Photo Credit: Mindy Georges || The umbrella belongs to Travelers

This is a bug in my bonnet, and I have written about this for at least 13 years, and maybe as long as 16 years, but insurance conglomerates don’t work well. After suggesting at least three times that AIG should break itself up, we are finally to the last stage of it doing so.

There is a saying in the industry “Life Insurance is sold, P&C Insurance is bought.” They are different markets, and there is no reason for shareholders to own a company that does both. But some companies diversify. Who does that benefit?

The main beneficiary is the management, as it gives them cover for underperformance. They can always blame transitory factors for underperformance of one division or another.

And much as Hank Greenberg blamed his successors for the failure of AIG, the main cause of longer-term underperformance stemmed from the purchases of SunAmerica and American General at high prices.

AIG was highly profitable in 1989 with its foreign and domestic P&C operations, and its foreign life operations. What should it have done with its profits?

It should have paid a higher dividend, bought back stock, and shrunk the company as many other successful insurers have done. Companies is mature industries should return capital to shareholders.

Big companies develop a culture, and it makes them less willing to change. That was true of AIG. Hank Greenberg should have eliminated all life companies early on, and run a domestic P&C company with high underwriting standards. Then maybe it would not have had to rely on Berkshire Hathaway to reinsure them.

Just as GE has suffered, so has AIG. Both CEOs were lionized, then despised. The main idea to take away from this is conglomerates where businesses have different sales models don’t work.

Picture Credit: Ron Mader || Humility is underrated. Without it everything is a fight.

“Size expectations to resources and you will rarely be disappointed.”

I would think that this one would be “common sense,” but I have another saying, “Common sense isn’t.” Many people engage in magical thinking, overspending and assuming that things will work out in the end. Under most conditions, it does not work out in the end.

Living in reality is a key to happiness. Delay gratification, have a buffer, and invest for the future. What could be simpler?

You might or might not be surprised at how many let short-term pleasure dominate over long-term well-being. I think it is hard if one is single to have the gumption to think long-term. There is a temptation to play when there is no one else relying on you.

The lessons of the Great Depression have been lost. Be self-reliant, or family-reliant.

Patience and humility are underrated virtues. Perhaps it seems like those who are proud and impatient do better, but that’s just the unequal signal problem. What’s the unequal signal problem, you say? Those that publicly succeed get more notice than the many more that privately fail because they offend others with their pride and impatience.

I’m not saying don’t take moderate risks to improve your position in life. I am saying that trying to hit home runs begets a lot of strikeouts. If you are not capable of bearing the losses of strikeouts, don’t try to hit home runs. Instead, try to hit singles more reliably.

This is one reason why I say to diversify. Here’s something I haven’t said before, but when I was a kid, I used to read Value Line. They would talk about cash as a diversifier, and highlight stocks that were growth at a reasonable price, and had momentum of earnings and price. It’s good to keep short bonds (cash) on hand for the opportunity to invest at lower prices when they become available. Or, to use the cash in an emergency, because you can’t always be sure of future spending needs.

Investing in stocks requires patience. Holding cash (short bonds) requires humility. With patience and humility you can take on the markets and not worry much about the future. You know you can hold your positions. You know you can meet surprising cash needs. You are ready for anything, because you have enough slack in your asset allocation to hold onto your risk positions under almost all circumstances.

For me, humility meant paying off my mortgage debt early, even though my investing was going well. My investing went well because I didn’t have to worry in market downdrafts about how we would live. Really, I haven’t had a significant personal economic worry in 18 years.

Patience for me meant slowing down buying and selling stocks. Hold them longer. Think harder about the purchase decision. Business plans take time to develop. Owning stock is owning a business. Real success comes over time, not by day-trading.

And, find happiness where you are. Retirement can be fulfilling even if you don’t have a lot of assets. Find work that isn’t too taxing, and keeps you in touch with others. Having purpose in life aids happiness. Then use your assets carefully to aid your life over the long haul. Remember that longevity is a risk, so don’t overspend.

Does this sound hard? Yes, it does. And that is our lives. Humility helps at this point, realizing that growing old isn’t easy. But if you size your expectations to your resources, it will be easier, recognizing that you did your best, and that you are getting a reasonable living in your old age.

Photo Credit: Lonnon Foster || Oh no! The cookie jar is empty!

(This is another of my occasional experiments. I know it’s not perfect. Please bear with me.)

James: Can I have a cookie?

Accountant: That’s not the right way to ask.

J: I did not know an accountant could be a grammarian as well. MAY I have a cookie?

A: Sorry, there are no cookies left in the jar.

J: I thought there were always cookies in the jar. I saw some people eating cookies recently.

A: Well, they may have gotten cookies via side agreements.

J: Side-agreements? What are those?

A: You know the cookie rules?

J: Uh ,no. What are they?

