Cutting Through The Noise

Altos Investments has merged with Silicon Valley based wealth management firm Three-Bell Capital

Three Bell and Altos Investments

Altos Investments has merged with Silicon Valley based wealth management firm Three-Bell Capital.

This combined relationship will provide clients with additional capabilities and resources in tax strategy, lending, estate planning, retirement plans, laddered bond portfolios, structured notes, pre-IPO private stock sales, performance reporting, and more.

Under the Three Bell banner, the combined firms will constitute the largest RIA in Los Altos with four seasoned advisors, a full client service and support staff, and over $500M in combined assets under management. 

Finding the Weigh

Valuation: Weighing Market Expectations - Part 2 of a 3-Part Series

Market expectations

Cutting Through the Noise - a financial blog by Bill Martin, CFA

  • Last month we showed that stock market valuations are currently stretched, demonstrated with the Shiller-CAPE model based on a historical perspective.
  • Stocks now appear the most expensive in history when we adjust market valuations for economic growth and earnings potential.
  • The single, largest offsetting factor that is currently supporting such high stock prices is the low level of interest rates relative to the earnings yield (Earnings/Price) of the market. 

Previously, we evaluated the market’s current and historical valuations. If you recall, the market appears pricey from the metrics provided by Robert Shiller and his Cyclically Adjusted Price/Earnings (CAPE) ratio.

Below, the graph shows more than 130 years of the CAPE ratio. The only times the ratio exceeded today’s high valuations were prior to the crash of 1929 and the during the dot-com bubble, when valuations soared much higher than today’s level. When these types of long-term measures approach their all-time extremes, it’s time for investors to get a plan that goes beyond hoping for higher prices.

Data extracted from, graph created by Altos Investments

Data extracted from, graph created by Altos Investments

It’s All About Perspective

Let’s start this month’s blog by putting some context to the CAPE, one of my preferred valuation tools. To draw insightful conclusions, valuations must be seen relative to the economic environment.

To gain perspective, I will provide a view through a couple of different lenses that suggest wildly different conclusions. If you’re anything like me, you’ll want to hear the bad news first, so we’ll start there, then make our way to the good.

The bad news, in a nutshell, is growth-adjusted valuation. Don’t fall asleep yet! There’s a kernel of wisdom in that snoozer of a word. Simply comparing P/E valuations from one period to another can be likened to mapping the earth onto a flat piece of paper—full of distortions.

In order to make the comparison “apples-to-apples” as much as possible, we must consider a couple of additional factors to adjust for different economic environments.  One of the factors to consider is the economic growth trajectory that underpins the relative valuations and sentiment of a given time. In other words, investors will pay up in good times that are likely to get better, but can’t justify paying up in bad times that might get worse. The other important factor is the level of interest rates, which dictate the extent to which the stock market can compete with less risky investments, like U.S. Treasuries.

A Methodical Walk on the Wild Side

We need to add some color to our CAPE. To do so, we want to “growth-adjust” this ratio.  If we can expect faster growth rates in the future, we can also justify a higher CAPE, which means paying more for future earnings. When prospects for earnings growth are high, the multiple (P/E) investors are willing to pay tends to be even higher. Let’s dive in.

Corporate earnings are a byproduct of economic activity. As such, growth in the Gross Domestic Product (GDP—our economy’s total output) and growth in earnings tend to be roughly equivalent. While it’s true that earnings growth can vastly differ from economic activity for time measured in years, in the long run, aggregate earnings growth and GDP growth are joined at the hip /move in tandem.  For evidence of this relationship, turn to the charts below. The graph on the left plots the three-year average GDP growth rate and its trend since 1950. The trend line helps us understand that growth has been on a steady downtrend during the post-World War II era despite the many ups and downs of the business cycle. The graph on the right shows the close relationship between overall economic growth and corporate profits.

As you can see, GDP growth is roughly equivalent to earnings growth. This observation is the basis for our next step—adjusting CAPE for growth for the entire modern era of investing. If you know where you’ve been, you are more likely to know where you are now.

Data courtesy of St Louis Federal Reserve (NASDAQ: FRED), Bureau of Economic Analysis (BEA), and Bloomberg

Data courtesy of St Louis Federal Reserve (NASDAQ: FRED), Bureau of Economic Analysis (BEA), and Bloomberg

Based on the chart that is above and to the left, it is fair to deduce that GDP growth and earnings growth trends are now more anemic than they were in the late 1990s, the last time valuations were this high.  The following table highlights some of the key differences between the two periods.

As shown in the 720Global table above, economic growth in the late 1990s was more than double that of today, and the expected trend for growth was also more encouraging.  There were plenty of good reasons to be excited in the late 1990s—high growth and productivity, low inflation, and the government actually ran a surplus, which is hard to fathom now.  Today’s weak trailing 3-5-10 year annual earnings growth rates stand in sharp contrast with the growth of the roaring 90s.  Additionally, government and household debt have ballooned to levels that are now constricting growth and productivity. The assets purchased with all of that debt have not offered much in return, and today’s low-interest rates reflect the current state of economic stagnation. And astonishingly, corporate earnings have barely moved an inch in the last five years, while stocks have posted strong gains over the same time frame.

Now, if we adjust the current market’s prices for the relatively low level of economic output, we clearly see that the market is the most expensive it has EVER been!

High Valuations in a Low Growth Environment

Looking forward, the standard CAPE level (as shown in the chart at the very top) needs to fall approximately 35% from current levels to reach its long-term, growth-adjusted level based on current GDP growth rates and estimates.  Now, I’m not calling for that, but it is always good to know how far that teeter-totter has to fall, when you’re the one at the top. 

Low-Interest Rates are This Market’s Best Friend

Now, it’s time for the good news! The earnings-to-price ratio of stocks actually looks attractive relative to bonds.

Looking at low-interest rates, we begin to find justification for stretched valuations.  What we see in the graph below is that interest rates are low, when compared to the level of earnings yield that an investor receives in the stock market.  This “relative yield” game is important in the battle for capital between asset classes.  When investors can earn a decent yield by holding a safe US Treasury bond, why not earn the easy money with very low risk?  However, when investors can earn a higher yield in the stock market (based on earnings) with a chance for those earning to grow, why settle for the low yields of Treasuries?  This is the key factor that Warren Buffet points to when he says stocks are not expensive. 

Data extracted from, graph created by Altos Investments

Data extracted from, graph created by Altos Investments

Beating inflation is the name of the game in investing. As you can see in the chart above, in the 1950s and 1960s, and even in the hyper-inflationary 1970s, investors used to demand more from equity yields (Orange Line) relative to bond yields (Blue Line) due to perceived risk.  That relationship has clearly changed since inflation peaked in 1980.  Since then, investors typically have gotten more from their bond yields. The thinking was that there was less need for an inflation hedge (stocks), and Treasuries suddenly looked like a sure thing with really attractive, double-digit yields (Treasuries).

However, since the Federal Reserve started to manipulate short- and long-term interest rates through unprecedented measures, the relationship between stocks and bonds has all changed.  As such, it appears that in this artificially suppressed interest rate environment, we have temporary, yet solid support for the stock market.  If we get a sense that rates may return to more normal levels, then stock valuations would face significant headwinds.


The equity valuations of 1999, as proven after the fact, were grossly elevated.  However, when considered strictly against a backdrop of economic factors, those valuations seem relatively tame versus today’s exorbitantly priced market. 

Economic, demographic, and productivity trends all portend stagnation. The amount of debt that needs to be serviced stands at overwhelming levels and puts our economy at risk of rising rates. The first whiff of significant inflation could lead our international creditors to demand higher interest rates. This means that policies that rely on more debt to fuel economic growth are likely to borrow from long-term growth. 

In contrast, policies that gear toward higher labor productivity and not just technological advancement are the answer for long-term economic growth. However, even the most effective policies will take a LOOOONG time before their impact is felt.  The one counter-weight in this equation is the pitifully low level of interest rates, which leaves investors craving more risk and more stocks, reaching ever further for return.  This condition sets the scale with the low level of interest rates on one side and the reality of expensive valuations on the other. 

Next month, we will investigate the outlook for future stock returns from these valuation levels.   

Here’s to getting it more right than wrong.

Come On Down, Let’s Play… Is The Price Right?

Valuation: The first in a three-part series

Cutting Through the Noise - a financial blog by Bill Martin, CFA

 “Price is what you pay and value is what you get.” ~ Warren Buffet

“Intelligent investing is value investing – acquiring more than you are paying for.” ~ Charlie Munger (Warren Buffet’s long-time partner at Berkshire Hathaway).

Let’s talk prices.  To do so, we don’t need Bob Barker, but we will need to choose some valuation tools.  There are dozens, maybe hundreds of ways to consider if an individual stock or broader stock market index is expensive or cheap vs historical pricing.  All of these valuation measures have imperfections. As you can imagine, investors have their favorite valuation tools that vary by focusing on expected earnings, earnings after stripping out certain items, sales, cash flows, ect. That is what makes stock market investing more art than science. We’ll look at three useful valuation measures in this blog—the Buffet indicator, the standard P/E, and the Shiller P/E.

The Buffet indicator

We can’t talk about value investing without mentioning Warren Buffet, a follower of Benjamin Graham, the father of value investing. The Buffet Indicator (below) uses the price of the broad stock market divided by the overall output (GDP – Gross Domestic Product) of the U.S. economy. This is an excellent big picture measure of what you have to pay for what you get. The Buffet Indicator’s greatest strength and greatest weakness is that the measure is not directly based on corporate earnings as reported. This measure reduces the volatility of earnings by taking the perspective that the U.S. economy’s output is the same as the U.S. economy’s earnings through time.  Next month you will see how accurate that assumption is over time.

Chart 1 march.png

As you can see, the market appears ~20% overvalued at present vs historical levels (net of inflation).  Mr. Buffet would no doubt point out that interest rates (the discounting factor for the stock market) are well below historical levels, thus leaving stocks cheap to fairly priced.

Plain Vanilla P/E

Perhaps the most common valuation ratio is a stock’s Price/Earnings, or P/E ratio.  The P/E ratio is typically based on the Last Twelve Month (LTM) of earnings and the ratio captures how much an investor is paying (P) for each dollar of earnings (E).  Sometimes this ratio can be inverted and quoted as an earnings yield (E/P) to better compare to the yield an investor may be able to earn on a bond.

For instance, if a stock has a price of $25 and earns $1 per year, that stock would have a P/E of 25 or an E/P yield of 4%.  Taken throughout time, 25 is a very high P/E ratio; however, when compared with U.S. Treasuries at or below 2.5%, a stock with a 4% earnings yield and a chance to grow earnings over time, it may look like a decent price to pay for what you get. 

One drawback to the standard P/E ratio is that often times the earnings for a company may drop to a very small number or even a negative number during a recession.  During rapidly shifting times, the P/E ratio can be volatile and a source of uncertainty for value investors. A company may look even more expensive if its price drops from $25 to $10, but earnings drop from $1 to ten cents a share.  Under this scenario, the P/E ratio is 100, even though the stock is down 60%.  Conversely, cyclical companies may look cheap at the wrong time—at “peak” earnings just prior to an earnings recession.  Since markets are often in flux, going into or out of recession, or simply weighing the odds of recession against the ends of animal spirits, the standard P/E ratio can take investors on a wild ride.

Data extracted from, graph created by Altos Investments

Data extracted from, graph created by Altos Investments

The Magic CAPE

To reduce some of these analytical challenges of the standard P/E, we look to the Cyclically Adjusted Price to Earnings Ratio, also known as CAPE or the Shiller P/E Ratio, a measurement conceived by Robert Shiller.   CAPE adjusts past company earnings by inflation and compares stock prices to the ten-year average, inflation-adjusted earnings, as opposed to the nominal earnings over just the last twelve months.  CAPE is more like a movie clip, whereas the standard P/E is more like a snapshot. The net result and graph contour of the CAPE chart below is more smoothed in a fashion that is similar to the Buffet Indicator chart. 

Data extracted from, graph created by Altos Investments

Data extracted from, graph created by Altos Investments

Choosing the Right Valuation Tool for the Job

The charts below show the two PE measures side by side. Shiller’s measure provides a steadier read on markets and better long-term perspective for determining the aggregate market’s valuation. The CAPE Shiller model represents ten years of market information in one number that tells you how the market is priced now. It’s a valuation tool that cuts through the noise and takes a broader and deeper view of the price you pay for what you get. For these reasons, CAPE is the valuation measure that we will use in the subsequent two parts of this three-part series.   

Data extracted from, graph created by Altos Investments

Data extracted from, graph created by Altos Investments

Robert Shiller won a Nobel Prize for Financial Economics, specifically for his work on empirical analysis on asset prices in 2013.  I’m sure this ratio weighed favorably in the minds of the selection committee. His measure uses the 10-year average of earnings, but we can also vary the calculation window to more accurately capture the business cycles in a given period.  In certain markets, this is a handy feature for an advisor.

The long term P/E averages for both valuation methods is about 16-17 times earnings.  So, no matter how you slice it, the market is looking pricey now based strictly on a long-term historical valuation basis.

Granted, over the long term, the two measures are highly correlated and look quite similar…and that makes sense.  However, the plain vanilla P/E and the CAPE can offer very different pricing perspectives during major turning points in the market and that is when investors need to have a sense of value to have conviction in their allocations.

For instance, let’s examine how each of these models handled the height of the financial crisis in 2009.  In the chart below, we see that the CAPE ratio (blue line), during the sell-off in 2009 valued stocks with a P/E below 15X earnings as a bargain…a buy signal!  Meanwhile, the standard P/E (red line) shows stocks were actually the most expensive in 2009….a sell signal!?!? Selling in 2009 put a lot of professional investors out to pasture. Similarly, the market’s value using the standard plain vanilla P/E veered from cheap to expensive in abrupt swings during the dot com crash, while CAPE was quicker to point out the overvaluation of the market.  It is really important to get these major turning points correct to make money through full market cycles.

Data extracted from, graph created by Altos Investments

Data extracted from, graph created by Altos Investments

The CAPE is a fantastic tool for smoothing out the vagaries of the business cycle for cyclical stocks and stepping back to get a broader view of prices.  And in recession, almost all stocks show their soft, cyclical under bellies. 

Now, one word of caution (and you aren’t likely to hear this anywhere else)—I think CAPE actually underestimates the earnings power for the rapidly growing F-A-A-N-G (Facebook, Apple, Amazon, Netflix and Google) type stocks, due to its long look back over 10 years.  These companies, and others like them, have become a larger and larger share of the overall market.  I think this means that CAPE probably underestimates the market’s value by about 10%, but that estimate is more art than science. CAPE still cuts through the noise better than most measures.

The current CAPE reading is at a level only seen once (tech bubble) since the stock market crash of 1929.  Based on only this figure, we would conclude that stocks are expensive.  Robert Shiller is also calling for caution: (dated 3/15/2017)

Next month, we will add context to valuation relative to interest rates.  Some important factors we will use to provide market context are gauging and ranking market “Headwinds and Tailwinds”.  Spoiler alert:  at present, low interest rates provide solid support for today’s relatively high historical valuation levels, while today’s moderate growth rates and high debt levels provide a sober outlook for stocks’ long-term return potential.

Lastly in part 3, we will evaluate how stock prices perform from different valuation levels.  This is the most important element of this analysis, and can mean a lot more than just winning “A NEW CAR”!

A Hawk in the Dove's Nest

A view into the Fed's inner-sanctum

Hawk in dove house

Cutting Through the Noise - a financial blog by Bill Martin, CFA

I recently had the pleasure of sitting in on a discussion with former Federal Reserve Bank President from Philadelphia, Charles Plosser.  Charles spent 10 years at the Fed, before terming off in 2016. 

We were hosted at a lovely home on University Avenue in Palo Alto.  Charles’s visit was made possible through his tour at the Hoover Institute at Stanford University.  Ten to twelve of us - venture capitalists, tech CEOs, money managers, and academics - gathered around the dining room table, chatted and asked questions.  Wine was served, which helped facilitate a collegial, informal atmosphere.

In short, the economic cure-all of cheaper and cheaper money has become the toxin that inhibits the natural order of the economic cycle.

What followed was an insider's view into the inner-sanctum of the Federal Reserve.  Charles is known as an inflation fighting “hawk” on a Federal Reserve Board, which has been dominated by easy money bankers known as “doves”.  The “doves” have more or less reigned supreme on the Fed going all the way back to Alan Greenspan’s “irrational exuberance” speech in 1996.  Since that time, every crisis and mini-crisis has been met with lower interest rates and overwhelming liquidity.  Our chat with Charles brought to light some of the challenges that he feels these easy money policies have fostered.  In short, the economic cure-all of cheaper and cheaper money has become the toxin that inhibits the natural order of the economic cycle.

