It’s Worse Than I Thought

Over the last couple days I’ve had the pleasure of corresponding with David Merkel of The Aleph Blog over differences in our S&P 500 expected returns modes. (Mine was much higher than his). Upon comparing models, I discovered I’d made a huge mistake. I’d essentially included only corporate debt in my calculation, excluding a huge swath of government liabilities from the total figure.

After adjusting my numbers to correct for this, and updating the model, I get a 3.74% expected return for the next 10 years. This is consistent with David’s 3.61% estimate. The small difference that remains is likely down to some minor differences in the time periods we used to estimate our models, as well as the type of S&P 500 return we use in the calculation (I believe David uses the price return and then adjusts for dividends, whereas I simply regress the S&P 500 total return against the “allocation” data).

SP500190630ERREV — Source: Federal Reserve Z.1 Data / Demonetized calculations / Corrections from David Merkel

Previously I’d been referring to my results as “A World of Meh.” I think I’m now comfortable revising that down to “A World of Bleh.” (“Meh” is kind of like an indifferent shrug, while with a “bleh” you are maybe throwing up in your mouth a bit)

I’ll give David the last word here, since I think his take on all this is a nice summary of the quandary investors face these days:

Not knowing what inflation or deflation will be like, it would be difficult to tell whether the bond or stock would be riskier, even if I expected 3.39% from each on average. Given the large debts of our world, I lean to deflation, favoring the bond in this case.

Still, it’s a tough call because with forecast returns being so low, many entities will perversely go for the stocks because it gives them some chance of hitting their overly high return targets. If this is the case, there could be some more room to run for now, but with nasty falls after that. The stock market is a weighing machine ultimately, and it is impossible to change the total returns of the economy. Even if an entity takes more risk, the economy as a whole’s risk profile doesn’t change in the long run.

In the short run it can be different if strongly capitalized entities are taking less risk and and weakly capitalized entities are taking more risk — that’s usually bearish. Vice-versa is usually bullish.

Anyway, give this some thought. Maybe things have to be crazier to put in the top. At least in this situation, bonds and stocks are telling the same story, unlike 1987 or 2000, where bonds were more attractive. Now, alternatives are few.

2Q19 Expected Returns Update

2Q19 Fed Z1 data is out so I have updated my little S&P 500 expected returns model. The model and its origins have been discussed rather extensively here on the blog so I am not going to belabor its strengths and weaknesses going forward. From a long-term forward return perspective, the message remains: “meh.” As of June 30 it was predicting a 7.81% annualized return for the next decade.

2Q19SP500ER — Source: Fed Z.1 Data; Demonetized Calculations

It is interesting to note that the model disagrees with the dire prognostications of much of the investment world regarding forward-looking S&P 500 returns. Many shops out there are predicting low single digit or even negative returns over the next 7-10 years. These folks correctly called the tech bubble in the late 1990s but missed the post-crisis rebound. The model, meanwhile, caught both.

Given the output from the model, and the investment opportunity set more broadly, I’d bet with the model when setting expectations for the next 10 years.

What I think those shops are missing, and what the model captures, is the TINA Effect.

For many investors There Is No Alternative to owning equities.

Given that global interest rates remain very low, investors need to maintain high levels of equity exposure to hit their return hurdles. In the US, for whatever reason, the aggregate equity allocation typically bounces around in the 30% – 40% range. Unless something occurs to dramatically and permanently shift that range lower, I suspect forward returns will end up being a bit better than many people are predicting these days.

Not great. But not dire, either.

Meh.

Hope Is Not A Strategy

Here is a question I get all the time, either directly or from colleagues on behalf of clients:

“I bought [INSERT RANDOM STOCK]. It is down 50%. Should I sell it or hold it?”

The answer should be obvious and it is that you sell ASAP. I kind of hate to say it (okay, not really), but if you need to ask someone like me this question, you had no business buying the damn thing in the first place. Note that the fact the stock is down 50% is basically irrelevant here. You should not take a position in a security if you have no framework in place for updating your views on the basis of new information.

There are lots of different ways to play the game. You can immerse yourself in 10-Ks and 10-Qs and try to find great businesses selling at reasonable prices. You can take the view that “price is all that matters” and trend follow or whatever. There are all kinds of sensible strategies for making money.

Hope is not one of them.

If you own something that has halved and the only reason you have for holding it is “gee, I really hate the idea of locking in a loss” then you are in trouble. No one will be able to begin helping you until you first help yourself by exiting the position. Hopefully it is at least in a taxable account and you can write it off. You can think of the slightly milder after-tax loss as discounted tuition.

When people talk about “dumb money” or “the suckers at the poker table” they are talking about hope-based investing.

