What are Stocks Worth?

Over the ten days between January 29 and February 8, the world’s stock markets  decided that equities were actually worth about 10% less than they were at the close on January 26. Of course, on that date markets priced equities more than 20% higher than they were immediately before Trump’s election. So prices have varied plus-or-minus about 25%, as shown in the chart of the S&P 500 below.

SP500 Election - Feb18

In terms of market history, there is nothing unusual about the recent price action. On Thursday February 8 we had the largest-ever single-day point decline in the Dow Jones Industrial Average, but nowhere close to the greatest percentage decline. At the end of trading on Thursday, February 8 we were officially in a correction, defined as a 10% decline from a prior market close. Since the Second World War, the US stock market has seen a correction about every 14 months. Nothing much to see here, then, in terms of unusual market action. But there may be an opportunity for increased understanding in examining the stated reasons for the decline.

The main driver of the decline was a rise in inflation fears. About one-third of the commentators noted that higher inflation will cause the Fed to raise interest rates, and those elevated rates will choke off economic growth, thus the decline has a legitimate economic basis. Another third of observers agree that the fear of inflation is causing a fear of rising rates, but think both fears are premature, and should not distract us from the current bullish reality–a strong world economy and a solid near-term corporate earnings forecast.

Both the bull and bear cases are based on the theory that economic growth drives stock prices. That theory is mostly wrong. To understand this, consider the stock market’s performance during the Obama years. By all accounts, economic growth during the years 2009-2016 was slow, especially after a deep recession. Yet the US stock market was up about 300% during Obama’s watch.

Here’s my take on the drivers of valuation:

Growth in GDP is almost irrelevant, unless the economy collapses into recession. More directly consequential is…

Growth in corporate earnings, which has been much stronger than overall economic growth, as corporations have used pricing power in labor markets to increase their margins. Corporate earnings are at unprecedented levels as a fraction of GDP. Earnings are the denominator in the pricing calculation, but the future streams of earnings and dividends we buy as stock investors are actually less important than…

The price we pay for them. There are three principal determinants of the price/earnings ratio. The least important is…

The prospective returns on competing investments. If Treasury bond yields were to rise to 6.5%, utility stocks (for example) would need to decline in price to remain competitive. This mechanism (direct and immediate competition for investor dollars) is way more important than the delayed, indirect, and hypothetical effect of higher interest rates on future economic growth, but still less important than…

Sentiment. Greed can drive markets upward much further and faster than any underlying change in the real economy, while fear can crater prices out of all proportion to actual economic declines. Earlier this month, stock prices fell by 10% in less than a week, but the US economy hasn’t seen a year-over-year decline in GDP of 10% since the 1930s. Sentiment-driven pricing changes can be abrupt and significant, but they are not structural. Which brings us to the most powerful driver of stock valuations…

Inflation. Contrary to the discussion in recent weeks, inflation is not an indirect driver of future earnings, mediated by the long-term effects of Fed policy on the availability and price of credit, and relevant only once it eventually results in changes in economic growth rates. In reality, inflation is the most direct component of the price we are willing to pay for future earnings.

Consider a company with $5.00 per share of future earnings. Assume the earnings grow by 5% per year. Within ten years, the EPS will be $8.14. (In the long run, growth in earnings that handily outpaces growth in GDP is nice work if you can get it, but that is a subject for another post.) In an environment of low inflation and corresponding low intermediate-term interest rates, prospective earnings a decade away can have substantial current value.

But what if inflation were 10% a year? In that case, those future earnings would be worth much, much less. Higher inflation makes future cash flows less valuable for two reasons–first, because the future dollars we’ll receive will be worth much less when we get them, and second because a high-inflation environment is more essentially uncertain and unstable. If I lack confidence in the magnitude of future benefits, I will give greater weight to current availability. I’ll have my dessert right now, thank you, rather than wait for something better tomorrow evening.

Corporate earnings, measured by the S&P 500, have grown from $13.30 in 1979, when I started work as a stockbroker, to over $105 today. That is an increase of just over 8:1. But the price of the S&P? That has gone up by more than 25:1. The price we are willing to pay for each $1.00 of earnings has tripled over almost forty years. That rising tide has lifted almost all boats, so much so that the inflation-adjusted trailing price/earnings ratio we pay for the median stock in the S&P 500 was recently the highest ever.

