Episode #193: Chris Brightman, Research Affiliates, “Here We Are With Emerging Markets Again Trading At A Shiller PE Multiple Less Than Half Of The US Stock Market”
Guest: Chris Brightman is a member of the Research Affiliates board and leads the Research, Investment Management, and Investment Strategy teams. In this role, he supervises Research Affiliates’ research and development activities, provision of index strategies, and management of client portfolios.
Chris has three decades of investment management experience in equities, fixed income, currency, and asset allocation. He has traded securities and derivatives, managed portfolios, supervised quantitative product development, and allocated assets to alternative investment strategies. He also has extensive organizational and people management expertise.
Prior to joining Research Affiliates, Chris served as board chair of The Investment Fund for Foundations (TIFF), vice chair of the Investment Advisory Committee for the Virginia Retirement System, chief executive officer of the University of Virginia Investment Management Company, chief investment officer of Strategic Investment Group, director of global equity strategy at UBS Asset Management, senior portfolio manager at Brinson Partners, vice president and head of asset/liability management at Maryland National Bank, and associate national bank examiner at the Comptroller of the Currency.
Date Recorded: 11/18/19
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Summary: In episode 193 we welcome our guest, Chris Brightman. Meb and Chris start the conversation with an evolution of economic and monetary theory over the past decades, and some detail behind Modern Monetary Theory. Chris then expands on inflation, the idea that high inflation is associated with volatile inflation, as well as some ways to protect portfolios from high inflation.
The pair then get into Research Affiliates’ forward looking asset class return expectations, including, the expectation of a 3.5% real return for the US stock market before any adjustments to valuations and the reality of low and even negative return prospects from fixed income. Chris talks about emerging markets as a potential bright spot.
As the conversation winds down, Chris reveals some ways investors can think about implementing the ideas he discusses in the episode, including the literature that shows investors engage in performance chasing, and they’d be far better off taking a buy-and-hold approach to a diversified set of passive instruments.
All this and more in episode 193, including a couple of Chris’s most memorable investments.
Links from the Episode:
- 0:40 – Welcome to our guest, Chris Brightman.
- The Meb Faber Show – Episode #18: “People Need to Ratchet Down Their Return Expectations”
- The Meb Faber Show – Episode #52: “This is a Market Where the Average Human Tendencies Are Precisely the Wrong Thing to Do”
- The Meb Faber Show – Episode #172: Cam Harvey, “This is a Time of Considerable Risk of a Drawdown”
- 2:01 – What Chris learned about economic theory in school and how that has all changed today
- 8:32 – The prospects for inflation and how to prepare for it
- 17:47 – Chris’s view on policy impacts on markets and where we stand in the current markets
- 26:51 – Common sense policy ideas that may put US and others on the right path
- 30:16 – Research Affiliates view on assets and how they should fit into portfolios
- 34:57 – Fixed income in a world with negative interests
- 37:43 – How underfunded pension survive
- 41:12 – Pockets of opportunities in emerging markets
- 41:23 – Pundits Predicting Panic in Emerging Markets (Brightman, Mazzoleni, Treussard)
- 48:14 – How people should apply Chris’s philosophies in their portfolios
- 57:58 – Anything Chris has changed his mind on over the span of his career, building an organization
- 59:38 – Most memorable investment
- 1:01:43 – Recent resources Chris has loved
- 1:02:44 – Best way to connect with Chris: researchaffiliates.com
- 1:03:12 – Future projects to keep an eye out for
- 1:03:34 – Oh My, What’s This Stuff Really Worth?
Transcript of Episode 193:
Welcome Message: Welcome to the “Meb Faber Show,” where the focus is on helping you grow and preserve your wealth. Join us as we discuss the craft of investing and uncover new and profitable ideas all to help you grow wealthier and wiser. Better investing starts here.
Disclaimer: Meb Faber is the co-founder and Chief Investment Officer at Cambria Investment Management. Due to industry regulations, he will not discuss any of Cambria’s funds on this podcast. All opinions expressed by podcast participants are solely their own opinions and do not reflect the opinion of Cambria Investment Management or its affiliates. For more information, visit cambriainvestments.com.
Meb: Welcome, podcast listeners. Another great show for you today. Our guest is the CIO and member of the board of Research Affiliates. We’ve had a few of those good folks on before, Rob Arnott, Jason Zoo, and Cam Harvey. Three awesome episodes we’ll link to in the show notes. As CIO, he leads the investment teams and supervises research and development activities, provision of index strategies management of clients’ portfolios. With Rob, he’s also the co-portfolio manager of the PIMCO all-asset all-authority funds. Before joining Research Affiliates, and this is sort of complicated because he used to be a Virginia Tech Hokie, he was also the CEO of the University of Virginia Investment Management Company endowment as well as the Strategic Investment Group. In today’s episode we get into the evolution of economic thought and some detail on the philosophy behind modern monetary theory. We discuss Research Affiliates expectations of low returns going forward for U.S. stocks and the outright bargains that exist in emerging market equities. We also talk about portfolio implementation and research that suggests investors engage in performance chasing and the idea that they would be better off if they adopt a low-cost, buy and hold approach. Welcome to the show, Chris Brightman.
Chris: It’s a pleasure to be with you.
Meb: Chris, we have to address this because I was just back in Virginia and you went to school down the road at Virginia Tech. Were you an engineer, undergrad, business? What’s the story?
Chris: Yeah. I was a finance undergrad.
Meb: Well, I figured we get started. You do a lot of awesome writing. We’ll post some of the PDFs to the website. But interesting times we live in as the year comes to a close, as the decade comes to a close and you’ve been writing about some of this over the years. But I’d love to walk back, because one of your papers does a pretty nice job of talking a little bit about the changes in economic and monetary theory and how they’ve changed over the past few decades. I’d love for you to take us back to when you were at Virginia Tech and what they were teaching in the classroom then. Maybe a little bit different than what the finance textbooks teach today, probably not a lot about negative interest rates. But we’d love to hear a little bit and we can kind of walk through a little bit about your MMT ideas and everything else.
