Search Results for “Estimating Future Stock Returns” – Page 5

Limits

Posted on 26 December 2019 by David Merkel

Photo Credit: David Lofink || Most things in life have limits, the challenge is knowing where they are

I was at a conference a month ago, and I found myself disagreeing with a presenter who worked for a second tier ETF provider. The topic was something like “Ten trends in asset management for the next ten years.” The thought that ran through my mind was “Every existing trendy idea will continue. These ideas never run into resistance or capacity limits. If some is good, more is better. Typical linear thinking.”

Most permanent trends follow a logistic curve. Some people call it an S-curve. As a trend progresses, there are more people who see the trend, but fewer new people to hop onto the trend. It looks like exponential growth initially, but stops because as Alexander the Great said, “There are no more worlds left to conquer.”

Even then, not every trend goes as far as promoters would think, and sometimes trends reverse. Not everyone cares for a given investment idea, product or service. Some give it up after they have tried it.

These are reasons why I wrote the Problems with Constant Compound Interest series. No tree grows to the sky. Time and chance happen to all men. Thousand year floods happen every 50 years or so, and in clumps. We know a lot less than we think we do when it comes to quantitative finance. Without a doubt, the math is correct — trouble is, it applies to a world a lot more boring than this one.

I have said that the ES portion of ESG is a fad. Yet, it has seemingly been well-accepted, and has supposedly provided excess returns. Some of the historical returns may just be backtest bias. But the realized returns could stem from the voting machine aspect of the market. Those getting there first following ESG analyses pushed up prices. The weighing machine comes later, and if the cash flow yields are insufficient, the excess returns will vaporize.

In this environment, I see three very potent limits that affect the markets. The first one is negative interest rates. There is no good evidence that negative interest rates stimulate economic growth. Ask those in nations with negative interest rates how much it has helped their stock markets. Negative interest rates help the most creditworthy (who don’t borrow much), and governments (which are known for reducing the marginal productivity of capital).

It is more likely that negative rates lead people to save more because they won’t earn anything on their money — ergo, saving acts in an ancient mold — it’s just storage, as I said on my piece On Negative Interest Rates.

Negative interest rates are a good example of what happens you ignore limits — it doesn’t lead to prosperity. It inhibits capital formation.

Another limit is that stock prices have a harder time climbing as they draw closer to the boundary where they discount zero returns for the next ten years. That level for the S&P 500 is around 3840 at present. To match the all time low for future returns, that level would be 4250 at present.

Here’s another few limits to consider. We have a record amount of debt rated BBB. We also have a record amount of debt rated below BBB. Nonfinancial corporations have been the biggest borrowers as far as private entities go since the financial crisis. In 2008, nonfinancial corporations were one of the few areas of strength that the bond markets had.

One rule of thumb that bond managers use if they are unconstrained is that the area of the bond market that will have the worst returns is the one that has grown the most during the most recent bull part of the cycle. To the extent that it is possible, I think it is wise to upgrade corporate creditworthiness now… and that applies to bonds AND stocks.

Of course, the other place where the debt has grown is governments. The financial crisis led them to substitute public for private debt in an effort to stimulate their economies. The question that I wonder about, and still do not have a good answer for is what will happen in a fiat money world to overleveraged governments.

Everything depends on the policies that they pursue. Will the deflate — favoring the rich, or inflate, favoring the poor? No one knows for sure, though the odds should favor the rich over the poor. There is the unfounded bias that the Fed botched it in the Great Depression, but that is the bias of the poor versus the rich. The rich want to see the debt claims honored, and don’t care what happens to anyone else. The Fed did what the rich wanted in the Great Depression. Should you expect anything different now? I don’t.

As such, the limits of government stimulus are becoming evident. The economic recovery since the financial crisis is long and shallow. The rich benefit a lot, and wages hardly rise. Additional debt does not benefit the economy much at all. We should be skeptical of politicians who want to borrow more, which means all of them.

One of the greatest limits that exists is that of defined benefit pension plans vainly trying to outperform the rate that their risky assets are expected to earn. They are way above the level expected for the next ten years, which is less than 3%. Watch the crisis unfold over the next 15 years.