Charles Plosser earned a bachelor of engineering degree from Vanderbilt University in 1970, and Ph.D. and M.B.A. degrees from the University of Chicago in 1976 and 1972, respectively.  Before joining the Philadelphia Fed, Plosser was the Dean of the William E. Simon Graduate School of Business Administration at the University of Rochester for 12 years. He also served concurrently as the school's John M. Olin Distinguished Professor of Economics and Public Policy. Plosser was also the co-editor of the Journal of Monetary Economics for over 20 years. [source: Wikipedia]

“A business cycle without recession is like religion without sin”. 

Here are my top five impressions from our discussion with Charles Plosser:

1.    Charles’ specialty is the business cycle:  his most memorable quote from the evening was, “A business cycle without recession is like religion without sin”.  Putting religion aside, Charles was pointing out that an economy needs “cleansing” that comes from a recession, to let unprofitable firms go and let leaner and more stable firms take their place.  He suggests monetary policy has inhibited creative destruction.  Is the appetite reduced for letting capitalism work in this way due to too much interconnectedness?  Perhaps. Given the U.S. economy’s total debt is four times GDP (not counting upcoming entitlement liabilities like Medicare/Medicaid and Social Security), are there too many unpayable debts and too little solvency to let a recession happen naturally, as a normal part of the business cycle? Also, perhaps. Charles’ view is that market participants have determined that the extreme downside risks should be trimmed, while also sacrificing upside return potential. In many ways, Europe has already embraced this view of the risk and return spectrum.  Charles suggests we are on a similar path.

2.    Given all the extraordinary monetary policy, why has this economy struggled to reach “escape velocity”? – Charles openly wondered if the economy is growing slower than otherwise expected because human capital is not keeping up with technological advancement.  As a bit of background, there are two key components of economic growth – growth in labor force and growth in productivity (measured output per unit of input).   By focusing on just these two components we ask… are there more or fewer people working and are they more or less productive at their job? 

Regarding the growth in the workforce, the economy is facing headwinds in the form of an aging workforce that continues to shrink through artificial intelligence and robotics, coupled with immigration challenges.  All of these factors do not bode well for employment gains, thus limiting a good portion of potential economic growth.

...long-term growth is unlikely to rise meaningfully above the slow pace of this current business cycle. 

Going to the second portion of the growth equation (productivity), Charles expressed concern that human capital is not keeping up with technological advancement. Productivity was a primary driver during the high-growth of the past 30 years. Bottom line, tech has brought both lots of positive changes along with disruption.   Going deeper, tech has dramatically changed the nature of most jobs, and worker skills have simply not kept pace, as the rate of technological change continues to compound at rates that may exceed our ability to adapt from generation to generation. Given Moore’s law, the quantum leaps in technology are unlikely to slow down.  As such, the full extent of tech benefits may be increasingly difficult to achieve. That means long-term growth is unlikely to rise meaningfully above the slow pace of this current business cycle. 

Tariffs are a central banker’s nightmare because tariffs encourage deflationary inflation – higher prices with lower economic output. 

3.    Administration policies – Charles went to pains to keep from sharing his overall views of the new administration, but he was willing to discuss policies, as they relate to the economy.  De-regulation is good… to a point.  Much of Dodd-Frank, the Volker rule, and the Affordable Care Act were compromises.  They should not be thrown out, but some tweaking could certainly be helpful.  Tariffs are a central banker’s nightmare because tariffs encourage deflationary inflation – higher prices with lower economic output.  How does the Fed set policy for that environment?  Tax cuts will not solve anything without productivity increases – cuts will largely take from one pocket and put into another and/or create a need for deficit spending, which leads to higher interest rates etc.  Repatriation could be a good one-time shot in the arm.  He also commented that limiting immigration is bad for the economy as it limits the potential pool of skilled workers. Productivity enhancing infrastructure projects would be a plus, and this is where the focus should lie. However, those projects often take years to bring economic benefit.  My sense is that an emphasis on job skills and training and re-training would be a great place to begin and end any government-led spending.  He expressed that a massive infrastructure bill will most likely lead to history’s largest pork barrel and vote grab.

Classical Keynesian economics would suggest that the government fill its coffers in good times and borrows to spend in bad times, thereby creating a counter-cyclical anchor to steady the economy from damaging extremes. From this vantage point, the time for expanding fiscal policy was from 2008 to 2012. In theory, with unemployment below 5%, now is time for tax hikes in preparation for next down cycle. Charles was openly unhappy with fiscal expansion at this point of the cycle.  This will complicate the Fed’s task going forward, as political uncertainty around the amount of government spending adds to the many uncertainties of the Fed’s dual mandate of stable growth and price stability. 

4.    In his interpretation of Fed policies to date, the Fed did not act independently during the Global Financial Crisis.  The Fed did Congress’s bidding, as they became the lender of last resort to Wall Street and Detroit, choosing the winners and losers instead of letting the market decide. In short, Congress outsourced their job to the Fed.

One problem with the path dependency of this system is that no one is ever individually proved correct or incorrect.

BIG REVEAL - No one in the Fed knows anything that anyone in our room didn’t know.  There is no special knowledge around the Fed Board Room.  They observe and react.  Simple as that.  Got to admit, this part was a bit unsettling.  I think he was attempting to point out that there are so many disparate views, from which each participant brings their own internal biases, based on their own staff’s research.  One problem with the path dependency of this system is that no one is ever individually proved correct or incorrect. As such, no one knows nuttin’. 

Fears for Fed’s independence – he pointed out that the Fed could be audited at any time, and that probably has the effect of making the Fed more political than otherwise. 

5.    An outlook for Fed policies – Charles indicated that the Fed should drain its own swamp of the reserves it created from quantitative easing (QE) operations—the Fed’s purchase of US Treasury securities intended to suppress interest rates and incent risk-taking behavior.  He repeatedly referred to excess bank reserves as “kindling”. This was in reference to providing the potential accelerant in the banking system, in the form of excess reserves, to ignite inflation that could be difficult to control or ultimately distort normal economic investment relationships.

In his view, the first round of QE was necessary, and the subsequent rounds were somewhere between risky and flat out irresponsible.  He believes that the use of reverse repo transactions will be a political land mine if reserves are not drained in a timely fashion.  For example, how will it look if the Treasury actually pays interest to the very same banks that they bailed out, just to keep those very same reserves on the banks' balance sheets to prevent the banks from using them to make loans?  What the heck? Right!

And therein lies the political landmine.

CAUTION – Wonky language ahead:  These reserves have been sitting idly, doing nothing for some time. Banks have not lent the money out, but treated it like a rainy day fund as they sought to repair their balance sheets by reducing leverage ratios and improving their solvency/durability. Now that the Fed has raised rates, the Fed finds itself in the awkward position of paying interest to banks on those reserves, even though these same banks worked against the Fed’s efforts by not lending when the Fed needed them to make loans to jump-start the economy… AFTER these very same banks brought the global economy to its knees in 2008. And therein lies the political landmine.  My apologies for the circular reasoning and going inside baseball, but it is a big deal and it really is twisted and we will be dealing with the aftermath for YEARS.

Charles suggested the Fed should have drained reserves (or at least communicated plans to term out holdings), prior to starting to raise rates. Because they did not take these primary, incremental steps before raising rates, US monetary policy is now years ahead of Europe and Japan. As the Fed tightens and other Central Banks ease, global monetary policy is out of sync, which has implications for the value of the dollar (and thereby growth and inflation). This is not a problem until it is a problem.  Charles made clear, this could be a problem.

Those of us sitting around the table gained new insight and respect for the job of a central banker. By the time we wrapped up, I’m pretty sure most of the business leaders sitting there could appreciate the difficulty of public service, and I didn’t get the sense that any of us were green with envy.

How have my views changed? The views at the Fed are more diverse than I realized.  We don’t necessarily get a clear picture of the true views at the individual level. 

How have my views been re-enforced?  Growth will be challenged long term, almost regardless of Administration policies.

The big takeaway is that the economy and market face more headwinds than tailwinds.

The big takeaway is that the economy and market face more headwinds than tailwinds.  You also get a sense that the big Super Tanker known as the US economy may have a smaller rudder than I previously understood. That’s fine for calm seas, but not for turning on a dime in rough waters. There also appears to be a respectful debate within the Fed, but that may not be the case between the Fed and Congress. They seem out of synch. As we saw, the Fed feels like it was left to do the heavy lifting, only to have Congress meddle with the economy at the wrong time. Meanwhile, some members of Congress have been quick to blame the Fed for a faltering economy or its improvisation during the crisis.

With the market priced for near perfection and the Super Tanker’s steel skeleton groaning under the heavy burden of debt, the ship’s crew will have to work like a well-oiled machine to keep this vessel sailing above water and on course.

Small Business Looking Large

Small Business looking large

Cutting Through the Noise - a financial blog by Bill Martin, CFA

I was all set to write about the headwinds and tailwinds impacting the markets going forward, when up popped an economic number that made me double take.  I typically create a mosaic of economic indicators for a sense of the economy’s future direction, but sometimes a particular number moves so much that requires focused thought and analysis. January’s NFIB Small Business Optimism number is one of those number’s.

 Now, I don’t want to give the impression that I am an outright Bull… I like to think I maintain a balanced view with an eye toward finding underappreciated opportunities.  Sometimes investment opportunities arise from caution and sometimes from optimism. 

I focus on this chart because small businesses, which are defined as companies with fewer than 100 employees, now make up 67% of all new jobs in the country.  As small businesses go, so goes the economy.  With all market participants watching so many economic numbers so closely, it’s important to focus on data that can actually make a meaningful impact on the underlying economy.  For example, although consumers comprise about 70% of all spending, the hyper-watched consumer confidence number is known to be fickle and more a reflection of the direction of stock prices.  That indicator is what I would call “noise” and is unlikely to be of much help foretelling the direction of the economy.  As another example, notice how Small Business Optimism last peaked in 2004-2006, well before any hints of the Great Recession were being picked up by other data.

The Small Business Optimism Index is comprised of 10 equal weighted factors that breakdown different aspects of capturing the outlook for a small business.  The recent "jump" in the SBO Index score for December (released in January) was driven primarily by the following 3 factors in descending order:  1.  Expect Economy to Improve  2.  Expect Higher Real Sales  3.  Now a Good Time to Expand.  Taken together, the magnitude of the scores in these three areas clearly point to more optimism heading into 2017.  

What we see in the chart is that the Small Business Optimism Index (SBO Index) has just popped to the positive more than at any other time in the 21st Century….by a long shot.  Small businesses are feeling as optimistic as they were during the strongest years of the housing boom, several years prior to the bust.  Business optimism is so important because it is often in response to expected profit.  That expected profit can lead to increased jobs and higher wages, which all lead to creating more demand.  Lather, Rinse and Repeat.  That is how an economy tries to break out of the slow-growth doldrums. 

Importantly, the SBO Index tends to get the larger trends in the economy correct.  It is not infallible, no single economic statistic is that good.  However, as you can tell, I think this number bears watching.  This level of breakout could be something that will bubble up and reverberate throughout the economy and propel us higher through other messy situations that arise, or it could just be a head fake (see mid-2008).   

The reason for the bounce is quite clear.  Small businesses are optimistic about the prospective cuts in de-regulation and costs that are on the horizon in the new administration.  A word of caution… we have traveled this path before, only to find that sometimes regulation is necessary and can be a governor for going too far in one direction.  Do you remember way back to 2008 and the lexicon of CDO’s, toxic mortgages, sub-prime loans and liar loans?  Yeah, that happened. 

That said, for today, many businesses and market participants are choosing to only see the positives in the prospective changes coming from the new administration.  As such, for now, we will just celebrate this one number.  However, as famed private equity investor, Howard Marks, likes to say…

“Sometimes the market interprets everything positively and sometimes it interprets everything negatively”. 

These strong leanings can create opportunities!

I’m now off to a small, informal gathering with former President of the Philadelphia Federal Reserve, Charles Plosser.  Charles was often one of the more hawkish (inflation fighter) members during his time on the Federal Reserve Board.  This should be fun, interesting and hopefully provide some insights for next month’s blog.

Here’s to sifting through the data in search of nuggets to help us get it more right than wrong, sooner rather than later…

Looking into the Future

Top 10 Surprises in 2017


This year, I will follow the format of one of my favorite year-end forecasts—Byron Wien’s annual Top Ten Surprises list. For more than 30 years, legendary investment strategist Byron Wien has rolled out his annual list of predictions, starting while he was at Morgan Stanley. Though he often hedges his bets with both bullish and bearish calls—no surprise there, any self-respecting strategist would do the same—his list exposes under-appreciated trends that could exert a strong influence on markets. These should not necessarily be perceived as market calls in the traditional sense, but as a fun thought exercise to stimulate dialogue with clients. 

Looking to next year, President-elect Donald J. Trump will become President on January 20, 2017. At that time, the economy will be entering its 93rd month of non-recessionary growth. That is the third-longest on record, following the 120 months from 1991 to 2001 and the 106 months in the 1960’s. Comparatively, the average recovery period lasts about 45 months. Four more years seems a long time to keep this train going.

At a high level, the economic battle will be between the rising risks to growth vs. rising hope for growth-oriented government policy. The nascent risks to growth include rising interest rates, global trade tensions, and a stronger U.S. dollar. In terms of government policy, deregulation, lower taxes (corporate and personal), repealing the Affordable Care Act (ACA), infrastructure spending, and cash repatriation could all have a positive influence on the stock market.

So, what does this all mean? My top ten themes to watch for 2017 explore these issues:

1.  Cash repatriation passes and Apple goes shopping for the holidays. This will be the single most important factor to keeping the stock market elevated in 2017, in the face of global headwinds.  Goldman Sachs has estimated that there could be as much as $3T of cash overseas, with much of that in the coffers of big tech companies.  That cash is just waiting to come home with a reasonable repatriation tax deal – a 10% tax on those monies could go a long way toward paying for an infrastructure bill…hmmmm?  It is a matter of time.  To put $3T in perspective, President-elect Trump’s entire infrastructure plan has been rumored at $1T…over 10 YEARS!  And much of that will be tied up in interest costs.  Repatriation could free up a lot of cash for Mergers & Acquisitions, dividends and share repurchases. Also, the Venture market could really benefit through M&A activity, as it provides the role of R&D lab for big Tech (see last month's blog/interview with Jason Portnoy).

2.  The IPO market picks up with Snapchat leading the way. This could be the largest IPO in years. A successful, high-profile offering should provide a spark to the equity markets, perhaps opening the floodgates for more private companies to go public. Uber and Airbnb are also prime, potential candidates to IPO next year.  The IPO/Venture market has a real chance to get double cappuccino frothy (loop back to #1 above).

3. Monetary policy passes the baton to fiscal policy, buying another leg for the bull market. Let’s call this one…everything is awesome!  The U.S. Federal Reserve Bank (the Fed) has done all of the heavy-lifting, keeping the economy and the markets moving forward for more than 5 years. I think this year we will finally see fiscal policy pull its weight. Most of the positive effects to the economy (if there are any) will be delayed until 2018.  However, the markets, which tend to look forward six to twelve months, are likely to respond favorably to all the "shiny objects" that appear in the forms of proposed tax cuts and infrastructure spending.

These policies will vary from deregulation and repeal of the ACA to tax cuts for individuals and corporations. Many of the tax cuts will be viewed as trade-offs.  The suggested corporate rate being discussed is to lower the actual current rate of 35% to around the estimated current effective rate of 25% - the mean corporate tax rate has been estimated at this level by Goldman Sachs and others. The cuts in the individual rate will likely be somewhat offset by declines in deductions. The benefits of infrastructure spending, including jobs, will be partially offset by higher interest rates related to deficit spending.  That is what is meant by "trade-offs".

The bottom line is that there is very little wiggle room to stimulate the economy without big increases in the deficit - and the bond market will not like that. can "everything be awesome", if there is no free lunch?   The stock market will have to contend with this at some point, but probably not in 2017.

4. Following the Fed’s lead, Europe and Japan scrap their bond purchasing programs. With fewer bond buyers, 10-year yields in the U.S. will rise above 3% from less than 1.5% a few months ago, and credit spreads will widen. Expect the markets to get cranky should central bankers start shouting "last call" at the punch bowl.

5. China is not named currency manipulator day one, the Trans-Pacific Partnership (TPP) is scrapped, but the North American Free Trade Agreement (NAFTA) stands. Taken together, these policies should delay the potential onset of trade problems in the U.S. through 2017. This is my boldest call of the ten, and it could go horribly wrong.

Based on early comments by Republican leaders, Treasury Secretary Mnuchin and Commerce Secretary Ross, I think there is enough common ground between President-elect Trump and most Congressional Republicans on other red-meat topics to enable the GOP to stick to their pro-trade bona fides. Sarah Palin calling out Trump for the Carrier deal for “crony capitalism” was a good start. However, I must say, the winds are blowing against me on this one.