Chris: Sure. When I was in school which started in a very late 1970s and then into the early 1980s, the core economic problem of the time was stagflation. We had very high and volatile interest rates and rates of inflation coexisting with a series of rather nasty recessions, and the dominant school of economic thought, at least, as was taught to me in macroeconomics at Virginia Tech was monetarism. And to greatly oversimplify, you can explain it as a simple equation, the MV equals PQ. Money times the velocity of money, how many times each dollar spent in a year, is equal to PQ, the price level times the quantity of goods and services produced and sold in the economy with the insight that P is approximately a constant, people tend to have whatever behaviour they have for turning over money, and in the short run Q is subject to all sorts of constraints, Q, meaning the aggregate output of the economy. You can’t simply call into the existence a bunch of new factories and produce a bunch of new goods and services simply by printing money. So, if M increases rapidly, P increases rapidly, the money supply determines the price level, or too rapid growth in money causes inflation and that was the problem that was bedevilling not just the U.S. but many of the world’s developed economies at the time. And ever since then, and I would say through until today, that has been received wisdom that monetary authorities should make sure not to increase the supply of money at an irresponsible pace because the result will be a terrible inflation problem, and that inflation problem can coexist with and probably causes or worsens real economic problems.
But, I think what’s rather fascinating about today’s environment is that there’s a heterodox school of economists who promote MMT, Modern Monetary Theory, suggesting that there really is no limit to the amount of money that a Central Bank can create and provide directly to the government so that the government is no longer constrained by the collection of tax revenues or the sale of bonds in its provision of government services and to the public. And if this were just a collection of out of mainstream economists perhaps with a small following of similarly out of mainstream politicians, it would be nothing more perhaps than a curiosity. But what got me so interested in this subject such that I spent a lot of time reading about it over the, well, basically in the spring, was that a lot of mainstream economists, really well-respected people like Larry Summers and perhaps more controversially, Paul Krugman, were starting to take these crackpot theories more seriously and commenting on them. Their commentary was overwhelmingly negative, but nonetheless, the fact that mainstream economists are paying attention suggests that there’s something that we should perhaps look into. Now. I think it’s even more fascinating because we have much more respectable people, thoughtful analysts advocating policy that sounds awfully similar to MMT. You probably are aware that I would be speaking of Ray Dalio’s Monetary Policy 3, and even more interesting to me is the paper written by Stan Fischer published with a couple of economists at BlackRock advocating the creation of some sort of fiscal facility under the control of Central Banks to print money and directly inject it into the economy when circumstances warranted. Now, I’m sure that, and in fact, the very paper that was co-authored by Stanley Fischer emphasized the differences between the emergency use of a fiscal facility and the seemingly less constrained advocation of money printing to fund government services and goods despite the economic environment. Yet, I still see an awful concern about the loss of the taboo of using money printing and sort of a dissipation of the collective memory of how bad the outcome gets when you start using money printing to fund government expenditures. Having said that, given where we are in the economic cycle, I don’t think this is imminent. Inflation is not about to go zooming up next year. Still, it’s ominous.
Meb: Yeah. I mean, you mentioned in your paper, you talk a little bit about historical experiences policies similar to MMT has resulted in kind of periods of higher and volatile inflation. Maybe talk a little bit, like how do you guys think about that possibility? How do you think about preparing what to do about it? Do you sort of discount the probability of it? What’s your thoughts?
Chris: Well, the prospect of high and volatile inflation. And I want to explain why I link those two. I’ve studied periods of high inflation, and everywhere that I can find data, high inflation coincides with very volatile inflation. There doesn’t seem to exist such a thing as high and stable inflation. You could imagine, I suppose, theoretically, if you had an economy with lots of indexation and predictability, you could adjust and do fine running an economy with 25% a year annual inflation. But the reality is that we never ever see high and stable inflation. Inflation is always accompanied by high volatility. And that volatility is not just in inflation, but also obviously in interest rates as well, but also in other dimensions like the economy and stock markets. And so while some might say that stocks are real assets and therefore, over the long run, you don’t need to be concerned with inflation, there may be some truth to that, but there’s also truth in Keynes’s observation that in the long run we’re all dead. In the intermediate run, when you get a huge increase in volatility of interest rates, inflation, the economy, the stock market, stock prices don’t like volatility. And besides which I think when you see that kind of environment with high and volatile inflation, I don’t know, I think Argentina and Venezuela come to mind, it’s generally a thermometer telling you that you have a very sick, not just economy, but probably sick society, and it’s just a horrible environment for the performance of capital markets. Stocks do terribly along with bonds. And we are cognizant that that may and likely will occur again and perhaps in the reasonably foreseeable future. What we take away from that is that investors should think through how they invest in the context of that kind of a scenario and not look over just the short horizon of the disinflationary environment that exists since I graduated and went to work. I went to work and my first job in the investment management industry was in 1982 in Chicago, and basically, from then till today, we’ve been in this huge disinflationary environment that has greatly flattered the returns of traditional stocks and bonds. And it’s very, very difficult for most people to imagine that what has been normal during their entire professional career isn’t normal. Trends of always declining interest rates, not just low-interest rates, but always declining interest rates is not a perpetual environment. And profits rising faster than the economy is not a perpetual environment either. And these are deeply related. And when this reverses, and I’m sure it will reverse, you won’t want to be in the sort of instruments that did so well during the disinflationary boom. So, what can you do to better diversify your portfolio? There are a number of traditional inflation protecting asset classes. Perhaps the most obvious and least risky would be TIPS. Problem with TIPS in today’s environment, of course, is zero real yields.
