8/22/23 –

 

 

 

An 8/22/23 NYT headline: “The massive central U.S. heat wave is expanding and could set hundreds of records.”

 

There are two aspects of equity investing. The quantitative, where relevant are future cash flows and therefore equity valuation, and the qualitative - the context of things - about management and now increasing about Nature and global heating. A really useful 8/17/23 Financial Times article is titled, “How investors are underpricing climate risks”

 

“In a world that is rapidly becoming more vulnerable to extreme weather events, outdated assumptions about asset values also need recalibrating. The big danger is of a ‘climate Minsky moment’, the term for a sudden correction in asset values as investors simultaneously realise these values are unsustainable. So far, businesses and investors have paid less attention to the physical effects of climate change and more to the costs and risks of decarbonising, as the world tries to limit the rise in average global temperatures….

 

Equities have not priced in climate change risks, research by the IMF and others has repeatedly shown…(So does our 6/29/23 post)…Cambridge Econometrics…recently crunched numbers for Singapore’s GIC. The sovereign wealth fund’s long-term investment horizon - and the city-state’s vulnerability to flooding - make it unusually mindful of climate risks. It wanted to know how a portfolio composed of 60 percent global equities and 40 per cent bonds would fare under varying climate policies.”

 

Here are the general results:

 

Net Zero Scenario -  cumulative returns over 40 years were 10 percent lower than a baseline that assumed no climate change.

Pessimistic Scenario - cumulative returns were 40 percent lower than the baseline. “…though some feel that the outcome could be much worse than that given the unknowable levels of disruption (also climate feedback loops) that such a rise might trigger.”

 

So given the above uncertainties – both analytical and political – what’s an investor to do? Equity investment requires a rather optimistic mindset. But all things considered, 1) We will not overpay for stocks already optimistically valued 2) Since stocks are long duration (payback) investments, we would decrease the duration of our portfolio by holding around 10% in cash.

 

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The best action for portfolio owners is to make sure that the political will exists to tackle global heating, requiring a sustained effort and investment.

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Is climate change all a plot to reduce American freedoms? Here’s a disproof from the bottom-line. The 9/3/23 Washington Post contains an article headlined, “Home insurers cut natural disasters from policies as climate risks grow”.

 

“In the aftermath of extreme weather events, major insurers are increasingly no longer offering coverage that homeowners in areas vulnerable to those disasters need most.

 

“At least five large U.S. property insurers – including Allstate, American Family, Nationwide, Erie Insurance Group and Berkshire Hathaway – have told regulators that extreme weather patterns caused by climate change have led then to stop writing coverages in some regions, exclude protections from various weather events and raise monthly premiums and deductibles. Major insurers say they will cut out damage caused by hurricanes, wind and hail from policies underwriting property along coastlines and in wildfire country…

 

“The variability in weather patterns means insurance companies can no longer rely on the previous risk projections that helped them make decisions. As insurers leave certain markets or cut certain perils out of policies, some homeowners are going without insurance. State governments have erected insurance policies of last resort.

 

“But even state-backed policies must face climate risks. ‘When you see the insurance companies pulling out en masse because the cost of rebuilding homes in Florida is bankrupting them,’ said Ben Jealous, executive director of the Sierra Club, ‘its either hubris or folly to think the state wouldn’t be bankrupted stepping in to help.’”

 

Climate change is getting more real every day. Both Democrats and Republicans need to start bailing the lifeboat.

 

 

9/30/23 –

 

Without the votes of some recalcitrant Republicans, the congressional House finally passed a 45-day stopgap government funding measure, that omitted aid to Ukraine. How can the House govern a nation, when they can’t even govern themselves. And how can former president Donald Trump again govern a nation, when he obviously can’t even govern himself. America needs a moderate-right Republican party to help solve the real problems we have in common: climate change, lack of an immigration policy, social problems of distribution, and increasing government deficits.

 

The humane U.S. rule of law (an external standard applicable to all) also requires citizen self-governance, in order to preserve true freedom for society and to preserve liberal society’s ability to parallel process (do more than one thing at once). Polarization and gridlock don’t solve problems. A stark alternative to MAGA manufactured social chaos is authoritarian rule, which is the likely goal of some in Congress.

 

Is that what you really want for the United States?

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The U.S. stock market is just waking up to the fact that r, the cost of capital, is high and rising.

 

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We voted our proxy in favor of the merger between Newmont Corporation and Newcrest Mining Limited.

 

 

10/23/23 –

 

 

 

This 10/19/23 WSJ graph illustrates that under conditions of low interest rates, bonds and stocks move in opposite directions – thus reducing portfolio risk. But under conditions of high interest rates, such as exist at present, bonds and stocks move in similar directions – because large interest rate changes dominate both (see the href="https://www.inv.com/realmarkets.htm">standard corporate finance formula for a stock’s price).

 

But as a behavioral matter, we think that most on Wall Street have never seen a bear market; and therefore will repeat the stock market mantra, “buy the dips.” The growth in high cash flow tech stocks has also resulted in this strategy. The logical opposite, of course, during a regime of monetary tightening, is to “sell the peaks.”

