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1/1/21 –
On 12/31/20 the S&P 500 closed at 3756 resulting in a total return of 18.40% for the year, closing out the very volatile COVID year. The return of the S&P 500 index for long-term investors is only 4.20%. The problem for investors is the very low rates on long-term governments. This could change in the future. Given present mutual fund alternatives, the current income yield of a 50/50 portfolio of intermediate term bonds and stocks is around 1.5%. For a portfolio to also handle inflation *, it is necessary to live within income. This is far off the 4% rule of thumb, that had been the portfolio management norm in the past. Considering how present conditions might reasonably change, we are going to have to settle for a total portfolio income yield between those two figures, but surely higher than the present.
In its September, 2020 Economic Projections Report the Federal Reserve confirmed its pledge to keep short-term interest rates near zero for years. It noted the following changes:
Median
Estimated Policy Path
2020 2021 2022
Fed Funds Rate 0.1 0.1 0.1
12/20 Projections 1.6 1.9 2.1
We will discuss how new economic conditions brought these changes about and their implications for the real economy, savers and investors in the financial markets.
The Real Economy
The most obvious factor affecting these Fed projections is the COVID-19 pandemic. In one year, the scientific community (building upon many prior years of fundamental research) has developed vaccines and begun to distribute them widely, doing what Americans do best – developing and distributing new products at broad scale. These truly hopeful achievements, however, have occurred against the backdrop of an horrific second wave of the coronavirus, which by the end of this winter, might have taken more lives than the 407,000 U.S. military casualties in W.W. II.
The first wave of the virus resulted in a K shaped recovery
in a predominately service economy, sparing the jobs of those who could work in
the rapidly developing online economy, but badly affecting the traditional jobs
that involved contact with the public. The S&P 500 projected average
operating earnings dropped 22.8% between 12/31/19 and 12/31/20. This is less
severe than the 37.9% 34.5% during the Great Recession between 9/30/08
and 9/30/09. The two major factors explaining this difference were that the
present drop has not involved the financial system, which is better
capitalized; and the Fed’s policy response to lower interest rates rapidly is
decisive. But, in the absence of fiscal policy from Congress, interest rates
are now at the zero bound and the U.S. is facing a second wave of the virus,
the 9/9/20 WP reports, “Jerome Powell, chair of the Fed, has repeatedly
said that his institution can’t keep equity and debt assets stabilized if the
economy continues to deteriorate.…Despite this grim reality, the Senate on
Thursday rejected a stimulus bill.”
Giving the real economy time to adapt, to adjust to new circumstances, should be a major priority.
Impact Upon Savers
But the above is not without cost to savers. Interest rates have trended lower in successive economic shocks, beginning with Long-Term Capital in 1998, the 2008 financial crisis and now the COVID crisis – this decline due to a continued decline in the natural rate of interest, the interest rate that supports the economy at full unemployment while keeping inflation constant. According to a 2016 speech by Fed Governor Lael Brainard, the natural rate of interest is now “close to zero.”
The reason why this has happened is structural changes in the economy. To give a simple example of this from the 12/15/20 Bloomberg, “…Butler County…straddles the suburbs and exurbs of Pittsburgh…the fate of an AK Steel plant on the outskirts of Butler that bills itself as the only U.S. producer of electrical steel used in transformers remains uncertain.” Transformer steel is a very pure specialized steel that avoids power losses. Industrial companies, such as AK Steel, are asset-heavy and provide investors with a demand for capital. Globalization and the significant deindustrialization of the economy are the likely reasons why the natural rate of interest has declined.
“Thanks to government action, many metrics of economic pain, such as bankruptcies and evictions, look better than they did before the pandemic. But economists…say that government help is just holding back a tide that may be unavoidable in the end - too many companies can’t last for long in an environment of reduced demand. (A typical small business requires about 70% capacity utilization to break even.) This state of suspended animation applies as well to corporate America, which has benefited from the Federal Reserve’s dramatic cuts in interest rates and moves to support credit markets. A Bloomberg analysis of financial data from 3,000 of the of the country’s largest publicly traded companies found that 1 in 5 were not earning enough to cover the cost of servicing interest on their debt, rendering them financial zombies. Collectively those companies – among them Boeing, Delta Air Lines, Exxon Mobil and Macy’s - have added almost $1 trillion in debt to their balance sheets since the beginning of the pandemic.”