A: Listen then:

• I gather the money for cookies each year from everyone.
• I use the money to buy cookies, usually around 950 of them.
• The amount that actually arrives varies — sometimes more, sometimes less, rarely near 950, but on average 950.
• Some want more cookies than received, and they enter into side agreements to request early delivery of cookies from future years. The catch is that the cookie merchant can demand immediate repayment at his whim. He tends to be lenient, but occasionally demands full repayment.
• The side agreements are supposed to be deposited in the cookie jar when it is empty.
• Side agreements get called in in order from the most recent to the oldest.

A: My purchase of cookies for 2021 paid off side agreements entered into in 2015 for cookies fronted then.

J: Can I do a side-agreement? I would like some cookies.

A: Wouldn’t we all. Look, the Cookie Merchant calls in the side agreements newest first. Are you ready to repay if he calls on you? Do have the resources?

J: Not really, but I do want a cookie.

A: No such thing as a free cookie. Hmm… let’s look at the jar. Yes, here is the most recent side agreement that I remember– in 2017, fronting the cookies from 2024 through 2026.

J: What’s that under the jar?

A: What do you mean under the…. ehhh, what is this? A 2019 side-agreement fronting cookies from 2027 and 2028? Urk, I wish I had known this,

J: It looks like there’s two more under that.

A: Uh, a 2020 side-agreement fronting cookies from 2029 and 2030, and a 2021 side-agreement fronting cookies from 2031 and 2032. My this is bad.

J: What’s so bad?

A: I wasn’t the accountant for this back then, but the last time cookies were fronted 11 years ahead was 1999. In 2000-2002 the cookie merchant started calling in the side-agreements like mad.

J: So there are no cookies?

A: No cookies without extreme risk.

J: I wish I had a cookie… but no.

A: Would you like a cracker? I may have some of those.

J: I could be interested.

A: We get only 500 of these per year on average, and the side-agreements aren’t as thick. Let me look in the cracker tin. It seems you are in the right place at the right time. There are side-agreements fronting crackers from 2022 through 2025, but I have 100 crackers remaining out of the 2021 allotment. Have a cracker.

J: Thanks. Umm… that’s a good cracker. Not as good as a cookie, but still good.

A: I’m glad you liked it. Supposedly back in the early 1980s the cookie jar and cracker tin were filled to overflowing, but nobody wanted any.

J: I would always want a cookie. Are you sure you don’t have any?

A: Aside from domestic cookies and crackers, we do have some foreign cookies and crackers as well. They aren’t as popular because of the unusual tastes, and payment must be made in another currency, adding to uncertainty. Oddly, in this case, many foreign crackers have a large number of side-agreements, but the foreign cookies have almost none.

J: Could I try a foreign cookie then?

A: Of course you could. [Pulls jar off shelf.] Reach in and pull out a cookie.

J: It crackles. Hey, this is a fortune cookie.

A: Well, eat it and read the fortune.

J: Typically, I throw the fortune away, because I don’t believe in luck.

A: Well, you ended up with a cookie by favorable circumstances, so humor me, and read it to me for my sake.

J: [Eats cookie.] Okay.

“Contemplate cookies

Eat and observe tiny crumbs

The cookies are gone”

Fortune cookie

J: Wait, this was a fortune cookie, and it had a haiku inside it. This is bizarre.

A: Almost as bizarre as our domestic cookie deficit. I would say that fortune cookie was the most honest that I have heard.

J: I guess that’s the way the cookie crumbles.

Photo Credit: amanda tipton || When I was younger, I wanted to read the whole local library. Now that I am older, I doubt the value of most books.

I’m getting older, and so are my readers. A practical impact of getting older is lightening up on possessions so that your heirs won’t have so much to dispose of when you die. My wife and I went through the whole house recently and eliminated 50% of the books that we owned.

We threw away 5% of the books, thinking that no one should read them, they were too damaged, or, they were out of date. We gave 15% to our children, after inviting them to peruse what we were getting rid of. We also gave them four bookcases. We gave 30% of the books away to Goodwill.

That still leaves us with around 1,500 books. But they are the books that we like, and as far as kids books go, the ones we think our grandchildren will like. Oh, yeah, I’m a grandpa now. Two grandsons, a granddaughter on the way, and yet another child coming first quarter of 2022. Wow.

My wife thought she would be more severe at eliminating books, but it turned out to be the opposite. I probably eliminated two-thirds of my economics, finance, and investing books. All of my finance and investing books are now in my office, and fit into one ordinary six foot tall, 27 inches wide bookshelf. The economics books fit on one shelf. Economic history books fit on two shelves. Why did I give away so many?

Longtime readers know I am not a fan of the neoclassical school of economics. I think economics is best understood apart from detailed mathematics. Even in finance and investing, you should never need calculus. We don’t live in a continuous time world.

Though actuaries are tested on calculus, they almost never use it. Early in my career, I tried applying calculus to some of my models, and it didn’t make much of a difference.

