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Investing Master Class

Valuation in Four Lessons: Aswath Damodaran

Aswath Damodaran (born 23 September 1957), is a Professor of Finance at the Stern School of Business at New York University (Kerschner Family Chair in Finance Education), where he teaches corporate finance and equity valuation.

Known as “Dean of Valuation” due to his expertise in that subject, Damodaran is best known as author of several widely used academic and practitioner texts on Valuation, Corporate Finance and Investment Management; he is widely quoted on the subject of valuation, with “a great reputation as a teacher and authority”. He has written several books on equity valuation, as well as on corporate finance and investments. He is widely published in leading journals of finance, including The Journal of Financial and Quantitative Analysis, The Journal of Finance, The Journal of Financial Economics and the Review of Financial Studies. He is also known as being a resource on valuation and analysis to investment banks on Wall Street.

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ETFs and Funds Investing

Buyer Beware: The Different Types of ESG Funds

The problem is that “ESG” is becoming a catch-all for “doing good”, and this is a big mistake.

As the ravages of climate change become increasingly apparent, investor interest in sustainable investing (aka ESG – Environmental, Social, Governance) is growing at an exponential rate. Seeing this trend, asset managers are launching a ton of ESG products.

The problem is that “ESG” is becoming a catch-all for “doing good”, and this is a big mistake. Investors see brochures with pretty pictures of trees, windmills and solar panels and assume that their investment in ESG products will help save the planet.

Trending Up for ESG

I hate to say it, but greenwashing in the investing business is rampant.

The twist is that a lot of it is unintentional.

You see, there are very few people within the asset management industry that truly understand the mechanics of what they’re building and selling. Many industry participants might have an above-average (i.e. more than the general population) understanding, but not deep enough to really get the nuances.

Consequently, product features and benefits can be misrepresented and many investors buying these products don’t have a complete understanding of what they’re buying.

Of those who are more knowledgeable about investing, many appear quite skeptical of the real value of ESG products. A recent informal survey shows this:

The goal of this article isn’t to rip anyone a new one (I’ll save that for other articles). Most people – asset managers and investors – have the best intentions. So instead, I’d like to provide a quick summary of major types of ESG investment products.

Values-Based ESG Funds

Most ESG investment funds use a set of screens to filter out sin stocks, like tobacco, energy and gambling companies. Some use a sweeping approach that removes entire sectors. Others look at revenue sources for individual companies to determine exposure. Regardless of the stringency of the filter, the general idea is to eliminate exposure to companies and industries that don’t align with an investor’s values.

These strategies were originally created to service religions endowments and foundations with strict values-based rules. The purpose is to avoid values conflicts and the effects are largely superficial.

Risk-Based ESG Funds

Similar to Values-Based ESG funds, these funds exclude certain companies or industries based on a set of pre-determined factors. The types of companies or sectors that are excluded might closely resemble those of values-based ESG funds. The main difference is the intent of the fund. While values-based funds seek to align with a set of morals, risk-based ESG funds seek to reduce exposure to risk.

While values-based funds seek to align with a set of morals, risk-based ESG funds seek to reduce exposure to risk.

Companies with poor ESG practices may theoretically be exposed to greater regulation, litigation or reputation risk. These potential challenges affect the ongoing profitability and financial position of certain companies, negatively changing their risk-return profiles. A devastating announcement, for example, could push a the stock of one of these companies down 5, 10, 20% or more. Many ESG funds seek to avoid exposure to these risks.

Conceptually, this is something all fund managers have been doing regardless of whether or not their funds are labeled ‘ESG’. Risk management is part of the investing DNA and ESG risks are simply one of many that are evaluated. Given this, drawing particular attention to ESG risks is more-or-less a outward manifestation of what was already taking place, but perhaps to a more explicit degree.

Values-based and Risk-based ESG funds generally avoid exposure but don’t create change.

Values-based and Risk-based ESG funds generally avoid exposure but don’t create change. This is because the market is not heterogeneous. There are investors that care about ESG considerations and others solely focused on profitability. Therefore, there will always be a class of investors willing to invest in companies with profitable business models, regardless of their ESG practices.

