Category: Asset Allocation

Estimating Future Stock Returns, December 2016 Update

Estimating Future Stock Returns, December 2016 Update

Posted on by David Merkel

What a difference a quarter makes! ?As I said one quarter ago:

Are you ready to earn 6%/year until 9/30/2026? ?The data from the Federal Reserve comes out with some delay. ?If I had it instantly at the close of the third quarter, I would have said 6.37% ? but with the run-up in prices since then, the returns decline to 6.01%/year.

So now I say:

Are you ready to earn 5%/year until 12/31/2026? ?The data from the Federal Reserve comes out with some delay. ?If I had it instantly at the close of the fourth?quarter, I would have said 5.57% ? but with the run-up in prices since then, the returns decline to 5.02%/year.

A one percent drop is pretty significant. ?It stems from one main factor, though — investors are allocating a larger percentage of their total net worth to stocks. ?The amount in stocks moved from 38.00% to 38.75%, and is probably higher now. ?Remember that these figures come out with a 10-week delay.

Remember that the measure in question covers both public and private equities, and is market value to the extent that it can be, and “fair value” where it can’t. ?Bonds and most other assets tend to be a little easier to estimate.

So what does it mean for the ratio to move up from 38.00% to 38.75%? ?Well, it can mean that equities have appreciated, which they have. ?But corporations buy back stock, pay dividends, get acquired for cash which reduces the amount of stock outstanding, and places more cash in the hands of investors. ?More cash in the hands of investors means more buying power, and that gets used by many long-term institutional investors who have fixed mandates to follow. ?Gotta buy more if you hit the low end of your equity allocation.

And the opposite is true if new money gets put into businesses, whether through private equity, Public IPOs, etc. ?One of the reasons this ratio went so high in 1998-2001 was the high rate of business formation. ?People placed more money at risk as they thought they could strike it rich in the Dot-Com bubble. ?The same was true of the Go-Go era in the late 1960s.

Remember here, that average returns are around 9.5%/year historically. ?To be at 5.02% places us in the 88th percentile of valuations. ?Also note that I will hedge what I can if expected 10-year returns get down to 3%/year, which corresponds to a ratio of 42.4% in stocks, and the 95th percentile of valuations. ?(Note, all figures in this piece are nominal, not inflation-adjusted.) ?At that level, past 10-year returns in the equity markets have been less than 1%, and in the short-to-intermediate run, quite poor.)

You can also note that short-term and 10-year Treasury yields have risen, lowering the valuation advantage versus cash and bonds.

I have a few more small things to add. ?Here’s an article from the Wall Street Journal:?Individual Investors Wade In as Stocks Soar. ?The money shot:

The investors? positioning suggests burgeoning optimism, with TD Ameritrade clients increasing their net exposure to stocks in February, buying bank shares and popular stocks such as Amazon.com Inc. and sending the retail brokerage?s Investor Movement Index to a fresh high in data going back to 2010. The index tracks investors? exposure to stocks and bonds to gauge their sentiment.

?People went toe in the water, knee in the water and now many are probably above the waist for the first time,? said JJ Kinahan, chief market strategist at TD Ameritrade.

This is sad to say, but it is rare for a rally to end before the “dumb money” shows up in size. ?Running a small asset management shop like I do, at times like this I suggest to clients that they might want more bonds (with me that’s short and high quality now), but few do that. ?Asset allocation is the choice of my clients, not me. ?That said, most of my clients are long-term investors like me, for which I give them kudos.

Then there is this piece over at Bloomberg.com called:?Wall Street’s Buzz Over ‘Great Leader’ Trump Gives Shiller Dot-Com Deja Vu. ?I want to see the next data point in this analysis, which won’t be available by mid-June, but I do think a lot of the rally can be chalked up to willingness to take more risk.

I do think that most people and corporations think that they will have a more profitable time under Trump rather than Obama. ?That said, a lot of the advantage gets erased by a higher cost of debt capital, which is partly driven by the Fed, and partly by a potentially humongous deficit. ?As I have said before though, politicians are typically limited in what they can do. ?(And the few unlimited ones are typically destructive.)

