Episode #55: “In Reality, Normal is Actually Volatile. Normal is Not Mellow”
Guest: Ed Easterling. Ed founded Crestmont Research, which provides financial market education services. Ed is also the author of Probable Outcomes: Secular Stock Market Insights (Cypress House, 2010) and Unexpected Returns: Understanding Secular Stock Market Cycles (Cypress House, 2005), contributing author to Just One Thing: Twelve of the World’s Best Investors Reveal the One Strategy You Can’t Overlook (John Wiley & Sons, 2005), and coauthor of chapters about Crestmont’s research in Bull’s Eye Investing by John Mauldin (John Wiley & Sons, 2004). In addition, Mr. Easterling previously served as an adjunct professor and taught the course on alternative investments and hedge funds for MBA students at SMU in Dallas, Texas.
Date Recorded: 5/23/17
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Summary: In Episode 55, we welcome Ed Easterling. Meb starts by referencing a survey he just conducted, asking readers’ opinions as to the single best investing book out there. It turns out that Ed’s book, Unexpected Returns, made the top 50 list, so Meb offers Ed a kudos.
But the guys hop into market discussions quickly. Ed tells us that the stock market is not driven by randomness. It’s predictable in the long run, driven by three components: 1) earnings growth, 2) dividend yield, and 3) the change in valuation level. Stock market returns over the short-term are unpredictable, but over the longer-term they’re highly predictable. And the key driver is the starting level valuation.
Meb brings up how numerous investors are currently expecting 10% returns (based on long-term averages). He asks Ed if that’s warranted.
It turns out, we need to distinguish between long-term returns (say, 100 years) and a return-period that’s more relevant to the average investor (say, 10 or 20 years). This is because changes in PE levels are much more significant for returns over 10-20 year periods for individual investors, more so than over 100 years.
Meb asks if Ed has a favorite PE ratio. Ed likes Shiller’s CAPE and the Crestmont PE – which is driven by GDP and EPS. Ed finds value in comparing the two. They have similar results yet have different approaches.
All the talk of valuation leads the guys into a discussion of secular versus cyclical markets. Ed offers some general context for secular versus cyclical, then says we’re definitely in a secular bear market. He offers up some great details here, factoring in valuations and the inflation rate.
Meb asks what will make the cyclical bear end? Ed says the PE has to get low enough where it can double or triple. So, starting out in the high 20s right now, the PE would need to get down to at least the mid-teens, if not the low-teens.
Soon, the conversation gravitates toward “volatility gremlins,” with Meb asking Ed to define the term and explain.
There are two volatility gremlins that compromise the compounded returns investors receive: 1) the effect of losses – Ed gives us example of the math behind wins and losses; 2) the dispersion of returns – steady returns yield the best compounding, but when returns are more dispersed, it adversely affects the compounding. Meb asks, “what then?” How does one build a portfolio knowing this? Ed answers by giving us a great analogy involving rowing and sailing.
Next, the guys touch on volatility and what will be the trigger that moves us from this mellow inflation environment. Ed says that volatility is a reflection of the movement of the markets, which also reflects investor sentiment and complacency. By one of the measures of volatility that Ed tracks, he says we’re well-into the lowest 3% or 4% of all periods since 1950. The other volatility measure is the VIX, which is settling again, back around 10. Do you know how many days since 1990 the VIX has dipped below 10? Ed tells us, and yes, we’re flirting with a sub-10 level right now.
There’s far much more in this episode: Where Ed would point a new investor starting in this environment… The biggest investing misconception Ed sees from his students… Ed’s favorite investing styles/strategies within the hedge fund space… And advice for retirees and/or income investors.
What is it? Find out in Episode 55.
Links from the Episode:
- Crestmont Research
- Ed’s/Crestmont’s analysis/charts on the stock market
- Ed’s/Crestmont’s analysis/charts on interest rates
- Ed’s/Crestmont’s analysis/charts on the economy
- Ed’s/Crestmont’s books and videos
- Survey showing investor return expectations and here
Transcript of Episode 55:
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Meb: Welcome listeners of the podcast today. We are super-excited to have all the way from the woods of Corvallis Oregon, Ed Easterling welcome to the show.
Ed: Well, thanks, Meb. I’m glad to be here today.
Meb: So Ed’s been a oft requested podcast guest and we actually just did a survey on my blog the other day and asked people, this is a question that Jeff and I have talked a lot about on the investment podcast before. And we said, ”Hey if you could give someone a single comprehensive investing book, what would you give them?” Because I don’t really have a great answer for that, and so people send in a thousand responses which poor Jeff and I had to put together, sort in Excel and just wanted to give you a pat on the back. One of your books made the top 50 list. So for those who aren’t familiar Ed has written two great books, runs Crestmont Research, has been a professor, and has a really incredible educational content on his website.
You can spend many hours on there, many videos on there. I joked that instead of doing this podcast, we could just start it say go watch these videos and be done and spend the rest of the time talking about who knows what. But it’s good to have you on today. So, Ed, I figured we’d get started in an area that particularly I think you think a lot about, we talk a lot about and that’s the US stock market. But also thinking about a framework for expectations and your most recent addition to your book, ”Probable Outcomes,” is such a wonderful title because it goes along with the way we think about the future. So talk a little bit about, you talk about future stock market returns.
And there’s only three components of the way you see the future. Maybe talk a little bit about your framework as a starting point and go from there.
Ed: Absolutely. I think the framework is to first keep in mind that the stock market is not driven by randomness. But instead is in the longer run a very predictable market. There are three theories that led to people expecting that the stock market is sort of this random environment that you can’t predict returns. And certainly, we know that you can’t predict returns over months, quarters or even a year or two. What makes it different over the longer term is the fact that the stock market’s driven by three components. And those three components are earnings, growth dividend yield and the change in valuation level.
