vinod1

William White probably wrote it best about Macro and specifically NOT to think of economy as a machine like Dalio: The fundamental problem is that modern macroeconomics is based upon a false belief: namely, that the workings of the economy can be understood and therefore closely controlled, as though a machine in the competent hands of its operator. A philosopher would say that we have made a profound ontological error. We have failed to realise that what one can know about a system depends upon its very nature. And the nature of our economies is simply too complex to be understood, much less controlled. Consider that the analytical frameworks generally accepted by central banks totally failed to see the crisis coming or, despite concerted and persistent action, the weakness of the subsequent recovery. That alone should have been sufficient to raise some fundamental analytical questions. Moreover, support for scepticism is provided by reviewing the actual practice of monetary policy over the last 50 years. Every aspect of it–including its objectives, instruments and indicators–¬has been subject to repeated change. Generally these changes have been in response to previous policies failing to deliver the intended results, or producing unintended and unwarranted side effects. In short, monetary policy has systematically got it wrong. There would then be nothing unwarranted about another fundamental rethink in response to recent events. One approach with promise is to think of the economy not as a machine, but as “a complex adaptive system” with millions of interactive and adaptive agents following simple behavioural rules. Such systems characterise car traffic, movements of crowds, the spread of crime and disease, social networks, etc. These kinds of systems are everywhere in both nature and society, and exhibit recurrent instability and highly nonlinear outcomes. Does it make sense to assume that the economy, with all its flows and myriad interactions, should almost uniquely fail to exhibit these traits? Vinod

They might not last forever, but they might last long enough that betting on reversion to mean in profit margins might be an expensive mistake. Vinod

Regarding monetary stimulus: Pushing on a string and all that from Dalio, et all. Is this not his central point about deleveragings and 80 year cycles, that monetary policy is ineffective in a such a case? That it does not do much to growth? Do not want to argue too much about this, let us agree to disagree. I am quoting everything from memory but data is from the philosophical economics blog. I would urge you to read it. There is a ton more of detail and data that make a rather strong case to support my view. The earnings growth in nominal earnings (the start date is 1967 :) I just do not want to give you a point to argue about inflation helping out in this case. :) ). Vinod

Tax rates had an impact but not in the way one would generally think. Profits from foreign operations of US companies has increased as a percentage of total profits. Further foreign tax rates are lower than US. US Corporates profits from foreign operations have increased roughly by about 2.5% of US GDP compared to historical averages. Take GM for example, it gets $2 billion in equity income from Chinese JV's. Most of these sales dont show up in revenues, just adds to overall profits. This is extreme case to show the impact on net margins/sales, but think of all the tech companies profits from abroad. In these tech companies case, it shows up in net margins, but when you look at profits/(US GDP), it adds to the numerator but not the denominator. If you look only at domestic US corporate operations and foreign companies US operations, profits have not nearly been as high as when you look at overall profits. They are roughly only around 30% or so higher rather than the 70% levels when you look at overall profits. Tax rates have declined domestically as well. So if you look at domestic operations (of US and foreign companies), pre-tax levels are only about 20% higher than historical average. So we are now down to explaining the 20% gap over historical average. Interest rates had a bigger impact as well that accounts for more than half of the 20% gap. So if you put it all together 1. Profits from foreign operations have increased in importance compared to past. 2. Profits abroad are taxed at a lower rate. 3. Lower interest rates had an impact around 3/4 the size of 1&2 This is evident from the distribution of profit margin gains from a sector and size perspective as I already mentioned in earlier post. This is the most damming piece of evidence. Now as Krugman would say, I do not have the courage of my complacency. There is no doubt there are structural headwinds (emerging market governments and companies are not likely to sit still forever while US and other developed market companies make out like bandits, increased taxes, etc) to profit margins. But these would take decades to play out. I think we have enough data to show that we need to be cautious (like Buffett) but there is no need to panic (like Hussmann). Vinod

