Photo Credit: Davide Mauro || It is good to have relationships that transcend generational divides

Here is a comment from an old friend of mine who I knew when he was young.

I’m curious how your model works to claim that SPY is priced to grow 0.54% per year for the next 10 years. You may be going off the historical ~7% average annualized returns, but everyone knows past performance is no indicator of future performance. A few things…

1) yes, valuations in SPY are high. But you have to remember that SPY is market cap weighted, so somewhere around a quarter of the total balance is concentrated in high growth tech stocks (FAANG, etc).

2) getting into high growth tech stocks, yes valuations are through the roof. But so are the year over year revenue and EPS growth of these companies. This is a distinct difference from the dot com bubble. And this gets me into

3) the information revolution is the single greatest industrial/technological revolution since possibly the railroad, or steel, or the assembly line. In the history of SPY (at least since the 1900s when we had exchanges and a central bank) we have not had a truly transformative industrial revolution. We are still in the early phases of history here. And finally

4) 2020 was the swiftest recovery from a bear market in history. Year over year GDP growth went from negative 2% to a projected +6% in 2021. Stocks went from lows of -30% to record highs. This is clearly due to swift and competent action from the fed (injecting liquidity into the markets, keeping interest rates low, quantitative easing) and the government (leveraging historically cheap debt to deliver fiscal stimulus rapidly).

I truly believe it was lessons learned from the past – in the Great Depression, in the subprime crisis, and others – that kept this from being a major covid-induced market meltdown and recession. We now have over a century of fiscal, monetary and regulatory experience to keep markets operating smoothly. In summary, past returns do not take away from the fact that there is plenty, plenty, plenty of reason to be optimistic about the next 10 years.

Estimating Future Stock Returns, December 2020 Update

Thanks for writing. I always thought you were quite bright. But investing is something where raw intelligence does not always lead to a good result. Bright people can be overconfident, and can overprice assets that are very good… it has happened many times in history.

I explained this model in the greatest degree of detail in the first two articles in this series (one, two). I have made no significant changes since then, aside from coming up with a way to estimate the model more accurately between the quarterly releases of data that the Fed provides.

The model that I use estimates the percentage of assets that the average American holds in stock (public and private) versus total assets. When that percentage is high, future returns have been low. When that percentage is low, future returns have been high. Since 1945, the lowest percentage has been 21.9%, and the highest 51.8%. The current value is 47.6%, which implies returns over the next 10 years of 0.66%/year, less than what can be earned on a ten-year T-note.

It’s an ordinary least squares regression model, and is the best-fitting model of all the competing theories for valuing the market as a whole. It reflects human nature — manias and panics. If people are farsighted and rational, why should the value of equities as a percentage of all assets change so much?

Now, you might ask: doesn’t taking more risk always lead to more returns? My answer to you is no. There are prudent risks, and imprudent risks. An asset will be riskless at a low price, but very risky at a high price. Remember the dot-com bubble, the go-go years, and the Great Depression. These were separated from each other by 35 years on average — basically a generation. Each generation gets at least one mistake. Popular companies became overvalued because of overly easy monetary policy, and crowd mania (r/wallstreetbets is a current example).

Now, the amount held in stock on average by Americans is high now than at any point since the dot-com bubble. Now, in the dot-com bubble, companies that had no profits were notable. It was a nutty era. But they weren’t the biggest companies in the S&P 500 index, and most of the largest companies were overvalued, but to the same degree as the growth companies today are overvalued, and with similar growth prospects then as now.

There is a conceit around the “information revolution.” It’s difficult to measure whether there is truly productivity growth from it. Take a look at the charts of productivity growth since 1990, productivity growth has not accelerated over the years prior.. Personally, I think materials science has had a greater impact. All the substances that we can use now that have greater tensile strength, conductivity, durability, flexibility, ability to deal with heat, cold, moisture, etc. That has affected what information technology can do as well… without improvements in materials science, information technology improvements would be much slower, and programmers could not be as sloppy.

I wrote about the the bear and bull markets of 2020. It’s been an odd time, but no odder than any other time. There is the conceit that the present moment is the hardest to understand in the markets, but we forget how confused we were in the past because of the “benefit” of hindsight bias.

Where I disagree with you the most is with you is on monetary and fiscal policy. The proper lesson of the Great Depression is not “when things go bad run deficits and print lots of money (or credit).” The proper lesson is: under ordinary circumstances run balanced budgets, don’t let monetary policy get too loose, and regulate banks tightly so that you don’t have rashes of bank failures.” Our leaders have consistently failed at this, and what we are facing as a result is either a bout of significant inflation (which will hurt stocks less than bonds), increased taxation (gotta pay off those bonds), or deflation, as economies that ae highly indebted, as ours is, do not grow rapidly.