 

What is our portfolio policy during a regime of rising or high interest rates? This is why we have been emphasizing long-term income, rather than stock market appreciation. As a value investor, we believe that bonds or stocks should be bought at the proper and adequate yield. At an A/BAA level of credit quality, we believe that a bond yield to maturity of around 5.25% is adequate. Although the market is, at the moment, beyond that; it is possible to calculate the number of quarters (only) that are necessary to break even on original cost.

 

What also matters in a long-term portfolio is the right level to lock in the long duration (interest sensitivity or approximate payback period) S&P 500. We think the stock market at a level of 4,225 remains very much overpriced (a S&P level of 2,740 2,907 is more appropriate). We seek a general portfolio allocation of 50% bonds/40% stocks/10% cash for the long-term. The long-term condition of the financial markets depends upon the state of the general society and its politics – including its responsiveness to changing climate conditions.

 

 

11/7/23 –

 

The current market trading level of the S&P 500 is 4,378. We did a calculation according to our formula for the level of the S&P 500 assuming $222 in operating earnings for the year to 3/31/24, a 7% investment rate of return, and most important, therefore assuming a cyclical economic downturn would never, ever occur:

 

                         Level S&P 500 = (222/.07) x 1.33 = 4,218

 

The current market trading level exceeds even this totally optimistic assumption.

 

Assuming, that the economy will be cyclical, the 10 year average Robert Shiller CAPE earnings is $153. With this assumption:

 

                          Level S&P 500 = (153/.07) x 1.33 = 2,907

 

 

The standard corporate finance present value model has two parts: a cost of capital part, or the investor desired rate of return, and the dividend growth part that reflects future earnings growth. As the graph below illustrates, the last recession of 2008-2009, resulted mainly from a decrease in earnings (dividends), as the financial system itself became problematic. This time, the stock market has not yet responded much to increased interest rates, to a 10 yr treasury of 4.57%; and earnings due to decrease, because of economic cyclicality. The four most dangerous words in the English language are, “This time it’s different.”

12/15/23 –

On 12/15/23 the S&P 500 closed at 4719, resulting in a YTD return of 24.9%. A 50-50 mix between the return to the corporate bond index and the return of the S&P 500 would have a return of 14.9%. One of our portfolios, which excluded the effect of a so far successful start-up, returned 5.4%, an underperformance of 9.5%.

But comparing this underperformance with the previous year’s 12.06% 50-50 outperformance, the above result doesn’t disturb us much because, as the following illustrates, the long-term return of the S&P 500 is egregiously less relative to the return available from bonds, at an appreciably lower risk.

             Long-Term Logical Expectation                                     Actual Market 12/15/23   

                                2%   Policy Rate                                                    5.33%                        

                                2%   10 year treasury premium                            -1.42%                 

                                2%    BAA corporate bond premium                     1.57%                  

                                1%    Equity risk premium (S&P 500=4719)       -1.17% *          

                                7%                                                                          4.31%                   

                                * Assumes 1st quarter 2024 high in CAPE

                                   earnings = average $152.79      

 

As we illustrated in our 11/7/23 previous posting, the present level of the S&P 500 more than discounts the hereafter.  Quoting Benjamin Graham on the stock market, Warren Buffet wrote, “In the short run the market is a voting machine ¹; but in the long run it is a weighing machine.” ² It would be a mistake on the fundamentals not to consider weight.

 

Crucial to investments are investors. Short-term stock investors (and computers) look to profit from short-term market price patterns, some “technical.” Long-term investors look to sustainable rates of return where the valuations of companies relative to their market prices (and margins of safety, in the case of individual stocks) are important in order to preserve capital and to achieve required rates of return. To accomplish the first, value investing as a philosophy is crucial. People should really make sure that they know what kind of investor they are. People who are primarily interested in other things besides stocks should be long-term stock index fund investors.

 

The current level of the S&P 500 is supported largely by the appreciation of seven high-tech growth stocks such as Microsoft and Apple. According to a 12/5/23 WSJ article, these seven stocks have accounted for 11% of the S&P’s 19% yearly return. If an investor were to invest in the S&P 500 at current levels, 30% of their funds would be in these seven companies. Not a good idea from the standpoints of diversification and excessive valuations. But we think the very rapid progress of generative AI will likely have a beneficial effect on the productivity of the economy in the medium to long term. We will discuss this in the next article.

 

Before further investing, we would at least want the S&P 500 to be trading around its present value of around 2,903, because the economic environment, despite current Wall Street rallies, remains quite uncertain. Core CPI inflation, excluding volatile food and energy, might be stuck at 3%-4%, rather than at the Fed target of 2%. Furthermore, we are also making an optimistic assumption of a 7% cost of equity capital. Because the S&P 500 is currently so far off the 2,903 level, we’re going to keep that optimistic assumption; but it remains quite optimistic. The current S&P 500 rally approaches a 12/29/21 high level because the BAA bond rate has dropped to a similar level (5.84% vs. a current 5.48%).

 

Over the next two or three years, the U.S. financial markets will experience two major events that could increase the demand for all capital, and thus adversely impact the prices of long-term assets like stocks and bonds. Thus, the reason for going for a portfolio split of 50/40/10, with the last figure representing cash to reduce the duration (interest sensitivity) of the portfolio, if interest rates again increase.