I probably jettisoned 75% of my economics, investment and finance books. I did it because I didn’t think they represented reality well. Usually “ad hoc” modeling is superior to trying to apply academic models, if modeling is warranted at all.

I realize that authors have many reasons to write books.

• They have a passion for the topic.
• They want to gain name recognition to benefit their business.
• They are trying to make money off the book (bon chance)

Not that authors or publishers should listen to me, but most books don’t deserve to be published. Why?

• They don’t break new ground.
• They aren’t well-written or well-edited.
• They are wrong in the way they view the world. (They engage in wish-fulfillment.)
• They don’t deliver on what the cover promises.

The last one deserves amplification. Back when I was reviewing many books, this was my single largest complaint. Many books were advertised to answer a crunchy problem, and the book didn’t address the topic significantly. In talking with some of the authors, they told me that it was the publishers who engaged in chicanery to sell the books, even though the authors wrote the books with a different purpose.

Now, if I live long enough, I may write a book. I don’t expect that you will buy it. Why? I will probably have disclosed enough of the book at this blog. Why pay for what you don’t have to?

My main point here is to be skeptical, but not cynical. I eliminated some of my books, not all of them. There is truth in some books. Be careful and analyze the arguments made in books closely. Keep what you think is valid, and toss the rest, unless it is a classic error like “The Communist Manifesto.” The classic errors are worth keeping so that you can remain aware of the ways that important twisted people think.

Photo Credit: Mike Cohen || Certainty versus volatility

One question that many ask is “Should I invest or pay down debt?” Let me quote from a prior article Retirement — A Luxury Good.

What is a safe withdrawal rate?

A safe withdrawal rate is the lesser of the yield on the 10 year treasury +1%, or 7%. The long-term increase in value of assets is roughly proportional to something a little higher than where the US government can borrow for 10 years. That’s the reason for the formula. Capping it at 7% is there because if rates get really high, people feel uncomfortable taking so much from their assets when their present value is diminished.

How should you handle a significant financial windfall?

If you have debt, and that debt is at interest rates higher than the 10 year treasury yield +2%, you should use the windfall to reduce your debt. If the windfall is still greater than that, treat it as an endowment fund, invest it wisely, and only take money out via the safe withdrawal rate formula.

I have been debt-free for eighteen years. Being debt-free enables me to take more risk with my assets if I think it is warranted. At present, I think that if someone has debts with interest rates higher than 3.4%/year, it makes sense to pay down debt rather than invest more. Now there may be tax reasons why one would not liquidate assets to pay down debt, but if you have free cash not needed for a buffer fund, then use the excess cash to pay down debt. Don’t use the Dave Ramsey method, which is stupid. Pay down the highest interest rate debt first.

I can say this with greater confidence at present, because most stock portfolios and private equity portfolios will lose money in nominal terms over the next ten years much like the 2000-2010 decade. Valuations are comparable to that of the dot-com bubble, and unless you are invested in stocks with low valuations and low debt, you will get whacked when the next crisis hits, as growth stocks will decline by more than 50% unless the Fed intervenes, which it might NOT do if inflation is hot.

All other things equal, a debt-free lifestyle is pleasant — there is less worry. Anytime you lower the amount of money that must go out each month, life gets easier.

What’s that, you say? When would I be willing to invest rather than decrease debt? If I had an investment that I thought would return more than 7% over the interest rate of my highest yielding debt, I would invest, assuming that the investment has a sustainable competitive advantage.

I’ve given two rules here, and there is a considerable possibility that neither rule may apply. In that case, do half. Take half of the excess cash and pay down debt, and invest the other half. The “Do Half” rule exists to make good decisions easier when situations are uncertain. It’s not perfect but it will give you the second-best solution. And if you always do second-best, you are beating most of the world.

My bias is to pay down debt. It’s a happier lifestyle, and most people don’t do well acting like mini-hedge funds — borrowing to invest. In a bull market, it looks like genius, but when the bear cycle hits it is traumatic, and many don’t survive it well, particularly if they get laid off.

With that, in the present environment, I encourage you to reduce debt. Unless you invest in unpopular stocks, as I do, future returns will be poor. Reducing debt gives you a relatively high return, and with certainty. Take the opportunity to reduce debt when it makes sense.

Picture Credit: Infoletta Hambach || I suppose Euros are manna from somewhere, though not Heaven. After all, they appear out of nowhere [ECB], and there is no guarantee that any government will receive them in the long run.

“The lure of free money brings out the worst economic behavior in people.”

David Merkel, often said at Aleph Blog

Where is there “free” or at least “inexpensive” money?

• Jobs that are overly compensated compared to the skills needed.
• Demanding that the government give free money to people.
• Constraining interest rates to be low.
• Various “one decision” investment ideas.
• The prices of houses only go up.
• The government bails out bad investments.
• Various investments involving derivatives where one is implicitly short volatility

I started writing this two weeks ago, and then the idea for “Welcome to our Country Club!” came into my head, partially stimulated by a young friend of mine becoming a lifeguard at a swanky country club. It made me think back on my time as a youth being a caddy at a similar club. (And being one of the smallest guys there, I had to learn to defend myself, but that is another story.)