The above suggests that the market economy has painted itself into a corner of zero interest rates. As has become increasingly obvious, the health of your future investments depends upon the health of the U.S. economy, which increasingly requires government to deal with large and unavoidable problems requiring capital: the COVID epidemic, economic growth, climate change and inequality.
The Impact on Investors in the Financial Markets
One might think that decreasing real interest rates will inevitably lead to higher stock prices. But, historically, this has not been so. The present high level of the U. S. stock market is an exception. This really useful 12/20 chart by Minack Advisors charts Robert Shiller’s S&P Composite monthly inflation and cyclically adjusted P/E against the real ten year treasury rate for the years 1925 to 2020.
It shows that, with the present exception, the stock market declines when business is either very good (and all interest rates increase) or very bad (and expected short-term earnings decrease). This graph also shows why the financial planning mantra, “Keep to your plan” usually works – but not, we think, now. Interest rates at the zero bound have reduced portfolio income yields to inconsequential levels and the current graph data point, shown by the red dot, shows a very high valuation relative to the negative 10 year real treasury rate. Usually, this mantra works because the very large preponderance of lower stock P/Es are located in the right hand side of the graph, where real treasury returns are positive and P/E values tend to be lower.
The reason why low current interest rates result in high stock prices is due to the preponderance of the five FAANG stocks (Facebook, Amazon, Apple, Netflix and Google) which now account for 15% of the S&P 500. Business has been good for these companies, although interest rates are low. But, do you want the continued performance of your now non-diversified S&P 500 to depend on the 2X or more overvalued growth companies? Does this sound familiar, like the Internet stocks or the one-decision Nifty Fifty of the past? **
Furthermore, U.S. inflation might increase for the following reasons:
1) Sustained economic activity, financed either by continued government subsidies if the economy doesn’t restart on its own; or financed by the capital markets if it does.
2) The continued need to finance deficits as the government makes the necessary capital expenditures to repair our society.
3) The trade-weighted dollar has declined.
The major risk is this: What if the real 10 year treasury rate increases from -1% to 0%, which would cause investors in that bond to simply break even in real terms after a Fed targeted 2% inflation. With increased inflation, there could be a limit to the Fed put, the ability of the central bank to keep purchasing financial assets, thus further increasing the M2 money supply. This is a market for momentum investors only. The trend is your friend, until it isn’t.
Using our nominal interest rate stock market markup model, the long-term return of the S&P 500 could increase to 5.20%.
Financial
Conditions (12/18/20)
.86% 10 year treasury premium +1%
4.20%
Equity return +1%
Our readers can calculate what the large S&P 500 drop would be, or they can (with one additional assumption) solve the problem on the graph above.
Finally
Do finance or economics people know what the drawn curve at the right is? We will discuss this in a future essay.
Does real and sustainable economic growth matter? We think it does very much; but over more than one business cycle.
*Inflation is always a significant long-term threat to the real value of your portfolio. Stocks, a claim on equity in real assets, are supposed to be a hedge against inflation. But one of our earlier studies, using data for the 32 years from 1968 to 1999, found that the coefficient of the willingness of investors to buy stocks, rather than bonds, was negative.
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The reason for
this negative sign was that we were using yearly data. When expected
inflation increases, and do interest rates, the stock market goes down.
However, when inflation decreases and interest rates go down, the effect of
prior inflation remains on the companies’ balance sheets and income statements.
Thus, for long-term investors, it can be said that stocks are a hedge against
inflation.
** There is a
saying, “History doesn’t repeat itself, but it often rhymes.” We much respect
history, but some historically confused people within it don’t choose. Which
stock market event could be the most relevant? Is the better analogy the
Internet crash of 2001 or the Nifty Fifty crash of 1973? In spite of the
technology, we think it is the latter because that crash involved highly valued
large companies, which were “one-decision” investments, companies exhibiting
solid earnings growth for a long period of time. According to the Wikipedia,
“Because of the (subsequent) underperformance of most of the nifty fifty list,
it is often cited as an example of unrealistic investor expectations for growth
stocks.”
Our markup model
for measuring S&P 500 returns will likely remain valid. Here is a quick
analysis of the details:
ROI=
Level S&P 500 CAPE Earnings Yield CAPEx1.33 10 Yr. Treasury Equity Markup
10/73 109.8 5.25% 6.98%
6.91%
.07%
09/74 68.1 9.11% 12.12% 7.38% 4.74%
What prompted the
38% S&P 500 correction was the oil shock of 1973-74, that quadrupled the
price of oil from $3/bbl. to nearly $12/bbl. Stock market corrections of
overvaluations, such as the above, require catalysts. In 1973-1974, the main
overvaluation was in the S&P 500. Now, the temporary overvaluation is in
all financial assets due to the COVID crisis. The current long-term ROI of the
stock market is only 4.20%.
