On 12/31/18 the S&P 500 closed at 2507, resulting in a total return of -4.38% for the year. According to the November, 2018 Fed Open Market Committee, “…the labor market has continued to strengthen and that economic activity has been rising at a strong rate.” This observation correlates with the fact that, while bank lending was stagnating prior to the Great Recession of 2008, lending is now growing strongly.
But in the month of December, the S&P 500 declined by 9.1%, a worse December performance than the 6.0% December drop in 2002, giving investors a lump of coal in their stocking. The 12/24/18 NYT notes, “…the biggest worry for 2019 is not so much that…disruptions (are) so large to cause a recession. The real fear is that shaky policy allows small shocks to create a broader crisis of confidence.” For both the real and financial economies, confidence matters.
In The General Theory (1954) Keynes wrote, “The state of confidence…is a matter to which practical men always pay the closest and most anxious attention. But economists have not analyzed it carefully and have been content, as a rule, to discuss it in general terms….There is, however, not much to be said about the state of confidence a priori. Our conclusions must be mainly depend upon the actual observation of markets and business psychology. This is the reason why the ensuing digression is on a different level of abstraction from most of this book.”
The practical reasons for having confidence are surely the elements of intention, competence and reliability. What does it mean to have confidence in government, particularly the competence and reliability of Fed policy? In a 12/21/18 CNBC interview, John Williams, president of the New York Fed, crucially remarked:
1) The Fed seeks the best policy, to achieve its dual mandate of high employment and low inflation.
2) In developing this policy, it looks at the incoming data and, most crucially, talks to many others.
3) As a result, the Fed “judges” rather than “expects.”
The underlined words are the crucial elements of rationality under the condition of uncertainty. (Hopefully) with our readers, we now discuss what rationality is.
The most general definition of rationality is to do things for reasons, to obtain a given result. A more specific definition of rationality depends upon the conditions under which it occurs. Ref. (Russell and Norvig, 2010). For instance, when driving to a destination, a fog might roll in. Depending upon the degree of fog, one can look at different things to reach one’s goal.
1) On a clear day, there are no other vehicles, the environment’s landmarks are clearly visible; and one can drive along the best route with almost no other feedback. This is navigating under certainty.
2) The fog begins to roll in, there are no other
vehicles, the environment’s landmarks are visible only in blurry outline; the
prudent thing to do is to slow down and to verify that the landmarks are the
actual ones. This is navigating under risk, when the alternatives are known but
the probabilities of their realizations can be
identified estimated * by
numbers ranging from 0 to 1. The action to take is to proceed along the best expected
3) The fog becomes pea-soup thick, there are no other vehicles, the landmarks appear sporadically, the smart thing to do is to slow down more and to ask the expert passengers to help identify the landmarks. This is navigating under uncertainty, where the alternatives must be identified anew in a complex world. Under these conditions, taking the best route requires good judgment, consultation with other experts and continued communication in a “multi-agent environment.”
This discussion shows that Reason can be a very powerful tool – when reasonably used after considering conditions.
* This is a very crucial distinction. In the practical world, good judgment is really important. Russell and Norvig (2010) write, “The connection between toothaches and cavities is just not a logical consequence in either direction. This is typical of the medical domain as well as most other judgmental domains: law, business, design, automobile repair, gardening…” The title of their definitive book is, “Artificial Intelligence.” It discusses A.I. algorithms and design considerations, also philosophy from Aristotle to Gödel, in 1132 quite difficult pages.
What is useful to us is that computer programming forces clarity upon some questions that originate in the humanities; A.I. is likely to have a very large impact on society. However, this is not at all to reduce one field to another.
At the 1/4/19 annual American Economic Association meeting in Atlanta, Fed Chair Powell and former Fed Chairs Yellen and Bernanke placed the implementation of Fed policy in the perspectives of the U.S. and world economies.
1. Powell: The Fed will be patient and flexible in its implementation of monetary policy. The U.S. economy is growing moderately and well. In December jobs increased by 312,000 (our note: about 170,000 is normal), unemployment has been less than 4% for four months, wages are moving up along with labor participation.
The financial markets, however, foresee the opposite. With China pulling back, copper down. The financial markets are pricing in downside risk to global growth. We don’t have a fixed monetary policy. In the 2016 (international) taper tantrum, Chair Yellen nimbly adjusted rates and normalization resumed. We will be prepared to adjust policy quickly and flexibly.
We need the concept of the natural rate of unemployment, to give us an idea of whether interest rates are too high, too low or just right. The exact level of the natural rate is uncertain, but it is possible to go too fast in relation to resource constraints.