REITS also offer a nice, liquid, tradable real asset, in the short run are highly correlated with the U.S. stock market and for that reason, they’re probably pretty pricey in today’s environment as well. And then lastly, I would say probably commodities as another liquid publicly traded asset class that provides a measure of inflation protection. We also find other asset classes that are not typically thought of as inflation protection, but empirically do provide considerable inflation protection. For example, high yield bonds and bank loans. Bank loans because they’re floating rate, so obviously any kind of fixed income security that adjusts up with increases in interest rates and inflation rates is going to provide you a considerable protection. High yield bonds, you might scratch your head, you would say, “Well, geez, these are nominal bonds. They have duration. Interest rates go up, they ought to perform poorly.” And that’s true, but they have some interesting differences from, say, government bonds. One is that… Or in government bonds and high-grade bonds. One is that the capital markets are not willing to extend credit for as long a maturity to the low investment-grade borrowers as they are investment-grade borrowers. So, the high yield market tends to be at max a 10-year new issue and the average duration accordingly is much lower, so you have lower duration than in investment-grade corporate or government bonds. And two, the higher yields themselves further reduce the duration. But the most interesting phenomenon that creates some protection from high yield bonds is that the companies that issue those high yield bonds are highly indebted companies. And the reason that governments choose to pursue an inflationary policy is to inflate away the value of debt. Sometimes we refer to this as financial repression, and highly indebted companies like highly indebted countries are able to reduce the real value of their debts through the high inflation rate. Or another way to think of it is instead of balance sheet terms which I was just describing, we could think of cash-flow terms. Company issues a lot of fixed-rate debt, its interest rates are fixed. If you have a high inflation, a big rise in inflation, their top-line sales increase while their big chunk of interest expense is fixed, their margins improve. So, this is the explanation for the empirical observation that high yield bonds tend to do quite well in inflationary environments. Another group of assets would be all manner of emerging markets, the currencies, the bonds, local currency bonds, and emerging market equities for the rather obvious reason that the emerging markets tend to be much more influenced by the commodity cycle than largely service-oriented post-industrial economies that characterize the developed markets. A word of caution there. Not every company or even every country in the emerging markets is heavily dependent upon commodities prices, so this is not foolproof. Nonetheless, taken as a whole, the emerging market asset class is much more commodity-sensitive and likely to do relatively well in the high inflation environment relative to developed market economies. So, I think that’s a sort of a structural opportunity to reposition portfolios towards better diversification and away from the mainstream stocks and bonds that have provided such fabulous returns over the past several decades.
Meb: Well, it’s funny. As you mentioned some of these asset classes, investors are probably, they’re queasy thinking about some of these, because like commodities. I mean, if you go back 10 years, maybe 12 years ago, and so many of these were kind of hot products where a lot of people were rushing into them at the time when oil was peaking up around 120, 150 and everyone was super worried about inflation, of course, and then you don’t have much over the past 10 years. I mean, bank loans. That was such a hot category for years. And it’s funny to think about… We often think about, we say, “What’s going to cause people a lot of pain?” And often it’s environments where most of the money managers haven’t experienced it. I mean, the financial crisis, I think, was, in many ways difficult for a lot of investors because the most similar market in my mind was similar to the 1930s. And then you start to have at this point coming around in 2020, we’re starting to lose a lot of the investors, retiring or whatever they’re doing, that were around in the ’70s, that experienced that in their career and for the better part of 40 years, you know. It’s been a story of disinflation or outright low inflation. I’d be curious to see how many people are prepared for that sort of environment. So, stay on policy a little bit longer before going full cannonball into the investment world. A lot of the MMT ideas and a lot of the ideas getting kind of bandied about, seemingly come from the framework or foundation of inequality based on all sorts of different stuff. And you had a nice paper a couple of years ago, but I think it’s still relevant today on public policy profits and populism. And I’ll read the first sentence or two and then let you run with it. But you said, “Public policy prioritization of economic stability has coincided with slower new business formation, fewer and larger publicly traded companies, increased monopoly, pricing power, ballooning corporate profits, a sharp decline in the cost of capital, and stagnating wages. Refocusing policy away from inhibiting change and toward fostering growth through creative destruction will reduce bloated monopoly profits, raise wages, and increase yields on investment securities. Because highly organized special interests who profit handsomely from today’s status quo stand in the way, implementation of such healthy reform may fail. A populist reaction could dramatically increase the cost of capital and thereby raise the labour share.” Talk to me a little bit about this. This is as the new elections come down the pipe not too far down the road. Give us your thoughts on this paper and with a look and a nod towards the future.
Chris: Let me talk a little bit about what I’ve read and how I’ve come to this understanding and then relate that to the present environment in a little more colourful terms. I think I read a fantastic book several years ago by Edmund Phelps. For those listeners who might be a little younger than me or not as a frequent reader of economic textbooks, Edmund Phelps is a Nobel Prize-winning economist who after he did his work that he won the Nobel Prize, he then went after the Berlin Wall fell and became an advisor to many East European governments trying to help them make the transition from Communism to capitalism. And he since returned and written this terrific book called “Mass Flourishing,” a “Mass Flourishing” by Edmund Phelps. And he describes the problem that we have drifted into in many of the most advanced economies in the world, including much of Europe, Japan and the United States. And to use the current buzzword, what we’ve got is more crony capitalism than free markets. There’s just a huge amount of time and attention applied by the world’s largest companies to manipulate the system and the regulatory environment in their favour. And we have a set of governments that knowingly or unknowingly, and I think there’s some of both, collaborate and facilitate this capture of policy by large corporations. Sometimes it’s completely just really unconscious, I would say for example, Tim Geithner believing that bailing out all of the banks and all of the bankers who were part of his social and professional circles since probably before he can remember, was absolutely the right thing to do to save the world from going into the next Great Depression. And you can’t run the counterfactual, maybe he’s exactly right. That certainly did have the effect, the bailouts and the subsequent quantitative easing of inflicting most of the pain of the financial crisis on the least well off of our society and protecting an awful lot of people who probably bore more responsibility for it. I don’t know that there’s a real appreciation that that’s the case. I get a very defensive reaction when I talk to people who were involved in implementing those policies. And then there’s the much more explicit type of activity with the revolving door between people high placed in these various regulatory agencies and then the companies that they regulate. It’s not at all uncommon to see that revolving door spin, and you’d have to believe that people are not completely unaware of the process of manipulating the rules for the benefit of a particular company.