I am not faulting our leaders for their current actions to avoid a crisis, but the past actions that have created the crisis, and for which they will not admit blame. I understand deficits in wartime, but not peacetime.

I appreciate your questions, and hope for more of them. But if you want to get a economic education, here are a bunch of books to consider. Oh, here are some investment books as well.

Image Credit: Aleph Blog || Running on empty, running dry… what will happen when obligations can’t be met?

Welcome to Blunderland, boys and girls. At the end of the fourth quarter, the S&P 500 was priced to return 1.29%/yr for the next ten years, with no adjustment for inflation. You might say, “But David, you’ve reported levels that low in the past, and you were concerned, but you never said ‘Blunderland.’”

True, but the market has rallied further since the end of the quarter, and the level of the S&P 500 now is priced to return 0.54%/yr for the next ten years, with no adjustment for inflation. That’s in the 98th percentile of valuations. Another reason I didn’t say ‘Blunderland’ in the past was that we did not have a situation before where the only values comparable came from core of the the dot-com bubble. Thus, welcome to Blunderland.

Now, the valuation levels of the Blunderland era lasted for 2 years and 3 months, from the beginning of the fourth quarter of 1998 to the end of the fourth quarter of 2000. It was a period where monetary policy was extremely loose, before tightening enough to send the market into a tailspin, even as many claimed that interest rates have no effect on growth stocks.

Okay, I’m done imitating my last article on the topic. We are in the midst of a full-fledged mania. What is different no versus the dot-com bubble was that value only took off as the market began to implode. At present, value is outperforming even as valuations are at nosebleed levels. And for any who care, you would be better off buying a 10-year Treasury Note than buying the S&P 500 at present. There is an alternative… to lose less in purchasing power terms.

Of course, you could do what I did in mid-2000, and what I am doing now… own a bunch of cheap stocks that have been neglected over the last ten years, and hold them through the coming disaster. Many of them are cyclicals so they like inflation. Others are life insurers — they want long term interest rates to rise.

But will that be the path? Who can tell? And even with that path, I had gains in 2000 and 2001, and bruising losses in 2002, before rocketing out of it in 2003.

It will be different this time. It is always different. That said, valuations are very high. If you are wealthy and can pay on credit default swaps, no is the time to do it. If you are at the low end of the 1% like me, it is time to own more bonds and safer equities.

Yes, there are other possibilities. You could:

• Short SPY
• Buy puts on SPY
• Buy puts on HYG and JNK
• Short QQQ
• Buy puts on QQQ

You get the idea. If I were to do any of the above I would buy puts on HYG and JNK. I’m not doing that at present. This is the poor man’s way of paying on credit default swaps.

Yes, this is one of those rare times where you will lose is you own the broad market indexes like the S&P 500. note that the above is prices only, and does not include dividends. I think anyone invested in the S&P 500 will earn a tiny amount over the next ten years, and less than the ten-year Treasury Note or the CPI.

I can make this “advice” which is not investment advice in the technical sense simple: sell growth stocks and move to value. Sell stocks generally, and move to bonds.

Now I am not doing that. I am sticking with my cheap stocks with strong balance sheets, in industries that have lagged. And i have roughly 30% of my portfolio in investment grade bonds.

This is a good position to be in amid a mania. Maybe you should imitate me, lest you find that accidentally you became a financial maniac.

Photo Credit : Loren Javier || Maybe Convexity crises are like Heffalumps. They only come if you whistle, and only if the time of year is right…

Everyone remember 1994, when mortgage convexity forced the Fed to raise the Fed Funds rate? Or 2004, when the same thing happened in a more minor way?

Well, at present, long Treasury rates are rising. I think it is because the economy is booming, and we don’t need more “stimulus.” Note that labor employment is a trialing indicator and is the worst variable to base monetary policy off of, because it will constantly make monetary policy overshoot. If you want a stable fiat money monetary policy, go back to the ideas of Knut Wicksell, and use the slope of the yield curve as your target. Interest rates are forward-looking. Monetary policy can’t directly affect labor employment. Jobs get created on a lagging basis as the recovery occurs. If you are waiting for jobs to be created in order to begin tightening, monetary policy will create bubbles, lie we are seeing now, and you will be too late to tighten, creating more crises. Note that crises have become more common as we rely on monetary policy to do the impossible.

