Debt and wealth in a monetary system, part 2: discounted valuation issues in a declining frame with inequalities.

We are presently building up conflicts within the asset price frame:

  • Conflicts between asset values and GDP flows and their growth rates;
  • Between asset prices and return expectations;
  • Between human capital values and the distribution of those values and their impact on the overall wealth equation with respect to future consumption risks as well as asset pricing via increased asset focus of flows due to distribution dynamics;
  • Within portfolio structure and relative to the liquidity and capital security dynamics of liability streams. 

All of this tied to the relationship between frame transitions, emergent properties and structural imbalances and unconventional monetary policy focused overly on asset price support.

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No need to worry!

I recently came upon an article entitled “What You Can Do About The Upcoming Stock Market Crash”.  The title was tongue in cheek and perhaps unfortunately so given recent events.  Nevertheless, it made a number of important points about the difficulty of knowing when a market is at its peak and when a market is at its lows, and of knowing in which direction and by how much a market is going to move at any given point in time.  Much of this I agreed with, but not all:

When you think about it that risk and fear will always be there no matter how far the market goes up, down, or sideways. So what can you do?

Be prepared for a crash at any time. If you need to withdraw money in the next few years or you want to cushion the blows, then you need to diversify your portfolio with enough bonds, cash, or other assets that won’t fall along with the stock market.

Once you figure out what is right for your current situation you don’t have to worry about what happens because you are controlling the risks instead of letting them control you. That means you are safe to invest your money today and start earning your way to the freedom you want for yourself and your family.

Points 1 and 2 noted above are more or less correct, but the last point I have emboldened is where I diverge.  You are never ”controlling” risk, just diversifying it relative to return, and if possible, its covariance, itself a function of risk.  You cannot control risk, only minimise its impact through structure.  You are certainly not safe to invest your money today and there is no guarantee that you will earn your way to freedom. 

Return is an important consideration when accepting risk and many today who use simple mean variance models assume that expected returns are invariant and that risk is only volatility around this return.  In a general equilibrium, random, independent price movement model it does not pay on average to delay or defer investment (any benefit is purely attained by chance), but even here you are hostage to the probability distribution since the expected return in Monte Carlo land is only the average of many outcomes, some of which turn out to be quite disastrous from any level.

But expected returns do matter and while timing your investment to maximise your returns and minimise your losses is impractical and impossible for the market as a whole to do, making value judgements about market valuations and economic cycles to inform you of the boundaries of return and its significance is I believe worthwhile if you possess the expertise..  Where people run into trouble is where they either lack the knowledge and expertise to make the type of judgements needed to define the boundaries of expected return, and its impact on structure, as markets and economic cycles mature or react to market falls and meteoric rises as if one is the end of the world and the other its never ending bliss.

Deferring new risky investment at high market valuations is a value call and a discipline, but it is an act which relies on knowledge of the significance of valuation differentials.  It is one of my concerns that “we” have been taught that we should invest in markets at all times irrespective of the valuation, the cycle and the specific characteristics of either.  One of the reasons the world has been through innumerable crises since the late 1990s is because we have ignored significant accumulating structural economic and financial imbalances and the differential between asset valuations and economic fundamentals.  In a well balanced world we could probably ignore valuations and invest at will, ignoring volatility. 

But then again context is everything.  While one may not invest/sell at cyclical highs/lows there is little reason to sell all (high) and then attempt to reinvest all (lows) at perceived key turning points.  Portfolios should adjust to the relationship between valuation risks and the time frame of their liability profiles and it is here where we need to pay attention to valuation risks since these do have material impact.   As markets rise returns fall and the risks to the ability of assets to meet future needs increases, and vice versa.  When returns and risks pass barriers of significance that is where changes at the margin need to be made.  It is therefore not a question of timing but of tangible discipline and its benchmarks.

And, of course, I believe we are in the middle of a very long period of global economic and financial fragility, so safe is a word I would eschew for some time.

Critical perspectives on US Market Valuations 2…includes 17 charts

Many say that lower interest rates should raise asset valuations by lowering the rate at which future income streams are discounted.  This may be fine for high quality government bonds where coupons are fixed, but is not necessarily the case for equities where we are dependent on future flows (earnings, dividends, economic growth, CAPEX). 

What is the major determinant of long term real equity returns?  Earnings growth, and long term earnings growth is dependent on real economic growth.  If we look at real growth rates they are falling, and have been falling for some time.  This is part of the reason why interest rates have been falling; that is to accommodate falls in nominal and ultimately real flows.

