Photo Credit: Sarah Burget || Future returns of the S&P 500 will only be a trickle

Dear friends, after some time away, this will be a short post, though I hope to write more soon.

The S&P 500 model is forecasting returns of 2.23%/year over the next 10 years. Even if you compare that to the 10-year Treasury Note yielding 0.66%, that’s not enough of a risk premium. We are in the 97th percentile of valuations.

Now, I know that the Fed is encouraging this. Somewhere, maybe from Bernanke, they picked up the bad meme that the Fed should care about the stock market.

Let me tell you that that way lies madness. The Fed is banging hard on the “voting machine” aspect of the stock market, while the “weighing machine” quietly looks on saying, “You’re going to pay for this.”

Let me put it bluntly: Quantitative easing and policies like it are just blowing asset and debt bubbles. Can the Fed create conditions that lever up the economy, and create prosperity in the asset markets? Yes, but only for a time. Eventually, the markets begin to look through the actions of the Fed and the US Treasury and conclude that the emperor has no clothes. Gold is the silent witness in these matters, as is the value of the US Dollar to a lesser extent.

The Fed should only care about the solvency of the financial system, and act to avoid bubbles. Forget inflation, forget employment forget real GDP growth. In an open macroeconomy where there is a lot of technological change, the Fed can’t affect any of those much. If you are going to have a central bank, it should focus on avoiding financial crises.

And since Greenspan, the Fed has done the opposite of that. Instead of letting recessions liquidate bad debts, the Fed has “rescued” bad corporate and household decisions, by lower rates continually. Well, now we are near the end of this game, and current interest rates and likely future returns are lower than any other time than the dot-com bubble.

For investors, there are a few choices. Go low debt in stock selection, and look at small stocks, value stocks. and international stocks. All offer more future returns than the current FANGMAN consensus of largest-cap growth. Also, even though bond yields are low, short duration high quality bonds will lose a lot less in a panic than other assets.

That is what I am doing. You can do what you want, but this i a time to pay more attention to preserving capital, because even under the best conditions, you aren’t going to earn much in large cap US stocks over the next 10 years.

Photo Credit: premasagar || What a cute kid.

The stock market is acting like a bunch of bored teenagers. At present, we have a number of “Adults in the Room” who are arguing that a crisis will come upon us soon from the effects of C19.

My view is that the more the market is exposed to a concept, the less it reacts to it. Yes, in the initial phase, that is not true — briefly, the more we hear about new concepts, the more impact they have.

But that dies out, and as some Millennials might say : NEXT!

I am surprised at the resilience of equity and corporate bond markets amid the panic surrounding C19. That said, this is similar to how I think the markets should behave. The markets should focus on long-term profitability, not on current period profits.

It is better to think how the expectations of wealthy people and their institutional servants are changing, than to think about the “news” that gets reported each day. The former affects prices; the latter is noise. Focus on the permanent. Ignore the temporary.

Photo Credits: Michael Gray & Brian Turner || And thanks to Pine Tools for concatenating the images

When I was in Eighth Grade, I wasn’t very popular, and in World History class, I sat behind a guy who was even less popular than me, and he was usually quite shy. Still it was my policy not to look down on anyone because I knew what it was like to be lonely, so occasionally I tried to be friendly to him.

Well, one day he came up to me and said: “Have you heard of Hertz Rent-a-Car?”

DM: “Of course.”

Guy: “Have you ever heard of a Hertz Donut?”

DM: “What’s a Hertz Donut?”

He gives me a big hit to my shoulder and exclaims “Hertz Donut?!” [To non-English speakers, the joke is that he was saying “Hurts, Don’t it?!”]

Well, as was common for many jokes with 14-year old boys, there is more energy than brains, so it was less than a week before the joke traveled around the junior high school, running out of victims, and long since bereft of humor, if there was any to start with. What surprises me now is that there is now actually a real meaning to the phrase Hertz Donut — it describes the stock of Hertz in the near future.

The stock of Hertz will, with high likelihood, go out at zero.