Well, what else is rising now? Mortgage rates, and the ICE MOVE index (interest rate volatility). What’s falling? The repo rate on the 10-year Treasury note, which went to -4.25% yesterday at its nadir, closed at negative -0.5% as the Fed lent roughly 85% of its on-the-run 10-year notes into the market.

Things are weird, and there is no telling what may come of this. The Fed is of course “lost at sea” as it thinks it is all-powerful when it can’t discern what is going on in the bond market. Yes, the Fed will adjust (late) to a crisis, but it is certainly not all-seeing.

I’m not saying there will be a panic as in 1994 or 2004, driven by mortgage hedging. That said, there are some straws blowing in the wind to that effect. To the degree that hedging goes on in the mortgage markets, whether by originators or portfolio investors, after rates have hit new lows, and rates rise rapidly, the possibility of a self-reinforcing rise in rates can’t be discounted.

As it stands now, the equity market as a whole is priced to return less than a 10-year Treasury Note at present over the next ten years. When valuations are this high, it doesn’t take much to create a panic. We are in the 98th percentile of valuations now, akin to the dot-com bubble.

So, if you think that this is a reasonable hypothesis, the rational thing to do is raise cash. Sell stocks, reduce bond duration, give up income to preserve capital.

(Now, I don’t trade that much, so my cash levels have been rising slowly over time. Do I assume there will be trouble? No, but I have balanced the risks of being in the market and not being in the market. Aside from that, the stocks I own are out of favor, and their valuations are close to the bottom of market levels, so I am not too concerned.)

Regardless, take account of your portfolio and decide whether you need to take some risk off the table. Personally, I think this is an era where there is not much additional upside under any circumstances for a portfolio that is like the S&P 500, much less large growth stocks. But make up your own mind, and balance return versus risk.

Photo Credit: Crypto360 aka Cryprocurrency360.com [sic] || When will this stupid concept die?

Recently as I was reading Barron’s online, I ran across the following article: Small-Cap Stocks Could Keep on Rising. There’s a ‘Wall of Cash.’

I’ve subscribed to Barron’s for at least 20 years of my life. Really, I expect better of them. The meme that money flows in and out of the market is hard to kill. Stocks rise; money must have flowed in. Stocks fall; money must have flowed out. Some of this comes from the impulse that journalists must find a reason for the market action of each day, when really — there’s a lot of noise.

I have a few simple ways to explain this. Imagine that market player A wants to buy 100 shares of XYZ Corp at $50/share, and market player B wants to sell 100 shares of XYZ Corp at $50/share. Bam! Shares flow from B to A, and money flows from A to B. Total shares are the same. Total money in brokerage accounts is the same. The total amount of money is unaffected by trading.

Now, there are commissions. At least, intelligent people pay commissions. When I was a corporate bond manager, if my broker said, “I’ll just cross them to you to get the deal done,” I would say, “No, I will give you a plus. (1/64th of a dollar per $100 of principal) My broker must always be paid.” Why did I do this? It kept the relationships neat. When brokers don’t get paid, they look for hidden ways to earn their money. I much prefer my costs be explicit and fixed. (And, as a corporate bond manager, I valued loyalty. I had good relationships with my brokers.)

But by and large, trading does not affect aggregate cash levels. What does affect aggregate cash levels?

Increases Cash

• Dividends
• Mergers and acquisitions where cash is paid, whether partly or in full.
• Stock buybacks

Decreases Cash

• Primary and secondary public offerings of stock.
• Conversion of convertible securities.
• Rights offerings

And, there are probably more than what I have listed here, but the key condition for aggregate cash levels to change is that money must flow into or out of corporations, and shares must flow the opposite way.

But none of these changes happen through trading. They happen as a result of corporate actions.

Then Why Do Stock Prices Change?

Stock prices change because of two reasons, one minor, one major. The minor one: as trading goes on, either buyers or sellers are more desperate to get the trade done. Whichever side is more desperate pushes the price.

The major one: when markets are closed, people change their minds. Data builds up, and before any significant amount of trading happens, prices shift to reflect changed estimates of what the securities in question are worth.

To prove this, I will tell you that intraday trading is noise, and little return happens there. But while the market is closed — that is when returns happen. The difference between the prior close and the next market open explain all of the returns of the market over the last 20+ years. The difference between the current days open and close are close to zero.

Most of the reason why stock prices change is that people as a group change their minds as to the value of stocks. Trading has a modest impact on that. But most of the change in value happens while the market is closed. (Remember that corporations mostly break news while the market is closed.)

