-term CDs, but he never changed on that, and forever missed the rally in stocks and long bonds that kicked off in 1982.

When I became a professional bond investor at the ripe old age of 38 in 1998, it was the opposite — almost all bonds traded at premiums, and had relatively high coupons.  Now, at that time I knew a few firms that were choking because they had a rule that said you can never buy premium bonds, because in a bankruptcy, the premium will be automatically lost.  Any recoveries will be off the par value of the bond, which is usually $100.

2) Many stocks paid dividends that were higher than their earnings.  I first noticed that while reading through Value Line, and wondered how that could be maintained.  The phrase “borrowing the dividend” was bandied about.

Today as a professional I know that we should look at free cash flow as a limit for dividends (and today, buybacks, which were unusual to unheard of when I was a boy), but earnings still aren’t a bad initial proxy for dividend viability.  Even if you don’t have a cash flow statement nearby, if debt is expanding and earnings don’t cover the dividend, I would be concerned enough to analyze the situation.

3) A lot of people were down on stocks and bonds — there was a kind of malaise, and it did not just emanate from Jimmy Carter’s mind. [Cue the sad Country Music] Some concluded that inflation hedges like homes, short CDs, and gold/silver were the only way to go.  I remember meeting some goldbugs in 1982 just as the market was starting to take off, and they disdained the idea of stocks, saying that history was their proof.

The “Death of Equities” came and went, but that reminds me of one more thing:

4) There was a decent amount of pessimism about defined benefit plan pension funding levels and life insurer solvency.  Inflation and high interest rates made life insurers look shaky if you marked the assets alone to market (the idea of marking liabilities to market was at least 10 years off in concept, and still hasn’t really arrived, though cash flow testing accomplishes most of the same things).  Low stock and bond prices made pension plans look shaky.  A few insurance companies experimented with buying gold and other commodities, just in time for the grand shift that started in 1982.

Takeaways

The biggest takeaway is to remember that as a fish you don’t notice the water that you swim in.  We are so absorbed in the zeitgeist (Spirit of the Times) that we usually miss that other eras are different.  We miss the possibility of turning points.  We miss the possibility of things that we would have not thought possible, like negative interest rates.

In the mid-2000s, few thought about the possibility of debt deflation having a serious impact on the US economy.  Many still feared the return of inflation, though the peacetime inflation of the late ’60s through mid-’80s was historically unusual.

The Soviet Union will bury us.

Japan will bury us.  (I’m listening to some Japanese rock as I write this.) 😉

China will bury us.

Few people can see past the zeitgeist.  Many can’t remember the past.

Should we be concerned about companies not being able pay their dividends and fulfill their buybacks?  Yes, it’s worth analyzing.

Should we be concerned about defined benefit plan funding levels? Yes, even if interest rates rise, and percentage deficits narrow.  Stocks will likely fall with bonds if real interest rates rise.  And, interest rates may not rise much soon.  Are you ready for both possibilities?

Average people don’t seem that excited about any asset class today.  The stock market is at new highs, and there isn’t really a mania feel now.  That said, the ’60s had their highfliers, and the P/Es eventually collapsed amid inflation and higher real interest rates.  Those that held onto the Nifty Fifty may not have lost money, but few had the courage.  Will there be a correction for the highfliers of this era, or, is it different this time?

It’s never different.

It’s always different.

Separating the transitory from the permanent is tough.  I would be lying to you if I said I could do it consistently or easily, but I spend time thinking about it.  As Buffett has said, (something like) “We’re paid to think about things that can’t happen.