Start with this: the firm has filed for bankruptcy. Stockholders mostly get nothing in bankruptcy. Sometimes they might get a little new stock or some warrants to help them save face, because they are delaying the reorganization, but this is usually a trivial amount of money, and implies a big loss to the stockholders.

Second, the bond market is almost always smarter than the stock market, because it reflects the actions of institutional investors who are generally good at assessing risk. There are a large number of distressed debt investors out there, estimating what a reorganized Hertz will be worth. The senior unsecured debt is trading at $38 per $100 of principal. There is no preferred stock, and a minimal amount of second lien debt.

I don’t know all of the complexities of the asset-backed securities that they have issued, but the main physical asset of Hertz is their cars, and the cars secure most of the borrowing of Hertz, via asset-backed securities [ABS]. That means that the hard assets (cars) of Hertz are likely not available to unsecured claimants.

With the senior unsecured trading at such a large discount to par value, it seems impossible that the current stockholders would get much if anything out of a reorganization. Most of their assets are encumbered via ABS. The senior unsecured bondholders are the class of security holders that will receive partial payment, and as such, will likely be the controlling class of securities that will receive the equity in the new Hertz, while the old common stock is either cancelled, or receives some nominal allocation of securities in the new Hertz.

Thus I say to those who hold Hertz equity, sell your shares. Because of mindless speculation, the price is overly high. Take your opportunity, and sell to those who are less wise.

Now, some might ask… what are my motives in writing this? They are purely intellectual. I don’t short stock. It’s a very hard way to make money, and even if you are right, you could get caught in a severe short squeeze, and give up before the stock goes out at zero.

It is really tough to short a stock to zero. It is a “picking up nickels in front of a steamroller” type of play.

So, no, I am not long or short Hertz. Gun to the head, I would short it, rather than go long, but I would size any position to reflect the possibilities of a short squeeze. I.e., I wouldn’t short much.

Full disclosure: no positions in anything mentioned in this article

Photo Credit: GPA Photo Archive || FIreworks over New York City — beautiful, huh?

Though my adopted children were all black to some degree, I had not heard of Juneteenth until yesterday. When I read a little more about it, and the efforts of some to make it a Federal Holiday, I thought, “Okay, if Juneteenth became a Federal Holiday, which other Federal Holiday would likely disappear?”

Now some might ask, “Why not just add another Holiday?” I don’t think there’s a free lunch there — if there is less labor, people would get paid less, and that would affect poor people more than those better off.

Anyway, that made me think of doing a Twitter poll to see what holiday people would be willing to do away with. There are ten holidays and I wanted to make sure that each section of the poll would have a “none of the above” as a possibility.

That meant doing ten little polls with randomized competition among holidays. It was a small challenge to create randomized polls that did not have repeats in the choices for any particular poll, and where none of the ten polls were identical to each other. It’s harder than it seems, but using Excel 2007 I was able to get it done in 20 minutes with aid from the lesser known goal seek command.

All 10 polls are out. I would have done it as one poll, but twitter only allows for four choices, and I wanted to have none of the above as a choice in each poll, so it meant having ten polls with 3 randomized choices each, with no duplicates in choices or polls. Please vote.

— David Merkel (@AlephBlog) June 17, 2020

Note: if you play along with me on these polls, there will be a series of them where each of the ten federal holidays gets equal representation. I'm a quant with expertise in simulation analysis. Part of this is to unscientifically determine the least popular holiday

— David Merkel (@AlephBlog) June 17, 2020

As you can see, one goal of the polling is to unscientifically determine the least popular holiday. There were a few more goals. I thought it would be possible that some might think that Juneteenth and the birthday of Martin Luther King Jr. cover similar topics. Would some people suggest a trade of one for the other?

Also, would “none of the above” get a lot of votes? Are people happy with the current situation? That would indirectly answer the question of how much sympathy there is for Juneteenth as a Federal Holiday.

To that end, I ask my readers if they would be willing to vote on these polls.

