1937 Redux or Is It Really Different This Time?

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The same experts who repeatedly assured us that subprime was “contained” before the Financial Crisis now seem certain that an inverted yield curve is a broken signal that won’t lead to a recession this time, as it has every time in the last 50 years. It is apparent that intellectual humility is not passed out along with doctorates in economics.

Have Trillions of Fed Dollars Broken a Bond Market Warning Sign?

Are They Really Sure the Yield Curve is “Contained?”

The current Fed Funds rate target is 1.00% – 1.25%, and an increase to 1.50% is widely expected in December. The Fed also projects 75 additional basis points of tightening in 2018, which would bring the Fed Funds rate to 2.25%, while the 10 year Treasury currently yields 2.32%. So they are being pretty cavalier about causing a potential inversion. While the 10 year yield may increase in the next 6 months, that remains to be seen. But there seems to be no caution or conditions being placed on the tightening schedule. This seems rather foolish as inflation has not yet shown itself, and average employees are still waiting to see some decent wage growth in this weak recovery. It would seem enormously naive and reckless to simply assume clairvoyance on the part of the experts and completely ignore the historical reliability of the recession warning that an inverted yield curve provides.

“Every recession in the United States — and accompanying global economic recession over the past 50 years — was preceded by an inverted yield curve. The yield curve inversion usually takes place about 12 months before the start of the recession, but the lead time ranges from about five to 16 months. The peak in the stock market comes around the time of the yield curve inversion, ahead of the recession and accompanying downturn in corporate profits.”
— Jeffrey Kleintop

Hippocrates Would Counsel Caution

Why not pause Fed Funds hikes at say 1.75% and speed up the sell off of the Fed balance sheet if they don’t get the steepening of the yield curve that they want and expect? And if this accelerated sell off of Treasuries doesn’t get the market response they want, then shouldn’t they assume that the market is telling them the economy can’t take it and will likely succumb to recession if they proceed with tightening?

A little caution would seem appropriate in the absence of actual signs of inflation. Such a hard won and meager recovery shouldn’t be just thrown away before the little guy has participated through decent wage growth. Isn’t it just as likely that the Philips Curve model is flawed if not broken? With all of the wailing about the output gap since the Financial Crisis, I wouldn’t think they’d want to chance making it worse unnecessarily.

Better to make sure inflation is a clear and present danger before risking a recession. We can’t afford another misguided and premature tightening like the one in 1937 that caused the recession within the Depression. Remember: First, do no harm.

See also:

The Great Depression: A Diary

Aflac: A Valuation Conundrum? Fairly Valued Dividend Aristocrats – Part 1 Of 7

Embrace the Uncertainty

The 1990s Telecom Bubble. What Can We Learn?

Germany’s Green Energy Meltdown — Voters promised a virtuous revolution get coal and high prices instead

“Humility means loving the truth more than oneself.”
— Andre Comte-Sponville

“The conventional view serves to protect us from the painful job of thinking.”
— John Kenneth Galbraith

“There are all kinds of businesses that I don’t understand, but that doesn’t cause me to stay up at night. It just means I go on to the next one, and that’s what the individual investor should do.”
— Warren Buffett

Investing Equals Decision Making Under the Condition of Uncertainty

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Recently upon finding out I invest for a living, an acquaintance asked me to let her know if I see something coming in terms of a big market selloff, because she is approaching retirement and is scared of a bear market. This is both typical and mystifying to me in terms of the way regular folks tend to think. The reality is that I don’t know the future any more than she does. Investing equals decision making under the condition of uncertainty.

How an Investor Should Conceive of the Future

To properly conceptualize the future as an investor, you need to create different scenarios and assign subjective probabilities to them. You want a strategy and an approach that is robust against this subjective probability distribution of the future. You can’t control your returns, but you can control your risk profile. Managing your risk requires balancing the probabilities against their potential consequences. As Seth Klarman has said, nothing is more important than the ability to sleep at night.

How to Approach Investing In an Uncertain World

An investor’s task is to manage their assets and cash flows so they will provide for their needs over their lifespan. How do you do that? You estimate what you will need and make a plan that is likely to get you to a prosperous retirement. Don’t extrapolate to the best case scenario. Prepare for the worst and hope for the best. But, the big thing is to save and invest something. Anything is better than nothing.

If you are young and investing for retirement, Vanguard suggests putting aside 15% of your income toward this goal. If you can meet that number terrific. If not, 10% is a reasonable goal when getting started. If you get an employer match, so much the better as this will decrease the amount you need to contribute.