Shiller’s position is driven at least partly by the weak CAPE model, and the rest by his interpretation of current events. ?I don’t make much out of policy uncertainty indices, which are too new. ?The VIX is low, but hey, it usually is when the market is near new highs. ?Bull markets run on complacency. ?Bear markets plunge on revealed credit risk threatening economic weakness.

One place I will agree with Shiller:

What Shiller will say now is that he?s refrained from adding to his own U.S. stock positions, emphasizing overseas markets instead.

That is what I am doing. ?Where I part ways with Shiller for now is that I am not pressing the panic button. ?Valuations are high, but not so high that I want to hedge or sell.

That’s all for now. ?This series of posts generates more questions than most, so feel free to ask away in the comments section, or send me an email. ?I will try to answer the best questions.

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Late edit: changed bolded statement above from third to fourth quarter.

Everyone Needs Good Advice

Everyone Needs Good Advice

Posted on by David Merkel
Picture Credit: jen collins

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I am a fiduciary in my work that I do for my clients. I am also the largest investor in my own strategies, promising to keep a minimum of 80% of my liquid net worth in my strategies, and 50% of my total net worth in them (including my house, etc.).

I believe in eating my own cooking. ?I also believe in treating my clients well. ?I’ve treated part of this in an earlier post called?It?s Their Money, where I describe how I try to give exiting clients a pleasant time on the way out. ?For existing clients, I will also help them with situations where others are managing the money at no charge, no payment from another party, and no request that I manage any of those assets. ?I do that because I want them to be treated well by me, and I know that getting good advice is hard. ?As I wrote in a prior article?The Problem of Small Accounts:

We all want financial advice.? Good advice.? And we want it for free.? That?s why we come to the Aleph Blog, where advice is regularly dispensed, and at no cost.

But? I can?t be personal, and give you advice that is tailored to your situation.? And in my writing here, much as I try to be highly honest, I am not acting as a fiduciary, even though I still make my writings hold to such a standard.

Ugh.? Here?s the problem.? Good advice costs money.? Really good advice costs a lot of money, and is worth it, if you have enough money to spread the cost over.

But when you have a small account, you have a problem in getting advice.? There is no way for someone who is fiduciary (like me) to make money addressing your concerns.? That is why I have a high minimum for investing: $100,000.? With that, I can spend time on clients, even helping them with assets from which I make no money.

What extra things have I done for clients over time? ?I have:

  • Analyzed asset allocations.
  • Analyzed the performance of other managers.
  • Advised on changing jobs, negotiating salary, etc.
  • Explained the good and bad points of certain insurance companies and their policies, and suggested alternatives.
  • Analyzed chunky assets that they own elsewhere, aiding them in whether they keep, sell, or sell part of the asset.
  • Analyzed a variety of funky and normal investment strategies.
  • Advised on buying a building, and future business plans.
  • Told a client he was better off reinvesting the slack funds in his business that needed?financing, rather than borrow and invest the funds with me.
  • Told a client to stop sending me money, and pay down his mortgage. ?(He has since resumed sending money, but he is now debt-free.)

I take the fiduciary side of this seriously, and will?tell clients that want to put a?lot of their money in my stock?strategy that they need less risk, and should put funds in my bond strategy, where I earn less.

I’ve got a lot already. ?I don’t need to feather my nest at the expense of the best interests of my clients.

Over the last six years, around half of my clients have availed themselves of this help. ?If you’ve read Aleph Blog for awhile, you know that I have analyzed a wide number of things. ?Helping my clients also sharpens me for understanding the market as a whole, because issues come into focus when the situation of a family makes them concrete.

So informally, I am more than an “investments only” RIA [Registered Investment Advisor], but I only earn money off of my investment fees, and no other way. ?Personally, I think that other “investments only” RIAs would mutually benefit their clients if they did this as well — it would help them understand the struggles that they go through, and inform their view of the economy.

Thus I say to my competitors: do you want to justify your fees? ?This is a way to do it; perhaps you should consider it.

Postscript

Having some people in an “investment only” shop that understand the basic questions that most clients face also has some crossover advantages when it comes to understanding financial companies, and different places that institutional money gets managed. ?It gives you a better idea of the investment ecosystem that you live and work in.

