Financial Professionals Summer 2022

This is my quarterly missive intended primarily for my fellow financial professionals wherein I share items I have run across or thought about this quarter which I think might be beneficial to you. Enjoy!

We occasionally take consulting clients (typically RIA firms). The annual retainer for this is generally the square-root of your AUM (with a minimum of $10,000 and maximum of $50,000). For more details or to discuss further, please e-mail or call me at 770-517-8160. – David

First, here’s the abstract of this piece on bubbles:

We evaluate Eugene Fama’s claim that stock prices do not exhibit price bubbles. Based on US industry returns 1926-2014 and international sector returns 1985-2014, we present four findings: (1) Fama is correct in that a sharp price increase of an industry portfolio does not, on average, predict unusually low returns going forward; (2) such sharp price increases predict a substantially heightened probability of a crash; (3) attributes of the price run-up, including volatility, turnover, issuance, and the price path of the run-up can all help forecast an eventual crash and future returns; and (4) some of these characteristics can help investors earn superior returns by timing the bubble. Results hold similarly in US and international samples.

I believe points 1 and 2; not so much 3 and 4. Anecdotes from Swedroe:

The evidence of the ability of active managers to exploit the existence of “bubbles,” as evidenced by the annual SPIVA reports, is, at best, discouraging, as the following examples illustrate. Legendary investor Julian Robertson, who managed the Tiger Fund, actually predicted the tech bubble and refused to follow the herd because he thought the market was vastly overvalued. In 1999, the Tiger Fund was dissolved because of its underperformance. On the other side of the bubble story, was another legendary investor Stanley Druckenmiller, who managed George Soros’ Quantum Fund from 1988 through 2000. He believed the market was vastly overvalued, but also that the party was not over. He suffered a large loss in 2000 and resigned. Robertson and Druckenmiller were legendary investors, and both were right that there was a bubble present. Yet neither benefited as they could not get the timing right.

Second, I don’t know that I would call 48 pages “pocket” but good tax reference info from The American College of Trust and Estate Counsel is here.

Third, ThinkAdvisor had “9 Reasons People Find You Interesting” (click here for more detail):

1. You are interested in others.
2. You have depth.
3. You are reasonably smart.
4. You are genuine.
5. You can tell a good story.
6. You have done meaningful things.
7. You are tactful.
8. You have a sense of humor.
9. You know your local issues.

Fourth, do equity returns mean-revert? I’ve made exactly this point over the years: using United States market history as a method of estimating what will happen is simple survivorship bias. Laurence Siegel hits it well in a portion of this piece:

Do equity returns mean-revert, reducing risk for long-term investors?

A great deal of ink has been spilled on this question. My answer is complex. While equity returns may mean-revert, investors with long holding periods do not face less risk than short-term investors; they may even face more. Let’s explore.

Every market will exhibit apparent mean reversion over some time frame, as long as that market was not destroyed by war or some other force. That doesn’t mean the market is safe and that low returns will be followed by high ones – it means that a market survived because it was safe and low returns were followed by high ones. That’s what survival is. If you can’t know for certain that a market will survive, you should not count on mean reversion.

And some of the world’s most promising markets – Germany, Austria-Hungary, Japan, Russia, China – did in fact fail. Although the U.S. and U.K. would have looked pretty good to a global investor in, say, 1900, so did all those countries that lost a war or suffered a Communist takeover. The fact that some markets later rose out of the ashes and succeeded (I am thinking of China – it’s not clear what will happen to Russia) did not help the 1900 investor, who was wiped out. Those markets did not become safer with longer holding periods!

While the U.S. is a good bet for survival, nothing is guaranteed. We should invest as though risk expands with the holding period – Paul Samuelson said that “time spent recovering from crashes is also time spent waiting for more crashes” – and then hope that the opposite happens.

Fifth, I spoke recently at a NAPFA conference, and I picked up a few things from other sessions:

• One speaker had us use a template to create a mission statement for our practices. Here was my stab at it: “We create empowerment by providing wealth management excellence delivered with authenticity and respect.”
• Use “When would you like the ability to retire?” rather than, “When would you like to retire?” (Some people don’t plan to.)
• “Success is rented.”

Sixth, on becoming a better reader (and person), Ryan Holiday has 13 strategies. As Charles “Tremendous” Jones used to say: “You will be the same person in five years as you are today except for the people you meet and the books you read.”

(And I highly recommend Life is Tremendous – I gave it as a graduation gift to the seniors back when I taught high school for a year.)