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To discuss the future:
There are two major streams of Western political thought. The first goes back to Plato and the ancient Greeks. In this view, the state reflects a balanced human nature, a balance of powers among Reason, Spiritedness and Desire. This view, according to Harvard Professor Danielle Allen (2013), resulted in the administrative state, modifying Athens’ direct democracy. This state, relying upon Reason, requires foresight and competence.
The second, the Romantic movement, was in direct reaction to the Enlightenment. In “The Roots of Romanticism,” Isaiah Berlin (1999) wrote, “Fascism too is an inheritor of romanticism, not because it is irrational - plenty of movements have been that – nor because of a belief in elites – plenty of movements have held that belief. The reason why Fascism owes something to romanticism is, again, because of the notion of the unpredictable will either of man or of a group which forges forward in some fashion that is impossible to organize (sound familiar?), impossible to predict, impossible to rationalize. That is the whole heart of Fascism: what the leader will say tomorrow, how the spirit will move us, where we shall go, what we shall do – that cannot be foretold. The hysterical self-assertion and the nihilistic destruction of existing institutions because they confine the unlimited will, which is the only thing which counts for human beings; the superior person who crushes the inferior because his will is stronger…”
In the 2020 election, 74 MM Americans voted for the candidate of the extreme right for President. We might consider the consequences of trying to row in difficult weather, not having both oars in the water.
Some political expressions excel in local color. Charlie Dent, (House R-Pa ret.) said on the 12/28/20 CNN, that the leaving President's many legal challenges to the election have been, "Beaten like a rented mule."
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But the losing and outgoing President will try anything to stay in office. The Washington Post obtained a one hour phone call with Georgia secretary of state Brad Raffensperger:
Trump: I just want to find 11,780 votes (which will give me victory in the state)…
Trump: You should want to have an accurate election. And you’re a Republican.
Raffensperger: We believe that we do have an accurate election.
Trump: No, no, you don’t. No, no, you don’t. You don’t have….You’re off by hundreds of thousands of votes. You know what they did and you’re not reporting it. That’s a criminal, that’s a criminal offense.You can’t let that happen. That’s a big risk to you and to Ryan, your lawyer….But they are shredding ballots, in my opinion based on what I’ve heard. And they are removing machinery…You know, I mean, I’m notifying you. (an outright threat)
Raffensperger: Mr. President, you have people that submit information, and we have our people that submit information, and then it comes before the court…(that already ruled against Trump)
Trump: Well, under the law, you’re not allowed to give faulty election results, okay?...This is a faulty election result….And you would be respected, really respected if this thing could be straightened out before the (senatorial) election.
How can anyone who
supports the Republican party stand for this? It can finally be seen that the
thirst of Senators Cruz, Hawley and Vice-President Michael Pence for higher
office exceeds their devotion to our country and our democratic system.
As the Bard
wrote, “Out, damned spot…”, the lot.
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In his bunker,
Hitler moved around imaginary army divisions and gave orders to burn Paris.
After losing the presidency, the Senate and the House for a blinded Republican
Party, Donald Trump sought non-existent voters and then on January 6 encouraged
his supporters to unleash chaos, as Congress voted to certify Joe Biden as
president.
CNN 1/6/21
CNN
1/6/21
This Senate chamber inscription can be translated, “Providence
favors our undertakings.”
2/1/21 –
On 1/25/21 the S&P 500 closed at 3855. The return of the S&P 500 index for long-term investors is only 4.10%. The problem for investors is the very low rates on governments. The markup model below illustrates the problem:
Financial Conditions (1/25/21)
0% Policy rate
4.10% Equity return
It may be argued that although bond markets are overvalued by a zero percent monetary policy, the spread of the S&P 500 above that is still adequate. The problem with that idea is that in March, 2019 the U.S bond market had a value of more than $40 trillion and the U.S. stock market had a value of around $30 trillion. * If the bond market is overvalued relative to expected economic conditions (a rolling idea, everything is expected to be back to normal in a year or so), then the smaller stock market is also vulnerable to increased bond rates.
To discuss in further detail institutional behavior and the people involved:
This Bloomberg article is an excellent discussion of the difference between value and momentum investing. It also discusses how the use of option bets adds an immense amount of complexity (and, in our opinion, ultimate inefficiency) to the financial markets.