Ending Thoughts

Now, lest the above seem airy-fairy, here are my biases at present as I try to separate the transitory from the permanent:

  • The US is in better shape than most of the rest of the world, but its securities are relatively priced for that reality.
  • Before the US has problems, Japan, China, OPEC, and the EU will have problems, in about that order.  Sovereign default used to be a large problem.  It is a problem that is returning.  As I have said before — this era reminds me of the 1840s — huge debts and deficits, with continued currency debasement.  Hopefully we don’t get a lot of wars as they did in that decade.
  • I am treating long duration bonds as a place to speculate — I’m dubious as to how much Trump can truly change things.  I’m flat there now.  I think you almost have to be a trend follower there.
  • The yield curve will probably flatten quickly if the Fed tightens more than once more.
  • The internet and global demographics are both forces for deflationary pressure.  That said, virtually the whole world has overpromised to their older populations.  How that gets solved without inflation or defaults is a tough problem.
  • Stocks are somewhat overvalued, but the attitude isn’t frothy.
  • DIvidend stocks are kind of a cult right now, and will suffer some significant setback, particularly if interest rates rise.
  • Eventually emerging markets and their stocks will dominate over developed markets.
  • Value investing will do relatively better than growth investing for a while.

That’s all for now.  You may conclude very differently than I have, but I would encourage you to try to think about the hard problems of our world today in a systematic way.  The past teaches us some things, but not enough, which should tell all of us to do risk control first, because you don’t know the future, and neither do I. 🙂

 

Photo Credit: Attila Malarik

Photo Credit: Attila Malarik || In many but not all situations, doing half is a smart idea!

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

Four major stock indexes, the DJIA, S&P 500, Nasdaq, Russell 2000 all closes at records on the same day.  From that same article, Ryan Detrick, senior market strategist for LPL Financial said that it was the first time all of those indexes set records on the same day since December 31, 1999.

For those that missed the rally, do you feel bad about it?  Regretful?  Really, it’s too bad that the bear bug got you to the degree that you acted on it.  Those who have read me for a long time know that I often sound bearish, because I am natively bearish.  But, I don’t let it force me to take aggressive actions.  There is a point where I will hedge everything, but that is around 2600 on the S&P 500 at present.  I sit and worry a little, let Portfolio Rule Seven trim a little as my stocks hit new highs, but I won’t let cash go over 20% — we’re at about 16% now.  After I Bumped Against My Upper Cash Limit, I bought more stock — good thing too, at least in the short run.

If you think this is all a mirage, and there aren’t any structural reasons why the market should go any higher, and you are not going to do anything here — well, good for you.  Maybe you are right, and you can buy lower someday.  Just don’t get jumpy if the market continues to rise, and you don’t have much in the game.  (To those so inclined, don’t be macho fools and try to short into new highs — wait until there is some blood on the sword before shorting, something that I almost never do because of the bad risk/reward tradeoff.)

But if you are feeling jumpy and think you should get in on the action, let me give you two words: “Do Half.”  If at normal valuations you would have 60% of your assets in stocks, and you have nothing in stocks now, don’t take position above 30%.  Go up to half of a normal position.  If things continue to go up, you will be happy you have something in the market.  If things go down you can bring it up to a full position on weakness, and be grateful you didn’t go up to 60% all at once.

Now, I’m not telling you to buy anything, invest with me, or anything like that.  I just know that regret is one of the most powerful forces in the market, and lots of people make stupid decisions under its influence.  Rules that I use, like “Do Half” and the portfolio management rules are designed to keep me from making rash decisions influenced by my emotions.

The same “Do Half” rule could be applied to lightening up on bond positions and other matters, like raising cash or edging into commodities.  (I am doing neither of those now — they are just examples from others that I know.)

The main idea is to be self-controlled, and not let emotion drive you.  Investing is a business; determine your policies, and act on them, whether you do it yourself, or farm it out to others.  But if you feel that you have to do something now, then my advice to you is “Do Half.”  But if you feel that you have to do something now, then my advice to you is 'Do Half.' Click To Tweet

ecphilosopher-data-2016-q2

This is my quarterly update on how much the market is likely to return over the next 10 years.  At the end of the last quarter, that figure was around 6.54%/year.  For comparison purposes, that is at the 77th percentile of outcomes — high, but not nosebleed high, which to me, is when the market is priced to return 3% or less.  That’s when you run.

Adding in quarter to date movements, the current value should be near 6.3%/year (79th percentile).

