“Meh”, Again

Here are a couple updated charts courtesy of Aswath Damodaran’s latest data:

201901_Impl_Stdy_PE
Data Source: Aswath Damodaran
201901_Impl_Stdy_vs_FWD_PE
Data Source: Aswath Damodaran

I’ve posted similar charts before. These are a bit different in that I switched them over to use an implied equity risk premium and cost of equity derived from discounted free cash flows instead of dividends. The result is some moderation in the steady state multiple. However, the general trends in the data hold.

My reaction to the broad US market’s valuation continues to be “meh.”

Near as I can tell, at these levels you’re being roundabout fairly compensated for owning US equity risk. Yes, a near-term recession would send the market lower. But I’m not a recession forecaster, and I don’t adjust asset allocation on the basis of near-term economic data reads. The lower equities go, the more attractive the forward returns will become.

That said, if you pick individual stocks there are most definitely pockets of opportunity out there. It’s a great time to go bargain hunting if you were prudent about taking off some risk in the last couple years. Cash can be used to play offense as well as defense.

Mental Model: Market Regimes

Markets and economies go through cycles. We’re used to hearing about bull markets and bear markets. We’re used to hearing about economic booms and recessions. But we don’t talk quite as much about market regimes.

A regime is a particular iteration of a particular phase (or phases) of a market cycle. Understanding regimes is important because markets are adaptive systems. Investors respond dynamically to changes in the economic environment, since changes in the economic environment influence their preferences for different cash flow profiles. As I wrote here, these changing preferences are key drivers for asset prices.

What characteristics define a regime? Things like:

  • Economic growth
  • Inflation
  • Interest rates (cost of capital)
  • Credit expansion/contraction
  • Market volatility

Every market regime is a bit different, but regimes tend to influence investor behavior in relatively predictable ways (partly the intuition behind the old saw: “history doesn’t repeat, but it rhymes”). In a deflationary regime, investors sell stocks and buy long-dated Treasury bonds. In an an inflationary regime, investors sell long-dated bonds, while bidding up real assets. In a growth regime, investors will bid up stocks at the expense of long-dated bonds.

Of course, this is a massive oversimplification. Identifying and profiting from market regimes is no easy feat. That’s the goal of the top-down global macro investor, and it’s an extraordinarily complex and difficult task.

So what do us mere mortals take away from this?

We want to ensure our financial plans and investment portfolios remain robust to different market regimes. This doesn’t mean we have to become market timers or macro forecasters. It means we should be thoughtful about the bets we’re embedding in our portfolios.

Unintended Bets

Today, the consensus view is that we’re in a “lower for longer” regime. Low growth. Low inflation. Low interest rates. There are big secular drivers behind this. In developed countries, older populations need to save a lot of money to fund future liabilities. Lots of investment capital in need of a home pushes down the cost of capital. Technological advances have kept a lid on inflation in many areas of daily life.

If the regime is “lower for longer,” what you want to bet on is duration.

We can define duration in different ways. Usually we’re talking bond math. In this context, duration is the sensitivity of a bond’s price to changes in interest rates. The longer a bond’s future cash flows extend out into the future, the higher its duration. The higher the duration, the more sensitive the bond will be to changes in interest rates. The archetypical high duration asset is the zero coupon bond.

If the market regime is “lower for longer,” you have an incentive to bet on large cash flows further out into the future. Low rates and low growth mean the opportunity cost for making these bets is also low.

Duration isn’t just a bond thing. Every asset with cash flows also has duration. It’s just harder to quantify for equities and real estate because of the other variables influencing their cash flow profiles.

Your venture capital investments? They’re a duration bet.

Your small cap biotechs? They’re a duration bet.

Your cash burning large cap growth equities? They’re a duration bet.

All these things are attractive in a “lower for longer” world because they offer Growth! But they’re also sensitive to the cost of capital. In a world of cheap capital, it’s easy to convince investors to subsidize losses for the sake of Growth! If and when the regime changes, that may no longer be the case.