Future research ought to integrate macroeconomics (our note: assumes equilibrium) and markets (our note: assumes disequilibrium on the path to equilibrium ).
2. Yellen: We have a strong economy with consumer spending comprising 2/3 of it. The Philips curve (linking unemployment and inflation) is relatively flat, giving the Fed the opportunity to move carefully in a data dependent manner, managing risk. The growth rate of the economy is consistent with potential and may warrant some tightening.
When giving rate guidance, it will be important for the Fed to co-ordinate across asset classes.
3. Bernanke: It was very important for the Fed to anchor inflation expectations at 2%. As a result the Philips curve is flat, allowing the Fed to experiment with policy. Unanchored inflationary expectations mean that it is more difficult to stabilize the economy.
(This is really important because it provides an order that enables a rational and more deliberate management of the economy.)
On 1/18/19, the S&P 500 closed at 2671, providing a long-term investment return of only 5.3%.
The pricing of assets in the financial markets is based upon a risk markup from the short-term Fed policy rate, currently at 2.5%. Under normal spread conditions, the rates of return available from major financial investments are as follows:
Normal Conditions Current Conditions
2.5% Policy rate 2.5% Policy rate
2.0% 10 year treasury premium .4% 10 year treasury premium
2.0% Corporate bond premium 2.4% BAA corporate bond premium
2.0% Equity risk premium 0% Equity risk premium
8.5% Normal equity return * 5.3% Equity return 1/18/19**
* With the exception of the policy rate, these are returns available under normal conditions. For the ten year bond, a rule of thumb is 2% above the policy rate.
** The present ten year treasury premium of only .4% signals a flat yield curve and a low demand for capital either due to low growth (and the increased digitization of the economy) and/or an impending recession. The high BAA minimum investment quality bond spread signals a recession. The equity return of 5.3% assumes a cyclically adjusted 10 year S&P 500 operating earnings average. Growing this year’s earnings estimates in perpetuity would result in a much higher equity return.
But why is the equity risk premium zero (which is another way of saying the stock market is overvalued)? *** In theory, equities are supposed to be more risky than corporate bonds; but financial history is what actually happens. During the last ten years, the economy has been slowly recovering from the Great Recession, when rates were at the zero bound, overvaluing equities, which do not default the way bonds do. At a zero required rate of investment return, the price of an infinite stream of $1 payments is infinity. With rates low since the Great Recession of 2008, and just beginning to normalize, equities have been overvalued.
If this economic recovery continues, the Fed will very likely raise interest rates slowly, in a conditions dependent manner, to stabilize inflationary expectations and keep the real economy’s expansion going. If the economy slips into a recession due to a combination of factors affecting business confidence such as the shutdown of the Federal government and/or financial crises abroad, with a trillion dollar government deficit right now, future monetary policy is less likely to be effective. There will also be balance sheet (stock) problems that go beyond the decreased (flow) of exports. Equities will unlikely remain at a “permanently high plateau.”
*** Jagannathan, McGrattan and Scherbina (2000) from the Kellogg School and the Minneapolis Fed found that the equity premium relative to 20 year U.S. long-term government bonds in 1999 was -0.27%. Our calculation yields a present equity premium of 2.4% against 10 year government bonds.
The spreads above obviously vary according to financial conditions. It is possible to read the story of the markets from these spreads, and to ask whether the spreads justify the individual asset risks.
With U.S. economic growth still continuing, this is the time to seek reforms, to begin to solve many problems that only government can remedy. In his epic chronicle of the French Revolution of 1789, Citizens, Simon Schama writes that the ancien regime, distracted by modernization and unable to effect financial reform, frittered away its social order in discord – often incited by members of the aristocracy. The result was prolonged chaos. Writing On The Origins of War, the classicist Donald Kagan noted that the next generation of European statesmen then constructed an international treaty system that resulted in decades of peace and stability, a stability that vaunting national ambitions increasingly undermined prior to W.W. I.
The rest, as they say, is history. The 1/22/19 NYT reports that a major investor now warns against, “global social tension, rising debt levels and receding American leadership.” Social stability should not be taken for granted. U.S. social cohesion is quite challenged by a “whatever it takes” culture in business and politics.
On 2/25/19 the S&P 500 closed at 2797, providing a long-term investment return of only 5.10%. Asking for a 8% investment return in a 5.10% world might seem unrealistic. But the market is presently assuming business as usual: Agreement on all substantive trade issues with China; Britain negotiating an acceptable Brexit deal; interest rates remaining low for the duration (payback period) of the S&P 500, around 36+ years.