A number of parties have directly and indirectly mused about what I what analogizing in “Welcome to our Country Club!” Real Clear Markets put up a Bitcoin logo. I commented there:

Well, you made explicit what I left implicit. Good job, but you can also throw in penny stocks, meme stocks, some SPACs, etc. Thanks for mentioning me.

Me

In the bullet point above, I listed seven classes of cases where there is free money, or at least subsidized money. I’ll take them in order.

Jobs that are overly compensated compared to the skills needed

There’s always some of that naturally, but it tends to adjust over time unless the government does something to achieve a social goal. That can be unions with a closed shop as an example, or restricting the ability to enter into a simple business, if licensing is too tight. There are corrective mechanisms for both, but they take a long time. Technology can reduce the need for labor in certain types of simple jobs. Or, it can create a competitor to those in a regulated industry (think of Uber, Lyft, Airbnb). In some cases businesses move to non-union venues whether a different part of the US, or another country.

Demanding that the government give free money to people

I’m not in favor of Universal Basic Income. I’m fine with non-subsidized unemployment insurance (though I never tapped it the three times I was out of work — desperation is a good thing).

Many quotes are attributed to Ben Franklin than he actually said. Here’s an alleged one that is interesting:

However, when McHenry made the story public in the 15 July 1803 Republican, or Anti-Democrat newspaper, it had evolved. Now the exchange was:

Powel: Well, Doctor, what have we got?

Franklin: A republic, Madam, if you can keep it.

Powel: And why not keep it?

Franklin: Because the people, on tasting the dish, are always disposed to eat more of it than does them good.

How Dr. McHenry Operated on His Anecdote

If the quote is accurate, it fleshes out the ideas that Republics have to be limited in scope to survive, and that once people that they can use the republic for their self-interests. Even in the recent mini-crisis, knew of a lot of organizations that got PPP loans that didn’t really need them — they profited from the free money. They were organized, with clever accountants, and milked Uncle Sugar while he was throwing money around. (Here’s a particularly notable case.) But there are other places where this happens as well — corporations have gotten very good at slipping ta preferences into the tax code. Even if the US Government wants to encourage a certain behavior, if they are generous, they get overused. This applies to many mass programs as well such as Crop Insurance and Flood Insurance, both of which are subsidized.

The list goes on and on, whether for the upper classes, who benefit the most from this, and the lower classes, who get enough to blunt desperation.

Constraining interest rates to be low

With the Fed following a theory close to Modern Monetary Theory Banana Republic Monetary Theory, it has inflamed three areas of the bond market — Treasuries, Conforming Mortgage Backed Securities, and Junk Corporates. This has pushed housing prices higher, and facilitated high government budget deficits (and the unrealistic spending goals of many), and aided malinvestment by firms that have access to cheap capital, when they should have gone broke.

As Cramer would say, it’s time for me to ‘fess up. I was wrong on my piece Hertz Donut. Cheap capital and the end of the C19 crisis gave equity holders a big win. I know I will sound like the Grandpa from Peter and the Wolf, “What if Peter had not caught the wolf? What then?” To those who didn’t listen to me and won, congratulations. To those who listened to me and lost, I’m sorry. I gave orthodox advice that worked 99% of the time over the prior 60 years. I will give the same advice next time, because you can’t rely on the capital markets to do a favor for you.

When the history books are written 30 years from now, the historians will point at the easy monetary policy of the Fed from Greenspan to date as the major reason US markets overshot and crashed in real terms, along with underfunded promises made by the US and State governments.

Various “one decision” investment ideas

This was the main point of “Welcome to our Country Club!” This can apply to the FANGMAN stocks, promoted stocks whether penny or meme stocks, private equity, cryptocurrencies, etc. There are no permanently good ideas in the markets. Every sustainable competitive advantage is eventually temporary. You don’t own a right to superior returns, at most you can temporarily rent it. Even the idea of buying and holding an S&P 500 index fund means that you will have to endure 50-70% drawdowns once or twice every twenty years or so.

Few truly have “diamond hands.” Perhaps Buffett could have them, but even he makes changes to his portfolio. Let me give a practical example: few people wanted to default on their mortgages during the 2007-2012 crisis, but many were forced to sell at an inopportune time because of unemployment, death, disease, disability, divorce, etc. And far more panicked. There are very few people (and institutions) that are willing to buy the whole way down, and concentrate their holdings into their best ones during a crisis. It hurts too much emotionally to do so, and looks stupid in the short run.

Don’t deceive yourself. Keeping some measure of slack capital (“dry powder”) helps keep you sane. You will look stupid at times like now, but over the long haul you will persevere.