As much as we hate to admit it, our portfolios are products of our environment. It’s what people are talking about when they say “don’t fight the market” and “don’t fight the Fed.” They might as well be saying, “don’t fight the market regime.”

As I’ve written many times before, I’m not a fan of “all-in,” “all-out” calls. That doesn’t just go for market timing. It goes for all the unintended bets that seep into our portfolios over time.

Especially those driven by market regimes.

Wunderwaffen, Part II

My last post was about tradeoffs we must weigh when building investment portfolios. There’s no such thing as a magical asset. Most of the time we spend looking for superweapons (Wunderwaffen) is wasted. In this post I want to riff on Wunderwaffen from another angle: our fascination with things that are exciting conceptually but prove ineffective or even dangerous in practice.

This is a Messerschmitt Me-163 “Komet”.

Messerschmitt Me 163B
Source: USAF

The Komet was a rocket-powered interceptor designed to combat Allied bombers over Germany. Its distinguishing feature was its incredible speed–it could climb to combat altitude in just three minutes. One test pilot hit a speed of 700 mph in 1944. This set an unofficial world record that wasn’t broken until 1947, when Chuck Yeager set another unofficial record during a secret test flight. Officially, the flight airspeed record remained below 700 mph until 1953.

Unfortunately, the Komet’s incredible engine power was also the source of its greatest weakness. The volatile fuel mixture that fed the engine made it the rough equivalent of a flying bomb. The wiki on the Komet provides these details:

The fuel system was particularly troublesome, as leaks incurred during hard landings easily caused fires and explosions. Metal fuel lines and fittings, which failed in unpredictable ways, were used as this was the best technology available. Both fuel and oxidizer were toxic and required extreme care when loading in the aircraft, yet there were occasions when Komets exploded on the tarmac from the propellants’ hypergolic nature. […]

The corrosive nature of the liquids, especially for the T-Stoff oxidizer, required special protective gear for the pilots. To help prevent explosions, the engine and the propellant storage and delivery systems were frequently and thoroughly hosed down and flushed with water run through the propellant tanks and the rocket engine’s propellant systems before and after flights, to clean out any remnants. The relative “closeness” to the pilot of some 120 litres (31.7 US gal) of the chemically active T-Stoff oxidizer, split between two auxiliary oxidizer tanks of equal volume to either side within the lower flanks of the cockpit area—besides the main oxidizer tank of some 1,040 litre (275 US gal) volume just behind the cockpit’s rear wall, could present a serious or even fatal hazard to a pilot in a fuel-caused mishap.

Ultimately, the Komet had no impact on the European air war. It made very few kills and to the extent it did, its kill ratio was low. This disappointing operational performance hardly justified the many pilot deaths that occurred in development, testing and training.

There are lots of Komet-like investment products out there, including:

  • Levered and inverse levered ETFs
  • VIX Futures ETPs
  • Naked option writing strategies

Most of us shouldn’t get anywhere near these products and strategies. I’ll make an allowance for my trader friends who have a deep and intuitive grasp of the market forces that shape changes in both realized and implied volatility. For us tourists, the leverage and short gamma exposure embedded in many of these products are every bit as dangerous as the Komet’s rocket fuel.

Here’s what an engine fire looks like for these strategies:

201812_SVXY_Chart
Source: Morningstar
201812_HFXAX_Chart
Source: Morningstar

So why are we drawn to this stuff?

Mostly because it’s cool. It’s got Sophistication! It gives us an excuse to talk about things like the volatility risk premium. It makes us feel as if we’re part of some elite fraternity of financial markets people. We “get it.” “Have fun with your index funds, you buy-and-hold simpletons.” 

Except really, the joke is on us.

We should never underestimate our deep-rooted weakness for Sophistication! Most of us got into this business at least partly because we’re smart and competitive. We’re captivated by that powerful rocket engine as a feat of human ingenuity. Deep down, we want a shot at that airspeed record.

But it’s not necessarily the most powerful, most sophisticated engine that’s going to win us the war. It might not even make a difference.

And if we’re not careful, it’ll blow up on us.