If you understand this, you get the following benefits:

• You will ignore most media explanations of moves in the stock market
• The primary market will guide you — looking at M&A and IPOs.
• You will ignore the so-called “wall of money” which does not exist.
• Instead, you might notice how much of the total assets in aggregate portfolios are in stocks versus everything else.

Prices matter. Buy low, sell high. But don’t attribute anything to the “wall of money.” It is a bogus concept, and should be ignored. The biggest changes in prices happen when the market is closed, and trading is limited.

Photo Credit: Alex Alexi ||As Captain Kirk once said (something like): “If you are stuck in a losing game, find a way to change the rules.”

You might be a very good trader. More likely, you are not. The markets are not like Lake Wobegon where all the children are above average. Personally, I think that I am probably an average trader, which is why I don’t trade much. That said, there is a reason to avoid thinking of trading as a way to make money. It is a negative sum game for those who are not market makers, specialists, or high frequency traders, whose computer algorithms generally make intelligent trades against order flow from everyone else.

Stocks derive their value from the stream of free cash flows that can be used for:

• Dividends
• Stock buybacks
• Debt retirement, and
• Intelligent investments that improve future free cash flows.

Though I am not bullish on the market over the next ten years (my model indicates 1.11%/year from the S&P 500 over the next ten years, not adjusted for inflation), I know that over the long haul that equities tend to prosper unless there is war on your home soil, famine, or severe socialism. Investing over the long-term is a positive sum game, but it means you must have the capacity to invest for the long-term, and own things that are presently out-of-favor.

In short, people don’t make money on average when they trade. People make money as they hold their assets and wait.

Photo Credit: Juliana Dacoregio || Please relax, it is not that bad

What happened at the US Capitol today was unusual, but it was nothing severe. Don’t get me wrong; those that illegally entered the Capitol should be prosecuted. When I say it was not severe, I mean that it was unlikely to do any permanent damage.

Those who threaten violence, even if non-lethal, have to understand that once they fail, society will do the opposite of what they wanted. There is a saying that if you want to kill the King, YOU MUST KILL THE KING! Don’t do something halfway. It will result in your own demise.

What happened at the Capitol today was the actions of a bunch of disorganized malefactors who lucked into a situation where the guardians of the Capitol were inadequate to deal with their shenanigans.

Was it a coup, as some Democrats allege? No, it was just slop from a bunch of disorganized Trumpers. There was no chance that they could have taken over the US Government. If they had been organized, there could have been a lot of people killed, but that was not the case.

Was Trump culpable for their actions? Yes. He incited them by alleging election fraud with no detailed evidence. Even when telling them to go home, he still incited them by saying the election was stolen.

I think the greatest risk lies ahead, as the odds of assassination are relatively high, because of the stolen election rhetoric. I hope I am wrong, but in unstructured situations, the advantage is always with the offense. (Think of defending a fixed base against pirates.)

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Republican government and democracy are still experiments. Much of the world has not experienced these for any great length of time. In the United States, the great temptation is not Socialism, but the One Great Leader who will solve all of our problems. It is embarrassing to think that an idiotic liar like Trump could fill that desire, but the American people are genuinely that stupid. (No one ever went broke underestimating the taste of the American people.)

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So why should we relax? Because there never was any significant risk to the US Government as a whole. There was a lot of incompetence on the part of the Capitol police.

And though I sympathize with those that want to sideline Trump with the 25th Amendment, I would simply say bear with the indignities of Trump for two more weeks. After that, he will be gone, never to return, as his name is now tarred with violence. The tendency of the American people is not to return to someone who lost, but to seek someone new.

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PS — to my fellow evangelical Christians: why are you supporting a liar? Don’t you know what damage that does to the Gospel? Support someone noble, like Mike Pence. The Lord is our protector; we do not need Donald Trump. Let us not do evil, that good may come from it. Winning an election is far less important than keeping a clean testimony before God and the watching world.

Photo Credit: Jason Thibault also massivekontent.com/ ||Urban Wasteland

Before I write my piece this evening, I want to express and opinion that is unpopular to many of my friends. I think Trump lost fair and square. Since Trump is a greater liar than even Bill Clinton, he continues to protest, but with no significant data, only allegations.

