Value Investing – Page 3

Estimating Future Stock Returns, September 2017 Update

Posted on 8 December 2017 by David Merkel

Another quarter goes by, the market rises further, and the the 10-year forward return falls again.? Here are the last eight values:?6.10%, 6.74%, 6.30%, 6.01%, 5.02%, 4.79%, and 4.30%, 3.99%. ?At the end of September 2017, the figure would have been 4.49%, but the rally since the end of the quarter shaves future returns down to 3.99%.

At the end of June the figure was 4.58%.? Subtract 29 basis points for the total return, and add back 12 basis points for mean reversion, and that would leave us at 4.41%.? The result for September month-end was 4.49%, so the re-estimation of the model added 8 basis points to 10-year forward returns.

Let me explain the adjustment calculations.? In-between quarterly readings, price movements shave future returns the same as a ten-year zero coupon bond.? Thus, a +2.9% move in the total return shaves roughly 29 basis points off future returns. (Dividing by 10 is close enough for government work, but I use a geometric calculation.)

The mean-reversion calculation is a little more complex.? I use a 10-year horizon because that is the horizon the fits the data best.? It is also the one I used before I tested it.? Accidents happen.? Though I haven’t talked about it before, this model could be used to provide shorter-run estimates of the market as well — but the error bounds around the shorter estimates would be big enough to make the model useless. It is enough to remember that when a market is at high valuations that corrections can’t be predicted as to time of occurrence, but when the retreat happens, it will be calamitous, and not orderly.

Beyond 10-years, though, the model has no opinion.? It is as if it says, past mean returns will occur.? So, if we have an expectation of a 4.58% returns, we have one 4.58%/yr quarter drop of at the end of the quarter, and a 9.5% quarter added on at the end of the 10-year period. That changes the quarterly average return up by 4.92%/40, or 12.3 basis points.? That is the mean reversion effect.

Going Forward

Thus, expected inflation-unadjusted returns on the S&P 500 are roughly 3.99% over the next ten years.? That’s not a lot of compensation for risk versus investment-grade bonds.? We are at the 94th percentile of valuations.

Now could we go higher?? Sure, the momentum is with us, and the volatility trade reinforces the rise for now.? Bitcoin is an example that shows that there is too much excess cash sloshing around to push up the prices of assets generally, and especially those with no intrinsic value, like Bitcoin and other cryptocurrencies.

Beyond that, there are not a lot of glaring factors pushing speculation, leaving aside futile government efforts to stimulate an already over-leveraged economy.? It’s not as if consumer or producer behavior is perfectly clean, but the US Government is the most profligate actor of all.

And so I say, keep the rally hats on.? I will be looking to hedge around an S&P 500 level of 2900 at present.? I will be watching the FOMC, as they may try to invert the yield curve again, and crash things.? They never learn… far better to stop and wait than make things happen too fast.? But they are omnipotent fools.? Maybe Powell will show some non-economist intelligence and wait once the yield curve gets to a small positive slope.

Who can tell?? ?Well, let’s see how this grand experiment goes as Baby Boomers arrive at the stock market too late to save for retirement, but just in time to put in the top of the equity market.? Though I am waiting until S&P 2900 to hedge, I am still carrying 19% cash in my equity portfolios, so I am bearish here except in the short-run.

PS — think of it this way: it should not have gone this high, therefore it could go higher still…

“Bank” Some of Your Gains

Posted on 17 October 201717 October 2017 by David Merkel

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Recently I read Jonathan Clements’ piece Enough Already.? The basic idea was to encourage older investors who have made gains in the risk assets, typically stocks, though it would apply to high yield bonds and other non-guaranteed investments that are highly correlated with stocks.? His pithy way of phrasing it is:

If I have already won the game, why would I keep playing?

His inspiration for the piece stems from a another piece by William Bernstein [at the WSJ] How to Tell if Your Retirement Nest Egg Is Big Enough.? He asked a question like this (these are my words) back in early 2015, “Why keep taking risk if your performance has been good enough to let you reduce risk and live on the assets, rather than run the possibility of a fall in the market spoiling your ability to retire comfortably?”