 

01/08/19 Addendum: Got into a Twitter discussion on this topic and Corey Hoffstein of Newfound Research was kind enough to educate me on how inverse and leveraged ETFs can be used in a DIY risk parity implementation for small investors. Here is the link to his article. So as always, it seems, #notall applies.

Wunderwaffen

One theme I harp on relentlessly is that there’s no such thing as a magical investment strategy. By “magical strategy” I mean some asset class or system that’s inherently superior to all others. Hedge funds were once sold this way, and we’ve spent the last 10 years or so watching the ridiculous mythology built up around hedge funds die a slow and miserable death.

The unpleasant truth is that all investment strategies involve tradeoffs. In this way, investment strategies are a bit like weapons systems.

Tank design, for example, must balance three fundamental factors:

  • Firepower
  • Protection
  • Mobility

This is a Tiger tank:

Bundesarchiv_Bild_101I-299-1805-16,_Nordfrankreich,_Panzer_VI_(Tiger_I).2
Source: Bundesarchiv via Wikipedia

You might recognize it from any number of WWII movies and video games. The Tiger is often presented as a kind of superweapon (German: Wunderwaffe)–an awe inspiring feat of German engineering. In many respects, the Tiger was indeed a fearsome weapons system. Its heavy frontal armor rendered it nearly invulnerable to threats approaching head-on. Its gun could knock out an American M4 at distance of over a mile, and a Soviet T-34 at a little under a mile.

The Tiger had its weaknesses, however, and they were almost laughably mundane. It was over-engineered, expensive to produce and difficult to recover when damaged. Early models in particular struggled mightily with reliability. The Tiger was also a gas guzzler–problematic for a German panzer corps chronically short on fuel.

Viewed holistically, the Tiger was hardly a magical weapon. The balance of its strengths and weaknesses favored localized, defensive operations. Not the worst thing in the world for an army largely on the defensive when the Tiger arrived on the battlefield. But it was hardly going to alter the strategic calculus for Germany. In fact, there’s an argument to be made that German industry should have abandoned Tiger production to concentrate on churning out Panzer IV tanks and StuG III assault guns. (Thankfully, for all our sakes, it did not)

Likewise with investment strategies, the tradeoffs between certain fundamental factors must be weighed in determining which strategies to pursue:

  • Alpha Generation
  • Liquidity
  • Capacity

Alpha generation is typically inversely related to liquidity and capacity. The more liquid and higher capacity a strategy, the less likely it is to consistently deliver significant alpha. Smaller, less liquid strategies may be able to generate more alpha, but can’t support large asset bases. Investment allocations, like military doctrine, should be designed to suit the resources and capabilities at hand.

If I’m allocating capital, one of the first things I should do is evaluate my strategy in the context of these three factors.

First, do I even need to pursue alpha?

If so, am I willing and able to accept the liquidity constraints that may be necessary to generate that alpha?

If so, does my strategy for capturing alpha have enough capacity for an allocation to meaningfully impact my overall portfolio?

In many cases, the answer to all three of those questions should be a resounding “no.”

And that’s okay! Not everyone should be concerned with capturing alpha. For many of us, simply harvesting beta(s) through liquid, high-capacity strategies should get the job done over time. Identifying strategies and investment organizations capable of sustainable alpha generation ex ante is extremely difficult. And even if we can correctly identify those strategies and investment organizations, we must have enough faith to stick with them through the inevitable rough patches. These are not trivial challenges.

But even more importantly, in a diversified portfolio it’s unlikely you’ll deploy a single strategy so powerful and reliable, and in such size, that it completely alters your strategic calculus. In general, we ought to spend more time reflecting on the strategic tradeoffs facing our portfolios, and less time scouring the earth for Wunderwaffen.

