Buy and Hold

I’m not against buy-and-hold indexing. It deserves a place in some portfolios in your 20’s, 30’s and 40’s. My main problem with it is that very few people can hold on through the kind of drawdowns that happen every few years. They’ll say they can handle it, and sincerely mean it. You can give them suitability questionnaires, personality profiles, and any other kind of test. You can promise to hold their hand through tough times. But when half their life savings disappears within what seems like a matter of weeks, and they were counting on that money to reach their dreams, almost everyone gives up. They typically will regret it later because they probably sold near the bottom. But their reaction was natural and predictable. I don’t see the value of setting up yourself or our clients for that outcome.

Buy-and-hold strategies presume you can remove greed and fear from the equation. That is possibly true for a few highly educated, disciplined people. Not most, or anything close to most. Investors are human. They have emotions. Those emotions aren’t going anywhere, nor do we want them to, because they are important to other parts of life.

Passive managers (indexers) actually disprove their own theory. They assume markets will behave certain ways based on patterns and correlations they can’t know will continue. If forecasting is pointless, then looking at the past and extrapolating it into the future is also pointless. And indeed, those presumed correlations have sometimes fallen apart under stress. We saw it in the 1990s with Long Term Capital Management, and again in the 2008–2009 financial crisis.

Here is a chart showing the ups and downs back to 1928.

 

 

Some relevant questions for those who believe buy-and-hold is all you need:

  1. Buy-and-hold worked for the last 10 years. History has never showed a positive return in the next ten years from this market valuation. Never. Clint Eastwood said it best “Do you feel lucky?”
  2. We just ended the first decade in US history without a recession, and thus no significant bear market. Do you think that is likely to continue through the 2020s? What if we have two recessions in the 2020s? Are you prepared to hold through a decade of zero or negative returns?
  3. We are now clearly in the top 10% of historical P/E valuations, when 10-year long-term returns historically have been the lowest on record. On an inflation-adjusted basis, you can actually have negative returns for 20 years. It took 26 years to get back to breakeven from the bear market that began in 1966.
  4. We don’t know the future. I get that. But I also know that every time somebody like Greenspan or Bernanke says we are in a new era, it turns out not to be the case. P/E ratios matter. What happens at the beginning of bull and bear markets in terms of P/E ratios? Lower returns over the next 10 years is a real possibility based on history from our current market valuation. Just saying…

I think we see a recession in the early part of the 2020s, and I expect an extraordinarily volatile end of the decade, where another Great Recession is quite possible. If so, total returns will look more like the 2000s rather than the 2010s for buy-and-hold investors.

Bull markets simply don’t begin at valuation levels like we have today. Buy-and-hold ruled for the last 10 years. I think the 2020s will see the return of active management.

 

Wall Street Accounting

GAAP earnings are earnings calculated under Generally Accepted Accounting Principles (GAAP). Most Wall Street earnings are calculated by smoke and mirrors, I mean, non-GAAP calculations. Notice how far ahead the market has gotten from GAAP earnings AND notice what has happened in the past when GAAP earnings had a large gap.

 

 

January Payrolls

The headline number in this morning’s jobs report blew past expectations, but Peter Boockvar sees the rest of the data as less impressive. His flash analysis sums it up well.

Key Points:

  • Payrolls grew 225,000 in January, more than expected and the two prior months were revised slightly upward as well.
  • However, the key 25-54 age group actually had job losses. Combined with a growing labor force, this ticked the unemployment rate up to 3.6%.
  • Hours worked were unchanged and average hourly earnings missed expectations with a 0.2% rise. Combining the two puts average weekly earnings up a modest 2.5% in the last year (close to unchanged, adjusting for inflation.)
  • Construction employment showed solid growth, likely due to good weather. The retail and manufacturing sectors both lost jobs.
  • Job creation does appear to be picking up slightly. The six-month average is 206,000 vs. the calendar 2019 average 175,000.

Bottom Line: Jobs growth, however modest, is always better than the alternative. More troubling is the continued lack of real wage growth, especially since “average” earnings are distorted by a small number of high earners. Other data like rising jobless claims also raise questions. Nonetheless, the employment situation looks generally stable for now. The question is how long it will remain so.

 

Good News!
  • Manufacturers are more upbeat about future orders
  • Markit PMI and ISM moved into expansion
  • Index of new orders rebounded last month
  • The 90+ day delinquency rate on first-lien mortgages declined in December and is now near lows last seen in the mid-2000s.
  • The January ADP private payrolls report surprised to the upside, posting the biggest monthly gain since 2014.
  • Manufacturing payrolls rebounded.
  • Construction hiring strengthened.
  • The Chinese stock market is rebounding.
  • Housing has been exceptionally strong, according to Arbor Data Science.
  • New jobless claims remain at multi-year lows.
  • The Citi US economic surprise index is rebounding.
  • China to cut tariffs in half on $75B of US goods.

 

 

 

Germany Is a Problem

The financial engine of Europe is struggling.

 

 

Coronavirus Update

Comparisons to SARS continue to look scary.