6. Xenophobia continues to impact European elections, putting stress on the viability of the European Union. Brexit and the recently completed Italian elections are straining the commitment to a common currency.  In fact, the trend in elections across the globe (excepting Austria) has been toward more populism and provincialism.   With so many votes upcoming, it just feels like there are too many holes in the Euro wall and not enough fingers to plug them.  Next year may not be a good year to be a big European bank.

7. Emerging markets will outperform domestic markets. Why? Because emerging countries generally, and in aggregate, have higher growth rates with valuations that are half of those found in our domestic markets. Their aggregate debt levels tend to be lower, especially at the corporate and consumer levels. I know the emerging markets have a few proverbial warts, but most are in their pricing, which started to perk up after lagging developed markets for the last several years.

8.  Here’s where things can get really sticky - Geo-politics. Secretary of State is always an influential position, but in the context of Trump’s other cabinet picks,  more than usual seems to be hinging on this choice. After creating more of an international incident than necessary through his handling of a congratulatory call from Taiwan and challenging the One-China policy, President-elect Trump is clearly turning his focus away from China/Asia and toward Russia.   Trump nominated Rex Tillerson (CEO of Exxon) to run the State Dept.  As background, Tillerson has strong ties to Russia through the oil industry.  He also stands out as the first person in that position with no previous political or diplomatic experience.

This pick comes as a surprise, particularly on the heels of the recent CIA report that “allegedly” alleges Russian hacking involvement and attempts to sway our General election.   Delicate, to say the least.  This pick initially looks to have Putin's fingerprints. In fact, Tillerson has received the Order of Friendship medal, presented by Putin himself.  A cozy relationship that is raising alarms on both sides of the aisle.   The Kremlin went on to hail the pick and Tillerson’s “professionalism”. 

The good news is that Tillerson seems capable and will add an extra hand in business dealings, if not diplomatic relations.  The particularly "sticky" news is that President-elect Trump is rumored to be leaning toward John Bolton to be Tillerson's Deputy Secretary of State (the number 2 "diplomat" for the country).  Within the GOP establishment, conservatives tend to fall into three separate camps when it comes to foreign policy.  The isolationists, such is Ron and Rand Paul, are the most "dovish" camp.  Then there's the "Peace through Strength" camp, typically most associated with Ronald Reagan's policies.  This is the camp with whom Trump aligned himself during the election.  Then there are the “hawks” or neo-cons (aka Interventionists).  John Bolton is the most Hawkish of the Hawks.  He could be labeled an NEON-con and is possibly the most interventionist pick imaginable for this position.  To picture him side by side in the “war room” with General “Mad Dog” Mattis. at the Department of Defense, is an image most of our friends at NATO won’t enjoy.  Do you remember Trump questioning the necessity of standing by all of our NATO commitments during the election?  Europe does.  

To wrap up this long-winded segment, the currently proposed "diplomatic team" of Tillerson and Bolton has a long way to go before being confirmed by Congress.  So, I have to caveat this "surprise" pick.  If the checks and balance system works and the team currently being discussed at the State department gets revamped in some way, this will be a good sign that a non-confrontational approach of "Peace through strength" wins the day and we avoid hearing daily updates of Chinese nuclear bombers patrolling the South China Sea on the NEWS (that would be a good thing).  However, if the proposed “team of diplomats” at the State Department gets confirmed as currently suggested, this will clearly prickle our NATO allies, poke at China, and further the Trump-Putin bro-mance.  I summarize the outlook of this possibility with one word: Destabilizing.

9. While this is a crowded trade, I still look for the U.S. dollar to trend higher, and the dollar could buy more than one euro by the end of the year. The key to this call is that a higher dollar does much of the Fed’s heavy lifting. Higher inflation expectations reflected through the steeper yield curve (10-year treasuries have risen from below 1.5% to almost 2.5%, as of the time of this writing) should act as a counterbalance to an overheating economy, enabling short rates to stay lower for a longer period of time. Net/Net: A higher dollar helps keep inflation tame and limits interest rate increases by the Fed. This call would also mean a fire sale on European vacations in 2017.

9 1/2. Tame inflation Part Deux: Commodities have been on a tear lately- FADE THE TRADE! The market seems to be completely overestimating the commodities demand that would result from an infrastructure bill. The U.S. is actually a small to moderate player in terms of global commodity demand. China is the 900 lb gorilla in this market. China still accounts for almost half of the world’s demand for most global commodities. This is despite China’s declining economic appetite, as they have re-tooled their economy away from exports and toward their own consumers.

Looking at commodities through a different lens, one finds that higher interest rates create higher forward curve pricing, which brings out increased supply (all things equal) going forward.  Higher interest rates also dampen imported inflation and global demand, which in turn, weighs on demand for commodities. Commodities markets look vulnerable to me.

10. About one year from now, President Trump is censored—NOT impeached, but censored for conflicts of interest. This will mark the end of the honeymoon period and the beginning of the midterm season. Both the House and Senate are worried that he will turn D.C into Las Vegas East while they are out on recess. Upon return to Congress, they find Melania and Barron moved into Capitol Hill and the locks have been changed. This is done to save on security expenses. Too far?

Bonus pick A - Bad year for polar bears: Temperature rises to highest on record and ice-cap melt accelerates.

Bonus Pick B - Good year for Cubby Bears: Cubs win the World Series…again!

It will be an interesting year, but my call is that 2017 sets up for a far more pivotal 2018.

Here is to peace, love, and being present for those who are important to you!

Happy Holidays!



The Times, They Are A-Changin'

Public versus private markets | A conversation with Jason Portnoy


This year we have seen the impact of the unstoppable force, named global systems (global trade, central bank policies, currency management, ect.) run smack into the immovable object, named local politics….both here in the US and abroad. The results have been a pendulum swing back in the direction of protectionism and isolationism, at least at face value and on the margin.  I suggest, speaking ONLY for the markets and avoiding all social/political discussion, that the results of the most recent election could be considered a mixed bag. There are economic policies that are currently being put forth, which could only be considered “pro-business” (tax cuts, cash repatriation, de-regulation and infrastructure spending) and others, such as tariffs, that could be considered harmful to the deficit, inflation and to global trade.  I will not go further than to say that uncertainty has increased in many respects... markets typically do not like UNcertainty.   

Indeed, the times, they are a changin’ but not just in reference to political maneuvers and their outcomes. Rather, the times are changing in the way public markets are viewed vis-a-vis private markets (private equity and venture capital).  You didn’t see that coming, did ya?  Sorry, but I recently had the pleasure of seeing Bob Dylan perform in concert the evening following his Nobel Prize announcement.  Hence, the title for this blog was chosen prior to the election, so I had to weave it in somehow : )

The private markets have long been viewed as the “wild west” with little understanding of pricing mechanisms, while public markets had what were believed to be open and transparent price discovery mechanisms.  Keeping politics out of this discussion, it is not difficult to see how governmental organizations have moved to make public markets less transparent and perhaps more managed.  Is it now possible that the private markets provide more sanity and less systemic risk?  

The private markets have long been viewed as the “wild west” with little understanding of pricing mechanisms, while public markets had what were believed to be open and transparent price discovery mechanisms.
— Bill Martin

Much of the focus of earlier blogs was on the stagnant global economy.  The reasons for this stagnation are varied, political, and not necessarily straight-forward.  However, there is some consensus that one factor contributing to stagnation seems to be too much capacity.  Too much capacity discourages productivity enhancing investment on the margin.  A possible cause for too much capacity is posited to be too much “easy” money available due to central bank activities, which helped to keep sick companies on life support.  I don’t want to stir up old wounds about the role of the Fed with such little time, but will point out that private markets have not benefited from easy money policies to nearly the scale as public markets.  As such, they compete tooth and nail for every available investable dollar.  If growth opportunities dry up, so does the capital and life support.  At a high level, this is a model that has thus far worked and continued to create growth rates that are more in line with what we expect from the broader economy.

I am super excited to explore this public/private paradigm and new arc that has developed between them with successful entrepreneur and venture capitalist, Jason Portnoy.  

Jason Portnoy has spent his career contributing to some of Silicon Valley’s most impactful technology companies.  After first earning an engineering degree at the University of Colorado, he joined PayPal as employee number 34 while still a graduate student at Stanford University. As a Vice President on PayPal’s finance team, he helped support the company through its hyper-growth, Initial Public Offering (IPO) and subsequent $1.5bn acquisition by eBay in 2002.

Jason next gained privileged insight into the formation and rapid growth of two highly influential asset management firms. He was part of the founding team of Clarium Capital, which grew to over $3bn under management during his tenure. He later helped launch the Founders Fund whose early investments included Facebook and Palantir Technologies.  He was the first Chief Financial Officer at Palantir Technologies and later served that same role at Practice Fusion. In both cases, Jason helped guide the company’s early culture, fundraising strategies and industry leadership positioning.  

Jason honed his investment philosophies through angel investments in several ground-breaking companies including Facebook, Palantir Technologies, Yammer and Stemcentrix.  Today, Jason applies his many years of experience through the framework of Oakhouse Partners, a firm whose mission underscores his deep commitment to discovering and supporting talented entrepreneurs pursuing important challenges.

Jason is also a Kauffman Fellow, and a member of the famed and fabled PayPal Mafia whose membership includes icons like Elon Musk, Reid Hoffman, Peter Thiel, Max Levchin and Roelof Botha.

Bill:         Welcome Jason, it is great to have you here, especially during these uncertain times. Before we get into the topic at hand, I need to ask about what is on everyone’s you have any thoughts about the election and how this plays out in relation to the economy and the markets?

Jason:      Great to be here Bill, I really enjoy reading your blogs and have been looking forward to contributing.  As you know I am not a public markets person, but do have views on deploying risk capital.  I would also like to mention that I go to lengths to stay apolitical and am not willing to comment on social issues in this forum.  That said, following the morning-after hangover from a contentious campaign season, I am excited about the possibilities from a business perspective.  I believe the election results threw a lot of risk into the equation and this could either pay-off well or end in disaster.  But as a risk-seeker and risk taker, this feels good.  If we are re-entering a period of risk taking as a nation, I feel good in knowing that Silicon Valley will have a role.  Risk-taking is something Silicon Valley does very well.

Risk-taking is something Silicon Valley does very well.
— Jason Portnoy

Bill:          It is interesting that you focus the discussion on risk taking and not risk reduction, like most of my public market colleagues.  Do you see any parallels between how the public markets have gotten to where they are relative to the private markets within that risk framework?

Jason:      Absolutely, and I think you touch on some of that in your introduction.  Over the last few decades, most investors in the public markets have been looking for less risk, so public companies have responded by engaging in risk (aka volatility) reduction efforts like outsourcing their research & development (R&D) to the broader venture capital ecosystem and using financial engineering (e.g. stock buybacks using leverage) to deliver predictable returns on equity.  In fact, since the tech bubble burst in the early 2000’s, we have seen an explicit attempt by large tech and telecom companies to cut R&D spending in a desire to cut risk and increase cash flow.  These large, slower growing companies are using small start-ups as their R&D labs and then look to add these innovations through merger & acquisition (M&A) activity so they can leverage the growth opportunities over their larger platforms.  In any event, the net effect of outsourcing the R&D activity seems to segregate the consistent and lower risk cash flow businesses of a large public company from the high risk/high growth profile of a venture capital company.  

Bill:          That is so interesting, I saw the same “outsourcing” paradigm take place in the gold mining industry in the late 1990’s.  When the price of gold traded below the cost of production, the large mining companies reacted by cutting their exploration teams who identify “green field” growth opportunities. This was an attempt to cut budgets and risk, while increasing short term cash flow.  These exploration teams re-formed as mining start-ups (so to speak), and they are the ones who knew where the good gold deposits lay.  Those same mining start-ups then went to the Canadian capital markets to get cheap financing in order to drill out the properties and “prove up” the gold reserves.  This system continues to this day, where “wildcat” exploration teams find the gold and are then acquired by the larger, short-term focused, growth starved major producing companies. To your point, Jason, risk reduction by some leads to greater risk taking opportunities for others.

Bill:          And how has this dichotomy in risk translated to returns?

Jason:      As a result of the lower underlying risk, investors in public equities have been rewarded with commensurately lower returns.  I don’t see this happening in the private markets.  I’ll focus on venture capital for now since that is the area with which I’m most familiar.  If you look at the Cambridge Associates data below, you see that private market investors, who are comfortable taking risk over long time horizons, are rewarded with much higher returns than those available in the public markets.

US Venture Capital Index
...private market investors, who are comfortable taking risk over long time horizons, are rewarded with much higher returns than those available in the public markets.
— Jason Portnoy

Bill:          Those data are very compelling, Jason.  I’ll attempt to put those returns in perspective.   First, Warren Buffet returned 19.8% over his entire 50 year investing career (through 2015).  He has returned only ~14% over the past 25 years, while the Venture index has returned over 22%. Much of Warren Buffet’s tremendous growth occurred back when he was pursuing aggressive, small-cap opportunities along with private companies...similar to the venture capitalist of today.  It is tough to compare different investment era’s, but Mr Buffet achieved an approximate 30% compounded annualized growth rate over his first 25 years of investing, because his then smaller asset size allowed him to invest with a riskier profile.

Lastly, from a different dimension on this return comparison point, I would argue that the public markets have benefitted more than venture capital investments from the Fed’s aggressive monetary policy activities over the past 5-8 years.  These activities have likely had the effect of making the more recent returns even closer than they would have been.   

Bill:          So Jason, why do you think this bi-furcation in risk has occurred?  

Jason:         I’ve had friends say things like “Chicken or egg.  Lack of risk appetite or lack of opportunities?”, but I disagree.  There is no shortage of opportunities out there to take risk and invest in the future of our civilization.  I think a lot of it goes back to government and central bank intervention conspiring at every turn to try to reduce risk in our publicly accessible financial systems.  Forest fires are healthy, they clear out the dead brush.  Financial markets should be allowed to go through that same regenerative process.  When markets are allowed to self correct, capital and labor are freed up for more productive uses in the economy.  In the private markets, this dynamic still works quite well, so some investors are responding by seeking out investments in private companies.  A recent economist article shows that the fraction of total US equity enterprise value that is held in private companies has grown significantly over the years.

Bill:          This shift over just the 13 year period cited in the report is dramatic.  I’m sure with the growth of some of our ‘unicorns’ that shift toward privately backed companies has only accelerated.  I mentioned the surprising move toward fewer companies on the listed exchanges in a prior blog, but this really helps highlight what has been occurring.  I’m sure a part of this shift is simply growth of venture backed companies, as well as private equity acquisitions of companies that had previously been public, ala Dell.  Lastly, the private markets have just performed better and attracted more institutional money in response.  It all ties.

Bain & Company Private Equity chart

Bill:          And what has been the response to this bi-furcation of risk?

Jason:      Primarily, we’re seeing a corresponding bi-frucation in our capital markets.  Previously, companies had to go to the public markets to find the capital they needed to grow and scale their businesses.  More recently, if you are a risk-taking CEO focused on a very long time horizon, it’s been much harder for you to find like-minded public market investors to finance your vision.  Enter the private market investors, most of whom are hungry for growth, are willing to tolerate volatility and illiquidity, and have long time horizons.  These investors are now finding like-minded CEOs with whom to partner in the private markets..  On the other hand, investors who prefer predictability and liquidity continue to partner with like-minded CEOs in the public markets.  Neither one is right or wrong- if the right buyers (investors) and sellers (CEOs) are transacting with each other then that is a sign of a healthy market dynamic.  I believe it is only a matter of time before a private stock market works alongside the public stock market.

Bill:         I agree that the public markets have traditionally offered more predictability and definitely more liquidity.  However, I sense that with an artificially suppressed yield curve due to central bank activity, some of that “predictability” and transparency has been altered.  Investors just seem more uncertain about how the market operates and how they can benefit.  If I may, their returns seem more subject to be “Blowin’ in the Wind”.   

Jason:         Yes, it does indeed feel like participants in the public markets have to spend a lot of energy thinking about how government tinkering (either through the Fed, tax policy, etc.) is going to impact their investments, whereas we don’t tend to worry about those things in the context of most venture capital investments.  

Bill:         To what do you attribute private market success?  Is it just this uninhibited regeneration process?

Jason:      No, there is more to it than that.  In addition to the ability to regenerate, I believe private market investors benefit from having a very long term time horizon which allows them to tolerate more volatility.  They tolerate more risk-taking by the companies in which they are invested, and are generally rewarded for it.  

Bill:          Is there a way for retail investors to participate.  Should they start thinking longer term for the risk appetite portion of their portfolio?