You also want to make sure that you have enough in savings and disposable income to cover your living expenses during the portfolio building stage of your investing life. You don’t want to get disheartened or need cash during a bear market and either stop contributing or sell your investments at a loss.

Munger’s Approach to the Market’s Vicissitudes

Charlie Munger has said that he doesn’t try to predict the ups and downs of the market, he just tries to swim better than the tide. He has also said if you aren’t able to endure a decline in the quoted price of your stocks by 50% and react with equanimity two or three times in your life, then you deserve the mediocre returns you are likely to get.

I always get a kick out of market pundits who talk about how uncertainty is high right now. Uncertainty is always high. While trends persist, often far longer than you may think, recessions and bear markets many times begin when the consensus is fairly cheery. Anyone who tells you they know what is coming next in the markets is a liar, and they are probably trying to sell you something.

See also:

The House GOP’s tax bill is a dud — and they know it
Editor’s Note: This attempt at partisan tax reform is a disaster. It amounts to taking from individuals to cut taxes for corporations and passthroughs. And it will add further to the debt while likely increasing interest rates and inflation when the economy is already at full employment. They need to think like normal people and not try to jam through something that people will justifiably hate once they feel the real costs. Nothing would be better than this mess in my opinion. A smaller and less “transformational” tax cut would be second best.

The Freakishly Strong Base and the Almost Magical Power of Compounding

The industrial economy is enjoying broad based growth

One Bitcoin Transaction Now Uses as Much Energy as Your House in a Week

The Innovation Is the Blockchain

“There are two kinds of investors, be they large or small: those who don’t know where the market is headed, and those who don’t know that they don’t know. Then again, there is a third type of investor — the investment professional, who indeed knows that he or she doesn’t know, but whose livelihood depends upon appearing to know.”
— William Bernstein

“The difference between a prediction and a probability is the difference between a pundit and a professional. One makes concentrated bets on the belief that they can predict the future and the other diversifies with the understanding that they cannot.”
— Charlie Bilello

“The question about selling a really great business is never. Because to sell off something that is a really wonderful business because the price looks a little high or something like that is almost always a mistake. It took me a lot of time to learn that. I haven’t fully learned it yet. It’s rare it makes sense. If you believe the long term economics of the business are terrific, it rarely makes any sense to sell it.”
— Warren Buffett

“Having, and sticking to, a true long term perspective is the closest you can come to possessing an investing super power.”
— Cliff Asness

If Trump Picks Taylor for Fed Chief, Recession Odds Go Way Up

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So apparently President Trump asked for a show of hands at a Senate lunch on whether he should choose Jerome Powell or John Taylor as the next Fed chief, and Taylor won.

Trump Asks GOP Senators: Should Taylor or Powell Be Fed Chief?

Mr. Taylor, of the eponymous Taylor Rule, is loved by many on the right. But he would be a disaster as Fed chair. As Hayek told us in his Nobel Prize lecture, economics is not physics, and economists looking for mathematical precision are suffering from the mere pretense of knowledge.

As the following chart shows, the Taylor Rule would have been a huge policy mistake if followed post 2008. The red line is the actual Fed Funds rate, and the blue line is the rate implied by the Taylor Rule.

As disappointing as the economic recovery has been post Financial Crisis, it is certainly better than no recovery at all. Which is what we would likely have if Mr. Taylor’s Rule had been followed from the bottom of the Great Recession.

The Taylor Rule would have the Fed Funds rate at about 3.5% currently, versus the actual range of 1% to 1.25%. This would invert the yield curve and likely send us into a needless and destructive recession.

The economy and stock market have been doing well under President Trump thus far. Reduction in regulation and potential tax cuts are helpful. But selecting Mr. Taylor, who would raise interest rates to respond to his mechanical rule, would tank all of this progress for no good reason. Ditto for Kevin Warsh, although to perhaps a lesser extent.

Yellen has done a good job and should be reappointed, but Powell would be a good choice for a replacement. They seem to understand our current moment with demographic headwinds and an absence of inflation in the data. Appointing Taylor now runs the risk of a repeat of the misguided 1937 tightening that caused the infamous recession within the Depression. That is a policy mistake we can’t afford.

Hopefully, common sense will prevail and Yellen or Powell will be the choice. If not, recession odds will go way up.