The following shows annualised annual growth rates over rolling 15 year time frames (in other words geometric returns) compared to the Shiller Cyclically Adjusted PE ratio:


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A wider narrative is needed to fully frame risk for longer term investors

I read Dan Bortolotti’s “3 Reasons to ignore market downturns” last week and the more recent Jonathan Chevreau’s “If you can’t take the pain of plunging markets, don’t watch”.

They both pass some genuinely rationale advice…if you have a long term portfolio structured cognizant of risk then there is no point in reacting to a boundary you have already accepted you will cross numerous times.   But just what are the boundaries that you have accepted and just what are the risks since it is the context in which the statement is made that matters?

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Underfunded pensions..not such a slam dunk

I picked up the link to the following report on twitter: THE FUNDING OF STATE AND LOCAL PENSIONS: 2013-2017

The report stated that the funding status of state and local pension funds was at some 72% of liabilities and would likely rise further assuming a return to historical returns.   The report did look at current funding liabilities under a range of equity return scenarios none of which were as low as many pundits (Hussman, GMO and myself) would model.   The lowest return figure of 4% (all assets combined) would yield a liability with a net present value of $3.8trn or circa 22% of current GDP or 32% of personal consumption expenditure ….this translates into my vague assumption that if future GDP rates are based on current consumption, then future return assumptions would need to incorporate pension fund liability shortfalls.  

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“The future is now”

I have stolen a line from John Hussman’s most recent market commentary.  Like most who are focussed on valuation, Hussman is not concerned about how much stocks can rise or fall at any one point in time, but to what extent, or not, prices have discounted future earnings growth.  This is translated into an estimated total return that is likely available from stocks based on current valuations, expected future growth in earnings and an assumption regarding an appropriate valuation range. 

All decisions today are effectively based on an assumption about the future, so the future is always now, but when valuations are at extremes, inappropriately structured portfolios are exposed to the future.

There are three portfolio management mechanisms that need to be borne in mind as markets and risks peak and these are a) the return assumptions you use to project asset/liability modelling and management planning and decisions going forward, b) the extent to which your asset and liability management is impacted by the longer duration of short term economic and market risks to return and c) the extent to which you adjust asset allocation to take account of the longer duration of short term risk and the narrower margin of return on risky assets.

I do not believe that any of a, b or c are market timing exercises per se because our view is not now but the future – in other words the future is now.  I also believe that managing risks to return and the ability of assets to meet future and especially near term liabilities as markets peak to be a natural economic mechanism for managing consumption/production and savings/investment balances.    

The portfolio allocation should match the economic allocation!

A brief thought on market valuations

As I work my way back into the mental state required to hold the data points I just wanted to make one key point.   Many have commented on the pointlessness of market timing and therefore the pointlessness of listening to those who believe that a large negative market movement is around the corner.  I have never been one for wholesale market timing transactions, but I do believe that high market valuations impact one critical dimension of the portfolio and need to be treated with respect.   The higher a market is valued, in an out of equilibrium world, the lower the future expected returns.  Therefore, without an adjustment for future returns the liability demands  on the portfolio (which have likely been revised higher due to higher portfolio values) will place undue and increasing stress on the portfolio’s ability to meet those returns, especially in the event of an eventual market adjustment.   As markets rise and as the time frame of significant market risk extends, for a given level of liabilities, it makes sense to adjust asset allocation towards lower risk/fixed return asset classes.   We cannot ignore valuations and we cannot ignore their impact on the management of income and capital liabilities over time.    

What is investment risk?

“What is investment risk” is both simple and complex and in order to assess the information needed to assess risk we first of all need to qualify the world view of risk and return and then the model we are using to manage the risks and their impact. All this is beyond the subject matter expertise of the individual investor and why point of sale documentation can only ever inform about the broad nature of risk and return but never be sufficient to allow the investor to fully own the decision. Ownership of the transaction decision resides with ownership of the process and the significance of risk assumed with respect to risk via structure, assumptions and costs.

At a very basic level, risk is what happens to a price between two points in time and the impact of that movement in price – it can be both positive and negative.  But what gives rise to risk is more important than a mere list of risk factors, or indeed a narrow quantitative measure of risk.

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Long run predictability of asset prices..

Robert Shiller and Eugene Fama were two of three academics who won the Nobel Prize for economics for different accounts of asset price predictability: the former regarding its bounded long term predictability and the latter regarding its short term unpredictability.

