January 2015: What Doesn't Fit?


What Doesn’t Fit?

The perspective we have gained from more than 30 years of investment experience, and the lessons we’ve learned along the way, sometimes cause us to take a step back and ask ourselves, “What do I see here that doesn’t quite fit?  What does it mean?  How will it impact investments and our portfolios?” In the investment world, things that make sense to us do not capture our interest nearly as much as things that do not make sense!

Here we describe our top three “misfits” in the investment world. Working our way up the list:

Number 3: Desynchronization. Third on our list is the “Desynchronization of the Global Economy,” a phrase coined by George Friedman, author and Chairman of Stratfor Global Intelligence.   That is, an increasingly synchronized world economy is now experiencing de-synchronization.

Over the past 20 years, individual countries’ economies have become increasingly integrated—linked together and mutually affected by good times, bad times, struggles, and opportunities of each country.  Internet accessibility has all but erased barriers that once isolated national economies and protected jobs within those economies. In 2005, Thomas Friedman (in his book, The World is Flat) explained the impact of the internet, correctly predicting a leveling of the global economic playing field. In such a global, integrated economy, the major economies tend to move in sync.

Now, we notice an anomaly in the form of de-synchronization. Today, we observe the U.S. economy improving, while the other three largest economies are losing steam.  In the prior year, China experienced markedly slower growth, European growth stagnated, and Japan was in a recession.

This is an oddity that catches our attention.  Is the trend toward increasing global connectedness unraveling? Will the world become less globally connected? Or is this a temporary aberration, and the world’s four largest economies will again continue converging?  Furthermore, if they converge, will it be toward growth or toward recession?

Number 2:  Quantitative Easing. Our number two head-scratcher is the scheme concept of printing massive amounts of money to stimulate the economy Quantitative Easing (“QE”).  Quantitative Easing has no mechanistic relationship to making the economy grow.    Near-zero interest rates did not, as hoped, foster borrowing for the purpose of capital investments that increase the production of goods and services.  It did, however, serve to boost asset prices as investors shunned zero-interest cash holdings.  Investors tried to rid themselves of cash (which cannot be done; it can only change hands) by buying stocks, bonds and real estate investments despite their ever higher prices.  As prices rose and valuations reached nose-bleed levels, a cycle of positive feedback justified encouraged still more speculation.

One of the lessons we’ve learned is that correlation is not necessarily causation. Just because two things move in step with each other, doesn’t mean one necessarily caused the other. For example, the advancement of our ages (don’t those birthdays sneak up quickly?!) correlates very highly with a rising stock market.  Despite this correlation, our getting older did not cause the stock market to rise (or vice versa). Even though there is a correlation between increasing amounts of Quantitative Easing and increasing economic growth, it doesn’t necessarily mean that QE caused an increase in growth.

The science of economics is actually more like art masquerading as science, notwithstanding what economists, politicians and the talking-heads on CNBC would like you to  believe.  If the scientific rigor of the methods used by a surgeon were as inexact as those used by the Federal Reserve when determining monetary policy, the chances of surviving surgery would be on par with flipping a coin.

Number 1: Investor Complacency. Our top head-scratcher for 2014 is investor denial complacency in the face of simple arithmetic.  Today’s lofty prices mean one of two things:

  1. Valuations will eventually return to normal causing future returns to be low (because stock prices have declined) or,
  2. Today’s high stock market valuations will continue indefinitely and there will never be a return to normal valuations.

If stock market valuations return to their historical average over the next five years, the math shows that stock returns (dividends plus price changes) will average about -1.7% per annum, even if earnings and dividends grow by 5-6% per year!  If earnings and dividends remain flat, annual returns for the next five years would be about -6.9%.  The arithmetic speaks for itself—perhaps that’s why some people prefer instead to ignore the math and pretend that high valuations will stay that way forever.

Geek Notes: (if math makes your head hurt, feel free to skip this part.) Anticipated future stock market returns can be calculated using history and some basic math.

 The earnings growth rate is assumed to be the average since 1980, or 5.7%.
 The Shiller Cyclically Adjusted Price/Earnings ratio is 27.2; the historical average is 16.6.
 The current dividend yield for S&P 500 is 1.92%
 The projected time period for return to normal is 5 years.

The arithmetic of S&P 500 stock market returns:
 Price change = (1+ earnings growth rate)*(future PE/Current PE)^(1/time period) -1
 Plus Dividend returns: average of current dividend yield and future dividend yield, or

 Price change:  [(1+0.057)*((16.6/27.2)^(1/5))]-1  = -4.24% per annum for five years.
 Dividend return: 0.0192*((27.2/16.6)+1)/2 = +2.53%
 Total Return = Price change + dividend return = -4.24% +2.53% = -1.71%

Keep in mind that during the past 130 years of stock market history there have been only two instances of higher stock market valuations than today: the run-up to the 1929 crash, and the run-up preceding the 2000 meltdown. (Note: Current valuations now surpass valuations leading up to the 2008 financial crisis.)

Narratives to help people rationalize what they want to believe always accompany extreme valuations, like now. There is never a shortage of people willing to tell people what they want to hear provide a cozy, warm blanket of denial. However, we know how those prior episodes ended and we know that today’s narratives promoting complacency and denial will also prove to be specious.

This simple truth is that high valuations portend low future returns on the horizon.  That’s just the way the math works.  However, the good news is that this axiom applies to a passive investment strategy, e.g. a “buy and hold” strategy, but not necessarily to a strategy of proactive asset allocation. A proactive, flexible asset allocation strategy, like ours, allows us to reduce stock holdings when valuations are high, as we have done, and increase stock allocations when the prospects for low-risk, high-return profits reappear.

Investing Today

As we look back on the past year, we see a stock market valued at dizzying heights, exceeded only in 1929 and 2000.  Throughout the year we have cautioned that exceedingly high stock valuations portend low future returns.  Our caution remains steadfast, even more so as prices have risen and valuations have been stretched even higher.

Nonetheless, last year’s rising stock market caused us to ask if, perhaps, we should have invested your and our portfolios more aggressively.  Restated, should we have abandoned our concerns and sought to more fully participate in stock market gains? Or, as one client suggested, “Can’t we speculate just a little bit?” We could, but only if we want to be “a little bit” negligent remiss in our duties to our clients.  Instead, we choose prudence, learning from the recurring lessons of history, and abiding by our fiduciary responsibilities.

Conclusion

Some of life’s lessons are curious, yet they can also serve as valuable lessons for investing.  For example, “Patience is a virtue.” (Notice that the adage is not “Patience is a hindrance.”)  Patience is also a discipline.

"We must all suffer one of two things: the pain of discipline or the pain of regret or disappointment."  – Jim Rohn

Our commitment to you is to guide your portfolio to the best of our ability using our experience, our understanding of financial principles and history, and our judgment.

We thank you for your continued support and business and wish each of you a Happy, Healthy, Peaceful and Prosperous New Year! ***

Greg Schultz & Bruce Grenke

© Asset Allocation Advisors, Inc. 2015