Over the decades since the cyclical market low of August 19, 1982, the principal driver of rising stock prices has been falling inflation. For 90% of my career, starting in 1981, the inflation rate has either been declining or low and static. Most people working in the financial sector have never worked during a rising inflation environment. Quite a few have never actually experienced a bear market.

If inflation picks up, we won’t need to wait for a delayed and indirect effect on GDP growth and corporate earnings some years in the future. The effects will be felt much more quickly, as markets rediscover the pain of a less valuable future, manifested in the form of a lower structural P/E ratio.

What should we do about all of this? Two things. First, operate from a more-informed understanding of the true potential risks, which are about much more than hypothetical economic growth years from today. Our stock and bond portfolios contemplate higher inflation, along with other risks. Second, diversify internationally. Higher inflation in the US does not necessarily imply higher inflation worldwide.

 

 

Bitcoin Bubble

Our office has been closed the last two days because of the winter cyclone that hit the East Coast. I’ve spent this unexpected time off reading and thinking about Bitcoin. I’m putting together a white paper that will pull my thoughts together in long format, but I think it may be useful to get a few tentative conclusions out there quickly, just in case things fall apart in the near future.

The nature of bubbles is that inexperienced investors think they are making huge money because they are smarter than everyone else. This illusion is self-reinforcing. It is why bubble pricing goes parabolic before it crashes. The reality is always that the late stage of a bubble is when the greedy and inexperienced make big profits, while the expert and experienced stand on the sidelines shaking their heads. And then it all falls apart, and perhaps one of twenty of the peak-era traders has actually gotten out with substantial wealth intact.

My opinion, as someone who has been running investments since 1978, and has seen bubbles in gambling stocks, precious metals, oil services stocks, tech stocks, shore real estate, residential real estate, tech stocks, shore real estate, tech stocks, residential real estate, tech stocks, and cryptocurrencies, and has correctly identified the last five or more of them, is that we are in the blow-off phase of the cryptocurrency bubble. I’ll develop this thesis further in the coming white paper.

So this blog post is aimed at Bitcoin hodlers (a deliberate misspelling with meaning to Bitcoin enthusiasts) who are sitting on significant wealth, and who are open to the possibility that they might, just possibly, maybe perhaps, be making a mistake by holding a large portion of their net worth in Bitcoin and/or other cryptocurrencies.

I have come to three semi-firm conclusions about Bitcoin and its variants (including Bitcoin Cash, Bitcoin Gold, Bitcoin Diamond et al) and competitors (including Litecoin, Ripple, et al):

  1. Blockchain is a powerful new technology, which is likely to have huge impact going forward, especially in those parts of the economy (brokerage, real estate, insurance) where assets are bought and sold, and their ownership tracked.
  2. Bitcoin innovated blockchain, but has no priority claim on using it. People can design their own novel blockchain applications and Bitcoin does not benefit. Indeed, competitors or would-be successors can duplicate Bitcoin’s software in every respect, make a few tweaks, and launch their own competing cryptocurrencies.
  3. We can’t know the future. Even you, Mr. Bitcoin Hodler. In one possible future, Bitcoin becomes as valuable as Netflix, Google/Alphabet, Amazon, or Facebook. In another, a different crypto makes it big and replaces Bitcoin. And a third possibility is that all cryptos become worthless, while the big money from blockchain applications will be earned based on another use-case entirely.

Which leads to one simple suggestion. If you are sitting on big money in Bitcoin, especially if you got in early and your net worth has exploded, even more especially if Bitcoin and other cryptos represent most or all of your portfolio, do two things:

  1. Sell half your holdings right away. Take the proceeds, hold back enough to pay the capital gains taxes, and invest equal amounts in three things: an S&P 500 Index, a global stock index, and a money market fund.
  2. With the remaining holdings, consider diversifying, again into three equal buckets: Bitcoin, a “portfolio” of three to five credible crypto alternatives, and a portfolio of public companies that are doing important work in the crypto space.