Jason:         Yes, I believe they should.  They can learn from what large institutional investors have learned over the previous decades.  I’ll reference Cambridge Associates again.  They recently published a report that characterized the performance of foundation and endowment investors by how much they allocated to private market investments.  There is definitely positive correlation between their allocation to privates and their returns.   The table below shows how institutional investors begin to see outsized excess returns (mean = 4.0%) in their portfolios when they allocate greater than 15% of their capital to private investments.

Cambridge Associates research

I believe retail investors should follow suit.  At a high level, I would encourage them (and their financial advisors) to stop thinking of private company exposure as purely an “alternative investment”.  As we saw earlier, privates are becoming a much larger fraction of total equity enterprise value, so if you leave them out of a portfolio you are starting to leave a big hole.  In addition, the hole that is left is exactly the growth story that many retail investors crave.  Think of it this way: It has always been the case that some companies are growing and some are stagnating (or potentially being displaced altogether).  Now that private capital markets are increasingly more developed than in the past, and growth stage private companies wait much longer to go public, one can make the case that the private market represents a bigger fraction of growing companies, while the public market represents an increasing fraction of stagnating or soon to be displaced companies.  If true, then a portfolio that only includes public market equities is less exposed to growth than it was in the past, and that’s a problem.

...stop thinking of private company exposure as purely an “alternative investment”.
— Jason Portnoy

Bill:         That is an awesome point, Jason.  You brought up companies taking longer to issue an initial public offering (IPO).  Can you comment on the liquidity cycle in the private markets.  It is no secret that the IPO market has dried up.  Is that more from a supply/demand standpoint, and is it impacting the venture world?  Just as the public markets have perhaps had too much capital chasing too few good opportunities, is it possible the private markets have not gotten the good re-cycle of cash?  

Jason:      I have a couple thoughts on that.  First, successful companies have not gone public because they don’t have to, as I mentioned before.  They don’t want all the legal baggage and distraction that that goes along with being a public company, and they are finding great private market investors to finance their growth.  On the other hand, for a company where a good chunk of the employee compensation is in the form of equity ownership, an IPO still feels like the most efficient way to distribute the value to the employees who helped create it.  I’ve wrestled with the IPO issue for a number of years - I even wrote a blog piece about it called “IPO is not a Four Letter Word”.

In short, yes, the fact that companies are waiting longer to go public (if they ever do at all) is definitely having an impact on the venture ecosystem, although I would argue that it is a net positive.  In the late 1990s we saw too many companies go public because they could, even though their business models were not quite ready for it. That capital was quickly liberated, which may have led to excessive cash recycling and the first famous tech bubble of the late 1990s ensued.  I don’t think we’re seeing the same phenomenon this time around because so much of the capital is still held in private companies like Uber, AirBNB, etc.  That may be what is forcing VCs to be more disciplined than they were in that first internet bubble.

I believe we are living through a one-time shift in this regard - like a meal moving through a snake’s belly.  Let’s imagine companies went public in year 5 and now are waiting until year 8 or 10.  That means we’ll have a period of 3-5 years of very few IPOs, but then at some point all of the companies who would have gone public at year 5 will start going public, and the cohorts behind them will similarly.  The resulting pace will reach a new steady state.  As a venture capital investor it is OK for this liquidity shift to happen... as long LPs (the investors in those funds) are comfortable with it and believe they will be compensated for the wait.  Let me add that IPO has almost always represented the minority of liquidity events for venture backed private companies, with acquisitions making up the majority.  In recent years the M&A market has been fairly robust, so venture capital investors get liquidity this way as well.

I believe we are living through a one-time shift ... like a meal moving through a snake’s belly.
— Jason Portnoy

Bill:         Going back to the retail investor; how should they actually incorporate private equity exposure into their portfolio?

Jason:         Unless they are an expert in investing in private companies, they should invest in a fund, FULL STOP.  Whether it is private equity or venture capital, they should look for a great fund manager and allocate that way.  I’ll focus on venture capital since that is where I spend all of my time.  I see a lot of high net worth individuals go out and start making angel investments, only to watch the capital disappear in short order.  Private company investing, especially at the very early stages, where most high net worth (HNW) individuals get access to investments , is extremely risky.  In a portfolio of 20 companies you will have one or two (three if you are lucky) that drive all of the returns.  There will be a few investments that generate modest returns, and the rest will be a loss.  This was the case in my angel portfolio: the big gains were all driven by Facebook, Palantir Technologies, Yammer, and Stemcentrx.  I had about 35 angel investments in that portfolio and those four outcomes drove the entirety of the returns.  

So I recommend working with a professional.  You probably wouldn’t try to represent yourself in court or perform surgery on yourself.  Pay a professional to help you navigate the venture ecosystem.  Also, investing in early stage private companies is not just about picking companies - it is about post investment support.  That support does two things (ideally): 1) it helps improve the company’s chance of success, and 2) it gives the VC investor incredible amounts of data that help them assess if they should continue investing in that company.  Most venture capital gains are made by investing follow-on amounts in the best companies.  You can’t do that if you aren’t working on it full time and getting intimately connected to each company in the portfolio.  You don’t have the data and, perhaps more importantly, you don’t have the relationship to do it.  In the best companies the CEOs have the pick of who they want as investors, and they are going to pick investors with whom they like to work.  Without those relationships you won’t be able to invest in the best companies, and you will have an adverse selection problem on your hands.  

A further benefit of investing in a VC fund is that in many cases the fund will offer opportunities for you to co-invest with the fund down the road in the fund’s most promising companies.  Now you have a *proverse* selection situation, and that is a recipe for success.

Without those relationships you won’t be able to invest in the best companies, and you will have an adverse selection problem on your hands.
— Jason Portnoy

Bill:          Proverse selection.  I don’t think I’ve heard many investors use that term.  Can you tell me more about that?

Jason:         Well in that prior statement I was simply referring to the fact that if you are co-investing with a fund in later rounds of a company’s financing, you may have the opportunity to cherry-pick the best investments from that fund, which gives you great odds from the start that the investment has a chance at a nice return.  But more generally I refer to proverse selection as the phenomenon that exists, somewhat uniquely in venture capital, where great portfolio company outcomes (and fund returns) build up the brand of a VC firm, which then attracts a higher quality of company to seek out that firm for investment, and that then leads to more great investment returns.  It’s a positive reinforcing cycle, and it goes a long way toward explaining why certain venture capital funds consistently deliver the best returns.  I’ve written about this in the past in an article titled “The Secret Law Every Successful LP Understands”.

Bill:          Lastly, are there specific sectors that you believe offer tremendous growth opportunities?  Better yet, how would you suggest investors learn to identify some of these opportunities on their own?  

Jason:      Healthcare, finance, and robotics are all areas that I’m very excited about right now.  The first two have been popular for some time, but both industries are so big that there is still a lot of innovation coming which VC investors can help finance.  Robotics is in its early days because the commoditization of sensors and hardware that resulted from the proliferation of smartphones is still gaining speed.  As this continues and hardware costs continue to come down, robotics begins to look a lot like software, and that’s when innovation can start happening even faster.  There is a lot of discussion about artificial intelligence and blockchain, but I personally tend to focus on how those underlying technologies are going to disrupt various industries, and then look for investments in those industries (versus in the underlying technology itself).  

There is a lot of discussion about artificial intelligence and blockchain, but I personally tend to focus on how those underlying technologies are going to disrupt various industries, and then look for investments in those industries.
— Jason Portnoy

For investors to find these opportunities on their own, there is no good substitute for getting out and talking directly with entrepreneurs.  Or better yet, listening to them.  If you listen closely to enough conversations you start to stitch together an idea of where these new technologies are heading and which parts of an industry they will disrupt. That’s where you start doing your research.  

Bill:          That was fun, Jason.  Thanks for allowing us to “listen” in.  You speak as eloquently about risk as Dylan waxes about change - poetic.  It has been fascinating to hear you share your views and outlook for our Silicon Valley growth ecosystem and beyond.  No surprise, you also brought up a whole host of other questions. I hope you will come back next year and let us hear your thoughts on the long-term impact of disruptive industries on the broader economy.  

Have a Happy Thanksgiving!


Taking the Temperature of the Economy


Cutting Through The Noise, a financial blog by Bill Martin CFA

  • The yield on the 10-year Treasury is the economy’s thermometer. The economy’s current growth rate, growth and inflation expectations, and the cost of debt financing are embedded in one number—the rate our government borrows money at for ten years.
  • Our thermometer registered a feverish reading in the hyperinflation of the 1970s, and steadily fell for decades thereafter, measuring a much healthier interplay between growth and inflation.
  • The current reading of our thermometer indicates that the economy has walking pneumonia, which is to say that it struggles to maintain its current low level of activity, particularly with all the headwinds or potential viruses the global economy presents.   

About 25 years ago, as a newly minted analyst, I was invited to my first investment meeting, which included a guest speaker, Lang Wheeler, a successful hedge fund manager.  

Someone in the audience asked Lang, “what is the single most important piece of information that you look at?”  I have heard this question at least a thousand times in meetings since, but that was my first meeting, so I recall vividly Lang’s response… “The 10-yr Treasury Note”.  He continued “If I were on a desert island with only my satellite phone, and I had to choose one piece of information to trade my account, I would choose the yield of the 10-year Treasury.”  This surprised me because he was an value + momentum equity investor.

If I were on a desert island with only my satellite phone, and I had to choose one piece of information to trade my account, I would choose the yield of the 10-year Treasury

As I earnestly scribbled in my notepad, I knew I had just heard something incredibly important for my investment career. Of course in those early days, everything seemed incredibly important.  In any event, the single best indicator of the economy’s vigor and expectations of future growth, Lang told us, is the yield of the 10-year U.S. Treasury Note.  This instrument is considered risk free, often offers investors a fair return on their money to protect against inflation, and normally provides a bit of a premium for parting with their money for 10 years.  Think of it as a long-term savings bond with liquidity.

The yield on the 10-year Treasury tends to track with overall economic growth. As such, an investor can typically grow their money without risk at a level roughly similar to the rate of overall economic growth. As a point of reference, long-term economic growth has averaged around 6%--which breaks down to 3.5% actual growth and 2.5% inflation. 

Virtually all loans made in the market—mortgages, car loans, student loans, and more—are priced off the 10-Year Treasury.  The 10-year Note has such a strong history of yielding a bit more than economic growth adjusted for inflation, that knowing only this number meant you could also reliably gauge what was happening in the economy.  As Lang quipped, if the 10-yr Treasury is between 4-7%, then the economy is humming along fine.  Above 7%, we have inflation concerns, and much below 4%, we likely are headed for a recession, or contracting growth.

With the overall economy growing at about 3% per year, and 10-yr Treasury yields currently anchored below 2%, Lang’s trading strategy would not have worked well in the current environment. I can’t help wonder how many margin calls Lang would have received on his S&P 500 puts by now, had he continued to trade blindly off the 10-yr Treasury note. Times change and the data changes with them. I don’t say this to pick on Lang (well, maybe a little bit), but to demonstrate that much of the data we see today is unprecedented and was unthinkable from the perspective of twenty-five years ago.   

Of course, market relationships change over time, but there is still no underestimating the importance of the economy’s thermometer—the yield on the 10-year Treasury note. This first chart by the St. Louis Fed shows the yield on the 10-year Treasury note for the last fifty years.  After declining for three decades, the yield has been below what would typically be considered recessionary levels since at least 2008. 

FRED 10 year Treasury

This is our new reality.  What does the current level of the 10-yr Treasury tell us?  Firstly, it tells us there isn’t much current growth or fear of future inflation. In other words, the patient—our economy—is suffering from a case of walking pneumonia. It’s plodding ahead dutifully, but anytime it tries to run, it succumbs to a coughing fit. Investors are currently not being compensated for having the courage to avoid putting their money in the mattress.

...the patient—our economy—is suffering from a case of walking pneumonia

The chart below takes the yield on the 10-year Treasury and removes the loss of purchasing power due to inflation. As you can see in the chart, investors in the 10-yr Treasury get a negative return after factoring in the effect of inflation.  Risk-free assets are so expensive that they no longer cover the cost of most inflation measures. The only other times this has happened was during the rapidly accelerating inflation period of the 1970’s. At that time, the 10-Year Treasury, our financial thermometer, registered a dangerously high fever.  Historically, investors have earned 2.5% over and above inflation, which is a pretty penny for little risk.

FRED 10 year treasury

This phenomenon—a negative yield in the risk-free investment—encourages investors to seek a positive return in other “riskier” assets, but we will get to that in future blogs.  I want to use this opportunity to step back and understand this environment.  Take the temperature of the economy, if you will.

Again, our economy’s health could be likened to walking pneumonia—well enough to move forward on its own two feet after swallowing large doses of monetary medicine, but still very sick and in need of special care.

Basically, The US maintains a relatively high standard of living, but growth is still very anemic.  We have entered the 7th year of our economic expansion.  Unemployment is back under 5%, near all-time lows, while the stock market is at all-time highs and consumer debt is trending lower, yet we still have slow global growth, low wages, weak labor force growth, and low productivity.  I call it the 2% two-step.  Any time the economy has hinted at being able to grow at a faster rate, growth proves to be fleeting and falls back to below the long-term trend, and we continue to hover around 2% GDP growth.  Again, our economy’s health could be likened to walking pneumonia—well enough to move forward on its own two feet after swallowing large doses of monetary medicine, but still very sick and in need of special care.

Perhaps this is the new normal, as many have claimed.  But what does this imply for investors?  Well, low growth with high overall debt levels will likely lead to higher volatility once global Central Banks get out of the way with their Central Planning. 

Low growth does not mean NO growth.  So there will be relative winners and losers.  With so much money in the system, courtesy of central bankers, there will be crowding towards those perceived winners.  Crowding ultimately leads to disappointment and volatility.  I think this may be the new environment for which we must prepare; ”boom-bust” rather than “buy the dip.”

This conversation about the low growth-low opportunity reality  sets us up next month’s conversation where we will investigate some aspects of the private markets that are experiencing solid growth.  Private markets continue to offer access to growing industries without the “mark-to-market” volatility we see in the public markets.  I will be speaking with Jason Portnoy, Venture Capitalist with OakHouse Partners.  Jason is kind enough to drop by to give us some insights about the Venture and Private world.  I look forward to sharing my Q&A with Jason during our next blog.

Lastly, I want to supplement this offering with an ELECTION SPECIAL, a nod to my favorite blogger.  The Heisenberg’s latest blog incorporates some recent reports that help to distil the election environment. I am not sharing this to pick an election winner or even back a horse in this race.  I share it because I think this report provides a bit of perspective on trends in our system that make this election different. Call it the Bernie or the Trump effect. Either way, there is something new rising up and I think his report helps shed some light. Note: you may need to sign up (just enter your email) to access the blog, but I think it will be worth it.

Here’s to being more right than wrong and early rather than late (just not as early as Lang) : )

Do You Believe In Magic?

Stock market levitation

Cutting Through the Noise - a financial blog by Bill Martin, CFA

...The incredible levitating market

This month we investigate the forces that drive the stock market higher in spite of weaker corporate earnings:

  • Lower interest rates help discount a company’s future earnings to look more attractive than the rates investors can get on their cash and bond holdings.  Thus, lower rates encourage investors to pay higher multiples for each dollar of current earnings.
  • Corporations are buying back their own stock at record levels… this helps lower the number of shares outstanding and increase earnings per share over a reduced number of shares.
  • Merger and Acquisition activity increases demand for remaining shares, while reducing supply. 

Last time, we looked at how earnings have been impacted by a slow and maybe even stagnating global economy.  Indeed, the 2nd quarter earnings are now in the books and have declined for five quarters in a row when compared with the prior year. The last time this happened was during/following the great recession.  Although most people remember that one, it seems most investors have forgotten it.

Yet, the market still wants to go up… what gives?  Well, there are actually a few very logical explanations for the market’s rise, and these market dynamics could continue to play out for some time.  In the interest of showing both sides of the same coin, and putting aside the many reasons a professional investor might be skeptical, we will peer into the market’s bag of tricks to see what has been behind its impressive levitating act.  

OK, this one is Math, not Magic—Lower Rates Raise Equity Valuations more than earnings!

When rates go down, the multiples that investors are willing to pay for each dollar of earnings goes up. This relationship is built into the math of equity valuation, so it is a causal and deterministic relationship. In some ways it makes intuitive sense—you’ll forego low rates and pay more for future earnings when inflation is low, and pay less for future earnings when inflation is high.  You can see this relationship in the chart below by Robert Shiller.  The red line is the yield on the 30-year Treasury and the (blue/green?) line is the Price/Earnings multiple, calculated with the last ten years’ earnings.

