Photo Credit: amanda tipton || It may not be foreign, and not an ETF, but it IS a small cap


This should be a short post.  When I like a foreign market because it seems cheap (blood running in the streets), I sometimes buy a small cap ETF or closed-end fund rather than the cheaper large cap version.  Why?

  • They diversify a US-centric portfolio better.  There are several reasons for that:
  • a) the large companies of many countries are often concentrated in the industries that the nation specializes in, and are not diversified of themselves
  • b) the large companies are typically exporters, and the smaller companies are typically not exporters. Another way to look at it is that you are getting exposure to the local economy with the small caps, versus the global economy for the large caps.
  • They are often cheaper than the large caps.
  • Institutional interest in the small caps is smaller.
  • They have more room to grow.
  • Less government meddling risk.  Typically not regarded as national treasures.

Now, the disadvantages are they are typically less liquid, and carry higher fees than the large cap funds.  There is an additional countervailing advantage that I think is overlooked in the quest for lower fees: portfolio composition is important.  If an ETF does the job better than another ETF, you should be willing to pay more for it.

At present I have two of these in my portfolios for clients: one for Russia and one for Brazil.  Overall portfolio composition is around 40% foreign stocks 40% US stocks, 15% ultrashort bonds, and 5% cash.  The US market is high, and I am leaning against that in countries where valuations are lower, and growth prospects are on average better.

Full disclosure: long BRF and RSXJ, together comprising about 4-5% of the weight of the portfolios for me and my broad equity clients.  (Our portfolios all have the same composition.)

The future return keeps getting lower, as the market goes higher


Jeff Bezos has a saying, “Your margin is my opportunity.”  He has found ways to eat the businesses of others by providing the same goods and services at a lower cost.  Now, that makes Amazon more productive and others less productive.  The same is true of other internet-related businesses like Google, Netflix, etc.

And, there is a slight net benefit to the economy from the creative destruction.  Old capital gets recycled.  Malls that are no longer so useful serve lower-margin businesses for locals, become homes to mega-churches, other area-intensive human gatherings, or get destroyed, and the valuable land so near many people gets put to alternative uses that are better than the mall, but not as profitable as the mall prior to the internet.

Laborers get released to other work as well.  They may get paid less than they did previously, but the system as a whole is more productive, profits rise, even as wages don’t rise so much.  A decent part of that goes to the pensions of oldsters — after all, who owns most of the stock?  Indirectly, pension plans and accounts own most of it.  As I have sometimes joked, when there are layoffs because institutional investors representing pension plans  are forcing companies to merge, or become more efficient in other ways, it is that the parents are laying off their children, because there are cheaper helpers that do just as well, and the added profits will aid their deservedly lush retirement, with little inheritance for their children.

It is a joke, though seriously intended.  Why I am mentioning it now, is that a hidden assumption of my S&P 500 estimation model is that the return on assets in the economy as a whole is assumed to be constant.  Some will say, “That can’t be true.  Look at all of the new productive businesses that have been created! The return on assets must be increasing.”  For every bit of improvement in the new businesses, some of the old businesses are destroyed.  There is some net gain, but the amount of gain is not that large in aggregate, and these changes have been happening for a long time.  Technological progress creates and destroys.

As such, I don’t think we are in a “New Era.”  Or maybe we are always in a “New Era.”  Either way, the assumption of a constant return on assets over time doesn’t strike me as wrong, though it might seem that way for a decade or two, low or high.

As it is today, the S&P 500 is priced to deliver returns of 3.24%/year not adjusted for inflation over the next ten years.  At 12/31/2017, that figure was 3.48%, as in the graph above.

We are at the 95th percentile of valuations.  Can we go higher?  Yes.  Is it likely?  Yes, but it is not likely to stick.  Someday the S&P 500 will go below 2000.  I don’t know when, but it will.  There are enough imbalances in the world — too many liabilities relative to productivity, that crises will come.  Debt creates its own crises, because people rely on those payments in the short-run, unlike stocks.

There are many saying that “there is no alternative” to owning stocks in this environment — the TINA argument.  I think that they are wrong.  What if I told you that the best you can hope for from stocks over the next 10 years is 4.07%/year, not adjusted for inflation?  Does 1.24%/year over the 10-year Treasury note really give you compensation for the additional risk?  I think not, therefore bonds, low as they may be, are an alternative.