The prices of houses only go up

At least we know from recent memory that residential housing prices can decline across the nation as a whole. On the bright side, current financing terms are not as liberal as they were in 2004-2008. Loan quality is reasonable. But the recent run-up in prices is considerable, in real terms higher than the financial crisis. If we have a significant recession, will there be another crisis?

The government bails out bad investments

One of the failures of the financial crisis was to protect industries that were larger than what was needed. Too many banks, too many houses, too many auto companies, etc. The government, including the Fed, could have protected depositors, but let those who speculated on the continual rise in housing prices fail. They bailed them out with two negative impacts: 1) unproductive investments continue, rather than bein liquidated, which slows growth, and 2) moral hazard — firms take more risk because they know there is a decent chance they will be bailed out in a crisis.

I feel the same way about the recent mini-crisis. We should not have bailed out anyone. The Fed should not have provided excess liquidity. If you don’t let recessions clean out those who have been taking too many chances, you end up with a lot of underperforming junk-rated companies that are non-dead zombies. Over the last 30 years, this is why GDP growth has slowed, we don’t let recessions eliminate subpar uses of capital.

Various investments involving derivatives where one is implicitly short volatility

This was the portion of Where Money Goes to Die that was right in the short-run. During bull markets, many short volatility strategies will make seemingly risk-free steady profits. There are other strategies like it that do well in bull and placid markets, but get killed in a bear market, even a mini-version like early 2018.

Avoid complexity in investing, and stick to simple investments like stocks, bonds, and cash. Stick to things where custody of the assets is almost certain. Cryptocurrencies and derivative strategies typically have weaknesses in custodial matters, such that there are sometimes losses from misappropriation.

Summary

Good investing and good work result from taking moderate risks on a consistent basis. Avoid situations where other are running after what is seemingly free or subsidized money — those situations often come to a bitter end.

And against the advocates for Modern Monetary Theory Banana Republic Monetary Theory, I will tell you that eventually all of the borrowing and spending will come to an end. As in the Great Depression, the rich will ask to have their claims honored at par, while the rest of the nation suffers. Whether the government goes with the rich or not is an open question. But one should not assume that inflation will be the way out… after all, that route could have been taken in greater degree in the Great Depression, but it wasn’t.

Image Credit: Aleph Blog || The model fits the data well

I don’t plan on doing this often, but I got a number of good responses on the last article, and I want to answer them in a more complete way, rather than doing it in the comments, where they for practical purposes never get read.

Thanks for sharing your estimates and work on the average investor equity allocation. I recently wrote an email to you asking if you have done similar studies for other countries. I read that while the US has 45% the UK is at 10% average equity allocation. Have you seen if the average equity allocation can be applicable model for other countries or you reckon everything moves together with the S&P? The Hang Seng for example gained after the dot com bubble and was not flat to down in 10 years. Peak was 7 years later… this could be an opportunity to outperform if you are selective because while you are saying avoid large cap growth names it is worth noting that the US has outperformed the world last 10 years since Osama died and the USD has been the strongest currency. It may be the case of avoid US stocks here and be aggressive in Australia which has value oriented index and has been flat since GFC.

https://alephblog.com/2021/06/18/estimating-future-stock-returns-march-2021-update/#comment-39991

I haven’t run into any other nation where there is sufficient data to do what I am doing here. Remember, the data from the Fed’s Z.1 report include estimates of the value of private assets. I can’t believe the 10% number for the UK. That has to be wrong… it is probably not counting private assets, and may only be counting direct holdings by individuals and not those of institutions.

Is this CAPE forward returns, or the money-flow based model?

Also, how do you think about the fact that CAPE Excess spread is still positive?

Thanks.

https://alephblog.com/2021/06/18/estimating-future-stock-returns-march-2021-update/#comment-39992

Neither. This is the asset share model, not the CAPE, which less accurate than this model. I have no idea regarding the CAPE Excess spread. I don’t pay attention to that.

The asset share model measures the percentage of assets held by Americans in stocks. The highest figure ever is 52.3%, the lowest is 21.8%. When the value is high, future returns are low, and vice-versa. We are over 51% at present.

The bailouts always favor the rich. As I am sure you know, people like Charlie Munger have basically said that the peasants should shut up and be grateful because if the rich hadn’t been bailed out (bailouts are ongoing), the peasants would have had an even worse outcome.

Sheila Bair had a plan to go into these financial firms and do a few things: 1. protect depositors 2. fire management 3. re-open by selling to a healthy firm. She was laughed out of the room, and resigned (around 2008).

Never forget that all the rich folks you see on CNBC, even Warren Buffet, were bailed out. I wasn’t. Luckily I had taken action to retain most of my gains, so I did pretty well. These people that are supposed to be so much smarter than the rest of us? Probably not so much. They are just in the right club.

https://alephblog.com/2021/06/18/estimating-future-stock-returns-march-2021-update/#comment-39993

Charlie Munger is a bright guy, but he’s wrong here. Anyone reading Aleph Blog during the Financial Crisis knows that I did not favor the bailouts, and that I would not have minded another depression. That’s an unpopular view, but it would have punished the rich for borrowing too much. It would have leveled the playing field, and things would have normalized within ten years.

