Investing for Sustainable Gains

Brad DeLong, for whom I normally have more respect, recently wrote a takedown of a poorly-argued Atlantic Monthly piece by Megan McArdle. But DeLong himself does not live up to the standards of rigor that we need to adopt if we seek to invest for sustainable gain.  DeLong argued that since P/E ratios are currently in the 5 or 6% range (depending on the timeframe details), and bond yields are lower, stocks cannot be said (as McArdle claims) to be poor long-term investments. However, as I illustrate below, it’s not clear that todays P/E ratios are meaningful.  Nor is it true that just because bonds are currently horrifically overpriced, stocks are not also overpriced.  We could be facing (Japan-style) a very long period of subpar returns in both investment classes.

Here is the comment I posted to DeLong’s article:

C’mon, sir.  It’s trivial to find poorly-written financial articles.  Even your own qualifies!

For starters, it’s a non-sequitur to expect, in a world of creative destruction and transformational technologies, that your Atlantic Monthly should bear any resemblance to your great grandmother’s.  Nor Harper’s, nor even Newsweek.

More importantly, you start with the mathematical truism that “The return on stocks is the dividend yield plus the capital gain.” (but neglect both inflation and taxation) and then proceed to assume that “If the P/E ratio is stable, the capital gain is equal to the growth of earnings.”

The reason I call that an assumption is because, once more, we live in a world of creative deception and transformational technobabble. “If the P/E ratio is stable, the capital gain is equal to the growth of earnings” is only true in a world where “earnings” has a constant meaning.
In point of fact, it appears that ‘earnings’ is a very loosely defined term whose meaning has been subtly shifted during the credit bubble of the past decade(s).  Today, “earnings” as used in the “P/E of 16″ or “P/E of 20″ metrics, manages to exclude a whole host of one-time costs, and poorly accounts for incentive pay schemes.  Even if we shift to GAAP earnings (where P/E ratios have recently been both negative on a quarterly basis, or in the hundreds on an annualized basis — both wildly beyond historical norms and not at all “stable”), we still find fantastic obfuscation and all manner of mathematical mangling by managements.  My third favorite is corporations reporting as “earnings” the capitalized, computer-simulated change in value of mortgage securities holdings, despite the fact that no cash is actually flowing nor can reasonably be expected to flow.  Second best is when a dysfunctional company recognizes the devaluation of its own debt (sometimes due to imminent insolvency!) and then claims the reduction in debt valuation as “earnings” too!  But best of all is when corporations simply lie outright, and stuff things they don’t want to talk about into physically-fictional “off-balance sheet” legal creations… both on the earnings/assets side (to hide management’s side-dealing, personal siphons into what should be secure corporate profit streams) and on the liabilities/losses side…

Back in the glory days of Atlantic Monthly, owners — shareholders — were in most cases much more closely involved in managing the businesses they owned.  I think the current system has led to a lot of bezzle — destruction of shareholder wealth not yet revealed to shareholders — and we will find that recently claimed credit-bubble “earnings” are far from sustainable.

Sir, it used to be that “capital” had physical meaning and represented, usually in a tangible way, the surplus of actual production over actual consumption.  That era ended with the demise of the gold standard and the slow, steady, Chinese-water-torture devaluation of the dollar since.  Capital gains were things you could take home with you and believe in.  And so were earnings, because dividend yields were much higher.

Today, who knows?  But I sure wouldn’t consider P/E ratios as currently reported to be historically normal, nor stocks to be reasonably valued, given what we understand about legally fraudulent and/or morally bankrupt behavior by corporate managements in so many economic sectors.

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Let me quantify my point a bit further:  GDP growth can be factored in terms of population growth, employment/population ratio, and productivity of employees.  The first two are bounded demographically and the latter is limited technologically.  Meanwhile, corporate profits are currently near historic highs (as a fraction of GDP) and unlikely to grow faster than GDP going forward.  And P/E ratios are just coming off historic highs even including what appear to be more-than-usually fraudulent earnings.