We can clearly see how the run up in interest rates in the early 1980’s negatively impacted investors appetite for stock market earnings.  Conversely, the resulting decline in interest rates has largely increased the amount investors are willing to pay for a dollar of earnings.  The relationship between the valuation of all assets and the risk-free interest rate for US Treasury bonds is among the strongest in markets.

Declining interest rates have had a huge positive impact on equity valuation and equity returns. Of course, rates don’t fall forever. The (9/21/2016) 30-year Treasury’s yield is 2.39%, which is at least a half percent below the long-term rate of inflation, while inflation has been below the Fed’s target of 2.0% for most of the last four years. Buying Treasury’s is like putting your paper cash in a high-priced safety deposit box or taking $100 out of an ATM machine that charges a 75 cent fee. It is, of course, supposed to be an investment that attracts investors because it accrues interest at a rate higher than inflation. Rates are likely to be a headwind for equity valuation if inflation increases above 2%, and the headwind transforms into a gale force wind if inflation falls below 0%. That narrow range means the positive impact of declining rates on equities is relatively bound.  Only zero inflation or deflation (falling prices) is likely to drive rates lower, while deflation would also put a major dent in corporate earnings prospects.

"Buying Treasury’s is like putting your paper cash in a high-priced safety deposit box or taking $100 out of an ATM machine that charges a 75 cent fee."

The Buyback Trick

With record low interest rates helping to make equities appear undervalued relative to bonds, the corporations are getting in on the game of buying back their stock at record levels.  Buybacks achieve a few things—they increase earnings-per-share by retiring shares, they create demand in the market when they buy their own shares, and they reduce the supply of shares outstanding, which means higher prices if demand is constant, all else equal. All of those beneficial effects can occur without selling a single good or service, which was the raison d' être  for corporations. It is among the stranger side effects of the Fed’s aggressive interest rate policy. Move over David Copperfield, these CEOs are making their shares outstanding disappear faster than the Statue of Liberty.

Not only are corporations buying their stock with retained earnings, but also borrowing to buy their stock. We can see from the dark blue line in the chart above that approximately 30% of all share buy backs are now funded through debt.  Debt-financed buybacks will not be sustainable as rates begin to rise, but it sure gives the market a nice goose in the meantime.  As we discussed a couple months ago, wouldn’t it be nice to see these companies have opportunities to invest in their own businesses, as opposed to just buying back their own stock?

“Move over David Copperfield, these CEOs are making their shares outstanding disappear faster than the Statue of Liberty.”
source of funding  JPmorgan

Who’s Buying this Bull?

In the below chart titled “Bull Market’s only Buyer”, we see that bars centered on the “0” line, which represent natural equity buyers, have been predominantly negative for the past two years. In fact, outside of a brief buying spree in 2013, mutual fund investors have been net sellers of equity since the bull market began in early 2009. If that’s the case, why have stock prices tripled in value since then? Well, to answer that question, the white line demonstrates that the corporations themselves have been the buyer behind this bull market. As long as they have cheap debt or free cash flow they will continue to drive their stock prices higher. Of course, the fact that they spent the better part of the last decade buying their own stock instead of investing in their business may mean that the decision to buy their stock at relative highs could make their businesses less productive and less competitive in the next ten years. The last time buybacks were this high was just prior to the financial crisis in 2008. 

“Of course, the fact that they spent the better part of the last decade buying their own stock instead of investing in their business may mean that the decision to buy their stock at relative highs could make their businesses less productive and less competitive in the next ten years.”
Bull market buyer Bloomberg

Making Two Companies into One: the Oldest Trick in the Book

Mergers and acquisitions (M&A) have been another driving force behind the market’s ‘growth’. The level of M&A activity has picked back up to record levels. These types of transactions can be very supportive to the market because they provide demand for shares from the buying firm, while removing supply by reducing the number of companies available for investment. What’s more, plenty of empirical evidence demonstrates that companies with aggressive acquisition strategies are capital destroyers. This is no cheap sleight-of-hand trick. This is on the level of the legendary magic of Harry Houdini. When you can’t buy any more of your own stock and don’t have any attractive growth opportunities for your own company, it’s apparently time to buy-up your competitor’s stock instead.

“This is no cheap sleight-of-hand trick. This is on the level of the legendary magic of Harry Houdini.”
MandA mania wall street journal

The Case of the Disappearing Stock

You don’t have to be Sherlock Holmes to see what’s going on here—the supply of available stocks has also fallen precipitously. Our final graph shows the number of companies that are actually available for investment.  Some of the decline is due to a slow pace of Initial Public Offerings(IPO) and tech firms choosing to remain private because they have cheap access to capital and lower regulatory hurdles. The total number of stocks has been cut in half in less than twenty years, hitting a 40-year low.

“Many investors still see the US as the cleanest dirty shirt in the closet, or if you will allow, the skinniest horse in the glue factory.”
Stock market companies


Can all these tricks continue? You bet they can. Markets typically overshoot. Many investors still see the US as the cleanest dirty shirt in the closet, or if you will allow, the skinniest horse in the glue factory.  The US stock market can continue to win this relative valuation game.

Will it end well?  Probably not.  While US equities look cheap vs other assets on a relative basis, they can and will look expensive on an absolute basis if earnings continue to stagnate or interest rates back up to their more “normal” levels.  We may be approaching a fulcrum…if earnings pick up, then rates will likely rise and that can’t be good.  If earnings decline further, then rates will decline, adding support to valuations; however, the Fed will need to find a new bag of tricks to battle an all out earnings or economic recession. 

Next time, we’ll leave the magic jokes behind and dive into market valuation to see if we can get a sense for how much longer this market might be able to levitate.

How Long Will the Bears Let Goldilocks Sleep?

Cutting Through the Noise - a financial blog by Bill Martin, CFA

Goldilocks and the economy
  • Corporate earnings estimates have been lowered for 13 straight quarters
  • Corporate profits using GAAP are now only back to the level of earnings prior to the 2008 financial crisis
  • Earnings “massages” are back in vogue,  gimmicky accounting tactics not seen since the Great Recession.
  • Stock prices have recently been driven by corporate actions and low interest rates as opposed to the more typical earnings/stock price relationship. 


Good news is good news / bad news is good news - a Goldilocks market

We all know share prices follow earnings, right?  Here is how it is supposed to work:  companies do a good job of creating products that people want, while controlling costs and protecting against competitive pressures. Then, companies earn reasonable profit margins, and steadily grow their customer base. Their earnings grow from demand for their products, the earnings from which drive more investors to buy their stock, as a result the company’s stock price moves higher. 

“The stock market should make sense, and could make sense, but nobody ever said the stock market had to make sense.”  

~David Rosenberg, commenting on recent market behavior

I tend to agree with Mr. Rosenberg—it’s difficult to make much sense of current markets given that a great many fundamental economic relationships are being stretched, partially due to the Fed’s unconventional monetary experiment.  For example, stock prices generally should follow the path of earnings. Yet, the stock market keeps charging ahead, even though earnings have stagnated with the broader global economy.   Sure, there are companies that have done a good job of continuing to grow their earnings, but those companies tend to trade with expensive multiples in response to their stellar growth in a tough economy.  To understand the broader market as a whole we have to step back and look at the collective earnings prospects of the 500 largest companies in the U.S., otherwise known as the S&P 500.  

The stagnation of the U.S. economy that we evaluated in last month’s blog is visible in the charts of corporate revenues and earnings pictured above. Just as economists have had to adjust to economic reality by sharply lowering their growth expectations, so too have analysts who follow corporate earnings. These confirming signals reflect how various analytical perspectives on Wall Street have been slow to see the recent reality of stagnant economic growth since the financial crisis.  Ultimately, corporate earnings are beholden to the broader economy. In response to tepid demand, companies have squeezed costs and sought to benefit from lower interest rates in the short run. In the long run, companies need a growing economy to feed growing earnings. 


These Earnings Expectations are toooooo Warm… 


This graph above focuses on how actual earnings have compared with expected earnings.  Typically, we see stocks sell off when their earnings disappoint analysts’ expectations, but we have not seen that normal, self-correcting market behavior during this period.  Note that analysts have had to cut their earnings expectations in half in each of the last five years. And this year, once again, analysts are expecting double-digit earnings growth for the next two years. Every year for the last five, investors have started the year expecting earnings growth in the 10-15% range, and have had to cut them to below 5% and to near-zero growth in each of the last two years. Meanwhile, stocks have been setting new all-time highs throughout this period, undeterred by the reality of faltering growth and the perils of great expectations.  Investors are approaching the stock market with a good news is good for stocks, and bad news, which brings lower interest rates, is good for them too, mentality. 


These GAAP earnings are tooooo cold….

Instead of evaluating earnings on their merit, companies are offering an alternate view of their financial statements, via pro-forma earnings releases. Pro-forma earnings, which do not adhere to the Generally Accepted Accounting Principles (GAAP) put forth by the Financial Accounting Standards Board (FASB), often are an effort to paint a portrait of earnings in the best possible light.  Many companies prefer pro-forma earnings because they can sweep away mistakes and focus on the good parts of the operation.  Pro-forma earnings often allow for write offs, exclude stock-based compensation, and add back non-recurring items, which tend to smooth and inflate earnings. Needless to say, Warren Buffet is not a fan of pro-forma earnings statements, and neither am I. Nevertheless, we can broadly understand the quality of earnings by the gap between pro-forma, or management’s spin on earnings, and their GAAP earnings, which are used for compliance with financial statement regulation.


In the chart above, the blue bars represent the more conservative GAAP approach to company earnings, while the red bars are companies’ view of earnings through rose-colored glasses. We tend to see the bars deviate during times of stress, as companies stretch to make their numbers appear stronger.  Notice the last time we saw a discrepancy this wide was back in 2008 when companies were pulling every accounting trick in the book to appear strong and solvent.  At present, approximately 25% of reported earnings are “debatable” in quality.  Also, notice that the overall level of earnings rebounded from the Great Recession, yet seven years later, we have only reached the same level of earnings as the peak of the last business cycle in 2007. That means very little true earnings growth has been realized during this business cycle. 


These optimistic earnings estimates, low interest rates, Corporate buybacks, Mergers and Acquisitons make the stock market juuuust Right!


Investors are finding a way to get comfortable and feel “juuuuust right!” in every room of the bear’s house, ignoring all of the obvious signs of danger.  We see in the above chart by BMO that S&P earnings (orange line) have clearly been rolling over from approximately 14% earnings growth in 2012 to -3% within the last year.  The steady erosion in earnings has brought disappointments in each of the past 4 years. 

At the same time, the blue line in the chart above shows the P/E ratio, or the premium paid for current and expected earnings, has steadily grown from 14 times trailing earnings to over 19 times.  As of the time of this writing, the P/E ratio is currently over 21 times trailing 12 month earnings. That essentially means that investors have upped their bet from paying $14 for a dollar of earnings, to now paying $21 for the same bet. When investor optimism outpaces earnings growth, stocks become increasingly expensive.

The optimistic argument du jour has shifted to “We can no longer ignore the fact that earnings growth is declining into negative territory, but by golly, that means that earnings are hitting rock bottom, which means they’re just about to rise again!”  Of course, this tune of optimism is starting to sound a bit like “the Boy That Cried Wolf”, in that repeated cries for something that does not materialize eventually leads to doubt and loss of credibility… high hopes for next year’s earnings have not materialized for four straight years.    

In this issue we analyzed the level and quality of earnings, following last month’s blog on the broader economy, which looked at how optimistic forecasters have been continually disappointed by the realities of a stagnant economy. This analysis of earnings and earnings expectations shows the same pattern—earnings expectations continuously come out overly optimistic, only to be downgraded to easily beatable numbers. What’s clear is that earnings are not growing, yet stock prices are rising, and companies are putting the best possible spin on their stagnation to support their stock prices and executive compensation. If it’s not earnings, then what is driving stocks to new all-time highs? Is this just a Fairytale?  Will it be a Disney or Brothers Grimm ending?

Next month, we will dig into the corporate behavior that is disctracting the Bears in the forest for now and keeping them from returning home to crash the party.  To better understand what is helping to levitate the stock market, we will expand on share buybacks, mergers and acquisitons, and the impact of these transactions on equity prices.  In the meantime, I hope you are enjoying this Goldilocks rally.

Here’s to being more right than wrong….


Walking the Slow Growth Tightrope

Cutting Through the Noise - a financial blog by Bill Martin, CFA


“Greed is good.”

Gordon Gecko, the infamous mogul from the iconic 1987 film Wall Street

“Growth is good.”

Nearly every Central Banker on the planet

Stories of unbridled greed rarely end well.  During the rampant real-estate speculation that led to the financial crisis, Mr. Gecko’s audacious theory was tested yet again in financial markets. The Great Recession was the result.  Nevertheless, Mr. Gecko had it partially right. Something virtuous happens when people compete for relative wealth gains. That virtuous something is growth. Growth makes everything just a little bit better than it otherwise would be. Growth is so good, in fact, that you often find economic stress and difficulty in its absence.

Faster global economic growth is something that almost all economists agree would be welcome. Now that every major central bank in the world has undertaken unprecedented policies to increase economic growth, why has growth remained so elusive?  To dive deeper into the causes, let’s take a look at the economy:

  • U.S. and global growth have been disappointing since the recovery began in 2009, following the Great Recession.
  • Labor force growth and labor productivity—the twin engines of any economy—have been running at approximately half their historical rates.
  • The debate over the reasons for slow growth is divided into two camps:  one side posits that the global economy may have slipped into secular stagnation, while the other side argues that the economy is working through a prolonged cyclical recovery.  
  • Policy makers seeking to revive economic growth since the Great Recession have repeatedly pulled the usual levers of monetary and fiscal policy. Every time these economic levers are pulled, they generate less energy or response, while draining the potential energy stored up for the next pull.  

Strong growth tends to be a salve for other societal problems, while weak growth tends to accentuate underlying economic and social tensions. To understand where we are now and where we might be headed, we need to spend some time using the past for perspective.

There’s somethin’ happening here…

Source: St. Louis Fed    It doesn’t take a PhD in Economics to see that something out of the ordinary was happening in the 1960s, as well as in the recent decade. In the 1960s, easy money worked well for awhile until the great inflation of the 1970s. Thereafter, steady growth, cyclically fluctuating around the long-term average, persisted for several decades until the early 2000s. In the new millennium, long-term economic growth has steadily eroded to the lowest point in the post-WWII era. 

Source: St. Louis Fed

It doesn’t take a PhD in Economics to see that something out of the ordinary was happening in the 1960s, as well as in the recent decade. In the 1960s, easy money worked well for awhile until the great inflation of the 1970s. Thereafter, steady growth, cyclically fluctuating around the long-term average, persisted for several decades until the early 2000s. In the new millennium, long-term economic growth has steadily eroded to the lowest point in the post-WWII era. 

What it is, ain’t exactly clear…

Economists’ best guesses for the economy’s potential growth have missed the mark by a wide margin. Year after year, economists have been lowering their growth expectations, yet the economy’s performance has still fallen short of even these lowered standards. This is a sign of a major disconnect between expectations and reality. Economic models might be missing some major factors that have been influencing the economy since 2000.

Economists’ best guesses for the economy’s potential growth have missed the mark by a wide margin. Year after year, economists have been lowering their growth expectations, yet the economy’s performance has still fallen short of even these lowered standards. This is a sign of a major disconnect between expectations and reality. Economic models might be missing some major factors that have been influencing the economy since 2000.

Growth is elusive in the Eurozone

The view from the bridge for the Eurozone has been even more disappointing and is actually more akin to what Japan has experienced since 1990. Economists have been too optimistic about the economy’s prospects, and the Eurozone economy has not been able to live up to such great expectations. 

The view from the bridge for the Eurozone has been even more disappointing and is actually more akin to what Japan has experienced since 1990. Economists have been too optimistic about the economy’s prospects, and the Eurozone economy has not been able to live up to such great expectations. 

When three of the four largest economies in the world—the Eurozone, the U.S., and Japan—are showing the same slow growth with the same unrealistic expectations, it’s probably time to take note, and well past time to understand the root causes of such slow growth. 

Taking Stock

Investors are trying to figure out what to make of the economy’s strange economic behavior with so many swirling crosscurrents and so many underlying assumptions coming under question. Former Treasury Secretary Larry Summers offered up a compelling theory for why growth has been so slow despite central banks’ herculean efforts to lift the global economy. Summers believes the economy has entered a period of secular stagnation that has causes, effects, and cures that are separate from an ordinary recession.

The secular stagnation theory

Secular stagnation implies that there is too much savings, partially from income inequality, and partially because companies literally have more cash than they know how to profitably deploy. Their operations are chugging along reasonably successfully, but the top brass has so much spare cash that finding a home for it—or finding investments that will boost the bottom line—has become increasingly difficult.