With that said, if a large enough cohort of investors avoids an ESG-offending company its cost of capital could rise. This may prompt company executives to alter business practices (if possible) if company stock trades at a persistent discount. However, avoiding prime offenders like oil producers might only create a market where energy companies trade at a discount, but with little fundamental change to the underlying business. After all, an oil producer exists to produce oil. As long as it has access to capital – which has been proven the case with both the energy and tobacco industries – business will go on with little change (or worse, corporate window dressing).

It is important to understand cause and effect. Cigarette smoking has declined significantly over the decades, but not because Altria’s cost of capital has risen. Altria hasn’t changed its primary business model because many investors have avoided tobacco stocks since the 1990s. Rather, regulation, taxation, education and litigation forced dramatic change to both supply and demand, reduced smoking rates in the developed world.

Impact ESG Funds

The vast majority of ESG funds provide some combination of values-based and risk-based filtering. However, what many ESG investors believe they are actually getting (and what many asset management companies believe they are providing) are Impact ESG Funds.

Most ESG fund investors want to make a difference, but most ESG funds don’t make any difference at all.

Contrary to popular belief, investment funds that seek to make change must actually buy shares of ESG offenders.

Contrary to popular belief, investment funds that seek to make change must actually buy shares of ESG offenders. The recent proxy challenge started by activist investor Engine No. 1 is a perfect example of an investment manager actually making change. Via an activist approach, Engine No. 1 was able to secure 3 seats on Exxon’s board. This could only be done because Engine No. 1 owned Exxon shares, made a shareholder proposal and rallied other shareholders around its cause. These directors will help push Exxon to transform its business to address the risks of climate change. Engine No. 1 recently launched an ETF (VOTE) that will continue with these types of challenges.

How to Choose an ESG Fund?

Before you invest in an ESG fund you must first know what you’re trying to achieve. A good starting point is determining whether you want to align with personal values, mitigate specific risks or create positive change.

From there, look at the company that manages the fund. Who are the portfolio managers and what is their history with respect to environmental, social and governance issues?

What is the company’s historical environmental practices, beyond specific product offerings? Do executives fly in private jets, for example? Does the company have other business lines (e.g. investment banking) that services clients with opposing interests and how will the company overcome these conflicts?

Perhaps most importantly, use of ESG funds doesn’t absolve one of personal responsibility, nor does it replace government regulation and policy. To reduce carbon emissions, communities – individuals, businesses, governments – must work together to achieve common goals.

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Investing

Bonds for the Long Run?

If you look up Professor Jeremy Siegel’s work you’ll find one thing: He firmly believes that stocks are the best long-term asset class.

In 1994, Seigel published a classic book that helped shape his investing view and asset allocation decisions for millions investors around the world. “Stocks for the Long Run: The Definitive Guide to Financial Market Returns and Long-Term Investment Strategies” continues to be a top-selling investment book. His conclusions are based on stock market data going back about 200 years.

New research has compiled stock market data going back to 1793, adjusts for some erroneous methodologies and reaches a different conclusion – one that contradicts Siegel’s long-standing belief that stocks are the preferred asset class over the long run.

…both common stocks and long bonds are risk assets, capable of outperforming or underperforming over any human time horizon.

Edward F. McQuarrie, Professor Emeritus, Santa Clara University, presents these findings in a recent paper called “New Lessons from Market History: Sometimes Bonds Win“.

McQuarrie summarizes his findings as follows:

When Jeremy Siegel published his Stocks for the Long Run thesis, little information was available on stocks before 1871 or bonds before 1926. But today, digital archives have made it possible to compute real total
return on stock and bond indexes back to 1793. This paper presents that new market history and compares it to Siegel’s narrative. The new historical record shows that over multi-decade periods, sometimes stocks outperformed bonds, sometimes bonds outperformed stocks, and sometimes they performed about the same. More generally, the pattern of asset returns in the modern era, as seen in the Ibbotson SBBI and other datasets that begin in 1926, emerges as distinctly different from what came before. Contrary to Siegel, the pattern of asset returns seen in the 20th century does not generalize to the 19th century. A regime perspective is introduced to make sense of the augmented historical record. It argues that both common stocks and long bonds are risk assets, capable of outperforming or underperforming over any human time horizon.