Here’s my quick summary. In the four states that were the smallest wins for Biden (AZ, GA, PA & WI), the state Republican parties generally did not allege any major voting fraud. They may not have liked the concept of mail-in voting and/or increased absentee voting, and they might want to curtail those methods of voting, but given that those were the rules prior to the election, you can’t fight a case over the rules themselves. You have to show the rules led to specific cases of vote fraud — i.e., here is a case where:

• someone voted twice.
• a dead person voted.
• a person that doesn’t exist voted.
• and things like that.

After there is “proof of concept” then election officials can search more intently for fraud in the same area. As it is, the Republicans on the Wisconsin Elections commission had complaints, but eventually said, “There has been no credible evidence presented to the Elections Commission that any of these problems occurred in Wisconsin…” In Georgia, the Republican Secretary of State found similarly, despite considerable pressure from Trump. And in Arizona, the local GOP did not pursue any cases assiduously. The Pennsylvania GOP pursued a few cases, but even if they won, it would not have changed enough votes to flip the state.

Trump needed to win three of these four, and won none of them. As it is, why do I look at the state GOP efforts? State parties tend to be less partisan, but they are closer to the pulse of the local electorate. If there was genuine fraud, they would act. Something with less than factual data might lead some ideologues with their eyes on a US House seat to complain, but most would not, as they will have to live with the political consequences of being unreasonable in a tighter way than those who hold seats in the US House and Senate.

I am not a fan of Biden or Trump. I view them as being equal in term of my distaste for their characters and their policies. I voted for neither of them. That said, Trump’s actions are those of a demagogue and not a hero. He is willing to tear up things that are good for the body politic generally in order to profit his own interests.

One final aside. Watch the private lawsuits fly against Trump after he is no longer President. I don’t think any will file criminal charges against him for his time as President, but there is enough pent-up against Trump from 2016 and prior that he will have his hands full. (Also, the Trump Organization is weak, and will need to survive somehow.)

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In 1987, the city council in Davis, California was holding a meeting regarding an expansion of development in the growth-averse city of Davis. I decided to go to the meeting to express my opinions. I told the city council that:

• they were stealing the property rights of the landowner that wanted to sell to the developer, and
• they were creating a city where their children could not live, as land values were rising rapidly, and only well-off people could afford to live there.

As for me, I lived in the portion of Davis where the project would most negatively affect land values. As it was, the next day the main Davis newspaper (the Enterprise, otherwise known as the Empty-Prize) summarized my comments as “David Merkel spoke in favor of the Ramos project.” It wasn’t true, and I only learned about this when some of my co-workers at Pacific Standard Life pointed it out to me.

For my troubles, I got vandalized by a guy with a high-powered slingshot who broke my front window while my wife and I were sitting near the window. I chased him down the street, but he had too great of a lead.

So much for freedom of expression.

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There’s a greater reason why I write my tale of my opinion that I gave to the Davis city council. We are experiencing the same thing now with low interest rates. On net, we are discriminating against the young in favor of those who are older. We are denying most younger people the ability to be as well-off as the generation that preceded them.

The earnings and dividends yields that they invest at are lower than prior generations, and those that can use the low interest rates to borrow to buy homes are few. (Note: homes and autos are the only places where individuals get low lending rates.) And even for those that do borrow for homes, with inflated asset values, they run the risk of losing in another 2008-9 recession scenario.

The consistent policy of the US since the 1930s is to make life harder for successive generations. The unique and unusual growth post-WWII hid that, but declining growth is laying that bare now. Social Security was a very sweet deal then for old folks that has become a very sour deal now for young folks. Defined benefits plans are a thing of the past, replaced by modest encouragements to personal savings using defined contribution plans.

And now we see the same in monetary policy, where suppressed interest rates relatively favor those who are older. And, increased indebtedness slows future GDP growth.

To close, those who are young are disadvantaged on average versus those who are older. Relatively good times have passed, pushing up asset prices, leaving future earnings from assets to be light. Future returns will NOT be anywhere near those of the past, until interest rates and stock prices correct.

If you are young, you can make up for some of this by keeping expenses down, saving more, and if it fits your personality, starting an innovative business. Good ideas are always in short supply. Also, if you are able to invest in your own successful business, to some degree you can escape the box we are in now where future public investment returns will be low. Then you only have to deal with the risks of the business, and the regulatory challenges thereof.

PS — I’ve left out the fact that unskilled wages are capped by technology and stronger competition globally, and no, there’s little to be done about either of those except to compete harder and smarter. The Baby Boomers faced neither of those when they were young, leaving aside various inefficient unionized industries dealing in commoditized products. Suffice it to say that US Millennials have it harder than the Baby Boomers ever did.