Finally, consider the continued speculation that shorts equity volatility. You would think that after the disaster that happened in 2018 that shorting volatility would have been abandoned, but no. The short volatility trade is back, bigger and badder than ever. Watch out for when it blows up.

Summary

Be ready for the market decline when it comes. It may begin with a blowout with equity volatility, but continue with a retreat from risky stocks that offer low prospective returns.

Avoid Complexity in Limiting Risk

Posted on 19 October 201920 October 2019 by David Merkel

Picture Credit: Olivier ROUX || Simplicity almost always beats complexity.

I’m not a fan of EIAs. I’m not a fan of variable annuities, unless they’re really simple with rock-bottom expenses and no surrender charges. I’m not a fan of ETNs. I hate structured notes. I’m also not a fan of ETFs that are filled with derivatives.

Ten years ago, I wrote a piece called The Good ETF. It is still as valid now as before, along with its companion piece The Good ETF, Part 2 (sort of). And for Commodity ETFs, there was: Fusion Solution: The Stable Value Fund Guide to Commodity ETF Management. If you are rolling futures in an ETF, it had better be done like a short bond ladder.

You can add in the pieces that I wrote before and when the short volatility ETFs imploded. What did it say in The Good ETF?

Good ETFs are:
* Small compared to the pool that they fish in
* Follow broad themes
* Do not rely on irreplicable assets
* Storable, they do not require a ?roll? or some replication strategy.
* not affected by unexpected credit events.
* Liquid in terms of what they represent, and liquid it what they hold.
The last one is a good summary.? There are many ETFs that are Closed-end funds in disguise.? An ETF with liquid assets, following a theme that many will want to follow will never disappear, and will have a price that tracks its NAV.
The Good ETF

But tonight I have another complex investment to avoid, and a simple one to embrace. First the avoid…

There was a piece at Bloomberg Businessweek called ETFs With Downside Protection? It?s Complicated. These are called defined outcome ETFs. Basically they are a bundle of equity options that cut your losses, while limiting your gains on a given equity index. (Also, you don’t get dividend income, and have to pay manager fees.) In-between the cap on gains, and where losses kick in, your returns should move 1:1 with the index. The same will be true with losses after the first N% get eaten — below N% losses, you begin taking losses.

Illustration of Defined Outcome ETF returns as compared to an index fund using the same index as the Defined Outcome ETF

I wanted to keep the illustration simple. This hypothetical defined outcome ETF caps gains at 10%, and absorbs the first 15% of losses. This example assumes no fees, which would likely be lower on the index fund. This example assumes no dividends, which would get paid to you in the index fund, but not on the defined outcome ETF.

Defined outcome ETFs purchase and sell tailored options that are backed by the central counterparty the Options Clearing Corporation — a very strong, stable institution. Credit risk still exists, but if the OCC goes down, many things will be in trouble. The options exist for one year, after which gains are paid to and losses absorbed by ETF shareholders. The ETF then resets to start another year following the same strategy with slightly different levels because the relative amounts of the cap and the loss buffering rely on where equity volatility is for a given index at the start of the year.

Unlike an index fund, your gains cannot grow tax-deferred, though if you have gains, you can roll them over into the next year.

I’ve read the offering documents, including the sections on risk. My main argument with the product is that you give up too much upside for the downside protection. The really big up years are the places where you make your money. There aren’t so many “average” years. The protection on the downside is something, but in big down years it could be cold comfort.

The second part is the loss of dividends and paying higher fees. Using the S&P 500 as a proxy, a 2% dividend lost and a 0.5% added fee adds up to quite a cost.

There are implementation risks and credit risks but these risks are small. I ran a medium-sized EIA options book for a little more than a year. This is not rocket science. The investor who is comfortable with options could create this on his own. They list more risks in the offering documents, but they are small as well. What gets me are the costs, and the upside/downside tradeoff.

A Better, if Maligned Investment

Recently Bank of America declared ?the end of the 60-40? standard portfolio. I think this was foolish, and maligns one of the best strategies around — the balanced fund.

Yes, interest rates are low. Yields on some stocks are higher than the yields on the Barclays’ Aggregate [bond] Index. But if you only bought those bonds, you would have a rather unbalanced portfolio from a sector standpoint — heavy on utilities and financials. The Barclays’ Aggregate still outyields the S&P 500, if not by much, like 0.8%/yr.