Source: New Lessons from Market History: Sometimes Bonds Win, Edward McQuarrie

For most investors, it’s not news that bonds sometimes outperform stocks. Indeed, this is why we hold bonds within a portfolio – to diversify sources of risk and return. However, for most that’s as deep as the asset allocation decision goes, and bonds – particularly Treasury bonds – are simply viewed as a safety mechanism for short periods of risk asset downside. It remains that, over the long-run, the common view is one that aligns with Siegel’s thesis that equities is the better asset class over long periods of time.

…bonds can outperform for the duration of a human lifespan. It is therefore financially dangerous to adhere to the ideology that stocks are always the better choice.

McQuarrie disagrees: Simply, he finds that there are long periods of time during which bonds outperform stocks. The particularly troubling finding is that bonds can outperform for the duration of a human lifespan. It is therefore financially dangerous to adhere to the ideology that stocks are always the better choice.

History is an important guide, but it cannot predict the future. The purpose of this research is not to identify what will outperform over the next decade. Rather, it is to shift portfolio construction from a monolithic to multi-faceted choice.

The crux of Siegel’s case for stocks is exhibited by the following chart. Looking at this alone, it is understandable that someone might conclude that stocks are the better investment. McQuarrie, however, argues that Siegel’s methodology was misleading and the reality is that stocks and bonds performed in parallel until the post-war period (second chart below). Moreover, much of the final stocks-bonds cumulative performance variance is explained by a single time period from post WWII to around 1982, with bonds subsequently resuming parallel performance. (I.e. if you re-started the chart from 1983, the stocks and bonds lines would follow a similar path.) The difference flips the investing paradigm on its head.

It is critical to understand why the results are so different.

McQuarrie’s explanation for the superiority of his bond data is as follows:

Explanation: I observe municipal bond prices from 1857 to 1897 as compiled by the Boston stockbroker, Joseph G. Martin. Siegel relied on a tertiary source, the summary table in Sidney Homer’s History of Interest Rates. Homer does not state there that the municipal bond index he had tabled represents a theoretical construction erected by Macaulay upon Martin’s compilation rather than an observed portfolio. I also adjust for the greenback price of interest paid in gold coin—a distinguishing feature of Federal and some municipal bonds between 1862 and Finally, I use an aggregate bond portfolio up to 1897, and corporate bonds after that point. Corporate bonds returned more than the government bonds used by Siegel, especially when government bond yields were depressed by tax and other privileges.

Essentially, McQuarrie used actual bond portfolio data, whereas Siegel used computed theoretical data.

McQuarrie’s data also adjusts for the striking survivorship bias found within Siegel’s stock market data:

Here most of the variation comes before the Civil War, and this deviation is readily explained: Siegel’s sources omitted the largest single stock that traded before the Panic of 1837, the 2nd Bank of the United States. At the peak before the Panic hit, the 2nd BUS accounted for almost 30% of total market capitalization. It failed spectacularly as the Panic proceeded, with shares dropping in price from $120 to $1.50, and never recovered. To duplicate this omission in the contemporary stock market, it would be necessary to drop Microsoft, Apple, Amazon, Alphabet/Google, and Facebook from the S&P 500; and even these five would not account for as high a percentage of S&P 500 capitalization as did the 2nd BUS at its peak. Omission of the BUS is the single most glaring error I found in Siegel’s stock market sources. More generally, I found and corrected survivorship bias. Banks failed during panics, turnpikes and canals succumbed to railroads, and struggling railroads went bust in the 1840s and 1850s to an extent not previously understood. In short, Siegel’s sources had left out the bad parts, producing an overly rosy picture of antebellum stock returns.

Few probably realize that Siegel’s data contains such biases – especially when it’s standard practice to adjust accordingly. For example, modern fund performance evaluation, like Morningstar’s SPIVA reports, always account for survivorship bias. To read that Siegel excluded failed companies in his analysis is material. To be fair, however, this survivorship bias exists in many historical analyses as it is an embedded feature within index data.