It is quite likely that we will have (a) low population growth (due to birth rate and sustainability issues), (b) a secular flattening or even outright decline in employment/population ratio (due to an aging population), (c) limited productivity growth (it is always limited), (d) no growth in corporate earnings as a share of GDP, and (e) some reduction in reported “earnings” as accounting practices are cleaned up (to match actual sustainable earnings, as fraud-driven losses are inevitably recognized).

Under those assumptions there is no reason to expect stock market returns to grow much at all, for a long time to come, until one or another of those factors shows a secular change.  And (d) and (e) both point to a significant downside risk to stock prices.  Plus it is also quite possible that given the negative outlook, P/E ratios will mean-revert to the 10-12 range from the current 16-20 range as investors demand a higher risk premium.

It is therefore entirely plausible that money placed in the stock market now may decline in value by 50% over a fairly long time horizon (10-20 years) before the factors above improve.

And this does not include either inflationary losses in purchasing power, or tax-code changes.  One must keep in mind that the Federal Budget cannot remain this imbalanced for long, and those seeking to boost tax revenues will be forced to go where the money is…

For every debtor, there is a creditor…

I have read a lot of concern about the debt burdens of various nations, including not just government debt but also corporate, private, etc.  Mortgages, car loans, credit cards…  But, for every debtor, there must be a creditor.  Who are all the creditors?  And, with so much unsustainable debt, why is there so much credit?  Why have so many lent so much?

Did we try to sell the “New American Dream” of retirement to too many people?  Is there too much “retirement savings” chasing too few potential borrowers?  Can the economy support so many millions of non-working retiree creditors, as we will soon have?

Or is the distribution of wealth too skewed, with too many owing too much to too few?  Is the debt burden just another tax on the young and productive, transferring wealth to the aged and/or unproductive?

As for the creditors:  Why are they still trying to lend?  What happens when they stop trying?  Which borrowers will be able to pay off their debts, and which will default?

Unsustainably large sectors of the economy are likely to contract during a major economic upheaval (as we anticipate may happen!).  It’s fairly widely discussed that financials have overgrown their healthy natural bounds (40% of S&P 500 profits is a bit large for a sector that just reallocates capital?).  A similar complaint seems reasonable for the health care sector, where it appears that a large proportion of the spending (late in one’s life) just goes to keep unproductive retirees from dying until the last affordable moment.  Health Care is also an overgrown sector, we find from the ‘net, apparently from the HHS Medicare/Medicaid Summaries from 2003:

“Health spending in the United States has grown rapidly over the past few decades. From $27 billion in 1960, it grew to $888 billion in 1993, increasing at an average rate of more than 11 percent annually. This strong growth boosted health care’s role in the overall economy, with health expenditures rising from 5.1 percent to 13.4 percent of the gross domestic product (GDP) between 1960 and 1993.

Between 1993 and 1999, however, strong growth trends in health care spending subsided. Over this period health spending rose at a 5-percent average annual rate to reach $1.2 trillion in 1999. The share of GDP going to health care stabilized, with the 1999 share measured at 13.2 percent. This stabilization reflected the nexus of several factors: the movement of most workers insured for health care through employer-sponsored plans to lower-cost managed care; low general and medical-specific inflation; excess capacity among some health service providers, which boosted competition and drove down prices; and GDP growth that matched slow health spending growth.

In 2000 and 2001, growth picked up again, increasing 7.4 percent and 8.7 percent, respectively, to $1.4 trillion in 2001. Health spending as a share of GDP increased sharply from 13.3 percent in 2000 to 14.4 percent in 2001, as strong growth in health spending outpaced economy-wide growth. For the 283 million people residing in the United States, the average expenditure for health care in 2001 was $5,035 per person.”

Another useful dataset is at a Kaiser Family Foundation link.  Health care at 15.2% of GDP in 2003 vs. 7.0% of GDP in 1970, 8.8% in 1980, and 11.9% in 1990. And we can be reasonably confident that health care costs have outstripped inflation and GDP growth since 2003 as well.

Now, as a citizen and a taxpayer, I want to see the health care sector become more productive and efficient. As an investor, though, “productive” and “efficient” (from the consumer perspective) tend to suggest “reduced profits” (from the shareholder perspective).  I think this is good, because it will free up resources to do better things… or at least free up resources to actually provide decent care to the millions of retiring boomers.