A number of the large tech companies would be good examples of these cash-rich companies.  Larry Summers’ pet example is Facebook’s purchase of the four-year-old WhatsApp and their 55 employees for $19 Billion.  This is in comparison to 70+ year-old Sony Corp having more than 100,000 employees and a market cap of only $18 Billion.  Now, this is not suggesting that one company has greater or less future economic value, but it does feed into the narrative that more money in the hands of fewer individuals in less capital intensive industries will have an impact on the larger ecosystem and the equilibrium level of interest rates; a “hollowing out” of sorts.  

These “over” savings in the hands of the few go hand in hand with not enough final demand from consumers and businesses. For example, Facebook’s $19 billion could have been spent elsewhere—adding services to their platform, hiring, increasing wages, building their own messaging app, etc. Putting $19 billion to work in those ways could have had a marginally larger impact on the broader economy, but when you add up several similar deals, it begins to make a big difference. And high tech is not alone—the S&P 500 companies, as a group, have the largest cash coffers in more than 60 years, while mergers and acquisitions have been happening at a fast pace in some sectors of the economy.  For purposes of this discussion, we need to separate the impact of short-term cash hoarding vs long-term earnings outlook.  We will save our earnings outlook for next month.

With less demand for their products, companies are less inclined to forge into the wilderness by making risky, long-term investments.   Long-term investment tends to lead to increased productivity, higher incomes, and an increased standard of living.  Without a jolt to the system, this stagnation can stretch for a long period of time, as less demand can beget less investment, and less investment begets lower productivity in a self-reinforcing downward arc.

The Other Camp— “Move along, there’s nothing to see here.”

On the other side of the debate, some economists believe we are simply in a prolonged cyclical recovery. Cyclical recovery is akin to a typical recovery.  In a typical, cyclical recovery, borrowers eventually get their balance sheets in order and unproductive businesses get forced out.  This tends to bring supply and demand into equilibrium.  At that point, lower rates and expansive fiscal policy tend to operate in conjunction with pent-up demand and voila, we have a typical recovery.   A typical post-War cyclical recovery has tended to bring 4% growth after subtracting the inflation rate, or about 7% growth before inflation.

Our current economic recovery is very weak by any standards or comparisons. The economy has grown in fits and starts with an overall pace that’s about half of what it has been in past recoveries.  And it hasn’t been for lack of trying.  For the last seven years, global central banks have been performing an unprecedented, global experiment to kick-start the economy. That implies that either something is different from previous recessions/recoveries (secular stagnation) or the financial crisis was a helluva lot worse than we realized and any cyclical recovery will take longer to materialize. Are artificially low-interest rates, brought about through Central Bank QE (Quantitative Easing) policies, enabling weak firms to compete beyond their usefulness?  Thus, keeping capacity artificially elevated…and, is this combined dynamic preventing new and more productivity enhancing investment?  Possibly.

GDP Growth Components = Labor Increase + Productivity Increase

Economic growth can come from two sources—more jobs and more hours or doing more on the job in the same amount of time. Unfortunately, a closer look at our economy shows that labor is weak and productivity has declined. The combined effect of decreased productivity + subdued/declining labor force trends have a chilling effect on the GDP growth outlook. 

The labor portion has been relatively weak, particularly when considering that we are bouncing back from so many lost jobs following the financial crisis.  The labor portion of the equation has been contributing roughly 1.5% to GDP growth over the past 6 years with a small variation.  The more concerning side of the job growth equation is the growing number of people that either can’t find work or choose not to look.  The higher jobless number (see graph below) makes it tougher on the economy to provide necessary services and infrastructure with a relatively lower taxable base. 

Take This Job and Shove It!

The group of people not working is growing more than twice as fast as the actual working labor force.  This fastest (non-working) growing portion of the population is partially a byproduct of demographics and a choice of some to drop out of the labor pool – see declining participation rate, below.  One aspect that will put significant strain on this equation is the outlook for people to continue to live longer and need their government benefits, such as   medi-care   and social security, for a much longer time period.

The group of people not working is growing more than twice as fast as the actual working labor force.  This fastest (non-working) growing portion of the population is partially a byproduct of demographics and a choice of some to drop out of the labor pool – see declining participation rate, below.  One aspect that will put significant strain on this equation is the outlook for people to continue to live longer and need their government benefits, such as medi-care and social security, for a much longer time period.

I got better things to do…

The labor participation rate—the percentage of the population that has a job or is looking for one—has declined to a 35-year low. Our aging population is the primary reason and set to drive this chart much lower. The   baby-boom   generation drove up the labor participation rate  ,   but started driving it back down at the turn of the new millennium. 

The labor participation rate—the percentage of the population that has a job or is looking for one—has declined to a 35-year low. Our aging population is the primary reason and set to drive this chart much lower. The baby-boom generation drove up the labor participation rate, but started driving it back down at the turn of the new millennium. 

Unfortunately, I don’t have space for yet another graph on this topic, so please allow me to summarize…based on demographics associated with an aging workforce and immigration control, the expectation is for the rate of change of NON-workers to dramatically increase over the next 20-30 years.  Additionally, the participation rate highlighted above is forecast to drop down close to 50%.  Is this environment of having a lower % of workers paying for services for a growing % of non-workers sustainable over the long term?  Perhaps, but unlikely AND only with soaring productivity gains…we’ll get to that outlook next.   Lastly, I’m not sure if this is good or bad news, but as dismal as the job picture looks in the US, it is a much prettier view than most of the World’s other large economies are facing.

Productivity has not kept up its end of the bargain

In the post-WWII era, many of the largest developed nations have experienced very high productivity growth rates. Massive investment in cutting-edge technology meant that what a human being can accomplish on the job today is drastically more than what a human being could get done in the 1950s.  Now, productivity is growing at a much slower rate and investment is weak, which means that the next generation may not see quite the same quantum leaps in productivity that we experienced in the past.   

Could some of this stagnation in productivity be the result of big cut backs in infrastructure build…either by government or corporations?  With government not pulling its share, corporations are less likely to take all the risk.  Think of all the advancements that occurred when government worked somewhat in a hand/glove fashion with business – interstate highway project, electrification, the space race and NASA and all the products and advancements that came from that gov’t led effort, Sematech non-profit consortium between gov’t and chip manufacturers, the internet (no, it was not all Al Gore), cell phone technology led by the Department of Defense.   The list goes on and on.  This is the angle that most concerns the crowd that is putting forth the secular stagnation argument.

Monetary and Fiscal Medicine

We’ve established that economic growth has been pinched by technical difficulties in both of its twin engines, labor and productivity. What could jolt the economy into a higher growth gear? 

Monetary stimulus - Lower interest rates can spark economic growth.  Unfortunately, most developed nations have cut short-term interest rates to near-zero percent, and some central banks are even experiencing negative nominal (before inflation) interest rates out the curve.

Real interest rates are the return that a bond investor receives after subtracting the rate of inflation. Our entire financial system relies on positive real interest rates. After all, it doesn’t make any sense to lend someone your hard-earned money if their interest payments are less than the cost of rising inflation. In that scenario, you could buy more with your money now, rather than taking the risk of lending it, only to get back less spending power later on. It would make more sense to spend the money now. Global central bankers were counting on sparking a spending spree when they forced real interest rates below zero. For the most part, that has not happened. Instead, people are spending less and either paying down debt or investing in riskier assets, defying the conventional wisdom of economics. This dynamic hurts savers, while giving borrowers access to the cheapest capital in generations. In our current economy, savers are taking the pain, while businesses are certainly taking the cheap capital, but they are not deploying it for growth-enhancing activities.

Real interest rates are the return that a bond investor receives after subtracting the rate of inflation. Our entire financial system relies on positive real interest rates. After all, it doesn’t make any sense to lend someone your hard-earned money if their interest payments are less than the cost of rising inflation. In that scenario, you could buy more with your money now, rather than taking the risk of lending it, only to get back less spending power later on. It would make more sense to spend the money now. Global central bankers were counting on sparking a spending spree when they forced real interest rates below zero. For the most part, that has not happened. Instead, people are spending less and either paying down debt or investing in riskier assets, defying the conventional wisdom of economics. This dynamic hurts savers, while giving borrowers access to the cheapest capital in generations. In our current economy, savers are taking the pain, while businesses are certainly taking the cheap capital, but they are not deploying it for growth-enhancing activities.

Fiscal stimulus - The government can also kick-start the economy by borrowing from the future to spend money now. Unfortunately, most developed nations have done this for quite some time, which has left them with elevated debt levels and less room to borrow money for economic stimulus. The two charts below show the constraining debt situation the country faces. 

This chart shows government debt securities as a % of GDP, but does not include promised future obligations , such as Social Security or Medi-Care/Aid.  Once again, the relatively good news is that the U.S. actually looks better from a Debt/GDP perspective than most of the rest of the developed world.  Nevertheless, we still have very little wiggle room. 

This chart shows government debt securities as a % of GDP, but does not include promised future obligations , such as Social Security or Medi-Care/Aid.  Once again, the relatively good news is that the U.S. actually looks better from a Debt/GDP perspective than most of the rest of the developed world.  Nevertheless, we still have very little wiggle room. 

Aside from government debt, corporate and consumer debt levels limit a jump start to the economy through lower interest rates and easy credit.  This chart displays the disheartening effect that ever-increasing debt levels have had on our ability to grow our economy. All told, the U.S. economy’s total debt is approximately FOUR times the annual output of our economy.     

Aside from government debt, corporate and consumer debt levels limit a jump start to the economy through lower interest rates and easy credit.  This chart displays the disheartening effect that ever-increasing debt levels have had on our ability to grow our economy. All told, the U.S. economy’s total debt is approximately FOUR times the annual output of our economy. 


But Why Isn’t It Working?...

The velocity of money measures how many times money changes hands. In a robust economy, money typically changes hands rapidly, as people are generally buying each other’s goods and services. Right now, money is changing hands at the slowest pace in more than 50 years.  This chart seems to indicate something is different.  This could be the missing link in our sub-par economic growth question and the single best indicator to if/when we get faster economic growth and inflationary fears.  We will be keeping an eye on this indicator in the future.

The velocity of money measures how many times money changes hands. In a robust economy, money typically changes hands rapidly, as people are generally buying each other’s goods and services. Right now, money is changing hands at the slowest pace in more than 50 years.  This chart seems to indicate something is different.  This could be the missing link in our sub-par economic growth question and the single best indicator to if/when we get faster economic growth and inflationary fears.  We will be keeping an eye on this indicator in the future.

Daunting Challenges, Underwhelming Government Response

When we look around the world for government solutions to economic problems, we instead see gridlock in the U.S. on any major fiscal stimulus plan, a Grexit scare, and the Brexit reality. With Brexit in the headlines, I feel compelled to add my 2 cents.  I will use one of those pennies to simply remark that much of the initial response to Brexit has already been digested and discounted by the market. 

Going forward, we will see if this action creates a positive unifying response or a negative contagion effect within the rest of Europe.  The U.K. had only one foot in the European Union from the start because they kept the British Pound.  Exits for other EU countries could bring more turmoil because they would have to change their currency, in addition to changing trade agreements. 

Was Brexit a canary in the coal mine for other nations to follow with protectionist policies that ultimately lead to shrinking global growth?   In an era of stagnant growth, policy missteps or even de-synchronized policies can lead to business and investor retrenchment. Voters are reacting to the lingering pain of slow growth and resulting social strains.

Keeping score across the globe, most of the largest economies have a thin margin for error. The U.S., Japan and Europe have been growing at only 1-2% since 2010.  Inflation in these regions has been 0-1.5%.  Rates are pretty much at the bottom around the globe, while debt levels are more or less stretched to the max relative to GDP level.  With that as a background, how comfortable do you feel as an investor knowing that one of the key causes for the Great Depression was nationalism and protectionist policies crimping global trade and tossing the world into decline?  Bottom line, misidentifying the reasons for weak growth is a significant political risk for global markets.  

The Take-Away

The argument between secular stagnation and cyclical recovery will not be decided for some time.  However, I believe there are enough headwinds with markets priced for near perfection, that investors should consider de-risking into rallies to avoid volatility drag. 

Policy makers are walking a tight-rope with little wiggle room for additional monetary and fiscal policy.  The unprecedented policies pursued by the Fed to this point tell us how essential they view growth and fear the alternative.  Keep in mind, it will not be in the Fed’s best interest to ring the alarm bells.  One of the unspoken goals of the Fed is for stable and orderly markets.  As such, investors must look out for themselves and look to do as Warren Buffet preaches— “look to buy when others are fearful and sell when others are greedy.”   By definition, it is not a natural human emotion to be contrarian, but it has historically been one of the best paths to profits. 

Lastly, I must clarify that I am not expecting a revisit of the Great Financial Crisis.  We have many more policies and safeguards in place to protect against that outcome and the banks do appear to be in better financial shape.  However, the market’s valuation multiples are ultimately based on investor confidence in elected/appointed officials and in industry leaders.  That said, investors will vote and re-vote quickly and they will provide opportunity for gain and loss in this increasingly interconnected BOOM-BUST world.  As an investor, be prepared to embrace and capitalize on volatility.

Here’s to being more right than wrong…

Slow Growth Meets Market Turbulence

Cutting Through the Noise - a financial blog by Bill Martin, CFA

Slow Growth Meets Market Turbulence

Slow Growth Meets Market Turbulence

Opportunities in a slow growth/high volatility investment world…

We all know the proverb about the three blind men and an elephant, in which the blind men come to completely different conclusions about the elephant’s characteristics because of their limited perspectives. So what happens when the three blind men perfectly describe the entire elephant? Call me crazy, but I am going to tell you that it is, in fact, an elephant.

When three market sages with different training and varying vantage points happen to be seeing and describing the same tectonic shift in different ways, it’s time to take note. Bill Gross; legendary bond investor, Francois Trahan; renowned stock market strategist, and Lawrence Summers; accomplished government policy maker, all have indicated that there is a significant economic shift in the offing that may change the nature of investing for years to come. My investment perspective, informed by thirty years of fundamental and quantitative investing and economic analysis, generally agrees with their shared conclusions.

This tectonic shift is likely to include slow growth, low investment returns, and higher volatility due to “boom and bust” cycles. As investors, we need to modify our playbook to prepare for this economic shift.

Facing a New Reality in Investment Management

·      Low returns and high volatility—  Lower long-term returns are nearly a mathematical certainty at this point, and bouts of volatility typically coincide with low returns, particularly when excess liquidity is chasing returns in various markets. It is highly unlikely that the high stock and bond returns of the past 40 years will persist into the future.

·      Boom and bust cycles will prevail— the combination of low returns and high volatility will likely lead to an investment paradigm shift from “buy and hold” investing to “boom and bust” investing. Strong and sustainable sources of economic growth are becoming more and more elusive.  The last two business cycles—the dot com bubble and the real estate bubble—both ended in busts.

·      Investors must be more nimble, active, and diversified—with the correct strategy going forward, investors may still be able to achieve solid returns by tending to their investments more often and more actively.

Bonds: You Might Find Your Returns on Mars

A recent article entitled “Bon Appetite” by Bill Gross at Janus Capital, has been getting a lot of attention.  In this report, he convincingly argues that investors are spoiled by declining interest rates and the corresponding impact on equities over the past 40 years.  He calls this recent period an outlier and claims the odds of a repeat period are more likely to occur on Mars than on Earth. Mr. Gross implies that for bond investors to duplicate the historical returns they have seen over the past 40 years, the math dictates that interest rates would have to drop to approximately -17% (yes, that’s a negative sign)!

This fundamental disconnect in the math behind bond returns forces us to accept a new reality.  If you believe bonds will supply the solid, steady return that we’ve all grown to love, you also have to believe that your kids will be investing in a government bond with a -15% yield. In short, it makes little mathematical sense to believe bonds will deliver gains on par with the past. If you can hitch a ride to Mars, all bets are off.  

The bottom line is that investors need to get used to lower total returns from their investments.  Gross’s outlook points to annualized fixed income (bond) returns in the range of 1.5-3% going forward, with the impact on principal from rising rates being offset by higher coupon payments. 

Equities: Ground Control to Major Tom

Equities have spent the last forty years launching into the stratosphere, but the ship is now experiencing some technical difficulties. Forecasting the equity market (stocks) is always bit trickier than bonds because variables such as future earnings, productivity, earnings multiples, and risk aversion affect their long-range potential.  That said, these variables tend to suggest that investors should expect equity returns of 4.5-6%. 

Francois Trahan has been ranked the top strategist by Institutional Investor in 10 of the past 11 years. The only way to get such accolades in this industry is to be right more often than wrong.  He recently asked us, in a May 11, 2016 conference call, to consider the possibility that the era of “buy and hold” investing is past its prime, and that we are moving to “boom and bust” investing. Mr. Trahan added that this call may be his most important of the last 10 years. He also stressed that the one thing investors need to hear is… markets may be moving from a long-held “buy and hold” mentality to a new “boom and bust” paradigm, which may last for a very long time.