Let’s not make hasty conclusions and throw out all of Siegel’s conclusions. Stocks do outperform bonds during a meaningful range of time periods and scenarios. Stocks are still a core component to an investing portfolio. McQuarrie’s analysis simply illustrates that the probabilities have shifted away from stocks’ favour. This is an important consideration for professional asset allocators and Joe Smith saving for retirement.

Using McQuarrie’s new data, the table below shows the odds of stocks outperforming bonds across a range of rolling 1, 5, 10, 20, 30 and 50 year periods. The odds remain in stocks’ favour across all rolling periods between 1793-2019, and those odds increase with the length of period. However, it is critical to observe that these results are time-period sensitive. The pre-war experience is markedly different, especially prior to the US Civil War.

Modern-day assurances that stocks always outperform over the long run are based on post-war data (1943-2019). In contrast, the full history shows there’s a 32% chance that someone investing in stocks over 30 years – a lifetime of investing – would underperform bonds.

Why did stocks outperform during the post-war years?

During that period, the US dominated the world with military and economic hegemony acting as the global arbiter and enforcer of transnational trade and globalization, creating a ‘peace dividend’ for risk assets around the world. As that power fades, it’s quite possible the structural forces that created that environment will someday no longer exist.

The following chart shows something similar to the table above, focusing on rolling 10yr performance differentials between stocks and bonds. Again, it is apparent that stocks can underperform for life-altering periods of time.

How bad can stock market returns get?

If one asset goes up by 20% and the other by 10%, the second asset underperformed but still provided a decent return. Unfortunately, history shows that the stock market can provide dismal returns for very long periods of time.

The table below shows the worst 20, 30 and 50 year real total returns for stocks. The results show that stocks can perform poorly in both relative and absolute terms over investing lifetimes.

Real total returns

The standardization of time periods in the previous chart, however, doesn’t show the true extent of weak stock market performance potential over long periods of time. One only has to go back to the 13 year period ending 2013 to have witnessed one of the worst periods ever for US stocks. The table below shows the worst six periods for US stocks.

The implications for asset allocation decisions are immense, yet intuitive: Don’t rely on history alone to guide asset allocation decisions.

Investors must look at the prevailing environment to determine how to construct portfolios, understanding that long-term performance characteristics can change. Perhaps the most challenging part of this effort is understanding the relative variability of stocks and bonds, as illustrated by long-run correlations. Correlations change markedly over time, so the idea that one simply dumps a portion of a wealth into bonds with the purpose of creating a portfolio ballast is wrong. Stocks don’t always outperform and bonds don’t always move opposite to stocks. This is strikingly apparent (but shockingly rarely discussed) during the recent Covid-19 market crash, when US Treasuries (using TLT as a proxy) declined by almost 10% from March 1st to March 8th, while US stocks simultaneously declined by 8.8%. US Treasuries soon recovered and rallied as stocks continued to plunge, but this relative performance aberration – when the correlation between stocks and risk-free assets moved to 1 – is an example of how historical relationships can and do change. It is a critically important example of how expectations based on long histories can be false.

Will bonds outperform stocks? Are bonds still a good tool for diversifying portfolios?

Without spending considerable amounts of time and effort deciphering the current economic regime and its implications on forward asset prices, a more pragmatic approach to asset allocation might be to ensure broad representation across assets that have fundamentally different risk exposures. Stocks are probably still good to hold for the long run. Probably so are bonds (both corporate and a variety of sovereign). But it’s entirely possible that neither will perform as you expect.

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Investing

Inflation Today, But Deflation Tomorrow | Lacy Hunt

Lacy Harris Hunt is an economist and Executive Vice President of Hoisington Investment Management Company (HIMCO). He is Vice-Chairman of HIMCO’s strategic investment policy committee and also Chief Economist for the Wasatch Hoisington Treasury Bond Fund. He has authored two books, A Time to Be Rich and Dynamics of Forecasting: Financial Cycles, Theory and Techniques, and has had articles published in Barron’s, The Wall Street Journal, The New York Times, The Journal of Finance, the Financial Analysts Journal, the Journal of Portfolio Management, among other publication outlets. He received the Abramson Award from the National Association for Business Economics for “outstanding contributions in the field of business economics.”

