Cutting Through The Noise

economy

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 dqydj.net, graph created by Altos Investments

Data extracted from dqydj.net, 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 dqydj.net, graph created by Altos Investments

Data extracted from dqydj.net, 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 dqydj.net, graph created by Altos Investments

Data extracted from dqydj.net, 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 dqydj.net, graph created by Altos Investments

Data extracted from dqydj.net, 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…

Taking the Temperature of the Economy

AdobeStock_68814661.jpeg

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) : )