Mr. Trahan’s call is significant, because it will impact the returns of savers and investors for the next generation and perhaps beyond.  Investment returns can have a self-fulfilling effect on the overall economy – in both directions.  The Fed and other global Central Banks have made that exact bet with their fire hoses of liquidity provided through QE (Quantitative Easing) to increase the impact of the wealth effect on the economy.  Imagine the ramifications if that self-fulfilling effect starts to work in the other direction?  Think Japan (we will be thinking more on that in our next letter).  Paradigm shifts normally unfold very slowly, but it is better to accept the new reality early, rather than late.

Secular Stagnation: The Same View from a Different Bridge

If Trahan’s outlook is correct, we might expect to see persistently weak and disappointing economic growth as a precondition to a “boom and bust.” Well, both of the last two business cycles have ended in busts—dotcom and real estate—and since the financial crisis, the economy has only grown at about half of its long-term rate despite unprecedented amounts of monetary stimulus.   

Here again, skilled policy makers are taking note of the new environment. The economic backdrop that leads to “boom and bust” cycles is what Lawrence Summers, former Treasury Secretary, terms “secular stagnation”.  Too much savings supply and not enough product demand for those savings is the dynamic that produces secular stagnation.  Low product demand leads to slow revenue growth, lower overall economic growth, and correspondingly low levels of capital expenditure. Rising demand is required for a virtuous economic cycle. Absent strong contributions from government, economies can and often do stall or stagnate for long periods. (More on the combined responsibility of this phenomenon will be discussed in my upcoming blogs). Interestingly, the International Monetary Fund weighed in on the subject and fundamentally agreed with Summers’ secular stagnation thesis. 

So What?

When forecasters and market strategists decide on the amount of stocks and bonds investors should hold, they all tend to look at similar historical data.  The more data the better, as statisticians like to say!  If we go back far enough in time, we see that stocks tend to return 9-10% and bonds return 5-6% over the long run.

However, the basic math points to future returns that are much lower than past returns. Extrapolating on Gross’s bond return forecast and the equity return expectation detailed above, a typical, diversified buy-and-hold investor could expect a long-term return of approximately 3-4%. The outlook for buy and hold investing, a successful strategy over the past 40 years, is in a word… sobering.

The problem with allocating capital based on high long-term, historical returns is that the analysis masks some very weak market regimes on the way to these high returns. For example, there have been a number of times when stocks declined for ten- and twenty-year periods. Throughout history, Sometimes stocks recouped their losses in a matter of months. Other times, getting back above water took years, or even decades. There have been periods of very high volatility with little return (“boom and bust”), and periods with very high returns and low volatility (recent history).

During these long stretches of low returns with high volatility, “buy and hold” investors felt all of the risk of the market’s ups and downs for decades, but had nothing to show for it. Even more damaging, many investors lost patience with their long-term strategy at the worst possible time, and sold their holdings at market lows.

In that same “boom and bust” environment, investors had tremendous opportunities to improve their returns if they realized, early on, that fleeting gains would be followed by substantial downturns. Francois Trahan’s work demonstrated that “boom and bust” investment cycles are actually more common than the era of “buy and hold” that seems normal to most of us after enjoying the last forty years of outsized gains. That observation was likely an eye-opener for many younger professional investors on the call.

The starting point for the recent period of unprecedented gains was the high interest rates and inflation of the late 1970s. The Federal Reserve, led by the strong hand of Paul Volcker, finally did the hard work of killing inflation, unleashing an era of relative prosperity and rising asset prices. No such catalyst exists for the markets today, understanding that the Fed, which is the preeminent market force throughout history, is holding interest rates near zero. The Fed is not in a position to give another forty-year gift to the markets.

We believe that “boom and bust” is where we currently find ourselves within the long-term investment cycle.  The quicker we forget about a “buy and hold” investing strategy in this environment, the better off we will be.

This “paradigm shift” will be the basis for our first seminar series – “Opportunities in a slow growth/high volatility world”.  Future blogs will expand on and continue to examine the causes of a “boom and bust” investment world and the best ways to profit. I will dig deeper into the outlook for slower growth, and take a deep dive into the preconditions for more volatility going forward.

Here’s to being early instead of late and being more right than wrong.


Questions and Answers

Isn’t calling paradigm shifts risky?

When it comes to forecasting paradigm shifts in investment approaches, three axioms reign supreme: 

1.     There are many more false alarms than actual signals—a well known industry anecdote says economists “accurately” forecasted eleven of the past three recessions.

2.     If the relevant data and indicators consistently disprove your view, it might be time to change your view.    

3. In those rare occasions when a shift is actually taking place, it is better to be early than late.

Do you think things are really going to get that bad?

Our outlook is not a doomsday call in any way, shape, or form. I am not suggesting that we are about to revisit the Great Financial Crisis of 2008-09. The coming “boom and bust” strategy shift can be better described as a carry-over effect of our last Great Financial Crisis and the choices our politicians and central bankers made to deal with it. The booms and busts can be much less dramatic than the Great Financial Crisis or the Great Depression.

If this is a “call to arms” in anyway, it is a call to be realistic about the world in which we live, and make personal choices to better our situations and remove unnecessary risks.  We actually see meaningful opportunities to improve returns in the current “boom and bust” environment.

Is Mr. Summers alone in believing that we are entering a period of structural stagnation?

Summers and the IMF are not alone in recognizing that we are entering a period of structural stagnation. Many hedge funds are already positioned for such an outcome. Key signs of this symptom are weak organic revenue growth, manufactured earnings growth, and stock buybacks funded by earnings that have been artificially inflated through increased borrowing at artificially suppressed interest rates.

How does all this “boom and bust” and secular stagnation play out together?

We will likely see lower-than-expected global economic growth lead to low stock and bond returns.  With lower levels of economic growth, held back by lower levels of growth in the labor pool and lower productivity, we will have lower returns.  This will lead to growing debt.

What is the risk of sticking to a “buy and hold” strategy?

The big risk would be having little return for any level of risk taking. The even bigger risk to “buy and hold” investors is that they end up selling at the wrong time, just as the markets find their pain point.  This happens every cycle.

How will we know if “boom and bust” cycles aren’t in our future?  

We return to a period of organic revenue growth, not just earnings growth.  We will see revenues growing at higher levels, increased stability, and declining debt levels. Increased Cap-Ex spending and rising demand would be a clear indication that “boom and bust” had transformed into more sustainable growth trends.

What are the risks of a “boom and bust” cycle? 

Our biggest risk is that the first leg is a “boom” and we are relatively under weighted equities.  We see this risk to be manageable, particularly given the current high level of valuations for stocks and lack of clear room for meaningful appreciation.

Where are the opportunities?

…Smart rebalancing, tactical asset allocation, and active managers aligned with their investors would all present significant opportunities to boost returns in a “boom and bust” cycle. This approach could help to achieve higher than “buy and hold” equity-only returns with much less volatility. The results could lead to marginally higher returns with moderately lower risk and much better sleep, despite the noise of a low return/high volatility world.

TAKING STOCK: An insider’s view of the mutual fund ecosystem over the past three decades

Cutting Through the Noise - a financial blog by Bill Martin, CFA

The mutual fund industry has offered investors many benefits over the years:  professional management, diversification, and market access. However, these benefits have come at a price of relatively steep fees and middling results. Unfortunately, a strong case can be made that some of the benefits of professional management have slowly eroded as mutual fund management decisions are increasingly led more by sales and marketing teams, and less by the professional investment team. The good news is that as the industry has evolved and matured, many of the benefits can now be accessed in a less-expensive format.

The following is an insider’s view of the path the asset management industry has taken over the past 30+ years. We argue that the mutual fund industry’s “golden age” occurred roughly from 1980 to the bursting of the housing bubble in 2008. The remarkable growth in assets and profits resulted from the confluence of a series of regulatory, political, and economic changes on a global scale. Furthermore the evolution and competition in the mutual fund industry over this 30-year period leave it poorly positioned for the future in many respects. Indeed, the characteristics of successful fund companies—tremendous size, aggressive distribution arms, and high cost per unit of active risk—have been at odds with requirements for investing success for many years now. The dramatic rise of low-cost, index-replicating passive strategies on the one hand, and high-cost, less liquid and less transparent hedge funds, on the other hand, are evidence of this fact. Rather than stick to tightly prescribed processes where active risk and investment professional judgment are minimized, we argue for an approach favored by the most sophisticated investors, typified by the Yale and Stanford endowments, among others. This approach seeks to maximize compound returns (that is, what the investor actually receives) on a risk-adjusted basis over time. This can be accomplished through diversifying, keeping costs down in largely commoditized markets, and seeking superior managers in less followed markets that allow for higher excess returns.  In this paper, we will lay out in detail the important historical and coming trends that have and will impact investors, explaining how we got here, and where we are going. 


The last three decades mark a period of remarkable growth and transformation in the financial services industry. A series of events in the late 1970s and early 1980s transformed economic and financial conditions, and essentially gave rise to the modern mutual fund industry. In 1978, Congress created the 401(k) individual retirement account, taking the burden of retirement planning out of the hands of employers and putting it squarely on individual employees. Not only was this a massive boon for corporate America, but overnight it also created huge demand for professional management and market access offered by the mutual fund industry. It’s no coincidence that the number of Americans in private industry covered by defined benefit pension plans peaked in 1980 and has been in decline ever since. Similarly, the individual retirement account, or IRA, was created in 1974, and later became widely available in 1981. Other profoundly important events at that time which continue to resonate today included deregulation of the financial industry; the end of China’s isolation and entry into the global economic system; the dramatic increase in interest rates by the Volcker Fed, effectively breaking the back of inflation; and the introduction of the personal computer that ushered in the move away from an industrialized economy toward one driven by rapid technological change and productivity gains.       

From this backdrop, we saw an ensuing long, secular decline in interest rates and inflation; the increased globalization of the labor force and consumer markets; and decreased economic volatility (more modest growth and less severe recessions) all worked in conjunction with an elongated business cycle to reduce perceived market risk and increase investment asset prices. It is no coincidence that the S&P 500 went up in a more or less straight line from the early 1980s to 2000, during this period. Following this dramatic run-up, we have seen historic volatility in the wake of the dot-com bubble and 2008-09 Financial Crisis, yet the market still stands near a record high, as this is being written.

The undisputed beneficiaries of these events have been the asset management firms (mutual fund companies) themselves. Total assets under management (AUM) in the mutual fund industry have grown from approximately $100 billion in 1980 to almost $15 trillion in 2015. This does not count the rapid growth and proliferation in exchange-traded funds (ETFs), which now account for almost $5 trillion. Such spectacular growth in AUM led to a number of fad investments, diluted talent, and hubris, while the number of registered mutual funds has grown from around 500 in 1980 to well over 10,000 today. All of this rapid growth has occurred while the total number of listed stocks in the US peaked just short of 8,000 in 1997, and has since shrunk to under 5,000. There are now more mutual funds than there are stocks. Think about that for a moment. To quote one well-known observer of financial markets:  The parasite is now larger than the host.


Nothing was more important to asset management growth than the creation of the IRA and 401(k), created by Congress to alleviate pension funding burdens on Corporate America. As the accompanying graph shows from Money Zine (based on Department of Labor statistics), the growth in defined contribution plans has far exceeded that of defined benefit pension accounts since the introduction of these laws.

Plan Participation Rates

Department of Labor Statistics - defined contribution vs defined benefit participation 1979- 2009

Department of Labor Statistics - defined contribution vs defined benefit participation 1979- 2009


According to surveys conducted by the U.S. Department of Labor's Employee Benefits Security Administration, participation in defined benefit plans peaked back in 1980. At that time, there were 30.1 million participants in these retirement plans. Over the next 30 years, participation decreased by nearly 40%.

Not surprisingly, participation in defined contribution plans increased 281% from 18.9 million to 72.0 million participants over that same timeframe. This increase is attributed to both the scaling back of defined benefit offerings by employers as well as the rapid rise in the popularity of 401(k)-type plans.

Prior to the increased popularity of the IRA and 401(k), traditional defined benefit pension plans reigned supreme. These plans were run by employers and offered few choices. This approach largely bypassed the mutual fund industry and usually delegated investment decisions to the company’s treasury department or a big bank’s trust department and could often be over-reliant on company stock. The movement from traditional pension plans to defined contribution plans (IRA, 401(k), 403(b), SEP IRA, etc.) brought HUGE profits in the form of fees for the mutual fund industry, along with a dizzying array of choices for investors. Some of these changes were good, and some not so good for individuals. What we can say for sure is that these changes completely remade the retirement landscape for the average American worker and jumpstarted the entire financial services industry. 

Altos believes…  Because the responsibility for retirement savings has slowly transferred from the employer to the employee and the participation decision has become voluntary, the retirement savings/benefits have actually declined for the individual. The positives from moving away from the pension plan system have flowed to the corporations through lower costs (the same can be said for sharing costs of health care). The benefits of increased investment choices have not offset the commensurate loss in individual retirement savings contributions, thus putting the burden of an aging workforce with underfunded retirements on the increasingly hollowed out labor force. In most cases, individuals lack the investment acumen to make the appropriate investment choices to match their risk tolerance, investment horizon, and savings needs. In other instances, investors may get set up properly, but end up bailing out of their plan after a big drawdown (at just the wrong time), and then feel discouraged and avoid making future decisions altogether. This is where and when an experienced advisor can help investors stay the course or, better still, use market turbulence as an investment opportunity.


With individual investors increasingly responsible for their own retirement success, new services sprung up to advise individuals on their investment decisions. One such service was Morningstar, who created so-called “style boxes” to help investors better categorize and understand what was driving the performance of their investments. Morningstar helps investors view mutual funds through the prism of size and style, utilizing a three-by-three matrix with small-, medium-, and large-capitalization stocks on one axis and value, blend, and growth styles on the other axis. This matrix placed every domestic equity mutual fund in any one of the nine boxes.

Given the proliferation of mutual funds in the period since 1980, the need to organize and categorize funds was clear, and for this service Morningstar is to be commended. But this advent may have also had an unintended consequence of stultifying and “boxing in” good asset managers. Consider the interaction effect between style purity and the newly minted “investment consultant” community. The consultants were hired by large 401(k) plans and other large asset pools to help pick the best funds for each style box. Since money talks, and 401(k) plans became the largest recipients of new money inflow, these consultants gained considerable power over the allocation of investment dollars between mutual funds. The style box system made allocation simpler and easier for consultants to understand and explain. As a result, the mutual fund companies segmented each of their funds into a box to follow rigid investment processes. Fund managers were strongly discouraged from moving to another box or deviating from a stated investment process, regardless of prevailing market conditions. As a result, the value of an investment manager’s stewardship to identify the context around when a process is likely to be effective has been eroded in exchange for simplicity of messaging. 

The consultant community wanted to understand a mutual fund company’s process and expected them to stick to that process, even if the fund manager himself believed their proprietary process may have been out of step with current market conditions.

The following is an excerpt from an article by Alpha Architect titled Even God Would Get Fired as an Active Investor

"… consultants say they’re counseling clients in two ways. One is simple patience. The other is imparting a more sophisticated understanding of a particular strategy’s role in their portfolio. That means clients shouldn’t necessarily be troubled when a strategy performs poorly, but rather they should worry when returns are out of whack with what the manager said to expect", according to Steve Foresti, CIO at Wilshire Consulting. “It all comes back to education and understanding the whole investment process and what it is that’s driving the risk premia investors are trying to collect.”

We highlight this paradigm to show consultants’ views of mutual fund returns. Consultants wanted to be able to understand and explain exactly how a fund will perform in relation to all market movements. Therefore, they prized consistency of process and style purity above all other traits. If a manager was in the large value box, for example, and the other funds in that space declined, his fund also ought to have declined. Otherwise, in the immortal words of Ricky from “I Love Lucy,” you got some ‘splainin’ to do! The “active” mutual fund manager has become beholden to a narrowly prescribed process with little range to exercise his investment acumen or expertise with changing market conditions. In short, active managers have become less and less active over time.

The consultants also wanted to bring down a fund's risk relative to market benchmarks. Again, the goal of this exercise was to increase predictability of performance relative to a given market index or style box. Bringing down risk usually brings down returns. Since the mutual fund management companies were loath to bring down fees… investor returns got squeezed. Hard to imagine legendary investors like Warren Buffet, Peter Lynch, or Bill Miller would have been as successful as they were had they committed to stay within a box and simply harvest a “risk premia” when it was in style.