See also:

2/10 Spread Near 10-Year Low — When It Goes Negative It Is a Recession Warning

My Watch List – Eddy Elfenbein

The Theory of Maybes – Morgan Housel

How Google’s Quantum Computer Could Change the World

“It takes character to sit there with all that cash and do nothing. I didn’t get to where I am by going after mediocre opportunities.”
— Charlie Munger

A Survey of The Investing Horizon

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So where do we stand with the stock market? The S&P 500 trades at just under 22 times trailing operating earnings according to Bloomberg …

… and 17.5 times forward earnings estimates according to J.P. Morgan.

So by these measures, the market is overvalued compared to 25 year averages. However, when the earnings yield is compared to current interest rates, the market is — if anything — rather cheap.

Ed Yardeni calls the current conventional wisdom the “2-by-2-by-2” scenario: 2% real GDP growth, 2% inflation, and a peak Fed Funds rate of 2%.

What If We Have Much Higher Interest Rates?

But much higher interest rates could upset the apple cart. While there are many reasons for lower potential growth and inflation — such as the aging of society — what if the conventional wisdom is wrong and higher growth and inflation cause a substantial increase in interest rates?

As the above chart shows, interest rates don’t generally have a negative effect on stocks until the ten year Treasury is above 5%. While it’s not impossible for rates to go higher than 5%, I see no reason for it to happen any time soon without much higher growth and/or inflation rates. And demographics and global trade would seem to keep a lid on both.

Runaway Inflation Seems Rather Unlikely

There are a lot of smart people who seem to think a normalized 4%-5% ten year Treasury yield is a reasonable planning assumption. For instance, Morningstar has a 4-5% ten year Treasury baked into its discounted cash flow (DCF) models to come up with their fair value estimates on stocks.

There is a lot of room between the current 2.24% on the ten year Treasury and a potential 5 handle. But with gradual Fed balance sheet reduction and possible higher growth from a tax cut or infrastructure package, the 10 year Treasury could easily reach 3%-3.5% over the next year or so — maybe even 4%. But that would require the Keystone Cops in Washington to get their acts together. And don’t forget the Fed is pushing in the other direction with higher short term interest rates because their outdated Philips Curve Model suggests inflation should be on its way any day now.

While commodities prices are mixed (weak ag prices/strong industrial metals), global trade should ease pressures on inflation. The official unemployment rate looks low, but there still seems to be some slack in the labor market with the low participation rate and wage growth below par. And to the extent wage pressures exist, companies will likely invest more in automation.

Maybe A Lot More Long Term Upside?

The good folks at Bespoke show that trailing 10 and 20 year stock market returns are still pretty lousy, which hardly seems an indication of a bubble ready to be popped.

And as this chart shows, we may well have entered a new secular bull market in 2013, which could bring huge gains over the next decade plus.

Can The Fed Control Its Urge to Cause a Recession?

So even though we’ve had a great 8 year run since the bottom in March of 2009, it seems we have room to the upside if the economy continues to do well. Unless we have a big geopolitical shock or the Fed hikes us into a recession. If we get a recession, we get a bear market. This is as close to a certainty as you will find in the markets.

While it seems everyone is looking for signs of the bottom falling out of the stock market, the data shows no bubble that I can see. Well, Tesla and Nvidia look rather bubbly but M&A and the IPO market are certainly not red hot. Big Cap Tech has had a great run, but they have real earnings and cash flows, and valuations are much more reasonable than during the bubble era. This is not about metrics like eyeballs and page views like 1999-2000. There is no sock puppet bullshit this time; by and large, they are real, substantial businesses.

It seems to me there is no need for a recession unless the Fed decides it wants to cause one by raising rates too much — so they can get the dry powder to lower rates in case of a recession, which they will likely cause by raising rates…

How To Plan For An Uncertain Future

If you are worried about a bear market, you should reduce your risk while times are good. Make sure you have enough liquidity so you won’t stop buying during a bear market if you are young and in the accumulation phase. And don’t sell into a decline!

Planning for your liquidity needs is even more important if you are in or near retirement. If you are worried about a coming bear market, you should sell down to the sleeping point now, when times are good. Don’t put yourself in a position to be a forced seller into a big decline. That only makes you fail to meet your long term goals while lining the pockets of guys like Warren Buffett and Seth Klarman.

I try to stay hunkered down all the time, and I plan for my liquidity needs as if a bear market will begin tomorrow. This is more sensible than to assume you will have some magical insight nobody else has that will enable you to sidestep the worst of a bear market.