Which of the following Federal Holidays would you give up in order to make Juneteenth a Federal Holiday? (Choices chosen randomly)

— David Merkel (@AlephBlog) June 17, 2020

Which of the following Federal Holidays would you give up in order to make Juneteenth a Federal Holiday? (Choices chosen randomly 2/10)

— David Merkel (@AlephBlog) June 17, 2020

Which of the following Federal Holidays would you give up in order to make Juneteenth a Federal Holiday? (Choices chosen randomly 3/10)

— David Merkel (@AlephBlog) June 17, 2020

Which of the following Federal Holidays would you give up in order to make Juneteenth a Federal Holiday? (Choices chosen randomly 4/10)

— David Merkel (@AlephBlog) June 17, 2020

Which of the following Federal Holidays would you give up in order to make Juneteenth a Federal Holiday? (Choices chosen randomly 5/10)

— David Merkel (@AlephBlog) June 17, 2020

Which of the following Federal Holidays would you give up in order to make Juneteenth a Federal Holiday? (Choices chosen randomly 6/10)

— David Merkel (@AlephBlog) June 17, 2020

Which of the following Federal Holidays would you give up in order to make Juneteenth a Federal Holiday? (Choices chosen randomly 7/10)

— David Merkel (@AlephBlog) June 17, 2020

Which of the following Federal Holidays would you give up in order to make Juneteenth a Federal Holiday? (Choices chosen randomly 8/10)

— David Merkel (@AlephBlog) June 17, 2020

Which of the following Federal Holidays would you give up in order to make Juneteenth a Federal Holiday? (Choices chosen randomly 9/10)

— David Merkel (@AlephBlog) June 17, 2020

Which of the following Federal Holidays would you give up in order to make Juneteenth a Federal Holiday? (Choices chosen randomly 10/10)

— David Merkel (@AlephBlog) June 17, 2020

I think highly of my readers. I particularly appreciate the way that most of you who choose to comment at my blog are measured in your comments. I don’t have to deal with a lot of off topic or crude comments.

So, if you have a few minutes of time, go ahead and answer the polling questions. I’ll do a post with the results either tomorrow or Friday. Thanks.

PS — the polls cut off in the 2PM hour tomorrow, US Eastern Time.

Graphic Credit: Aleph Blog, natch… same for the rest of the graphs here. Data is from the Federal Reserve and Jeremy Siegel

As I said last time, a lot can happen in 3 months. At the end of March 2020, a rally was starting that would become a new bull market. At that time, the market was poised to deliver a return over the next 10 years of 6.84%/year. As I write this evening, after the rally the likely return over the next ten years is 4.63%/year.

Hee are a few more graphs, and then I will come to my main point for this post.

25 scenarios — one down, 24 up over ten years, with an average likely return of 4.63$/year.

In general, this model fits the data well, but who can tell for the future? This is likely the best estimate over a ten-year horizon.

So, do you go for stocks here with a likely return of 4.63%/year, versus the Barclays’ Aggregate at around 2.5%/year or cash at around 0.2%/year? You can hear the siren call of TINA (There Is No Alternative) loud and clear.

Let me peel this back a bit for a moment, as one who once managed a large portfolio of bonds. Why not always buy the highest yielding bonds? The answer that would come back from the bright students would be: don’t the highest yielding bonds default more?

The bond manager that buys without question the higher yielding names presumes stability in the financial markets, and likely the economy as well. Defaults can affect the realized yield a lot. You might be getting more yield today, but will you be able to realize those yields? In addition to losses from defaults, many managers lose value during times of credit stress because they are forced to sell marginal bonds that they are no longer sure will survive at distressed prices.

I think the estimate of returns that I have given on the S&P 500 is a reasonable estimate — it’s not a yield, but an estimate of dividend yield and capital gains. 4.63%/year over 10 year certainly beats bond handily. But do you have the fortitude, balance sheet, and time horizon to realize it?

More say they have it than actually do have it. The account application form at my firm stresses the risks of investing, and talks about stock investors needing a long time horizon. I still get people who panic. The present situation, given the novelty of a virus “crowning” (idiom for a whack to the head) the market, and the market largely ignores it makes many panic, assuming that there must be a big fall coming soon.