Here is my general approach as far as risk management is concerned 1. We cannot really protect ourselves from risks of much greater severity than the Great Depression. Really guns and ammo and that kind of survivalist stuff. So I just leave this alone. 2. Risk of similar magnitude to GD are possible but very unlikely. So I keep a portion of my portfolio in cash (I-Bonds bought at 3% real yields and above) in nearly all circumstances. This should help me carry me through a similar occurrence. Sure this is suboptimal if GD scenario does not play out. A lot of stuff has to go wrong for this scenario to play out. Since this is very unlikely I only tie up the absolute minimum that I would need in such a scenario. 3. The rest of my portfolio, I just ignore GD type scenarios. I invest in simple Graham and Buffett manner. I try to bake in pretty negative scenarios in my baseline case and I end up with IV estimates lower than most others. I buy when they are at a discount and sell when they reach close to 90% of IV - except for a few "exceptionals" that I hold even if they are a bit richly valued. Vinod

I think overall Dalio's framework makes sense in describing the past. It is I think a good framework for thinking about the future with two exceptions: 1. The long term debt cycle (the 50 year to 80 year cycle). As I have mentioned earlier, how many cycles did we really have, especially where we have reliable data? At most it is 1.5 cycles in US. It is a stretch to expect it to repeat based on such limited data. Here is how Dalio refers to as cycle: A cycle is nothing more than a logical sequence of events leading to a repetitious pattern. In a market-based economy, cycles of expansions in credit and contractions in credit drive economic cycles and they occur for perfectly logical reasons. Each sequence is not pre-destined to repeat in exactly the same way nor to take exactly the same amount of time, though the patterns are similar, for logical reasons. It is to the expectation of repetitious pattern that I object to. There is a sense of near inevitability to this which I do not agree with. I believe that we (including central bankers and politicians) have learned from the Great Depression and Japanese experience, so that in itself might invalidate a "pattern". I, for one, am very impressed with the way Bernanke and Paulson responded to the credit crisis. This is in no small measure due to experience gained from Great Depression and Japan. So future might play out quite differently from the past. Even if the pattern holds true, can we really say for example, how the next 10 years or 20 years are going to play out? It could just be that cycle needs another 10 or 20 years to turn. If that is the case, our bet would be right eventually but it might take 10-20 years to play out. How can we be really confident in any such estimate. This is a general problem with macro. You get to make a bet and you would have to wait many many years for it to play out to know if you are right or wrong. How long should one wait to say they are wrong? The entire portion of the portfolio dedicated to this approach would be either a huge win or a loss. So over an entire lifetime you get to make 3 or 4 macro bets at a maximum. If we follow someone who had success in macro, it could be from 2 or 3 successful macro calls. How can we separate out luck from skill in this case? 2. No attention is given to the distribution of debt within a society. Debt in general would not be a problem regardless of the absolute level under one condition. This is the case because one man's debt is another man's asset. The problem really occurs because of uneven distribution of debt in society. Denmark had one of the highest household debt ratios in the world in 2007 at 267% of income. US was 125% at its peak. But default rates peaked at 0.6% in Denmark where as they were 12% in US. This is because the debt is concentrated mostly in high income households in Denmark and mortgages were limited to 80% of value of property. So just because debt has increased does not tell us a whole lot were we are in the cycle and how it is going to play out. Are you not making a bet that you know (a) that there is such a thing as an 50 or 80 year cycle (b) you know how it is going to play out © you also know the timing of it, and (d) the market has not priced this in. If you are wrong about anyone point either (a) or (b) or ©, or (d) portfolio returns would be unsatisfactory. Vinod