Decent question.? If you are young enough, your time horizon is long enough that you can ignore it.? But if you are older, you might want to consider it.

Here’s the problem, though.? What do you reinvest in?? My article?How to Invest Carefully for Mom?took up some of the problem — if I were reducing exposure to stocks, I would invest in high quality short and long bonds, probably weighted 50/50 to 70/30 in that range.? Examples of tickers that I might consider be MINT and TLT.? Trouble is, you only get a yield of 2% on the mix.? The short bonds help if there is inflation, the long bonds help if there is deflation.? Both remove the risk of the stock market.

I’m also happier in running with my mix of international stocks and quality US value investments versus holding the S&P 500, because foreign and value have underperformed for so long, almost feels like 1999, minus the crazed atmosphere.

Now, Clements at the end of the exercise doesn’t want to make any big changes.? He still wants to play on at the ripe old age of 54.? He is concerned that his nest egg isn’t big enough.? Also, he thinks stocks will return 5-6%/year over the long haul (undefined), versus my model that says 2-6%/year over the next ten years.

What would I say?? I would say “do half.”? Whatever the amount you would cut from stocks to move to bonds if you were certain of it, do half of it.? If disaster strikes, you will pat yourself on the back for doing something.? If the market rallies further, you will be glad you didn’t do the whole thing.

What’s that, you say?? What am I doing?? At age 56, I am playing on, but 10-12% higher in the S&P 500, and I will hedge.? At levels like that future market outcomes are poor under almost every historical scenario, and even if the market doesn’t seem nuts in terms of qualitative signals, the amount you leave on the table is piddly over a 10-year horizon.? If I see more genuine nuttiness beyond certain logic-free zones in the market, I could act sooner, but for now, like Jonathan, I play on.

Full disclosure: long MINT and TLT for me and my fixed income clients

Book Review: The Best Investment Writing, Volume 1

Posted on 5 October 2017 by David Merkel

I was pleasantly surprised to be invited to contribute a chapter to this book.? I am going to encourage you to buy this book, but let me give some of the reasons not to buy this book:

Don’t buy it to give me something.? I don’t get anything from sales of this book.? Neither does Mebane Faber, who is giving all of the profits to charity.
Don’t buy it to read my article.? You can read it for free here.? Better, you can read the updated version of the article, which I publish quarterly, here.? (Those reading this at Amazon, there are links at my blog.? Google “Alephblog The Best Investment Writing” to find them.)
Don’t buy it to get current ideas.? There are none here.? The weakness of the book is that the articles are dated by 9-21 months or so, BUT… that doesn’t keep the book from being relevant.
Don’t buy it if you want one consistent theme.? It’s like reading RealMoney.com, except with a broader array of authors.? There is no “house view.”
Don’t buy it for the graphics in the book.? The grayscale images in the book are good for black & white, but some are hard to read.? The graphs for my article are far better at my blog.

The book is a good one because there is something for everyone here.? Do you want quantitative finance?? There is a good selection here. Do you want good basic articles about how to think about investing?? There are a good number of those as well, particularly from well-known financial journalists, and some of the most well-regarded bloggers.? Do you want a few unusual articles that might cause you consider some asset sub-classes or techniques that you haven’t considered before?? They are here too.

The writers fall into four buckets — journalists, asset managers, pundits/authors, and those who sell information at their websites.? I will tell you that my personal favorites from this volume are Tom Tresidder, Mebane Faber, Chris Meredith, Ben Carlson (how was he the only one with two articles in the book?), Jason Hsu & John West, and Cullen Roche.

Don’t get me wrong, I like almost all of the authors in this volume, and am proud to be featured among them.? For a number of them, though, I would have picked other things they have written in 2016 that had more punch, and offered more of a difference in perspective.

Why buy this?? After you read this, you will be a smarter, more well-rounded investor.? In my calculations, that’s? pretty good — 32 articles that will take you 4 hours to read.? Got seven minutes?? Read an article; it just might help you a great deal.

Quibbles

Already stated, though if you don’t like statistics, one-third of the articles may not appeal to you.? Also, a few articles veer into political commentary (not that I would ever do that 😉 ).