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Investing Wealth

How Do You Invest within an RESP?

I’ll have to admit that I’ve thought and re-thought about how I should invest my kids’ education money. I feel an extra sense of responsibility because I don’t consider the money ‘mine’.

While I control the account and I can get the money back now or if the kids don’t go to school, for its intended purpose – funding an education – it’s not mine anymore, and that’s how I treat it.

If I allocated $20,000 towards my childrens’ education, the last thing I want is for them to end up with less than $20,000. The second-last thing I want is the stress of trying to earn back losses. While some argue that kids can take on debt to fund their education, I’ve seen how huge college debts can be debilitating. When a fresh graduate needs to start repaying big student loans within six months of graduating, they don’t have the time to be picky. They take the first decent job they can get and become debt-slaves for the rest of their lives. Many probably won’t be debt-free again until retirement – and debt is the antithesis to freedom.

Student loans –> credit cards –> car loans –> mortgage

Everyone I know who graduated with big student loan debts has not lived a free life. All these people have dreamt about ‘doing what they love’ but none could because they could never get a break from their debt repayments. I don’t want my kids to go through that.

So, if I put in $20k I want my kids to receive at least $20k. Of course, if invested in equities the probability that I accomplish this rises with my kids’ investing time horizon. Research has shown that very few historical 5yr equity market returns are negative.

How do you invest within an RESP?

The first step is simple. Simply put money into an RESP account and get that sweet, sweet Canadian Education Savings Grant (CESG) of up to $500 per child per year. This easy first step nets an instant 20% ROI.

Next, consider when your child(ren) will need the money. If it’s in less than 5 years I would suggest being very conservative. More than 5 years? Then you can start to take a little more risk.

Personally, I add an extra layer of conservatism on top of my baseline allocation. For example, if I considered a baseline allocation for a particular person with a 7 year time horizon to be 70/30 then I might ratchet down to 60/40. Also, within this mix, despite ridiculously low rates, I consider an allocation to risk free deposits (high interest savings accounts, GICs, CDs).

I know I’ll get flack for being too conservative, but I do this because time-lines are fixed. When a child graduates from high school they immediately (usually) go to college and have to pay a fixed cost. In contrast, I can delay retirement or adjust my expenses to live off less if I mess up my retirement account.

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Investing Life Wealth

Investing, Hope and Climate Catastrophe

There was a time when an HIV+ diagnosis was a death sentence.

Not anymore.

According to Elizabeth Ranes, RN, “life expectancy for a person infected with HIV now extends to 70 years of age. That’s a remarkable improvement from the early days of HIV, when many men succumbed to the disease in their 30s.”

Someone diagnosed with HIV in 1989 would have little to look forward to, and no need for retirement planning at all. Anyone with any savings would spend it all, as most had no heirs and many were isolated from their families.

However, as diagnosis and treatments quickly improved during the 1990s, a subset of HIV patients started to outlive their wealth. This subset had planned for the worst, but unexpectedly benefited from new treatments. This new hope was a mixed blessing, as many of these people were now penniless.

Today, a growing number of teenagers are increasingly hopeless about the future. Instead of a disease, a convergence of global warming, resource shortages, political extremism and wealth disparity is painting a bleak picture.

Guidance counselors and therapists have commented on a growing number of young people seeking help amid existential gloom. Like it or not, agree or disagree, Greta Thunberg is the poster child for global teenage grief, anger and hopelessness.

The thread below illustrates what’s going on:

I know people love to hate on Greta, but remember she is a child. The value she provides might not necessarily be her arguments. Rather, the fact she is expressing her worry is what we need to take away. She is a barometer for the psychology of a growing portion of tomorrow’s leaders.

As I’ve explained by looking at the AIDS epidemic, when people lose hope they adjust their behaviours. They live like they have no future.

What does that mean for teenagers today?

And what if they are wrong?

Let me tell you a secret. When I was a teenager I had little hope for my future. I’m not entirely sure why. Perhaps I received no encouragement or help. Maybe I had pessimistic tendencies. I definitely had no path in front of me.