You Can’t Borrow Conviction

palumbo_callahan_barlow
Source: David Palumbo

“Nowhere left to go,” Barlow murmured sadly. His dark eyes bubbled with infernal mirth. “Sad to see a man’s faith fail. Ah, well…”

The cross trembled in Callahan’s hands and suddenly the last of its light vanished. It was only a piece of plaster that his mother had bought in a Dublin souvenir shop, probably at a scalper’s price. The power it had sent ramming up his arm, enough power to smash down walls and shatter stone, was gone. The muscles remembered the thrumming but could not duplicate it.

[…] And the next sound would haunt him for the rest of his life: two dry snaps as Barlow broke the arms of the cross, and a meaningless thump as he threw it on the floor.

[…] “It’s too late for such melodrama,” Barlow said from the darkness. His voice was almost sorrowful. “There is no need of it. You have forgotten the doctrine of your own church, is it not so? The cross… the bread and wine… the confessional… only symbols. Without faith, the cross is only wood, the bread baked wheat, the wine sour grapes.”

–Stephen King, ‘Salem’s Lot

Whenever the market falls, you start to see symbol-waving. This famous Charlie Munger quote about equity drawdowns, for example:

If you’re not willing to react with equanimity to a market price decline of 50% two or three times a century you’re not fit to be a common shareholder, and you deserve the mediocre result you’re going to get compared to the people who do have the temperament, who can be more philosophical about these market fluctuations.

This is core doctrine for the Church of Value Investing. It works for Charlie because Charlie has Faith. Unfortunately, many of us who wave the symbols of Buffett and Munger in the face of Scary Things do not, in fact, have Faith. We fancy ourselves members of the Church of Long-Term, Buy & Hold Investing when times are good. But when things go bump in the night, we find ourselves waving cheap plaster crosses at the drawdown monster.

barlow

And it works about as well for us as it did for Father Callahan.

So we make arbitrary changes to what are meant to be long-term asset allocations designed to capture structural risk premia. We fiddle with exotic alternative strategies we don’t properly understand. We sell to cash without any idea how we’ll convince ourselves to buy back in. We seriously damage our chances of achieving our long-term objectives.

This chart?

CRSP_2018_big_picture
Source: CRSP

This chart is a plaster cross. I show it specifically because it’s the most common exhibit financial advisors use to harp on “a long-term view” in client presentations.

But if you don’t believe equities should earn a structural premium over gold or T-bills or credit over very long periods of time, this chart will do nothing whatsoever to help you when your equity holdings halve. Same if don’t believe your portfolio has enough of a liquidity buffer to withstand a lengthy drawdown. You will waver. The drawdown vampire will snap your plaster cross and eat you.*

How do you build Faith?

Honestly, I had only the vaguest idea how to answer that question, so I punched it into Google and found this article (no idea what The Living Church of God might be–link isn’t an endorsement). Suggestions include:

Prove what you believe (or try to, anyway).

Study what you believe.

Endure the trials that arise as you go.

Because ultimately, there are no shortcuts to Faith.

Faith is a Process, not an Answer.

You can’t borrow conviction.

 

 

*Yeah, I know Barlow doesn’t actually kill Father Callahan in ‘Salem’s Lot. ‘Salem’s Lot purists can extend the metaphor and imagine the drawdown vampire turning them into unclean market-timers, doomed to wander the earth for all eternity with low returns and even less credibility.

“Could you put in some Mayans?”

480px-Harlan_Ellison_at_the_LA_Press_Club_19860712
Source: Wikipedia

Harlan Ellison died this year. A terrible loss.

He was one of the better science fiction writers of all time. Thinking about “I Have No Mouth, And I Must Scream”  still gives me the jibblies. Ellison was no shrinking violet when it came to the business side of his chosen art form. He was also famously protective of his artistic integrity.

In fact, he might written the original Star Trek movie, if only he were a bit more flexible. Stephen King recounts the story in his (underrated) book, Danse Macabre. In a lengthy footnote, he gives Ellison’s version of events:

Paramount had been trying to get a Star Trek film in work for some time. [Gene] Roddenberry was determined that his name would be on the writing credits somehow… The trouble is, he can’t write for sour owl poop. His one idea, done six or seven times in the series and again in the feature film, is that the crew of the Enterprise goes into deepest space, finds God, and God turns out to be insane, or a child, or both. I’d been called in twice, prior to 1975, to discuss the story. Other writers had also been milked. Paramount couldn’t make up their minds and had even kicked Gene off the project a few times, until he brought in lawyers. Then the palace guard changed again at Paramount and Diller and Eisner came over from ABC and brought a cadre of their… buddies. One of them was an ex-set designer… named Mark Trabulus.