But it looks to me as though the “health care growth to take care of retiring boomers” trend may have played out.  I don’t think this sector (as a whole) is a sustainable-gains sort of investment.  Although I will be keeping my eyes open for  companies leading the way to “productive” and “efficient” healthcare!

Investors are typically most sensitive to portfolio “drawdowns”; those periods when, on balance, the investments are worth less than their peak. “Drawdown”, commonly used by hedge funds, refers to the percentage that a fund’s Net Asset Value (NAV) is below peak. We don’t pay hedge fund managers, but it helps to think like one*, and the “drawdown” concept is quite useful.  We strictly limit our maximum conceivable drawdown to ensure we do not jeopardize our investing/savings goals.  We then manage our portfolio accordingly.

Our first step is to monitor our own NAV. This just involves summing up the value of all holdings periodically (weekly), and tracking inflows and outflows. We use an imaginary number of “shares” and then pretend that each inflow/outflow is “buying” or “selling” some shares in our “personal hedge fund”. Meanwhile, market-driven changes in portfolio value push the NAV ($/share) up and down. After a few hours of setup, having our own NAV is trivial with a spreadsheet.

Now, given a NAV and a drawdown limit, one starts to invest rather differently.

First, the drawdown limit forces conservatism when it is most needed: when things are going badly. With a drawdown limit, there is no “doubling down”, Martingale doom path. When things go bad, you have to get into zero-risk assets and let the yield rebuild NAV before you take on risk.  For those with a trading appetite, this provides a “reset” time to get back in the groove. For those without a high risk-appetite, it provides a “nerve-soothing” time to re-assess the market before getting back into risky assets.

Second, it leads one to ask whether a given investment is really the best way to get the intended return, because other methods might deliver the same return with less drawdown risk. For instance, a ladder of individual Treasury bonds held to maturity has zero drawdown, whereas a bought-and-held intermediate Treasury bond fund can swing by many percent — yet both deliver similar yields. Similarly, it leads one to ask when and how buy-and-hold is a sensible option for stock-market money.  Suppose the maximum drawdown limit is 10% and the stock market has just shown that it can move down 50%.  Chasing performance and buying back into a broad market index after a long bull run puts a lot of drawdown risk into the portfolio - with more than just 20% of assets in a market index, a 50% crash hits the drawdown limit!  But chasing performance is a dumb strategy for a buy-and-hold 401k type fund. Maybe it would be better to buy dividend-yielding stocks whenever they are near 52-week lows, and then carry them in the portfolio only at purchase value, while harvesting the dividends and only noting the capital gains when “profit taking” time comes?

Third, it leads one to reassess asset allocation across the portfolio, and look into sensible market timing strategies. Correlated drawdown risks are most deadly, but also hidden from sight. The sales pitch for Modern Portfolio Theory was that diversification reduced volatility without greatly impairing returns. That was thoroughly disproven from September 2008 to March 2009, when the only assets that didn’t plunge 10% or more were U.S. Treasuries and cash readily exchangeable for them. A simple 75/25 Stock/Bond index method outperformed most MPT-diversified portfolios (though still having a horrific drawdown). Those who used tactical asset allocation based on things like 200-day moving averages did much better still.  MPT may reduce portfolio variability in bull markets, but it’s no defense in a liquidity panic, when everyone else has the same “exotic” investments and needs cash fast.

All of these effects are right in line with the “Investing for Sustainable Gains” philosophy.  And our claim is that a drawdown management approach, implemented well, can deliver long-term total returns comparable or better than other approaches, without jeopardizing one’s financial goals. We will explore some of these ideas in future posts, and if there’s interest, we can post some performance results from time to time as well.  (We will have 3 years of data to show at the end of March.)

- W.S.

* Hedge fund managers only get paid the big bucks (the 20% of total returns, measured by peak NAV) when they are pushing peak NAV up and having minimal drawdowns.  Drawdowns more than 10-20% tend to cause fund investors to pull their money from the fund. Also, looking at the long period of strong performance that is typically needed in those circumstances just to get back to peak NAV, many fund managers realize they won’t get paid big bucks again for a long time, and simply shut down the fund. But individual investors don’t have the luxury of “pulling their money out of their portfolio”, nor can they “shut down” their portfolio. We are stuck with our portfolios! So we believe in not taking excessive losses in the first place.  After all, we’re managing Our Own Money, not OPM!