On 7/9/07 Citigroup’s former CEO, Chuck Prince, notoriously said, “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance.” It was easy for him to keep dancing for a while due to a policy of using OPM, other people’s money, to indirectly guarantee risky assets. A 1/25/21 Bloomberg article writes, “Across Wall Street, signs of speculative excess are everywhere. Penny stocks surging, Cash pouring into trendy thematic bets. Risky debt paying less than ever. With unchecked animal spirits and historic (high) valuations, what’s an investor to do? Keep buying, apparently.” In a 1/5/21 article titled, “Waiting for the Last Dance,” value investor Jeremy Grantham writes, “The long, long bull market since 2009 has finally matured into a full-fledged epic bubble. Featuring extreme overvaluation, explosive price increases, frenzied issuance, and hysterically speculative investor behavior, I believe this event will be recorded as one of the great bubbles in financial history, right along with the South Sea Bubble, 1929 and 2000….this bubble will burst in due time…with consequent damaging effects on the economy and on portfolios. Make no mistake – for the majority of investors today, this could very well be the most important event of your investing lives.”
Recurring excesses are in the nature of markets. A survey of Kindleberger’s epic “Manias, Panics, and Crashes” (2011) reveals that in 390 years there have been 49 financial panics, the last one mentioned in 2007-2008. But improved institutional design and policy might be able to mitigate some of the excesses; to mention two:
1) Treasury market illiquidity in 3/20. Stanford GSB professor, Darrell Duffie, notes the decreasing assets in the dealer banks relative to increased Treasury issuance. He suggests a central clearing house for Treasury transactions.
2) Dampening parabolic stock price increases by increasing the attractiveness of alternatives, raising long-term rates (this will take great finesse, market reactions to changes can be very non-linear), either by reducing long-term bond purchases or increasing long-term treasury bond sales. Stocks are extremely long-duration assets whose durations greatly exceeded those of corporate bonds and nearly all corporate investments.
* Zacks 3/6/19 Report.
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When day comes we ask ourselves,
where can we find light in this never-ending shade?
…The
new dawn blooms as we free it
For
there is always light…
Amanda
Gorman
Joe Biden Inaugural, 2021
In the series, Blueprints
to Generate Economic Growth and Dynamism, the Brookings Institution notes
the three major priorities of the United States should be: 1) Improving fiscal
and monetary policy 2) Generating productivity and growth 3) Boosting the
middle class. To do so, as President Biden noted in his inaugural address, “it
is importance to defend the truth and defeat lies.” Why is this so? The United
States was founded as the world’s first Enlightenment state, where in
Federalist No. 51, Madison wrote, “In the extended republic of the United
States, and among the great variety of interests, parties and sects which it
embraces, a coalition of a majority of the whole society could seldom take
place on any other principles than those of justice and the general good…” In
other words, the founders believed that it would be obvious to all what to do,
when confronted with the truth of a set of common facts. To cite an example, it
would have been obvious to all in 1812 that the British had no right to kidnap
American citizens to fight their wars on the Continent. In 2020, it should have
been obvious to all that the COVID-19 virus presented a mortal threat to the
nation.
Why this did not occur is due to the politization of fact that occurs in totalitarian societies, that is in societies that seek centrally held power for its own sake. As Hannah Arendt wrote in 1948, “The elite is not composed of ideologists (who produce propaganda for mass consumption); its members’ whole education is aimed at abolishing their capacity for distinguishing between truth and falsehood, between reality and fiction. Their superiority consists in their ability to dissolve every statement of fact into a declaration of (political) purpose.” * A society so governed becomes responsive not to external facts from nature, the economy or elections, but to “alternative facts” (justifications) whose sole purpose is serving the whims of the leader. A society in this state will willingly “drink the Kool-Aid” and fail; so will a political party if it cannot be a coherent policy-based “loyal opposition,” loyal to the country.
* Hannah Arendt; “The Origins of Totalitarianism”; Houghton Mifflin; New York; 1948, 1985; p. 385. In the 2016 campaign, candidate Donald Trump ominously said, “…there’s something happening…” This is what’s happening to U.S. politics. A historian said that the U.S. has survived as the oldest republic in the world because it continually and publicly asks how things can go wrong.