Summary / Who Would Benefit from this Book

Though almost anyone could benefit from this book, it is geared toward investors with intermediate-to-higher levels of knowledge and experience.? If you want to buy it, you can buy it here:?The Best Investment Writing: Selected writing from leading investors and authors.

Full disclosure:?I received two free copies of the book for contributing the article.? That’s all, unless someone buys the book through the link above.

If you enter Amazon through my site, and you buy anything, including books, I get a small commission. This is my main source of blog revenue. I prefer this to a ?tip jar? because I want you to get something you want, rather than merely giving me a tip. Book reviews take time, particularly with the reading, which most book reviewers don?t do in full, and I typically do. (When I don?t, I mention that I scanned the book. Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website. Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites. Whether you buy at Amazon directly or enter via my site, your prices don?t change.

Estimating Future Stock Returns, June 2017 Update

Posted on 22 September 2017 by David Merkel

I’d say this is getting boring, but it’s pretty fascinating watching the rally run. ?Now, this is the seventh time I have done this quarterly analysis. ?The first one was for December 2015. ?Over that time period, the expected annualized 10-year return went like this, quarter by quarter: 6.10%, 6.74%, 6.30%, 6.01%, 5.02%, 4.79%, and 4.30%. ?At the end of June 2017, the figure would have been 4.58%, but the rally since the end of the quarter shaves future returns down to 4.30%.

We are now in the 93rd percentile of valuations.

Wow.

This era will ultimately be remembered as a hot time in the markets, much like 1965-9, 1972, and 1997-2001.

The Internal Logic of this Model

I promised on of my readers that I would provide the equation for this model. ?Here it is:

10-year annualized total return = 32.77% – (70.11% * Percentage of total assets held in stocks for the US as a whole)

Now, the logic of this formula stems from the idea that the return on total assets varies linearly with the height of the stock market, and the return on debt (everything else aside from stocks) does not. ?After that, the formula is derived from the same formula that we use for the weighted average cost of capital [WACC]. ?Under those conditions, the total returns of the stock market can be approximated by a linear function of the weight the stocks have in the WACC formula.

Anyway, that’s one way to think of the logic behind this.

The Future?

Now, what are some of the possibilities for the future?

Above you see the nineteen scenarios for where the S&P 500 will be in 10 years, assuming a 2% dividend yield, and looking at the total returns that happen when the model forecasts returns between 3.30% and 5.30%. ?The total returns vary from 2.31%/year to 6.50%, and average out to 3.97% total returns. ?The bold line above is the 4.30% estimate.

As I have said before, this bodes ill for all collective security schemes that rely on the returns of risky assets to power the payments. ?There is no conventional way to achieve returns higher than 5%/year for the next ten years, unless you go for value and foreign markets (maybe both!).

Then again, the simple solution is just to lighten up and let cash build. ?Now if we all did that, we couldn’t. ?Who would be buying? ?But if enough of us did it such that equity valuations declined, there could be a more orderly market retreat.

The attitude of the market on a qualitative basis doesn’t seem nuts to me yet, so I am at maximum cash for ordinary conditions, but I haven’t hedged. ?When expected 10-year market returns get to 3%/year, I will likely do that, but for now I hold my stocks.

PS — the first article of this series has been translated into Chinese. ?The same website has 48 of my best articles in Chinese, which I find pretty amazing. ?Hope you smile at the cartoon version of me. 😉

How to Invest Carefully for Mom

Posted on 21 September 2017 by David Merkel

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Just a note before I begin. My piece called “Where Money Goes to Die” was an abnormal piece for me, and it received abnormal attention. ?The responses came in many languages aside from English, including Spanish, Turkish and Russian. ?It was interesting to note the level of distortion of my positions among those writing articles. ?That was less true of writing responses here.

My main point is this: if something either has no value or can’t be valued, it can’t be an investment. ?Speculations that have strong upward price momentum, like penny stocks during a promotion, are dangerous to speculate in. ?Howard Marks, Jamie Dimon and Ray Dalio seem to agree with that. ?That’s all.

Now for Q&A:

Greetings and salutations. ?:)

Hope all is well with you and the family!