The top line there is a 4.07%/year return, not adjusted for inflation

If you are happy holding onto stocks, knowing that the best scenario from past history would be slightly over 3400 on the S&P 500 in 2028, then why not buy a bond index fund like AGG or LQD that could virtually guarantee something near that outcome?

Is there risk of deflation?  Yes there is.  Indebted economies are very susceptible to deflation risk, because wealthy people with political influence will always prefer an economy that muddles, to higher taxes on them, inflation, or worst of all an internal default.

That is why I am saying don’t assume that the market will go a lot higher.  Indeed, we could hit levels over 4000 on the S&P if we go as nuts as we did in 1999-2000.  But the supposedly impotent Fed of that era raised short-term rates enough to crater the market.  They are in the process of doing that now.  If they follow their “dot plot” to mid-2019 the yield curve will invert.  Something will blow up, the market will retreat, and the next loosening cycle will start, complete with more QE.

Thus I am here to tell you, there is an alternative to stocks.  At present, a broad market index portfolio of bonds will likely outperform the stock market over the next ten years, and with lower risk.  Are you ready to make the switch, or at least, raise your percentage of safe assets?

Photo Credit: Steve Rotman || Markets are not magic; government economic stimulus is useless with debt so high

Weird begets weird

I said in an earlier piece on this topic:

I use [the phrase] during periods in the markets where normal relationships seem to hold no longer. It is usually a sign that something greater is happening that is ill-understood.  In the financial crisis, what was not understood was that multiple areas of the financial economy were simultaneously overleveraged.

So what’s weird now?

  • Most major government running deficits, and racking up huge debts, adding to overall liability promises from entitlements.
  • Most central banks creating credit in a closed loop that benefits the governments, but few others directly.
  • Banks mostly in decent shape, but nonfinancial corporations borrowing too much.
  • Students and middle-to-lower classes borrowing too much (autos, credit cards)
  • Interest rates and goods and services price inflation stay low in the face of this.
  • Low volatility (until now)
  • Much speculative activity in cryptocurrencies (large percentage on a low base) and risk assets like stocks (smaller percentage on a big base)
  • Low credit spreads

No one should be surprised by the current market action.  It wasn’t an “if,” but a “when.”  I’m not saying that this is going to spiral out of control, but everyone should understand that The Little Market that Could was a weird situation.  Markets are not supposed to go up so steadily, which means something weird was fueling the move.

Lack of volatility gives way to a surfeit of volatility eventually.  It’s like macroeconomic volatility “calmed” by loose monetary and fiscal policy.  It allows people to take too many bad chances, bid up assets, build up leverage, and then “BAM!” — possibility of debt deflation because there is not enough cash flow to service the incurred debts.

Now, we’re not back in 2007-9.  This is different, and likely to be more mild.  The banks are in decent shape.  The dominoes are NOT set up for a major disaster.  Risky asset prices are too high, yes.  There is significant speculation in areas Where Money Goes to Die.  So long as the banking/debt complex is not threatened, the worst you get is something like the deflation of the dot-com bubble, and at present, I don’t see what it threatened by that aside from cryptocurrencies and the short volatility trade.  Growth stocks may get whacked — they certainly deserve it from a valuation standpoint, but that would merely be a normal bear market, not a cousin of the Great Depression, like 2007-9.

Could this be “the pause that refreshes?”  Yes, after enough pain is delivered to the weak hands that have been chasing the market in search of easy profits quickly.  The lure of free money brings out the worst in many.

You have to wonder when margin debt is high — short-term investors chasing the market, and Warren Buffett, Seth Klarman, and other valuation-sensitive investors with long horizons sitting on piles of cash.  That’s the grand asset-liability mismatch.  Long-term investors sitting on cash, and short-term investors fully invested if not leveraged… a recipe for trouble.  Have you considered these concepts:

  • Preservation of capital
  • Dry powder
  • Not finding opportunities
  • Momentum gives way to negative arbitrages.
  • Greater fool theory — “hey, who has slack capital to buy what I own if I need liquidity?”

Going back to where money goes to die, from the less mentioned portion on the short volatility trade:

Again, this is one where people are very used to selling every spike in volatility.  It has been a winning strategy so far.  Remember that when enough people do that, the system changes, and it means in a real crisis, volatility will go higher than ever before, and stay higher longer.  The markets abhor free riders, and disasters tend to occur in such a way that the most dumb money gets gored.