So one way to think about it is capital gains and dividends. And capital gains are driven by earnings growth and are driven by the by the multiple. And if earnings are growing and the multiple is growing you get super returns like we had in the ’80s and ’90s. When we’re in environments where the earnings are growing but if the multiple is declining like we saw in the ’60s and ’70s, and like we’ve had happen over the past 18 years coming off of the late ’90s bubble, you tend to have that earnings growth offset by the decline in multipoint and it lowers your capital gains. To that, you can add dividends.
So the key point here is that there are fundamental principles that drive the stock market.
That stock market returns over the short run are unpredictable, but over the…at least generally unpredictable. Over the longer run are highly predictable. And the most significant factor that determines whether we’re in an above average period or below average period, is actually the starting level of valuation. So if I had to sort of sum up in an elevator ride to someone what the Crestmont Research approach in view of the market would be, it’s that it’s driven by fundamental principles, not by randomness. And over the short run it may be unpredictable but over the long run, it’s highly predictable. And the key driver is the starting level of valuation.
Meb: So I think this is a great starting point and we’ve talked a little bit about this and I mean people like John Bogle have been even writing about this for 30 plus years. And people are often surprised to hear that Bogle has written about this very basic stock market formula. And put these numbers to context if you could go back to 1900s. So the past whatever 117 years, historically we’ve had about a 9.6% return, 4.2% was dividend yield broadly speaking, earnings growth around 4.7. And you had a slight bump from valuations increasing of 0.3%. And so that’s been your historical return. Now real, because of inflation knocks that down to about 6. But in general, that’s why people expect this historical roughly 10% return. If you think about the current environment Ed, what does it saying right now? Is it saying we’re going to get 10% or is that saying something maybe a little bit different?
Ed: Well, so a couple of things. First is, I think it’s important to distinguish the difference between long-term returns at 117 years. And relative returns and investors’ horizon of 10 or 20 years. And so I think the first thing to do is to recognize that those long term series, for example, the one you mentioned that goes back to 1900 or the very famous series that comes from Roger Ibbotson which is the one that was published by Morningstar now published by Duff & Phelps in the annual compendiums yearbook. That series starts in 1926. The most important thing to recognize and I think you’ve began to kind of give us an insight there when you outlined the returns from those three components.
You see those series started when P/E ratio was lower than it is today. And over 117 years or over a 90 year period like Ibbotson series, a significant change in P/E in the case of Ibbotson series a doubling of P/E from less than 10.2 to now over 20, the compounded effect over 100 years is relatively small. That’s why it’s less than 1% a year. And that’s why academics and pundits often talk about that P/E change has such a small effect on stock market returns over the long run. But for individual investors that have a 10 or 20-year horizon, which by the way may sound long to some, but in terms of…and when we’re talking about long-term returns those are considered shorter term periods, the change in P/E can be much more significant often adding 5, 7, 10% [inaudible 00:08:14] points to returns.
So the other thing significant is this dividend yields component. So when you start with low valuations, the amount of dollars of dividends that you receive represent a higher yield than when you pay a higher price. So if you pay paid 10 times earnings for a stock, that dividend on that price is going to have a certain yield like the earnings yield. If you pay a high price for a stock, that dividend yield will be less. So in the case of the series that you mentioned at four point something percent and the Ibbotson series which is over 4%, those were periods started with high P/Es and therefore dividend yield is a much higher portion contributor to return. In today’s environment, where the price-earnings ratio was over 20, at this point normalized P/E is near 30, dividend yield is 2% or less. So going forward, that compounded is going to be less than half of what it was in that historical return.
Meb: Right and which is where you find it today which is we have a dividend yield of about 2% in the US. And it’s funny because most people listen to John Bogle and his message is always buy and hold indexing which we think is totally fine. But the question I always have because he just came out yesterday I think it was a CFA conference and he said he expected US stocks to do 4%. Which was this 2% dividend yield will give the stock market the historical earnings yield 4.7. So that it gets you up to it mid-60s but then he lops off some for the high valuations and gets you back down to the 4%.
So I’m always curious. I’d love to ask him let’s say is there some valuation to where you would say it no longer makes sense to invest in stocks at all? Because…and we’ll get into this a little bit about draw downs and everything else. So I just think this is such an interesting and I wanted to interject but didn’t want to interrupt you. When we talk about P/E ratios a lot of people there’s like 50 different variants. Do you have a favorite or like is there one that is as you mentioned the Crestmont P/E. Is there one that you think is one of your pet P/E ratio type?
Ed: So I would say there’s two. First is I like Shiller’s CAPE, P/E 10. I think it’s well understood, well recognized and readily available and easily computable. At the same time, also you’ll find a number of the charts at crestmontresearch.com are based on a Crestmont P/E, which is driven by a long-term relationship regression between GDP and earnings per share. What you’ll find both in unexpected returns and in probable outcomes is that I do a lot of comparing especially in probable outcomes of the Shiller approach to the Crestmont approach. And it’s not to say that one is better than the other but instead is to say that both of them have very similar results but come at normalizing P/E from very different approaches.
So the fact that you have two different approaches and have very similar results, I think give both of them credibility as opposed to saying that one is better than another. Much like looking at the GDP deflator and CPI. Because people often criticize CPI for shortcomings. But I think when you compare that to the GDP deflator which is another measure of inflation comes up with very similar results but takes a completely different approach. There’s a certain amount of validation that I think takes place when you have that comparison.