Just have what I believe is a quick question. I already know [my husband’s] answer to this (Vanguard index funds – it his default answer to all things investment), but this is for my Mom, so it is important that she get it right (no wiggle room for losing money in an unstable market), hence my asking you. My Mom inherited money and doesn’t know what to do with it. a quarter of it was already in index funds/mutual funds and she kept it there. The rest came from the sale of real estate in the form of a check. That is the part that she doesn’t know what she should do with. She wanted to stick it in a CD until she saw how low the interest rates are. She works intermittently (handyman kind of work – it is demand-dependent), but doesn’t have any money saved in a retirement account or anything like that, so she needs this money get her though the rest of her life (she is almost 60). What would you recommend? What would you tell [name of my wife] to do if she were in this position? BTW, it is approx $ZZZ, if that makes a difference. Any advice you can give would be very much appreciated!

Vanguard funds are almost always a good choice. ?The question here is which Vanguard funds? ?To answer that, we have to think about asset allocation. ?My thoughts on asset allocation is that it is a marriage of two concepts:

When will you need to spend the money? and
Where is there the opportunity for good returns?

Your mom is the same age as my wife. ?A major difference between the two of them is that your mom doesn’t have a lot of investable assets, and my wife does. ?We have to be more careful with your mom. ?If your mom is only going to draw on these assets in retirement, say at age 67, and will draw them down over the rest of her life, say until age 87, then the horizon she is investing over is long, and should have stocks and longer-term bonds for investments.

But there is a problem here. ?Drawing on an earlier article of mine, investors today face a big problem:

The biggest problem for investors is low future returns. ?Bonds have low rates of returns, and equities have high valuations. ?You?ll see more about equity valuations in my next post.

This is a real problem for those wanting to fund retirements. ?Stocks are priced to return around 4%/year over the next ten years, and investment-grade longer bonds are around 3%. ?There are some pockets of better opportunity and so I suggest the following:

Invest more in foreign and emerging market stocks. ?The rest of the world is cheaper than the US. ?Particularly in an era where the US is trying to decouple from the rest of the world, foreign stocks may provide better returns than US stocks for a while.
Invest your US stocks in a traditional “value” style. ?Admittedly, this is not popular now, as value has underperformed for a record eight years versus growth investing. ?The value/growth cycle will turn, as it did back in 2000, and it will give your mom better returns over the next ten years.
Split your bond allocation into two components: long US high-quality bonds (Treasuries and Investment Grade corporates), and very short bonds or a money market fund. ?The long bonds are there as a deflation hedge, and the short bonds are there for liquidity. ?If the market falls precipitously, the liquidity is there for future investments.

I would split the investments 25%, 35%, 20%, 20% in the order that I listed them, or something near that. ?Try to sell your mom on the idea of setting the asset allocation, and not sweating the short-term results. ?Revisit the strategy every three years or so, and rebalance annually. ?If assets are needed prematurely, liquidate the assets that have done relatively well, and are above their target weights.

I know you love your mom, but the amount of assets isn’t that big. ?It will be a help to her, but it ultimately will be a supplement to Social Security for her. ?Her children, including you and your dear husband may ultimately prove to be a greater help for her than the assets, especially if the markets don’t do well. ?The asset allocation I gave you is a balance of offense and defense in an otherwise poor environment. ?The above advice also mirrors what I am doing for my own assets, and the assets of my clients, though I am not using Vanguard.

Book Review: Big Money Thinks Small

Posted on 6 September 2017 by David Merkel

Joel Tillinghast, one of the best mutual fund managers, runs the money in Fidelity’s Low-Priced Stock Fund. ?It has one of the best long-term records among stock funds over the 28 years that he has managed it.

The author gives you a recipe for how to pick good stocks, but he doesn’t give you a machine that produces them. ?In a style that is clever and discursive, he summarizes his main ideas at the beginning and end of the book, and explains the ideas in the middle of the book. ?The ideas are simple, but learning to apply them will take a lifetime.

