This August, the global Central Bankers conference in Jackson Hole provided significant insight to global economic conditions. Mario Draghi was the center of attention as he sent signals of a European Central Bank easing effort to “stabilize prices”. Most of my life, “stabilizing prices” meant keeping inflation under control. However, Mario Draghi is trying to avoid deflation of prices. I needed to go to my history books for this side of price stability. Meanwhile, across the pond in the U.S. Janet Yellen’s experiment with monetary policy is to focus on wage and employment growth.
This is a significant departure from the central banks historical role. The role of the Federal Reserve (Fed) has been to stabilize prices in the economy. The Fed accomplishes this by attempting to provide enough credit to the economy to support the expansion of economic activity without creating too much money to chase too few goods being produced. Most people my age are painfully aware of a prolonged policy of creating more credit than production output. The devastating inflation of the 1970s was a result of nearly 10 years of poor monetary and fiscal policy. Inflation reached 13% in the 1970s* and wages quickly lost purchasing power resulting in stagflation. The new threat of deflation has not been experienced since the 1930s and the 1870s before that experience.
So, we do not have a lot of experience with mitigating deflation. In fact, I do not think there is anyone alive today who was actually involved in fighting deflation. Therefore, we only have our economic history books to try and understand the effects of deflation. It is not quite clear why the Fed is targeting something completely new; (wage and employment). Many of us are bewildered. However, it sounds good. Unfortunately, history provides a dismal track record for the economy when the Fed deviates from the main mission of stabilizing prices to create an environment of growth and economic stability.
One fact we do know about deflation is the following: governments with large debt loads fear deflation the most because their debt must be paid back with more expensive dollars. While inflation allows heavily indebted countries to actually substantially reduce their debt in real dollars, this is accomplished by using the erosive effect that inflation has on investors that buy their long term debt. If wages remain stable during deflation then real purchasing power increases. So, deflation has some positive effects if it remains mild. For example, during the period between 1870 and 1890, the average deflation rate was a negative 1.7%per year*. Yet living standards for individuals substantially increased during this period as wages remained stable, prices went down and economic activity expanded.
However, the deflation of the 1930s was so severe because economic activity contracted causing deflation, lost jobs and lower wages. We believe that deflation resulting from lower prices is not bad for our economy so long as the economy continues to expand as in the late 1800s. We believe events in Japan and the Bank of Japan (BOJ) activities need to be mentioned at this point.
During the Jackson Hole summit, there was not a lot of discussion of the BOJ’s attempts to right size a two decade long economic malaise in Japan. Haruhiko Kuroda, the BOJs Governor has been the architect of the feeble rebound in Japan’s economy which was accomplished with a massive quantitative easing (QE) program that was much larger, on a relative basis, compared to the QE programs within the U.S. The BOJ has targeted a 2% inflation rate as well as working to increase wages in order to reach a 2% inflation rate.
Japan also increased the consumption tax and they actually seemed surprised that the tax increase may be at the root of the recent economic slowdown in consumption which, not surprisingly, resulted in a setback in Japan’s economic recovery. Therefore, on a relative basis, the BOJ has failed to reach any of their economic targets with a massive stimulus policy that dwarfed the U.S. QE policy. We are skeptical of the effectiveness of all the central banking activities evolving globally.
The Central Banks are taking credit for avoiding a depression, but we have no way of knowing for sure if this is true. It’s kind of like a pilot taking credit for keeping the airliner at 30,000 feet. Is it the fundamentals of the plane structure keeping us at 30,000 feet or that the pilot has not pushed the nose of the plane downward? We as investors must begin to pay close attention to the activists monetarism evolving since the 2008 financial crisis, a crisis that was caused by the Fed and Congress permitting the over stimulation of the housing market.
Politicians blamed greedy Wall Street bankers for the financial crisis not the governments housing policy. However, Wall Street bankers have always been greedy but the government aggressively inserted itself in the housing market in 1998 with the housing affordability legislation, which promoted much lower under writing standards for loans. The greedy bankers just helped them facilitate their quixotic goal. Remember, it was the collapse of the mortgage market that sent the global financial system into a rapid and near fatal decent. So the bottom line is, Japan has been attempting to stimulate their way out of slow to a negative growth economy for two decades with little success. I remain skeptical that the U.S. Fed will find a different outcome than the BOJ.
Despite our monetary skepticism, we believe at this point the market is behaving very rational. The equity market is no longer at a discount at current levels, nor is the market overvalued. We believe the most likely course for the equity market will be to move sideways as investors wait for economic growth. We believe the current growth rate should provide an average 6% to 8% rise in the equity market over the next 3 to 5 years. We believe that as long as the Fed and Congress develop growth policies such as rational tax reform.