I’ve had this unscratchable itch after reading CR’s post about the labor force participation rate decline.  I wanted to know how labor force was defined (in the U.S., it’s everyone 16 and up minus students and a bunch of other exceptions), and whether the declining participation was related to the boomers hitting retirement age (or at least, early-retirement age), as opposed to their kids maybe not being so numerous to make up the difference.  At first glance, not so…  I went over to Wikipedia and found the population pyramid from the 2000 census data, which showed that the generational cohort currently entering the workforce is larger in number than the boomers.  Also, only the leading edge of the boomer population is in the 55-64 age group now, where early retirement might make sense for large numbers.

So I went looking for more information.  The BLS has a very nice economist named Mitra Toossi, who publishes reports every couple of years analyzing the labor force.

The most recent report (PDF alert) came out in November 2009.  Not too far back!  It says, on the first page, “the aging of the labor force will dramatically lower the overall labor force participation rate and the growth of the labor force”.  

I can see this.  The population aged 65+ is getting larger compared to the population aged 16+.  And those over 64 are less likely to be labor force participants.  Similarly, the population aged 55-64 is “booming” right now, and they are also less likely to be labor force participants (e.g. kids thru college and house paid off, so a lot of folks have more choices about whether or not to work…)

But then I ask myself, how much of this is “prediction” and how much is rear-view-mirror economythics?

So I open up the same report but from November 2007 (the previous version).  It says “BLS projects that the labor force participation rate will be 65.5% in 2016.”  That’s a no-growth prediction from the rate prevailing in 2007.  The all-time high was 67.1% in 1997 (or 67.3% in 1999-2000 if you look at their data (possibly revised since 2007)… The participation rate dropped to about 65.5% in 2004 after the dot-com recession.

More from the article:  “projected continuation of the decrease in the labor force participation rate of youths…”

“once the baby boomers exit the last years of the prime age group and enter the 55-and-over group, with participation rates roughly half that of the prime age group, the overall labor force participation rate will decline significantly…”

So it seems that some of this “labor force participation decline” was anticipated prior to the recession, and it’s just demographics.  If the marginal benefit from working is reduced (lower pay, less pleasant work environment), some folks who don’t HAVE to work right now, will wait for a better chance later.

On the other hand, given that the decline in participation was forecast years in advance, shouldn’t policymakers have anticipated a deeper recession that normal just from the workforce demographics?  And perhaps more importantly going forward, since we know the boomers are going to be retiring en masse over the next few years (many with their belts fully tightened by the recession) doesn’t this imply a very weak recovery?  If workforce participation is going to be declining even in good times, the number of willing workers will be suppressed, and might even decline outright, even if total population remains stable to slightly increasing.  (It doesn’t help that the 2000s were a weak decade for population growth, with no sign of improvement, either.)  After all, it’s a mathematical identity that GDP is the product of the size of the workforce, the hours per worker, and the productivity per worker…  Size has some headroom due to layoffs, but not as much as it would if population were booming.  Hours are stagnant and honest-work productivity may be plateauing due to computer technology reaching the saturation point…  All of which points to weak growth in the U.S. for a while, which is not bullish for optimistic P/E multiples in the stock market.  Nor for bond default and/or rollover risks, with a lot of bond issuance predicated on perpetual-growth thinking…

Ruh-Roh!  The economy may have had “enough!”

W.S.

This refreshes a comment I made some months ago on Calculated Risk.  What if we looked at the current market using the same approach that prevailed in 1929-1932?  Instead of the “Dow 30″ (which is officially still called the Dow Jones Industrial Average, but no longer actually contains primarily industrial stocks), let’s use the S&P 500 Industrials (ticker: XLI) as a proxy for the health of the wealth-producing part of the economy.  There may be better choices, since this doesn’t include Tech, materials or utilities, but it will do.  Also, instead of using the current (fiat) dollar as the pricing unit, we should use the same one used in 1929-1932, which was gold.  Back then there was a fixed exchange rate between the dollar and gold.  I’m not a gold bug, but the truth is that since 1930 the dollar has evolved quite a bit, and gold is still … a chemically pure heavy metal useful for jewelry and electrical circuits, hard to produce and easy to identify, thus useful for stockpiling “value”.