Here are the five ideas as written in the beginning (page 3):

Make decisions rationally
Invest in what we know (did I mention Peter Lynch wrote the foreword to the book?)
Worth with honest and trustworthy managers
Avoid businesses prone to obsolescence and financial ruin, and?
Value stocks properly

At this point, some will say “You haven’t really given us anything! ?These ideas are too big to be useful!” ?I was surprised, though, to see that the same five points at the end of the book said more (page 276). ?Ready?

Be clear about your motives, and don’t allow emotions to guide your financial decisions
Recognize that some things can’t be understood and that you don’t understand others. ?Focus on those that you understand best.
Invest with people who are honest and trustworthy, and are doing something unique and valuable.
Favor businesses that will not be destroyed by changing times, commoditization, or excessive debt.
Above all, always look for investments that are worth a great deal more than you are paying for them.

That says more, and I think the reason they are different is that when you read through the five sections of the book, he unpacks his initial statements and becomes more definite.

Much of the book can be summarized under the idea of “margin of safety.” ?This is a type of value investing. ?When he analyzes value, it is like a simplified version of reverse discounted cash flows. ?He tries to figure out in a broad way what an investment might return in terms price paid for the investment and what “owner earnings,” that is, free cash flow, it will generate on a conservative basis.

One aspect of the conservatism that I found insightful is that he assumes that the terminal value of an investment is zero. (page 150) ?In my opinion, that is very smart, because that is the area where most discounted cash flow analyses go wrong. ?When the difference between the weighted average growth rate of free cash flow and the discount rate is small, the terminal value gets really big relative to the value of the cash lows prior to the terminal value. ?In short, assumptions like that say that the distant future is all that matters. ?That’s a tough assumption in a world where companies and industries can become obsolete.

Even though I described aspects of a mathematical calculation here, what I did was very much like the book. ?There are no equations; everything is described verbally, even the math. ?Note: that is a good exercise to see whether you understand what the math really means. ?(If more people on Wall Street did that, we might not have had the financial crisis. ?Just sayin’.)

One more fun thing about the book is that he goes trough his own experiences with a wide variety of controversial stocks from the past and his experiences with them. ?His conservatism kept him a great number of errors that tripped up other celebrated managers.

I learned a lot from this book, and I enjoyed the writing style as well. ?He clearly put a lot of effort into it; many people will benefit from his insights.

Quibbles

His methods are a lot like mine, and he clearly put a lot of thought into this book. ?That said, he doesn’t understand insurance companies as well as he thinks (I’m an actuary by training). ?There are a number of small errors there, but not enough to ruin a really good book.

Summary / Who Would Benefit from this Book

I highly recommend this book. ?This is a book that will benefit investors with moderate to high experience most. For those with less experience, it may help you, but some of the concepts require background knowledge. ?If you want to buy it, you can buy it here: Big Money Thinks Small: Biases, Blind Spots, and Smarter Investing.

Full disclosure:?The publisher asked me if I wanted a free copy and I assented.

Perceived Versus Real Risk Tolerance

Posted on 8 July 201712 July 2017 by David Merkel

Picture Credit: Denise Krebs || What RFK said is not applicable to investing. ?Safety First! ?Don’t lose money!

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Investment entities, both people and institutions, often say one thing and mean another with respect to risk. ?They can keep a straight face with respect to minor market gyrations. ?But major market changes leading to the possible or actual questioning of whether they will have enough money to meet stated goals is what really matters to them.

There are six factors that go into any true risk analysis (I will handle them in order):

Net Wealth Relative to Liabilities
Time
Liquidity
Flexibility
Investment-specific Factors
Character of the Entity’s Decision-makers and their Incentives

Net Wealth Relative to Liabilities

The larger the surplus of assets over liabilities, the more relaxed and long-term focused an entity can be. ?For the individual, that attempts to measure the amount needed to meet future obligations where future investment earnings are calculated at a conservative level — my initial rule of thumb is no more than 1% above the 10-year Treasury yield.

That said, for entities with well defined liabilities, like a defined benefit pension plan, a bank, or an insurance company, using 1% above the yield curve should be a maximum for investment earnings, even for existing fixed income assets. ?Risk premiums will get taken into net wealth as they are earned. ?They should not be planned as if they are guaranteed to occur.