The real reason that you hold bonds and cash equivalents is not the income; it is risk reduction. I’m assuming no one is thinking of buying the TLT ( 20+ Year Treas Bond Ishares ETF), which is more of a speculator’s vehicle, but something more like AGG ( US Aggregate Bond Ishares Core ETF), which yields 0.3% more, but the overall volatility is a lot less.

With AGG, fixed income claims of high investment grade entities will make it through a deflationary crisis. In an inflationary situation like the 70s, the bonds are short enough that over a five year period, you should make money, just not in real terms.

It’s good to think long term, and have a mix of fixed and variable claims. The bonds (fixed claims) lower your volatility so that you don’t get scared out of your stocks (variable claims) in a serious downdraft.

The models I have run have returns max out in an 80/20 balanced fund, and the trade-off of risk for return is pretty good down to a 60/40 balanced fund. In my personal investing, I have always been between 80/20 and 60/40.

As it is, if you are looking the likely returns on the S&P 500 over the next ten years, it’s about the same return available on a A3/A- corporate bond, but with a lot more volatility.

Thus the need for bonds. In a bad scenario, stocks will fall more than bonds, and the balanced fund will buy stocks using proceeds of the bonds that have fallen less to buy stocks more cheaply. And if the stock market rises further, the balanced fund will sell stocks and use the proceeds to bank the gains by buying bonds that will offer future risk reduction, and some income.

As such, consider the humble balanced fund as a long-term investment vehicle that is simple and enduring, even when rates are low. And avoid complexity in your investment dealings. It is almost never rewarded.

The Rules, Part LXIV

Posted on 6 February 2018 by David Merkel

Photo Credit: Steve Rotman || Markets are not magic; government economic stimulus is useless with debt so high

Weird begets weird

I said in an earlier piece on this topic:

I use [the phrase] during periods in the markets where normal relationships seem to hold no longer. It is usually a sign that something greater is happening that is ill-understood. ?In the financial crisis, what was not understood was that multiple areas of the financial economy were simultaneously overleveraged.

So what’s weird now?

Most major government running deficits, and racking up huge debts, adding to overall liability promises from entitlements.
Most central banks creating credit in a closed loop that benefits the governments, but few others directly.
Banks mostly in decent shape, but nonfinancial corporations borrowing too much.
Students and middle-to-lower classes borrowing too much (autos, credit cards)
Interest rates and goods and services price inflation stay low in the face of this.
Low volatility (until now)
Much speculative activity in cryptocurrencies (large percentage on a low base) and risk assets like stocks?(smaller percentage on a big base)
Low credit spreads

No one should be surprised by the current market action.? It wasn’t an “if,” but a “when.”? I’m not saying that this is going to spiral out of control, but everyone should understand that?The Little Market that Could?was a weird situation.? Markets are not supposed to go up so steadily, which means something weird was fueling the move.

Lack of volatility gives way to a surfeit of volatility eventually.? It’s like macroeconomic volatility “calmed” by loose monetary and fiscal policy.? It allows people to take too many bad chances, bid up assets, build up leverage, and then “BAM!” — possibility of debt deflation because there is not enough cash flow to service the incurred debts.

Now, we’re not back in 2007-9.? This is different, and likely to be more mild.? The banks are in decent shape.? The dominoes are NOT set up for a major disaster.? Risky asset prices are too high, yes.? There is significant speculation in areas?Where Money Goes to Die.? So long as the banking/debt complex is not threatened, the worst you get is something like the deflation of the dot-com bubble, and at present, I don’t see what it threatened by that aside from cryptocurrencies and the short volatility trade.? Growth stocks may get whacked — they certainly deserve it from a valuation standpoint, but that would merely be a normal bear market, not a cousin of the Great Depression, like 2007-9.

Could this be “the pause that refreshes?”? Yes, after enough pain is delivered to the weak hands that have been chasing the market in search of easy profits quickly.? The lure of free money brings out the worst in many.