 

·      Climate Change

 

Increasingly devastating changes will occur to the earth’s ecosystems if the average temperature exceeds 1.5° C above the preindustrial level. The current level of already 1.2° C. According to the U.N.’s World Meteorological Association, there is an increased likelihood of reaching an average global temperature of 1.5° C within one of the next five years.

 

There isn’t much time. The determination of over 100 nations at the U.N. sponsored COP28 convention in Dubai about that to do was crucial. To achieve the 1.5°C goal by 2050, the scientific reports that inform COP say this decade will be decisive. Greenhouse Gas emissions need to fall at least 43% (sic) by 2030 from 2019 levels.

 

The meeting resolutions require a unanimous approval of all nations. It nearly concluded very badly, with no resolution calling for the phase-out of fossil fuels. At the last moment, there was a “transitioning away from fossil fuels” agreement to meet a zero emissions target by 2050. In the absence of a central authority, the resolutions of COP28 are non-binding; but at least the beast is moving in the right direction. There are, however, doubts that this emissions target and a 1.5° global warming goal will be in fact met. Next year’s COP will discuss the financing of these initiatives.                                                                        

 

Regardless, achieving climate goals is going to be expensive, placing a heavy load on the cost of capital. A 1/22 McKinsey & Company report titled, “The net-zero transition (by 2050),” states:

 

“This research…seeks to demonstrate the economic shifts that would need to take place if the goal of 1.5 degrees is to be attained through a relatively orderly (our emphasis) transition between now and 2050.…this report…does not focus on such issues as technological breakthroughs…this report does not explore the critical question of who pays for the transition. What is clear is that the transition will require collective and global action, particularly as the burdens of the transition would not be evenly felt. The prevailing notion of enlightened self-interest alone is unlikely to be sufficient to help achieve net zero, and the transition would challenge traditional orthodoxies and require unity, resolve, and ingenuity from leaders.” ³

 

The report highlights the three main sources of Greenhouse Gas emissions: Power, Industrial Processes and Mobility. The greatest burden of transition costs will be upon the developing countries such as India, China and Brazil. Transition costs will be front-loaded to 8.8% of global GDP between to 2026-2030 to about 7.5% of global GDP between 2026-2050. Transition costs will increase total infrastructure spending from $5.7 trillion to $9.2 trillion, an average annual increase of $3.5 trillion. (In comparison, the world”s GDP was $100.56 trillion in 2022.)

 

To place this increased spending in other contexts, that $3.5 trillion is equivalent in 2020 to,“…half of global corporate profits, one-quarter of total tax revenue, and or 7 percent of household spending.” ⁴ Although these projects will have positive returns, the initial capital costs will be high, thus raising interest rates.

 

·      Large U.S. Deficits

 

In the years 1980-2000 the U.S. deficit was around 2.7% of GDP. After 2027, the Congressional Budget Office projects the U.S. deficit to be around 6.9% of GDP. Americans want welfare state benefits, notably Social Security and Medicare, but they don’t want to pay for them with taxes.

 

 

Given the climate challenges that everyone faces, the U.S. should not look to the world to finance these deficits.

 

In the above, we think we are being realistic as long-term investors. However, we assume relatively orderly institutional solutions to both problems. But major U.S. problems are currently not being well-attended to, because of ideological blinders in the U.S. and short-term time horizons in many matters. The US. equity markets will eventually suffer from what are present risks. But this is the Anthropocene era, where what you do will make a difference. So, don’t just sit on that 401(k); make that political difference.

 

 

 

 

¹ Financial votes cast in markets can depart very far from the present value fundamentals, and thus short-term investors (and computers) search for patterns in stock prices. A classic text on market speculation is economist Charles Kindleberger’s “Manias, Panics, and Crashes (2005), p. 39.” In this book, he wrote:

 

“The word ‘mania’ suggests a loss of a connection with rationality, perhaps mass hysteria. Economic history is replete with canal manias, railroad manias, joint stock company manias, real estate manias, and stock price manias – surges in investment in a particular activity (like AI). Economic theory assumes that men and women are rational - and hence manias would not occur. There is a disconnect between the observations that manias occur episodically, and the rationality assumption….Contrast the rational expectations assumption with the adaptive expectations assumption that the values of certain variables in the future are extensions of their recent values -  the assumption that is implicit in the view that there are ‘trends’ in the changes in asset prices, The cliché that ‘the trend is your friend’ reflects that prices will continue to increase if they have been increasing.”

 

Microsoft (MSFT) is a major component of the S&P 500. We did a present value analysis of MSFT, assuming that the company’s digital businesses and, particularly Cloud and AI, would grow at a constant rate in the future twice that of the 2% real growth in the economy. Given current high margins, return on capital, and a 10% investor required rate of return (higher than that required of the S&P 500), the present value of the stock of this $212 billion 2023 revenues company is $189, a P/E on trailing earnings of 19.3. On 12/15/23 it was quoted at $370, a P/E on trailing earnings of 37.7. MSFT is a growth company, but we wouldn’t pay at around twice its present value.

 

² Berkshire Hathaway1987 letter to shareholders.