With all of the hoopla over how high the market is, why is this measure not screaming run?  This is because average investors, retail and institutional, are not as heavily invested in the equity markets as is typical toward the end of bull markets.  There are many articles calling for caution — I have issued a few as well.

From an asset-liability management standpoint, bull markets get particularly precarious when caution is thrown to the wind, and people genuinely believe that there is no alternative to stocks — that you are missing out on “free money” if you are not invested in stocks.

We aren’t there now.  So, much as I am not crazy about the present state of the credit cycle (debts rising, income falling), there is still the reasonable possibility of more gains in the stock markets.

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

For more on this series, see the first four articles in this search, which describe the model, and its past estimates.

ecphilosopher data 2015 revision_21058_image001

You might remember my post Estimating Future Stock Returns, and its follow-up piece.  If not they are good reads, and you can get the data on one file here.

The Z.1 report came out yesterday, giving an important new data point to the analysis.  After all, the most recent point gives the best read into current conditions.  As of March 31st, 2016 the best estimate of 10-year returns on the S&P 500 is 6.74%/year.

The sharp-eyed reader will say, “Wait a minute!  That’s higher than last time, and the market is higher also!  What happened?!”  Good question.

First, the market isn’t higher from 12/31/2015 to 3/31/2016 — it’s down about a percent, with dividends.  But that would be enough to move the estimate on the return up maybe 0.10%.  It moved up 0.64%, so where did the 0.54% come from?

The market climbs a wall of worry, and the private sector has been holding less stock as a percentage of assets than before — the percentage went from 37.6% to 37.1%, and the absolute amount fell by about $250 billion.  Some stock gets eliminated by M&A for cash, some by buybacks, etc.  The amount has been falling over the last twelve months, while the amount in bonds, cash, and other assets keeps rising.

If you think that return on assets doesn’t vary that much over time, you would conclude that having a smaller amount of stock owning the assets would lead to a higher rate of return on the stock.  One year ago, the percentage the private sector held in stocks was 39.6%.  A move down of 2.5% is pretty large, and moved the estimate for 10-year future returns from 4.98% to 6.74%.

Summary

As a result, I am a little less bearish.  The valuations are above average, but they aren’t at levels that would lead to a severe crash.  Take note, Palindrome.

Bear markets are always possible, but a big one is not likely here.  Yes, this is the ordinarily bearish David Merkel writing.  I’m not really a bull here, but I’m not changing my asset allocation which is 75% in risk assets.

Postscript for Nerds

One other thing affecting this calculation is the Federal Reserve revising estimates of assets other than stocks up prior to 1961.  There are little adjustments in the last few years, but in percentage terms the adjustments prior to 1961 are huge, and drop the R-squared of the regression from 90% to 86%, which also is huge.  I don’t know what the Fed’s statisticians are doing here, but I am going to look into it, because it is troubling to wonder if your data series is sound or not.

That said, the R-squared on this model is better than any alternative.  Next time, if I get a chance, I will try to put a confidence interval on the estimate.  Till then.

Photo Credit: GotCredit

Photo Credit: GotCredit

This is another piece in the irregular Simple Stuff series, which is an attempt to make complex topics simple.  Today’s topic is:

What is risk?

Here is my simple definition of risk:

Risk is the probability that an entity will not meet its goals, and the degree of pain it will go through depending on how much it missed the goals.

There are several good things about this definition:

  • Note that the word “money” is not mentioned.  As such, it can cover a wide number of situations.
  • It is individual.  The same size of a miss of a goal for one person may cause him to go broke, while another just has to miss a vacation.  The same event may happen for two people — it may be a miss for one, and not for the other one.
  • It catches both aspects of risk — likelihood of a bad event, and degree of harm from how badly the goal was missed.
  • It takes into account the possibility that there are many goals that must be met.
  • It covers both composite entities like corporations, families, nations and cultures, as well as individuals.
  • It doesn’t make life easy for academic economists who want to have a uniform definition of risk so that they can publish economics and finance papers that are bogus.  Erudite, but bogus.
  • It doesn’t specify that there has to be a single time horizon, or any time horizon.
  • It doesn’t specify a method for analysis.  That should vary by the situation being analyzed.