So, here’s the chart!  Anyone see a recovery here yet?  Looks to me like the Dow Theory folks, if they hadn’t forgotten that the Fed-manipulated fiat “dollar” isn’t the right metric, would agree that this shows no sign yet of returning to a bull market.  The automatic ZigZag feature of StockCharts still shows lower lows and lower highs…

“Wisdom Speaker” is a working physical scientist living on the east side of the San Francisco Bay Area.  Wisdom Speaker is between 30 and 50 years old and has a top-tier Ph.D. in his field.  W.S. also has a spouse, 2 children in school, a house with a mortgage, and occasionally a sharp tongue. Like many his age, W.S. manages a portfolio that is “big enough to worry about, but too small to retire on”.

For years, W.S.’s spouse led the family to develop strong saving habits, and over the years they invested using conventional buy-and-hold, dollar-cost-averaging, asset-allocation methods. But in 2005 realized that conventional financial wisdom was no longer adequate to the times. Unfortunately this occurred after buying a new home near the peak of the 2000-2006 housing bubble. Although the home equity could not be saved (for some years, anyway), the housing experience “woke them up” to the speculative/Ponzi financial environment. Time was invested in a more detailed financial education. Abandoning “buy-and-hold” and taking detailed control of the household finances, W.S. went to cash and avoided the 2008 financial panic.

The family finances came out well ahead of their 75/25 allocation benchmark, but now the question arises as to how, exactly, one should invest for sustainable gains going forward.  The classic definition of an “investment operation” is one which, “upon thorough analysis, promises security of principal and a reasonable rate of return” (Benjamin Graham). In short, a sustainable gain!  Now, some of what is often considered speculation is in fact investment (e.g. trading with a high probability of success, but a short time horizon).  On the other hand, the lesson America failed to learn from Enron and the dot-coms is that too often, what is sold as “investment”, is actually speculation - or worse, fraud!  Clearly we cannot trust others to do our “thorough analysis”, guarantee “security of principal”, or deliver a “reasonable rate of return” for us.  How now to invest?  W.S. hopes to share what he has learned about investing for “Sustainable Gains”, and to learn from others with similar interests.

W.S. also believes that Graham missed a critical element of what constitutes an “investment”.  There is an ethical or moral dimension to investing:  one must put one’s time and treasure to good use, and be able to sleep well knowing what the “investees” are doing with one’s treasure.  An “Investment Operation” must be one which “upon thorough analysis, promises security of principal and a reasonable rate of return while putting capital to a use one can agree with.  Wave upon wave of financial scandal shows that this issue is far wider than “socially responsible” index fund sellers would have one believe.  Even the simple act of buying a CD, or a T-bill, has an ethical component. So ”Ethical Investing” will be another theme covered here.

Another issue that comes up almost immediately is that the fiat money we use today isn’t wealth, or capital, or anything really.  It’s a bunch of carefully arranged electrons (or paper, or metal disks, but always of minimal intrinsic value) which record the exchange of debts.  But debt is not capital!  Capital is the surplus of production over consumption.  Debt is an agreement to deliver future production in exchange for current production.  True wealth might be better defined as accumulated resources to meet human needs.  W.S. has only dabbled in this area so far, but understanding the “Nature of Wealth” is vital to having “Sustainable Gains” in this area, and will be another theme here.

Finally, there is the eternal issue of time. One can often earn more money, or save it, but one’s time is far more strictly limited. Time spends itself whether one likes it or not, one never knows how much one has left, and it’s darned hard to get more!  But perhaps careful “Time Investing” (not just time management), particularly in conjunction with financial investing, can lead to sustainable gains (measured in terms of any personal goal) as well?  At any rate, between work, family, and personal needs, W.S. feels time-poor, and struggles to fit all the joys and sorrows of life into the 24-hour day, so “Time Investing” will be another theme here.

Hope you enjoy the site!  I look forward to seeing where this goes…