 

³  McKinsey & Company; “The net-zero transition”; Jan, 2022; p. iii.

 

⁴ Ibid.; p. vi.

 

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What underlies free markets?  In the short-run, there is always something new to write about; note this 12/27/23 WSJ article. But in the long-run, facts matter in free markets; as events play out, for either better or worse. In market economies, the public is willing to accept that, ultimately, reality is a common resource. The Jan/Feb 2024 issue of The Atlantic notes:

 

“(Real) facts are work. They require study; they require curiosity; they require patience; they require humility. Democracy (that practice of polling society to determine its ultimate direction) requires the same. The demands of both become greater in an information environment teeming with stories that are ever more suspect.”

 

 

1/29/24 –

 

Generative AI is likely not just a fad involving matrix multiplication; according to Bill Gates, Microsoft is investing $50 billion this year in this technology. According to a 1/28/24 article by Bloomberg, investor, “Blackstone Is Building a $25 Billion Empire of Power-Hungry Data Centers.” The site of this major investment is Phoenix, Arizona. The main point we wish to make is that in the U.S., and also at a meeting in Davos, Switzerland, large corporations plan to pour billions into the improving technology of predicting the next word in an answer.

 

What does this mean for investors, in particular, for value investors? Summarizing Seth Klarman’s famous book, “Margin of Safety,” a writer boiled it down to three principles: “1) Avoiding loss should be the primary goal of every investor. 2) The way to avoid loss (for individual stocks) is by investing with a significant margin of safety. 3) A margin of safety is necessary because valuation is an imprecise art, the future is unpredictable, and investors are human and make mistakes.”

 

Recall that over the next 20-30 years, we said that equity investors have to be optimistic. We therefore projected a recent historic rate of S&P 500 earnings growth into the future, despite impending:

 

·      Climate Change

·      Large U.S. Deficits

·      Deglobalization                           Call this parent class: PROBLEMS

·      Demographic Changes

·      Threatened Political Change

 

The market, at new highs, presently ignores these risks. The investment environment around AI, may be a positive for the productivity of the economy and for general progress; but it is also very fraught. So, what is a value investor to do? Fortunately, the growth assumptions are explicit in the present value model:

 

The “Magnificent Seven” tech stocks ranging from Apple to Nvidia, now constitute around 30% of the S&P 500. We had previously considered the S&P 500 a well-diversified portfolio with a long-term return characteristic of the equity market in large cap stocks. From our article, “Portfolio Returns in Real Financial Markets,” we calculated the present value of the S&P 500 for long-term investors. Investors concerned with mainly with other things besides the stock market should be long-term. There are two ratios in our study that we would change to measure the present value of the AI S&P 500 for a 7% rate of return:

 

            S&P 500 historically     S&P 500 #s but consisting of only 7 Stocks

 ROC/R       1.7 =12/7               2.0 = 14/7 (return on invested capital increases)

 LTG/R         .57 = 4/7                 .86 = 6/7 (real economic growth doubles)    

 Multiplier           1.33                     2.50

 S&P 500 Level  2903                    5456

 

 

To derive a present value of the S&P 500, assuming an AI doubling in growth of 30% of the stock market, we simply split the above two portfolios 70/30 to get a present value of an AI motivated S&P 500 of 3669. This calculation shows the present level of the S&P 500 of 4927 is not at all realistic. We would consider a buy range for the S&P 500 somewhere between 3669 and 2903 – we think the future economy is going to be cyclical and subject to changes.

 

The social effects of this technology are worrisome and could be quite substantial. Generative AI is a general-purpose technology like electricity. The difference between the two are time frames. It took decades for electrical technology to be adopted, to replace water mill power with motor power. The infrastructure for consumer generative AI already exists, in the cell phones that most people already have.

 

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The technology of vector similarity (also defining a context) will enable businesses to rapidly search large databases of customers and products to possibly create better customer experiences and more efficiency. But investors should not throw their money around like popcorn.

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So, what’s happening (this is always a question to ask in finance) with the “Magnificent Seven” stocks, that are responsible for 30% of the S&P 500 (there are 494+ others, Nvidia is NASDAQ). According to a 2/2/24 Bloomberg article:

 

“The seven largest tech stocks were traded at (n.b.) 48 times profits, more than two times as high as the average stock in the S&P 500. As stretched as they looked, however, their profit trajectory can be framed as justifying the supremacy, Thanks to their dominant position in everything from e-commerce to cloud computing and electronics, the big seven’s profits are expected to expand at an average annual pace of 14% in the next three to five years…When a secular trend like AI kicks in, valuation analysis stops working because companies have years or decades to grow into multiples (we think not for large companies), according to Ankur Crawford, co-manager of the Alger Capital Appreciation fund….These are the leaders and the dominant players in this next technological revolution. And it’s really difficult to say that they are over-hyped…”

 

A June 2023 McKinsey study titled, “The economic potential of generative AI” surveyed 63 industry use cases, and concluded eventual annual revenues of $2.6-4.4 trillion, world-wide. The major functional areas to be improved would be customer operations (such as call centers), marketing and sales (strategization and customer awareness), software engineering (obvious), and product R&D (such as ideation and virtual design). The McKinsey study predicts an eventual annual 3.5% addition to the 2022 level of world GDP growth of 3.1%, due to generative AI. That really sounds high.