Meb: Yeah and I think that’s the way we talk about valuations is we say they’re often a blunt tool. But in general, the vast majority of your valuation indicators should agree typically particularly when you’re in extremes. So when you have a market that’s expensive like the US, any valuation indicator you look at and it doesn’t matter what it is and this is a great example right now. You can’t find one that says stocks are screamingly cheap or even cheap at all.
Almost all of them whether, it’s median earnings, whether it’s market cap to GDP, whether it’s P/E ratio, all I’m saying there’s some degree of overvaluation.
So I wanted to touch on under this topic of valuations and how they have such a massive impact on future returns. You talk a lot about secular bull and bear markets as well as cyclical bull and bear markets. And you have a pretty interesting comments and this is still brief and I’ll let you talk about it. Some listeners might be surprised to know that despite these big run-ups since the global financial crisis, you’ve commented in the past that we could still be in a secular bear market. So maybe talk a little bit about the long timeframe in secular and cyclical and all that good stuff.
Ed: Absolutely. And obviously when you talk about secular stock market cycles, we’re talking about secular that comes from a Latin term saeculum which means an era or extended period. So what we’re talking about is long-term periods of bulls and bears which is different than a cyclical period which would be a year or two or three or four or five. And I would contend that we are definitely in a secular bear market. There’s a chance that we were in what I would term a bear in hibernation. That’s where valuation stay high for an extended period. You get below average returns, but you don’t see the decline in valuation that is representative indicative of a secular bear market.
A secular bear market is an extended period of time where valuations are generally declining that general decline offsets some of that earnings growth, gives you below average returns. Secular bull markets are the opposite. They’re a generally rising period valuations. Valuations tend to rise and fall over time because they’re driven by the inflation rate. When we have periods of low and stable inflation drives high valuation levels. When you have periods of bad inflation which is either high inflation or deflation that drives low valuations. And it does it for a series of financial tradeoffs.
When you’re moving from bad to good, that creates a secular bull market because you see inflation coming back to all those stable levels and you see valuations rising. You mentioned the current condition the current condition is that we have high valuations but they’re high for a reason. They’re high because inflation has been low and stable for an extended period. And that justifies and supports and drives valuation higher. That turns out that valuations in the past six months or so almost year have moved to beyond the natural level for low inflation into an extended full overvalued high level. But it’s only 10 or 20% overvalued. It’s not dramatically overvalued in the context of a low inflation low-interest rate environment.
Meb: There’s some great charts, we’ll post to the show now. It’s about secular born bear markets and it compares what we would consider to be this, the secular bear which it has starting in 2000. And the CAPE ratio if you guys remember the highest that ever experienced in the US at a value of 45-ish and comparing kind of the other big bear. So the one after the roaring ’20s and another one near the end of the ’30s, the 1966 which lasted 16 years and the longest in this chart was 1901 and 1920 which lasted 20. And it’s really cool to see the valuation where this started and how long they took to get in. What do you see as kind of the zone for really a bear and for P/E ratios? Is that below a certain level, is kind of a range? What do you think?
Ed: Well, I think let’s keep in mind. We have our…so at the end of the day there’s no a statistic to kind of get us started on this. If you go back to 1900 and you look at every 10 year period, and I think a lot of people continue to consider 10 years to be a reasonably long environment that it’s relevant to an investor. But short enough that we can do some assessments. And by the way, since 1900, there have been over a 100 of these 10-year periods. 1900 to ’09, 1901 to 1910, 1911 to etc.
If you look at the total return from stocks, so that’s capital gains plus dividends for all of those 10-year periods, the average is 10%. But what percent of the time was for the 10 year periods average? How many of those past 110, 10-year periods have been not exactly 10% because we know none of them were exactly 10.00. But let’s use a range for average, for discussion. What’s extended all the way out to 8 to 12? So if it’s between 8 and 12% it’s considered average. It’s above 12 it’s above average and if it’s below 8 it’s below average. Most people are surprised to find out that only 20% of the year, 20% the decade periods fall between 8 and 12%.
So the odds on bet, is that returns for any given decade are going to be above 12 or below 8. In that above 12 group which is about 36% of the time those are periods that are associated with increasing valuations where P/E expands and then conversely the ones below 8 or where P/E contracts. So where do we stand today? With P/E high, almost no one is expecting that valuations are going to increase from here. And even some of the often bullish folks like you just mentioned see a slight contraction in P/E from here.
So we know we’re not set for a secular bull. How low does it have to get? Well, it has to get to the point where P/E can double or triple. So if anything, I think we’re starting out in the high 20s right now. P/E would have to get down, gosh at least to the mid-teens if not the low teens to then have a chance to double. Because if we don’t get a doubling of P/E over a 10-year period, you can’t get enough extra oomph to get you from below average to above average.
Meb: To be clear listeners, like Ed’s not necessarily saying the stock market has drop 50% tomorrow, but this could mean that there is a very elongated period of very low returns. And I think the classic example would certainly be something like Japan where it had this massive bubble. But there’s plenty of other expensive markets over the past 10 years. Think about China and Colombia, Mexico India. They got very expensive and they did work out their valuation by very large bear markets where price crashes. But you could also have a just terrible muddling along situation of zero or low single digit returns or even slightly negative returns for a long period.
But that’s usually what gets the wash-out stage and it’s funny Ed because we’ve seen a couple of surveys and I actually just posed the ones Twitter which we’ll read here in a minute. That show expectations for investors of around 10% US stocks were actually 10 and a half percent. And we demonstrated with your equation and said, “Look if you plug in the numbers today and assume historical earnings growth stocks have to…the P/E multiple has to rise to the highest it’s ever been in history just to hit expectations.” So the biggest problem with investors, of course, is they’re living in fantasy world. It’s hard for people just like losing weight or anything else to kind of take their medicine.
Ed: And actually what you just described right there Meb, I call the reconciliation principle. And if anything I think this is one of the key things for an investor or an adviser to put in their toolbox. So when you hear a pundit say, ”Gosh we’re expecting returns over the next decade 10%.” The first question should be just as you described second ago, what are the component parts let’s reconcile that back to the three parts? And I think there’s a tendency for people to again think in terms of because we’ve been taught that the only return that you can get is from market returns. It’s a matter of portfolio theory taught us to diversify portfolios to get rid of company risk and just take market risk. And then mamma taught us that markets are efficient. Now they’re actually an efficiency process and an official event but nonetheless. And then Malkiel wrote the random walk down Wall Street.
So people have been walking around for decades thinking that well stock market returns are random You can’t predict it when in reality because of those three fundamental components if they are predictable. So I think to get to the 10% just like you described you’ve got two points for dividends. The question is if from an earnings growth, as to be generally is very close to economic growth over the long run and in an environment, we have relatively low economic growth and inflation that means a phenomenal growth in earnings is going to be below average. That requires that third component just like you described that requires P/E move up to go 50% from here. To add that extra oomph.
Meb: It’s simpler answer is that I just watched the Sci-Fi movie Moon which I’d never heard of which listeners is basically the concept where we have found unlimited energy source on the moon. So I think if Elon Musk finds unlimited energy on the moon, maybe we’ll get 10% returns but otherwise it’s going to be tough. You actually have another interesting chart. And I’m just skipping ahead because I did love your comment on average rarely happens. I think that’s a really interesting discussion because most investors think they can 5 10% returns that’s going to be likely but in reality, normal stock market returns are extreme so you have these huge outliers both to the upside and downside and in part that volatility you mentioned is what you call volatility gremlins. You’ve mentioned this for the past. Could you explain what that means for investors? What do you mean by volatility gremlins?
Ed: Sure. There are two volatility gremlins that have a significant impact on compromising the compound of returns that investors will see. The first of those volatility gremlins is the effect of losses. I think that best way to demonstrate that is let’s assume that one year you have a 24% return and then next year you have a 20% loss. So obviously if you for that two-year period up 24 down 20, well that’s 4% divided by 2 that’s 2% simple return per year. But in reality, if you run a portfolio through that equation where it goes up 24 and then down 20 you’ll actually end up almost down 1%. So because the effect of negative numbers on compounding effect of losses and that effect has is greater as you increase the amount of loss.
So we know that if you lose 10% you have to make 11 to make it up. If you lose 20% it takes 25% to make it up. And as investors in the Nasdaq know from the late 90s if you lose 80% it takes 400% to make it up. So the point is that Warren Buffett said the first rule of investing is don’t lose money. And the second rule is to not forget the first rule. The reason is because losses have such a disproportionate effect. And that’s one that’s the first volatility gremlin. But the second volatility gremlin is that the dispersion of return. Basically, if you get the same level of return every year let’s assume you get 15% 15% 15% just to use an extreme number, you get the best compounding.
If you instead have dispersion and returns so one year it’s five when you’re at 15 one year it’s 25 and that manner of the order, that would actually give you less compounded return benefits and even [inaudible 00:24:26] each year. The reason that’s important is there’s a perception that you need to take more risk to get more return and that volatility is good. But in reality the impact of losses and the variable and the effect of the variability returns on compounding, those operate together to work against investors converting simple returns into compounded returns the ones that count. And that’s why I often say that this is an example of where the tortoise gets an edge over the hair on this race. And this is an example of where you don’t have to have more pain to get more gain.
That in many cases although it’s psychologically desirable to be sick it is psychologically desirable to have smooth returns and have fewer losses, it’s also better for compounding which is contrary to the notion that risk is not to turn up to get better returns.
Meb: That’s a great point in thinking about all kinds back the valuations we’ve done this and we’ve seen a lot of others do this where you show that high valuations not just in the US but globally, if you can stair-step up valuation is the starting point is that the higher the valuation, the larger your future drawdown will be at whatever time frame three to 10 years meaning that if you’re buying stocks at P/E of 30, you have a higher chance of a big fat loss than if you bought them at say 10. And this goes back to the classic margin of safety or that’s been around for 100 years. And it doesn’t just apply to stocks it applies to anything.
You buy a car has a baseball card that has really high tethered to cash flows or have multiple to cash flows chances are probably the odds are not in your favor. So what’s an investor to do? We’ve been talking a lot about stocks as one thinks about building their portfolio. People take their medicine get 4% returns and move on or how do you think about building a portfolio. What are the steps? You talked a little bit about rowing and sailing in your book and videos. You could maybe go down that thread?
Ed: Certainly. And as we go into the discussion of rowing and sailing, let me just take a moment to say that I know if one could listen to this conversation, could read some of the stuff, look at the charts on Crestmont Research and get the impression that I’m bearish for negative about the market. And let me say it’s actually not the case. This is really about assessing the market environment. And then when we talk about the level of returns the forecast at this level valuation is for returns of somewhere in the 05% range. And that’s about half of the historical average for stocks and that sounds low. But keep in mind that that’s actually pretty reasonable in historic context.
Earlier in our discussion, you talked about how you break it all down that 10% return turns into about 6% real right? And that includes a dividend rate that’s over 4%. So since we’re starting at higher valuations we need to adjust that down by a couple of points. So in an environment historically it starts at a high valuation 4% real is right in line with history and if you’re in a low inflation environment like we are today with 1 to 2% inflation you add that to four, you get nominal returns close to 5. So keep in mind I’m not talking about a really negative scenario. What we’re talking about is an environment that we start with low-inflation, low-interest rates and therefore stocks are naturally priced for lower returns.
So the reason that’s really important is two things. The first if you go in with really the one it’s I think there’s a tendency to think if one understands looks at the environment and says ”Gosh it sounds like the market is priced for 5%” And that that’s a reasonable expectation then it becomes empowering. It empowers an investor to understand that they’re not at… the environment isn’t controlling them but they’re essentially in control of their portfolios within that environment that let you then pick the appropriate strategy. So that when you use that as a segue into rowing versus sailing. In chapter 10 of unexpected returns, I titled ”Row not Sail.”
And what you find is and I think that I talk about I’m a market climatologist I talk about what drives the market over the long term and then investment philosophy but that’s as far as they go. So I’m not one that analyzes securities or industries or individual investment strategies but instead investment philosophy. Rowing is the boatman’s analogy that says that there are periods of time like the current environment where returns are relatively low. You can’t [inaudible 00:29:17] to have to be the wind at your back, and so you’ve got to pull out the oars and row. And that means a more diversified actively managed portfolio.
Sailing, in contrast, is the more passive approach. It says the market winds are at your back. So just open the sail log, and like the ’80s and ’90s enjoy the ride. But we’re not set for that today. We’re set for rowing when we row, that gives us a chance to look internationally, look across different investment alternatives. But the most empowering part of recognizing that the environment is currently priced for 5% returns is that a lot of other alternatives that people wouldn’t look at if you thought you were lowering the return of your portfolio by putting in a 5 or 6% rate or master limited partnership or commodity fund or otherwise because if you’re putting in 5 and 6 and 7% return investments you’re taking away or you think you’re taking away from that 10% get in stocks that that looks like you’re compromising your returns.
But if instead, you recognize we’re in an environment where stocks are priced for 5% they’re not priced for 10. And that the market is this Babel of returns. So below average and Babel which is not the bell-shaped curve that ensures you that if you wait long enough you’ll get back to the middle. That empowers you to start including those other things in a portfolio and not only are you actually increasing returns in many cases you’re lowering risk because with the additional diversification you reduce some of that volatility and so hence you’re impairing your portfolio to take advantage of a tip to immunize against those two volatility gremlins.
Meb: And you also mentioned the effect of rebalancing you know where you want to come back to target more in the environment rather than this trend falling environment of the P/E expansion. I’m just curious that I think about this is I wonder what the eventual trigger is from this mellow period of 1 or 3% inflation or whatnot because we’ve shown this is was you have as is others where you have this sort of inflationary P/E mountain top where we’re in the Candy Land perfect environment. And so what’s the trigger for and you know things are getting a lot worse? Is that an inflationary deflationary? I know you talk about the 60-year rule or is it something like a recession which we haven’t seen in a really long time in the US? Any thoughts there or it’s the who knows question?
Ed: Well, you see the first I would say is that and when I go talk to folks and make presentations I usually survey the audience to try to get a sense on whether people today are expecting low stable inflation, deflation or inflation. And hands down two-thirds to three-quarters expect higher inflation. So I think that is a reasonable scenario to make sure that someone breaks into their thinking. Deflation is a possibility. Lots of things could trigger it but that seems to me to lower probability. Not many see 10 years of low stable inflation.
So with that in mind what could trigger it? I guess there are lots of things that could. With all the liquidity has been put in the system in the last eight years, if that’s not properly managed and removed. You mentioned recession, we just passed in March. March represented this particular expansion that we’re in. Became the longest in history as of March of this year. And next May if it makes it that long it will become the second longest in history. The following July, July 19 if it gets there, it will become the longest expansion in history and the following January, January of 2020 if we get there we will have exited the 2010’s without a recession.
And that’s and we’ve never had a decade a calendar decade that didn’t have at least one recession going back to 1850. And matter of fact in since the 1930s, every decade has had one or two and two-thirds of the time it was two recessions, not one. So only having one recession decade is not all. If we get zero if we make it all the way to I’m not predicting a recession I’m just saying if we don’t make it to January 2020 which is not too far away this will be the first time in 150 whatever that is. 150 years not 150 years I’m sorry. Actually, it is 150 of years that we didn’t have a recession during a decade. So now what are recession trigger?
I’m not sure if a recession triggers deflation or inflation but certainly, the policy response that might happen with that trigger the potential for an inflationary response especially with the Fed right now not having many tools in their toolbox. To use they’ve extended quite a bit.
Meb: It’s fun to watch because if you were to tell people if you’d simply said if you could like men in black or raise people’s memory from the past year of what markets have done, and just describe the political climate of what’s gone on over the past year in the US, but also abroad is that no one in their right mind would probably say, ”We have one of the least volatile stock markets in the US in history.” Most people would assume that things would be going haywire and crazy which there’s a good lesson there that it’s hard to extrapolate geopolitical events to market returns and in many ways the market is forecasting the economy in many ways.
And so it’s gonna be really interesting to watch how this transpires because for many people and if you look back in history a lot of the events that play out in markets are very obvious in retrospect. But in many cases, they’re hard to forecast.
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Meb: Do you have any sense from being a publisher and having a lot of interaction with readers, do you have any sense on sentiment? And does that play anyway in your thoughts and calculations or forecasting at all and is any comments pulls on what the sentiment today feels like?