You have to wonder when margin debt is high — short-term investors chasing the market, and Warren Buffett, Seth Klarman, and other valuation-sensitive investors with long horizons sitting on piles of cash.? That’s the grand asset-liability mismatch.? Long-term investors sitting on cash, and short-term investors fully invested if not leveraged… a recipe for trouble.? Have you considered these concepts:

Preservation of capital
Dry powder
Not finding opportunities
Momentum gives way to negative arbitrages.
Greater fool theory — “hey, who has slack capital to buy what I own if I need liquidity?”

Going back to where money goes to die, from the less mentioned portion on the short volatility trade:

Again, this is one where people are very used to selling every spike in volatility. ?It has been a winning strategy so far. ?Remember that when enough people do that, the system changes, and it means in a real crisis, volatility will go higher than ever before, and stay higher longer. ?The markets abhor free riders, and disasters tend to occur in such a way that the most dumb money gets gored.

Again, when the big volatility spike hits, remember, I warned you. ?Also, for those playing long on volatility and buying protection on credit default ? this has been a long credit cycle, and may go longer. ?Do you have enough wherewithal to survive a longer bull phase?

To all, I wish you well in investing. ?Just remember that new asset classes that have never been through a ?failure cycle? tend to produce the greatest amounts of panic when they finally fail. ?And, all asset classes eventually go through failure.

So as volatility has spiked, perhaps the free money has proven to be the bait of a mousetrap.? Do you have the flexibility to buy in at better levels?? Should you even touch it if it is like a knockout option?

There are no free lunches.? Get used to that idea.? If a trade looks riskless, beware, the risk may only be building up, and not be nonexistent.

Thus when markets are “weird” and too bullish or bearish, look for the reasons that may be unduly sustaining the situation.? Where is debt building up?? Are there unusual derivative positions building up?? What sort of parties are chasing prices?? Who is resisting the trend?

And, when markets are falling hard, remember that they go down double-speed.? If it’s a lot faster than that, the market is more likely to bounce.? (That might be the case now.)? Slower, and it might keep going.? Fast moves tend to mean-revert, slow moves tend to persist.? Real bear markets have duration and humiliate, making weak holders conclude that will never touch stocks again.

And once they have sold, the panic will end, and growth will begin again when everyone is scared.

That’s the perversity of markets.? They are far more volatile than the economy as a whole, and in the end don’t deliver any more than the economy as a whole, but sucker people into thinking the markets are magical money machines, until what is weird (too good) becomes weird (too bad).

Don’t let this situation be “too bad” for you.? If you are looking at the current situation, and think that you have too much in risk assets for the long-term, sell some down.? Preserving capital is not imprudent, even if the market bounces.

In that vein, my final point is this: size your position in risk assets to the level where you can live with it under bad conditions, and be happy with it under good conditions.? Then when markets get weird, you can smile and bear it.? The most important thing is to stay in the game, not giving in to panic or greed when things get “weird.”

Since 1950, the S&P 500 in 2017 Ranks First, Fourth, Tenth or Twenty-third?

Posted on 3 January 2018 by David Merkel

Credit: Roadsidepictures from The Little Engine That Could By Watty Piper Illustrated By George & Doris Hauman c. 1954

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I wish I could have found a picture of Woodstock with a sign that said “We’re #1!”? Snoopy trails behind carrying a football, grinning and thinking “In this corner of the backyard.”

That’s how I feel regarding all of the attention that has been paid to the S&P being up every month in 2017, and every month for the last 14 months.? These have never happened before.

There’s a first time for everything, but I feel that these records are more akin to the people who do work for the sports channels scaring up odd statistical facts about players, teams, games, etc.? “Hey Bob, did you know that the Smoggers haven’t converted a 4th and 2 situation against the Robbers since 1998?”

Let me explain.? A month is around 21 trading days.? There is some variation around that, but on average, years tend to have 252 trading days.? 252 divided by 12 is 21.? You would think in a year like 2017 that it must? have spent the most time where 21-day periods had positive returns, as it did over each month.

Since 1950, 2017 would have come in fourth on that measure, behind 1954, 1958 and 1995.? Thus in one sense it was an accident that 2017 had positive returns each month versus years that had more positive returns over every 21 day period.