That was one piece of background. I also found a very interesting book, a very short book, one anybody could read on a flight called “The Curse of Bigness” by Tim Wu. Tim is a former Obama official and a law professor at Columbia University. Left Columbia, went into the Obama Administration, now back at Columbia University. And he’s not an economist. He’s a lawyer, but he has this nice little book on how we’ve failed to keep up antitrust regulation and antitrust policy, and as a result, there is just a huge increase in monopoly profits and rent-seeking in the economy. I don’t blame really the companies that pursue these policies. The system is what it is, and they are successfully navigating the system that we have to build moats and generate fabulous profits. And one man’s fairly built moat is another’s unfair moat extraction. But when I find a right-wing economist like Edmund Phelps and see similar arguments with a left-wing policy advisor like Tim Wu, I start to pay attention that maybe there is something going on there. And let me offer the additional observation that the assumption that all the output of the economy, all the income that doesn’t go to labour goes to capital is dangerously out of date and inaccurate. Let me explain. Back in the ’70s and ’80s when I was in school, we were taught that basically, the output of the economy is shared between capital and labour. You’ve got the labour share, and what doesn’t go to labour goes to capital. And there was this kind of asterisk in the textbook that in theory, you could have monopoly profits or what economists would call rents, but that in a competitive economy that ensures that while it pops up from time to time a little bit here and there in this or that industry, at the aggregate economy level, there really are no persistent rents or monopoly profits. That’s what the antitrust policy is for. And so we can just assume that’s a rounding error and just say everything goes to labour and capital. But more recently, economists have been directly measuring the amount that goes to labour and the amount that goes to capital. And while the amount that goes to labour has been plummeting and dropping, the amount that goes to capital has not been increasing, it’s actually been declining too. And you might say, “Well, wait a minute. Aren’t the capitalist getting rich?” Well, no. Think about somebody that’s living off of their accumulation of capital. They’re trying to live off of coupon payments from bonds and dividends, from equities and the rents that a piece of real estate might provide.
Well, I can tell you interest rates are rock bottom, dividend yields are poultry, and cap rates have fallen through the floor. Nobody is enjoying a retirement living clipping coupons these days. That’s not where the money is going. The money is going to these economic rents or monopoly profits. And who’s enjoying those? Well, if you’re exiting, if you were an entrepreneur who built a wonderful business and you’re selling that business, it’s fantastic. If you are a corporate insider that’s being paid with stock options, you’re participating in this bonanza of rent extraction, but the rent extraction is taking money out of the pockets of retirees, and it’s taking money out of the pockets of labour, and people are noticing. They’re angry. You see the rise of populism not just in the United States, but all around the world. It’s not just in developed countries. I mean, we see it in Europe. We see it in the U.S. And my gosh, we’re seeing it in Latin America. Chile, one of the most prosperous and stable of all South American countries and there have been riots in the streets, there’s something about the system that isn’t working. And Ray Dalio has been writing at length on this subject. I think one way or another it’s going to have to be fixed. I think that reform is far the preferable way. I suppose revolution is the more frightening way. And of course, those are not either/or binary choices, but you can have lots of gray area in the middle, I guess, with Elizabeth Warren and Bernie Sanders staking out the revolutionary side of the change with, I don’t know. I’ll leave it to the listeners, who’s proposing reasonable and sensible reforms.
Meb: Well, and so let’s say you have the ear of the newly elected president, whoever he or she may be, are there any ideas that you think are just common sense that seem somewhat obvious that gets us to on a runway of a sustainable path and fixes some of these struggles that are going on, not just here, but you mentioned elsewhere too?
Chris: Yeah. I think eliminating crony capitalism is probably the most important, much easier said than done. Then I think there’s also a… I wish we could get to honesty and a recognition of willing the means to the ends that people want to achieve. Let me give a concrete example of what I mean. We have progressives in the United States who strongly advocate on very kind of moral grounds a vast expansion of state programs to provide various benefits for people, from universal health care to free college education to a right to a job, etc. And yet, when we look at the sort of tax system that Europe has found is able to fund these sorts of programs, it’s a value-added tax. It’s a very, very broad-based consumption tax. And I think that that would make a lot of sense. Right now in the United States, we have a collection of income taxes and very, very regressive payroll taxes. Our tax system is not nearly as progressive as some people think it is. The income tax system is incredibly progressive, but the payroll tax system is incredibly regressive, and you put them together and it’s just kind of a crazy mismatch. And payroll taxes are just a terrible idea because they discourage work, and income taxes… Let’s just say I think consumption taxes make more sense than income taxes because if somebody is enormously productive, but they’re not consuming their productivity or reinvesting it in the economy or providing it as philanthropy, that’s probably better than somebody that’s consuming even more than their large income. So, I think it’s just very good reasons for why a consumption tax would lead to better productivity and increasing wages and just a more sensible way to tax. And yet, we have a, taking no position on whether we should or shouldn’t provide increased social benefits, I would just say, we’re unlikely to do so without the sort of broad consumption-based taxes that every other country that provides base level of benefits provides. So some sort of accommodation and agreement that, yes, people do seem to want some more benefits and in order to provide those benefits, yes, we should all broadly as a country be willing to pay a broad tax like a value-added tax. I think if you start to see us trending in that direction, we’re moving in the reform direction. But if all we’re trying to do is confiscate the wealth of billionaires and that’s the way to provide better social outcomes, I think that probably doesn’t end well.
Meb: Interesting time we live in. As I mentioned before, we’re winding down the year, winding down the decade which is often a great time to reflect on your portfolios, but also take a look to the horizon. Your company, Research Affiliates, has one of the best websites on interwebs with a wonderful asset allocation tool. Listeners, if you have not been there, certainly check it out. We’ll put links in the show notes. But it is a beautiful visual representation of how Research Affiliates thinks about the world. And it’s not how most people think about the world if you look at some of their expected return beliefs, etc. The one that probably most listeners have their biggest allocation to, I smile when I say Research Affiliates’ forecast, there’s about a 2% chance of U.S. large-cap stocks hitting their historical return targets going forward. In fact, I think you guys propose that returns are darn well near a real return of zero. Talk to me a little bit about how you guys see assets and how they may fit into portfolios and beliefs on what the world may look like in the next 10 years.