I would argue that falling profits (and therefore falling margins) had a LOT to do with the sell-off in stocks in 2008/9. That was, in fact, mean reversion. The fact that it didn't *last* was down to huge stimulus. And if people had correctly diagnosed the original high margins (as being caused by too-low interest rates) then they would also have predicted that, with huge stimulus, margins would bounce back to new highs after the crisis. Point being, there's macro and there's the policy response to macro and you have to look at both together. But I believe you were right to worry about aggregate margins and that they will eventually mean revert. I try to stick with market sectors where margins are not above long run norms. Mean reversion of profit margins is a core cherished belief of mine for 10 years from 2004 to 2014, when I finally let go of that notion. I wasted much effort reading arcane economic and other papers related to this, so I can say with some conviction I was wrong. Stimulus can mean fiscal or monetary. So l will take one at a time. Fiscal Stimulus: If profit margins are due to say fiscal deficit as GMO and others have made a case. It was debunked both in theory and in actual results. Fiscal deficit has dramatically been cut down from around $1.4 trillion range during the crisis years to less than $500 billion now. Profit margins have increased even as the fiscal deficit has come down. Last 15 years there is a sort of negative correlation instead of positive correlation between these two measures. Monetary Stimulus: There is this notion going around that the federal reserve pumped money into the system with QE and that money is causing financial assets to be bubbly or you seem to be pointing it to increase in profit margins. Both of these notions are false. Fed has essentially engaged in a massive security swap. Banks have swapped their mortgage and long term treasury bonds to Fed and in turn Fed has credited them with reserves on which it pays 0.25%. So the Fed is essentially acting as a massive commercial bank to the tune of $4 trillion in assets on which it earns around 3.5% and it pays 0.25% to fund those assets. It is generating $100 billion annually from this. So all it did was reduce interest rates at the long end of the treasury bonds and in mortgage bonds. No money has really leaked into other assets nor did it cause profit margins to rise. Any effect it has is indirect via lowering of interest rates and causing people to choose to hold more risky assets and thereby increasing their valuations. So I do not think profit margins are impacted by stimulus in a material way. One more way to look at this is to look at distribution of profit margins across all the companies. 80% of the companies did not see any profit margins at all. Many have declined in fact. The profit margin expansion is concentrated in 20% of companies, many in technology and some in financials (obviously not the banks). The suspicion is that this might be due to winner take all economics in these fields. If this is true it can persist for a very long time and may or may not ever revert. Ok. Let us say even now you are not convinced about the fallacy of mean reversion of profit margins. What has happened the last time profit margins got cut down it half? The last time there was a long term shift down in profit margins over a 20 year period, coming down from 12% to 6%, what do you think happened to earnings? They increased 10% annually over this 20 year period, when profit margins got cut in half. So there are multiple ways in which worries about profit margins can be be resolved without earnings getting wacked. Vinod

Hey Vinod, last post of the night for me :) When I first started investing, I wanted to know why I could find so few stocks that fulfilled Graham's requirements. Then I stumbled across that 100 year Schiller PE diagram which seemed to make more sense than the index charts because it explained where people lost money. The thing that struck me about that diagram was how high above historic norms the Schiller PE had been the past 40 years. If that was true, 2 generations of investors had entered the markets with a fundamentally unsustainable picture of equity returns relative to historic averages. So while you may not agree with my long-term worldview, you can at least understand why I hold it - according to my worldview there should be investors like yourself who view the last 40 years as a sustainable reality where stock-picking without macro insights is safe, whereas Dalio was born in a different reality where said investors had been annihilated by the 70s fallout and commodities was the only game in town. Given that my worldview explains both I tend to give it more credence, but I am always open to correction. My main goal for now is to enhance my asset value to be prepared for a day when I too can hopefully ignore macro - although I hope to ride the commodities wave first. FWIW - Soros' annualized returns exceeded Buffett's. I cannot do justice in anything less than a 20 page missive. So I would urge to read Philosophical Economics blog. Especially the posts about profit margins and Shiller PE. I do not think investors got burnt in 70s or any other period by following value investing. Superinvestors of Graham and Doodsville article by Buffett gives at least a few people who did well. Vinod

petec, I think our views are much closer that I thought. I do think current environment of high valuations, leverage and the many central bank interventions point to an environment of elevated risks. The way I would approach this is by incorporating it into my valuations. So to take BAC for example, in my baseline scenario, I have factored in a long period of likely very low rates (the average length of financial repression is around 22 years and we are in year 8). So that leads to a low estimate of IV. But as long as I can get it at a discount that I am comfortable with to my estimate of IV, I am going to buy it. Also I am not going to hold a business (unless it is of exceptional quality) if IV starts getting close to 85% to 90%. Other than that I am trying to tune macro out. On profit margins, I got lucky because the financial crisis caused market to go down. It did not go down due to mean reversion of profit margins. So I was right for the wrong reasons. So it was a mistake on my part and if not for luck, it would have been a major mistake that could have cost be very dearly. That again happened in 2011. If not for the banking crisis, I would have very low allocation to stocks. So again a major mistake. In investing, doing the same thing again and again, we can get different results. :) Thanks Vinod

Our views are so far apart that discussion would likely not yield much. If you could, I would love to hear more about why your investment philosophy has changed and what influenced that. Thanks for bringing William White to my attention. I spent quite some time reading up many of his writings over the last one week. My views are pretty much in alignment with him which is not a surprise since he seems to be influenced by some of the economists I like as well. Vinod

I think marco is a waste of time but it is good to be knowledgeable about it, just so you can spot nonsense when you see it. If anyone is interested here is what I would recommend and no these would not tell you what would happen in the future, just the concerns are not so much that we just have to huddle up in gold and ammo. 1. House of Debt 2. Balance sheet recession - Richard Koo 3. The Great Rebalancing - Pettis 4. End the Depression Now 5. Philosophical Economics blog These guys know what they are talking about and importantly with exception of Krugman, are not crusaders trying to hoist a particular view. They let you make up your mind by showing why their point of view is more supported by data than their opposite view. Thanks Vinod

William White had excellent papers that show you why macro is dangerous. He points out that central banking (and by implication macro) is mostly art rather than science. He notes that what is thought of as good policy has changed several times over the last 50 years and often these policies are dramatically different from past policies. So he says we need to be much much less certain about our macro theories. Since they are quite likely to be invalidated after a period of time. There are other problems as well. Take the example of 50 to 75 year debt cycle. Do we really have data to support that? We hardly have 100 to 150 years of good data that is two cycles. Can we really try to form a theory based on something that happened twice and really only in one country? How do you know if the cycle is really ending since the range is 50 to 75 years. If it is only 50 years, it can last 25 more years. So we patiently wait out 25 years to know if that theory works? The current state of macro is such that we just do not know much. Those who think they know, are only fooling themselves. Vinod

Somebody said this, might be Howard Marks. The hardest time to invest is always right now. Put yourself in any moment in the past century. There was always something terrible happening that seemed like it was going to tip us over the edge of the cliff. And every bad time seemed uniquely bad. But I suspect that, outside of a giant meteor hitting the earth, the global economy will survive whatever adversity is thrown at it. If you look at the 20th century, in every decade there is something extraordinarily worrisome (WW I, WW II, Great Depression, Cold War, Vietnam War, Inflation in double digits, etc.), but the markets have moved higher and individual stock picking worked. Even valuations are an unreliable guide as to what the markets are likely to do in the future. Cautious optimists have thus fared much better than pessimists. I think those who are macro concerned about QE, Debt and Deleveraging would likely have had similar concerns in the past and tilted their portfolios likewise to their detriment. Buffett I think would not have had the record that he did, if he let his worries affect his portfolio. From my own experience, I learned to ignore macro. In 2001 I was reading up Shiller, Smithers and Grantham and those concerns have kept me to a low equity level. I had dollar cost averaged over 2001 to 2004 and did reasonable well. So far so good. Then again based on these guys concerns about profit margins and housing bubble, I reduced my allocation significantly from 2006 and by 2008, Q3 I had only around 35% in equities with BRK and FFH being large holdings. So when markets collapsed I invested heavily as that took care of my concerns around profit margins and valuations. By 2010 markets again rallied and in early 2011 I reduced my investments again due to concerns about valuations and profit margins. But as financials went down in 2011, I invested heavily in them despite my concerns about macro. Looking back I had been dead wrong about my concerns about profit margins. Fortunately the financial crisis bailed me out in 2008. The markets went down due to the financial meltdown and that had nothing to do with my concerns about profit margins. Again the financial stock meltdown bailed me out in 2011. Otherwise I would have missed most of the market gains. If euro crisis and mortgage concerns have not come up, I would have been sitting out the market rise due to concerns about profit margins, etc. Now, I see where Smithers (Tobin Q, executive compensation, etc) and Grantham (profit margins unadjusted for changed in accounting, market structure) got it wrong. I can completely understand why Buffett has said: Forming macro opinions or listening to the macro or market predictions of others is a waste of time. Indeed, it is dangerous because it may blur your vision of the facts that are truly important. Show me an investor who spends time thinking about macro and I will show you a portfolio that underperforms the market. Vinod

Like Internet for example. Oh, wait... or Microchip GPS Google Vinod

One more factor to think about when thinking of indexing vs. picking stocks is one's conviction level. For me, I have more conviction (whether in reality that is true or not is an entirely different question) in my ability to assess the earnings of an individual company than in my ability to assess the earnings level of an index. So I find it easier to hold an individual stock in face of severe market losses than an index fund where I have lower confidence. If an index investor does not drink up the kool aid that long term it is going to be ok - I am not talking pejoratively, it is a very effective strategy if you just believe in it - then it does no good to the investor since he is likely to panic and sell at the wrong time. Vinod

Vinod, Tx. I recall reading your notes in conjunction with Security Analysis when I reread it a few years ago. FWIW, Canada's markets are in a bear, with energy, banks, and services all being hit, energy the worst obviously. I have no holdings of US companies right now, and moved all of my margin cash over to Cdn. dollars. I hold SSW but it is not really a US company with its offices in Hong Kong and Vancouver. So, I am still a value investor. I didn't even do this on purpose. The deals in Canada were just better from a Canadian currency perspective. For example the price for RY, and FN present a more compelling value than BAC, and I will get paid to wait. Keeping in mind this is from the perspective of a person operating in Canada. Our dollar will rebound at some point. From a rebounding Cdn dollar perspective a Us stock has an extra 30% hurdle rate. I have definitely shifted to a "being paid to wait approach". With that I am accepting lower likelihood of homeruns, but also lower risk. Al, Makes sense. A 30% currency headwind is too big a hurdle to overcome. I too have taken a lower risk approach by eliminating LEAPS almost entirely and moving up the quality curve in companies, the vast majority of which are happen to be decent dividend payers. Vinod

Vinod, I respect you a lot, but analogy arguments don't necessarily work. We are not in a huge bubble like we were in 2000 although market is a bit overvalued perhaps. My concern is that the argument is "just continue trying for another year and then another year and then another year". Of course, it all depends on a person. If they believe that past 5 (or whatever) years of underperformance was due to market running up from the bottom and it's going to change now, then perhaps they should keep trying. Although, I am afraid that there is a lot of rationalization. In 2013-2014 it was "index is running up too fast, I can't keep up, all stocks are running up without differentiation". In 2015 it was "index did not run up, but was kept up by FANG, value stocks were slaughtered". At which point should investors face the facts and realize that the issue might be them and not what index did? Anyway, I am not saying that people who have underperformed should jump to index right now. I share some concern that this might be wrong time. But like somebody said keeping doing the same thing and expecting different outcome may indicate foolishness. Or it may indicate strong belief in the method that may be rewarded. Or not. ;) Choose your poison wisely. Peace. Jurgis, I do not disagree one bit with what you have written. Current market is no way comparable to that in 1999 either in terms of overvaluation or dispersion in market values. For most of 2014 and 2015, I thought pretty much everything is closer to fully valued, very little opportunities (at least among the companies I follow) and actively dissuaded some friends from picking stocks and put them in index funds. The market action over the last few weeks, opened up a few opportunities and that I think value investors are likely to benefit from. My comments are more directed towards UCCMAL, who I know is a good investor and who I learned a lot from. I am just trying to point out to him that this might be wrong time to give up on value investing. Vinod

