The S&P 500 move this year is completely outside the historical seasonal trends.
Graph Credit: Deutsche Bank via @SoberLook at The Wall Street Journal
Averages reveal, but they also conceal. ?When I look at a graph like this, I know that any given year is highly likely to look different than an average of years. ?So, no surprise that the returns on the S&P 500 are different than the averages of the prior 11 or 19 years.
But how has the S&P 500 fared versus the last 68 years? ?At present this year is 20th out of 68, which is good, but not great or average. ?But look at the graph at the top of this article: up until the close of the 25th trading day of the year (February 7th) the market had performance very much like a median year. ?All of the higher performance has come out of the last nine days. ?(For fun, it is the ninth best out of 68 for that time of year; even that is not top decile.)
I can tell you something easy: you can have a lot of different occurrences over nine days in the market. ?The distribution of returns would be quite wide. ?Therefore, don’t get too excited about the returns so far this year — they aren’t that abnormal. ?You can be concerned as you like about valuation levels — they are high. ?But 2017 at present is a “high side of normal” year compared to past price performance.
And, if you want to be concerned about a melt-up, it is this kind of low positive momentum that tends to persist, at least for a while. ?Trading behavior isn’t nuts, even if valuations are somewhat steamy.
I’m around 83% invested in equity accounts, so I am conservative, but I’m not thinking of hedging yet. ?Let the rally run.
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.
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.
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?
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.
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.
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:
I think the thing that would hurt the most money managers is a melt-up that they would feel forced 2 chase, followed by a hard correction $$
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.
It was shortly after the election when I last moved my trading band. ?Well, time to move it again, this time up 4%, with a small twist. ?I’m at my cash limit of 20%, with a few more stocks knocking on the door of a rebalancing sale, and none near a rebalancing buy. ?(To decode this, you can read my article on portfolio rule seven.) ?Here is portfolio rule seven:
Rebalance the portfolio whenever a stock gets more than 20% away from its target weight. Run a largely equal-weighted portfolio because it is genuinely difficult to tell what idea is the best. Keep about 30-40 names for diversification purposes.
This is my interim trading rule, which helps me make a little additional money for clients by buying relatively low and selling relatively high. ?It also reduces risk, because higher prices are riskier than lower prices, all other things equal.
There are two companies that are double-weights in my portfolio, one half-weight, and 32 single-weights. ?The half-weight is a micro-cap that is difficult to buy or sell. (Patience, patience…) ?With cash near 20%, a?single-weight currently runs around 2.2% of assets, with buying happening near 1.75%, and selling near 2.63%.
But, I said there was a small twist. ?I’m going to add another single-weight position. ?I don’t know what yet. ?Also, I’m leaving enough in reserve to turn one of the single-weights into a double-weight. ?That company is a well-run Mexican firm that has ?had a falling stock price even though it is still performing well. ?If it falls another 10%, I will do more than rebalance. ?I will rebalance and double it.
Part of the reason for the move in both number of positions and position size at the same time is that both the half-weight and one single-weight that is at the top of its band are being acquired for cash, and so they (3.5% of assets) behave more like cash than stocks.
Thus, amid a portfolio that has been performing well, I am adjusting my positioning so that if the market continues to do well, the portfolio doesn’t lag much, or even continues to outperform. ?I’m not out to make big macro bets; I will make a small bet that the market is high, and carry above average cash, but it will all get deployed if the market falls 25%+ from here.
I keep the excess cash around for the same reason Buffett does. ?It gives you more easy options in a bad market environment. ?Until that environment comes, you’ll never know how valuable is is to keep some extra cash around. ?Better safe, than sorry.
Photo Credit: eflon?|| The?title of the article comes from a comment Greenberg supposedly made to Buffett when AIG was much bigger than Berkshire Hathaway — times change…
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The?title of the article comes from a comment Greenberg supposedly made to Buffett when AIG was much bigger than Berkshire Hathaway [BRK] — times change…
It’s come to this: AIG has sought out reinsurance from BRK to cap the amount of losses they will pay for prior business written. ?It’s quite a statement when you are willing to pay $10 billion in order to have BRK pay 80% of claims over $25 billion, up to $20 billion in total. ?At $50 Billion in claims AIG is on its own again.