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We think there is a great advantage to having in government people who know what they are doing. On 1/27/21 the White House held a press briefing on Climate Change with press secretary Jen Psaki, presidential envoy John Kerry, and administrator Gina McCarthy (who will integrate policies across the administration). Rather than featuring the untruths and blathering of an incoherent former president, this press conference featured people who are “experienced, passionate, and tenacious.”
President Biden is due to sign a set of executive orders which will align administration efforts to combat the existential crisis of climate change along many dimensions:
1) Jobs, that will open up investment capital and government policies to promote the new economy jobs of the future, rather than trying to preserve the economy of the past. Relevant to this will be new research, technologies, manufacturing and profitable investment opportunities. Relevant to this will be new technical jobs in wind and solar power and local employment opportunities that enable people to work where they live, cleaning up abandoned gas wells (a big problem with fracking), coal mines and a new Civilian Conservation Corp (which will give people a chance to do public service with a benefit to future politics).
2) Our security will be the same as world security. China currently accounts for about 30% of world emissions and the U.S. accounts for about 15%. Presidents Obama and Biden have the credibility (trust) to enable the U.S. to re-engage with the world community and to help lead new efforts to curb global warming. When negotiating with other countries, it is possible – and indeed important - to keep good boundaries, not to confound climate issues with others.
3/1/21
–
On 2/25/21 the S&P 500 closed at 3829. The return of the S&P 500 index for long-term investors is only 4.13%.
Financial Conditions (1/25/21) Current Financial Conditions
(2/25/21)
0% Policy rate
.97% 10 year treasury premium 1.47% 10 year treasury premium
2.14% BAA
corporate bond premium 2.12% BAA corporate bond premium
4.10% Equity return 4.13% Equity Return
The problem this month, and likely in the future, is increased interest rates. On 2/27/21 Warren Buffet wrote, “…bonds are not the place to be. Can you believe that the income recently available from a 10-year U.S. Treasury bond – the yield was 0.93% at yearend – had fallen 94% from the 15.8% yield available in September 1981? In certain large and important countries, such as Germany and Japan, investors earn a negative return on trillions of dollars of sovereign debt. Fixed-income investors worldwide – whether pension funds, insurance companies or retirees – face a bleak future. (our note)” U.S. pension funds generally assume a long-term rate of return around 7%-7.5%.
Long-term investors have and will face a difficult situation. When the national economy was cyclical, rates would fluctuate – typically in a cycle measured by four years or so. As we have illustrated, rates have been trending lower for many years now reaching zero and below for sovereign debt, increasing financial asset prices but decreasing returns. The problem now is likely to be the reverse. A trend of decreasing asset prices but increasing returns. The world-wide demand for capital should increase due to the partial reversal of globalization and increased labor costs, increasing energy costs and -necessary- costs to bring greater social stability.
We have been considering how to deal with this environment. Likely the best way will be to consider stocks and bonds returns only loosely linked, now that conditions are unprecedented. With an ultimate allocation goal of 50% stocks and 50% bonds, we will more rapidly phase into stocks when long-term returns are x. (We will leave this figure open now to avoid front-running.) When 10 year treasury yields to maturity are at least (x-3%), we will begin to phase into a shorter-term bond fund and a treasury bond (step) ladder. The resulting portfolio may experience some losses, but we see no way around this in an increasing interest rate environment. (Option hedges are very expensive; and you have to be right in both time and level, violating a time-tested Wall Street rule pertaining to markets.)
Excluding the effects of inflation, if a reliable portfolio income is your goal:
Income = Constant = (bond income yields to maturity and stock income yields) ↑↓ x (account value) ↓↑
The above equation is one way to think about portfolios, when only income matters. The most important factor over time is likely your career savings rate.
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The recent near failure of the Texas power grid shows that private enterprise, alone, cannot solve problems that are widespread and uniform. The provision of dependable U.S. electric power is normally a highly cooperative and coordinated effort within two major power grids, called East and West; except in Texas which operates a resolutely independent system that nearly melted down on February 14-15, 2021 when the weather, driven by the long-term climate, changed.