 

We have invested in two startup AI companies in automated driving and warehousing.* But, does major improvement apply to companies such as Nvidia and Microsoft (respectively $59 and $212 billion in 2023 sales)? Are realized improvements in seven companies really worth a present P/E of 48? Will large GDP growth increases in the U.S. really occur? Value investing is not about very rapid earnings growth. The S&P 500, at present, is certainly not a choice for value investors.

 

* A small portion of an investment portfolio can be just for the thrill of the chase, to see if things turn out.

 

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So, to counterpose two ideas of investment: the formal economic idea and the investor-centric idea.

 

The formal economic idea is that of equilibrium. Where the supply price equals the demand price (if you think of the intersection of the supply and demand curves in economics), in a single market or across all markets. This is the theoretical economic idea that makes possible all the algebra of economic equations and, of course, the optimizations of CAPM. One of the key results of the free economic model (which is why, we think, the field is ultimately studied), is the maximization of individual happiness (utility) and also of societal GDP.

 

The model, however, is theoretical because it assumes: 1) A simple world of price (which is always correct), with all other variables such as consumer preferences and politics “exogenous.” 2) Rational actors with uniform preferences and perfect information. 3) An equilibrium with no markets, the quantity supplied always equaling the quantity demanded.

 

Contrast this economic equilibrium view with the view of the markets from the standpoint of an investor, who can take advantage of incorrect prices, differing time preferences and unbalanced markets. We have shown that within the financial markets: Fed policy, various stocks, bonds of differing maturities and credit qualities - all exist in sub-markets that are sometimes related, and sometimes not, with varying correlations. But it’s possible to calculate the approximate long-term return for the S&P 500, to enable bond comparisons. So, what is a practical investor to do?

 

This is what the founder of value investing, Benjamin Graham, thought of financial markets. In, “The Intelligent Investor; (1973); p. 108”, probably the best investment book ever written, he wrote:

 

“Imagine that in some private business you own a small stake that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects, as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little sort of silly….The true investor is in that very position when he owns a listed common stock. He can take advantage of the daily market price or leave it alone, as dictated by his own judgement and inclination.”

 

This is the Anthroprocene era, where what you do will make a difference.

 

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2/24 With the exception of one company, AI semiconductor companies in this very rapidly progressing field have no moats protecting their franchises. Regarding NVIDIA, a specialist in training, as opposed to commodity inference AI chips - their nearly $2 trillion stock market capitalization far exceeds the likely sales potential of training chips. (The market capitalization of this one company is about 1/14 of U.S. 2023 GDP, no joke.) That leads to a sustainability question.

 

In generative AI, the requirement for the number of network training chips is much higher than the number of inference chips, to answer a particular question. The reason for this is that in the network training phase, the computer must adjust the mathematical biases, neuron training weights, and activation potentials to minimize the error between the network prediction (of the next word) and the actual one that occurs. That requires a lot of matrix computation. In the inferences required to answer a question, the weights remain as is.

 

As a computer note: NVDIA chips and its CUDA software enable generative AI, that requires the parallel processing of very large data sets with neural networks. However, sequential processing (e.g. with Intel processors) is still required to perform the necessary tasks of memory management, data transfer, and synchronization. A single NVIDIA GPU, when installed in a Dell server, will be around 72% of total cost, and might be suitable only for answering questions.

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The present long-term returns for U.S. equities are too low.

 

           Long-Term Logical Expectation                                   Actual Market 2/29/24                                

                                2%   Policy Rate                                                    5.33%                        

                                2%   10 year treasury premium                            -1.08%                 

                                2%    BAA corporate bond premium                     1.55%                  

                                1%    Equity risk premium (S&P 500=5096)       -1.81% *          

                                7%                                                                          3.99% 

                                * Assumes 1st quarter 2024 high in CAPE

                                   earnings = average $152.79.   

 

The 3/2/24 Economist writes, “Equities could underwhelm in many ways. Perhaps AI-exhilaration will cause a dotcom-style bubble that pops. Another war or crisis could lead to a crash. Or prices may stagnate in a gentle bear market that takes years to reverse.” What matters for holders of all long-term financial assets is that the financial system remains sound, and that interest rates remain quite low. We hope the U.S. voters will make the correct choice in November.

 

Value investors are obviously concerned with valuation. On 3/5/24 Bloomberg financial columnist John Authers wrote, “Valuation is more or less irrelevant when trying to predict the next year, but it’s everything you need to know to predict the next decade.” The following graph shows there is about an 83% correlation between current market P/Es and subsequent ten year returns. This graph uses an adjusted P/E.

 

 

During the California Gold Rush of 1848-1855, hundreds of ships were simply abandoned in San Francisco Bay as the sailors rushed off to the hills to make their fortunes. We aren’t going to participate in this new Gold Rush because the risks don’t presently justify the returns.

 

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AI is probably useful in intrinsically low variance process situations: like call centers, manufacturing, inventory control and parts of accounting. When the variance gets extremely high, say in short-term markets, you would want a human (trader) to have the final say.

