Photo Credit: David Lofink || Most things in life have limits, the challenge is knowing where they are
I was at a conference a month ago, and I found myself disagreeing with a presenter who worked for a second tier ETF provider. The topic was something like “Ten trends in asset management for the next ten years.” The thought that ran through my mind was “Every existing trendy idea will continue. These ideas never run into resistance or capacity limits. If some is good, more is better. Typical linear thinking.”
Most permanent trends follow a logistic curve. Some people call it an S-curve. As a trend progresses, there are more people who see the trend, but fewer new people to hop onto the trend. It looks like exponential growth initially, but stops because as Alexander the Great said, “There are no more worlds left to conquer.”
Even then, not every trend goes as far as promoters would think, and sometimes trends reverse. Not everyone cares for a given investment idea, product or service. Some give it up after they have tried it.
These are reasons why I wrote the Problems with Constant Compound Interest series. No tree grows to the sky. Time and chance happen to all men. Thousand year floods happen every 50 years or so, and in clumps. We know a lot less than we think we do when it comes to quantitative finance. Without a doubt, the math is correct — trouble is, it applies to a world a lot more boring than this one.
I have said that the ES portion of ESG is a fad. Yet, it has seemingly been well-accepted, and has supposedly provided excess returns. Some of the historical returns may just be backtest bias. But the realized returns could stem from the voting machine aspect of the market. Those getting there first following ESG analyses pushed up prices. The weighing machine comes later, and if the cash flow yields are insufficient, the excess returns will vaporize.
In this environment, I see three very potent limits that affect the markets. The first one is negative interest rates. There is no good evidence that negative interest rates stimulate economic growth. Ask those in nations with negative interest rates how much it has helped their stock markets. Negative interest rates help the most creditworthy (who don’t borrow much), and governments (which are known for reducing the marginal productivity of capital).
It is more likely that negative rates lead people to save more because they won’t earn anything on their money — ergo, saving acts in an ancient mold — it’s just storage, as I said on my piece On Negative Interest Rates.
Negative interest rates are a good example of what happens you ignore limits — it doesn’t lead to prosperity. It inhibits capital formation.
Another limit is that stock prices have a harder time climbing as they draw closer to the boundary where they discount zero returns for the next ten years. That level for the S&P 500 is around 3840 at present. To match the all time low for future returns, that level would be 4250 at present.
Here’s another few limits to consider. We have a record amount of debt rated BBB. We also have a record amount of debt rated below BBB. Nonfinancial corporations have been the biggest borrowers as far as private entities go since the financial crisis. In 2008, nonfinancial corporations were one of the few areas of strength that the bond markets had.
One rule of thumb that bond managers use if they are unconstrained is that the area of the bond market that will have the worst returns is the one that has grown the most during the most recent bull part of the cycle. To the extent that it is possible, I think it is wise to upgrade corporate creditworthiness now… and that applies to bonds AND stocks.
Of course, the other place where the debt has grown is governments. The financial crisis led them to substitute public for private debt in an effort to stimulate their economies. The question that I wonder about, and still do not have a good answer for is what will happen in a fiat money world to overleveraged governments.
Everything depends on the policies that they pursue. Will the deflate — favoring the rich, or inflate, favoring the poor? No one knows for sure, though the odds should favor the rich over the poor. There is the unfounded bias that the Fed botched it in the Great Depression, but that is the bias of the poor versus the rich. The rich want to see the debt claims honored, and don’t care what happens to anyone else. The Fed did what the rich wanted in the Great Depression. Should you expect anything different now? I don’t.
As such, the limits of government stimulus are becoming evident. The economic recovery since the financial crisis is long and shallow. The rich benefit a lot, and wages hardly rise. Additional debt does not benefit the economy much at all. We should be skeptical of politicians who want to borrow more, which means all of them.
One of the greatest limits that exists is that of defined benefit pension plans vainly trying to outperform the rate that their risky assets are expected to earn. They are way above the level expected for the next ten years, which is less than 3%. Watch the crisis unfold over the next 15 years.
Finally, consider the continued speculation that shorts equity volatility. You would think that after the disaster that happened in 2018 that shorting volatility would have been abandoned, but no. The short volatility trade is back, bigger and badder than ever. Watch out for when it blows up.
Summary
Be ready for the market decline when it comes. It may begin with a blowout with equity volatility, but continue with a retreat from risky stocks that offer low prospective returns.