Two protections we have against the above uncertainties are:
1) Requiring a higher rate of return on the S&P 500 to compensate for the above risks and those developing.
2) Considering the future, with its risks - although interest rates in Europe remain very low, the bias in the United States is likely towards slightly higher interest rates to keep control of inflation in a growing U.S. economy. At some time, we will probably begin to lock in bond returns before stock returns; bonds are shorter-term assets than stocks.
The present overpricing of equities is due less to “irrational exuberance,” but the result of generally low interest rates (if you consider a low discount rate capitalizing a perpetual stream of S&P 500 operating earnings). In “The General Theory (1954),” Keynes wrote, “In practice we have tacitly agree, as a rule, to fall back on what is, in truth, a convention. The essence of this convention – although it does not, of course, work out quite so simply – lies in assuming that the existing state of affairs will continue indefinitely, except in so far as we have specific reasons to expect a change.”
(1) Unlike the analysis of individual financial markets, the goal of quantitative portfolio management is to evaluate the risks and returns of individual financial assets (so calculated) to match the risk and return of an entire portfolio (so calculated) to the requirements of the owner.
The following is what we intend to do at this time. We definitely encourage our readers to consult with their qualified investment advisors to discuss how their unique financial situations should determine an appropriate portfolio structure.
A major input into a quantitative analysis of portfolio management is the concept of average portfolio returns. But:
1) In volatile markets, cumulative portfolio returns will be lower than average returns. The value of a portfolio that increases for two years at a steady state of 6% per year will be $112.36. In a very volatile market, the value of a portfolio that increases by 50% in the first year and then decreases by 38% in the second year will be only $93.00. In both cases, the portfolios will have an average return of 6% per year.
2) A prolonged period of very low or negative portfolio returns can cause a portfolio to run out of money, even though the returns of subsequent years are very high.
Considering only average portfolio returns is very misleading. There are two fundamental principles of traditional portfolio management that investors should bear in mind:
1) In normal (we’ll get to this later in the case of stocks) markets, portfolios should be structured with high-quality asset classes bearing a lower degree of risk.
2) Draw down the portfolio only to the extent of income, not drawing upon “principal,” to which the present value formula is agnostic.
As an example, we consider the income
implications of a conservative 50/50 S&P 500 stock portfolio and two
intermediate maturity mutual fund bond portfolios. In practice, we will phase
in our investments in these assets, and realized income yields will differ
(investors propose and the markets dispose) from the below:
Asset Weight Income Yield Weighted Income Duration (years)
S&P 500* 50% 3.0% 1.50% 36 +
Bonds ** 50% 3.5% 1.75% 6.1 -
* Return of 8% rather than current return of 5.1%
**Return of 3.5% rather than a current return of 3.1%
We think a global low interest rate environment, with possible excursions to the zero bound, is much more likely than a high interest rate one - due to globalization and digitization where many services have become virtual. This is our take. During 1970s, inflation and thus very high interest rates were caused by much more localized economies enabling, we think, a few producers (including of course OPEC) to cause high inflation by their price hikes. Markets now, particularly the labor markets, are much broader.
The major risk to portfolios is therefore prolonged recession, causing interest rates to again reach the zero bound. We will therefore lock in bond yields before stock yields. Conversely, if interest rates increase drastically, a 6.1 year duration bond portfolio is much less risky than a 36 year duration stock portfolio.
(2) This figure graphs * long-term government bond yields in five developed economies. It illustrates that since 1990 there has been a precipitous decline (but a present slight rebound) of interest rates and thus financial asset returns due to structural and technological changes in the world economy. As a result, investors in search of high returns, have been taking increasing risks – 2008 was a frenzied peak of this. We will be taking some credit risk (but the mutual fund bond portfolios we are considering each contain more than 1500 – hopefully not highly correlated – bonds). These two portfolios will also average out to around 25% U.S. governments. If we can get a 3.5% income yield with a single bond portfolio containing 50% governments, all the better. We think that would be a bargain in the risk space.
We carefully chose ten highly rated corporate bond issues in our own portfolio (there is an advantage to holding individual issues because the duration and therefore interest rate risk of the bond portfolio will decrease over time). But several years later, the ratings agencies drastically downgraded a bond we had already sold. The company had made bad acquisitions that drastically reduced its margin of safety. Like stock portfolios, bond portfolios also need to be diversified and monitored.