4/1/21 –
On 3/24/21 the S&P 500 closed at 3,889, yielding a long-term investor a return of only 4.06% per year. The following which exhibits asset returns since the beginning of the year illustrates what is happening:
Financial
Conditions (1/25/21) Financial Conditions
(2/25/21)
0% Policy rate
.97% 10 year
treasury premium 1.47% 10 year treasury
premium
2.14% BAA
corporate bond premium 2.12%
BAA corporate bond premium
4.10% Equity return 4.13% Equity return
Current Financial Conditions
(3/24/21)
0% Policy Rate
2.10%
BAA corporate
bond premium
.41% Equity risk premium
4.06%
Equity return
So, what’s
happening? Contrary to equilibrium economic theory, which posits a perfect (and
usually uniform) discounting of the future, real financial markets exhibit
non-uniformity. What’s happening here is what we call “compression.” At the
short end of the yield curve, the Fed has pinned the policy rate at zero, in
order to facilitate an economic recovery. At the equity long end, investors and
computers have been conditioned for years to “buy the dips,” thus holding up
stock prices. In a declining interest
rate environment, that is a fool-proof trading (not investing) strategy; that
will be a recipe for its mirror-opposite, when interest rates really increase
due to the economic rebound.
At current
question is whether a massive 25% increase in the M2 money supply, from the
first quarter of 2020 to the last quarter of 2020, will overdrive the economy
and create acute short-term and long-term inflation. In the short-term,
inflation will likely increase somewhat due to money supply growth, the beginning
reversals of globalization, supply-chain constraints around the world
(including the Suez canal) and the reduction of
Covid-caused lockdowns. Considering the long-term, the recent Treasury
announcement that President Biden’s infrastructure program will be paid, in
part by more tax revenue, is a relief. Interest rates and stock market returns
should normalize in the long-term, and inflation not accelerate.
However
Investors,
now us included, like to think, finally, the COVID problem may be solved by
vaccines that will result in, “one and done.” As doctors learn more about the
virus itself and as the virus learns about us, this might not be so. It is
estimated that the “herd immunity” level for the present COVID virus is around
80%; but 30% of all Americans are likely to refuse to take vaccines.
Furthermore, this does not take into account variants: of which there are now
three major strains. Most worrisome is the Brazil P.1 variant, that continues
to evolve rapidly; changes in the spike protein affecting antibody response. A
1/28/21 CDC Science Brief reports that in the city of Manaus, the P.1 accounted
for 42% of all variants sequenced from late December, 2020. The 3/27/21 WSJ
reports that Brazil’s more severe P.1 cases and deaths now surpass the U.S.’s; the
virus there continues to fester and generate even more new variants. This won’t
just, “go away.” To deal with this, disease experts recommend continual
monitoring and contact tracing.
If U.S.
COVID infections again spike, we’ve again got major problems. The 3/29/21 Barrons reports that, “Yes, You Can Retire on
Dividends.” But to do so, you have to give up diversification; we don’t think it
is appropriate to give up diversification (over assets and time).
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Long-term equity investing is mainly concerned with the
valuation of prospects. “Price is what you pay; value is what you get.” Are you
buying perfume or groceries? Consider the event of a price drop. Do you buy
more or lighten up? Are you basically a value investor or a momentum
investor; if you don’t know, the market is an expensive place to find out.
5/1/21 –
incl. two addenda
In 4/23/21
the S&P 500 closed at 4180, yielding a long-term investor a return of only
3.77% per year. It is very likely that the U.S. economy is on the cusp of
increasing interest rates (also rates of investor return) and under these
circumstances, it is crucial – in an environment of uncertainty – to determine
when to start locking in these rates of return. We strongly suggest that you
talk with a qualified investment advisor, should you choose to consider this
strategy.
The
overriding investment factor is that interest rates are likely to increase, due
to an increase in the world-wide demand for capital to combat climate change.
The Biden administration has announced a plan to reduce greenhouse gas
emissions by 50-52% (compared with the baseline year of 2005), by 2030, and
becoming carbon-neutral by 2050, the year chosen by the Paris Agreement that
the U.S. has rejoined. Meeting these ambitious goals will hold the world’s
total warming to 1.5-2 degrees centigrade, up from an increase of 1.2 degrees
at the present time- leaving a livable world for us and our children.
We will look
to an equity rate of return of 6% or above and an investment in a well-managed
BAA or better intermediate term corporate bond fund when 10
year U.S. treasury rates are 2% or above – the two being separate
considerations,
These are
the following reasons for our 6% equity choice.
1) Assume that the Fed will leave its
policy rate at the zero bound. The following is an equity markup analysis.
3% BAA
corporate bond premium *
1% Equity risk premium
6% Equity return
2)
The following is an equity markdown analysis.
9% Cost of equity capital of a low-risk
company,
per Greenwald, in class, 2007.
-1% due to S&P 500 diversification (our
judgment)
-1% due to reduced economic productivity
7% Equity return
3) An S&P market rule of thumb by a
noted value investor.