Problems with Constant Compound Interest (6)

Problems with Constant Compound Interest (6)

Posted on by David Merkel
Doctored Photo Credit: Marvin Isidore Macatol || And I say this is heresy!

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My last post produced the following question:

What if your time horizon was 60 years? Would a 5% real return be achievable?

I am answering this as part of an irregular “think deeper” series on the problems of modeling investment over the very long term… the last entry was roughly six years ago. ?It’s a good series of five articles, and this is number six.

On to the question. ?The model forecasts over a ten-year period, and after that returns return to the long run average — about 9.5%/year nominal. ?The naive answer would then be something like this: the model says over a 60-year period you should earn about 8.85%/year, considering that the first ten years, you should earn around 5.63%/year. ?(Nominally, your initial investment will grow to be 161x+ as large.) ? If you think this, you can earn a 5% real return if inflation over the 60 years averages 3.85%/year or less. ?(Multiplying your capital in real terms by 18x+.)

Simple, right?

Now for the problems with this. ?Let’s start with the limits of math. ?No, I’m not going to teach you precalculus, though I have done that for a number of my kids. ?What I am saying is that math reveals, but it also conceals. ?In this case the math assumes that there is only one variable that affects returns for ten years — the proportion of investor asset held in stocks. ?The result basically says that over a ten-year period, mean reversion will happen. ?The proportion of investor asset held in stocks will return to an average level, and returns similar to the historical average will come?thereafter.

Implicitly, this assumes that the return series underlying the regression is the perfectly normal return series, and the future will be just like it, only more so. ?Let me tell you about some special things involved in the history of the last 71 years:

  • We have not lost a war on our home soil.
  • We have not had socialism to the destructive levels experienced by China under Mao, the USSR. North Korea, Cuba, etc. ?(Ordinary socialism isn’t so damaging, though there are ethical reasons for not going that way. ?People deserve freedom, not guarantees. ?Note that stock returns in moderate socialist countries have been roughly as high as those in the US. ?See the book Triumph of the Optimists.)
  • We have continued to have enough children, and they have become moderately productive workers. ?Also, we have welcomed a lot of hard working and creative people to the US.
  • Technology has continued to improve, and along with it, labor productivity.
  • Adequate energy to multiply force and distribute knowledge is inexpensively available.
  • We have not experienced hyperinflation.

There are probably a few things that I have missed. ?This is what I mean when I say the math conceals. ?Every mathematical calculation abstracts quantity away from every other attribute, and considers it to be the only one worth analyzing. ?Qualitative analysis is tougher and more necessary than quantitative analysis — we need it to give meaning to mathematical analyses. ?(What are the limits? ?What is it good for? ?How can I use it? ?How can I use it ethically?)

If you’ve read me long enough, you know that I view economies and financial markets as ecosystems. ?Ecosystems are stable within limits. ?Ecosystems also can only develop so quickly; there may be no limits to growth, but there are limits to the speed of growth in mature economies and financial systems.

Thus the question: will these excellent conditions continue? ?My belief is that mankind never truly changes, and that history teaches us that all governments and most cultures eventually die. ?When they do, most or all economic arrangements tend to break, especially complex ones like financial markets.

But here are three more limits, and they are more local:

  • Can you really hold for 60 years, reinvesting and never taking a material amount?out?
  • Will the number investing in the equity markets remain small?
  • Will stock be offered and retired at ordinary prices?

 

Most people can’t lock money away for that long without touching it to some degree. ?Some of the assets?may get liquidated because of panic, personal emergency needs, etc. ?Besides, why be a miser? ?Warren Buffett, one of the greatest compounders of all time, might have ended up happier if he had spent less time compounding, and more time on his family. ?It would have been better to take a small?part of it, and use it to make others happy then, and not wait to be the one of the most famous philanthropists of the 21st century before touching it.

Second, returns may be smaller in the future because more pursue them. ?One reason?the rewards for being a capitalist are large on average is that?there are relatively few of them. ?Also, I have sometimes wondered if stock returns will fall when the whole world is employed, and there is no more cheap labor to be had. ?Should that bold scenario ever come to pass, labor would have more bargaining power in aggregate, and profits would likely fall.