A dirty little secret… statistics show that consultants are no better than the little guy at picking asset managers. Both tend to buy five-star funds after they outperform and sell them after they underperform and become three-star funds. This approach tends to “book” both the higher fee offered by active management as well as the poor performance period of a fund’s performance contour.

Altos believes... over the past 30 years, the impact of style boxes and investment consultants has effectively stacked the deck against investors…  Not just against small investors, but against all investors. The decline in net investment returns has resulted in increased competition from two relatively new animals in the investment ecosystem, the hedge fund and the index fund (or exchange-traded fund (ETF)).  


First let’s discuss hedge funds, which are not pinned down by style boxes and remain free to go anywhere in pursuit of higher returns—and fees. Hedge funds contrast with typical registered mutual funds not only in process and fee structure, but in other important dimensions as well. For example, there is typically less liquidity and transparency in hedge fund positions. Crucially, many hedge funds seek to provide the highest risk-adjusted return, rather than absolute return. Indeed, the name “hedge fund” connotes that managers are actively seeking to hedge risk. Contrast this with a typical mutual fund whose risk must match that of the market, give or take a few percentage points. Hedge funds also typically give primacy to the investment decision, and are much less concerned about sales and marketing dynamics. So much so that many successful managers often end up returning client money at some point and only continue to manage the partners’ capital.

The hedge fund vehicle has often been looked upon derisively, as ‘carried interest’ made its way into the political discussion. Plus, the fees are onerous when the results don’t meet expectations. Nevertheless, this type of investment entity has attracted the most talented asset managers, and is where investors get the best bang for the buck—even after higher fees. Hedge funds typically demand 2% annual fees and 20% of the profits, are generally available only to investors with liquid net worth greater than $2,000,000, and have minimum investments above $250,000. Additionally, hedge funds usually only allow liquidity once per quarter with the request being made 30 days in advance. This liquidity feature provides protection for the remaining shareholders, as in the film “The Big Short”. In that film, had investors been allowed to redeem at the wrong time, the big gains would not have been realized. Those really big gains were only available in a hedge fund format. Of course, the goal of a long holding period and limited liquidity is to provide hedge fund managers with broad leeway to pursue their investment objective. Ideally, then, hedge fund investors will often be compensated for this lack of transparency and liquidity.

Altos believes… Like in all walks of life, there are good and bad hedge fund managers and a select few very good managers. The really good ones more than compensate for the fees paid by the investor. Specifically identifying hedge funds with excellent track records and proven and flexible processes offers good risk/returns for certain high net worth investors. Hedge funds can be an excellent source of excess returns given current economic and market conditions— GDP growth looks muted going forward, stock valuations are comparatively full, and market volatility is likely to increase. Due to our industry contacts and Advisory Board members, we can identify select hedge fund managers with whom we place and monitor investments.


The second group of animals that emerged from the declining investment return climate were the index funds and ETFs that lay on the opposite end of the fee and value-add spectrum from the hedge fund. An ETF, or exchange traded fund, is a marketable security that tracks an index, a commodity, bonds, or a basket of assets like an index fund. Unlike mutual funds, an ETF trades like a common stock on a stock exchange. ETFs experience price changes throughout the day as they are bought and sold. This investment vehicle offers market access, typically at a very low fee. The defining feature of these vehicles is that they offer investors passive exposure to security returns as opposed to active management. The ETF market continues to gain market share as professional mutual fund managers continue to struggle to beat passive benchmarks after transaction costs and fees. The Russell 3000 index ETF is an example of these types of vehicles. This ETF offers the exact returns of investing in the top 3000 stocks in the US market using a market capitalization weighting scheme, at a cost of about eight basis points (a basis point equals 0.01%, so eight basis points equal 0.08%). There are also more customized and extremely targeted ETFs, such as an ETF that invests only in companies with growing dividends or a specific industry. These more customized ETFs offer construction challenges and are not as straight-forward as basic benchmark investing, so the fees may climb to as high as 40 basis points, though this is still noticeably below standard mutual fund fees of 0.75% to 1.50%. The advantages that ETFs offer in certain markets is starting to have an impact. The chart below created by the U.S. Department of Labor demonstrates that ETFs have grown at more than three times the rate of standard mutual funds, while hedge fund asset growth falls somewhere in between. These data end in 2013, but antecdotal evidence shows these trends have only accelerated in recent years.

Altos believes… We want to be very thoughtful and considerate with respect to managing client expenses. In pursuit of a client’s investment objectives, we may utilize both high- and low-cost vehicles commensurate with their potential reward and role in client portfolios. As such, we expect to utilize ETFs as an efficient means to access segments of the market that are largely commoditized with few value-add opportunities. Examples may be to gain market exposure to large-cap global markets and most fixed-income markets. We also see a use for ETFs in certain special cases, such as “rising dividend” funds or targeted and opportunistic exposure to investment styles such as value versus growth, or large versus small stocks, or to capitalize on investment themes such as tech, Asian productivity gains, aging population, or cyber security.


To this point, we have tried to make the case that the classic mutual fund industry is severely challenged by comparatively high management fees and low value add in an investment vehicle adhering to tightly prescribed investment parameters regardless of market conditions. The reasons for these deficiencies are many, and include the ascendance of sales and marketing regimes both within and beyond the mutual fund companies themselves. These conditions have given rise to growth in low-fee, low-value-add ETFs on the one hand and high-fee, high-potential-value-add hedge funds on the other hand. Next, we want to provide a real-life example of how it can be beneficial to deviate from style box and process constraints when attractive investment opportunities present themselves. Finally, we close with a discussion about size and the advantages of comparatively small, nimble boutique managers over their larger brethren.

Warren Buffet and his flagship conglomerate Berkshire Hathaway successfully demonstrated what could happen when asset managers are not confined to a style “box” by Morningstar, consultants, and mutual fund marketing and management teams. Consider that Warren Buffet was long hailed as a value investor. He was willing to take big risks in large positions of individual companies. He was willing to utilize leverage, and to engage with private company management teams to help maintain or improve the company’s advantage. However, Warren Buffet did not always stick to a “style” box. One of his most profitable positions of all time was his purchase of Coca-Cola (KO) in the 1980s. KO was not a value stock, but Warren contended it was cheap based on where he saw the market going… not on historical measures. This would not fly in today’s style box world, nor in a world where a consultant expects all of a mutual fund’s investment positions to fall within a tightly articulated stock selection process.

It would have been a shame had Warren not found early success and not become bigger than the fund rating companies early on in his tenure. It was indeed this early success—his ability to define attractive investment opportunities for himself and his clients without regard to size, style, or other constraint—that allowed him to be considered a legendary investor. His early success may not have been possible in the more segmented mutual fund environment of today.

Altos believes… Indeed, Warren Buffet was able to go anywhere/do anything, including invest in private companies to achieve his success. However, we believe there is also a cautionary tale in his Berkshire experience. Returns over the last decade or so lead one to question whether Berkshire has gotten too big—perhaps too big to invest without leaving a trading footprint, or just too complex to manage efficiently. Not to mention the obvious succession issues associated with an 86 year old Investment Chief. Consider that in the 30 years ended 2007, Berkshire Hathaway outperformed the S&P 500 21.3% versus 11.8% per annum (according to Bloomberg). This actually compounds out to a whopping difference of 4700% versus 828%! The power of compounding and superior asset management cannot be overlooked. However, since the end of 2007, as AUM and complexities increased at Berkshire, we have seen a bit of a reversal. From 12/31/2007 to 2/29/2016, Berkshire has underperformed the S&P 500 by 1400 basis points, 43% versus 57% on a cumulative total return basis. This is but one prominent example of a phenomenon documented in academic and industry research—it becomes harder to outperform as AUM increase. The good news is that there are still outstanding, comparatively small investment managers that have taken Warren’s example and stepped out on their own. Which leads to boutique investment firms.


Much like Warren Buffet and unlike large mutual fund companies, boutique firms do not have ascension, succession, or survivorship issues. At large mutual fund companies, it is very common for successful mutual fund managers to be moved to larger and more profitable funds within the company after a period of successful outperformance. This often leads to manager turnover and a lack of team cohesion. Eventually, successful managers often leave those large mutual fund companies to launch their own boutique firms or hedge funds. Boutiques fund firms tend to have much more freedom than typical largely distributed mutual funds because they tend not to play the style box game to help raise assets. Investment focus as opposed to marketing focus can make a huge difference.

Altos believes… that boutique investment funds tend to be more nimble than their largely distributed brethren. In most cases, these strategies can still invest anywhere, outside the “box” so to speak, and thereby stand in direct contrast to large mutual fund companies. We feel there is a role for boutique managers for our clients, particularly in markets that have a history of offering large opportunities to beat market-based benchmarks. These investment areas include tactical asset allocation funds, small-cap funds, and emerging market funds. We believe that in certain instances the best talent in the industry has landed with these boutique funds. 

The latitude afforded these managers, alongside an “investment first” culture as opposed to a culture based on asset gathering, helps explain the long term superior returns offered by boutique investment shops.  As described in an article by Bloomberg and an AMG press release… first and second decile boutique funds respectively best their relevant benchmarks by over 10% and 5% annually.  This outpaces more mass distributed competitor funds by multiples and more than pays for investor fees. 

It is important to understand how to buy and sell these funds, rather than to simply identify them.  The Social Science Research Network published an article by 3 professors from Caltech, UCLA and Penn State that identifies a number of typical mistakes institutional and individual investors commonly make when selecting a mutual fund.  Simply put, buying after a prolonged period of outperformance and having high Morningstar ratings typically leads to periods of underperformance, and vice versa. It takes discipline, but it is critical to identify a solid process and a team that knows that their approach may not always be in style...and most importantly, be willing to do something about it by re-shaping the contour of their investment process. This leads to long-term outperformance, even after fees. After spending more than a quarter of a century in the mutual fund management business and either participating in a panel discussion or competing in a finals presentation with these managers, we feel we have the necessary insights to lead this search.


Next, we turn to the trend toward targeted income investing. This trend is a result of very low interest rates, as a result of the Federal Reserves asset purchase program (e.g. Quantitative Easing - QE) that benefit investors, but punish savers.  Income investing was pushed as a necessary style of money management, particularly for investors in or near retirement that are living on a fixed income. Arguably, income-focused investing was an investment product created by the fund industry to target older investors that tend to have more significant assets (from which the industry can take fees). The fad of fixed-income focused investing came about when the industry began to sell the idea that an investor on a “fixed” income needed to achieve this target income amount from bonds or dividends, often at the expense of growth and stocks. It also should be noted that the rise of income investing coincided with the proliferation of debt in America (repackaged and sold as asset-backed securities) and the abundance of fixed-income securities that the government and industry needed to sell. Finally, management fees present a challenge for fixed-income investing in general and income investing in particular. Low levels of volatility and interest rates at present mean it is very hard for fixed-income mutual fund managers to earn back their fees.

Altos believes… In contrast to specific, targeted income products we believe it makes more sense to adopt a sophisticated, institutional approach focusing on total growth and capital preservation. A winning strategy focuses on the total portfolio throughout the entire investment cycle, rather than just the amount of income thrown off at any one time. Then, when one needs income, taking distributions from the larger asset pool can offer more flexibility with less risk. This is a very institutional approach to providing income distributions, similar to what is seen from large endowments, such as that of Stanford University, or a public pension plan, such as Calpers.

We believe the best way to manage income needs is to achieve the best risk-adjusted after-tax returns for our clients in every investment environment. This strategy keeps the horse in front of the cart by outpacing inflation and avoids the current problem of “yield grab” in low interest rate environments. Yield grabs tend to reach for higher yields than market available rates, while taking on more risk, and with less diversification than the investor may realize. The problems associated with pursuing higher yields will become apparent in a rising interest rate environment or the next recession.

To be clear, there absolutely is a place for fixed income (bonds) in an investment portfolio, but the benefits come more from diversification, capital preservation, reduced risk, and potential price gains when interest rates are declining. Fixed-income securities are often a great compliment to equity securities. However we are dubious about the merits of an income-only portfolio, or investing to yield targets, which can lead to investors unintentionally acquiring credit risk or interest rate risk inconsistent with their goals and risk tolerances. Regardless of the specific role fixed-income securities play in a portfolio, we believe strongly that this asset class should be accessed in a cost-effective manner.        


Congress is intent on helping small investors and providing confidence that the financial deck is not stacked against them. Lawmakers are putting the onus on the advisor to act in their client’s best interest in a fiduciary role. This will be evaluated on a net return (after fees) basis. As such, if advisors are charging fees for products, they need to demonstrate that their advice is worthwhile or they will be subject to penalties. The regulatory emphasis will be on the retirement plan advisor to allocate investments that maximize return versus risk and keep costs low. In general, the market is moving in the direction of the fiduciary role that has always been the cornerstone of the (RIA) Registered Investment Advisor.

In particular, Congress is not happy with the large fees that mutual fund companies charge for relatively low returns. As such, they are tightening the reins on investment advisors by increasing their fiduciary responsibility. This will drive many “old boy” transactional brokers (e.g. Merrill Lynch and Morgan Stanley) to change their business model and offer opportunity for objective and independent fee-based advisors that find low fee investments (such as ETFs) or funds that outperform over the long terms….i.e. boutique shops!

To its credit, the CFA Institute, the leading organization run by and for investment professionals, has long had a strong ethical component in its charter, by emphasizing integrity and best practices in the behavior of all its members. The very changes Congress, the SEC, and Department of Labor are seeking to implement have long been practiced by CFA charter holders, of which this author is one. As a result, our clients can rest assured that we always put our investors first and operate to the highest ethical standards.


Automated asset allocation models (robo-advisors) are the traditional asset management advisory industry’s response to Congress’ tighter fiduciary laws. The benefit of robo-advisor tools is that they help simplify a concept that can be complicated to the novice investor. Robo-advisor tools also help to rebalance risk as markets move. These tools are taking concepts that professional investors have used for years and putting them in the hands of individuals. They can be beneficial if used properly and by the right person. However, it is also true that the tools are generally created by and for the benefit of the big brokerage shops by drawing new assets to their firm, or retaining current assets that otherwise may be seeking out lower-fee solutions.

Altos believes… Automated investment solutions have a role in portfolio allocation. However, one must keep in mind that robo-advisor models are based on historical regressions over-layed with correlations of assets and asset classes. As a strong user of these types of models for over a quarter of a century and an early adopter of this technology, we know these models work until they don’t. Said differently, they do a fabulous job of providing a path when markets are behaving “normally” and an investor doesn’t really need help. The other side of the coin is that these models lead investors to a false sense of security and can really do damage during times of market stress, as was the case in 2007-09. Within the institutional asset management industry, optimizers such as these are known cynically as “error maximizers” and experience “fat-tail events” during times of financial stress. They will tend to lead to an extreme and incorrect solution. Therefore, we feel it makes sense to have someone at the helm that understands the inputs and the instruments when navigating a storm. Altos will use these types of tools to provide analysis for our clients. But we will also use our market experience and understanding of context to avoid the pitfalls that ultimately arise during times of market stress.

That’s a wrap…

The investment arena has undergone tremendous changes over the past three decades. With so much at stake and continued advancement in financial technology, we can expect the industry to continue to evolve at a rapid pace. We feel in some ways that the scales are tipping in favor of the small investors in relation to access to information and investment tools, as well as a more investor-friendly regulatory environment and emphasis on cost containment. At the same time, however, expected investment growth rates are clearly compressing from that to which investors have become accustomed based on historical returns. This disconnect between investor expectations and market realities as the baby-boom generation moves into retirement will likely lead to increased market turbulence in the future. We shall leave this topic for the basis for our first seminar series scheduled for the fall.

In conclusion, we hope we have laid out the path to attack the investment markets through targeting the right product types within the right market segments and proper pricing. We continue to believe that it is possible to identify superior asset managers by knowing where to look, knowing when to accumulate, and knowing when to taper. We hope we've identified ways for investors to successfully navigate the changing investment landscape by; using the benefits of financial technology, while avoiding some of the pitfalls to create a risk- and time-horizon appropriate portfolio, and sticking to the simple tools of boutique mutual funds and cost-efficient ETFs, while mixing in some alternative investments that provide downside protection or market-beating opportunities. Regarding the topic of downside protection and creating a smoother performance contour... that's fodder for future discussions. We look forward to regularly diving into the topic of risk management and “taking the market’s temperature” through this blog. Thank you.


Cutting Through The Noise

Cutting Through the Noise - a financial blog by Bill Martin, CFA

Financial news is so ubiquitous that it has become financial noise.  I will not add to that sound chamber.  Instead, this blog commits to cutting through the cluttered jabber, and promises to never simply summarize the summaries.  The opinions within pull from analysis of respected research, delivering insights and perspectives that inform investment decisions.  Significant and topical articles that stand on their own will occasionally be highlighted.