Image Credit: Aleph Blog || Recently I was talking with a younger pastor friend of mind who is pretty bright. I have known him since he was a teenager. He said to me, “I have concluded the the stimulus actions of the Fed and the Government benefit the rich predominantly.” I told him that he was certainly correct.

Sorry for being late with this update. Have you ever considered the idea that trying to avoid depressions encourages cronyism — the government favors the rich through QE and deficit spending? QE inflates assets and commodity prices. The rich benefit from the first, and the poor are hurt by the second. The same applies to most government spending programs. The rich employ accountants and lawyers, and find ways to benefit from changes in the law, and lobby for exceptions to policies that seem to favor “soak the rich.”

The main thing supporting the market as a whole is low interest rates. And as the Fed suggested they are thinking of tightening policy two years from now, short rates rose and long rates fell. Markets anticipate. I can tell you that if the yield curve gets very flat, the Fed won’t do much tightening, unless they are nuts, which is occasionally true.

On March 31st, the S&P 500 was priced to return 0.07%/year over the next 10 years. Today, that figure is -0.67%. At the close on Monday, that figure was -1.03%. These figures do not take account of inflation, so it indicates real annual returns between negative 2 and negative 3 percent.

The only period that compares with this is the dot-com bubble. If we want to hit new valuation records, 4450 on the S&P would exceed the valuations of the dot-com bubble. Thus when I hear investment banks call for 4800 on the S&P 500 in 2022, I think they are just doing what profits them. They push people to take on more risk, particularly near market tops. If ordinary people get more aggressive here, some of the investment banks will take the opposite side of the trade, so they can profit as the market falls. Those at r/wallstreetbets are being the dumb money that the investment banks will eventually profit from.

Investment banks make a lot of money from offering the shares of speculative firms during a bull market. Then they run for cover faster than retail clients can during the transition to a bear market.

In he past, valuation levels like the present have always led to losses 10 years out. Unless your portfolio is vastly different from the market as a whole, you will suffer these losses. Only if you buy the stocks that have not done well over the past 5 years do you have a chance of producing positive returns. It is exactly parallel to the dot-com bubble. You must avoid large cap growth.

At some point in time the S&P 500 will have a value under 3000. The more interesting question is whether it will have a value under 2000. I don’t think it will ever reach three digits again, unless we get significant deflation.

This is an ugly situation. Pare back risk positions. Focus on undervalued companies in industries that will not go out of fashion. Add investment grade bonds to your portfolio to lose less in real terms than you will get from investing in the S&P 500 index.

Just as no one thought they would lose in late 1999, so it is now. Be aware, and reduce exposure to large cap growth stocks. Replace them with value stocks or investment grade bonds.

Image Credit: Aleph Blog || Running on empty, running dry… what will happen when obligations can’t be met?

Welcome to Blunderland, boys and girls. At the end of the fourth quarter, the S&P 500 was priced to return 1.29%/yr for the next ten years, with no adjustment for inflation. You might say, “But David, you’ve reported levels that low in the past, and you were concerned, but you never said ‘Blunderland.’”

True, but the market has rallied further since the end of the quarter, and the level of the S&P 500 now is priced to return 0.54%/yr for the next ten years, with no adjustment for inflation. That’s in the 98th percentile of valuations. Another reason I didn’t say ‘Blunderland’ in the past was that we did not have a situation before where the only values comparable came from core of the the dot-com bubble. Thus, welcome to Blunderland.

Now, the valuation levels of the Blunderland era lasted for 2 years and 3 months, from the beginning of the fourth quarter of 1998 to the end of the fourth quarter of 2000. It was a period where monetary policy was extremely loose, before tightening enough to send the market into a tailspin, even as many claimed that interest rates have no effect on growth stocks.

Okay, I’m done imitating my last article on the topic. We are in the midst of a full-fledged mania. What is different no versus the dot-com bubble was that value only took off as the market began to implode. At present, value is outperforming even as valuations are at nosebleed levels. And for any who care, you would be better off buying a 10-year Treasury Note than buying the S&P 500 at present. There is an alternative… to lose less in purchasing power terms.

Of course, you could do what I did in mid-2000, and what I am doing now… own a bunch of cheap stocks that have been neglected over the last ten years, and hold them through the coming disaster. Many of them are cyclicals so they like inflation. Others are life insurers — they want long term interest rates to rise.

But will that be the path? Who can tell? And even with that path, I had gains in 2000 and 2001, and bruising losses in 2002, before rocketing out of it in 2003.

It will be different this time. It is always different. That said, valuations are very high. If you are wealthy and can pay on credit default swaps, no is the time to do it. If you are at the low end of the 1% like me, it is time to own more bonds and safer equities.

Yes, there are other possibilities. You could:

• Short SPY
• Buy puts on SPY
• Buy puts on HYG and JNK
• Short QQQ
• Buy puts on QQQ

You get the idea. If I were to do any of the above I would buy puts on HYG and JNK. I’m not doing that at present. This is the poor man’s way of paying on credit default swaps.

Yes, this is one of those rare times where you will lose is you own the broad market indexes like the S&P 500. note that the above is prices only, and does not include dividends. I think anyone invested in the S&P 500 will earn a tiny amount over the next ten years, and less than the ten-year Treasury Note or the CPI.

I can make this “advice” which is not investment advice in the technical sense simple: sell growth stocks and move to value. Sell stocks generally, and move to bonds.

Now I am not doing that. I am sticking with my cheap stocks with strong balance sheets, in industries that have lagged. And i have roughly 30% of my portfolio in investment grade bonds.