Finally, you have to recognize that the equity return statistics are somewhat overstated. ?I’m not sure how much, but I think it is enough to reduce returns by 1%+. ?Equity tends to be offered for initial purchase expensively, and tends to get retired inexpensively. ?Businessmen are rational and tend to go public when stock valuations are high, pay employees in stock when valuations are high, and do stock deals when valuations are high. ?They tend to go private when stock valuations are low, pay employees cash in ordinary times, and do cash?deals when valuations are low.

As a result, though someone that buys and holds the stock index does best, less money is in the index when stocks are low, and a lot more when stocks are high.

Inflation Over 60 Years?

I mentioned the risk of hyperinflation above, but who can tell what inflation will do over 60 years? ?If the market survives, I feel confident that stocks would outperform inflation — but how much is the open question. ?We haven’t paid the price for loose monetary policy yet. ?A 1% rise in inflation tends to cut stock returns by 2% for a year in real terms, but then businesses adjust and pass through higher prices. ?Vice-versa when inflation falls.

Right now the 30-year forecast for inflation is around 2.1%/year, but that has bounced around considerably even within a calm environment. ?My estimate of inflation over a 60-year period would be the weakest element of this analysis; you can’t tell what the politicians and central bankers will do, and they aren’t sure themselves.

Summary

Yes, you could earn 5% real returns on your money over a 60-year period… potentially. ?It would take hard work, discipline, cleverness, frugality, and a cast iron stomach for risk. ?You would need to be one of the few doing it. ?It would also require the continued prosperity of the US and global economies. ?We don’t prosper in a vacuum.

Thus in closing I will tell you that yes, you could do it, but there is a large probability of failure. ?Don’t count on buying that grand villa on the Adriatic Sea in your eighties, should you have the strength to enjoy it.

Two Questions on Returns

Two Questions on Returns

Posted on by David Merkel
Picture Credit: Valerie Everett

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I recently received two sets of questions from readers. Here we go:

David,

I am a one-time financial professional now running a modest ?home office? operation in the GHI?area.? I have been reading your blog posts for a couple years now, and genuinely appreciate your efforts to bring accessible, thoughtful, and modestly stated insights to a space too often lacking all three characteristics.? If I didn?t enjoy your financial posts so much, I?d request that you bring your approach to the political arena ? but that?s a different discussion altogether?

I am writing today with two questions about your work on the elegant market valuation approach you?ve credited to @Jesse_Livermore.?? I apologize in advance for any naivety evidenced by my lack of statistical background?

  1. I noticed that you constructed a ?homemade? total return index ? perhaps to get you data back to the 1950s.? Do you see any issue using SPXTR index (I see data back to 1986)?? The 10yr return r-squared appears to be above .91 vs. investor allocation variable since that date.
  2. The most current Fed/FRED data is from Q32016.? It appears that the Q42016 data will be released early March (including perhaps ?re-available? data sets for each of required components http://research.stlouisfed.org/fred2/graph/?g=qis ).? While I appreciate that the metric is not necessarily intended as a short-term market timing device, I am curious whether you have any interim device(s) you use to estimate data ? especially as the latest data approaches 6 months in age & the market has moved significantly?

I appreciate your thoughts & especially your continued posts?

JJJ

These questions are about the Estimating Future Stock Returns posts. ?On question 1, I am pulling the data from Shiller’s data. ?I don’t have a better data feed, but that should be the S&P 500 data, or pretty near it. ?It goes all the way back to the start of the Z.1 series, and I would rather keep things consistent, then try to fuse two similar series.

As for question 2, Making adjustments for time elapsed from the end of the quarter is important, because the estimate is stale by 70-165 days or so. ?I treat it like a 10-year zero coupon bond and look at the return since the end of the quarter. ?I could be more exact than this, adjusting for the exact period?and dividends, but the surprise from the unknown change in investor behavior which is larger than any of the adjustment simplifications. ?I take the return since the end of the last reported quarter and divide by ten, and subtract it from my ten year return estimate. ?Simple, understandable, and usable, particularly when the adjustment only has to wait for 3 more months to be refreshed.

