Tyranny of Mathematics
By Julien B. Booth
September 29, 2017
I hope this note finds you doing well. The Summer was wonderful and I trust your Fall is going well.
Doubt is not a pleasant condition, but certainty is absurd. -Voltaire
We have the privilege and challenge of working in an industry that is built around expectations. Expectation’s are funny things…they are often not anchored to any rational, measurable, or mathematical device, but they can morph from destitute to grandeur, seemingly overnight.
While trying to teach our children that exceptional expectation can be the root of heartache, yet be understanding, appreciative and grateful for the fruit of their expectations. At almost 11 and 14 they seem to get the joke – as they so often find pleasant surprise!
The post-election period has been wonderful. (Note: I only speak in financial market return terms. We so try to remain apolitical/neutral, out of fear of creating dangerous behavioral bias in our process.) The tremendous expectation has been built into the present markets (corp./personal tax reform the largest amongst other political promise).
While we cherish the intellectual banter (what markets should do) we have far too much respect for underlying human behavior in driving the financial markets. Absolute conviction, politics, finance, relationships, etc. can be dangerous.
Bull markets are fantastic. They make everyone (ourselves included) feel like a geniuses (https://goo.gl/J3fcrz). Dunning-Kruger effect seems to fit a lot of topic matter lately.
We love bullish, sentiment-driven events that we so desire to embrace, yet our core belief in the durability of value, cash flow quality, credit indicators, and behavioral factors (confirmation bias, etc.) generally bring us back to mathematical reality, not to mention, experience (i.e. losing once-made money).
We do encourage investors to be appreciative. The past few years have been fantastic by investment return standards – and future expectations…dare we say are not guaranteed. Past returns are wonderful…however; we are paid to generate positive returns for tomorrow, not last quarter or last year. 20+ years in-(forced wisdom) provides a good perspective.
Net, net, we are concerned with Future return expectations. Forwards returns are driven by a myriad of factors, but one of the single most important is where you are starting the clock (present valuations vs. lower). Tripling from S&P 666 is far easier (mathematically/statistically low valuation) than S&P 2500 (present).
Guggenheim report: https://goo.gl/H5PbtU
Please see charts (below) and attached for quick briefing on where we find ourselves.
We are not recommending any dramatic portfolio action, merely an appreciation of what has already occurred and a prudent eye to where we stand today. For the past 7+ years the Federal Reserve/ECB/BankJapan have essentially manufactured a new America (by creating $19 Trillion of new $$$ via Quantitative Easing/QE). This effort has grossly elevated financial asset values.
The US Federal Reserve has just embarked on QT – the slow reversal of this process. I am not confident anyone knows how it ultimately plays out.
Regardless, our daily job is to find value.
Strategically we are adjusting our more risk-oriented positions in favor of more consistent income positions. Value is constantly evolving…more often than not it is found on the scrap heap (h/t Ben Graham).
Thank you for your interest in Forest Capital and Sixty Guilders Research.
September 2017: Markets in Pictures – High Yield Bonds + US Stocks
Credit spreads indicate investor willingness to fund risk assets (credit risk). Current spreads are at historic lows = very low forward return potential and/or significant capital risk. Yield chasing by institutional and private investors is often a contrary indicator.
Stock valuations are at significant historical premiums. There is significant margin debt (right chart) funding this effect. Additionally, tremendous Federal Reserve stimulus is likely making its way into stock assets. The Fed just began the gradual removal of this QE stimulus.
September 2017: Markets in Pictures – Buffett Indicator + Foreward Expectation
The “Buffett Index” and the Wilshire 5000 variant suggest that today’s market remains at lofty valuations — similar to the housing-bubble peak in 2007, although off its interim high in Q1 of 2015. While this indicator is a general gauge of market valuation, it’s not useful for short-term market timing. Source: Doug Short
Based on the historical relationship between market cap to GDP ratios and subsequent 10-year returns, today’s market valuation suggests that the annual return on a broad U.S. equity portfolio over the next 10 years is likely to be very disappointing….RE: Income – We believe active fixed-income management that focuses on the best risk-adjusted opportunities—whether in or out of the benchmark—offers the best solution to meeting investors’ objectives in a low-return world. —Brian Smedley, Guggenheim Securities