* This graph is in .pdf file form. If you don’t have Adobe Acrobat: In the 1990s government bond yields ranged (12%-6%), in 2019 they are now (3%-0%).
On 3/22/19 the S&P 500 closed at 2801.
The economic slowdown in Europe and the rest of the world is beginning to affect the U.S. markets. The European governments did not quickly deal with their problem bank loans the way the U.S. government dealt with its problem bank loans (with the Tarp programs that ended in 2014, netting a $15.3 billion profit).The 3/22/19 WSJ quotes, “(The banks) have been slow to clear their balance sheets of problem loans and so are unable to help the economy grow…In Europe, you end up still with hundreds of billions of bad loans on bank balance sheets more than 10 years (sic) after the crisis and that restricts growth.” As a result, German bund yields are again negative and that drags down U.S. treasury rates, causing low returns in all U.S. asset classes and…(we noted above) affecting the feasibilities of structuring portfolios that will provide decent returns for the future.
The WSJ article further notes, “The fall in European yields has put pressure on U.S. yields as investors starved of returns in Europe are moving into Treasurys. Investors’ other option is to take more credit risk (finance calls this ‘a reach’) by buying lower-quality debt or longer-term bonds. Investors are left confronted with a conundrum…either accept a definite small loss from a negative yield, or take risks that could lead to bigger losses.”
This is essentially the dilemma that all investors face; because the productive use of their savings to generate income depends upon the health of the future economy. This, as the following also suggests, can occur only in a well-regulated system - not in someone’s vision of a totally unregulated and therefore uncorrected markets. In the present financial environment, we aren’t taking large risks until the market pays us to.
The climate, like markets, is a natural phenomenon. Like gusts of wind before a hurricane, the effects of global warming are beginning to be manifest; Cyclone Idai displacing hundreds of thousands of people in Mozambique, Zimbabwe and Malawi; as floodwaters recede in the Midwest, NOAA expects that nearly two-thirds of the lower 48 states face an elevated risk of flooding through May; the 2018 wildfire season in California resulted in a record total of 8,527 fires burning an area of 1,893,913 acres.
Our next essay, “Climate Change and the Economy” will discuss the scientific evidence for taking action to control global warming, if we are to have a livable future. The larger effects of global warming will take effect in at least ten years, well within the 36+ year duration of the S&P 500.
Although our financial asset buy points remain the same, we do think it is appropriate to be slightly more cautious in our planned asset allocation because effective political responses to global warming have yet to occur.
During a European financial crisis, we were analyzing a European bank credit. What would happen, we asked, if the European banking system collapsed? The level-headed response was, “If that happens, we’re all in trouble.”
In the face of global warming, we think this is the appropriate attitude for a long-term investor in a climate challenged world. Our strategy will be to hold a steady course, paying special attention to portfolio risk structure, valuation, and to rely on the managers of partially U.S. government bond portfolios (with an average maturity of around 8 years) and the turnover of the S&P 500 (now forecast by Inc.to decrease to 14 years by 2026) to make the appropriate adaptions. This crucially assumes that governments will act to protect their peoples and their investors from the worst effects of climate change. If governments do not act to limit catastrophic levels of CO2 , investors need not consider whether their then abstract net worths matter in relation to other more basic needs, like food and water. What follows is a further discussion of the science of global warming and the likely efficacies of its remedies.
In the history of life on earth, there have been five large life extinctions. Of the five, one was caused by a large meteor that eliminated the dinosaurs at the end of the Cretaceous period 66 million years ago. The other four were likely caused by the carbon dioxide belching from large volcanoes (most notably during the Permian period that formed the current Permian basin in Texas) or triggered by the release of methane, also a greenhouse gas, from the sea floor. Of special interest to climate scientists is the Paleocene Thermal Extinction which occurred 56 million years ago, when the dominant animals were large carnivorous birds (descended from their dinosaur ancestors) and animals such as smaller birds, mammals, amphibians and insects.
56 million years ago, the concentration of atmospheric carbon dioxide was around 1,000 parts per million; the current concentration is around 406 ppm and rapidly increasing. According to the 3/27/18 Washington Post, “To many scientists today, many of the phenomena observed during (that period) will feel familiar – so familiar ‘it’s almost eerie,’…Humans burning fossil fuels have produced the same kind of carbon isotope spike researchers find in 55-million-year-old rocks. The ocean has become about 30 percent more acidic and it’s losing oxygen – changes that are already triggering die-offs. The world has witnessed dramatic weather extremes – deadly heat waves, severe storms, devastating droughts.” At that time, the Antarctic ocean was about 68 degrees Fahrenheit. The tropical temperature off the coast of West Africa (the changing continents were in slightly different positions) was 97 degrees. Needless to say, these torrid conditions caused extinctions. It should also be noted that there was no ice on earth at that time, to become unfrozen. “In all major ways it’s more perilous now then it would have been then…”
As with A.I., the key factor determining the future is human agency. Whether we will survive the effects of global warming depends on what people collectively do, acting through the agency of government. Substantial global warming will be a fact, but there are two major carbon pathways of handling global warming; both require the actions of governments.