I am no macroeconomist but would inflation not favor the rich, seeing as they hold a lower proportion of their net worth in monetary assets than the poorer strata?
Strongly agree with the skepticism toward government leverage, public discourse on debt is quite unsophisticated.
Poorer people are typically more indebted. Inflation reduces the real value of their debts. Also, most of their future economics comes from their labor — inflation does not eat at that. Bonds get clipped, stocks get clipped a little from inflation.
I was aware of the effect on lenders vs debtors but unsure about the aggregate result. I suppose it would come down to the respective allocation/composition of people’s assets.
Regarding labor, my question would be whether wages keep up with consumer good price rises which the poor are more vulnerable to than the rich as well.
My sense is that inflation’s impact on wealth distribution is potentially far more complicated and nonlinear than a simple direction one way or the other.
In any case, I have been reading your blog for 5ish years and am happy you are back to the old format!
We always seem to fight our last battle. There is no way the Fed or the Government will allow deflation (unless they lose complete control of everything, which they might.) They have shown that they will print money if they have to just like they are doing now. When the Fed buys government bonds and they rebate the interest to the Treasury, that is free money for the government. They are in all reality just printing money. We all know that the government debt will never be repaid. The crisis will come when we and the rest of the world starts losing faith in our dollar. The history of fiat currencies is not good when governments can’t control themselves and start printing in excess to try to fix the problems they have caused.
David – the local CFA society doesn’t know the answer to this, and I thought you might: what happens if a CFA member drops his/her membership? Legally, they can’t use the designation — but that is rarely if ever enforced anyway. More practically speaking, they are allowed to say they passed the exams and were a member for more than “n” years (leaving the current status ambiguous). There seems great value in passing the exams initially (early in one’s career), but the organization does very little for its members (especially if one’s employer does not pay for annual conferences). Becoming a member is valuable, staying a member is pointless. One can always join (as example) Boston or NY societies as a “non-member” even if you live elsewhere in the USA. Am I missing anything?
I will give a response to this, but it is worth an article.
For those who were members of AIMR and New York Society (NYSSA)… part of the CFAI merger agreement was that NYSSA members could continue using the CFA designation with, or without, CFA Institute. It was a serious bone of contention when AIMR/ICFA merged, and NYSSA members insisted on the clause.
Ergo, if “Paul” was an AIMR/NYSSA member, he can continue to use the designation even if he drops Charlottesville. I don’t have any specific knowledge about this arrangement with other societies (outside of NYSSA), but others may have a similar arrangement.
A lot of employers have recently stopped reimbursing for CFA Institute membership, which speaks volumes about how much they (don’t) value on-going membership. The knowledge that one gains in passing the exams is, as Paul states, invaluable. But employers expect members to demonstrate the applied use of said knowledge when working with clients, they don’t care about the credential in itself.
Headcounts are falling all across the financial industry, and those remaining are not being reimbursed for member dues. I think a lot of current CFA members are going to be asking the same questions that Paul did.
I have a call into CFAI to ask them a few questions, but you’ve given me one more. As an aside, actuarial dues are a LOT higher than CFA dues, and you don’t get as much useful out of them.
AIMR was a practitioner oriented organization, something that was constantly emphasized. CFAI is overwhelmingly academics. Its a very different organization with a very different culture and a different focus. Employers notice this, even if they don’t act on the change immediately. Responses often get delayed until the next retreat in profits (aka now) — many employers have recently halted member dues reimbursement.
CFAI is an alleged non-profit that pays its CEO over $1.6 million per year
(that is just one person, there are countless support staff on the payroll).
https://news.efinancialcareers.com/us-en/321842/pay-at-the-cfa-institute
This (and previous) CFAI staff always stay at the nicest hotels, and expense everything back to the non-profit. For profit companies stopped this type of behavior after 2008.
I suspect the reduced pay in the financial sector, and especially the reduced headcount, are going to matter a lot more to membership levels going forward than whether CFAI acknowledges the CFA designation predates the organization.
Clients and employers value the knowledge needed to pass the exams, but its not obvious they value on-going credentials. Expense reviews have led many employers to cut / eliminate member dues reimbursements. Those expense cuts speak much louder than anything the CFAI says about the value of maintaining membership.
I look forward to hearing if Margaret Franklin is more responsive than her predecessors, but I will listen and watch for signals from my employer and my clients.