If Bitcoin is gonna be Google, and cryptocurrencies as valuable as the Internet, you’ll still get filthy rich, but not quite as rich as you might have. A billionaire, perhaps, instead of a multibillionaire. If some other crypto replaces Bitcoin as the future Google, you’ve still got a shot at owning it, and getting much richer than if you stay concentrated in what might end up a loser. And if the whole digital currency thing is not the second coming of electricity, the internal combustion engine, and the internet rolled into one can’t-miss digital asset, you’ve still got a chance for profits owning real companies that derive economic advantage from blockchain innovation.

If Bitcoin is in a stupid bubble, and loses 90% or more of its value, you will have changed your life, and you will be the envy of your techie friends who didn’t get out, even a little bit.

Either way you win. Fail to diversify, and there is a non-zero possibility you end up with nothing, or something close.

This is going to be real interesting to watch.

 

Vaccinate Your Portfolio

Faith in institutions is near all-time lows. Americans don’t trust the mass media. We certainly don’t trust politicians. The internet allows each of us to construct a comfortable cocoon of congenial opinions. It appears we are each allowed to select our preferred set of “alternative facts.” Absent trusted sources of data, confirmation bias runs rampant.

Yet there remains an objective reality out there. In many disciplines there are recognized best practices that define how well-informed and prudent individuals and institutions should act; failure to follow those best practices risks adverse consequences.

Consider vaccination.

My wife is an epidemiologist trained at Johns Hopkins School of Public Health. Some of my closest friends, and many of my clients, are physicians. None of them have any doubt whatsoever that vaccination is safe and effective. All recognize the absolutely central role of vaccines in improving public health.

We no longer have thousands of children and adults confined to iron lungs because of polio. I don’t know anyone whose brother, sister, son, or daughter died of measles, mumps or whooping cough as a child. Unless the Iranians or Russians have retained live smallpox cultures, a disease that has killed millions over the centuries is gone from Planet Earth.

All because of vaccinations. Yet vaccination has become controversial because of misinformation spread on the internet. Even intelligent people, when struggling with a personal tragedy, can be led astray into believing in the non-existent dangers of vaccination.

Vaccination remains a sensible, indeed essential, best practice for the protection of something precious–the lives and health of people we love. Bad information about vaccination puts unvaccinated individuals at risk, but it also harms all of society as we lose the important protection of “herd immunity.”

A recognized best practice also exists in investment management. Diversification is the proven, sensible, documented best practice for managing investment portfolios. All professional investors, charged with managing entire portfolios for individuals or institutions with long-term goals, diversify.

Period. Hard stop. No capable investment professional ever fails to diversify, regardless of the temptations of today’s “hot” speculative opportunity. No sensibly-run college endowment ever puts all its money in one asset class. No foundation decides to bet it all on a single hot stock, fund or manager. No pension plan abandons diversification to go entirely into cash, stocks, venture capital, pork belly futures or Bitcoins.

All of these professional investors recognize that diversification is the key strategy to manage risk and deal with the intrinsic uncertainty of the financial markets. The intellectual foundations for diversification are simply too robust, well-documented, and mathematically compelling to be ignored.

That doesn’t mean institutions never make mistakes. As behavioral finance demonstrates, we humans are all potentially subject to information-processing and decision-making errors. At market extremes, many tend to over-weight the best-performing asset classes, confusing recent price trends with long-term economic advantages. (For a great summary of the thought process that leads investment committees astray, here is a recent piece from the smart folks at GMO, one of the world’s premier asset-allocation firms.)

Despite the abundant evidence in favor of diversification, we’ve recently observed a small number of investors choosing more focused portfolios. They believe they have identified the specific assets that will perform best in the near future–as at prior market highs, usually those assets that have performed best in the recent past. Right now, some smart people are inclined toward investing all of their money in U.S. large-cap stocks, believing that the “Trump trade” will continue to drive domestic stock markets to new highs.

I doubt that any of these folks would consider not vaccinating their children. But they may be in danger of making a tactical blunder with important consequences for the health of their portfolios. We’d hate to see that result.

Be smart. Vaccinate your portfolio. Stay diversified.

J

 

Mad Libs for Investors

The emotions are really starting to heat up. During most of the typical stock market cycle, most investors are able to keep their emotions well in check. That is particularly true of our clients, who tend to be a patient, mature, and generally cerebral bunch.