PS — don’t suggest that I write on politics. ?I annoy too many people with my comments on that already. 😉

Now for the next question:

I have a quick question. If an investor told you they wanted a 3% real return (i.e., return after inflation) on their investments, do you consider that conservative? Average? Aggressive? I was looking at some data and it seems on the conservative side.

EEE

Perhaps this should go in the “dirty secrets” bin. ?Many analyses get done using real return?statistics. ?I think those are bogus, because inflation and investment returns are weakly related when it comes to risk assets like stocks and any other investment with business risk, even in the long run. ?Cash and high-quality bonds are different. ?So are precious metals and commodities as a whole. ?Individual commodities that are not precious metals have returns that are weakly related to inflation. ?Their returns depend more on their individual pricing cycle than on inflation.

I’m happier projecting inflation and real bond returns, and after that, projecting the nominal returns using my models. ?I typically do scenarios rather than simulation?models because the simulations are too opaque, and I am skeptical that the historical relationships of the past are all that useful without careful handling.

Let’s answer this question to a first approximation, though. ?Start with the 10-year breakeven inflation rate which is around 2.0%. ?Add to that a 10-year average life modification of the Barclays’ Aggregate, which I estimate would yield about 3.0%. ?Then go the the stock model, which at 9/30/16 projected 6.37%/yr returns. ?The market is up 7.4% since then in price terms. ?Divide by ten and subtract, and we now project 5.6%/year returns.

So, stocks forecast 3.6% “real” returns, and bonds 1.0%/year returns over the next 10 years. ?To earn a 3% real return, you would have to invest 77% in stocks and 23% in 10-year high-quality bonds. ?That’s aggressive, but potentially achievable. ?The 3% real return is a point estimate — there is a lot of noise around it. ?Inflation can change sharply upward, or there could be a market panic near the end of the 10-year period. ?You might also need the money in the midst of a drawdown. ?There are many ways that a base scenario could go wrong.

You might say that using stocks and bonds only is too simple. ?I do that because I don’t trust return most risk and return estimates for more complex models, especially the correlation matrices. ?I know of three organizations that I think have good models — T. Rowe Price, Research Affiliates, and GMO. ?They look at asset returns like I do — asking what the non-speculative returns would be off of the underlying assets and starting there. ?I.e. if you bought and held them w/reinvestment of their cash flows, how much would the return be after ten years?

Earning 3% real returns is possible,?and not that absurd, but it is a little on the high side unless you like holding?77% in stocks and 23% in 10-year high-quality bonds, and can bear with the volatility.

That’s all for now.

Streaking Into the Record Books?

Streaking Into the Record Books?

Posted on by David Merkel

Well, this market is nothing if not special. ?The S&P 500 has gone 84 trading days without a loss of 1% or more. ?As you can see in the table below, that ranks it #17 of all streaks since 1950. ?If it can last through February 27th, it will be the longest streak since 1995. ?If it can last through March 23rd, it will be the longest streak since 1966. ?The all-time record (since 1950) would take us all the way to June.

Here’s another way to think about this — look at the VIX. ?It closed today at 10.85. ?Sleepy, sleepy… no risk to be found. ?When you don’t have any significant falls in the market, the VIX tends to sag. ?Aside from the election, which is an exception to the rule, the last two peaks of the VIX over the last six months were after 1%+ drops in the S&P 500.

The same would apply to credit spreads, which are also tight. ?No one expects a change in liquidity, a credit event, a national security incident, etc. ?But as I commented on Friday:

This is an awkward time when you have a lot of people arguing that the market CAN’T GO HIGHER! ?Let me tell you, it can go higher.

Will it go higher? ?Who knows?

Should it go higher? ?That’s the better question, and may help with the prior question. ?If you’re thinking strictly about absolute valuation, it shouldn’t go higher — we’re in the mid-80s on a percentile basis. ?On a relative valuation basis, where are you going to go? ?On a momentum basis, it should go higher. ?It’s not a rip-roarer in terms of angle of ascent, which bodes well for it. ?The rallies that fail tend to be more violent, and this one is kinda timid.