Chris: Well, we have a straightforward approach to creating forward-looking expectations for asset class returns. We start with the cash flows that are being generated by an asset class and then look at the price that the market currently assigns to those cash flows which creates a yield. In the case of the U.S. stock market, that’s about a 2% yield. And then we add an increment for growth and cash flow and that would be a growth in real earnings per share for the U.S. stock market. The long-term historical average of growth and earnings per share for the U.S. stock market has been about 1.5%. That, by the way, is a bit faster than the average across most other countries. You might call the U.S. the grandest example of a successful emerging market in history. And over that long history, the average growth in real earnings per share has been 1.5% real. We are now at what I call peak profits with three decades of corporate profits growing faster than the economy, and as we’ve already talked, a populist revolt, in at least some measure caused by this fabulous growth and corporate profits for three decades or more. And so I think that you would likely forecast lower growth in earnings per share in the future than we’ve had in the past. But even if we don’t make that downward adjustment and just say, let’s just pencil in the long-term historical average of 1.5%, we get to a 3.5% real return for the U.S. stock market. With inflation call that a 5% or 6% nominal return, but that’s before any change in valuations. We assume that we’ll go halfway back to historical average, cyclically adjusted PEs. Not all the way back, just halfway back and halfway back over a 10-year period. But that, instead of PE for the U.S. equity market being about 30% whereas the long-term historical average is more like 17% or 18%, even going halfway back that knocks several percentage points off of your 5% or 6% nominal return to get it down to a 2% or 3% real return or, excuse me, the multiple compression gets your nominal return down from 5% or 6% to 3% or 4%, and then if you take inflation off of that you’re into the very low single digits. So I would say kind of your best-case scenario for the U.S. stock market is that 5% or 6% return, assuming that we’re not gonna have any kind of multiple compression, which is 2% or 3% real return, and near-zero or even very modestly negative returns over the next decade are entirely plausible. And by the way, you’ve seen that multiple times in history. We’ve seen decades and more than one where growth in earnings per share for the U.S. stock market was negative for the entire decade, and we’ve seen negative real returns from the U.S. stock market for decades. This is not sort of an implausible kale scenario that’s never occurred. It’s just saying since we have those decades in the past, given where we are and given how expensive the market is, we shouldn’t be surprised if we’ll see another one of those decades pop up.
Meb: And you guys have some even worse looking asset classes. Bonds, in general, seem pretty unattractive according to Yale’s models. Talk to us a little bit about fixed income in a world where there’s negative yielding sovereigns, even some corporates around the world. How does that play out?
Chris: I didn’t look at my screen right before I came in here. I don’t know where the 10-year is trading, but let’s say it’s trading at 1.75%, to pick a round number. If the Fed is successful at producing 2% inflation, then I think the risks are skewed to higher rather than lower inflation over a longer horizon. Let’s just say too, you buy a bond at 1.75% yield and 2% inflation, you’re getting a negative real return. And with most of the U.S. Treasury securities being issued these days are being sold at negative real returns. When we go to Europe and Japan, we get negative nominal returns, not just negative real returns, you got actually negative interest rates. And so it doesn’t really take much analytical work to figure out how your wealth compounds if you’re investing at negative interest rates. That said, I continue to be amazed when I go and see pension reports and they put together an asset allocation and assumed return from that asset allocation and they just plug in your average return for bonds and say, “Well, that’s what the bonds will do.” You may think that I’m just completely kidding about this, but I’m not. This is actually happening. This is how we get to these 7% to 8% return assumptions for corporate pension plans and the even more absurd assumptions for say local government return assumptions. So, it may be obvious to anybody who thinks about it for a while that zero interest rates or negative interest rates means zero returns or negative returns on their bond portfolios, but oddly, people don’t seem to change their expectations of the returns that their portfolios are going to provide to them using this obvious information, that zero interest rates means zero bond returns.
Meb: Yeah. I’m smiling as we’re talking about this because having successfully run a large endowment for a number of years and as we look around the landscape of both public, private pensions and endowments, many of which have these expectations of… Some have come down a little bit, but whether you call it 7% or 8% is still pretty high. And then I was really smiling when I was going through the Yale’s module because looking at the LBO and corporate bond returns, two of which are very heavy and traditional, many of these endowment, pension fund allocations, return is not much better for those either. And so how do you see this playing out? I mean, there’s a number of funds around the country that are after a monster decade for capital market returns in the U.S. are still underfunded, and some by a lot. Do you see this as a problem going forward? Is this something, you know, fits into some of your earlier thesis? How does that resolve?
Chris: Political strife. Detroit went bankrupt. That was a nasty political process. Puerto Rico went sort of bankrupt, that I don’t think has sorted itself out fully yet. Illinois doesn’t look to be in very good shape. Connecticut doesn’t look to be in very good shape. I think that we are going to have some political issues. And the populism and the demonization of capitalists probably is not going to get better. That gets back to the article that we wrote that said, “Look, this decades-long policy of trying to put out every fire and make sure that all of our biggest banks and biggest companies don’t ever have to go bankrupt just kind of, oh, maybe to use an analogy. If you put out every fire for a century, then all of the accumulated fuel on the forest floor creates the condition for a much worse fire when that happens. I think that if we don’t address some of these problems that we have, the ultimate correction will be much more severe. That was kind of the point we were making is if we have a return to sensible antitrust policies, we find a way to reduce, probably eliminate would be too aspirational, but reduce the regulatory capture where industries and companies are able to basically dictate their regulatory environment to their benefit and to the detriment of their lesser funded smaller startups and competitors, we could get back to a more sort of dynamic capitalism which creates a rising tide that lifts all boats. But if we’re not able to do that, we’re probably going to see a less stable or more chaotic revolution in the system. That will certainly raise risk premiums. Yields will go way up, stock prices will go down, the expected returns will be improved, but the value reported on your brokerage statement will have gone down to a fraction of what it is today before those higher expected returns emerged.