UCCMAL, I was investing in index funds from 2001 to 2005. I was a strong proponent of EMH at that time and spent a lot of time studying various finance topics - EMH, factor models, behavioral finance, historical asset class returns, valuation models, etc. As I studied behavioral finance and watched markets and participants, my faith in EMH weakened. At the same time, the expected returns from markets are looking very low. My estimate at that time was if we are lucky we would get 5% to 7% returns and there is a possibility of lower returns. So I started looking at alternatives to indexing and found Buffett and then Graham. As the financial crisis was starting I sold off the last of my index funds and have been investing on my own in stocks. I mention all this to just highlight that I spent 7-8 years in indexing and another 7-8 years investing directly in stocks so I can sympathize with both approaches. I think indexing makes sense for vast majority of the people. But to the inhabitants of Grahamsville, inoculated with teachings of Graham, value investing is a worthwhile and lucrative approach. Expected returns are again in the 5% to 7% range over the long term for the markets. This is a hurdle value investors are likely to overcome. An equal weight of the largest 10 stocks in S&P 500 returned 20% while the remaining 490 stocks returned around -1% in 2015. We have seen this movie before in 1999. The following three years turned out to be among the best ever for value investors (relative to market) as far as I can remember. Given the market level and expected returns, given the opportunity set currently available, I think this is a pretty good time for value investing. Anecdotally also, what can be a better time to be a value investor then many value investors are under performing the market and the market is just coming off a 200% return from bottom? Vinod

Aside from impact on global warming and renewable energy, I cannot think of a single negative to low oil prices. I have no idea about #5, but I do not think #1 to #4 are correct. As to why low oil prices are good, this has been addressed 170 years ago in this letter. http://bastiat.org/en/petition.html Vinod

If you want to understand some of the behavior read "Pedigree: How Elite Students Get Elite Jobs". The book itself is very good and would be useful if you have kids. http://www.amazon.com/Pedigree-How-Elite-Students-Jobs/dp/0691155623 Vinod

Great opportunities might come even if a general market crash doesn’t happen. Think about the recent rout in the pharma and biotech industry. If you hold a company that is very diversified and very well hedged against the gyrations of the stock market, you can sell it when some great opportunities present themselves. I agree with Eric that in a general market crash FFH might not prove to be a good cash equivalent, but in almost any other circumstance I think it could serve that purpose quite satisfactorily. In fact I would say FFH will be a better substitute for cash, if no general market crash comes our way. If, instead, we will continue to witness crashes circumscribed to specific sectors (energy, biotech, whichever will be next), I guess FFH will be a fantastic substitute for cash: because, as Eric has pointed out, the effect of a slow compounding machine will be added to the great optionality cash offers. Cheers, Gio I am a lot more paranoid than you about the risks to FFH (inflation, catastrophic losses, etc) to consider it as a cash equivalent. Vinod

My point is, if you see FFH as a portfolio diversifier, I can understand but as a cash substitute I am not so sure. Vinod

The assumption that FFH would do spectacularly well in crash might not hold. Prem Watsa has a view of how the crash might happen (heavily influenced by the the great depression and the Japanese crash) and optimized FFH for that particular view of the world. If crash happens say due to inflationary reasons - FFH would likely suffer just as much as others. Of course, it seems like nearly everyone seems to discount inflationary risks. Or do 100 year storms come only from what everyone worries about? Vinod

Per efficient market theory the reason for Third Avenue funds under-performing the benchmark beyond the expense ratio must be because they are taking lower risk than the markets :) :) The only other reason that efficient marketeers could point to - idiosyncratic risk - I would think should tend to be close to being eliminated over the very long term. Larry Swedroe (the author) had the most influence of me before I found Graham and Buffett and I am pretty familiar with his writings. I participated in many online discussions with him and he was very generous with his time. My comments above are partly tongue in cheek and I think he has made many excellent points. But he also goes a bit extreme - suggesting that Buffett has no outperformance once we adjust for a new factor (quality). Vinod

If you had to chose between the McKinsey book and Damodaran's book, which would you chose? Did not see this until now. I would pick Damodaran's book. To me the terminology is a bit more intuitive. But you cannot go wrong with either one. Vinod