But during certain parts of the cycle, the mass of investors, including even our cohort of unusually smart and even-tempered clients, begin to behave less as individuals and more as a herd. As emotions take over, reasoning ability becomes compromised. Vision narrows, blood pressure elevates, time horizons shorten, and calculation gives way to expectation; what is happening right now becomes all important, while what is likely to happen longer-term appears entirely unimportant. The chance for profits seems both immediate and certain, while the danger of loss appears theoretical and distant.

With the market making new highs day after day, we are beginning to get those phone calls, and have those conversations. The content of these discussions sound something like this:

“Everyone is getting rich! Why do I still have cash?”

“We need to buy now!”

“I’m tired of underperforming when the markets are going straight up. I need a better strategy.”

At market extremes, whether the market is making exciting new highs or scary lows, the emotions of the crowd are a deadly danger to our long-term financial interests. At those market inflection points, our job as financial advisors is to refuse to validate our clients’ emotions as a basis for action.

That sounds really harsh. I still remember, more than twenty years later, one of my favorite clients, a retired woman of unusual grace and poise, telling me in a profoundly wounded tone, “You don’t want me to have any feelings!”

I was trying to explain to her, at the depth of the 2000-2003 market decline, that she should not sell out at the market low, amid all the bad news, as she had done in the three prior bear markets.

When my kids were younger, they loved Mad Libs, and filling out those forms prompted great hilarity during long car rides. “I need a noun! Now a verb! An animal!”

So here is a very simple Mad Libs style exercise about the current exciting market. I’ll provide four phrases with blanks, and a choice of words to fill them in.

Active investors are advantaged if they ______ low and ______ high.

Right now, the market is at an all-time ______. The mass of investors are _______ing. We should be _______ing.

The four words to use to complete our Investor Mad Libs are:

Buy

Sell

High

Low

(One hint. You will need to use only three of the four words.)

Please let me know if this exercise makes sense to you, and if it changes your current thinking in any way.

Ponzi Redux

“What we mostly learn from history is that people are unable to learn from history.”

Warren Buffett

Back in the 1920s, Carlo (Charles) Ponzi got an entire class of financial fraud named after him, when he convinced greedy investors that he had a mechanism to double their money in a short period by buying international postal coupons at a discount and redeeming them at face value. Hundreds lost their life’s savings in his scheme.

A Ponzi scheme, also called a pyramid scheme, offers apparently superior returns through some kind of financial legerdemain, but actually pays early investors with the funds of later investors. Pyramid schemes inevitably collapse when there are too many early investors expecting cash flow, or demanding their money back, and not enough new money flowing in to keep the illusion going.

The financial press has just broken the story of the collapse of a Ponzi scheme based in New York City, in which investors were promised high returns from buying up blocks of theater tickets for hot shows, which would then be re-sold at higher prices. The big draw for many was the understanding that they’d be capitalizing on the success of Hamilton, one of the most popular musicals in Broadway history, with the highest ticket prices ever.

Of course, there was no actual buying of theater tickets. A money manager cooked up the scheme to reimburse investors whose money he had misappropriated in his investment firm. Three guys were arrested, one is pleading, and the other two will go to trial.

Who was taken in by this nonsense? Surely only credulous old ladies on Long Island or the equivalent?

Actually, not. Among the victims were billionaire computer titan Michael Dell, billionaire hedge fund manager Paul Tudor Jones, an executive at Och-Ziff Management Group (an investment firm) and 125 others.

The moral of the story is that simply following the crowd, even the famous and supposedly sophisticated crowd, is no guarantee of good results. Often it is precisely the richest and most sophisticated who are the victims of scam artists. (See Madoff, Bernie.) If it sounds too-good-to-be-true, it very probably isn’t, you know, true.

The Election and Your Money

In past years, I’ve written on this topic once the results of the Presidential election are known. This year, I’m posting prior to the election, because some of the potential short-term effects of the election results are worth considering, so as to be ready if market dislocation follows next Tuesday’s vote.

This is my eleventh presidential election, and surely the most contentious. I won’t tell you how to vote, or even touch the arguments against the two major-party candidates. Good luck to all of us when we step into that booth and confront the duties of our citizenship.