So I behaved like I had no future. I did many stupid things. Luckily I snapped out of it and doubled-down on forging my own path. But I could have easily gone the other way and simply continued to be a burden to those around me. Or worse.

What happens when a big segment of the population feels this way for similar reason, thus reinforcing their belief? They certainly won’t be thinking about retirement savings. More likely, they’ll be drop-outs, criminals and pot-heads. Not all. But more than under normal circumstances.

Maybe they’ll be proven right in the end. Maybe there is no future. But if they’re wrong, they’re basically cornering themselves into a pretty shitty life. In the end, it becomes a self fulfilling prophesy.

I’m not blind to the problems we face, but I think it’s important to maintain some hope. We each have our ways. Acceptance, action, religion.

We must continue saving and investing like we have a future. Perhaps the nature of those investments and the way we budget for risk change. We need to broaden our definition beyond financial instruments and invest in skills, resiliency and self sufficiency. We also need to plan for a greater number of contingencies and develop a better understanding of ‘risk’.

As we’ve learned during the AIDS crisis, simply dropping the ball to sulk on the sidelines won’t do anyone any good.

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Investing Life Wealth

How Can Inflation Coexist with Deflation?

How does one explain a world in which macro trends are deflationary (DumbWealth: The Case for Deflation) yet the basic necessities of life are increasing in price?

While it sounds contradictory, the two paradigms can coexist. Look at housing prices and healthcare costs over the past 10 or 20 years. Look at commodity prices during the 2000s.

From the late 1990s to early 2010s commodity prices across the board were going through a super-cycle, driven by rising Chinese demand. Commodity prices were booming, yet – despite some cyclical bounces along the way – the secular disinflationary trend that began around 1980 continued until present day.

Medium Term Crude Oil Prices

Makes no fucking sense, right?

There are those who argue the CPI stats don’t reflect reality. The thing is, price ‘reality’ for one person isn’t ‘reality’ for another. We all have different baskets of goods and all spend different proportions of income on those goods, so our true experiences will differ.

ShadowStats has re-calculated CPI based on its own interpretation and has consistently printed double the reported inflation rate:

So, despite the long-term deflationary pressures of debt, demographics, productivity and imports, one must still respect how quickly commodity prices have risen lately. We’ve seen this battle before.

Over the near term, we’re going to see rising prices. Perhaps the scariest part of all this is how quickly global food prices are rising. Over the past year, the FAO Food Price Index has risen almost 40%!

This doesn’t necessarily mean that you’ll witness a 40% price increase in the grocery stores or a huge impact to your food budget. However, for the poorest portions of global society this could mean the difference between paying rent and feeding their kids.

In the end, the cure for high prices is high prices. This means two things.

  1. Much of the current increase in commodity prices is caused by supply chain issues created (exposed?) by the pandemic plus growing shortages of raw commodities. Higher prices are incentivizing production (and delivery) to quickly come back on line, which will eventually mitigate further price increases – potentially even lowering prices.
  2. Higher prices could break demand. At some point people simply can’t afford to pay higher prices. There’s an argument that the final straw that broke the housing market’s back prior to the 2008 Global Financial Crisis was higher gas prices. People could no longer justify longer drives, eroding demand for new suburban sprawl developments. Simply put, higher prices eventually erode demand somewhere, somehow and this can have a domino effect on the economy, ultimately replacing rising prices with a deflationary shock. This is what we saw in 2008.

Final thoughts

Although the ‘peak oil’ movement seems to have disbanded with the influx of lower quality, relatively expensive American shale oil, it is quite possible the world is riding a deflationary low-tide coupled with broad resource shortages that result in inflationary waves.

My prevailing shower theory (i.e. something I came up with in the shower) is that the secular deflationary forces will remain omnipresent, but most of the world will fixate on the boom/bust cycles driven by resource demand and shortages, exacerbated by fragility in the global just-in-time supply chain.

There will be rotation from good times to bad and back, but ultimately there is no end to this inflation-deflation battle. We can’t make more easily accessible, high quality oil, copper, etc. Yet, ‘economic progress’ requires us to use more and more. However, demographics and debt will continue to act as a counterbalancing force for our destiny.