Meb: Yeah. I think the underfunded pensions is one of the most foolish and avoidable but also likely problems we’re gonna see in the coming years. I think individuals, however, are not in much better shape. Most of the surveys we see people consistently have expectations for over 10% returns. The millennials, you see up around 11.5% or 11.7%, and historically, assets even in a higher inflationary environment just don’t even return that. And so in a world of 2% and south bond yields and slightly more expensive domestic equities, that’s a pretty lofty expectation. The bright side that you guys have and believe is that there are some pockets of opportunity. I think the modules suggest foreign developed equities look more interesting, but, in particular, and you wrote a piece about this, emerging markets are one that seem to be, I don’t know if hated is the right word, but certainly unloved and under-allocated too and potentially trading at cheaper valuations. You wanna talk about that as a potential bright spot? You’re going all in on Russia and Turkey and Malaysia or what?
Chris: Let me very quickly highlight your observation about developed ex-U.S. equities in comparison to U.S. equities. Many of the “this time is different” arguments we hear to justify the soaring stock prices in the U.S. would seem to apply to other markets as well. Lower interest rates, changes in the nature of the 21st Century economy towards intellectual property and away from traditional manufacturing, all our arguments and beyond those to say that it’s perfectly understandable and normal that U.S. should trade at a cyclical adjusted PE multiple that’s nearly double its long-term historical average. But why don’t those same arguments apply to places like England and Germany and Japan and other similarly advanced economies? Because their stock prices are average. They’re not cheap by historical standards, but they’re just completely average. So, expecting average stock market returns from average valuations makes a lot of sense. Expecting average stock market returns from double historical valuation doesn’t make any sense. So, there’s a wonderful opportunity, I think, for those investors who have heavily homebuyers’ equity portfolios to take a step in the direction of international diversification given the enormous bargains relative to the U.S. available in developed ex-U.S.
When we go to emerging markets, now we’re talking about outright bargains. They’re not just cheap by comparison to the expensive U.S., but they’re just outright cheap. Now, with some good reason, a lot of people will respond, “Well, of course, they’re cheap. These are very risky markets and look at all the horrible things that are happening in these emerging economies. They damn well better be cheap.” And there’s some truth to that. And they are cheap, and that’s how you get to fat miscreants. However, it’s not true that they always trade cheap. There have been two times in my career where the MSCI EM asset class, emerging markets, the proxy for emerging markets, has traded at a Shiller PE multiple above the U.S. The first time was in the mid-1990s. If you think back to what was going on in the early 1990s, this was an environment where the Japanese and the other Southeast Asian countries were just eating our lunch. Everybody was buying Hondas and Toyotas and Ford and GM and Chrysler were really on the ropes. And it wasn’t just in automobiles, but was in consumer electronics where everybody’s walking around with Sony headphones on. And everybody in the capital markets just knew that all the growth was going to be in emerging markets, but we didn’t call it an emerging markets, and basically it was the tiger economies of Southeast Asia, Japan, but also Hong Kong, Singapore, South Korea, Taiwan, Malaysia, Philippines, Indonesia, etc. And money just went pouring into those countries and it went to such an extent that it raised the Shiller PE multiple of emerging markets to above that of the U.S. stock market. And then of course, we had the Thai Baht crisis which occurred in ’97 which turned into the Asian financial crisis, and then Russia defaulted on its local treasuries in ’98, long-term capital blew up, etc., etc. and all the money that was invested outside of the U.S. came rushing back into the U.S. and back into the U.S. stock market, and not just into U.S. stocks, but into U.S. tech stocks. If you had the presence of mind, and I don’t think all that many people did, but if you had the presence of mind in 1998, or ’99, or 2000, or 2001, any of those years, you had a four or five-year period where it didn’t really matter what the entry point was, you put your money into a simple emerging market index fund and held it for 10 years, you received compound annual real returns greater than 10%, double digit compound annual real returns from investing in an entire asset class that was trading at a Shiller PE multiple in the single digits. If you bought into the hype of the U.S. stock market in 1998, or ’99, or 2000, or 2001, what you got for the coming decade was a compound annual real return that looks like the goose egg. And then, in the mid-2000s, we kind of replayed that movie again. Capital market investors decided again that all the growth was going to be not in East Asian Tiger economies, but in BRICS, and all kinds of money went pouring into emerging markets under the BRICS theme, and then, of course, we had the global financial crisis and all the money came pouring back and all the money went into the U.S. stock market and it didn’t just go into U.S. stocks, but it went into U.S. technology stocks and now here we are with the emerging markets again trading at a Shiller PE multiple less than half of the U.S. stock market, and I think we’re back to the situation where it’s very plausible that you could get compound annual real returns in 10% or more in emerging markets and not much better than a goose egg in the U.S. stock market. So, yeah, I think emerging market equities, if you’re talking about opportunities and liquid capital markets, are probably the most attractive opportunity and that’s where we have our biggest bets placed.
Meb: So, talk to me a little bit… And the nice thing about valuations is at least gives investors somewhat of an anchor to have a common-sense approach to work around. So many people that simply buy and hold regardless of valuations, it’s stressful because there’s no sense of, “Hey, is this totally reasonable? Is this crazy?” Whatever it may be. And you mentioned the emerging markets in mid-2000s and some of those countries were trading in the cape ratios of 40 and 60. And at least, hey, look, maybe you can justify that, but at least take a step back and say, you know, “Is this something that I’m at least aware of?” And if so, I can justify it. Maybe I believe 50 PE is justifiable. All right. So, for the people that are listening and say, “Okay. I like what you’ve said. I think it’s thoughtful.” From someone who’s managed institutional, non-profit, everything in between, allocations, what’s the best ways to think about putting this together? Is it something where you… I know you guys manage a fund that does this, but how should people think about adding some of these portfolio philosophies and ideas for the next year, 10 years? What’s your general thoughts on actual implementation?