Again, when the big volatility spike hits, remember, I warned you.  Also, for those playing long on volatility and buying protection on credit default — this has been a long credit cycle, and may go longer.  Do you have enough wherewithal to survive a longer bull phase?

To all, I wish you well in investing.  Just remember that new asset classes that have never been through a “failure cycle” tend to produce the greatest amounts of panic when they finally fail.  And, all asset classes eventually go through failure.

So as volatility has spiked, perhaps the free money has proven to be the bait of a mousetrap.  Do you have the flexibility to buy in at better levels?  Should you even touch it if it is like a knockout option?

There are no free lunches.  Get used to that idea.  If a trade looks riskless, beware, the risk may only be building up, and not be nonexistent.

Thus when markets are “weird” and too bullish or bearish, look for the reasons that may be unduly sustaining the situation.  Where is debt building up?  Are there unusual derivative positions building up?  What sort of parties are chasing prices?  Who is resisting the trend?

And, when markets are falling hard, remember that they go down double-speed.  If it’s a lot faster than that, the market is more likely to bounce.  (That might be the case now.)  Slower, and it might keep going.  Fast moves tend to mean-revert, slow moves tend to persist.  Real bear markets have duration and humiliate, making weak holders conclude that will never touch stocks again.

And once they have sold, the panic will end, and growth will begin again when everyone is scared.

That’s the perversity of markets.  They are far more volatile than the economy as a whole, and in the end don’t deliver any more than the economy as a whole, but sucker people into thinking the markets are magical money machines, until what is weird (too good) becomes weird (too bad).

Don’t let this situation be “too bad” for you.  If you are looking at the current situation, and think that you have too much in risk assets for the long-term, sell some down.  Preserving capital is not imprudent, even if the market bounces.

In that vein, my final point is this: size your position in risk assets to the level where you can live with it under bad conditions, and be happy with it under good conditions.  Then when markets get weird, you can smile and bear it.  The most important thing is to stay in the game, not giving in to panic or greed when things get “weird.”

This should be a brief article.  I remember back in 1999 to early 2000 how P&C insurance stocks, and other boring slower-growth industries were falling in price despite growing net worth, and reasonable earnings.  I was working for The St. Paul at the time (a Property & Casualty Insurer), and for an investment actuary like me, who grew up in the life insurance business it was interesting to see the different philosophy of the industry.  Shorter-duration products make competition more obvious, making downturns uglier.

The market in 1999-2000 got narrow.  Few groups and few stocks were leading the rise.  Performance-conscious investors, amateur and professional, servants of the “Church of What’s Working Now,” sold their holdings in the slower growing companies to buy the shares of faster growing companies, with little attention to valuation differences.

I remember flipping the chart of the S&P 1500 Supercomposite for P&C Insurers, and laying it on top of an index of the dot-com stocks.  They looked like twins separated at birth, except one was upside down.

When shares are sold, they don’t just disappear.  Someone buys them.  In this case, P&C firms bought back their own stock, as did industry insiders, and value investors — what few remained.  When managed well, P&C insurance is a nice, predictable business that throws of reliable profits, and is just complex enough to scare away a decent number of potential investors.  The scare is partially due to the effect that it is not always well-managed, and not everyone can figure out who the good managers are.

So shares migrate.  Those that fall in the midst of a rally, despite decent economics, get bought by long-term investors.  The hot stocks get bought by shorter-term investors, who follow the momentum.  This continues until the gravitational effects of relative valuations gets too great — the cash flows of the hot stocks do not justify the valuations.

Then performance reverts, and what was bad becomes good, and good bad, but as with almost every investment strategy you have to survive until the turn, and if the assets run from the prior migration, it is cold comfort to be right eventually.

As an aside, this is part of what fuels dollar-weighted returns being lower than time-weighted returns.  The hot money migration buys high, and sells low.

Thus I say to value investors, “Persevere.  I can’t tell you when the turn will be, but it is getting closer.”

Photo Credit: jessica wilson {jek in the box}


It’s been a while since we last corresponded.  I hope you and your family are well.

Quick investment question. Given the sharp run-up in equities and stretched valuations, how are you positioning your portfolio?

This in a market that seemingly doesn’t go down, where the risk of being cautious is missing out on big gains.

In my portfolio, I’m carrying extra cash and moving fairly aggressively into gold. Also, on the fixed income side, I’ve been selling HY [DM: High Yield, aka “Junk”] bonds, shortening duration, and buying floating rate bank loans.