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Investing

Not All Stocks Rise When Markets are Up

Did you know that during any given year when the market is rising, up to 42% of stocks may simultaneously be declining?

Simply being ‘in the market’ during an up year doesn’t guarantee positive performance. Some years are worse than others, but history shows stock-pickers can easily lose money despite being right about market direction.

The chart below demonstrates this phenomenon over the past 20 years. The blue bar shows calendar year performance for all positive years dating back to 2002. The red line shows the % of stocks that were negative during the same year.

Lesson: unless you have the golden touch, it’s best to tap into market gains by building exposure to a broad basket of stocks. The easiest and cheapest way to achieve that is by using a low cost index fund.

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Investing Wealth

The Case for Deflation

Inflation is a hot topic right now. Understandably so, as prices for a range of commodities (lumber, copper, etc.) have risen substantially over the past several months.

Chart: Google Search Trends for ‘Inflation’ in the United States

Raw materials price pressures are now showing up in consumer prices with CPI rising 4.2% year over year ending April 2021. This level of CPI has not been seen since the early days of the 2008 global financial crisis.

However, it is becoming increasingly clear that this inflationary burst is temporary. The conditions simply don’t exist to support long term inflation, like that seen during the 1970s.

There are several reasons.

1) Milton Friedman once said that “inflation is always and everywhere a monetary phenomenon”. I’d argue that he is only half right. Central banks can increase the money supply all they want, but to have an inflationary effect the velocity of money must remain stable or rise. Real world experience clearly shows that money velocity is not constant and tends to have an inverse relationship with the level of a country’s indebtedness. And as you all know, we are drowning in debt right now.

It is becoming increasingly clear that this inflationary burst is temporary. The conditions simply don’t exist to support long term inflation, like that seen during the 1970s.

The relationship between indebtedness and money velocity is clear in the following chart. As the level of indebtedness of the US economy started to significantly rise in 2008, money velocity declined. Ultimately, money velocity plummeted to new lows during the Covid-19 crisis and has yet to recover, despite an improving economy.

Effectively, what this means is that new money entering the system (generally to fund new debt) is simply tucked away, mitigating any inflationary effects of monetary expansion.

This phenomenon is also illustrated by the declining marginal economic benefit created by new debt. The economic impact of additional debt today is much lower than it was in decades past. Therefore much more money needs to enter the economic system to have the same impacts it did in the past. Of course, more new money means more debt. By now you’ve probably noticed this is a vicious cycle.

2) The current inflationary pulse was triggered by the partial paralysis of the global supply chain. Exports out of low-cost producing countries grinded to a halt, forcing Western countries to purchase from more expensive domestic suppliers or compete over dwindling supply.

As vaccines are delivered the mechanisms for global trade – offshore manufacturing + shipping – can resume. Imports into the US are already back to pre-pandemic peaks and it’s only a matter of time until renewed competition from cheaper sources pushes prices down.

3) Labour productivity tends to rise coming out of recessions. Higher productivity offsets higher wages, thus putting a cap on unit labour costs that can flow into prices. I believe this phenomenon will be even stronger as we exit the pandemic.

The nearly immediate and widespread adoption of new software and methods of working have compressed a decade’s worth of productivity gains into the present. Not only that, but companies that maintain a remote workforce can benefit from labour cost arbitrage across geographic regions. Over the long run, both of these advances will keep a lid on unit labour costs. This is disinflationary.

4) Population growth in the US continues to be very weak and will be for the foreseeable future. 20-something year olds simply can’t afford to have kids. Or they are choosing not to bring new people into the world for ethical reasons.

The point is that forward demand driven by new consumers entering their prime spending years continues to decline. When demand declines prices fall.

While nobody can predict the future, one can use data and hard evidence to create a guide. Evidence suggests that those calling for a shift in the economic regime – from disinflationary to inflationary – could be wrong. I believe, as a diversified investor, it is important to prepare for the possibility that the pundits are wrong.

While I won’t know if I’m right or wrong until some point in the future, it appears that the bond market might agree with my thesis, as the yield on the 10yr has flatlined since March 2021.