 

Generative AI is a technique, a tool just like the much simpler ordinary least squares (OLS) in the graph above. It’s not a new industry, and certainly not a support for the entire U.S. economy; but this technology is also interesting in its own right. As a practical matter, Oracle (2024) writes, “It is important to remember that machine learning is a very iterative process, and the steps outlined in this book will be reiterated and improved upon many times.” AI won’t be a panacea.

 

 

3/21/24 -

 

Amar Bhidé is a finance professor at Tufts University. In the 6/1/21 issue of the Harvard Business Review, he articulated the difference between two different types for investors and what the economy requires. The article is, “Capitalism Won’t Thrive on Value Investing Alone.” If you invest in individual stocks, it is crucial that you know whether you are, by nature, a value investor or a growth investor. For, the high price of a stock will cause the former to sell and cause the latter to buy; and vice-versa.

 

In this article, he wrote:

 

“Investors fall into two camps: value investors, who base decisions on a careful analysis of revenues and costs, looking for steady performance, and growth investors, who place bets on risk projects with very high potential payoffs….

 

Start with their views of history. “The two camps have profoundly different views about history. Value investors share Ecclesiastes’ conviction: ‘What has been will be again, what has been done will be done again;…there is nothing new under the sun.’ They buy when their favored multiples – of profits, assets, cash-flows, rents per square foot, or whatever – are historically low and sell when the multiples are high. This world view in turn encourages investments in stable franchises managed by conservative executives who won’t deviate from the tried and true.

 

“For forward-looking growth enthusiasts, ‘history is bunk,’ as Henry Ford put it. Like the robotics pioneer…Seiuemon Inaba (and founder of Fujitsu Fanuc), they believe that for technological innovators, ‘The past doesn’t exist. There is only creativity, always looking to what is next.’ In this domain, comparisons to past valuations and multiples mean little and the eccentricity and unpredictability of visionaries like Tesla’s Elon Musk are hardly disqualifications….But even with careful research and great acuity, investors cannot reliably distinguish undepreciated gems from the duds. Buy tomorrow’s Teslas – and hanging on through stomach churning fluctuations – therefore requires an intestinal fortitude at least comparable to investing in out-of-favor stocks. For the growth investor there is no margin of safety and no comfort from cheap historical valuations….  (our note: The Silicon Valley motto is, ‘Move fast and break things.’)

 

But, “The dynamism of our economy also requires both sensibilities. (our note: Keynes said much the same. Bhidé, himself, is a value investor.) In Max Weber’s classic formulation, thrift is the bedrock of capitalism…And thrifty prudence which disdains this time it’s different rationalization, promotes the efficient exploitation of existing resources, releasing more capital for more investments. But capitalist economies would not survive just by investing in more of the same. Their adaptability, technological progress, and appeal to the human love for adventure, requires innovators whose dreams defy objective calculation of the risks and returns and investors with the guts to back them.”

 

This is why, for most people, the S&P 500 is a good investment because, unlike people successfully choosing individual stocks over the long-term, it partakes of both contradictory philosophies, leading to both stability and change for the entire economy. * But we are, by nature, value investors whose basic tendency is to value our investments. The S&P 500 at this writing, with AI enthusiasm permeating the index **, has much more the characteristic of a growth stock than a value stock. Diversified it may be, but the bias is clearly towards rapid growth. Is this growth justified over a thirty + year stock (payback) duration, we think not. Because at current pricing for a long-term 7% annual return, the market is assumed never to be cyclical, or if cyclical, consisting of only 7 tech stocks that will grow at twice the historical rate of the entire economy (consider our 1/29/24 posting). Given current problems with the climate and internationally, neither can really occur. The S&P 500 should get more into balance between value and growth, around a level of 2900-3600, before we would invest.

 

Not unreasonably, at some point, markets will ask for reality; for a reasonable analysis of a stream of (realized and/or realizable) profits. In the long run, capitalist markets are logical, as the graph above suggests.  add: Further, with a S&P 500 level of 5123, the percentage downward change (for a 7% return) in present value price, is close to the percentage downward change in actual market P/E (for a 7% return) – meaning that our S&P 500 present value model and long-term financial reality coincide.

 

 

 

* This is a really crucial point, as to the advantage of market systems over purely planned, dictatorial systems. According to Kroenig (2020), “Democracies have not made better decisions because they possess and process more (AI) data. They excelled because they used the data they had to consider multiple points of view, weighing pros and cons, and make sound decisions.  Dictators make poor decisions (think of Putin’s decision to invade Ukraine) because they dismiss, or are not even exposed to, contrary arguments.” This is the meaning of markets, and of a broad freedom. Financial markets and, dare we mention, political markets coordinate the manifold interests of society.

 

** We think that AI will make a difference in the economy, but over time. If you consider how AI will likely most contribute to growth, it will be in order of realized profitability:

 

·      Increased personalization through smart phone assistants.      

·      Fine tuning parts of operations (using domain specific large language models).                                                                                                                 

·      New service adjacencies (they had better be adjacencies).                                                                                                                               

·      New discoveries in medicines, materials, and robotics.   