Please let me know your thoughts.



Dear JJJ,

Good to hear from you.  It has been a long time.

Asset allocation is always a marriage between time horizon (when is the money needed for spending?) and expected returns, with some adjustment for risk.  I suspect that you are like me, and play for a longer horizon.

I’m at my lowest equity allocation in 17 years.  I am at 65% in equities.  If the market goes up another 4-5%, I am planning on peeling of 25% of that to go into high quality bonds.  Another 20% will go if the market rises 10% from here.  At present, the S&P 500 offers returns of just 3.4%/year for the next ten years unadjusted for inflation.  That’s at the 95th percentile, and reflects valuations of the dot-com bubble, should we rise that far.

The stocks that I do have are heading in three directions: safer, cyclical and foreign.  I’m at my highest level for foreign stocks, and the companies all have strong balance sheets.  A few are cyclicals, and may benefit if commodities rise.

The only thing that gives me pause regarding dropping my stock percentage is that a lot of “friends” are doing it.  That said, a lot of broad market and growth investors are making “new era” arguments.  That gives me more comfort about this.  Even if the FAANG stocks continue to do well, it does not mean that stocks as a whole will do well.  The overall productivity of risk assets is not rising.  People are looking through the rearview mirror, not the windshield, at asset returns.

I can endorse some gold, even though it does nothing.  Nothing would have been a good posture back in the dot-com bubble, or the financial crisis.  Commodities are undervalued at present.  I can also endorse long Treasuries, because I am not certain that inflation will run in this environment.  When economies are heavily indebted they tend not to inflate, except as a last resort.  (The wealthy want to protect their claims against the economy.  The Fed generally helps the wealthy.  Those on the FOMC are all wealthy.)

I also hold more cash than normal.  The three of them, gold, cash and long Treasury bonds form a good hedge together against most bad situations.

The banks are in good shape, so the coming troubles should not be as great as during the financial crisis, as long as nothing bizarre is going on in the repo markets.

That said, I would be careful about bank debt.  Be careful about the covenants on the bank debt; it is not as safe as it once was.  I don’t own any now.

Aside from that, I think you are on the right track.  The most important question is how much you have invested in risk assets.  Prudent investors should be heading lower as the market rises.  It is either not a new era, or, it is always a new era.  Build up your supply of safe assets.  That is the main idea.  Preserve capital for another day when risk assets offer better opportunities.

Thanks for writing.  If you ever make it to Charm City or Babylon, let me know, and we can have lunch together.



Credit: Roadsidepictures from The Little Engine That Could By Watty Piper Illustrated By George & Doris Hauman c. 1954


I wish I could have found a picture of Woodstock with a sign that said “We’re #1!”  Snoopy trails behind carrying a football, grinning and thinking “In this corner of the backyard.”

That’s how I feel regarding all of the attention that has been paid to the S&P being up every month in 2017, and every month for the last 14 months.  These have never happened before.

There’s a first time for everything, but I feel that these records are more akin to the people who do work for the sports channels scaring up odd statistical facts about players, teams, games, etc.  “Hey Bob, did you know that the Smoggers haven’t converted a 4th and 2 situation against the Robbers since 1998?”

Let me explain.  A month is around 21 trading days.  There is some variation around that, but on average, years tend to have 252 trading days.  252 divided by 12 is 21.  You would think in a year like 2017 that it must  have spent the most time where 21-day periods had positive returns, as it did over each month.

Since 1950, 2017 would have come in fourth on that measure, behind 1954, 1958 and 1995.  Thus in one sense it was an accident that 2017 had positive returns each month versus years that had more positive returns over every 21 day period.

How about streaks of days where the 21-day trialing total return never dropped below zero (since 1950)?  By that measure, 2017 would have tied for tenth place with 2003, and beaten by the years 1958-9, 1995, 1961, 1971, 1964, 1980, 1972, 1965, and 1963.  (Note: quite a reminder of how bullish the late 1950s, 1960s and early 1970s were.  Go-go indeed.)

Let’s look at one more — total return over the whole year.  Now 2017 ranks 23rd out of 68 years with a total return of 21.8%.  That’s really good, don’t get me wrong, but it won’t deserve a mention in a book like “It Was a Very Good Year.”  That’s more than double the normal return, which means you’ll have give returns back in the future. 😉

So, how do I characterize 2017?  I call it The Little Market that Could.  Why?  Few drawdowns, low implied volatility, and skepticism that gave way to uncritical belief.  Just as we have lost touch with the idea that government deficits and debts matter, so we have lost touch with the idea that valuation matters.