This is a good position to be in amid a mania. Maybe you should imitate me, lest you find that accidentally you became a financial maniac.

Image Credit: Aleph Blog || No, abnormal monetary has many significant costs, not the least of which is an asset bubble that feeds a debt bubble.

Welcome to Wonderland, boys and girls. At the end of the third quarter, the S&P 500 was priced to return 2.92%/yr for the next ten years, with no adjustment for inflation. You might say, “But David, you’ve reported levels that low in the past, and you were concerned, but you never said ‘Wonderland.'”

True, but the market has rallied further since the end of the quarter, and the level of the S&P 500 now is priced to return 1.79%/yr for the next ten years, with no adjustment for inflation. That’s in the 97th percentile of valuations. Another reason I didn’t say ‘Wonderland’ in the past was that there were a few values in the 1960s that were comparable to valuations. Now the only comparables are from the dot-com bubble. Thus, welcome to Wonderland.

Now, the valuation levels of the Wonderland era lasted for 3 years and 3 months, from the end of the first quarter of 1998 to the end of the second quarter of 2001. It was a period where monetary policy was extremely loose, before tightening enough to send the market into a tailspin, even as many claimed that interest rates have no effect on growth stocks.

Let me post the rest of my graphs, and I will finish my thoughts.

Note that we are considerably closer to the maximum valuation levels than to the minimum levels. If we wanted to create a new maximum level, we would have to rally 19.4% from present levels.

Note: this model fits reality a lot more tightly than most models… but it is not a short run model. It is very accurate over ten years. My, but this model seems to be forecasting another “lost decade.”

There are only seven values from history that compare with present levels. I choose scenarios where the expected return then was within 1%/year of the expected return now. Now, the estimate for where the S&P 500 will be 10 years from now is 3,555, which is lower than today, but given a 2% dividend yield, that still gives a 1.79%/year total return.

But empirically, the seven comparable scenarios give a lower total return of 0.92%/year for the next ten years. Admittedly, this is the “Law of Small Numbers.” (Would that academic finance writers would have that humility when analyzing models that have only twenty years of data, which means their results might just be an anomaly of the short period — which is true of most ESG studies.)

So now that you have had a tour of Wonderland, what should you do? Perhaps you should buy some 10-year single-A corporate bonds. You will likely get more return and your risk will be a lot lower. And who knows? If there is another market crisis, which is likely given abnormal monetary and fiscal policy, with high valuations, you might get a chance to buy stocks a lot lower. The same logic applies to gold, or even T-bills.

I’m not saying move everything immediately. After all, there is momentum, so things can go higher still. The odds of getting new highs are highest near new highs. Besides, we haven’t had any significant bankruptcies that weren’t C19-related.

But eventually, the tide will turn. Me? I’ve already lightened up, and have dry powder to buy good companies at moderate prices. As in the dot-com bubble, value investing finally turned after so many threw in the towel. I own companies that make good earnings relative to their prices, and have strong balance sheets. They will prosper better than most through tough scenarios.

They do ring a bell during the topping process. The trouble is that most put in earplugs as a result of the festivities so that they can ignore the naysayers. As such, I say to you, make adjustments before you get scared and wish you had done it earlier.

That’s all for now.

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.

Mmmm… it’s been 18 months since I did an update on this model. Here was the last one. The old article was written on 14 March 2018, and it said:

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.

https://alephblog.com/2018/03/14/estimating-future-stock-returns-december-2017-update/

And so now I say to you: As it is today, the S&P 500 is priced to deliver returns of 3.39%/year not adjusted for inflation over the next ten years.? At 6/30/2019, that figure was 3.61%, as in the graph above.

It’s fascinating how little changed over that period of time. SInce the last article, the S&P 500 returned 8.8% on a price basis with around 3% of dividends over the 18 month period. The ratio of their assets the US investors keep in stocks has also barely changed, going from 43,8% to 44,2%, (Geek note: the Fed’s estimate of that for prior periods shifts over time — today they estimate that ratio for 12/31/2017 to be 44.6%. This makes comparability of results and backtesting difficult.)

Using the ten scenarios from the past where the model was expecting returns between 2.39% and 4.39%, here’s what the results look like for the future on a probabilistic basis:

The ten scenarios came from the following years: 1968, 1969, 1997, 2001 and 2002. The high scenarios are 1997. The low scenarios come from 2001-2002.

My point forecast and the median value are close to each other. That is usually true.

So, should we be excited to earn 3.39%/yr for 10 years? Preserving capital would be a good thing, but many pension systems need a lot more than that. 3.39%. 3.39% is what an average low Single-A or High-BBB/Baa would yield in this environment.

Not knowing what inflation or deflation will be like, it would be difficult to tell whether the bond or stock would be riskier, even if I expected 3.39% from each on average. Given the large debts of our world, I lean to deflation, favoring the bond in this case.

Still, it’s a tough call because with forecast returns being so low, many entities will perversely go for the stocks because it gives them some chance of hitting their overly high return targets. If this is the case, there could be some more room to run for now, but with nasty falls after that. The stock market is a weighing machine ultimately, and it is impossible to change the total returns of the economy. Even if an entity takes more risk, the economy as a whole’s risk profile doesn’t change in the long run.

In the short run it can be different if strongly capitalized entities are taking less risk and and weakly capitalized entities are taking more risk — that’s usually bearish. Vice-versa is usually bullish.

Anyway, give this some thought. Maybe things have to be crazier to put in the top. At least in this situation, bonds and stocks are telling the same story, unlike 1987 or 2000, where bonds were more attractive. Now, alternatives are few.