The agreement covers 80% of substantially all of AIG?s U.S. Commercial long-tail exposures for accident years 2015 and prior, which includes the largest part of AIG?s U.S. casualty exposures during that period. AIG will retain sole authority to handle and resolve claims, and NICO has various access, association and consultation rights.
The pact covers such product lines as workers? compensation, directors? and officers? liability, professional indemnity, medical malpractice, commercial automobile and some other liability policies.
Now, AIG is not among the better P&C insurance companies for reserving out there. ?2.5 years ago, they made the Aleph Blog Hall of Shame for P&C reserving. ?Now if you would have looked on the last 10-K on page 296 for item 8, note 12, you would note that AIG’s reserving remained weak for?2014 and 2015 as losses and loss adjustment expenses incurred for the business of prior years continued positive.
For AIG, this puts a lot of its troubles behind it, after the upcoming writeoff (from the WSJ article):
AIG, one of the biggest sellers of insurance by volume to businesses around the globe, also said it expects a material fourth-quarter charge to boost its claims reserves. AIG declined to comment on the possible size. Its fourth-quarter earnings will be released next month.
For BRK, this is an opportunity to make money investing the $10 billion as claims on the long-tail business get paid out slowly. ?It’s called float, which isn’t magic, but Buffett has done better than most at investing the float, and choosing insurance business to write and reinsure that doesn’t result in large losses for BRK.
I expect BRK to make an underwriting profit on this, but let’s assume the worst, that BRK pays out the full $20 billion. ?Say the claims come at a rate of $5 billion/year. ?The average payout period would be 7.5 years, and BRK would have to earn 9.2% on the float to break even. ?At $3.75B/yr, the figures would be 10 years and 6.9%. ?At $2.5B/yr, 15 years and 4.6%.
This doesn’t seem so bad to me — now I don’t know how bad reserve development will be for AIG, but BRK is usually pretty careful about underwriting this sort of thing. That said BRK has a lot of excess cash sitting around already, and desirable targets for large investments are few. ?This had better make an underwriting profit, or a small loss, or maybe Buffett is ready for the market to fall apart, and thus the rate he can earn goes up.
All that said, it is an interesting chapter in the relationship between the two companies. ?If BRK wasn’t the dominant insurance company of the US after the 2008 financial crisis, it definitely is now.
Full disclosure: long BRK/B for myself and clients
I was driving to a meeting of the Baltimore CFA Society, and listening to Bloomberg Radio, which was carrying President-Elect Trump’s Press Conference. I didn’t think too much about what I heard until Sheri Dillon talk about what was being done to eliminate conflicts of interest. Here is an excerpt:
Some have asked questions. Why not divest? Why not just sell everything? Form of blind trust. And I?d like to turn to addressing some of those questions now.
Selling, first and foremost, would not eliminate possibilities of conflicts of interest. In fact, it would exacerbate them. The Trump brand is key to the value of the Trump Organization?s assets. If President-elect Trump sold his brand, he would be entitled to royalties for the use of it, and this would result in the trust retaining an interest in the brand without the ability to assure that it does not exploit the office of the presidency.
[snip]
Some people have suggested that the Trump ? that President-elect Trump could bundle the assets and turn the Trump Organization into a public company. Anyone who has ever gone through this extraordinarily cumbersome and complicated process knows that it is a non-starter. It is not realistic and it would be inappropriate for the Trump Organization.
It went on from there, but I choked on the last paragraph that I quoted above. (Credit: New York Times, not all accounts carried the remarks of Ms. Dillon, a prominent attorney with the firm Morgan Lewis who structured the agreements for Trump) ?As I said before:
Trump to Outline Plans for ?Leaving My Great Business? Dec. 15 https://t.co/iIwweP2LcN Time to IPO and sell off the Trump Organization $$
An IPO of the Trump Organization was?realistic. ?I’m not saying it could have been done by the inauguration, but certainly by the end of 2017, and likely a lot earlier. ?I’ve seen insurance companies go through IPO processes that took a matter of months, a few because they had to sell the company to raise liquidity quickly for some reason.