When I talk to professionals (and some amateurs) about the valuation model that I use for the market, increasingly I get pushback, suggesting that we are in a new era, and that my model might have been good for an era prior to our present technological innovations.  I simply respond by saying “The buying power has to come from somewhere.  Our stock market does not do well when risk assets are valued at 40%+ of the share of assets, and there have been significant technological shifts over my analysis period beginning in 1945, many rivaling the internet.”  (Every era idolizes its changes.  It is always a “new era.”  It is never a “new era.”)

If you are asking me about the short-term, I think the direction is up, but I am edgy about that.  Forecast ten year returns are below 3.75%/year not adjusted for inflation.  Just a guess on my part, but I think all of the people who are making money off of low volatility are feeding the calm in the short-run, while building up a whiplash in the intermediate term.

Time will tell.  It usually does, given enough time.  In the intermediate-term, it is tough to tell signal from noise.  I am at my maximum cash for my equity strategy accounts — I think that is a prudent place to be amid the high valuations that we face today.  Remember, once the surprise comes, and companies scramble to find financing, it is too late to make adjustments for market risk.

Another quarter goes by, the market rises further, and the the 10-year forward return falls again.  Here are the last eight values: 6.10%, 6.74%, 6.30%, 6.01%, 5.02%, 4.79%, and 4.30%, 3.99%.  At the end of September 2017, the figure would have been 4.49%, but the rally since the end of the quarter shaves future returns down to 3.99%.

At the end of June the figure was 4.58%.  Subtract 29 basis points for the total return, and add back 12 basis points for mean reversion, and that would leave us at 4.41%.  The result for September month-end was 4.49%, so the re-estimation of the model added 8 basis points to 10-year forward returns.

Let me explain the adjustment calculations.  In-between quarterly readings, price movements shave future returns the same as a ten-year zero coupon bond.  Thus, a +2.9% move in the total return shaves roughly 29 basis points off future returns. (Dividing by 10 is close enough for government work, but I use a geometric calculation.)

The mean-reversion calculation is a little more complex.  I use a 10-year horizon because that is the horizon the fits the data best.  It is also the one I used before I tested it.  Accidents happen.  Though I haven’t talked about it before, this model could be used to provide shorter-run estimates of the market as well — but the error bounds around the shorter estimates would be big enough to make the model useless. It is enough to remember that when a market is at high valuations that corrections can’t be predicted as to time of occurrence, but when the retreat happens, it will be calamitous, and not orderly.

Beyond 10-years, though, the model has no opinion.  It is as if it says, past mean returns will occur.  So, if we have an expectation of a 4.58% returns, we have one 4.58%/yr quarter drop of at the end of the quarter, and a 9.5% quarter added on at the end of the 10-year period. That changes the quarterly average return up by 4.92%/40, or 12.3 basis points.  That is the mean reversion effect.

Going Forward

Thus, expected inflation-unadjusted returns on the S&P 500 are roughly 3.99% over the next ten years.  That’s not a lot of compensation for risk versus investment-grade bonds.  We are at the 94th percentile of valuations.

Now could we go higher?  Sure, the momentum is with us, and the volatility trade reinforces the rise for now.  Bitcoin is an example that shows that there is too much excess cash sloshing around to push up the prices of assets generally, and especially those with no intrinsic value, like Bitcoin and other cryptocurrencies.

Beyond that, there are not a lot of glaring factors pushing speculation, leaving aside futile government efforts to stimulate an already over-leveraged economy.  It’s not as if consumer or producer behavior is perfectly clean, but the US Government is the most profligate actor of all.

And so I say, keep the rally hats on.  I will be looking to hedge around an S&P 500 level of 2900 at present.  I will be watching the FOMC, as they may try to invert the yield curve again, and crash things.  They never learn… far better to stop and wait than make things happen too fast.  But they are omnipotent fools.  Maybe Powell will show some non-economist intelligence and wait once the yield curve gets to a small positive slope.

Who can tell?   Well, let’s see how this grand experiment goes as Baby Boomers arrive at the stock market too late to save for retirement, but just in time to put in the top of the equity market.  Though I am waiting until S&P 2900 to hedge, I am still carrying 19% cash in my equity portfolios, so I am bearish here except in the short-run.