But this is a blog on finance and investing risk, so now I will focus on that large class of situations.

What is Financial Risk?

Here are some things that financial risk can be:

  • You don’t get to retire when you want to, or, your retirement is not as nice as you might like
  • One or more of your children can’t go to college, or, can’t go to the college that the would like to attend
  • You can’t buy the home/auto/etc. of your choice.
  • A financial security plan, like a defined benefit plan, or Social Security has to cut back benefit payments.
  • The firm you work for goes broke, or gets competed into an also-ran.
  • You lose your job, can’t find another job as good, and you default on important regular bills as a result.  The same applies to people who run their own business.
  • Levered financial businesses, like banks and shadow banks, make too many loans to marginal borrowers, and find at some point that their borrowers can’t pay them back, and at the same time, no one wants to lend to them.  This can be harmful not just to the banks and shadow banks, but to the economy as a whole.

Let’s use retirement as an example of how to analyze financial risk.  I have a series of articles that I have written on the topic based on the idea of the personal required investment earnings rate [PRIER].  PRIER is not a unique concept of mine, but is attempt to apply the ideas of professionals trying to manage the assets and liabilities of an endowment, defined benefit plan, or life insurance company to the needs of an individual or a family.

The main idea is to try to calculate the rate of return you will need over time to meet your eventual goals.  From my prior “PRIER” article, which was written back in January 2008, prior to the financial crisis:

To the extent that one can estimate what one can reasonably save (hard, but worth doing), and what the needs of the future will cost, and when they will come due (harder, but worth doing), one can estimate personal contribution and required investment earnings rates.  Set up a spreadsheet with current assets and the likely savings as positive figures, and the future needs as negative figures, with the likely dates next to them.  Then use the XIRR function in Excel to estimate the personal required investment earnings rate [PRIER].

I’m treating financial planning in the same way that a Defined Benefit pension plan analyzes its risks.  There’s a reason for this, and I’ll get to that later.  Just as we know that a high assumed investment earnings rate at a defined benefit pension plan is a red flag, it is the same to an individual with a high PRIER.

Now, suppose at the end of the exercise one finds that the PRIER is greater than the yield on 10-year BBB bonds by more than 3%.  (Today that would be higher than 9%.)  That means you are not likely to make your goals.   You can either:

  • Save more, or,
  • Reduce future expectations,whether that comes from doing the same things cheaper, or deferring when you do them.

Those are hard choices, but most people don’t make those choices because they never sit down and run the numbers.  Now, I left out a common choice that is more commonly chosen: invest more aggressively.  This is more commonly done because it is “free.”  In order to get more return, one must take more risk, so take more risk and you will get more return, right?  Right?!

Sadly, no.  Go back to Defined Benefit programs for a moment.  Think of the last eight years, where the average DB plan has been chasing a 8-9%/yr required yield.  What have they earned?  On a 60/40 equity/debt mandate, using the S&P 500 and the Lehman Aggregate as proxies, the return would be 3.5%/year, with the lion’s share coming from the less risky investment grade bonds.  The overshoot of the ’90s has been replaced by the undershoot of the 2000s.  Now, missing your funding target for eight years at 5%/yr or so is serious stuff, and this is a problem being faced by DB pension plans and individuals today.

The article goes on, and there are several others that flesh out the ideas further:

Simple Summary

Though there are complexities in trying to manage financial risk, the main ideas for dealing with financial risk are these:

  1. Spend time estimating your future needs and what resources you can put toward them.
  2. Be conservative in what you think you assets can earn.
  3. Be flexible in your goals if you find that you cannot reasonably achieve your dreams.
  4. Consider what can go wrong, get proper insurance where needed, and be judicious on taking on large fixed commitments to spend money in the future.

PS — Two final notes:

On the topic of “what can go wrong in personal finance, I did a series on that here.

Investment risk is sometimes confused with volatility.  Here’s a discussion of when that makes sense, and when it doesn”t.