In an IPO, Trump, all of Trump’s children and anyone else with an equity interest would have gotten their proportionate share of the new public company. ?Trump could have provided a lot of shares for the IPO, and instructed the trustee for his assets to sell it off?the remainder over the next year or so.
While difficult, this would not have been impossible or imprudent. ?Trump?might lose some value in the process, but hey, that should be part of the cost for a very wealthy man who becomes President of the US. ?There would be the countervailing advantage that all capital gains are eliminated, and who knows, that might settle his existing negotiations with the IRS.
Ending the counterfactual, though conflict of interest rules don’t apply to the President, Trump had?an opportunity to eliminate all conflicts of interest, and did not take it.
PS — Many major hotels are in the “name licensing” business — I also don’t buy the argument that Trump could not sell off the organization in entire, with no future payments for the rights of using the name. ?A bright businessman could create a new brand easily. ?It’s been done before.
Comments are always appreciated from readers, if they are polite. ?Here’s a recent one from the piece?Distrust Forecasts.
You made one statement that I don?t really understand. ?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.?
What is the danger of balance sheets proving insufficient? Does that mean that the company doesn?t have enough cash to cover their ?burn rate??
Not having enough cash to cover the burn rate can be an example of this. ?Let me back up a bit, and speak generally before focusing.
Whether economists, quantitative analysts, chartists or guys who pull numbers out of the air, most people do not consider balance sheets when making predictions. ?(Counterexample: analysts at the ratings agencies.) ?It is much easier to assume a world where there are no limits to borrowing. ?Practical example #1 would be home owners and buyers during the last financial crisis, together with the banks, shadow banks, and government sponsored enterprises that financed them.
In economies that have significant private debts, growth is limited, because of higher default probabilities/severity, and less capability of borrowing more should defaults tarry. ?Most firms don?t like issuing equity, except as a last resort, so restricted ability to borrow limits growth. High debt among consumers limits growth in another way ? they have less borrowing capacity and many feel less comfortable borrowing anyway.
Figuring out when there is “too much debt” is a squishy concept at any level — household, company, government, economy, etc. ?It’s not as if you get to a magic number and things go haywire. ?People have a hard time dealing with the idea that as leverage rises, so does the probability of default and the severity of default should it happen. ?You can get to really high amounts of leverage and things still hold together for a while — there may be extenuating circumstances allowing it to work longer — just as in other cases, a failure in one area triggers a lot more failures as lenders stop lending, and those with inadequate liquidity can refinance and then fail.
Three?More Reasons to Distrust Predictions
1) Media Effects — the media does not get the best people on the tube — they get those that are the most entertaining. ?This encourages extreme predictions. ?The same applies to people who make predictions in books — those that make extreme predictions sell more books. ?As an example, consider this post from Ben Carlson on Harry Dent. ?Harry Dent hasn’t been right in a long time, but it doesn’t stop him from making more extreme predictions.
2) Momentum Effects — this one is two-sided. ?There are?momentum effects in the market, so it’s not bogus to shade near term estimates based off of what has happened recently. ?There are two problems though — the longer and more severe the rise or fall, the more you should start downplaying momentum, and increasingly think mean-reversion. ?Don’t argue for a high returning year when valuations are stretched, and vice-versa for large market falls when valuations are compressed.
The second thing is kind of a media effect when you begin seeing articles like “Everyone Ought to be Rich,” etc. ?”Dow 36,000″-type predictions come near the end of bull markets, just as “The Death of Equities’ comes at the end of Bear Markets. ?The media always shows up late; retail shows up late; the nuttiest books show up late. ?Occasionally it will fell like books and pundits are playing “Can you top this?” near the end of a cycle.
3) Spurious Math — Whether it is the geometry of charts or the statistical optimization of regression, it is easy to argue for trends persisting longer than they should. ?We should always try to think beyond the math to the human processes that the math is describing. ?What levels of valuation or indebtedness are implied? ?Setting new records in either is always possible, but it is not the most likely occurrence.
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.