Roddenberry suggested me as the scenarist for the film with this Trabulus, the latest… of the know-nothing duds Paramount had assigned to the troublesome project. I had a talk with Gene… about a storyline. He told me they kept wanting bigger and better stories and no matter what he suggested, it wasn’t big enough. I devised a storyline and Gene liked it, and set up a meeting with Trabulus for 11 December (1975). That meeting was canceled… but we finally got together on 15 December. It was just Gene and Trabulus and me in Gene’s office on the Paramount lot.

I told them the story. It involved going to the end of the known universe to slip back through time to the Pleistocene period when Man first emerged. I postulated a parallel development of reptile life that might have developed into the dominant species on Earth had not mammals prevailed. I postulated an alien intelligence from a far galaxy where the snake had become the dominant life form, and a snake-creature who had come to Earth in the Star Trek future, had seen its ancestors wiped out, and who had gone back into the far past of Earth to set up distortions in the time-flow so the reptiles could beat the humans. The Enterprise goes back to set time right, finds the snake-alien, and the human crew is confronted with the moral dilemma of whether it had the right to wipe out an entire life form just to insure its own territorial imperative in our present and future. The story, in short, spanned all of time and all of space, with a moral and ethical problem.

Trabulus listed to all this and sat silently for a few minutes. Then he said, “You know, I was reading this book by a guy named Von Daniken and he proved the Mayan calendar was exactly like ours, so it must have come from aliens. Could you put in some Mayans?”

Is there not a more perfect parallel for client meetings?

You spend hours, if not days or weeks, agonizing over the minutiae of asset allocation and return expectations and manager changes and security selection only for the client to turn around and ask for some Mayans.

“I hear weed is going to be huge. Can we buy some pot stocks?”

Or:

“I found a company that wants to build a bridge to Mars. They’re crowdsourcing investors. Can I invest?”

Unfortunately, we can’t respond the way we’d like to respond in our darker moments–how Harlan Ellison responded to Mark Trabulus during their fateful meeting in 1975:

I looked at Trabulus and said, “There weren’t any Mayans at the dawn of time.” And he said, “Well, who’s to know the difference?” And I said, “I’m to know the difference. It’s a dumb suggestion.” So Trabulus got very uptight and said he liked Mayans a lot and why didn’t I do it if I wanted to write this picture. So I said, “I’m a writer, I don’t know what the fuck you are!And I got up and walked out. And that was the end of my association with the Star Trek movie.

There are a lot of reasons clients ask for Mayans for their portfolios. Greed. Fear of missing out. We learned all that in Behavioral Finance 101. But there’s another reason clients ask for Mayans. It’s the same reason Mark Trabulus asked for Mayans back in 1975, while sitting there in the long shadow of Harlan Ellison, the creative genius.

They want to contribute.

Imagine yourself on the client side of the table. You sit in meeting after meeting going over dreary reports full of inscrutable data tables. You’re bombarded with jargon. You scan your portfolio and it’s full of abstracted stuff like foreign SMID cap value funds.

Can we really blame people for wanting to contribute some of their own ideas? It’s their money in the portfolios, after all.

Yes, their ideas are usually bad ideas. You can’t let them run roughshod all over the place. There’s a reason they’ve hired a professional for advice. But it’s just as important to recognize some of the most annoying things clients say and do don’t necessarily come from a place of fear or greed or arrogance.

This is why I am generally a fan of “play money” accounts for individuals. Some side pocket of the portfolio over which the client has complete discretion, but that’s sized so it won’t blow up the financial plan if it goes to zero. Not everyone wants a play account, or needs one. But for clients who do, it’s an important outlet.