We sometimes ask in investing “who has the most to lose?” ?As in my tweet above, that very well could be asset allocators with low stock allocations that conclude that they need to chase the rally. ?Or, retail waking up to how great this bull market has been, concluding that they have been missing out on “free money.”

Truth, I’m not hearing many people at all banging the drum for this rally. ?There is a lot of skepticism.

As for me, I don’t care much. ?It’s not a core skill of mine, nor is it a part of my business. ?I am finding cheap stocks still, and I will keep investing through thick and thin, unless the 10-year forecast model that I use says future returns are below 3%/year. ?Then I will hedge, and encourage my clients to do so as well.

Until then, the game is on. ?Let’s see how far this streak goes.

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Streaks of over 50 days since 1950

Rank Date Streak Year
1 10/8/1963 154 1963
2 2/28/1966 154 1966
3 6/7/1954 142 1954
4 6/3/1964 131 1964
5 4/17/1961 119 1961
6 7/26/1957 115 1957
7 6/12/1985 112 1985
8 5/17/1995 110 1995
9 12/15/1995 105 1995
10 10/30/1967 103 1967
11 5/13/1958 102 1958
12 11/2/1993 95 1993
13 11/24/2006 94 2006
14 2/12/1993 87 1993
15 8/15/1952 86 1952
16 12/20/1968 85 1968
17 2/10/2017 84 2017
18 8/31/1979 82 1979
19 11/30/1964 81 1964
20 6/2/1950 75 1950
21 6/1/1965 75 1965
22 8/23/1972 74 1972
23 5/8/1972 73 1972
24 2/4/1953 70 1953
25 4/24/1962 67 1962
26 7/16/2014 66 2014
27 10/14/1958 65 1958
28 6/10/1969 65 1969
29 12/2/1996 65 1996
30 1/27/2004 65 2004
31 2/3/1994 63 1994
32 1/4/1962 60 1962
33 8/18/1976 60 1976
34 12/20/1985 60 1985
35 9/18/1961 58 1961
36 5/14/1971 58 1971
37 2/9/1989 58 1989
38 7/19/1968 57 1968
39 1/19/2006 56 2006
40 10/18/1951 55 1951
41 9/13/1978 55 1978
42 2/27/1963 54 1963
43 3/29/1977 54 1977
44 6/23/2016 54 2016
45 8/21/1953 53 1953
46 7/11/1960 53 1960
47 11/19/1969 52 1969
48 9/8/1994 52 1994
49 9/8/2016 51 2016
Yield = Poison (3)

Yield = Poison (3)

Posted on by David Merkel
Photo Credit: Brent Moore || Watch the piggies run after scarce yield!

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If you do remember the first time I wrote about yield being poison,?you are unusual, because it was the first real post at Aleph Blog. ?A very small post — kinda cute, I think when I look at it from almost ten years ago… and prescient for its time, because a lot of risky bonds were about to lose value (in 19 months), aside from the highest quality bonds.

I decided to write this article this night because I decided to run my bond momentum model — low and behold, it yelled at me that everyone is grabbing for yield through credit risk, predominantly corporate and emerging markets, with a special love for bank debt closed end funds.

I get the idea — short rates are going to rise because the Fed is tightening and inflation is rising globally, and there is no credit risk anymore because economic growth is accelerating globally — it’s not just a US/Trump thing. ?I just have a harder time playing the game because we are in the wrong phase of the credit cycle — profit growth is nonexistent, and debts are growing.

I have a few other concerns as well. ?Even if encouraging exports and discouraging imports aids the US economy for a while (though I doubt it — more jobs rely on exports than are lost by imports, what if there is retaliation?) there is a corresponding opposite impact on the capital account — less reinvestment in the US. ?We could see higher yields…

That said, I would be more bearish on the US Dollar if it had some real competition. ?All of the major currencies have issues. ?Gold, anyone? ?Low short rates and rising inflation are the ideal for gold. ?Watch the real cost of carry go more negative, and you get paid (sort of) for holding gold.