 

It’s important not to change a long-term investment philosophy. The stock market is a really good test of that.

 

                                                                                                              

6/19/24 –

 

Long-term investors ought to be ultimately invested in both stocks and bonds, to maintain asset diversification – not to put all eggs in one basket.

 

Shorter-term investors such as institutions require, not only diversification, but also short-term quantitative risk control - risk defined mathematically as variance or volatility. To reduce portfolio volatility, managers look to negative correlations between stocks and bonds.  But the graph below shows only episodic negative correlations. Further, we would expect only a positive correlation between stock prices and bond prices due to changes in the cost of capital to the economy. What is the cause of positive or negative correlations? To investigate this apparently perplexing question we turn to an interesting technological tool:

 

Say you see in a publication a graph, that could come from finance, physics, biology or whatever. Using a computer program called WebPlotDigitizer (works with our O/S only on Chrome), you can requantize that graph, turn it into a general .csv file, and then apply analysis in Excel or other programs to find (according to theory or the common sense business situation), the relative importances of the independent (causal) variables – but remembering the maxim, correlation does not imply causality. We applied this program to the stock-bond price correlation graph in the WSJ 10/23/23, which depicts a three year rolling correlations with monthly price changes, and came up with these results for 80 years of data.

 

 

                                     Stock-Bond Correlations

                                     for the Years 1944-2023

                                                            

                          Average         Corr.     Yearly          Sign Inflation

   Periods       Correlations       Sign     Inflation ¹   Above Average

1944-1954           .18                  +         3.97%            +

1955-1967          -.15                  -          1.85                -

1968-2000           .35                  +         5.06                +

2001-2021          -.26                  -          2.24                -

2022-2023           .26                  +          4.45               +

For the Periods    .03     Yearly inflation 3.65% ¹

Excluding the Last                                     

 

¹ U.S. Bureau of Labor Statistics

 

Using a simple sign test, we have shown that an inflation above or below an average for the whole period explains whether stock and bond prices are correlated or not. High inflation causes a positive stock/bond price correlation, and low inflation causes the reverse. For the entire 80 year dataset, the correlation of stock and bond prices is .03, or effectively zero. In the future, we expect somewhat higher inflation than in the last twenty + years.

 

Amundi Asset Management is the largest asset manager in Europe. In April, 2024 they published, “Stock-Bond Correlation: Theory and Empirical Results.” Using a different methodology of financial economics, they reach essentially the same conclusion about the importance of inflation. This study also applies to the capital markets of other major countries as well, and notes, “…the stock bond correlation is mainly explained by the extreme market regimes, since the stock-bond correlation can be assumed to be zero in normal (whatever that is) market regimes.” This study is furthermore useful because it concludes, “...the stock-bond correlation is a parameter determined by both macro-financial fundamentals and (n.b.) investor perceptions. This assumption would explain why the stock-bond correlation varies so much across countries.” This observation has a cultural component that can be also applied to the present U.S. markets.

 

Since the Financial Crisis of 2008-2009, in a regime of declining interest rates, Wall Street and their computers have known one major formula, “Buy the dips.” This is a formula for ever increasing stock prices, although the market environment has changed. There is, however, another saying, “Trees Don’t Grow to the Sky.” Switching an investment philosophy to growth, particularly now, would not be a good move at all. If you haven’t already, please read the previous article and decide for the long-term, being also aware that pensions should be more conservatively managed.

 

 

7/2/24 –

 

Due to constant disruption, a unified risk-return profile of the financial markets is not possible. Therefore to deal with heterogeneous financial markets, Warren Buffet’s baseball analogy is the way to handle them. Swing for the ball if you like the pitch.

 

So what are the alternatives to a unified theory? In the U.S. equity market, the two choices are now very clear. Are you a value investor, concerned with the tides, or are you a growth investor, concerned with the waves. Its really recommended that you can’t be both because in a competitive situation, like in tennis, you have to play either at the baseline or at the net. You can’t be, “caught in the middle.” You will then lose. This is also how state politics is very different from international business, which is basically apolitical.

 

We are value investors, concerned with the value of stocks, where what you see is what you get. This website, however, studies the entire S&P 500 equity market. Having established a present value for that stock portfolio, it is now possible to consider the remainders, which contain interesting stories. With this type of analysis, stock prices are no longer mere fluctuations on a graph.

 

Mervyn King is a former governor of the Bank of England, and a graduate of Cambridge and Harvard. As a central banker, he was continually confronted with the question, “What is going on here?” His conclusion:

 

 “We live in a world of radical uncertainty in which our understanding of the present is imperfect, our understanding of the future even more limited, in which no one person or organization can hold the range of information required to arrive at the “best explanation”. Narrative reasoning is the most powerful mechanism available for organizing our imperfect knowledge. Understanding the complex world is a matter of constructing the best explanation - a narrative account - from a myriad of little details and the knowledge of context derived from personal experience and the experience of others.” ¹

 

The considerations of central banking are shorter-term. Stocks are long-term assets. The exhibit below graphs the present value definition of value (the red line), the beginning discounted the actual BAA rate of 4.80% + a 1% equity premium, against the S&P 500 Shiller earnings + growth. The end of the graph is discounted at 7%, a required rate. The range of 6-7% in the average annual S&P 500 equity return is not large, and thus we can substantially remove from stock prices long-term interest rate changes and can concentrate on shorter-term events, and thus construct a narrative of stock market changes.