Chris: Well, you brought up buy and hold. And I think that we find an enormous amount of good quality research that suggests that most investors would do far better in accumulating wealth and meeting their investment goals if they stopped what they were doing now and they simply invested in a diversified collection of passive instruments and bought and hold, even better if they rebalanced. However, let me just say what the research says they do now. What the research says they do now is performance chasing. They look around at what has been doing well for the past two or three years and they rotate their investments into what seems to be the winning strategy. The problem is that to the extent that you can profit from momentum, that occurs over periods of weeks and months, not over a period of years, and over periods of years we see mean reversion and the performance chasing over periods of years transfers a lot of wealth away from many individual and not a few institutional investors, and they would be far better off if they were just to buy and hold low-cost index portfolios. However, there’s kind of a mystery there. If most people don’t do the low-cost buy and hold and they’re doing performance chasing and destroying hundreds of basis points a year of value from the portfolios, where is all that money going? Well, I’m gonna tell you that it’s going to the rebalancer.
Imagine a simple scenario where you have only three types of investors in the world, buy and hold investors, performance chasers or another word for that is portfolio insurers. That’s the idea that when your prices go up, you feel more wealthy and you’re happy to take more risks, and when prices go down, you feel more frightened and you take chips off the table. That’s portfolio insurance. Another way of describing that is procyclical investing or performance chasing. And rebalancing is the third investment style. And everybody starts out with a 60/40 portfolio, 60 in risky assets, let’s call them stocks, and 40 in non-risky assets, let’s call that cash, and the market declined by 10% on the second day. Now everybody is not 60/40, everybody is 54 in the risky asset and 46. And so the buy and hold investor says, “Well, that’s good. I’m gonna stick here, and that’s what I do. I’m buy and hold. I’m not gonna trade.” And the portfolio insurer says, “I’m really worried. I’m closer to this threshold of wealth beyond which I just would never be comfortable going. I need to take risk off the table. I need to sell.” And then you have the rebalancer and the rebalancer says, “Oh, hey, 60/40 is my policy. I gotta stay at 60/40. I need to go buy some equities.” Well, the rebalancer trades with the performance chaser. And we had a group of very smart finance professors at Berkeley in the 1980s demonstrate that you can replicate the payoff portfolio of portfolio insurance through a dynamic hedging strategy that replicates an option, and you’re basically buying options or paying option premium. And so if the portfolio insurers or the performance chasers are paying option premium, who are they paying the option premium to? They’re paying it to the rebalancers. And so the people that rebalance, people like Warren Buffett or David Swensen at Yale and various other esteemed value investors, who by the way often own insurance companies and like to write options, are collecting this money like the house does or the insurance company does from people that are paying premiums. And so that’s another way to look at it is most people are performance chasing and paying these premiums for making themselves feel better, perhaps they’re getting some protection. Not everybody that buys insurance is crazy, but you’re buying insurance, you’re buying lottery tickets, you’re buying options, probably often expensive ones, and you’re transferring that money to the people who are systematically rebalancing, and rebalancing is in essence value investing.
Meb: So let’s say people… We say a similar thing. I say most people should just buy the global market portfolio and be done with it. But let’s say you’re willing to get a little weird and on the other end of the weird spectrum we just had Ben Inker on and I asked him, “How much U.S. stocks do you own in your benchmark free?” And he said zero. So, he’s like, the ultimate in weird. But as investors who think about this and let’s say they’re willing to be a little different in the decade coming forward, how should they think about putting it together? If they have the framework together, they understand rebalancing, they got a mindset of, “Hey, I get the diversified portfolio rebalance,” how far should they think about straying? What’s your general thoughts there and still survive it?
Chris: Well, I had to come up with a really simple executable portfolio when I demanded that my children start saving for their retirement beyond the 401k, and I told them, “You will set up a Schwab brokerage account and you will transfer $1,000 a month out of your checking account into the brokerage account. And I can teach you how to do investing or you can just use dad’s cookbook.” And dad’s cookbook was here at 10 ETFs they’d create a broadly diversified portfolio. And you can think of it as 50/50, low-risk, high-risk assets or you can think of it as 30% equities, 30% kind of real assets, and 30% credit, and 20% government bonds. But specifically the DTF categories are U.S. equities, developed ex-U.S. equities and emerging market equities. That’s three. And REITs and commodities, there’s another kind of inflation protection, along with TIPS, government bonds, bank loans, emerging market debt, and high-yield bonds. So, three credit asset classes, two government bonds, three equities and a few real assets thrown in. So, that’s 10 ETFs. And I said put the exact same amount of money in each one of those 10 ETFs. And every month when you get your automatic wire transfer into your brokerage account, look at your brokerage account and see which of those 10 ETFs has the lowest market value. Put the new $1,000 into the one with the lowest market value. Now you’re over rebalancing. You’re putting your money into whatever is cheapest. And I said just continue to do that on autopilot for about the next 40 or 50 years, and when you retire, you’ll have more than sufficient assets to last you the rest of your life. But when you do get to that point, you just reverse the process. Go on to the brokerage account and transfer your money out of your brokerage account into your checking account, and each time pick the one asset class of the 10 that has the highest value and sell that one. So, essentially, my investment advice to people is start saving now, buy a diversified portfolio, always maintain your diversified portfolio, but make your additions to the asset classes that are cheapest, and when you’re in the decumulation phase, systematically sell with most expensive. And as I said, I can boil it down to a very, very simple cookbook. I think that will do quite well.
Meb: You know, we’ll call it the Brightman rebalance algorithm, but it’s funny, I laugh because we talk a lot about everything in investing being old is new again. We joke that there’s the Talmud where it talked about investing your labour a third into business, a third into land, and a third keep in reserve, which is pretty darn close to your allocation of equities, bonds and real assets, so that’s pretty funny. How are the children complying? Are they following the plan?