(Average historical S&P 500
P/E=16) x (estimated earnings next year) = our readers can figure this out
We will
assume a midpoint of 6% (and an income yield of 2.2%). Starting with this, we
would simply increase our equity or bond investments every six months, over two
years. (25%,25%,25%,25%). This strategy might involve losses, if interest rates
continue to rise; but we see no other way around the Wall Street saying, “State
a market level; state a time; but not both.” (That is unless you are an options
trader, but then you are a trader rather than an investor.)
This is the
expected long-term return of a 50/50 portfolio structured according to the
above:
Total Rate of Return Income Rate of Return
50% S&P 500 equity fund
3.0% 1.1%
50% BAA bond fund 2.5% 2.5%
5.5% 3.6%
The income
result of this portfolio will be less than the rule of thumb that portfolios so
invested can spend 4% of their current balance per year. To further reduce
risk, it would be possible to split the bond fund further into two parts: a BAA
bond fund and a laddered portfolio of U.S. treasuries. Again, we encourage you
to discuss these strategies with a qualified investment advisor.
*We think we
are making a very reasonable assumption that the Moody’s BAA corporate bond
yield will be 5% or above in the near-intermediate term future. This is the
historical record of the rate
(look at the entire record). Ideally, the bond portion of a portfolio should
represent, to use Keynes’ words, a “really secure” income. Bonds rated Moody’s
BAA are still considered “investment grade,” but considered of “moderate
investment risk.” Bond investors can deal with this problem by investing in
well-managed mutual funds that contain add: many (relatively) small and
diversified investments.
add: Taxable purchasers of bond mutual funds are responsible
for long and short-term capital gains (or loss) distributions, for shareholders
of a certain record date, the timing of these depending upon the judgment of
management. These are facts to be aware of and to ask about.
According to
a 2/13/20 Moody’s Analytics Report, US$ denominated corporate bond issuance had
increased year over year by 25% for investment-grade bonds and 83% (sic) for
high-yield bonds. This is not in general a good state of affairs; what, for
instance, will happen when interest rates increase? In finance, there should be
at least some degree of standard (in this case, interest expense coverage).
This is our observation.
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This is the
political economy context which pertains to the above.
The U.S.
accounts for around 15% of greenhouse gas emissions, such as CO2.
The cooperation of the rest of the world is necessary, and all can work
steadily towards the common interest. The Biden administration has
re-established the cooperation of Russia (which has a permafrost problem),
China (which has ecological problems), Great Britain and the E.U. (which have
record heat wave problems).
Returning to
the U.S. the $2.3 trillion Biden Infrastructure Plan (it isn’t as massive as it
sounds, as the expenditures will occur over eight years) promises to
restructure the U.S. economy. A conservative will balk at the idea of
government intervention. A poll has
shown that 72% of all Democrats agree that there is a climate crisis, but only
10% of all Republicans do. But affecting all Americans are the facts that the
independent Texas energy grid collapsed last winter, the Midwest is flooding,
California has and will experience massive forest fires, and permafrost is
melting in Greenland, affecting the Florida coasts. These are all observable
problems, requiring remedies.
On 4/22/21 CNN held a Town Hall, featuring John Kerry,
Special U.S. Envoy (to other nations) for Climate; and Jennifer Granholm, head
of the Department of Energy.
According to EPA statistics the
bulk of greenhouse gas emissions come from the transportation sector of the
economy (29%), electricity generation (25%) and industrial processes (23%).
Surprisingly, the direct household use of oil and gas account for only 6% of
the total. These proportions suggest the following policies:
1) The
electrification of transportation.
2) The
growth of electric grid capabilities, to move energy around, and the
development of modular and safe nuclear energy to handle the baseload.
3) The
development of new industrial processes to produce commodities, such as cement
and petrochemicals.
The specifics of the Biden plan will result in the above
and:
1) Be good for all Americans, producing new jobs in new
industries.
2) Repair the damage done by fracking and by environmental
degradation.
3) The trillions of dollars spent by the government and the
private sector will reconfigure U.S. production.
4) Those who do not change appropriately will simply be
confronted with stranded assets.
5) With climate change increasingly obvious, the old ways
simply will not work anymore.
6) Democracy, at times, requires good leadership. Now is such
a time.
7) The American public can demand real change, and public
officeholders will respond.
Under the previous administration, the world became
increasingly chaotic and was set adrift. Americans can lead
on climate warming because of the value of seeking appropriate change,
technological skills, and the ability to distribute the benefits to all people
– a promise made in the preamble of our Constitution.