If growth and inflation?persist globally (consider some of the work @soberlook has ?been doing at The WSJ Daily Shot — a new favorite of mine, even his posts are?too big) then almost no bonds except the shortest bonds will be any good in the intermediate-term — back to the ’70s phrase “certificates of confiscation.” ?One other effect that could go this way — if the portion of Dodd-Frank affecting bank leverage is repealed, the banks will have a much greater ability to lend overnight, which would be inflationary. ?Of course, they could just pay special dividends, but most corporations lean toward growing the business, unless they are disciplined capital allocators.

But it is not assured that the current growth and inflation will persist. ?M2 Monetary velocity is still low, and the long end of the yield curve does not have yield enough priced in for additional growth and inflation. ?Either long bonds are a raving sell, or the long end is telling us we are facing a colossal fake-out in the midst of too much leverage globally.

Summary

I’m going to stay high quality and short for now, but I will be watching for the current trends to break. ?I may leg into some long Treasuries, and maybe some foreign bonds. ?Gold looks interesting, but I don’t think I am going there. ?I’m not making any big moves in the short run — safe and short feels pretty good for the?bond portfolios that I manage. ?I think it’s a time to preserve principal — there is more credit risk than the market is pricing in. ?It might take a year or two to get there, or it might be next month… I would simply say stay flexible and look for a time where you have better opportunities. ?There is no fat pitch at present for long only investors like me.

Postscript

To those playing with fire buying dividend paying common stocks, preferred stocks, MLPs, etc. for yield — if we hit a period where credit risk becomes obvious — all of your “yield plays” will behave like stocks in a poisoned sector. ?There could be significant dividend cuts. ?Dividends are not guaranteed like bonds — bonds must pay or it is bankruptcy. ?Managements avoid defaulting on their bonds and loans, but will not hesitate to cut or not pay dividends in a crisis — it is self-preservation, at least in the short-run. ?Even if they get replaced by angry shareholders, the management typically gets some sort of parachute if the company survives, and far less in bankruptcy.

One final note on this point — stocks that have a lot of yield buyers behave more like bonds. ?If bond yields rise above current stock earnings yields, the stock prices will fall to reprice the yield of the stock, even if there is no bankruptcy risk.

And, if you say you can hold on and enjoy the rising dividends of your high quality companies? ?Accidents happen, the same way they did to some people who bought houses in the middle of the last decade. ?Many could not ride out the crisis because of some life event. ?Make sure you have a margin of safety. ?In a really large crisis, the return on risk assets may look decent from ten years before to ten years after, but a lot of people get surprised by their need to draw on those assets at the wrong moment — bad events come in bunches, when the credit cycle goes bust. Be careful, and don’t reach for yield.

Distrust Forecasts

Distrust Forecasts

Posted on by David Merkel
Photo Credit: New America || Could only drive through the rear-view mirror

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

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

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

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

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

Patience and a Little Courage

Patience and a Little Courage

Posted on by David Merkel
Photo Credit: G E M

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

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

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

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

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

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

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

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

And now for something completely different

I wrote these three pieces at unpopular times:

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

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

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

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

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

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

Back to the Beginning

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

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

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

Estimating Future Stock Returns, September 2016 Update Redux

Estimating Future Stock Returns, September 2016 Update Redux

Posted on by David Merkel
Idea Credit: Philosophical Economics Blog || I get implementation credit, which is less…

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

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

On to the questions:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

[bctt tweet=”As such, if you look the model now, we should be Teddy Bears, not full-fledged Grizzly Bears.” username=”alephblog”]

Estimating Future Stock Returns, September 2016 Update

Estimating Future Stock Returns, September 2016 Update

Posted on by David Merkel
Idea Credit: Philosophical Economics Blog || I get implementation credit, which is less… 😉

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Are you ready to earn 6%/year until 9/30/2026? ?The data from the Federal Reserve comes out with some delay. ?If I had it instantly at the close of the third quarter, I would have said 6.37% — but with the run-up in prices since then, the returns decline to 6.01%/year.

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

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

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

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

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

[bctt tweet=”Are you ready to earn 6%/year until 9/30/2026?” username=”alephblog”]

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