Seventh, I saw this on the cost of vehicle ownership. I don’t think he included sales, and other, taxes and fees that you incur to trade. That would mean you should trade less because there is a cost to do so. So, my reading of this is, in general, you should buy a two-year-old car and drive it for five or six years (less if you put a lot of miles on it and more if you don’t).

Eighth, using figures from Bloomberg as of 7/7 when I am writing this, 30-year inflation, based on the spread between TIPS and nominal bonds is expected to be about 2.2%:

1.0319/1.0098 - 1 = 2.18%

Thus, the current relatively high inflation is expected (by the market) to be short-lived.

For those interested, here’s the math for the next five years and the five years following that, so we can see what the near-term expectations are.

The five-year expected inflation is 1.0305/1.0048 - 1 = 2.56% and the ten-year is 1.0301/1.0066 - 1 = 2.33%

Since the ten-year number contains the five-year number, we can find the second five years with a little simple algebra:

1.0255^5 * (1 + X)^5 = 1.0233^10

1.1346 * (1 + X)^5 = 1.2596

(1 + X)^5 = 1.2596/1.1346 = 1.1102

Taking the fifth root of each side:

1 + X = 1.0211

And:

X = 2.11%

(I used Excel and thus all the decimal points, so in the extremely unlikely event you are checking my math, the answers above may be trivially different due to rounding.)

In short, the market expects inflation to average 2.11% over the period from six to ten years from now. That’s pretty much the fed target. We’ll see!

Nuances for nerds:

• Since TIPS are slightly less liquid than nominal treasurys we would expect a small liquidity premium (much like the difference between on-the-run treasurys and off-the-run treasurys). In other words, the TIPS yield is a little higher due to being less liquid which means expected inflation is a little higher than the spread would indicate.
• Since TIPS eliminate inflation risk, buyers should be willing to pay a small premium to avoid that risk. In other words, the TIPS yield is a little lower due to having less risk which means inflation is a little lower than the spread would indicate.
• Astute readers will have noticed that the previous two items go in opposite directions, so they offset each other. They are also difficult to estimate and are likely small in magnitude. In practice that means I ignore them.
• Finally, inflation is:
• heteroskedastic – the volatility of inflation is correlated to the level of inflation
• autocorrelated – the current level of inflation is related to the previous level of inflation
• positively skewed – high inflation is further away from the median than low inflation

(On those last issues, this means if your MCS software is modeling inflation as a random variable it’s almost certainly doing it wrong. They are using false precision to appear more sophisticated without adding any value or even making the projection worse. Sells well though to advisors who don’t know better.)

Also on the topic of inflation, a quality paper is out that is more pessimistic. (Blog post on it here.) You can skim past the math and more technical parts and still get the gist of it. It’s depressing as it argues a “soft landing” would require Congress to spend less money. That seems … optimistic.

Ninth, there was a good empirical article on rich people and happiness (two different topics) but I would have preferred he use the term “high income” rather than “rich” – it annoys me how those are confused. They are correlated, certainly, but not perfectly.

There was also a paper on the personality traits of millionaires here. From the abstract:

High wealth was associated with higher Risk tolerance, Emotional Stability, Openness, Extraversion, and Conscientiousness. This “rich” personality profile was more prominent among individuals who had accumulated wealth through their own efforts (“self-mades”) than among individuals who had been born into wealth (“inheritors”). Thus, our evidence is suggestive of a unique configuration of personality traits contributing to self-made millionaires’ economic success.

And one-third of Americans making $250,000 live paycheck to paycheck because, again, it’s behavior, not income (source).

Tenth, you can read this on how to handle concentrated positions, but I’ll summarize for you: SELL! Do not pass go, do not collect $200, just SELL!

Unless:

1. Your life expectancy is very short and there will be a step up.
2. It doesn’t matter to you if the position goes to zero.

Of course, it might be better to use some of the strategies in this book but if that will cause procrastination, then JUST SELL!!!

Eleventh, some good advice on recent market volatility (source):

If you’re following the right people, you’re taking this well. Doing very little. Tax loss harvesting. Adding to long-term retirement accounts on a regular schedule. Focusing on raising your savings rate, not ratcheting up your investment returns expectations. Biding your time til the next bull market. Exercising outdoors. Reading books, not newspapers.

Twelfth, I know I have been hitting crypto pretty frequently (here, here, here, here, and here), but there’s a lot out there:

• Annotated version of the NYT “puff piece” from a while back here.
• Computer Scientist Says All Cryptocurrency Should “Die in a Fire” here.
• Good basic introduction from Tyler Cowen & Alex Tabarrok here.
• Alt-right researcher/exposer moves on to crypto frauds here.
• More on cryptocurrencies and blockchain here.

