Response to Carl: Part 2

It occurs to me that I evaded some of the more obvious things to say about investment opportunities at the moment. Allow me to correct that oversight now.

One of the big problems with being an investor right now is that expectations are wildly distorted. By this I mean investors are expecting yields that simply are not there. Nor will they be any time soon.

The stock market is showing a marked increase in volatility. It is one of the great mysteries of finance that the stock market has been able to show the returns it has over the years. In general it yields about 6% more than a risk free investment – i.e. a US government bond. The question is, why? The risk inherent in an equity can account for some of that, but not all. Indeed, if we adjust for historic losses the stock market premium due to risk should be much less than 6%. So why the extra return? One theory is simply supply and demand. People have invested heavily in stocks and that has meant that demand for equity has run ahead of supply. The inevitable consequence is that stock prices have risen way beyond any level justified simply by the risk adjusted return – price appreciation and dividend payments – produced by owning stocks. That this is the case is supported by the absurd levels of the P/E ratio of the average stock. The price to earnings ratio is a rough measure of the way in which a stock will return on an investment. In theory a stock price should be close to the discounted value of the future earnings, and thus can be expressed as some multiple of current earnings. Hence P/E ratio. At present the market is still way over valued when a historic P/E ratio is compared with present ratios. I think that this distortion accounts for a great deal of the recent volatility: the market is poised for a move back to more ‘normal’ valuations.

Obviously, that unwinding of distorted values can happen in either of two ways. Stock prices can go down. Or earnings can go while prices stay relatively flat. As the market tries to decide which of these is the likely trend it dithers about and gets very volatile. Which is where it is today.

The really big problem the market is having is deciding the trajectory of demand. If the economy begins to flourish then it is reasonable earnings will rise. So, as long as stock prices don’t boom, P/E ratios can fall to safer, normal, and more sustainable levels. Volatility will diminish and the stock market will return to the dull old days when nobody much cared about it.

And that last point is very important.

One of the little recalled facts about the 1950’s is that disdain with which most people held the stock market. In the aftermath of the Great Depression stocks were considered a fool’s game. Rightly so. Hence throughout the 1950’s and 1960’s the average household held little of their wealth directly in stocks. What investment they had in the stock market was indirect through the old fashioned defined benefit pension schemes that businesses offered as a retirement benefit. As the years of Reagan illusion took hold and companies abandoned defined benefit pensions, average households became more and more exposed to the vicissitudes of the stock market. As more of a household’s retirement depended on its ability to invest more money poured into 401k plans and housing. This flood of investment distorted both the stock market and housing. The real estate bubble was one consequence of the rush for retirement funding. The growth of the mutual fund business was another.

In a desperate attempt to establish a safe retirement households began to chase and expect returns that simply were not there historically. They failed to understand that higher returns implied higher risk. The level of leverage within the economy allowed high returns on equity – and housing [remember that a mortgage adds leverage to a household’s balance sheet], but the underlying risk was poorly articulated.

That risk has now surfaced bringing the returns available down across the board. All asset classes are now priced to include a revised estimate of system wide risk. Hence they are all much less atttractive than they used to be.

Or rather they are now more realistically priced relative to the illusory pricing we suffered through for decades.

So that is one more reason why Carl will find it hard to chase down a ‘good’ return: it doesn’t exist anymore.

Another is more temporary.

We are suffering from a worldwide glut of savings. The entire global economy is throwing off too much cash. There are not enough good risk adjusted opportunities to absorb that cash and so returns have plunged. This is a buyers market for cash.

Alternatively put: investors are withdrawing from anything that smacks of risk and plunking their money into risk free investments. Withdrawals by private households from mutual funds has been at a historic rate. This conforms with the analysis I just gave: as the risk adjusted rate of return drops households initially react by withdrawing their cash from the market in an attempt to avoid the perceived increase in risk and to find alternative places to invest at a higher return. The volatility of returns has induced this reaction. People are far more exposed to risk than ever before and so this reaction is far more noticeable than in the past. Average households have a much greater dependence on their own portfolios than in the past and so are trying to protect their retirements by flooding into less risky investments. Ironically this is adding to the very volatility they are seeking to avoid.

Adding to this urge to get into risk free assets is the huge hit many households have taken on their home valuations. This is where treating a house as an investment hurts the economy. The huge amount of capital we have locked up into unproductive assets called homes is astonishing. Instead of investing in assets that produce future wealth – factories, schools, infrastructure, and R&D – we have built houses to live in. The result has been a steady erosion of our potential wealth, which has, in turn, eroded earnings prospects for business, increased our reliance on foreign production, and limited the number of good returning investment opportunities here in America.

At this point allow me to hammer away more at housing.

People who bought their homes before the insanity have most likely forgotten that home prices were very stable for decades. House prices were well tethered to incomes and rents. The relationship between incomes and real estate was well established and held for long periods of time. Then came the bubble. Inflation took over, and that generation was handed a massive windfall at the expense of the future of the economy. An unprecedented cross-generational wealth distribution took place. Home owners from the 1980’s and earlier pillaged the future. Worse: they altered their investment patterns and added to the future bust by over-allocating into housing.

Add to this something called the ‘price illusion’ by economists and this distortion became a behemoth burden on the economy. A price illusion exists when an individual only focuses on the cash price of something – be it wages, house prices, or any goods they buy – rather than on the inflation adjusted price. This focus distorts the person’s estimate of value since they are ignoring the effects of inflation. In the case of housing the price illusion has had the pervasive and negative effect of inducing ever more investment in real estate at the expense of other assets. People though they were being smart investors, when, in truth, they were riding a wave of inflation.

As that wave is unwound households are forced to realize that they failed to save correctly. This manifests itself in a sudden, huge, and irrational burst of risk aversion. Hence the withdrawal from the stock market and the search for returns to replace the illusory return on housing.

But, since those returns were an illusion they cannot be replaced. The implosion is a return to reality.

Of course, what we are also witnessing is an over-reaction to the crisis of 2007/2008. As people face up to the new reality of more limited opportunity they have to reassess their savings and consumption choices. In order to preserve safety in retirement many younger people will have to save more than the currently retired generation – the one whose over investment in real estate has caused the problem. This will limit the economy unless we can channel that extra savings into productive wealth expanding assets classes and away from housing.

Thus I see home prices as a major demon in the current malaise.

One last comment: some analysts have berated the current surge in government debt as having the same damaging effect that housing has had. They argue it keeps cash away from the private sector where it would be put to better use and generate wealth down the road.

This is an absurd and dangerous argument worth my time debunking.

First: all the recent evidence suggests that the private sector is not very good at allocating investment. