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Can someone convince me we aren't in for a decade or two of no return?


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https://money.cnn.com/magazines/fortune/fortune_archive/1999/11/22/269071/

 

http://fortune.com/2017/12/07/corporate-earnings-profit-boom-end/

 

http://www.thelatremoillebegggroup.advisor.news/say-goodbye-to-the-stock-markets-secret-sauce/?c=eyJ0eXAiOiJKV1QiLCJhbGciOiJIUzI1NiJ9.eyJub2RlX2lkIjoxMjcwLCJwcmV2aWV3IjpmYWxzZSwiY29tbV9pZCI6MTAyNjAxNiwiZGVzdF9pZCI6MTQ2MTgxNn0.WRb9-ttgdUxehrodcEhRoGMC8eBFprnIMgH7eIXjpdo&fbclid=IwAR3k7trLBMiBJK7xIv6DGCNg0q0CzLH9FAs0-qRM0gT3uo8w958HKlMmwzY

 

 

Friedman and Buffett both say you can't have corporate profits growing so much faster than GDP. Check, happening now. 9%-10% (way above average) versus gdp growth of at best 2-3%.

 

Rates are ultra low still at 2.5 to 3%. This is obviously different than 1999 when rates were 6% and PE on SP was 30x.

 

But today it's around 20x and profit margins are huge. But it could all be due to low rates and tax breaks.

 

Sure, the bubble could double before the next 10 to 20 years of 0% return.

 

A big difference is the chronically low rates and high debts. Does this mean financial repression and low rates is a scenario unlike any other in history and likely to persist?

 

 

 

 

 

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There hasn't been "financial repression". Low rates signify policy has been too tight, not too easy.

 

That said, with lower RGDP growth and 2% inflation going forward, multiples will be a lot higher than their historical average. Stocks are about fairly valued right now (assuming the Fed can keep NGDP on a 4% growth path and not batch it like they did in 2008)

 

 

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What has the above with your stock picking to do?

Your question hurts so it must be a good one.

The obvious answer is nothing.

But.

 

I guess the point that Mr. Buffett was making in 1999 was to differentiate expected returns and realized returns and this may have something to do with the two components of returns: fundamentals and sentiment especially if the end point is shorter term.

 

And this is a question that an individual investor needs to answer for every stock selection by going through some set of investment criteria within a certain opportunity set.

 

But what is an investor to do if opportunities are trickling down?

The obvious answer is to expand the opportunity set and/or to "improve" criteria but isn't a big risk (not conscious) to lower return standards and to adopt the general public's expectations?

 

In the last few days, I read reports from Chou Funds and Patient Capital Management, two funds that I respect. It seems that I looked at many "picks" that they made in the last few years. Opinion: In the last 5 years, they likely lowered their standards and would have been better off returning funds to shareholders or investing in short-term government bonds, given their specific opportunity set.

http://choufunds.com/pdf/AR%202018%20ENG.pdf      (page 2 for returns)

http://www.patientcapital.com/calendar-year-returns#chart3

 

Also, another value-related aspect is that Mr. Chou and Mr. Maida are not the only typical value investors underperforming. In the last few years, riding financials, energy and commodities without catching the information technology wave likely hurt results on a relative basis.

https://alphaarchitect.com/2018/12/11/after-a-lost-decade-will-value-get-its-groove-back-in-2019/

 

So, the idea appears to be to keep your eye on the ball and, of course, one shouldn't mind others' prodigy.

See, I was able to produce a full post without writing the word bubble.

 

mjohn707, in another thread, recently suggested that the enlightened value investor should engage with lower expectations and I would say this is not a quixotic advice.

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When people ask Buffett if the stock market is over valued his standard response is to start with long term US government bond yields. The US 10 year yield is currently at 2.4%. My read is stock averages are not crazy expensive. There is a chance the 10 year could go below 2% (if the Fed stops QE, cuts rates and starts QE3). This will support even higher stock prices.

 

This is not to say this is what i expect to happen. However, i think the probability of the 10 year falling below 2% is higher than Mr Market thinks.

 

Free money will likely result in asset prices (stocks and real estate) going much higher than people feel is rational or possible.

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I guess the two questions I have are

 

Why are profit margins so much higher now than historical averages of 6% on the high end , and even lower on the low end? And can it last ?

 

And if we should look to the future of rates, while we never know, would someone invest at high pe now because rates are going to be lower for longer or , if they double , then it's likely at today's prices an Investor gets no return . Buffet doesn't seem to be buying at these prices, except a few value stocks and maybe his own stock. Seems he fears higher rates to come, even though he says not to predict rates he isn't selling public stocks or buying them (except banks which do well with higher rates potentially and are value stocks atm)

 

some counter arguments -

https://www.bloomberg.com/news/articles/2019-03-07/fed-and-ecb-confront-a-new-normal-that-looks-a-lot-like-japan-s

 

https://www.businessinsider.com/james-bullard-fed-zero-interest-rates-forever-japan-growth-2015-9

 

 

 

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I find looking at what others are doing as helpful.

 

For instance, Dan Loeb is waging war on family owned, Campbell's Soup. That tells me quite a bit about what he thinks of the US markets and their expected returns right now.

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I think your concerns about stock valuations are warranted.  My own expectation is that the long term returns on the S&P will be above zero but not by much.

 

The high level of corporate debt IMO is more of a short/mid term (i.e., < 5 years) issue that could potentially turn what would otherwise be a minor economic slowdown into something more painful.  I don’t have a strong opinion on this but I will note that a lot of bond experts seem really bearish on this. 

 

All this being said, I don’t think the US will end up being like Japan.  Japan has its unique problems, the biggest of which IMO is that their companies have a tendency of not doing what they’re supposed to do in a capitalistic system, which is to maximize shareholder value.  Watch out if we get a “socialist” government though!

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We've been through a decade? of deliberately artificially low interest rates, & extreme quantitative easing to avoid the next great recession. So ... if we include that history as a predictor of future events, are we not saying that we expect these historic conditions to continue?

 

If we 'forecast' the future as just a series of short-term events, this might even essentially be true. Whitehouse pressure today to ease rates in response to economic slowdown; repeated tomorrow, and the next day, and the next. If we 'forecast' that over a period of time we should get back to historic rates, it might be true in the 'long-run'; but we're all dead! The short-term momentum (technical analysis) view versus the long-term value (fundamental analysis) view.

 

So what? If would seem that if your investment horizon is very long; one should be betting on mean reversion via leveraged derivatives, and on the party continuing via long positions. Graham went broke waiting for the market to turn his way; we don't have to - we have derivatives that Graham DIDN'T have.

 

If rates go up, only cash wins. BOTH equity multiples AND bond values go down

But there is no reason that cash can't actually be a bar-bell allocation of cash + derivatives, al la Taleb  ;)

 

SD

 

 

 

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Base rates.  The average return for the market is 10% per year.  The average volitility is 18% a year (despite the name this is a standard deviation).  Going 15 years into the future: 1.1^15=4.17.  So the market is on average expected to appreciate 317 percent over 15 years.  The standard deviation of that appreciation is .18*sqrt(15)= .7. This is not exactly correct because vol is correlated but is imo ok napkin math.  -3.17/.7= -4.5 standard deviations which implies a probability of occurring of less than .00005.  Does the particular circumstances of the s&p today really shift your beliefs so much such that something that has a .00005 chance of happening become what you expect to happen?

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When people ask Buffett if the stock market is over valued his standard response is to start with long term US government bond yields. The US 10 year yield is currently at 2.4%. My read is stock averages are not crazy expensive. There is a chance the 10 year could go below 2% (if the Fed stops QE, cuts rates and starts QE3). This will support even higher stock prices.

 

This is not to say this is what i expect to happen. However, i think the probability of the 10 year falling below 2% is higher than Mr Market thinks.

 

Free money will likely result in asset prices (stocks and real estate) going much higher than people feel is rational or possible.

 

But this is simply not true. Historical data shows little-to-no correlation between interest rates and P/Es. Further, Europe has significantly lower rates and significantly lower P/Es. I don't know where Japanese equities sit today, but they also have had significantly lower interest rates than the U.S. and have been at a discount to U.S. equities for much of the last decade.

 

If interests rates are low because inflation is stable, it tends to be a positive. If interest are low because growth is low, it tends to be a negative.

 

It's inflation that matters. Not rates. And what we're seeing is the first tell-tale signs that wage inflation MIGHT be picking up. Last time I looked, it was trending near 4% for 2019.

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I don't think it will be no return but I wouldn't expect much more than inflation.  Over 20 years though, inflation is going to cut your cash in half so that is something to think about.

 

I don't worry about profit margins being peak, there are too many variables.  Some industries are just going to have higher profit margins.  Certainly you would never expect a middleman such as a retailer to have similar profit margins to some patent holding company.  So if retailers start crashing and you end up with a greater percentage of higher quality companies then profit margins would move up in the indexes.  You can see how that metric can be difficult to analyze.

 

I do agree that the US valuations are high in general and that is the concern but it can remain like that for so long, look at the 90's.  The question is, is it 1995 or 1999?

 

Outside of the US, markets aren't expensive and the past growth has been very weak for over a decade.  However it's a mixed bag as the government debt levels are very high.

 

TLDR, it is complicated, stay invested but keep some money as a hedge.

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Base rates.  The average return for the market is 10% per year.  The average volitility is 18% a year (despite the name this is a standard deviation).  Going 15 years into the future: 1.1^15=4.17.  So the market is on average expected to appreciate 317 percent over 15 years.  The standard deviation of that appreciation is .18*sqrt(15)= .7. This is not exactly correct because vol is correlated but is imo ok napkin math.  -3.17/.7= -4.5 standard deviations which implies a probability of occurring of less than .00005.  Does the particular circumstances of the s&p today really shift your beliefs so much such that something that has a .00005 chance of happening become what you expect to happen?

 

The tricky thing is that stock returns, viewed as a univariate process, don’t appear to be i.i.d.  Instead, a sequence of very high returns tends to be followed by much lower returns - just as most value investors would predict.

 

If you have the inclination, you can actually go fetch some data from Robert Shiller’s website and see this for yourself. 

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I guess Buffett was looking at historical margins which pre-dated many IP and internet businesses. But I get his argument that the growth rate of profit margins as a % of GDP cannot exceed the growth rate of GDP over the long term which includes the aforementioned companies plus much more.

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Base rates.  The average return for the market is 10% per year.  The average volitility is 18% a year (despite the name this is a standard deviation).  Going 15 years into the future: 1.1^15=4.17.  So the market is on average expected to appreciate 317 percent over 15 years.  The standard deviation of that appreciation is .18*sqrt(15)= .7. This is not exactly correct because vol is correlated but is imo ok napkin math.  -3.17/.7= -4.5 standard deviations which implies a probability of occurring of less than .00005.  Does the particular circumstances of the s&p today really shift your beliefs so much such that something that has a .00005 chance of happening become what you expect to happen?

 

The tricky thing is that stock returns, viewed as a univariate process, don’t appear to be i.i.d.  Instead, a sequence of very high returns tends to be followed by much lower returns - just as most value investors would predict.

 

If you have the inclination, you can actually go fetch some data from Robert Shiller’s website and see this for yourself.

 

So there is some correlation between returns as I did mention as a disclaimer, and there are ways to take into account autocorrelation (HAC/HAR).  However, I don't want to spend that much time on actually doing this, but, you can clearly see, the p-value is so low, it's likely the same condition will hold true.  For example, even if you doubled the 15-year volatility the p-value would be around 5%. 

 

Another way of thinking about this basically you are assuming real growth will contribute -50% growth commulatively (off of todays 100%) in 15 years as I think you have to assume around 2% inflation every year.  Are valuations 50% to 33% overvalued currently, and at the same time is productivity not going to grow at all over 15 years.  It's easy to look at outside information and see high CAPEs and PEs and say the market is overvalued, but compared to the magic of compounding, valuation within normal ranges hardly matters going over long periods. 

 

If productivity grows 2%, population + increased share of capital grows 2%, and inflation is at 2%, that's 6% growth per annum which is 140% growth over 10 years.  Even if the market is only worth half what it is trading for right now, in 15 years it still should on average have grown by 20% (on our original current 100%).  This is why I never try to market time.  It's simply not worth it to assume my outside information is enough to outweigh the massive effect of compounding. 

 

Edit: One more thing, even if volatility was 100% correlated which it is the most it can be for all 15 years, this equals a volatility of 360% which implies that using my original 10% growth rate average you are still -.9 standard deviations below the mean which implies that getting a constant return or worse has a base rate of only 18%. 

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cameronfen:  Let me see if I understand your view correctly…  Do you believe, based on the information that we currently have, that the expected annual return on the S&P going forward is 10%?  (Just to be sure, note that this question is about the conditional expectation, and has nothing to do with volatility.)

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If you top ticked the S&P 500 in 2007 and held all the way down then back up to present, you'd have averaged something like 7.5% a year. 

 

I don't think stocks are nearly as expensive now as they were in 2007, so i'll throw my guess in the there and predict that stocks will do about 7 or 8% a year over the next decade. 

 

Also don't see a recession on the horizon at the moment, of course that involves some guess work on the intentions/future actions of the Fed, so take it with a grain of salt.

 

As cameronfed alluded to, multiples should be higher going forward. The standard average 16 P/E Ratio occurred when nominal G.D.P. averaged over 6% in the 20th century.

 

I think N.G.D.P. will be more like 4% going forward, so multiples will likely be higher...and current multiples are justified on a long term basis

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cameronfen:  Let me see if I understand your view correctly…  Do you believe, based on the information that we currently have, that the expected annual return on the S&P going forward is 10%?  (Just to be sure, note that this question is about the conditional expectation, and has nothing to do with volatility.)

 

The 10% number is the average return of the market over the past 100 years.  It's an unconditional expectation.  I then adjust down to the return expected 0% over 15 years and suggest how far away from this average return you have to be for your outlook (i.e. conditional expectation) on the world to make sense. 