PS — think of it this way: it should not have gone this high, therefore it could go higher still…

Don’t look at the left side of the chart on an empty stomach


This will be a short post.  At present the expected 10-year rate of total return on the S&P 500 is around 4.05%/year.  We’re at the 94th percentile now.  The ovals on the graph above are 68% and 95% confidence intervals on what the actual return might be.  Truly, they should be two vertical lines, but this makes it easier to see.  One standard deviation is roughly equal to two percent.

But, at the left hand side of the graph, things get decidedly non-normal.  After the model gets to 2.5% projected returns, presently around 3100 on the S&P 500, returns in the past have been messy.  Of course, those were the periods from 1998-2000 to 2008-2010.  But aside from one stray period starting in 1968, that is the only time we have gotten to valuations like this.

My last piece hinted at this, but I want to make this a little plainer.  For sound effects while reading this, you could get your children or grandchildren to murmur behind you “We know it can’t. We know it can’t.” while you consider whether the market can deliver total returns of 7%/year over the next 10 years.

There are few if any things that remain permanently valid insights of finance.  Anything, even good strategies, can be overdone.  Even stable companies can be overlevered, until they are no longer stable.

In this case, it is buying the dips, buying a value-weighted cross section of the market, and putting your asset allocation on autopilot.  Set it and forget it.  Add in companies always using spare capital to buy back shares, and maxing out debts to fit the liberal edge of your preferred rating profile.

These have been good ideas for the past, but are likely to bite in the future.  Value is undervalued, safety is undervalued, and the US is overvalued.  A happy quiet momentum has brought us here, and for the most part it has been calm, not wild.  Individually prudent actions that have paid off in the past are likely to prove imprudent within three years, particularly if the S&P 500 rises 10-15% more in the next year.

People have bought into the idea that market timing never matters.  I agree with the idea that it usually doesn’t matter, and that it is usually is a fool’s game to time the market.  That changes when the 10-year forward forecast of market returns gets low, say, around 3%/year.

Remember, the market goes down double-speed.  Just because the 10-year returns don’t lose much, doesn’t mean that there might not be better opportunities 3-5 years out, when the market might offer returns of 6%/year or higher.

Also, remember that my data set begins in 1945.  I wish I had the values for the 1920s, because I expect they would be even further to the left, off the current graph, and well below the bottom of it.

This isn’t the most nuts that things can be.  In fact, it is very peaceful and steady — the cumulative effect of many rational decisions based off of what would have worked best in the past, in the short-run.

As a result, I am looking 10 years into the future, and slowly scaling back my risks as a result.  If the market moves higher, that will pick up speed.

Picture Credit: Roadsidepictures from The Little Engine That Could By Watty Piper, Illustrated By George & Doris Hauman | That said, for every one that COULD, at least two COULDN’T


So what do you think of the market?  Why are both actual and implied volatility so low?  Why are the moves so small, but predominantly up?  Is this the closest impression of the Chinese Water Torture that a stock market can pull off?

Why doesn’t the market care about external and internal risks?  Doesn’t it know that we have divisive, seemingly incompetent President who looks like he doesn’t know how to do much more than poke people in the eyes, figuratively?  Doesn’t it know that we have a divided, incompetent Congress that can’t get anything of significance done?

Leaving aside the possibility of a war that we blunder into (look at history), what if the inability of Washington DC to do anything is a plus?  Government on autopilot for four years, maybe eight if we decide we are better of without change — is that a plus or minus?  Just ignore the noise, Trump, other politicians, media… ahh, the quiet could be nice.

Then think about Baby Boomers showing up late for retirement, and wondering what they are going to do.  Then think about their surrogates, the few who still have defined benefit pension plans.  What are they going to do?  Say that the rate that they are targeting for investment earnings is 7%/year forever.  Even if my model for investment returns is wrong in a pessimistic way — i.e., my 4% nominal should be 6%/year nominal, you still can’t hit your funding target.  As for those with defined contribution plans, when you are way behind, even contributing more won’t do much unless investment earnings provide some oomph.

I am personally not a fan of TINA — “there is no alternative” to stocks in the market, but I recognize the power of the idea with some.  It is my opinion that more people and their agents will run above average risks in order to try to hit an unlikely target rather than lock in a loss versus what is planned.  Most will “muddle in the middle” taking some risk even with a high market, and realizing that they aren’t going to get there, but maybe a late retirement is better than none.