Ed: Sure. And I tend to think in terms of again I think that’s very difficult. There are some people who are able to get a pretty good record at forecasting shorter term trends may be doing it technically or otherwise. Again I’m a market climatologist so when we start talking about short term in meeting your term predictions that’s certainly outside the scope of what I would typically do.
But I do look at a dashboard. And the dashboard includes things like valuations high versus low and not how high are they because it’s basically an insight into the vulnerability. You mentioned volatility.
Volatility is a reflection of the movement of the markets which also tends to reflect investor sentiment and complacency toward risk. We are today by two measures of volatility. The first is a statistical measure of volatility the standard deviation of the stock market on a rolling basis. And right now we’re well into the lowest three four percent of all period since 1950. So that means that complacency is relatively high, markets are reasonably calm right now. The other measures the VIX it’s starting to settle back down. It’s got a 10 handle again.
Just recently a couple of weeks ago we actually broke 10. And it’s been a couple of days down below 10. In the history, the VIX goes back to 1980 that which is that volatility index measure. And we only had 11 days since 1990 over almost 7,000 days. Only 11 of them had VIX below 10. And here we are getting ready to flirt with it again. And we did have two days this year where we had below 10. That’s an indication of a high level of vulnerability. It doesn’t mean it was set to have a decline it’s not a prediction of a decline for the market. It just means that we’re very vulnerable to conditions that can naturally occur and that could set up for a correction.
The other is that with corrections we haven’t had a correction in quite a long time. And those are usually healthy for a market. When you don’t have them, I think when you don’t have recessions, when you don’t have corrections people just get a sense that maybe things are back to what we call normal and they’re stable and just ready to cruise along. In reality that’s that normal is actually volatile. Normal is not mellow.
Meb: We think a lot about many of these topics. And you talked a little bit about… we’ve been talking a lot about people starting out and investors that are just learning about markets and starting to put together portfolios. But I think it broadly applies to investors in general while. And so you’re to talk to someone who’s just starting out in investing, what would be the main healer that you would suggest them if they want to get educated and practically start to get together portfolios? What do you tell people like building a portfolio given the current environment, what advice are where do you nudge them and start to make suggestions on how to go about it?
And answer a totally reasonable answers. Just go watch my videos on Crestmont research because listeners Ed’s got a lot of great videos and about 200 charts and publications including one of my favorites was on the executive summary which is just Crestmont Research putting it all together that has about a dozen bullet points with hyperlinks which is a great way to spend a lazy afternoon if you want to learn something. Where else would you point people or what would you tell them as the foundation on getting started?
Ed: So I think the first thing I would do is suggest that when I taught investment’s course as an adjunct a number of years ago. The one thing about this students it was advanced course and a lot of it was coming in it already had the basic math courses. And it took us the first part of the class for a smart course to get people to unwind a bit of their thinking. And so I think what I would suggest to a young person is to try to inoculate them to the notion that the stock market is random. So I think the first would be to try to get them to be skeptical of conventional wisdom and to read a variety of pieces and look for the fundamental drivers of the market, look for the fundamental understanding of what drives the market.
And to reject some of them to make sure that they apply to the extent they’re exposed to tools or apply tools that are readily used in the industry is to think about the way they’re applying them.
So for example, if a person applies modern portfolio theory and Monte Carlo simulations which is very common in the industry. Monte Carlo is a great technique. It’s just too often which is Monte Carlo is where they take history and create a whole bunch of different random scenarios so that you have millions of scenarios that you then can statistically profile and come up with a prediction on the outcome of the future.
And that’s a great idea and just like modern portfolio theory is a great approach. But Marco would let off that paper saying the first phase is to start with relevant assumptions. And the second phase is about his approach. But the first one which is my model if you ask me he said my model is only as good as your assumptions. So to that, I would offer that if you’re going to Chicago and you call me up and you say what clothing should I wear and I spent some time in Chicago, I would say well gosh on average at 65 degrees there. So just dress accordingly. But anybody who’s in Chicago knows that it’s typically 90 or 30. It’s not typically 60.
So if you’re gonna run a scenario the first question I should ask is not the first answer I should give is not wear for 6, wear for the average. It should be when are you going and let’s look at the relevant weather for the periods that you go there. So let’s run Monte Carlo for your trip either using winter days or summer days not using every day of the year. When we apply that to the stock market it would be for somebody today that’s running of Monte Carlo simulation on future returns looks at history and look at the periods of average valuations and look at the outcomes that came from those periods not just look at every period. So I think it’s so I guess that was an illustration an example of going in and just thinking about what a young person is how they’re applying the tools and also be a little skeptical of conventional wisdom.
Meb: So when you were teaching classes at SMU and MBA, what was the biggest mistake or misconception a lot of the students came in class with? Was it was something that you heard over and over because there’s some that we get on the podcast and email that’s like nails on a stock board. Is there anything in particular that stands out?
Ed: The one that stand out the most is at risk drive return and that the way that you increase the return from portfolio is to increase at risk. Don’t forget is you know I did some research and some work in the hedge fund industry when I first went to teach the course at SMU and again this goes back to the early 2000s. The head of the finance department said ”just before you get started an issue you could talk to some of the other professors just let you teach just so that they know what to expect.” So I remember talking to one of the other professors that teaches traditional finance and if it is going to be a course about alternative investments, it’s going to cut discussion about hedge funds it’s going to hedge fund managers come to the course and talk about things it’s hedge funds.
Those are the higher risk higher return strategies right and so well not exactly. They tend to apply skill to portfolios and generate higher returns with lower risk. And so how do they do that because returns are driven by risk? So I think we’ve always been that the conventional wisdom is that risk drive returns it turns out that that process. When you take higher risks because of the lower probability of success, those who do get success get higher returns but it isn’t necessarily the higher risk drives higher return. And that’s why when I contributed to John Muldoon’s book ”The 12 Things Investors Need to Know,” my chapter was risk is not an ob that investors need to realize that.