People forget the the promiscuous monetary policy of the Fed set us up for both crises 1929 and 2008. It’s setting us up for another one now. BTW, Buffett did not get bailed out. He didn’t need it with his fortress balance sheet.

You’ve persuaded me. How do I persuade my young?

https://alephblog.com/2021/06/18/estimating-future-stock-returns-march-2021-update/#comment-39994

That’s a tough question. I raised eight children, who all got to listen to me for a long time. Only three out of eight ended up doing well in their finances. (Two are stay-at-home moms who married the right guys. Note: the good ones marry early. Those who purposely delay marriage typically have troubles.) Four are marginal, and one is a total failure. Did I expect better? Yes. but once the arrow leaves the string, you can’t influence it any more.

One of the smartest guys I know said to me, “Once they become adults, don’t say anything, but pray for them a lot.” I think he is correct, though if a teachable moment comes, seize it.

I think most people have to pay “market tuition.” Losses teach investors a lot, and do much good, so long as the investor does not give up. Those that give up will likely never learn.

The children of mine that are succeeding ask my advice. Now, you could tell your kids about Aleph Blog, but they might find me boring.

Given the extreme valuations of the market and exuberant behavior by average investors, I wonder if even deep value stocks and funds will provide a reasonable return going forward. What worked back in 2000 – 2010 may not work this time around. I currently like Aegis Value (AVALX) which is heavily invested in resource stocks including precious metal miners. Manager is a deep value investor with portfolio currently having a P/B of 0.8 and average stock market cap < $800M. This fund outperformed during the 2000 to 2010 bear market but does lag during times when growth stocks are in vogue. Currently looking for other deep value funds to protect capital over the next 10 years. Just wish T. Rowe Price Capital Appreciation was still open. I’m thinking maybe a good balanced fund from Dodge & Cox or Oakmark might be a worthy holding at this point.

https://alephblog.com/2021/06/18/estimating-future-stock-returns-march-2021-update/#comment-39995

Those are credible investments, and seem reasonable to me. There is still a huge valuation gap between growth and value stocks. I am not worried about value here.

There are ways to get shares of funds that are closed, but you might have to pay a premium to get them.

Any thoughts about the attractiveness of local-currency (or hard) emerging sovereign bonds at this point in time?

https://alephblog.com/2021/06/18/estimating-future-stock-returns-march-2021-update/#comment-39996

If the Fed is moving to tighten, or even taper, these are not good ideas. I lost money in those asset classes after Bernanke uttered “taper.” Emerging market debt typically does not do well when the Fed is tightening policy.

IMO valuations will go higher than the last tech bubble. Trend over time has been bubbles getting bigger and valuations getting higher. Accommodative FED, low interest rates will support the market and technology which is truly changing the world will cause euphoria in investors and the market. We have a ways to go before the top is in, IMO.

I work in the tech industry (software for years, now in IT), and I see the world moving to the cloud in droves. I see the SAAS companies growing 30-100%+ per year in revenue. Yes they are 20-50x sales valuations, but when you are growing that fast and your growth is accelerating every quarter, and it’s obvious the entire world is going to be using your product in the near future, what is the proper value? All I can do is buy on pullbacks, and wait for euphoria signals like the 90s (CNBC on the tv at the country club instead of ESPN, stuff like that). When I start seeing that stuff, I’ll sell some on pops, and then trail the rest with a moving average to get me out after the bubble pops.

David I believe you are a very smart guy, and a very good investor. As with most good value investors, they are early. Just my opinion.

https://alephblog.com/2021/06/18/estimating-future-stock-returns-march-2021-update/#comment-39997

I think you are a good investor as well, but you fish in a different pool than I do. Yes, I know value investors are early. When I worked for a value-oriented hedge fund, I was the the “black sheep” that looked at momentum and tried to coax my associates out of short positions that looked doomed.

I am not as sanguine as you, but you know that. The model that I use implies that there are limits to how high or low equity valuations can get. We are near that top now. The dot-com bubble was worse then the bubble before the financial crisis as far as the equity markets go, though the financial crisis was more severe for the economy as a whole, as it affected the banks.

On a macroeconomic basis, my concern is that the Fed will run into a zugzwang situation where they have to choose from two bad options. Personally, I think they will choose to deflate, but really, who knows? They tend to favor the unlevered rich, and not the working poor.

Dumb question but when you say the expected returns are under 1% are you simply just doing an inverse of the current S&P PE ratio, which is around 44?

https://alephblog.com/2021/06/18/estimating-future-stock-returns-march-2021-update/#comment-39998

That’s not a dumb question. No, that’s not what I am doing. I am using the asset share model. The asset share model measures the percentage of assets held by Americans in stocks. The highest figure ever is 52.3%, the lowest is 21.8%. When the value is high, future returns are low, and vice-versa. We are over 51% at present.