How about streaks of days where the 21-day trialing total return never dropped below zero (since 1950)?? By that measure, 2017 would have tied for tenth place with 2003, and beaten by the years 1958-9, 1995, 1961, 1971, 1964, 1980, 1972, 1965, and 1963.? (Note: quite a reminder of how bullish the late 1950s, 1960s and early 1970s were.? Go-go indeed.)

Let’s look at one more — total return over the whole year.? Now 2017 ranks 23rd out of 68 years with a total return of 21.8%.? That’s really good, don’t get me wrong, but it won’t deserve a mention in a book like “It Was a Very Good Year.”? That’s more than double the normal return, which means you’ll have give returns back in the future. 😉

So, how do I characterize 2017?? I call it?The Little Market that Could.? Why?? Few drawdowns, low implied volatility, and skepticism that gave way to uncritical belief.? Just as we have lost touch with the idea that government deficits and debts matter, so we have lost touch with the idea that valuation matters.

When I talk to professionals (and some amateurs) about the valuation model that I use for the market, increasingly I get pushback, suggesting that we are in a new era, and that my model might have been good for an era prior to our present technological innovations.? I simply respond by saying “The buying power has to come from somewhere.? Our stock market does not do well when risk assets are valued at 40%+ of the share of assets, and there have been significant technological shifts over my analysis period beginning in 1945, many rivaling the internet.”? (Every era idolizes its changes.? It is always a “new era.”? It is never a “new era.”)

If you are asking me about the short-term, I think the direction is up, but I am edgy about that.? Forecast ten year returns are below 3.75%/year not adjusted for inflation.? Just a guess on my part, but I think all of the people who are making money off of low volatility are feeding the calm in the short-run, while building up a whiplash in the intermediate term.

Time will tell.? It usually does, given enough time.? In the intermediate-term, it is tough to tell signal from noise.? I am at my maximum cash for my equity strategy accounts — I think that is a prudent place to be amid the high valuations that we face today.? Remember, once the surprise comes, and companies scramble to find financing, it is too late to make adjustments for market risk.

Short-Term Rational, but Intermediate-Term Irrational

Posted on 24 October 2017 by David Merkel

Don’t look at the left side of the chart on an empty stomach

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This will be a short post.? At present the expected 10-year rate of total return on the S&P 500 is around 4.05%/year.? We’re at the 94th percentile now.? The ovals on the graph above are 68% and 95% confidence intervals on what the actual return might be.? Truly, they should be two vertical lines, but this makes it easier to see.? One standard deviation is roughly equal to two percent.

But, at the left hand side of the graph, things get decidedly non-normal.? After the model gets to 2.5% projected returns, presently around 3100 on the S&P 500, returns in the past have been messy.? Of course, those were the periods from 1998-2000 to 2008-2010.? But aside from one stray period starting in 1968, that is the only time we have gotten to valuations like this.

My last piece hinted at this, but I want to make this a little plainer.? For sound effects while reading this, you could get your children or grandchildren to murmur behind you “We know it can’t. We know it can’t.” while you consider whether the market can deliver total returns of 7%/year over the next 10 years.

There are few if any things that remain permanently valid insights of finance.? Anything, even good strategies, can be overdone.? Even stable companies can be overlevered, until they are no longer stable.

In this case, it is buying the dips, buying a value-weighted cross section of the market, and putting your asset allocation on autopilot.? Set it and forget it.? Add in companies always using spare capital to buy back shares, and maxing out debts to fit the liberal edge of your preferred rating profile.

These have been good ideas for the past, but are likely to bite in the future.? Value is undervalued, safety is undervalued, and the US is overvalued.? A happy quiet momentum has brought us here, and for the most part it has been calm, not wild.? Individually prudent actions that have paid off in the past are likely to prove imprudent within three years, particularly if the S&P 500 rises 10-15% more in the next year.

People have bought into the idea that market timing never matters.? I agree with the idea that it usually doesn’t matter, and that it is usually is a fool’s game to time the market.? That changes when the 10-year forward forecast of market returns gets low, say, around 3%/year.

Remember, the market goes down double-speed.? Just because the 10-year returns don’t lose much, doesn’t mean that there might not be better opportunities 3-5 years out, when the market might offer returns of 6%/year or higher.