The first pathway is might be called the “consensus” pathway. As described by Vox and advocated by Shell Oil and some other unaffiliated researchers, it sets forth a pathway to 2° warming and zero emission growth by 2070 assuming a continued high growth in energy consumption, up 237% by this date, and also assuming in main:
· Carbon pricing mechanisms adopted by governments in the 2020s, leading to a meaningful cost of CO2 embedded within consumer goods and services.
· A rate of global electrification reaching a level nearly five times today’s level.
· New energy sources grow up to fifty-fold with primary energy from renewals.
· A change in the efficiency of energy use leading to gains above historical trends.
· And most heroically, some 10,000 large carbon capture and storage facilities, compared with fewer than 50 in 2020.
The report however then says, “…achieving net-zero emissions in just 50 years leaves no margin for interruption, stalled technologies, delayed deployment, policy indecision, or natural back-tracking.” In other words, everything has to go just right. The deus ex machina in all this is, writes Vox, “…we can exceed 2° C some time mid-century (known as “overshoot”), but then pull enough carbon out of the atmosphere in the latter half of the century to restore balance and pull the temperature beneath 2°.” The problem is that that carbon sequestration technology is presently unproven at scale; it would be a rash to gamble the fate of your families on this unproven technology. Worse, considering climate complexity, the non-linear effects of global warming are likely to be much more manifest by then.
The second pathway is the practical one. In 2015, 195 nations signed the Paris Agreement, with the goal of holding global warming below 2° compared to pre-industrial levels. In 2017, President Trump announced the US withdrawal from that Agreement in 2020. The 2017 UN Environment Program Emissions Gap Report writes, “The overarching conclusions of the report are that there is an urgent need for accelerated short-term action (starting right now)…if the goal of the Paris Agreement is to remain achievable – and that practical and cost-effective options are available to make this possible.” We think that these options are the best alternatives because, “…(they) can be implemented at relatively low cost and based on significant existing experience. Together they represent more than half of the (reduction) potential identified.” The message is that there is still time; but there is no longer a free lunch in environmental matters because Mother Nature is starting to react badly.
The 2018 UN report graphs the world’s greenhouse gas emissions in units of billions of tons of C02. * This graph shows to achieve at least a 66% chance that global warming will be 2° C or below by 2100, CO2 emissions will have to drop from around 52 billion tons at present to 40 billion tons by 2030, a decrease starting right now of around 12 billion tons or 23%. (Note that Shell, of course, projects a large increase in energy use.) This table shows that the major world-wide potentials for cost-effective emissions reduction are in the energy sector (10 billion tons), industry (5.4 btons), forestry (5.3 btons), and transport (4.7 btons). The total emissions reduction potential of these and other measures is 33 btons of CO2. Since these figures are from a large number of sources and utilize existing technology, the worst of global warming can be avoided. But it is necessary to act now.
How to make greenhouse gas reductions happen?
· Reaffirm the Paris Climate Agreement, and then work with other countries to improve it.
· The media can play a very large role in publicizing the increaing effects of global warming and increasing the public's undersanding of this issue, informing how it will affect them. A detailed 3/21/17 NYT article notes a Yale survey; 75% of the U.S. public support CO2 reduction.
· Organize broadly to affect the political process. There are committed climate change deniers on the other side, like the Tea Party and some business interests, that can take candidates out in the Republican primary.
On 4/18/19 the Justice Department issued a redacted Mueller Report, chronicling the President’s attempts to end Robert Mueller’s investigation and staff resistance to these. But when the histories of this time are written, they will likely record that the worst mistake of the Trump administration and the Republican party was to deny global warming. The election of 2020 will really matter, for the future of your family and your investments. Elections have consequences.
*The Shell study graphs the amount of work that global energy consumption provides in units of 1018 joules/yr. The UN study graphs greenhouse gas emissions in units of billions of tons of CO2/yr. Since we calculate percentage changes in both cases, the differing units do not matter if you assume that efficiencies do not change.