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From the Credit Suisse Global Investment Returns Yearbook 2013…

“The high equity returns of the second half of the 20th century were not normal; nor were the high bond returns of the last 30 years; and nor was the high real interest rate since 1980. While these periods may have conditioned our expectations, they were exceptional. The long-run averages documented in this Yearbook provide a more realistic guide to the future.

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Asset allocation in a financial crisis..

Portfolios with liability demands need to be run along liability tracks with a greater sensitivity towards a) liability risks in terms of benchmark allocations to risky assets and allowed for deviations from those benchmarks and b) cyclical market and economic risks and especially significant structural risks that could materially impact returns on risky assets.  

It is more what portfolios do in terms of adjusting allocations given liabilities profiles as risky asset prices inflate, than what portfolios can and cannot do in a risk event when asset price declines have pre-empted any possible move.

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Stocks are never cheaper..according to the Federal Reserve Bank of New York

“We surveyed banks, we combed the academic literature, we asked economists at central banks. It turns out that most of their models predict that we will enjoy historically high excess returns for the S&P 500 for the next five years. But how do they reach this conclusion? Why is it that the equity premium is so high? And more importantly: Can we trust their models?”

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Risk and return from the back of an envelope and….we may well have a bubble..

Quantitative easing is designed to bring forward asset returns before we get the economic returns, in the hope that the confidence and increased wealth generate demand in the real economy. By its very nature its objective is to create a bubble in asset class valuations in the hope that the bubble drives the real economy forward

It is possible that markets have got well ahead of themselves, and could well be in bubble territory. 

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Debt and the risks of debt to expected returns..

This  is the historic picture of debt accumulation in the US relative to nominal GDP growth:


This is another perspective:


Real GDP growth since 2000 according to BEA data is some 1.57% per annum (2000 to 2011), which covered a time when debt accumulation exceeded nominal GDP growth. Continue reading

Growth dynamics have changed a bit and are in between times…

Historical equity returns reflect past growth dynamics, dynamics which may be either weaker or in transition, or both – indeed, dynamics in mature economies are weaker, and combined global dynamics are in transition.  Return expectations need to be cognisant of these structural drivers of return.

The main drivers of growth are well known: a) population growth and employment participation rates, b) capital investment and c) increases in total factor productivity, or rather efficiency gains from the combination of a and b. Continue reading

The reverse yield gap and the long bond/nominal GDP growth dynamic

Bond yields used to be lower than equity yields, and significantly so, up to the 1950s. The reversal of this relationship during the late 1950s, a reversal which peaked at the end of the 1990s, helped provide a significant revaluation of equities during this period.  Many a long term equity return expectation has been built upon the reversal of the original yield relationship.

The following charts use US data sourced from the Shiller/Yale dataset to highlight this input to historic equity returns and risk premium.


And of course, the same goes for the more pronounced earnings yield relationship (Shiller/Yale source data): note the earnings yield/ten year bond yield ratio: Continue reading

“It’s time to reset your investment assumptions”..says the Globe and Mail. But is it, and should it be up or down?

Is it really time to reset your return assumptions downwards? A Rob Carrick articlein the Globe and Mail suggested that it might be so.

Revising return assumptions down after poor stock market returns is a Bete Noire of the financial services industry.  All other things being equal, and depending on your paradigm, you should be revising them up after a period of poor returns.

But you cannot revise upwards if your return assumptions were too high to start with. If you have relied on historical average returns or risk premiums to set return expectations you have also more than likely failed to adjust for cyclical and structural risks in markets and economies. Continue reading

What return assumptions can we expect going forward?

The major driver of stock market returns, all else being equal, is earnings growth, which while not totally equivalent to nominal GDP growth, tends to exhibit similar rates of growth. 

Gross revenue should more or less increase at the same rate as expenditure based GDP growth, even though earnings growth will differ due to changes in corporate taxes, depreciation factors, cost cutting and productivity factors.

From December 1966 to December 2011, real US earnings growth (source Shiller data) rose by some 1.85% per annum, while real GDP growth (BEA data) has been some 2.02% – all figures are geometric averages.   Nominal GDP growth had averaged 6.65%.   

Total real return, going forward, based on this data would be 1.85% per annum + the dividend yield (close to 2%).  So for say the US, if the future were to represent the past, we would expect non compounded real returns of 3.85% per annum: compound real returns would differ, but not everyone receives compound returns, especially those living off their assets.  Continue reading