Time

The longer it is before payments need to be made, the more aggressive the investment posture can be. ?Now, that can swing two ways — with a larger surplus, or more time before payments need to be made, there is more freedom to tactically overweight or underweight?risky assets versus your normal investment posture.

That means that someone like Buffett is almost unconstrained, aside from paying off insurance claims and indebtedness. ?Not so for most investment entities, which often learn that their estimates of when they need the money are overestimates, and in a crisis, may need liquidity sooner than they ever thought.

Liquidity

High quality assets that can easily be turned into spendable cash helps make net wealth more secure. ?Unexpected cash outflows happen, and how do you meet those needs, particularly in a crisis? ?If you’ve got more than enough cash-like assets, the rest of the portfolio can be more aggressive. ?Remember, Buffett view cash as an option, because of what he can buy with it during a crisis. ?The question is whether the low returns from holding cash will get more than compensated for by capital gains and income on the rest of the portfolio across a full market cycle. ?Do the opportunistic purchases get made when the crisis comes? ?Do they pay off?

Also, if net new assets are coming in, aggressiveness can increase somewhat, but it matters whether the assets have promises attached to them, or are additional surplus. ?The former money must be invested coservatively, while surplus can be invested aggressively.

Flexibility

Some liabilities, or spending needs, can be deferred, at some level of cost or discomfort. ?As an example, if retirement assets are not sufficient, then maybe discretionary expenses can be reduced. ?Dreams often have to give way to reality.

Even in corporate situations, some payments can be stretched out with some increase in the cost of financing. ?One has to be careful here, because the time you are forced to conserve liquidity is often the same time that everyone else must do it as well, which means the cost of doing so could be high. ?That said, projects can be put on hold, realizing that growth will suffer; this can be a “choose your poison” type of situation, because it might cause the stock price to fall, with unpredictable second order effects.

Investment-specific Factors

Making good long term investments will enable a higher return over time, but concentration of ideas can in the short-run lead to underperformance. ?So long as you don’t need cash soon, or you have a large surplus of net assets, such a posture can be maintained over the long haul.

The same thing applies to the need for income from investments. ?investments can shoot less for income and more for capital gains if the need for spendable cash is low. ?Or, less liquid investments can be purchased if they offer a significant return for giving up the liquidity.

Character of the Entity’s Decision-makers and their Incentives

The last issue, which many take first, but I think is last, is how skilled the investors are in dealing with panic/greed situations. ?What is your subjective “risk tolerance?” ?The reason I put this last, is that if you have done your job right, and properly sized the first five factors above, there will be enough surplus and liquidity that does not easily run away in a crisis. ?When portfolios are constructed so that they are prepared for crises and manias, the subjective reactions are minimized because the call on cash during a crisis never gets great enough to force them to move.

A: “Are we adequate?”

B: “More than adequate. ?We might even be able to take advantage of the crisis…”

The only “trouble” comes when almost everyone is prepared. ?Then no significant crises come. ?That theoretical problem is very high quality, but I don’t think the nature of mankind ever changes that much.

Closing

Pay attention to the risk factors of investing relative to your spending needs (or, liabilities). ?Then you will be prepared for the inevitable storms that will come.

Estimating Future Stock Returns, March 2017 Update

Posted on 10 June 201711 June 2017 by David Merkel

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I lost this post once already, hopefully it will be better-written this time. ?I’ve been playing around with the stock market prediction model in order to give some idea of how the actual results could vary from the forecasts.

Look at the graph above. ?it shows potential price returns that vary from -1.51%/year to 4.84%/year, with a most likely value of 2.79%, placing the S&P 500 at 3200 in March 2027. ?Add onto this a 2% dividend yield to get the total returns.

The 26 paths above come from the 26 times in the past that the model forecast total returns within 1% of 4.79%. ?4.79% is at the 90th percentile of expected returns. ?Typically in the past, when expected returns were in the lower two deciles, actual returns were lower still. ?For the 26 scenarios, that difference was 0.63%/year, which would imply 10-year future returns in the 4.16%/year area.

The pattern of residuals is unusual. ?The model tends to overestimate returns at the extremes, and underestimate when expected returns are “normal.” ?I can’t think of a good reason for this. ?If you have a good explanation please give it in the comments.