Eh? There might be such a fall. The S&P 500 could reach a new high in July. Who cares — that is why I run a 10-year model — to take the emotion out of this. If you are afraid of the market now, you should do one of three things:

1. Sell your stock now — you are not fit for stock investing.
2. Sell your stock now, and choose two points where you will reinvest. What is the lower S&P 500 that would give you comfort to invest? Second, if after an amount of time the market doesn’t fall to the level that you dream of, at what date would you admit that you were wrong, and reinvest then.
3. Do half — sell half of your risk away, moving it to safety. Again, try to set a rule for when you would reinvest.

In general, I don’t believe that there is no alternative to stocks, and I don’t think stocks are cheap, but in general, the optimists triumph in investing. I have been shaving down risk positions, but with the Fed doing nutty things like QE infinity (whatever it takes), buying corporate bonds and doing direct lending, I don’t see how the markets fall hard now. The dollar may be worth less when it is done, but I think it is likely that you will have more ten years from now by investing in stocks and risky assets like stocks, than to invest in safe assets.

When the Fed shifts, things will be different. As Chuck Prince, infamous former CEO of Citigroup once said:

“When the music stops, in terms of liquidity, things will be complicated,” Prince said. “But as long as the music is playing, you’ve got to get up and dance.”

What we have learned 10 years after Chuck Prince told Wall St to keep dancing

As I wrote in my Easy In, Hard Out pieces, the Fed will have a hard time removing stimulus. They tried and the market slapped them. Now they live in a “Brave New World” where they wonder what will ever force them to change from a position from a position of ever increasing liquidity. They try to not let it leak into the real economy, so there is little inflation for now.

But there is no free lunch. Something will come to discipline the Fed, whether it is inflation, a currency crisis — who knows? At that point, “things will be complicated.”

So what do I do? I own assets that will survive bad scenarios, I raise a little cash, but I am largely invested in stocks. To me, that is something that balances offense and defense, and doesn’t just focus on one scenario, whether it is a disaster, or the Goldilocks scenario of TINA.

Photo Credit: frankieleon || Even with low inflation, money shrinks. Wages move with inflation, few assets do.

There’s no free lunch. The ideal of an inflation-protected defined benefit plan was indeed wonderful, but the costs were prohibitive. Few companies were willing to shoulder the costs of them, and what few were willing ran into the roadblock of the IRS telling them they could not put too much into their defined benefit plans — for the IRS feared it was a tax dodge.

By nature the IRS is shortsighted, and could not appreciate the idea that you needed more assets than the liberal (meaning you don’t need to contribute much today) funding formulas said they would need. The IRS wants taxes now. They don’t care about taxes five years from now, much less thirty.

As it is today, most of us (including me), are stuck in the box where we have to make our assets last over our retirements. There are no guarantees. How do we make the assets stretch?

It’s a tough problem. I often talk to my friends about the challenge, because we really don’t know whether the idiotic policies of our government will lead to inflation or deflation as a result of the crisis. Most people assume the government will inflate, and that seems to be an easy solution.

But they didn’t do that to any great extent in the Great Depression or in the 2008-9 financial panic. I’ve got bad news for most people: the government of the US, nay, most governments tend to favor the rich. As such, they tend not to inflate aggressively.

But as with most matters in economics, past is not prologue. Who can tell what the government might do in an entitlements crisis mixed with a weak dollar? What happens when so much credit is extended that foreign creditors distrust the value of the dollar (or euro)?

But suppose inflation is your worry. How can you hedge?

First there is storage: t-bills and gold. You won’t earn anything, but you won’t lose anything either.

Wait, why not buy gold miners? I class gold miners in the basket of industries that I call “cult industries.” Cult industries attract businessmen and investors that are “true believers,” who have a view of the world that says the activity is more valuable or cool than most other industries.

