Before I begin, if you have never read the Philosophical Economics blog, written by Jesse Livermore, go do that right now. Read them all. It may take quite some time, it usually takes me a day or two just to read a single blog post, with an additional day or two to digest, but it is worth it. I have stolen (Thank you Jesse) a few different ideas about investing from his blog posts, including my favorite economic/market indicators, of which I track every month to get a sense of where we have been, where we are, and where we might go.
With that off my chest, I wanted to try and think (Yes sometimes it is a challenge to think after I read a post of his) through Jesse’s most recent post entitled: Diversification, Adaption, and Stock Market Valuation. No, I will not go paragraph by paragraph and give thoughts, instead, I want to focus on the notion that US equities have become, are perceived as, and may continue to be, less risky compared to in the past, and what does that mean for us.
The following excerpt from Jesse’s post illustrates what I am talking about:
Over time, markets have developed an improved understanding of the nature of long-term equity returns. They’ve evolved increasingly efficient mechanisms and methodologies through which to manage the inherent risks in equities. These improvements provide a basis for average equity valuations to increase, which is something that has clearly been happening.
So let’s briefly go over some of the improved efficiencies, mechanisms, and methodologies (Full explanations are in Jesse’ post):
- The time needed, risk, and cost of investing have been greatly diminished.
- In 2017 we have the benefit of over a century of market history which gives us increased knowledge and confidence when investing.
- Central banks and other policy-makers seem more than willing to step-in and help markets survive particularly nasty downturns.
The theory goes that we SHOULD have to pay more (From a valuation standpoint) for stock exposure now. We have too many advantages in today’s world compared to an investor back in 1950. Using item #1 from above as an example, it’s like a see saw. As the costs to gain stock diversification have decreased, thus increasing investors net return, in theory, the market corrects itself by increasing valuations so that the net return to the investor remains similar to when costs were higher, as well as to stay in-line with the risk/reward trade-offs of other asset classes and investments.
In a vacuum, it makes sense that we would pay a higher price for lower risk (Part of that is behavioral since as a species we try to reduce risk wherever possible), given similar outcomes, but we are not in a vacuum. There is another side to this coin: Returns.
If you believe what was laid out in Jesse’s article, then you must also believe in one of two ideas:
- That there has been a permanent shift in US equity markets, creating a new “normal” valuation range and that “normal” returns for the foreseeable future will be lower than the past (Say by 2-3%)
- That we are simply in another period of paying higher prices due to demographics, low interest rates, home country bias, etc. for lower future returns.
This is our quintessential fork in the road.
Will stocks really return 2-3% less per year over the next century? What are the implications of this? Will we have to save a lot more than current retirees to achieve financial independence? Will wage growth increase to compensate? Will other asset and goods prices decrease to compensate? Will inflation remain low to compensate? Is this really a permanent shift? Is this time different?
Jesse’s article makes great points. I have heard Larry Swedroe make similar points as well when discussing the increased valuation range of the last 25 years. Some I agree with and some I do not.
The cost to investing argument makes intuitive sense to me. As an investor, my hurdle rate is roughly 2% lower today compared to 75 years ago, so I can understand why expected returns would be lower from this standpoint.
On the other side, I question if central banks will always be there as market back-stops. This reminds me of Pascal’s Wager. If you plan on central bank policies to always take care of deep market drops and recessions, and they do, great. However, if they do not, real panic and devastation could ensue. I also believe that eventually these policies will be scrutinized and will be replaced by something “better”. Markets have a way of learning and subsequently over-coming our defensive tricks over time. I believe this argument makes sense in the current environment, but looking out into the future, this becomes something I would not always want to rely on.
Increased knowledge is definitely a benefit in our current time:
We say that stocks should be expensive because interest rates are low and are probably going to stay low forever. The rejoinder is: “Well, they were low in the 1940s and 1950s, yet stocks weren’t expensive.” OK, but so what? Why does that matter? In hindsight, investors in the 1940s and 1950s got valuations wrong. Should we be surprised?