We believe a revenue neutral tax reform emphasizing growth and rational regulation would generate economic growth exceeding 4% in the U.S. and over 5% growth globally. This type of growth without inflation above 2% could assist the U.S. in reducing its debt, reduce unemployment, creating real growth in wages and easing world tensions. Without any tax and regulatory changes, we believe growth will remain slow and the equity market will move higher and possibly too high for the fundamentals.
In either case we recommend an overweight to equities and zero allocation to fixed income above 7 years. We would only use fixed income for liquidity to fund 1 to 5 years of financial needs. We recommend to bar bell your investments with at least 60% to a global equity portfolio and the remainder allocated to 1 to 5 year maturities in fixed income, mostly corporates and mortgage backed securities.
Recently, CNBC commentators provided us with timely advice on the upcoming stock market correction. One prescient financial expert even projected as much as a 60% correction in the U.S. Stock market. Each commentator pointed to a particular factor in our economy that was blinking a red light for the stock market. The biggest culprit was the Federal Reserve according to many commentators. According to them, the Fed was manipulating asset prices higher by creating artificially low interest rates and we investors were drinking the Kool Aid and would suffer the consequences. After 30 years as an investment advisor, I have never been provided such advance warning on a correction in the stock market. I also reflect back on my 30 year career and suddenly realized that I did not know anyone or any organization that successfully predicted a top in the market and then successfully put me back in at the low or even close to the low.
Never have I experienced such a trade not even one of the 13 stock market down turns since 1968 and subsequent upturns was I provided advanced warning. Although, I began my career in 1984 not 1968, I have experienced the greatest bull market, the most severe down markets and crashes (even the new FLASH crashes).
Although, there are many individuals that have provided solid insight on overbought markets and even identifying over sold markets, but no one in my 30 years has identified all of them and then successfully advising when to sell and then when to successfully re-enter. Unfortunately, for many investors fear of loss is a far more significant motivator than a rational buy and hold strategy.
The greatest hurdles Investors have encountered in my financial career has been their inability to follow the most successful investment strategy that is available to them. The strategy I refer to is the much maligned strategy of creating a global diversified buy/hold long only portfolio. In the past decade, we have witnessed the explosion of hedge funds of all flavors. The fees attached to these strategies have dwarfed the mutual fund industry. Quite often, I have been lectured on the inferior, boring, unimaginative and feeble academic approach of recommending buy/hold long only portfolios. However, the buy/hold long only strategy has generally outperformed all other strategies during my career in the investment management business. I know it’s boring but I believe it works.
Our research has led us to believe that love may make the world go around but “Money” makes the stock market go up. I suspect money may make the world go around as well, despite our romantic inclinations. As stated earlier in this paper, the stock market in the U.S. has experienced 13 negative calendar years over the past 45 years*. On the other hand the total revenues of the stock market, as measured by the S&P 500, only experienced 5 negative years*. So investors predicted 13 of the past 5 recessions. When we discovered this fact it caught us by surprise because of the efficient market theory. So we reviewed the U.S. Equity market total nominal returns for the past 150 years. We identified six, 10 year periods since the U.S. Civil War in whichthe stock market returned less than 4%.
We selected 4% because that was close to the average bond market returns during the period. We also reviewed the subsequent 10 year period after each of the six underperforming 10 year equity market periods. The subsequent 10 year periods all rewarded the investor with double digit returns. In fact, there were no 20 year periods in which the stock market did not outperform every other asset class. Statistically, we believe, that any part of your portfolio that is designated to fund anything beyond 7 years should be invested in a basket of well diversified global equities.
Now, if you find our very long term point of view unconvincing and not sensitive to the fear of short term losses, let’s look at the statistics of experiencing a negative return in the equity market in any given new calendar year. The data reviewed by us on the 45 year performance of the S&P 500 since 1968 provides a solid base to develop some probabilities. If the market was down randomly 13 of the 45 years, then we could imply that in any given calendar year there is a 29% chance the U.S. equity market will end the year lower and a 71% chance the market would end the year up. Certainly, we can calculate various other outcomes such as, what if the market is up 3 years in a row? Are the odds higher or lower that year 4 is up or down?
Unfortunately, this practice of timing equity market movements has a very dismal track record. The question is, what is the optimal barometer for predicting the future movement of equity prices? Frankly, we have not found a full proof answer. However, a company’s price to sales has promise but only at the highest end. Where the price to sales exceeds 5 times for a company, there is some evidence that those companies will underperform in the next 12 months but not a sure bet.
We believe the only way to manage the future returns of your portfolio is to place the odds in your favor. By way of example, the data tells us there is a 71% chance of a positive market each year. These are great odds but not full proof. However, the data indicates that a positive return increases to over 95% by holding stocks over 5 years, 99% over ten years, and 100% over 20 years. The data on the S&P 500 since 1968 is not a great deal different back to 1900. Therefore, we believe the probabilities here are convincing and they should be used to invest in a diversified global equity portfolio with at least a 5 year time frame.
This piece was written by RevenueShares CEO Vince Lowry.