Categories
Investing

Dennis Gartman’s 22 Rules of Trading

Note: These ‘rules’ are for the active trader. Not for the normal person looking to build a retirement nest egg while working a full time job. For most of us – including the financially well-educated – the best strategy is to buy and hold low cost index ETFs.

1. Never, under any circumstance add to a losing position…. ever! Nothing more need be said; to do otherwise will eventually and absolutely lead to ruin!

2. Trade like a mercenary guerrilla. We must fight on the winning side and be willing to change sides readily when one side has gained the upper hand.

3. Capital comes in two varieties: Mental and that which is in your pocket or account. Of the two types of capital, the mental is the more important and expensive of the two. Holding to losing positions costs measurable sums of actual capital, but it costs immeasurable sums of mental capital.

4. The objective is not to buy low and sell high, but to buy high and to sell higher. We can never know what price is “low.” Nor can we know what price is “high.” Always remember that sugar once fell from $1.25/lb to 2 cent/lb and seemed “cheap” many times along the way.

5. In bull markets we can only be long or neutral, and in bear markets we can only be short or neutral. That may seem self-evident; it is not, and it is a lesson learned too late by far too many.

6. “Markets can remain illogical longer than you or I can remain solvent,” according to our good friend, Dr. A. Gary Shilling. Illogic often reigns and markets are enormously inefficient despite what the academics believe.

7. Sell markets that show the greatest weakness, and buy those that show the greatest strength. Metaphorically, when bearish, throw your rocks into the wettest paper sack, for they break most readily. In bull markets, we need to ride upon the strongest winds… they shall carry us higher than shall lesser ones.

8. Try to trade the first day of a gap, for gaps usually indicate violent new action. We have come to respect “gaps” in our nearly thirty years of watching markets; when they happen (especially in stocks) they are usually very important.

9. Trading runs in cycles: some good; most bad. Trade large and aggressively when trading well; trade small and modestly when trading poorly. In “good times,” even errors are profitable; in “bad times” even the most well researched trades go awry. This is the nature of trading; accept it.

10. To trade successfully, think like a fundamentalist; trade like a technician. It is imperative that we understand the fundamentals driving a trade, but also that we understand the market’s technicals. When we do, then, and only then, can we or should we, trade.

11. Respect “outside reversals” after extended bull or bear runs. Reversal days on the charts signal the final exhaustion of the bullish or bearish forces that drove the market previously. Respect them, and respect even more “weekly” and “monthly,” reversals.

12. Keep your technical systems simple. Complicated systems breed confusion; simplicity breeds elegance.

13. Respect and embrace the very normal 50-62% retracements that take prices back to major trends. If a trade is missed, wait patiently for the market to retrace. Far more often than not, retracements happen… just as we are about to give up hope that they shall not.

14. An understanding of mass psychology is often more important than an understanding of economics. Markets are driven by human beings making human errors and also making super-human insights.

15. Establish initial positions on strength in bull markets and on weakness in bear markets. The first “addition” should also be added on strength as the market shows the trend to be working. Henceforth, subsequent additions are to be added on retracements.

16. Bear markets are more violent than are bull markets and so also are their retracements.

17. Be patient with winning trades; be enormously impatient with losing trades. Remember it is quite possible to make large sums trading/investing if we are “right” only 30% of the time, as long as our losses are small and our profits are large.

18. The market is the sum total of the wisdom … and the ignorance…of all of those who deal in it; and we dare not argue with the market’s wisdom. If we learn nothing more than this we’ve learned much indeed.

19. Do more of that which is working and less of that which is not: If a market is strong, buy more; if a market is weak, sell more. New highs are to be bought; new lows sold.

20. The hard trade is the right trade: If it is easy to sell, don’t; and if it is easy to buy, don’t. Do the trade that is hard to do and that which the crowd finds objectionable. Peter Steidelmeyer taught us this twenty five years ago and it holds truer now than then.

21. There is never one cockroach! This is the “winning” new rule submitted by our friend, Tom Powell.

22. All rules are meant to be broken: The trick is knowing when… and how infrequently this rule may be invoked!