What I will comment on is the investment implications of this election. You can also watch a recording of our recent webinar, The Markets & The Election Season. How will the results affect our portfolios? Is there anything we should do in advance of the election, either to protect ourselves or to maximize our opportunities? Are there actions we should be prepared to take after the election, depending on the result?

As always, let’s start by examining the data. We have really good data going back to the presidential election of 1952 about how U.S. financial markets have reacted in the short-term, over the two months on either side of presidential votes, to different election outcomes.

Here’s a summary of some of the key points:

  • Markets usually go up slightly in the two months bracketing the presidential election.
  • They go up more if the election is close.
  • If the election is a landslide, they go down a bit.
  • If the party in the White House changes, they go down. If the White House remains with the same party, they go up.
  • If a Democrat wins, markets decline, while a Republican victory sends markets up by exactly the same margin.
  • None of these historical moves averages as much as 2% in either direction.

So the best scenario for the markets is if the Democrats retain the White House by a slim margin, and a Republican wins the presidency. Which is clearly self-contradictory, and thus no help at all.

Does either party have a longer-term advantage? Yes, there is a slight advantage for Democrats in long-term returns. But if you deduct the market crash of 1929-1932, the Republicans have a slight edge. As investors, we really have no reason to prefer either candidate based on historical market reactions to partisan outcomes.

Is there a more reliable metric we could apply?

As we often do, we fall back on valuation. Economist Robert Shiller of Yale University won the Nobel Prize in Economics for his insight, captured in the Shiller CAPE (Cyclically-Adjusted Price Earnings ratio), that when stock market valuations are high, future returns are lower, and when valuations are low, future returns are higher.

The last two times the presidency changed hands, in 2000 and 2008, we used Shiller CAPE to inform our broad perspective on the markets.

In 2000, when George W. Bush finally won, valuations were high, and we warned that risks were high and prospective returns likely to be low. We took a defensive posture. As the tech crash continued through 2003, our portfolios largely avoided the market decline.

In 2008, when Barack Obama won a compelling victory in the midst of the worst stock market decline since the Great Depression, we observed that stock prices were below average. With risks lower and opportunities higher, we pounded on the table in favor of buying stocks. At the market bottom in 2009, our stock holdings were the highest ever. We were ultimately well-paid for owning stocks, as Barack Obama’s first term was one of the most profitable for U.S. stock market investors in a generation.

Today, market prices are high. With Shiller CAPE at 26.5 times trailing earnings, we are in the top 7% of historical valuations (93.6th percentile). Our portfolios are defensive, just as they were in 2000 when Bush 43 was elected.

A little more than a week ago, a Hillary victory with limited “coattails” appeared to be priced in.[1] A sharply different result—either a Trump victory or a Hillary victory with big coattails, giving the Democrats control of the House and Senate, would have been surprising, and thus likely to lead to a short-term market decline. (For what little it is worth, historically market returns have been highest with a Democrat in the White House and Republicans in control of Congress, just as we have now.) As Trump closed the gap, the U.S. stock market declined for nine straight sessions, the longest losing sequence since 1980. We have done limited buying during this decline, mostly for clients who were over-weight cash.

There is an aspect of our portfolio strategy that may intersect in interesting ways with the election results. While U.S. valuations are very high, all foreign stock markets are cheaper as measured by CAPE, without exception. We are overweight foreign equities.

To evaluate how this positioning might perform after the election, let’s examine the reaction of markets to the British vote on whether to leave the European Union (Brexit). Immediately before the vote, the final polls predicted Brexit would fail and Britain would remain in the EU. Markets rallied sharply. But Britons actually voted for Brexit, against polling predictions. Markets fell sharply, both in the U. S. and in Great Britain. But within weeks, markets fully recovered in both the U.S. and overseas. So far, so unremarkable.

But one market fell sharply and has continued to fall in reaction to Brexit—the currency market for the British pound, which fell by 6.0% the next day and has fallen another 10.4% since, with no sign of recovery.

What is the similar scenario in the U.S.? It would be a Trump victory, against the indications of the majority of polls. If we followed the Brexit path afterwards (no guarantees of that at all), we would see a sharp decline in the S&P 500, followed by a full recovery in stock prices, but we would also see a sharp and persistent  decline in the value of the U.S. dollar.