And I think that’s the one that came out immediately when you start talking about the fact that there are ways to invest the modern portfolio theory way which is to eliminate individual security risk and to just take…eliminate security risk and just take market risk. In that situation your returns are strictly driven by the market. And therefore they’re driven by the risk of the market.
In the case of investors that actually pick individual securities, allocate the very strategies that they used skill to generate returns they can often generate returns without taking additional risk but by doing it by being better at their investment approach or their investment securities selection. In conventional wisdom skill because the efficient markets hypothesis Eugene Fama’s theory that from the 1970s that markets were efficient that eliminated the notion for many that skill could provide extra return. Because how can you beat the market with skill if the market is efficient?
So I think it’s the outgrowth of those three different theories that lead to a conventional wisdom that you often have to overcome before you can begin to see this fundamental driver to the market and the chance to diversify portfolios and use alternative types of investments and international investments to create returns.
Meb: The listeners out there who weren’t familiar I mean the historical concept of risk according to return I mean even with the basics of data in stocks and volatility it turns out that in many ways risk did predict return but it was exactly opposite. So that low volatility stocks did better than that. It was correct the sign was wrong is backward and then one of my favorite quotes on this is an active manager who runs White Box Funds which I think is at Minnesota somewhere in the upper Midwest and Redleaf, I think is his name. But his great quote is that look my job is to minimize as many risks as possible in the sense of trying to minimize drawdown and minimize the possibility that this entire portfolio will be ”risky.”
So as you think about you know you mentioned hedge funds in kind of some alternative times are there any favorite styles or strategies that you gravitate to and for investors that are listening it’s kind of this limitless world of choice. It’s like going on Netflix and the like ”I’m the go pick out a movie”. Do you have any suggestions for kind of people looking to allocate to that world or is it hey you get this a full time 24/7 career to pick these guys with. What’s any your general thoughts on the active hedge fund space?
Ed: So as I mentioned I really don’t research analyzer or write about individual securities funds or even specific strategy styles.
What I would offer here is that I think is probably relevant to investor’s process of selecting those things is one recognize if there are a lot of choices and it does take lots of research to do that. In this environment where returns are so low adding an incremental 100 or 200 or 300 basis points can be very significant to a future compound returns. If that comes out and so in this environment, it can be worthwhile to pay a little more to find people who have that expertise because if you can add that extra 100 to basis points even though it may cost you 100 to 200 basis points it can be very rewarding.
The other thing I would offer is we talk about diversification most people think about just having more stuff in the portfolio. And I think the important thing is if you’re in this environment the stock market is relatively highly valued you’re probably allocating some of that stock market allocation to alternatives but still keeping a significant stock market exposure. Recognize that the most significant risk to the stock market today would be a rising inflation or rising inflation that would also drive up interest rates and would cause valuations to decline which give us not just our 4 or 5% return but it could give us a zero return over a five or 10 year period.
So if inflation is a significant risk to a significant portion of the portfolio, the stock allocation if you found two alternatives there were equally good but one of them was a hedge on inflation and the other was vulnerable to inflation. There’s great value in adding to one in that would be a hedge to inflation. So at least you have some ZIG to offset your ZAG if we go into that higher inflation environment that a lot of people expect. So looking at the risk across the portfolio not necessarily just looking at the variety across the portfolio.
Meb: And there’s a lot of asset in commodities is one that is in particularly hated over the past few years is commodities, in general, have done very poorly. Incredibly popular asset class in the mid-2000s but one that has really struggled that historically has had a pretty decent correlation to rising inflation. I would love to keep you for many hours today but we’re gonna start to wind down and ask a few more questions. We have a lot of investors on the podcast that are late career and maybe retirees that are focusing on income. Is any of your advice differ for them because they have an opportunity set where US stocks like you mentioned low single digits US bonds 2%. Any particular advice that you were or is just same advice differently applied?
Ed: For that group, I would actually provide I would emphasize some of things we talked about. One thing about that young person that we talked about earlier is that they’re in an accumulation phase. And so they’re constantly adding new dollars into the portfolio. So if we have dips in markets etc, their new investments can be reinvested at lower valuation or rebound or be used to rebalance the portfolio. For an older investor that’s going to begin to harvest that portfolio or live off the income from their portfolio, they’re particularly vulnerable to early declines and they’re particularly in need of more current cash flow.
So I would say some of the things we talked about because right now the opportunity is with some of those alternative investments are to pick things that have a more current yield that can provide that income and provide that balance against any if we do have some vulnerable to some work in the near term and any draw-downs that might occur there.
Meb: So one or two more and then we’re gonna have to let you go. This is one we’ve asked everyone in 2017. Thinking back over your personal history, what is the most memorable trade of your own or investment good or bad that comes to mind?
Ed: Well, I think the one thing that makes it hard to answer is that I tend not to do a lot of individual…in the past, I did quite a bit of individual investing or use of auctions in portfolios.
Meb: Jeff just picked up.
Ed: And spent a few years in the commodities industry and could tell you some stories, horror stories about the lessons learned there. But I think the best way to answer that question right now would be to say I think that some of the most valuable lessons have been the need to keep losses to cut your losses soon. And I think the biggest mistake that I find when I talk to a lot of investors. They all look back across the year and they say ”if it wasn’t for those one or two or three big losses they would have done pretty well.” Many investors that are diligent will have a pretty would have a pretty good hit ratio.’ They tend to have 55, 60, 65% of their individual choices securities funds etc be successful.