Now if errors followed a normal distribution, a 95% confidence interval on total returns would be plus or minus 3.8%, i.e., from 1.0% to 8.6%. ?I find the non-normal confidence interval, from 0.5% to 6.8% to be more plausible, partly because valuations would be a new record in 2027 if we had anything near 8.6%/year for the next ten years. ?Even 6.8%/year would be a record. ?That”s why I think a downward bias on results makes sense, with high valuations.

At the end of the first quarter, the model forecast total returns of 5.06%/year for the next ten years. ?With the recent rally, that figure is now 4.79%/year. ?Now, how excited should we be about these returns? ?Not very? ?I can buy that.

But what if you were a financial planner and thought this argument to be plausible? ?Maybe you can get 3.5%/year out of bonds over the next ten years. ?With 4.79% on stocks, and a 60/40 mix of stocks/bonds, that means returns of 4.27%. ?Not many financial planning models are considering levels like that.

But now think of pension plans and endowments. ?How many of them have assumptions in the low 4% region? ?Some endowments are there as far as a spending rule goes, but they still assume some capital gains to preserve the purchasing power of the endowment. ?Pension plans are nowhere near that, and if they think alternative investments will bail them out, they don’t know what they are doing. ?Alternatives are common enough now that the face the same allocative behavior from institutional investors, which then correlates their returns with regular investments in the future, even if they weren’t so in the past.

I don’t have much more to say, so I will close with this: if you want to study this model more, you need to read the articles in this series, and the articles referenced at the Economic Philosopher blog. ?Move your return expectations down, and diversify away from the US; there are better returns abroad — but remember, there are good reasons for home bias, so choose your foreign investments with care.

Goes Down Double-Speed (Update 4)

Posted on 9 June 2017 by David Merkel

Markets always find a new way to make a fool out of you. ?Sometimes that is when the market has done exceptionally well, and you have been too cautious. ? That tends to be my error as well. ?I’m too cautious in bull markets, but on the good side, I don’t panic in bear markets, even the most severe of them.

The bull market keeps hitting new highs. ?It’s the second longest bull market in the last eighty years, and the third largest in terms of cumulative price gain. ?Let me?show you a graph that simultaneously shows how amazing it is, and how boring it is as well.

The amazing thing is how long the rally has been. ?We are now past 3000 days. ?What is kind of boring is this — once a rally gets past two years time, price return results fall into a range of around 1.1-2.0%/month for the rally as a whole, averaging around 1.4%/month, or 18.5% annualized. ?(The figure for market falling more than 200 days is -3.3%/month, which is slightly more than double the rate at which it rises. ?Once you throw in the shorter time frames, the ratio gets closer to double — presently around 2.18x. ?Note that the market rises are 3.2x as long as the falls. ?This is roughly similar to the time spans on the credit cycle.)

That price return rate of 1.4%/month isn’t boring, of course, and is?close to?where the stock market prediction model would have predicted back in March 2009, where it forecast total returns of around 16%/year for 10 years. ?That would have implied a level a little north of 2500, which is only 3% away, with 21 months to go.

Have you missed the boat?

If you haven’t been invested during this rally, you’ve most like missed more than 80% of the?gains of this rally. ?So yes, you have missed it.

?The Moving Finger writes; and, having writ,
Moves on: nor all thy Piety nor Wit
Shall lure it back to cancel half a Line,
Nor all thy Tears wash out a Word of it.?

? Omar Khayy?m?from The Rubaiyat

In other words, “If ya missed the last bus, ya missed the last bus. ?Yer stuck.”

We can only manage assets for the future, and only our decrepit view of the future is of any use. ?We might say, “I have no idea.” and maintain a relatively constant asset allocation policy. ?That’s mostly what I do. ?I limit my asset allocation changes because it is genuinely difficult to time the market.

If you are tempted to add more money now, I would tell you to wait for better levels. ?If you can’t wait, then do half of what you want to do.

A wise person knows that the past is gone, and can’t be changed. ?So aim for the best in the future, which at present means having at least your normal percentage of safe assets in your asset allocation.