Chris: Well, they are, but I have some leverage in that I see their bank accounts because they’re joint with me. And I told them if they didn’t comply, their allowance would end.
Meb: That’s a good nudge. You have the police officer monitoring the behaviour. I agree with you. The behaviour part is such a massive input. We talk a lot about ideas. I think some innovative young entrepreneurs, aspiring entrepreneurs could probably start to put some hard-earned intelligence towards coming up with a better way to do personal pensions. I love the automated advisors, of course, but I think that’s some opportunity when you’re looking at the average annuity fee, I think in 2019, is 2.25%. There’s probably some disruption to come there. We’d love to keep you forever. I wanna few more questions that we have some time with. As you look back on your career, you’ve done a lot different things. Is there anything you look back on and say, “I’ve changed my mind a lot about,” whatever it may be? I’ve had a few, certainly. But is there anything where you say, “Look, I now believe this that I didn’t believe 10, 20 years ago.”? Anything come to mind?
Chris: More about how to build an organization and collaborate with a team of people to achieve success. I was insufferably arrogant, self-confident and egotistical when I was young and just had no time for most people and just wanted to get ahead. And I’ve learned over and over and over again that in order to succeed on anything important, one has to collaborate and cooperate. And there, humility and empathy are crucially important. And I don’t know that I’ve managed to become a particularly humble or empathetic person, but I’m doing much better than I did quarter-century ago.
Meb: I think that’s a very important characteristic is not just to organizations but markets. And for the biggest compliment, we’ve said over and over on this podcast is, biggest compliment you can give someone and our business is simply surviving. And those of us who are still at it and surviving, and probably have done so with lots of scars and markets certainly have a way of humbling all of us. That’s for sure. Chris, what’s been your most memorable investment, you look back on your career, good, bad, in between? Anything that comes to mind?
Chris: I’ll give you two. When Mike Aked, Mike works for us here at Research Affiliates. He’s doing his third tour of duty. He works for me here now. He worked for me at University of Virginia Investment Management Company and then he worked for me in Chicago back in the ’90s when I was at UBS Asset Management running global equity portfolios. And Mike and I, when we were at the University of Virginia, before the global financial crisis we were trying to figure out what the cheapest way to put on some protection was. And what we figured was Yen. And so we had just a fascinating trade of having all of our bonds in long German bonds but funded with Yen, because we just looked at how markets behave and we thought that if there is a crash, bonds will do quite well and also there will be a flight to quality and that would be very much to Yen. That might be Swiss Francs today rather than Yen, but currency can be a very powerful protection, owning the funding currency, the reverse carry trade, if you will. And that made just a really fabulous profit when the stuff hit the fan. In my personal investing, the best decision was just a few years later to go and buy up a whole bunch of really well-built little houses in southwest Atlanta for just absurdly low prices and fix those up and put them out as rental properties as a little bit of a business. In today’s environment, having real assets that are not subject to the whim of a central banker and having decent visible cash flow on those real assets is a nice diversifier to your liquid financial part of your portfolio.
Meb: Yeah. The post-financial crisis, housing investment in many places has been an absolutely wonderful trade. It’s my nightmare being a landlord, of course. I would lose sleep over that every single night, but it’s been a fantastic investment in trade. I hear you’re also, as I was listening to your old Ritholtz podcast and you mentioned that you’re a pretty big reader particularly in the world of sci-fi and fantasy. Anything good been on your nightstand or bookshelf over the past 12 months that you’ve been reading you thought was particularly wonderful?
Chris: We’re a value investor here. And I’ve been putting in a lot of hours on work, so, my pleasure reading has been suffering of late. One book that I would recommend as just a pick-me-up to put a smile on your face, I recommend people read “Enlightenment Now” by Steven Pinker. It’s a reminder that despite all of these kind of divisive politics and seemingly intractable problems that we have from unfunded pensions to climate change, actually, in many, many, many ways, the world’s getting to be a much better place.
Meb: Yeah. Two great books that you mentioned that readers should definitely check out. Chris, where’s the best place for people to follow what you’re up to, everything you got going on? Any good places to keep tabs on what you’re up to?
Chris: Come to researchaffiliates.com, take a look at our asset allocation website, and if you are nice enough to give us your email address by creating a log-on, we’ll helpfully send you all of our updates to our tools for free as well as share all of our research.
Meb: Are you gonna give us any sneak peeks of any future writing pieces? I love and read everything that you put pen to paper. Anything you’re working on right now that you can give us a hint towards or anything that’s got you curious as we close out the decade?
Chris: Yeah. I think probably the next publication on our website under my name, the working title that I’m using right now is, “Oh, my, what’s this stuff really worth?” The point is that when markets are risk-on and everything’s going well and stock prices are going up, people equate price with value. If you ask somebody, “What’s Amazon worth?” Well, they look up on the screen and they could tell you what the Amazon stock price is and they don’t worry about trying to figure out what the intrinsic value of Amazon or Netflix is, it’s just whatever the price is. But when markets turning a little bit more turbulent, prices are discontinuous, then people stop thinking that the stock price is the value of their investment, then they start looking around and saying, “Oh, my, what’s this stuff worth?” So, we have a little nice article on that subject that may come out soon. From a academic research standpoint, we’re trying to remind people that risk factors are just those risks. And when factor investing, the idea of how much factor exposure can I get might be kind of wrong. You probably really actually want the return not the risk. But that’s gonna be more of a journal article type publication.
Meb: Does Adam Neumann of WeWork make an appearance in this article?
Chris: Well, we haven’t finished, but it’s a great idea.
Meb: Chris, it’s been a blast. Thanks for taking the time today.
Chris: Thank you.
Meb: Listeners, we’ll add links to the show notes, mebfaber.com/podcast. You can see all the old episodes there. We’re coming on close to 200 of them now. Leave us a review on iTunes. We love to read them. Thanks for listening, friends, and good investing.