Investing for Sustainable Gains

On DeLong’s Blog, I got some replies to my comment (see previous post here where I expanded on the comment).Robert Waldmann responded: “Brad didn’t assert that stocks are reasonably valued — he asserted that they are undervalued from the perspective of a long term investor. His claim is that stocks have always been undervalued from the perspective of a 35 year old saving for retirement.”But even with a 30-50 year time horizon, one should not put money into an investment that is quite likely to stagnate for the first 10-20 years.  The opportunity cost is too high.With regard to the stock market, one can write out a trio of trivial identities which, when combined, have some distressing import:Stock Prices = (P/E) * Earnings.Earnings = (Earnings/GDP) * GDP.GDP = Population * (Employment/Population) * (Productivity/Employee).From which:  Stock Prices = (P/E)*(Earnings/GDP)*(Population)*(Employment/Population)*(Productivity/Employee)The value of this is that each of the components on the right-hand side is fairly well measured, allowing some insight into the broad trend for Stock Prices on the left hand side.Now, before we dive in to stock price trends, note that total return is of course related to both dividend yields and capital gains.  But currently dividend yields are historically very low, so any 30-something (or any other age) investor seeking a comfortable retirement needs capital gains.  So consider the factors affecting prices:1) P/Es are still on the high side and have not yet reverted to anywhere near their historical low points, despite the two market crashes in the last decade.2) Earnings/GDP is still on the high side and has refused to revert to historical norms (despite a sharp nudge in the right direction in late 2008) thanks to government giveaway policies.  But revert it will; go higher it cannot, if history is any guide.3) Population growth is slowing and the rising anti-immigration sentiment will not help.4) Employment/Population is on a downtrend and faces secular headwinds from aging demographics (not just in the U.S. either).  There is some room for near-term improvement from uptake of the unemployed (and the overseas military who are not necessarily contributing to domestic economic production), but the long-term scenario is not positive.5) Productivity/Employee has been squeezed hard already during the recession and, absent another huge technological revolution which is not yet evident to investors, is unlikely to grow at anything more than the usual 2-3% for a while to come.So where exactly are we to find the factors that will even yield positive returns, much less 6% returns, within the next 10-2 years?Footnote:  The above statements can be backed with hard data, which I will endeavor to (re-)post in future notes here.

A post today on CalculatedRisk caught my eye:  What might the Fed do?  There is a lot of anxiety about the future of the economy,  leading to wondering about whether the Fed may extend the current period of low short-term interest rates, or even buy down longer-term Treasury bonds to reduce rates further.

Implicit behind this is the idea that lower interest rates stimulate the economy.  There’s a lot of history behind the approach, but does it still hold true in today’s environment?  I am not so sure.

Low rates stimulate borrowing… but today we have few creditworthy borrowers with an appetite for additional credit. Instead we have debtors scrambling to get out of debt, unemployed people needing to live off savings, and a lot of people in and near retirement who are trying to figure out how they will generate enough income to get by.  I can see lower rates allowing debtors to reduce their interest costs, but savers then need to “save more” in order to maintain their income levels… or they need to cut spending.

Low rates encourage the government to borrow… but is that really the way to generate an economic recovery?  At present that just scares taxpaying consumers into worrying about future taxes… so they save more.

Low rates stimulate tangible investment… but today we have a surplus of capacity in everything: housing, commercial real estate, industrial production capability.

Low rates tend to make stocks more attractive than bonds… but do we want another stock market bubble?

It seems to me that what we need are new industries, new lines of work to employ the current surplus workforce and provide new demand for existing production capability. But we probably want those to be financed primarily out of equity capital rather than debt!

And it seems to me that we want to encourage saving and productive investment, by allowing those actions to generate reasonable rates of return — without frenzied capital-gains bubbles.

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!

I spotted this quote over on The Big Picture today, and thought it apropos given the subtitle of this blog (”making the most of time and treasure”):

“Riches do not consist in the possession of treasures but in the use made of them.” —Napoleon Bonaparte

(Whatever one thinks of Napoleon, he certainly knew something about both treasure and many of its uses!)

From this perspective, much of Wall Street, though it has accumulated “treasure”, knows nothing of “riches”. Money not responsibly invested is wasted wealth, as is the labor (”time”) of those involved.

It is also worth pointing out that banks do not own their money.  They merely borrow it from their depositors and other creditors.  If they accumulate riches (i.e. siphoning profits off the spread between their borrowing costs and their lending rates), it is only because they are better at making “use” of your treasure than you are!

From July 10, 2009.  This is a comment relative to a post on Aleph Blog.  I held posting the comment here, so I could think this out more, but in the end I like the train of thought as it was and haven’t edited it much…

In the end, ownership is about the strategic selection of risks, calculated risks, where the likely rewards outweigh the risks. If the likely rewards don’t outweigh the risks then ownership (”investment”) is not a good choice. As Ben Graham put it, thorough analysis, security of principal and a reasonable return are the essential ingredients. Complexity bedevils analysis; hedging tends to involve concealment of risks to principal; financial intermediation (e.g. with a counterparty) requires sharing the expected return. The odds of mis-estimating risk become much higher.

On a more philosophical plane: I would hate to live in a world where everyone was “hedged” or “insured” and thought they had no risk, and yet would earn some kind of return. A world of prudent risk-takers, willing to put actual capital on the line because they’ve done their homework and willing to work to make their commitments work out, is better than a world of “hedged” risk-averse “free lunch” seekers who just want some counterparty to make everything all better for them if they turn out to be wrong.

There’s a moral hazard aspect to insurance — think about how popular the high-hazard “extreme” sports are, now that everyone feels entitled to having someone else pay for their wrecks. There’s also the problem that your average individual, regardless of means, is just not sufficiently sophisticated financially to make proper use of these “hedging” tools. We live in a nation where much of the population cannot do something as simple and obvious as paying off their credit cards in full each month! This applies all the way up to the highest levels of business and government — Representatives, Senators and even national presidential candidates are up to their eyeballs in debt that apparently is not in their financial interest. Should we really be turning the Wall Street marketing mafia loose with new “financial innovations”, on such ignorant prey?

My intuition tells me that it would be better for society if people who aren’t comfortable owning a particular asset were encouraged (”invisble hand” style) to stop owning it, NOT for them to maintain “ownership” but with “insurance”. Shiller and other advocates of hedging tools seem to be living in the pre-crash mentality, where financial complexity seemed like a good thing, and counterparty risks could be ignored. Such is not the case now. With the number of publicly filing businesses down about 1/3, and the number issuing “going concern” warnings rising dramatically, it’s flawed logic to assume that “insurance” (as a generic concept) is “guaranteed”. Would you sell a future on your home to the next AIG? The next Countrywide? The next Lehman Brothers? In the absence of financial transparency, how would you know?  Particularly with respect to off-balance-sheet (and allegedly “hedged”) risk exposures, there’s no way to tell that your counterparty of choice won’t blow up in the next 10 years (or whatever time horizon). In such an environment, hedging makes little sense from a Graham-ian investment perspective, because upon thorough analysis the risks are quite likely too high.