09/19 Permanent Portfolio Rebalance

Today marks the second rebalance of my leveraged permanent portfolio with its volatility (12% target) and trend following overlays. I thought it might be fun to do brief posts on the monthly rebalances going forward, partly to keep myself honest and partly to record for posterity what it “feels like” to be invested this way.

Perhaps unsurprisingly, the portfolio is now below its risk target, with a trailing volatility of only 5.16%. So the cash position created at the last rebalance will now go back to work in ex-US equity (most segments of ex-US equity appear to have poked back above their 200-day moving averages). In fact, I need to be fully invested now and will STILL be below my risk target.

The new target portfolio looks like this:

When the leverage employed within NTSX is taken into account, you end up with:

28% S&P 500

19% Laddered Treasuries

32% Gold

4% EM Large Cap

4% EAFE Small Cap

14% EM Small Cap

15% EAFE Large Cap

~116% notional exposure, just shy of 1.2x leverage

Note that the weights of the portfolio as implemented will differ modestly from this “ideal” due to transactional frictions and such. For example, in an ideal world I would reallocate the two small Vanguard positions across the whole portfolio rather than overweight ex-US equity. However, I recently rolled this account over to a new platform and am trying to be mindful of transaction costs. And anyway, if you’ve read this blog for any length of time you’re no doubt familiar with my view that, in the grand scheme of things, these little overweights and underweights don’t materially impact portfolio performance.

Here is updated performance versus the S&P 500 for context as of pixel time:

Despite being so short, it’s an interesting period to look at live performance for the strategy (net of fees and transaction costs) as it exhibits precisely the type of behavior you would expect from backtests of both leveraged and unleveraged permanent portfolios. The portfolio protects well during periods of broad market stress but lags during sharp rallies. Additionally, it’s worth noting that gold has had an exceptional run during this brief period, which is a complete coincidence.

The Modern Bear Trap

A colleague asked me for my thoughts on this piece by Bob Rodriguez. It is your usual anti-Fed, value investor screed. For example, he writes:

As for optimism, I would have some if I could see the insanity of the present monetary and fiscal policy environments changing for the better. But that seems like a very long, long shot. In the past two years, I’ve grown far more pessimistic, given what I see unfolding.

I have liquidated virtually 100% of my equity holdings and this occurred back in 2016 and 2017. I’ve always been early. I’ve deployed capital into 2-3 year Treasury bonds since I do not want to have any credit risk exposure in this distorted economic environment. As for risk assets, I’ve been acquiring rare, fully paid-for hard assets. I expect the latter to probably get hit in the coming recession but then they may well perform better in the ensuing monetary inflation. At least I don’t have to worry about managements leveraging their respective company balance sheets by buying back stock at elevated prices because the math works with these ultralow interest rates.

I am deeply sympathetic to a lot of this stuff on an intellectual level, but considerably more wary on a practical level. Below are my comments, edited slightly from my original email for clarity…

At a high level I basically agree with all of this.

Quibbles:

The portfolio changes he describes are too extreme, in my view. I do think the US market has conditioned us to be overly complacent about equity risk over the last 30 years. But there is a huge potential opportunity cost to sitting in cash. I think there are much better ways to manage the kinds of risks we face in this environment such as vol targeting and/or trend following overlays. The problem with the permabearish approach he describes is that there is nothing to help him get back into the market if he ends up being wrong. He will just sit in cash tilting at windmills forever with the permabear crowd.

PV30YR

Regarding negative rates, the idea of owning negative yielding debt is not necessarily irrational if you believe rates will get more negative. The reason is that there is a non-linear relationship between price and yields (see below). For some reason we are taught all about duration in basic bond math but not convexity (convexity is the curvature). The greater the change in yields and the longer the duration of your bond, the more convexity comes into play.

Even with a negative coupon, you can potentially earn a positive return DEPENDING ON THE FUTURE PATH OF INTEREST RATES. If your view is that nominal yields are headed for -3%, -4%, -5% then it is perfectly rational to own negative yielding debt as from a price perspective you are potentially looking at equity-like returns. Who said fixed income had to be boring?

On top of that, it is possible for the owner of, say, negative yielding German Bunds to earn a positive yield by owning the bonds long and then swapping back to dollars using a currency swap or currency forwards.

That’s not to say I think negative nominal rates will achieve the policy objectives central banks have set out to achieve. In fact, I believe it’s just the opposite and the post-GFC and Japanese experiences provide empirical evidence in support of that view. But I do quibble with comments about owning negative yielding debt being “completely irrational” as I think folks making this argument are either forgetting their basic bond math or are ignorant of it. There is an important difference between merely being wrong about the future path of interest rates and being completely irrational.