12/15/21 – note
On December 15, 2021 the S&P 500 closed at 4710, close
to a peak, yielding a long-term investor a total return of only 3.61%. On the
same date we bought a substantial holding of Verizon Communications, Inc. (VZ)
at a price of $51.05 and an expected total return of 7.01% (5.01% + 2%), at
close to a yearly trough. This is almost exactly the total return we would hope
for at a much lower level of the S&P 500, (6% +1% return premium for a
single stock). Before you try this, we would definitely encourage you to talk
with a qualified investment advisor.
We purchased this utility stock at a (less relevant)
S&P 500 peak (forget about the CAPM model) because VZ is a sort of long
bond equivalent. Verizon’s current return on total invested capital is an
annualized 7.38%, almost equivalent (including heavy capital expenditures to
build out 5G) to its 7.01% cost of equity capital - (using precise decimals
just to keep track of the various quantities). We don’t expect much growth from
this stock, but do expect a quite decent bond-equivalent income over time.
There are, of course, short-term risks to this investment;
especially since the Fed has signaled that it is wheeling the punch bowl towards
the door. On 12/31/2000 the U.S. treasury 10 yr. bond rate was 5.12%. That
benchmark rate has since decreased to around 1.47% on 12/15/2021. The reasons
for this large decrease were:
1) The large
world-wide growth in the central bank M2 money supply, as the central banks
countered the effects of the 2008-2009 sudden-stop world
wide recession, and then the COVID recessions of 2020 +.
2) The continued
opening up of China’s labor market to the multinationals.
3) The growth of
finely tuned supply chains (and the efficient reduction in inventories) around
the world.
It is possible to construct a cogent argument that all
these effects are now reversing. Central banks around the world are beginning
to signal tighter money and finely tuned supply chains are being compromised by
supply shortages (notably semiconductor), transocean
shipping expenses, and (certainly in the U.S.) trucking shortfalls. The trimmed
mean CPI takes out the most extreme price changes. The following graph shows
that inflationary price pressures have entered the general economy.
This is why the Fed must act decisively to contain embedded
price pressures. But how decisive is “decisive.” When is the right time to act,
to what degree. It’s a matter of judgment.
But, furthermore, and this is crucial, what about the shape
of the bond (now including the S&P 500) yield curve? With interest rates at
a historic low, a yield curve that maintains its current slope when rates rise
will spell great problems for long-term assets. But, if the yield curve becomes
negatively sloped (short rates become higher than long rates), the price
depreciation at the long end will be less.
Over the short term, the VZ holding will at least provide
some income until interest rates rise. If we are wrong, and interest rates rise
greatly, our holdings in cash will become very profitable and we would consider
VZ a long-term investment, which it is. As a long-term value investment, VZ has
a decent expected rate of return; and that is our investment horizon.
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A Wall Street analyst once said confessed, “The
stock market is like life; it cannot be predicted.” This is why we don’t really
try to predict long-term interest (discount) rates, but choose to invest when
rates of return reach a certain level. The core issue, as Isaiah Berlin once
said, is the contingent elements of history.
An example of this is a 12/16/21 report
on the Omicron strain of the Covid virus from the Imperial College of London.
Although this study has not yet been peer reviewed, Professor Neil Ferguson (et
al.) note:
“Using logistic and Poisson regression(s) to identify
factors associated with testing positive for the Omicron virus…Hospitalization
and asymptomatic infection indicators were not significantly associated with
Omicron infection, suggesting at most limited changes in severity
compared with Delta.”
The highly contagious Omicron strain has the potential to
overload the healthcare system.
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A Bloomberg 12/29/21 article titled :
“How Errors, Inaction Sent Deadly Covid (Delta) Variant Around the World”;
clearly illustrates that the isolationist MAGA philosophy, “Make America Great
Again,” is precisely what America (and your life) do not need. The same
holds true for the long-term performance of your portfolio. In general, MAGA is
maladaptive.
The reason that MAGA is maladaptive is that, in fact,
people are all biologically related, and therefore all susceptible to diseases,
“…explaining why two years into this epidemic, the world remain on the brink of
economy-shattering shutdowns, with another new variant emerging out of
vulnerable, under-vaccinated populations. But while South Africa acted swiftly
last month to decode the heavily mutated omicron and publicize its existence,
India’s experience perhaps better reflects the reality faced by most developing
countries-and the risks they potentially pose.”