That single, entirely speculative scenario would actually benefit our target portfolios, because we are strongly over-weight foreign equities. A falling dollar increases the price of foreign stocks. Of course, there are multiple other scenarios under which we would not benefit.

Our advice is to exercise your franchise in line with your moral, political, and philosophical convictions, and to expect markets to react to the election results in unpredictable ways. Know that our portfolios are defensive and diversified, that we have cash available to invest in the event of a large market decline, and that we remain committed to a global perspective on investing. As always, we are devoted to your lifetime financial success, and none of our personal political perspectives will ever deflect us from making decisions solely based on what we believe to be your best long-term interests.

[1] A President’s election is said to have “coattails” when it also results in large gains for down-ticket candidates for Congress, Governorships, or state-house races. Examples during my lifetime were Johnson in 1964, Reagan in 1980, and Obama in 2008.

Brexit or Bust

As it happened, my wife and I were in Europe when the Brexit vote took place, and had several conversations with bemused Britons, Scots and Italians about the vote and its potential consequences. I was out of the office until July 5, so I missed the sharp market decline and equally sharp recovery, though I followed both the commentary and the market activity quite carefully.

The Economist, the English-speaking world’s most reliable source of utterly conventional wisdom, called the Brexit Leave vote “a senseless, self-inflicted blow.” Nigel Farage, head of Britain’s nationalist UKIP party, called it “a victory for ordinary people, for decent people.” Wealthy London, home to the UK’s powerful finance sector, voted to Remain, as did poorer, welfare-dependent Scotland. Most of the rest of the country voted to Leave.

The contrast says much of what one needs to know about the two closely-balanced factions throughout the West. Bureaucratic elites, finance types  and wards of the state versus strained working and middle classes struggling with a moribund global economy and stagnant wages.

The immediate consequences for the markets were negative. Worldwide, equity markets fell sharply, then rallied. For the second time this year, bears cried havoc and were proved wrong…or at least, premature.Markets dislike uncertainty, but amid record low interest rates on cash, stocks remain the preferred asset class. The dollar strengthened against both the pound (significantly) and the Euro (slightly).

A key investment principle is that disorder creates opportunity. The V-shaped market action (sudden fall, quick recovery) has been a pattern in recent years, as one market break after another has failed to transition into a true bear market. As usual, we took careful advantage of the market break to buy low in accounts with excess cash.

What will Brexit mean long term? That is very hard to predict. Protectionism weakens economic growth, but the UK leaving the EU does not necessarily mean adopting higher tariffs. All that must be negotiated.

Brexit is a very different proposition from Grexit. In the case of Greece, a net recipient of Eurozone transfers required immediate financial assistance in order to avoid defaulting on its obligations and possibly suffering a chaotic exit from the common currency. Brexit, on the other hand, contemplates one of the Eurozone’s wealthiest members, a net payer into the system, exiting the common market but not the common currency. (Britain never joined the Euro, keeping the pound.) Further, the Leave vote represents a mandate without a mechanism. There are provisions within the Lisbon agreement for member states to leave, but they have never been tested. Britain’s departure is likely to be a protracted process of negotiation and compromise. There could even be another vote repudiating the Leave vote.

We appear to be witnessing the end of the post-war project of economic and political integration in the Western democracies. That project paid great dividends, both in rising wealth and  (more important) in two generations of peace in Europe. (Or at least Europe’s core. The Balkans wars of the 1990s demonstrated the inability of united Europe to deal with even minor security issues, absent American leadership.)

Free trade and free markets create wealth, as Adam Smith argued centuries ago. But not everyone wins from globalization. In recent years, the economic benefits of a more-connected world have been concentrated in the hands of the finance sector and government. They have almost entirely bypassed the working and traditional middle classes. For those voters, Brexit was a rational rejection of the status quo.

Reducing regulation and bureaucracy, making markets more free and hence more dynamic and productive, could have widespread benefits. But higher growth would come at the cost of reducing both the power and the compensation of entrenched, unaccountable elites in both Europe and the United States. We’ll see whether those members of the New Class get the message.