 

 

The cumulative number of new cases outside of China keeps rising.

 

 

Market Valuations…. Again

The problem is that P/E, even Shiller’s cyclically adjusted P/E ratio (CAPE), is a potential value-trap measure in the current economy because of three issues:

  1. Profit margins are unsustainably high today, not only within this business cycle but compared to other business cycles making P/E ratios understated;
  2. The P/E ratio completely ignores debt in its valuation, not a good idea at a time when corporations have record leverage; and
  3. The most common measures of total market P/E use the mean rather than median company valuation which understates the average company’s multiple today by putting more weight on bigger, more profitable companies – the median better captures the valuation of the breadth of the market.

Below we show the gamut of measures currently at record high fundamental valuation for the market at large based on their historical percentile ranking. Data for MAPE and CAPE ratios go back prior to 1929! The other measures are based on the entire history of available data, which goes back at least two and half business cycles:

 

 

Are higher market valuations justified by lower interest rates?

The chart below shows how interest rates and stock prices do NOT correlate:

 

 

If we isolate the times when interest rates were extremely low, the 1940s and currently, we find in the 1940s stock valuations were low. So, the statement that low interest rates justify high stock valuations is only supported by one event… now.

A better understanding is achieved by the relative value argument that extremely high interest rates coincide with extremely low stock market valuations, which occurred in 1921 and 1981. Although a sample size of two observations is not enough to draw a statistically significant conclusion, at least it is two events with the same outcome.

The historical relationship between extremes in stock market valuations with extremes in interest rates is as follows:

  • Extremely high interest rates, which have occurred twice, coincided with low stock market valuations.
  • Extremely low interest rates, which have occurred twice, have coincided with high stock market valuations only once; today.
  • Extremely high stock valuations have occurred three times. Only once (1/3 probability) did high stock valuations coincide with low interest rates; today.
  • If extremely low interest rates do not justify extremely high stock market valuations,then a rise in rates should not necessarily cause a decline in stocks, but rising rates do lead to market corrections and bear markets.

 

Make No Mistake

Jerome Powell clearly understands that a decade of monetary infusions and low interest rates has created an asset bubble larger than any other in history. However, they are trapped by their own policies as any reversal leads to the one outcome they can’t afford – a broad market correction. With the entirety of the financial ecosystem now more heavily levered than ever, due to the Fed’s profligate measures of suppressing interest rates and flooding the system with excessive levels of liquidity, the “instability of stability” is now the most significant risk.

 

MIT Study

A new study from the MIT Sloan School of Management and State Street Associate reportedly has found a 70% chance that a recession will occur in the next six months.

The index currently stands at 76%. Looking at data back to 1916, the researchers found that once the index topped 70%, the likelihood of a recession rose to 70%.

The researchers analyzed four market factors — industrial production, nonfarm payrolls, stock market return and the slope of the yield curve — on a monthly basis. They then measured how the current relationship between the four metrics compares to historical readings,” CNBC said.

Meanwhile, some experts say lackluster productivity is squeezing corporate profits. Economists say this could make businesses, which have already cut back on capital expenditures, cautious about hiring.

“Compression of profit margins usually precedes a recession, as it causes businesses to become more cautious,” said Ryan Sweet, a senior economist at Moodys’ Analytics in West Chester, Pennsylvania. “This is likely one factor behind the recent weakness in business investment,” he told Reuters.

 

 

Market Data
  • Despite a recent new high in the Nasdaq Composite, many of its stocks are still lagging. More than half the stocks on the Nasdaq exchange are still more than 20% below their own highs, and nearly 70% are more than 10% below.

 

The Fed’s Great Betrayal

We all know monetary policy isn’t accomplishing its stated goals. You may not know just how much it is aggravating our inflation, wage, and wealth problems. Michael Lebowitz and Jack Scott explain in this cogent analysis:

Key Points:

  • Aggregate prosperity is a function of wages and economic growth.
  • Price movements are an effect, not a cause. The money supply is a key component of demand and therefore a significant factor affecting prices.
  • Fed chair Jerome Powell says the Fed regulates the money supply based on demand from banks, not economic growth.
  • This is a problem because money is being demanded mostly for consumption and speculation, not growth-producing investments.
  • If debt were being used productively, we would see it dropping relative to GDP. Instead we see the opposite.
  • By allowing the money supply to grow for consumptive and speculative purposes, the Fed generates excessive inflation and reduces real wealth.
  • Since 2000, the M2 money supply grew 234%, GDP grew 117%, and the Consumer Price Index only 53%.
  • M2 growth implies annualized inflation over the last 20 years was 6.22%, or three times more than reported CPI.
  • If not for increased government debt, organic GDP growth would have been negative for most of the last two decades.

Bottom Line: Lebowitz and Scott argue that the Fed’s interference in market pricing mechanisms is a recipe for failure. Those who trust the Fed to steer the economy “should prepare themselves for even more radical social and political movements than we have already seen.”

 

All content is the opinion of Brian Decker.