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If productivity grows 2%, population + increased share of capital grows 2%, and inflation is at 2%, that's 6% growth per annum which is 140% growth over 10 years.  Even if the market is only worth half what it is trading for right now, in 15 years it still should on average have grown by 20% (on our original current 100%).  This is why I never try to market time.  It's simply not worth it to assume my outside information is enough to outweigh the massive effect of compounding. 

 

Your math is wrong. 6% growth leads to +80% after 10 years. -50% of that and you are at a negative return (1.8*0.5=0.9) and that is after inflation. You can think about valuation a little different, historically the S&P500 dividend has grown by about 2-3% real per year (after inflation). It currently yields 1.8%, so without valuation change your real return is 4-5%. Compounded over 10 years this leads to your stash being 55% in real terms. Crash by 50% and you are negative again. Cash currently yields more than inflation, so you are better of just holding cash and wait. When you are lucky and the next recession and bear market is just 24 months away (which the yield curve inversion points to) you will be a lot better off.

Personally i just hedge, because 5% alpha > 2% cash yields and i am really happy that i do it this way. Buts thats just my approach to the current situation.

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cameronfen:  Let me see if I understand your view correctly…  Do you believe, based on the information that we currently have, that the expected annual return on the S&P going forward is 10%?  (Just to be sure, note that this question is about the conditional expectation, and has nothing to do with volatility.)

 

The 10% number is the average return of the market over the past 100 years.  It's an unconditional expectation.  I then adjust down to the return expected 0% over 15 years and suggest how far away from this average return you have to be for your outlook (i.e. conditional expectation) on the world to make sense.

 

Thanks for the explanation.

 

My baseline view at this time is that expected future returns are around 4% nominal. Compounded over 15 years that leads to an 80% gain. So if we get unlucky in year 15 and have a > 45% drop we will end up with a < 0% return. The likelihood of that happening is not high but not negligible either IMO — probably between 0.1% and 1% if you believe in normality and higher if you believe in fat tails.

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I think CBs don't want to play the bubble game but the politicians - on purpose or unwittingly, as well as continued lowflation are doing everything possible to generate one. Why do we always say after something like a Great recession we will never blow bubbles again, and yet we always keep doing it?

 

 

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The last two recessions (2001 and 2008) caused 50% corrections in the stock market. The 2001/2002 was just a garden variety Recession by the numbers, yet it caused a severe correction because it was preceded by bubble valuations.

 

I guess one way to frame the question by OP is to ask yourself how likely is another 50% correction in the next 10 years? If we get such a correction, results overall may still be positive, but most likely they won’t be great.

 

Also, I have mentioned this before, I think the next stock market rout may well be caused by political events. We have populist movements in almost any country now, so it will be harder to predict what the political environment will look like. For example, we have now almost 40 years of tax reductions for corporations in most countries, starting in the 80‘s basically, which helped valuations tremendously - what happens if voters decided that it didn’t work for them and decide let’s try the another way around? That’s just one example of political risk, another one is trade wars, elimination of trade blocks and free trade. All of the above are common themes with politicians.

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You cannot talk about expected returns without factoring in required returns. It has a big impact on valuations.

 

Most just assume that since the realized returns were around 6.5% real over the last century or so, that is also what investors would/should require going forward.

 

Think back to the time around 1900, people started hearing about Dow Jones averages for 5 to 15 years at most. They had very little data on the stock market and not much information to form an opinion on what returns to expect.

 

Most importantly to put together a portfolio of 20 to 30 stocks would have been very expensive that consumed a significant portion of the expected returns.

 

So the 6.5% real returns that investors realized would have been more like 4% or 5% real, because of expenses (transaction costs, fraud, cost to physically secure the paper certificates, etc).

 

Now we have practically cut down on the expenses to zero and a widely diversified portfolio can be put together easily at the click of a button. I would think that probably reduced the actual cost paid by the investors by 2% or so compared to the 1900s.

 

In addition, I would also argue that the economic/political risks are much less than in the past. So that would require even less of required return.

 

If you put all of these together, I think the required real return for investors is going to be much less than in the past. I do not know how much, but 4% real does not seem to be too outlandish to me.

 

Put this into the valuation and you might get a much less scary picture of the valuation.

 

But the fact remains that we have less than 150 years of stock market data. If you believe long term to be 20 to 30 years, then we have non-overlapping sample size of 5 or 7.

 

Hardly the amount of data that you could use to draw conclusions. Maybe in another 1000 to 2000 years we would be a better position.

 

But to me, at this time with the data we have, to draw strong conclusions about market valuation based on such short data set seems to be unwise.

 

Vinod

 

 

 

 

 

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