It’s a way for them to participate in the financial markets and the investment process.

It’s a way for them to express… (dare I say it?)… some creativity.

Even if their ideas are dumb.

A World Of “Meh”

Right now, a lot of people are sitting out there trying to decide whether to dip-buy this market. They want to tick the bottom. Perhaps you are one of these people. In my own humble opinion, they are fools–fools engaged in a foolish game. Most will ultimately do more harm to their net worth than good, whipsawing themselves based on “sentiment” (a.k.a what they are seeing and hearing from the financial media).

For some perspective, I want to revisit forward-looking return expectations from a couple of different sources.

The chart below looks at prospective 10-year S&P 500 returns as a function of the equity share of US financial assets (a mouthful, I know). This is similar to the Buffett Indicator of stock market capitalization/GDP. The data runs through 3Q18, which is the most recent Z1 release from the Federa l Reserve.

(As far as I know, Jesse Livermore at Philosophical Economics was the first to do a deep dive into the efficacy of this model. David Merkel at Aleph Blog used to update it quarterly. Since David seems to have abandoned the project, I’ve decided to pick this up on my own)

SP_500_Proj_Return
Data Sources: Federal Reserve, Morningtsar

The predicted forward return bottomed in 1Q18, below 5% nominal. Since then, the proportion of equities to total assets has decreased a few points. This corresponds to a modest increase in predicted return over the next 10 years, to approximately 7%.

The second chart is an updated expected return bar chart from Research Affiliates:

201812_RAFI_10YR_ERs
Source: Research Affiliates

RAFI’s methodology is the simple model discussed in my post on investment return expectations. RAFI’s estimates are even less inspiring than the equity allocation model. Here US Large Cap is expected to return about 2.7% nominal over the next 10 years.

If we weight each forecast 50/50 to account for the inevitable errors and uncertainty, we get something like 4.8% as an expected return for US Large Cap Stocks over the next 10 years.

To which I say: “meh.”

This is neither a “run for the hills” number nor a “go all-in” number for someone whose investment strategy is oriented around asset allocation over a long time horizon. In fact, it’s rare to arrive at either of those conclusions from an exercise like this. Which is the whole point. For most of us, our reaction to most market moves should be “meh.”

Now, this certainly isn’t the only lens through which you can view financial markets. A trader or trend follower can safely ignore everything I’ve written here. Traders and trend followers are playing an entirely different game. Same for pure, bottom-up stock pickers.

However, most of us building portfolios for institutions and individuals are not traders, trend followers or pure, bottom-up stock pickers. We’re asset allocators who merely need to be directionally correct about the performance of a handful of different asset classes over a couple of decades.

How does a fundamentally-oriented allocator invest in a world of “meh?” 

I’d suggest the following core principles:

Balance. Never make “all-in” or “all-out” calls. Investing is an exercise in decision-making under uncertainty. It’s a probabilistic exercise, except we don’t know the “true” probabilities of the various outcomes. Only fools make all-in, all-out calls when making decisions under uncertainty. And yes, gunslinging hedge fund guys, fools who make all-in, all-out calls can become billionaires.

Prudence. Don’t reach for yield or return. Our world is overrun with yield pigs, but they’re generally not being well-compensated for the incremental risks they’re running to juice their returns. And yes, middle market private credit investors, that’s directed at you.

Flexibility. As Henri Poincaré famously said, “geometry is not true, it is advantageous.” Asset allocation is similar. You become overly attached to particular asset classes, strategies and their historical performance at your peril. And yes, “VOO for the long run” investors, that’s directed at you.

Creativity. If the financial markets are giving you “meh”, consider changing the way you play the game. For individuals, that could mean saving more, or starting a business to generate wealth through “real world” economic activity. For institutions, it’s tougher to make those kinds of changes, but mostly for political reasons.

It is a frustrating thing, to be stuck in a word of “meh.” But recognizing it and acting accordingly is a hell of a lot more productive than staring at your E-Trade account trying to tick the bottom for SPY.