The problem with gold miners is depletion. Has the price of gold risen? Yes, but so has the cost of mining gold. There are many people who have bitten the romantic lure to mine gold, and as such, typically gross margins are poor. Buying gold miners has been a bad bet for a long time. So just buy a little gold instead, and not the miners.

Short duration bonds can be useful if their yields are higher than expected inflation plus default losses. Otherwise, bonds are usually not a good hedge for inflation.

With stocks, for the market as a whole, rising inflation is a small net negative. Businesses will raise their prices, but a higher cost of capital overall will make stocks lose ground to inflation in real terms.

But if you tweak your stock portfolio, and pursue either a low P/E approach, or one that favors a overweight of cyclicals, you can use those stocks as a hedge against inflation. Just be aware that when the cycle shifts to deflation, those stocks will underperform.

Real estate typically does well in times of inflation, just make sure any loans you have against the real estate won’t reprice upward to reflect the new higher interest rates.

That’s my quick summary for asset classes. Before I close, I have a few words regarding the unique ways that inflation affects seniors:

First, inflation affects you more because you don’t have wage income coming in. Wages mostly adjust to inflation — if you have work, that is a source of support.

Second, things that are necessary — food, energy and healthcare, have tended to inflate at a rate faster than other goods and services. That might not be true of energy now, but it was true for a long time.

My main bit of advice is to be conservative in your spending. That’s the one thing you can control. Making assets last for a long time, is difficult, but it becomes impossible when your asset levels get too low.

With that, invest wisely. Personally, I would pursue a middle course that partially hedges inflation risk, because the cost of being wrong on either side is significant.

Photo Credit: Dawn Beattie || A sharp s-curve can jolt us

The only thing more steep than the twist in the s-curve of the progress of COVID-19, was the twist in the s-curve of human action and talk as people tried to catch up with the projected implications of the virus, and likely overshot the mark.

That second s-curve not only affected what human institutions would close, what & how testing would or wouldn’t be done, quarantining, social distancing, and so called economic stimulus that will do little, but it also drove the market. It created the fastest transition from a market high on February 19th to a new bear market on March 12th. That’s 22 calendar days, or 16 market sessions.

It usually takes a lot to move a market from the bravado of the bull market, which takes time to create, but seems inevitable once it gets going, to raw fear. It typically does not spin on a dime, as signs of weakness meet resistance, even if new highs are not being made.

I could make the comment that when valuations are so high, it doesn’t take that much to create a bear market, and in the Great Depression, that was true (42 days, or 30 trading sessions). But in the dot-com bubble it was not so, and valuations were at their highest then. The transition to a bear market there was 353 days, or 242 trading sessions. That’s almost a year.

But what if there is an interruption in credit conditions? Weak entities that require access to the credit markets get knocked for a loop. That was certainly happening in energy names and various companies with junk credit ratings. It not only matters that a company has enough flexibility for an average disruption, but enough for something that can’t happen. As Buffett sits on a big pile of cash, he may still say, “We’re paid to think about the things that can’t happen.” Hopefully he’s deploying some cash now.

I like the companies I own to have low debt levels as a result. Nonetheless, I was knocked around last week by companies that had low debts, but had some economic cyclicality. Personally, I’m not worried about a deep recession, at least not yet. The economy will slow down. Real GDP may even shrink for two or more quarters in a row.

I think that the national and global fears from COVID-19 will relent, and be replaced by modest local outbreaks that may not go away for a while. I also think that the Saudis will eventually return to restricting oil production. The Saudis play games like this, then realize that they don’t work, and so they stop. The Russians may be a little more serious, but they will realize within a year that they are losing as well. A decent number of firms that frack in the US may go broke in that time, but that is a minor effect on the economy.

In other words, I don’t think the two scares are really that scary in the intermediate-term.

I do think there might be some similarities of last week to what happened in October 1987. My only question is where forced selling was going on? Risk-parity funds? Hedging gone awry? Difficult to tell, and I haven’t seen anything definite, but the implied volatility of last week rivaled that of October 2008.