Using what the asset share for stocks was in the past, I run a regression to calculate how sensitive 10-year returns on the S&P 500 are to the asset share of stocks. Then I use that equation to forecast future performance. At present the model is forecasting returns of -0.91%/year over the next ten years, not adjusted for inflation.

To those asking how David calculates this, the model is here:

https://alephblog.com/2016/04/16/estimating-future-stock-returns-follow-up/

https://alephblog.com/2021/06/18/estimating-future-stock-returns-march-2021-update/#comment-40000

Thank you for saying that. And hey, you got comment 40,000. Well done.

Now that said, I should add one thing. Roughly one year ago, I figured out how to more accurately estimate the values between the quarterly data that the Fed puts out. I ran some regressions to estimate how much money goes into stocks and everything else, independent of returns on the asset classes. It has made the model work better over the last two years.

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At Aleph Blog, I try to say what I think is true, whether it is popular or not. I think we are in a precarious place at present and am reducing risk. I don’t think there is much upside in this environment, aside from some safe and boring value stocks, and those only maybe — but that is where my money is, along with 30% in very short fixed income.

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.

Photo Credit: Bartleby || Remember the 2020 toilet paper, paper towel, and cleaning supplies shortage. That got worked out after a reasonable period. Now if we could only find corrugated cardboard.

After I wrote last night’s piece, I thought of another area that is investable. It is unfashionable today to be vertically integrated. There’s a good reason for that. When you are vertically integrated your immune from the pricing signals between divisions that could instruct you to do things differently. (i.e., sell your intermediate goods to other companies, or buy intermediate goods from other companies.  Low price wins.)  As such, because of activist investors, companies have been broken up into simpler component units because management teams are sharper when they are managing just one thing.

But the benefits of vertical integration mean that when there is a supply crisis, they can keep running their business on affected. I’ll give you an example: a favorite company of mine called Industrias Bachoco [IBA]. They’re one of the biggest meat producers in North America; mostly they grow chickens, and they produce most of the feed that they use. Did you know that there is a feed shortage? I don’t think it’s affecting Industrias Bachoco. Anyway, it has cheap valuation, no debt, and in this case, an advantage from being vertically integrated.

I want to talk about another aspect of what I discussed last night. I read an article today which said that the most scarce resource in the United States for building homes is not lumber, but land that is already approved to be built on. Zoning is perhaps well-meaning, but that doesn’t help younger people who are looking to buy homes.

So this is in this environment there are bidding wars, and 20% of the buyer base is investors looking to buy at least the house out. In the old days, and this may not be true anymore, but I doubt it, we used to say a market was overheating when it had more than 10% investors.

And this article indicates that housing prices in the United States are as high as they were at the peak of the housing bubble back 2007-2008. Does that mean we’re in a bubble now?

Well, we might be in a bubble for stocks. You can only be in the 99^th percentile of valuations for a couple years at most.  But housing is different in this environment because the terms of the loans being done are better than back during the bubble. However, bit by bit we are seeing leverage rise on home purchases. A bubble might be forming, but we’re not there yet. (Hey, thanks Fed.  You never admit to being wrong.)

And Now for Something Marginally Related Completely Different

Before I close this evening, I want to talk about a somewhat different topic. I think one of the weaknesses of academic economics, and those who use it within the government and the central bank, is that they think that they can eliminate the boom bust cycle. When I read about the startup, shutdown, and switching costs that many capital intensive industries have to go through in order to increase or decrease capacity, or change capacity to a different form, I think economists don’t realize that it is impossible to eliminate the boom bust cycle.

It takes a long time and a big opportunity to make capital intensive firms expand capacity. It takes a long time and a dearth of opportunities to make a capital intensive firm go through shutdown of some capacity. And getting them to shift from one type of production to another takes a long time. They must be convinced that the shift will be profitable for many years.

Economics is a lot more complex than it seems for academics sitting in their chairs with their toy models. It would be far better to get some of them out working in some industrial, financial, and utility firms so that they can understand how difficult it is to work amid volatility.

And as I said, not quite in the same way last night, the virtue of capitalism is that it can deal with volatility more effectively than any other economic system. Supply and demand imbalances will get addressed, and the price mechanism will be the incentive to do so.

The supply imbalances will end, likely in the next two years. It will be replaced by other imbalances. That’s normal. We need to stop treating every problem as a crisis. We especially need to stop asking the government to intervene. In most cases they will do more harm than good, and sometimes they will even prolong the crisis.

And if I didn’t say it last night, be sure to own companies that have strong balance sheets. You want them to be able to survive times of imbalance. As we have seen over the last 15 months, there are often unexpected troubles in an interconnected world.