Part of me wonders if market knowledge would have really mattered back in the 1950s though. Maybe investors didn’t get valuations wrong? Maybe they just didn’t care? Retirement was still a pretty foreign concept. Not only did most people work longer back in the 1940s and 1950s, but they also made up a smaller percent of the overall population compared to today AND their “retirement” was a much shorter period. Investing in stocks becomes much less important when you only need 8 years of income versus 17.
I also have a hard time agreeing with Jesse’s network of confidence argument here:
In terms of price risk, this is what your rear view mirror looks like:
Sure, you might get caught in a panic and lose a lot of money. But you’ll get it back in due course–history proves that. Importantly, other investors are aware of the same history that you are aware of, they’ve been exposed to the same lessons–think long-term, don’t panic. They therefore have a basis for similar confidence. The result is a network of confidence that further bolsters the price. Panics are less likely to be as reasons to panic, and more likely to be seen as opportunities to be taken advantage of.
I agree that on the margin, some investors may, psychologically speaking, be better equipped for the next market downturn, but before 2008, the previous chart looked like this:
There were still plenty of investors who lost confidence in 2008, so it is hard for me to believe that this one last recession will be the reason for a mass number of individuals to start behaving better as investors.
Lastly, what if a market drop is not what tests us as investors in the future? What if something else challenges us behaviorally?
As always, my guess is that this time is both different and not different. There are always different “micro” reasons (tech bubble, housing crisis, inflation, depression, etc.) that cause investors to perform the same act on the “macro” level, fleeing equities. But given the above, how can this happen? What will an investor in 2075 look at in the 2017 period to describe us as uneducated? My best guess? The Fizzle and No Bang Theory (I am working on getting this trademarked of course).
Much of stock history is littered with large drops that shake investor’s confidence: 30%, 40%, 50% up through 90%. Those are the types of losses (Draw-downs really) we have always studied and learned to guard against. As Jesse Livermore pointed out though, we (Investors, policy-makers and institutions) have learned from them. We have a perspective on those losses now that no other investing generation had. The amount of clean data we have today to study market history is unparalleled. This is precisely why I do not think any “run of the mill” 30-50% market drop will change the recent, “new normal”, high valuations of stocks.
My guess of course is that what Jesse is describing for the future, comes true.
Imagine a scenario where we have a prolonged period of low returns (In comparison to the past). Imagine if US stocks start to exhibit corporate bond returns. Imagine we look back in 15 years and we have earned roughly 3%-4% a year, in nominal terms, from US stocks. Would that justify paying 25-30X earnings? Maybe. My guess is that investors would get frustrated and would flee US stocks for “greener” pastures. Maybe that is international markets, maybe that is real assets, maybe investors buy actual corporate bonds because the returns are too close to justify taking on the increased capital risk. Things like this have happened before.
Here is one of my favorite charts from Jesse Livermore, Household Equity Allocations:
As we can see, way back in the mid 70s through late 80s, equities made up a much smaller piece of household’s assets compared to today. Of course this money had to go somewhere, and housing is where it went (For the most part).
In the following chart, we can see Household Home Equity Allocations:
Makes sense that when the interest rates on a mortgage are anywhere from 8-16%, you probably want to payoff that bad boy as quick as possible. The charts are essentially opposites.
Now I do not think that this scenario is exactly what will happen? No, but I do think we forget just how unique certain financial periods are.
My opinion is that we are in a yet another unique period that will be studied 50 years from now, much like how we studied the Great Depression or inflationary period of the 70s. It is plausible to envision a scenario in a decade from now where a mortgage will be 5-6% and over the previous decade (2017-2026) US stocks had returned 3-4%, nominal, per year.
Financial advice will quickly become to “Pay off your mortgage with extra savings” instead of today’s, “Buy a market-cap weighted index fund with extra savings”.
What Jesse is predicting, in terms of future returns, is precisely what might disprove the “new normal valuation” theory in my opinion. It is an ironic thought, but could be possible.
Thank you Jesse for always making me think about things way too much.
Have some fun out there!