That’s the power of bonds returning 3% at best over the forecast horizon, unless interest rates jump, and then we have other problems, like risk assets repricing.  If you are older, almost no plan is achievable at reasonable cost if you are coming to the game now, rather than starting 15+ years ago.

And so I come to “the little market that could…” for now.  My view is that those with retirement obligations to fund are bidding up the market now.  That does two things.  Shares of risk assets (stocks) move from the hands of stronger investors to weaker investors, while cash flows the opposite direction.  In the process, prices for risk assets get bid up relative to their future free cash flows.

Unlike “the little engine that could,” the little market that could has climbed some small hills relative to the funding targets that investors need. Ready for the Himalayas?  The trouble with those targets is that regardless of what the trading price of the risk assets is, the cash flows that they produce will not support those targets.

Thought experiment: imagine that the stock market was gone and all the shares we held were of private companies that were difficult and expensive to trade.   Pension plans would estimate ability to meet targets by looking at forecasts of the underlying returns of their private investments, rather than a total return measure.

Well, guess what?  In the long run, the returns from public stock investments reflect just that — the distributable amount of earnings that they generate, regardless of what a marginal bidder is willing to pay for them at any point in time.  Stocks aren’t magic, any more than the firms that they represent ownership in.

So… we can puzzle over the current moment and wonder why the market is behaving in a placid, slow-climbing manner.  Or, we can look at the likely inadequacy of asset cash flows versus future demands for those cash flows for retirement, etc.  Personally, I think they are related as I have stated above, but the second view, that asset returns will not be able to fund all planned retirement needs is far more certain, and is one mountain that “the little market that could” cannot climb.

Thus, consider the security of your own plans, and adjust accordingly.  As I commented recently, for older folks with enough assets, maybe it is time to lock in gains.  For others, figure out what adjustments and compromises will need to be made if your assets can’t deliver enough.

Tough stuff, I know.  But better to be realistic about this than to be surprised when funding targets are not reached.


Recently I read Jonathan Clements’ piece Enough Already.  The basic idea was to encourage older investors who have made gains in the risk assets, typically stocks, though it would apply to high yield bonds and other non-guaranteed investments that are highly correlated with stocks.  His pithy way of phrasing it is:

If I have already won the game, why would I keep playing?

His inspiration for the piece stems from a another piece by William Bernstein [at the WSJ] How to Tell if Your Retirement Nest Egg Is Big Enough.  He asked a question like this (these are my words) back in early 2015, “Why keep taking risk if your performance has been good enough to let you reduce risk and live on the assets, rather than run the possibility of a fall in the market spoiling your ability to retire comfortably?”

Decent question.  If you are young enough, your time horizon is long enough that you can ignore it.  But if you are older, you might want to consider it.

Here’s the problem, though.  What do you reinvest in?  My article How to Invest Carefully for Mom took up some of the problem — if I were reducing exposure to stocks, I would invest in high quality short and long bonds, probably weighted 50/50 to 70/30 in that range.  Examples of tickers that I might consider be MINT and TLT.  Trouble is, you only get a yield of 2% on the mix.  The short bonds help if there is inflation, the long bonds help if there is deflation.  Both remove the risk of the stock market.

I’m also happier in running with my mix of international stocks and quality US value investments versus holding the S&P 500, because foreign and value have underperformed for so long, almost feels like 1999, minus the crazed atmosphere.

Now, Clements at the end of the exercise doesn’t want to make any big changes.  He still wants to play on at the ripe old age of 54.  He is concerned that his nest egg isn’t big enough.  Also, he thinks stocks will return 5-6%/year over the long haul (undefined), versus my model that says 2-6%/year over the next ten years.

What would I say?  I would say “do half.”  Whatever the amount you would cut from stocks to move to bonds if you were certain of it, do half of it.  If disaster strikes, you will pat yourself on the back for doing something.  If the market rallies further, you will be glad you didn’t do the whole thing.

What’s that, you say?  What am I doing?  At age 56, I am playing on, but 10-12% higher in the S&P 500, and I will hedge.  At levels like that future market outcomes are poor under almost every historical scenario, and even if the market doesn’t seem nuts in terms of qualitative signals, the amount you leave on the table is piddly over a 10-year horizon.  If I see more genuine nuttiness beyond certain logic-free zones in the market, I could act sooner, but for now, like Jonathan, I play on.

Full disclosure: long MINT and TLT for me and my fixed income clients