See also:

J.P. Morgan Guide To the Markets as of June 30, 2017

“Run of the Mill” Market Returns – Bespoke

S&P 500 Remains Reasonably Valued – Brian Gilmartin

Jeff Saut Still a Huge Secular Bull

“Success in investing doesn’t correlate with I.Q. once you’re above the level of 125. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.”
— Warren Buffett

High Returns From Low Risk

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Pim Van Vliet’s book High Returns from Low Risk examines the investment paradox that the lowest risk stocks (measured by volatility) outperform the highest risk stocks over the long term. This phenomenon has been established across markets and eras. The book builds on the work of Eric Falkenstein in The Missing Risk Premium and his paper on risk and return at SSRN.

According to the deans of finance, this should not be the case. For instance, the Capital Asset Pricing Model (CAPM) assumes a linear relationship between risk and reward. But of course this does not represent the real world.

    “Bearing higher risk generally produces higher returns. The market has to set things up to look like that’ll be the case; if it didn’t, people wouldn’t make risky investments. But it can’t always work that way, or else risky investments wouldn’t be risky. And when risk bearing doesn’t work, it really doesn’t work, and people are reminded what risk’s all about.”
    — Howard Marks

So You’re Telling Me There Is a Free Lunch?

The following diagram shows a frown whereby risk increases return up to a point, but the highest risk stocks underperform the lower risk stocks. You should take some risk, but not too much.

Valuation Still Matters

Since the low risk anomaly has been identified, several ETFs such as USMV & SPLV have been created to exploit it. In recent years, a lot of hot money has chased the strategy and driven up the prices of low volatility stocks. The observation of the phenomenon has changed it.

So returns from low risk may be somewhat muted going forward until the excitement fades and the hot money moves on to chase something else. As in any other investment strategy, valuation matters, and you should seek a margin of safety.

Low Risk Outperforms in Bear Markets, but Lags In Bull Markets

While low risk stocks tend to outperform in a bear market, it can be difficult to hang on during a bull market when you are likely to lag. The sense that everyone else is getting rich can be hard to take without capitulating. Persistence over an entire market cycle is needed to get the outperformance the low risk strategy can deliver.

    “The low volatility portfolio wins by losing less during times of stress.”
    — Pim Van Vliet

An Antidote to Financial Noise and Unnecessary Complexity

Pim Van Vliet’s book is a breath of fresh air. That one can ignore all of the noise and succeed with low risk stocks is a blessing for the individual investor, if he is willing to put in the work and can stand to be different from the crowd. I am perfectly happy ignoring the horserace and earning high returns with low risk.

I love to find boring, cash cow companies that it is hard to brag about owning. Sacrificing your ego for financial gain can be emotionally counterintuitive, but very lucrative. I would much rather have the cash register ring reliably than have bragging rights.

To me it is a matter of personal preference and goals. My goal is to comfortably afford the life I want to live. Pim Van Vliet shows that a low risk strategy can even outperform. I may beat the market without even really striving to do so.

A Dividend Oriented Strategy Beats Dollar Cost Averaging In Reverse in Retirement

While a low volatility strategy and a dividend oriented strategy are not precisely the same, I believe they are close cousins. A substantial benefit of the dividend growth strategy over the “living off of the pile” strategy promoted by most of the financial industry is that it is perfect for turning a portfolio into a stream of income during retirement.

This solves a major weakness in the mainstream advice to gradually sell off part of your portfolio every year in retirement. Dollar cost averaging in reverse destroys value just as dollar cost averaging in the accumulation phase creates value. A low risk, dividend growth strategy is simply much more practical in the real world for real people than trying to live off of the pile.

And the smoother ride of investing in largely defensive, low risk stocks with secure and growing dividends means that I won’t panic and sell during a downturn. The key is that I believe in it, and I know it will get me to my goals if I stick with it. That is much more than good enough for me.

    “The great strategy you can’t stick with is obviously vastly inferior to the very good strategy you can stick with.”
    — Cliff Asness

See also:

DR 167: Interview of Josh Peters of Morningstar March 18, 2015: Soundcloud and Transcript

The Joys of Hunkering Down

Worrying is a serious offense

The Seduction of Pessimism

Why Simple Beats Complex

4 Signs of a Bubble

Mohnish Pabrai Lecture at UCI, 6-7-17 — Few Bets, Big Bets, Infrequent Bets

Is the staggeringly profitable business of scientific publishing bad for science?

“Humility means loving the truth more than oneself.”
— Andre Comte-Sponville