Also:

Four factors to proxy Bitcoin prices explains 88% of the variance in prices the last four years, as shown in the chart below. The proxy portfolio matching one Bitcoin today consists of – in round numbers – $82,000 of the Nasdaq 100 Technology Index, with $21,000 of borrowed money and $50,000 of borrowed gold. So, the value of that proxy today is $11,000, but we add $8,000 for the current level of the Nasdaq index and $6,000 for the value of Bitcoin volatility, to get $25,000, versus a current market price for Bitcoin of about $20,000.

In other words, apparently you can roughly model Bitcoin as:

• Long $82k NDXT
• Short $21k SPY
• Short $50k GLD
• Plus some long vol on both the Nasdaq index and Bitcoin itself

(I do admit some schadenfreude with prices down about 70% from the highs.)

Thirteenth, it’s good to remember the long-run trends are great even though the short-run news reporting focuses on the terrible:

Fourteenth, generally whenever you pre-pay for something (hotel room, gift card, etc.) you become an unsecured creditor of that business. Always good to keep in mind if the dollar amounts are significant, as they would be when buying into a CCRC: When Continuous Care Becomes Continuous Grief

Fifteenth, good stuff from Morningstar:

• Growth vs. Value
• More on value from Asness
• Thaler on Behavioral Economics (aka Behavioral Finance)
• 6 Things To Know About Stock Market Crashes and Downturns

Sixteenth, I wrote what I think is a pretty good and timely blog post: How to Cope with a Market Downturn.

Seventeenth, consumer sentiment hit a record low in June (source). This is good news because the market reflects the pessimism. It won’t go lower if people are at maximum pessimism! Do we have capitulation?

Eighteenth, I have been seeing a lot of articles such as this (“Markets Post Worst First Half of a Year in Decades”) and this (“The S&P 500 just had its worst first half in more than 50 years”) – and there are lots more.

So, of course I had to see how bad it was. The “first half” thing is silly. Who cares when a bad six months happens? What we want to know is how does this rank on six month returns? Here’s the lowest six month returns on the S&P 500 (total return):

It’s #41:

If I restrict it to modern times (post-WWII), it’s still just #12:

I did the same analysis with five-year Treasurys and it’s ugly. The first half of this year was the sixth worst since 1926:

So, of course, that just cries out for a 60/40 ranking. Using the S&P 500 and five-year Treasurys combined 60/40, and rebalanced monthly, the first half of this year was #24:

You’ll notice a lot of Great Depression figures in there, so let’s (as we did earlier) restrict the universe to post-WWII, and it’s #8:

I’m curious though, about what the next six months were like in those periods. Not too shabby:

The average is almost 13%. And remember, that’s a six month return on a 60/40 portfolio!

Even if we do the full series (so pick up the Great Depression), it’s still an average of almost 9%, but the dispersion is pretty high with a maximum of 57.5% and a minimum of -26.6%. Here are the instances:

So, we are currently at the 24th worst six month period out of the last 1,153 (close to being in the worst 2% of historical periods). But the future (based on history) may be bright.

You may wonder why I don’t do the real (rather than nominal) figures as well since the GFC and Great Depression had deflation and the 1970’s periods had inflation. There are two reasons. First, CPI data for June isn’t available yet as I write this. Second, due to changes in the CPI calculation over time, I don’t think it would be particularly accurate. The CPI is pretty good over a long period (understatements balanced by overstatements) but using it with very short periods when there was high inflation (the 1970’s) probably wouldn’t be very accurate. (The OER figure used now would lag vs. the housing figure used before 1983. See here for details on changes over time.)

Finally, my recurring reminders:

J.P. Morgan’s updated Guide to the Markets for this quarter is out and filled with great data as usual.

Morgan Housel and Larry Swedroe continue to publish valuable wisdom. Just a reminder to go to those links and read whatever catches your fancy since last quarter.

That’s it for this quarter. I hope some of the above was beneficial.

If you are receiving this email directly from me, you are on my list of Financial Professionals who have requested I share things that may be of interest. If you no longer wish to be on this list or have an associate who would like to be on the list, simply let me know.

We have clients nationwide; if you ever have an opportunity to send a potential client our way that would be greatly appreciated. We also have been hired by some of our fellow advisors as consultants to help where we can with their businesses. If you are interested in learning more about that arrangement, please let us know.

We also offer a monthly email newsletter, Financial Foundations, which is intended more for private clients and other non-financial-professionals who are interested. If you would like to be on that list as well, you may edit your preferences here.

Finally, if you have a colleague who would like to subscribe to this list, they may do so from that link as well.

Regards,
David

Disclosure