Full disclosure: Long IBA for clients and me

Picture Credit: AJC1 ||We are dealing with many different types of bottlenecks, with many second-order effects happening due limits in the system. Neoclassical economics in its simple form doesn’t deal with issues like these, and even what I got in Grad School was pretty limited.

According to some of my friends who work at T. Rowe Price, the founder, Thomas Rowe Price, Jr. said something like, “The hardest time to invest is today.” There are also those who say, “It’s different this time,” to which the pithy response is, “It’s always different this time.”

Uncertainty is normal in life as well as investing. It is not a bug. It is a feature of the system. It keeps away people who otherwise might profit if they were willing to take moderate risks. That makes the returns higher for those that do participate.

Leaving aside Covid-19, and all of its side effects we have many fascinating things going on partially as a result of trying to overstimulate the economy. The economy is meant to have small amounts of stimulative government influence, not large amounts. When the stimulative government influence gets too large, elements of the system begin to get hyperactive. Because interest rates are so low, mortgage rates are low. Because mortgage rates are low, many people are buying new houses who otherwise would not. Because many people are buying new houses, lumber is in short supply. And not only lumber, but many industrial metals, parts, and skilled labor are also in short supply.

Typically it takes time to develop skilled labor, and to ramp up supply of parts, commodities, transport, etc. If you try to get these done things done too quickly, you get supply shortfalls which are bottlenecks on the economy.

It doesn’t help that we had “just in time” manufacturing, lean manufacturing, and businesses hoarding commodities and goods that are used in early stage production. When firms realize that there are supply shortages, they take action, accentuating the shortages.

Of course, there is the well known shortage of semiconductors that are slowing down the production of various technological hardware, and particularly automobiles. But what company had the sense to always maintain a stockpile that would be adequate to survive a 6-month crisis? Of course no one does that. They would be told by their management that that much investment in inventory would kill the return on equity.

We can add in the supply problem stemming from the Ever Given and it’s blockage of the Suez canal, and the delays induced in much global shipping while the ships waited for the canal to clear. We can also bring up how Los Angeles ports are hopelessly clogged. And how intermodal lacks enough trucks and drivers to cart the stuff away.

For another example consider the trouble stemming from Colonial Pipelines getting hacked. The gasoline shortage resulting from that came mostly from hoarding, but showed us how much we rely on a single enterprise to provide energy to the South and Northeast.

There’s not enough slack in the system. We need more redundancy. And that won’t happen because firms are looking to maximize the return on equity, and as such they tend not to keep too much excess supply of ability to produce or transport. Most government regulation does not help here, but it would be interesting to see what would happen if the government mandated that firms maintain sufficient slack capacity for production or transport. That would be an ugly regulation, but if it affected everyone maybe it wouldn’t be so bad. How to enforce that would be an absolute headache and so it will never happen.

And at Aleph Blog, in the past I would talk about plague, pestilence, war and other things that people typically don’t anticipate. Not that I thought that any particular one was going to happen at any particular time, but just to make you think about what could happen. Well, now we have experienced plague. Let me try out another idea on you: how many people are expecting a war right now? Yeah, not many people. Can you imagine how badly a war might snarl global trade, particularly since the division of labor is global? Who is prepared for this? Probably no one.

This is one reason among many that I try to emphasize caution in investing. We are running an economic system that has no slack. We are overstimulating by a monetary policy and creating asset bubbles. The government is borrowing far beyond its means which means that someday it will not be able to pay it all back, and at that point in time what will the dollar be worth? When the government has to borrow the money in order to pay the interest, something is so wrong that eventually foreign creditors will not lend any longer.

No, if I can get off that bleak topic of macroeconomics for a moment, let me talk about what probably would not work in investing now. In general, these shortages will be transitory. The capitalist system will overcome these things, despite the best efforts of the government to thwart that. So, I don’t think it’s time to invest in semiconductor equipment or semiconductor stocks. I don’t think it’s a time to invest in trucking. We invest on the basis of the long haul, not on the basis of temporary disruptions.

I would rather invest in the companies that will do well once the supply shortages or bottlenecks are eliminated. In other words who uses the products or services that are currently less available? That is where to invest.  Look for the areas that have continuing usefulness and are still down considerably since 2019. That’s where I’ll be digging; I’m not sure I have the answers yet, but I think that’s where to look. In the meantime, hold enough slack assets in short-dated bonds to give additional buying power, and average in as prices of stocks fall.

Postscript

• Using Sentieo I did massive searches through their databases to see when the shortage talk began — it started four months ago, peaked in March/April, and is still quite high now.
• There’s a neat transcript of Tracy Alloway and Joe Weisenthal talking to an executive of a logistics company about current transportation issues. It’s long but good.
• Another article from Bloomberg on the same topic.
• We know about US housing issues, but they are even more severe in Canada.
• A CEO friend of mine who runs a small manufacturing firm says he has more orders than he can fill. He just can’t get the parts, and the same is true for his industry globally.