But boy they’re usually those one or two big losses that turn what could have been a good year into a bad year. And that usually happens because of the lack of discipline or the susceptibility to human nature. It hopes that that loss will stop they begin to lose a rational view. Now, this doesn’t mean that you always get out of every investment that goes to a loss but you have to be more diligent about reassessing its value and make sure that you’re properly valued in that investment because sometimes a dip in investment creates an opportunity.
But the key there is and I think that’s one of the reasons that a lot of skill based managers and the hedge fund industry, in the commodities industry etc tend to be the ones that tend to be successful over time are the ones that are able to bring a rational discipline to investing and they can suppress the human emotion that has a tendency to commit to make us play whack a mole with our portfolios.
Meb: Yeah I see that quite a bit where people will hold on to losses all the way to zero and sell their winners. And part of the reason is that it’s so hard to hang onto the winners and if you pull up a chart of some the biggest winners of the past 20 years Amazon, Netflix whatever it may be the fortitude to assert through that investment with multiple 40 60 80% losses is really, really hard in general and so coming up with some process I think is really important. We’ve talked on in the past look buying all the perfectly good solution. But as is using stocks losses. We’ve got a bunch of people on podcast say, ”Look guys systematically slap on this stop loss on all my individual investment picks, it hits it I saw it and I move on.”
So it’s is really finding out what works for you. Ed, it’s been a blast today. We’ve had a really good time. Last question before we go. What are you most excited about or what are you thinking about these days in the woods of Oregon? Any research areas any topics that you’re mulling around kicking around your head working on these days that we can look forward to you writing about in the future?
Ed: A couple of things that started to…you’ve seen the recent couple of analyses about that I think you’ll see more about is the economy and economic growth and the risks of economic growth to the market. I raised the issue in probable outcomes.
But I think it’s becoming more relevant now that we’ve had even more time. And that is the long-term average P/E ratio and the range for high and low P/E ratio was in an environment of historically average growth. Economic growth of just over 3% real growth. And I think everyone would agree that if you have a portfolio of high growth stocks that you expect it to have a higher P/E ratio than a portfolio of low growth stocks.
If we’re going forward into the future likely to have a slower growing economy than we had in the past, we’re going to have slower growth and earnings. And if we have the next few decades of slower growth and earnings, we should expect that that effect alone is likely to lower the price earnings ratio beyond whatever the inflation rate does. And that’s not baked into the market right now. There’s no recognition that I’ve seen that a slow growth economy which drives slower growth earnings over time and with normally drive a lower average P/E ratio is having any effect on current valuations. So to me that’s a vulnerability it’s something we should keep in mind. I think that probably gets recognized coming out of the next recession because for now people are assuming a 2% growth economy and we haven’t had a recession a long time.
You take a 2% or 2 1⁄2% growth economy like we’ve had the last eight years. And you add in an occasional recession and all of a sudden we’re looking at a future of sudden 2% growth. And that’s a lot less than a three and change that we had historically. And so me that’s a vulnerability. Just have to keep in mind that it could potentially lower the returns from stocks below that 4, 5, 6% that we talked about earlier.
Meb: Let us know when you publish, we’ll have you back on the podcast. Ed, it’s been super fun. Where can listeners find more information if they want to follow your work and keep up to date?
Ed: Sure. At the crestmontresearch.com, it’s an open access website. There are no banner ads or fee subscriptions. I look forward to. There’s a page on the Web site where investors or readers can send questions or comments those comments questions often help generate additional research. There is on the website a sign up for notifications when there are updates. As a market climatologist, I am not writing about this every week or month.
But generally, it’s once or twice a quarter and investors can include their email. There’s no fee for that and that’s not never used never shared with anyone else other than just notifications periodically updates the website. On the website in the books and video section, you referenced it earlier. There is a video series that’s based upon the book” unexpected returns.” It’s a complimentary video series and I think it is a trailer an eight-minute trailer there that person can take a look at and see if they want to spend the time listening to the video series. And then if they really get interested they’re always the books and obviously, Amazon has as both books if an investor or a listener would like to dig in even deeper.
Meb: By the way, we’ve got to talk you into getting to eBooks. Do you not have eBook, Kindle copies for either book?
Ed: Well the ”The Unexpected Returns” actually went digital a few years ago. So ”Unexpected Returns” is available on Kindle on eBook. So obviously it’s beyond Kindle. ”Probable outcome” has not gone digital yet but I expect returns is available that way.
Meb: All right. Summer Project. I could care less because I’m a physical book guy but so many of my readers now are or eBook converts.
Ed: Just you know Meb, one of the challenges in going eBook for that both of my books. The books contain about 60 to 75 color charts and graphs. That’s one thing you’ll find different about the ”unexpected returns” and ”probable outcomes” books as they are printed in color so that the graphs can be of it can be more insightful. In eBook format that’s a little more challenging to manage and a lot of people’s eBook readers are monochrome. Some are not but some are. Some of those charts just don’t quite look the same when they’re in black and white. Thanks for the chance to share those things with the readers today.
Meb: Yeah just go download them up Ed’s website and print them out and put them up on the wall, they’re good. Ed, it’s been a pleasure, thanks so much. Listeners thanks for taking time to tune in today. We always welcome feedback and questions at the mailbag at [email protected] As a reminder, you can always find the show notes. We’ll post links to a lot of Ed’s publications and other episodes in mebfaber.com/podcast. Subscribe the show on iTunes and if you’re enjoying it, hating it, please leave a review. Thanks for listening friends and good investing.
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