(the closing graph shows the frequency and size of market gains since 1928)

Operating vs Financial Cash Flows

Posted on 27 April 2017 by David Merkel

Photo Credit: Daniel Broche || To the victor goes the spoils, or, does a victory get spoiled?

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I was at a CFA Baltimore board meeting, and we were talking before the meeting. ?Most of us work for value investors, or, growth-at-a-reasonable-price investors. ?One fellow who has a business model somewhat like mine, commented that all the money was flowing into ETFs which were buying things like Facebook, Amazon and Google, which was distorting the market. ?I made a?comment that something like that was true during the dot-com bubble, though it was direct then, not due to ETFs, and went to a different group of stocks.

Let’s unpack this, starting with ETFs. ?ETFs are becoming a greater proportion of the holders of stocks, and other assets also. ?When do new shares of ETFs get created? ?When it is profitable to do so. ?The shares of the ETF must be worth more than the assets going into the ETF, or new shares will not get created.

It is the opposite for ETFs if their shares get liquidated. That only happens?when it is profitable to do so. ?The shares of the ETF must be worth less?than the assets going out of?the ETF, or shares will not get liquidated.

Is it likely that the growth in ETFs is driving up the price of shares? Not much; all that implies is that people are willing to pay somewhat more for a convenient package of stocks than what they are worth separately. ?Fewer people want to own individual assets, and more like to hold bunches of assets that represent broad ideas. ?Invest in the stock market of a country, a sector, an industry, a factor or a group of them.

The creators and liquidators of ETF shares typically work on a hedged basis. ?They are long whatever is cheaper, and short whatever is more expensive — but on net flat. ?When they have enough size to create or liquidate, they go to the ETF and do that. ?Thus, the actions of the creators/liquidators should not affect prices much. ?Their trading operations have to be top-notch to do this.

(An aside — long-term holders of ETFs get nipped by the creation and liquidation processes, because both diminish the value of the ETF to long-term holders. ?Tax advantages make up some or more than all of the difference, though.)

Does the growth in ETFs change the nature of the stickiness of the holding of the underlying stocks? ?Does it make the stickiness more like a life insurer holding onto a rare “museum piece” bond that they could never replace, or like a day trader trying to clip nickels? ?I think it leans toward less stickiness; my own view of ETF holders is that they fall mostly into two buckets — traders and investors. ?The investors hold a long time; the traders are very short term.

As such, more ETFs owning stocks probably makes the ownership base more short-term. ?ETFs are simple looking investments that mask the underlying complexity of the individual assets. ?There is no necessary connection between a bull market and and growth in ETFs, or vice-versa. ?In any given market cycle there might be a connection, but it doesn’t have to be that way.

ETFs don’t create or retire?shares of underlying stocks or bonds. ?And, the ETFs don’t necessarily create more net demand for the underlying assets. ?Open end mutual fund holders and direct holders shrink and ETFs grow, at least for now. ?That may make a holder base a little more short-term, but it shouldn’t have a big impact on the prices of the underlying assets.

My friend made a common error, confusing primary and secondary markets. ?No money is flowing into the corporations that he mentioned. ?Relative prices are affected by greater willingness to pay a still greater amount for the stock of growthy, highly popular, large companies relative to that of average companies or worse yet, value stocks.

Now the CEOs of companies with overvalued shares may indeed find ways to take advantage of the situation, and issue stock slowly and quietly. ?The same might apply to value stocks, but they would buy back their stock, building value for shareholders that don’t sell out. ?In this example, the secondary markets give pricing signals to companies, and they use it to build value where appropriate — secondary markets leads primary markets here. ?The home run would be that the companies with overvalued shares would buy the companies with undervalued shares, if the companies were related, and it seemed that management could integrate the firms.

What we are seeing today is a shift in relative prices. ?Growth is in, and value is out. ?What we aren’t seeing is the massive capital destruction that took place when seemingly high growth companies were going public during the dot-com bubble, where cash flowed into companies only to get eaten by operational losses. ?There will come a time when the relative price of growth vs value will shift back, and performance will reflect that then. ?It just won’t be as big of a shift as happened in the early 2000s.