Also, remember that my data set begins in 1945.? I wish I had the values for the 1920s, because I expect they would be even further to the left, off the current graph, and well below the bottom of it.

This isn’t the most nuts that things can be.? In fact, it is very peaceful and steady — the cumulative effect of many rational decisions based off of what would have worked best in the past, in the short-run.

As a result, I am looking 10 years into the future, and slowly scaling back my risks as a result.? If the market moves higher, that will pick up speed.

The Little Market that Could

Posted on 20 October 2017 by David Merkel

Picture Credit: Roadsidepictures from The Little Engine That Could By Watty Piper, Illustrated By George & Doris Hauman | That said, for every one that COULD, at least two COULDN’T

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So what do you think of the market?? Why are both actual and implied volatility so low?? Why are the moves so small, but predominantly up?? Is this the closest impression of the Chinese Water Torture that a stock market can pull off?

Why doesn’t the market care about external and internal risks?? Doesn’t it know that we have divisive, seemingly incompetent President who looks like he doesn’t know how to do much more than poke people in the eyes, figuratively?? Doesn’t it know that we have a divided, incompetent Congress that can’t get anything of significance done?

Leaving aside the possibility of a war that we blunder into (look at history), what if the inability of Washington DC to do anything is a plus?? Government on autopilot for four years, maybe eight if we decide we are better of without change — is that a plus or minus?? Just ignore the noise, Trump, other politicians, media… ahh, the quiet could be nice.

Then think about Baby Boomers showing up late for retirement, and wondering what they are going to do.? Then think about their surrogates, the few who still have defined benefit pension plans.? What are they going to do?? Say that the rate that they are targeting for investment earnings is 7%/year forever.? Even if my model for investment returns is wrong in a pessimistic way — i.e., my 4% nominal should be 6%/year nominal, you still can’t hit your funding target.? As for those with defined contribution plans, when you are way behind, even contributing more won’t do much unless investment earnings provide some oomph.

I am personally not a fan of TINA — “there is no alternative” to stocks in the market, but I recognize the power of the idea with some.? It is my opinion that more people and their agents will run above average risks in order to try to hit an unlikely target rather than lock in a loss versus what is planned.? Most will “muddle in the middle” taking some risk even with a high market, and realizing that they aren’t going to get there, but maybe a late retirement is better than none.

That’s the power of bonds returning 3% at best over the forecast horizon, unless interest rates jump, and then we have other problems, like risk assets repricing.? If you are older, almost no plan is achievable at reasonable cost if you are coming to the game now, rather than starting 15+ years ago.

And so I come to “the little market that could…” for now.? My view is that those with retirement obligations to fund are bidding up the market now.? That does two things.? Shares of risk assets (stocks) move from the hands of stronger investors to weaker investors, while cash flows the opposite direction.? In the process, prices for risk assets get bid up relative to their future free cash flows.

Unlike “the little engine that could,” the little market that could has climbed some small hills relative to the funding targets that investors need. Ready for the Himalayas?? The trouble with those targets is that regardless of what the trading price of the risk assets is, the cash flows that they produce will not support those targets.

Thought experiment: imagine that the stock market was gone and all the shares we held were of private companies that were difficult and expensive to trade.? ?Pension plans would estimate ability to meet targets by looking at forecasts of the underlying returns of their private investments, rather than a total return measure.

Well, guess what?? In the long run, the returns from public stock investments reflect just that — the distributable amount of earnings that they generate, regardless of what a marginal bidder is willing to pay for them at any point in time.? Stocks aren’t magic, any more than the firms that they represent ownership in.

So… we can puzzle over the current moment and wonder why the market is behaving in a placid, slow-climbing manner.? Or, we can look at the likely inadequacy of asset cash flows versus future demands for those cash flows for retirement, etc.? Personally, I think they are related as I have stated above, but the second view, that asset returns will not be able to fund all planned retirement needs is far more certain, and is one mountain that “the little market that could” cannot climb.

Thus, consider the security of your own plans, and adjust accordingly.? As I commented recently, for older folks with enough assets, maybe it is time to lock in gains.? For others, figure out what adjustments and compromises will need to be made if your assets can’t deliver enough.