Throughout the week I added to stock positions for my clients and me, slowly, but enough to raise equity levels a few percent. That doesn’t sound like much, but when your equity percentage is falling in a bear market it takes thought to decide where to go when buying amid carnage.

I had fairly high cash positions for the strategies that I run. Though many thought differently, I thought there was an alternative to stocks — cash and high-quality bonds. In the bear phase, they definitely don’t lose as much as stocks.

But at present, stocks are offering more competition versus bonds. My stock model forecasts 5.25%/year returns for stocks over the next 10 years. That’s a lot different than a month ago, when that figure was 2.2%, and the Barclays’ Aggregate had a higher yield.

I’m not going nuts here. I have schedules for stock exposure for my two main strategies, and I will adjust as the markets go up and down. 5.25%/year still isn’t that great, but it was worth adding a little more to stocks, especially as cash yields decline further.

One final note, always worth remembering: the nature of rallies in a bear market is that they are sharp and short, as hope gets overwhelmed by the crisis du jour. When the rallies become longer and flatter, and credit risks seem modest, that is what a bull market is like.

One final note, maybe not worth remembering: when will the marginal buyers of Treasury notes and bills get tired? Now that’s a risk that would really shake things up.

Photo Credit: theblackdog2071 || Remember, if some from the sidelines come onto the field, an equal number of others have to leave.

Anytime you hear a bull or bear argument about cash on the sidelines, understand that it is bogus. Ordinary trading does not add or subtract cash on the sidelines, excluding commissions.

If bulls are more motivated to buy, then stock prices go up as they buy, and cash moves into the hands of those they bought from, who were less bullish. If bears are more motivated to sell, then stock prices go down as they sell, and they receive cash from those they bought from, who were less bearish.

In both cases, the amount of cash on the sidelines does not change. Cash moves the opposite direction of shares.

So, when does cash enter the market?

• IPOs
• Rights offerings
• Employee stock options plans are tricky as shares are potentially created, and sometimes some cash comes back to the corporation.
• Employee stock purchase plans or grants are also tricky. Shares are issued, and sometimes cash come back to the corporation.

With the employee benefits, note that the employees may get slightly lower wages than if the benefit was not there.

When does cash exit the market?

• Buybacks
• Acquisitions of companies where cash is a component of the transaction

When cash enters the market, shares are created and cash goes into corporate coffers. When cash exits the market. shares are bought into corporate coffers, and cash exits the corporations.

As such, don’t listen to cash on the sidelines arguments. There is always cash on the sidelines. The question is whether new companies are being created, and whether companies are being consumed, and what the relative profitability levels are.

Note to readers: after the initial publication, I modified the lists to take out dividends, as no stock gets issued. I added in employee benefits, as the stock share count often rises as a result.

Photo Credit: Free Fergerson || Old & Young — we’re all human

It is often said that young people should invest more in stocks because they have more time to bounce back from bad market environments, and so they should take more risk. There is some merit to that argument.

But young people don’t have to fear inflation so much, because they have more years to earn wages. Older people should fear inflation because they aren’t earning anything more from their labor. If they are investing in bonds, they lose economic value, while with stocks that is less true. Commodities and short debt are helpful regarding inflation, but when inflation is non-existent, they are a dead weight in the portfolio.

I argue this way in order to say that there are good reasons for both the old and the young to own stocks. My personal view is that a constant asset allocation somewhere between 80% stocks and 20% bonds and an even split of 50/50 is optimal for almost everyone, most of the time.

My asset allocation has been near 70/30 for most of my life. Part of the reason for that is so that I can invest more aggressively during crises. I never have to worry about running out of assets. I don’t fear deflation or inflation.

Now to the Present

In the present environment, the stock market is poised to deliver 2.52%/year over the next ten years. You can do better with an investment-grade portfolio of bonds.

Should you reduce stock exposure? Yes, and your bonds should be split between long and short. The long bonds protect against deflation, the short bonds against inflation.

Do I know which risk will come — inflation or deflation? No. But I do know that stocks are stretched, and it will only take a minor crisis to knock them down. As such, add to your pile of safe assets.