 

 

Beginning in 6/2014, the S&P 500 followed our stock market model almost perfectly. But in 1/2017, something happened to the equity market, but what? The total return of the market in 2017 was around 22.1%. The Trump administration also reduced the corporate tax rate from 35% to 21%, also increasing the deficit. These were essentially one-offs. However, low interest rates continued (resulting in nearly free money for credit worthy borrowers) between 6/2014 and 12/2021. During that period, which included an economic shutdown and a massive COVID liquidity injection, the average T bill interest rate was only .52%². In 2017 investors finally began to react to nearly free money and increased earnings (2016 to 2017 operating earnings increased by 17%), by bidding up asset prices, including of course stocks, thus driving S&P 500 ultimately way above justified value, “buying the dips.”

 

But subsequently the financial markets at least exhibited some symmetry. To combat an increasing inflation that approached an annual rate of 9.1% in 2022, the Fed began to increase interest rates from a short-term T Bill rate of .03% on 1/2022 to 3.95% on 12/2022. The S&P drop reached 24% until 10/2022 when the S&P 500 started to increase again, in the face of still increasing interest rates that are now more than 5%.

 

Why would stock prices increase with greatly increasing short-term rates? That reason was the latest thing to entrance the market, generative AI. As we noted in a previous essay, “…it will take several years for the billions invested in generative AI to turn a profit.” Subsequent press articles (anecdote) and the U.S. Census Bureau (survey) note the same.

 

Press Article (WSJ, 6/17/24)

 

“When generative A.I. surged into the public consciousness in late 2022, it captured the imagination of businesses and works with its ability to answer questions, compose paragraphs, write code and create images. Analysts projected that the technology would transform the economy by driving a boom in productivity. Yet so far, the impact has been limited. Although adoption of A.I. is rising, only about 5 percent of companies are using the technology, according to a survey of businesses from the Census Bureau. Many economists predict that generative A.I. is years away from measurably affecting economic activity – but they say change will come. ‘To me, this is a story of five years, not five quarters said…the global chief economist at Boston Consulting Group.’”

 

U.S. Census Bureau (“Tracking Firm Use of AI in Real Time:, 3/24)  

 

 From an adjusted sample of 164,500 businesses (to inference the entire population), the Census Bureau found, “…that the fraction of firms using AI is relatively low but rising: from about 3.7% at the start…AI use is expected to rise further to about 6.6% by Fall 2024. There is enormous variation in current use by sector from a low of 1.4% in Construction and Agriculture to a high of 18.1% in Information….larger businesses are more likely to use AI.

 

All the information we have suggests that the growth of generative AI use will be a lot slower than Wall Street anticipates, which is an immediate doubling of real economic growth in perpetuity (forget about the details). We would certainly not bet our equity portfolio on the continued rapid growth of one cyclical semiconductor company, which seems to be holding up the entire market – that has become impervious to large interest rate increases and to the principle of diversification.

 

Our long-term target for the S&P 500 is 2937, without the consideration of AI. Our 1/29/24 analysis placed a 3669 upper bound level for AI valuation. But we would like to see how AI develops and to also consider market behavior as well. Finance is one of the most quantitative business areas; there are lots of numbers; but you have to know what to add and what to divide.

 

In 1720, Master of the Mint, Sir Issac Newton said, “I can calculate the motions of the heavenly bodies (today’s orbital mechanics) but not the (short-term) madness of people.” Sir Issac lost a fortune of £20,000 on the Great South Sea bubble. ³ At that time, wages were about £1 per month.

 

 

 

¹ John Kay and Mervyn King; “Radical Uncertainty (Decision-Making Beyond the Numbers)”; W.W. Norton & Company; 2020; p. 410.

 

² To calculate the average short-term T-Bill rate between 6/30/14 and 12/31/21 we divided all the data into six significant periods: (6/14-12/16), (1/17-1/20), (2/20-3/20), (4/20-12/21), (1/22-9/22), and (10/22-6/24). The average T-Bill rate (simply calculated within each of the first four periods) was only .52%.

 

³ Charles Kindleberger; “Manias, Panics, and Crashes”; Palgrave McMillan; New York, N.Y.; 1978, 2011; p. 47.

 

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John Stepek, senior reporter for Bloomberg, has written an article that well summarizes the risks of investing in generative AI; we don’t, however, agree with all of the article. He references an extensive Goldman Sachs study that features Daron Acemoglu, professor of economics at MIT and Jim Covello, head of global equity research at Goldman Sachs. If you are further interested in generative AI, its worth reading.

 

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We don’t worry about the effect of a general market decline upon our portfolio because it is presently configured almost totally for income *, with about 26% in money market cash. Only 2.7% is, essentially (for fun and profit), in risky venture capital type investments.

 

The market is gradually getting the idea that the economy will not grow forever, the economy being fundamentally cyclical. This has always been our assumption.

 

 

*Which can be either saved or spent.

 

   

       

 

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