Tough stuff, I know.? But better to be realistic about this than to be surprised when funding targets are not reached.

“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.

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.

Overvaluation is NOT Due to Passive Investing

Posted on 22 July 2017 by David Merkel

Photo Credit: Hagens_world || I want to buy 1% of all of the items there in one nice neat package! 😉

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There’s been a lot of words thrown around lately saying that indexing has been leading to overvaluation of the US stock market. ?I’m here to tell you that is wrong. ?I have two reasons for that:

1) Active managers have been pseudo-indexing for a long time. ?The moment they get benchmarked to an index they do one of two things:

a) accept it, gain funds for mandates that are like the index, and then they constrain their investing so that they are never too different from the index, and hopefully not in the fourth quartile of performance, so they don’t lose assets. ?This is the action of the majority.

b) Ignore it, get less fund flows, and don’t let the index affect your investment decisions. ?The assets should be stickier over time if you explain to clients what you are doing, and why. ?Only a minority do this.

This has been my opinion since my days of writing for RealMoney. All of the active managers out there add up to something close to a passive benchmark, less fees. ?It can’t be otherwise.

The one exception of any size would be stocks excluded from indexes because they don’t have enough free float available for non-insiders to own/trade. ?Even that is not very big — it might be 5% of the total stock market, though this is just a wild guess.

2) If you want to talk about valuation issues, you really want to talk about the trade-off between stocks and bonds, or stocks and cash. ?Stock valuations are never absolute — it is always a question of the other assets you are measuring the stocks against, and how you desirable those other assets will be in the future, and how sustainable the profitability of stocks will be over time. ?I broke apart some of these issues in my piece?The Dead Model. ?Desirability of stock investing can be broken into three components: maturity risk, credit risk and business risk. ?At present, the first two are getting thinner. ?The last one is thicker, and at least at present, there is no great rush to encourage people to trade slack cash for newly issued shares of stock. ?If anything, stock is getting retired on net. ?(Just a guess.)

Part of this stems from demographics: the Baby Boomers and others still sock away money so that they can get payments in the future, when they are too old to work much. ?That’s the maturity risk that I mentioned above, and the reward from that is low because so many are trying to do it. ?Flat yield curve and low overall yields are the cause of a lot of worries for investors. ?The same thing applies to credit spreads: people are searching for yield, and it leads them far afield — that said, I don’t see a lot of obvious places where credit metrics look bad, aside from auto loans, student loans, and overleveraged governments.

The demographic effect means that nothing looks safe and cheap. ?Yields are low, and price/earnings multiples are high. ?The question is what could lead those to change. ?When the markets are pricing in something like continued perfection, sometimes it doesn’t take much to jolt them out of what is an unstable equilibrium. (Note: contrary to neoclassical economics, most economic equilibria are unstable.)

Profit margins could fall, but most of the factors underpinning high profit margins look pretty strong — using technology to make labor more productive, ability to shift work globally to talented people who are paid less, and clever uses of accounting to reduce taxable income and tax rates seem intact, if not growing.

That said, remember my saying:

Governments are smaller than markets; markets are smaller than cultures.

There is always the possibility of a shock happening that no one expects:

War, even if undeclared
Cultural unrest leading to political change: remember the partial nationalization of Amazon and Google that took place in 2030? ?They got broken up and parts were turned into utilities by the US government because they were so pervasive, and then foreign governments expropriated their local assets, and banned them in their countries.
Another example could be a type of Luddite behavior that attempted to force corporations to hire people proportionate to the profits.
Hyperinflation in Japan, or somewhere else big.
China has a bigger credit crisis than its last one, leading to drops in commodity prices, and further global deflation.

Point 2 was a joke, but meant to illustrate how cultural systems abhor entities that get too powerful.

Closing

I do think stock valuations are high, but the best way to see that is in my quarterly post on stock valuations. ?It takes into account the changing preferences economic actors have regarding what assets they hold — this is one indicator that explicitly reflects actual changes in stock and bond issuance and retirement, as well as changes induced by the Fed in creating more cash and credit, or, destroying it.

Passive investing is a sideshow as far as stock valuations go. ?Pay attention to the supply and demand for stock on the whole, and the factors that might lead supply and demand to change.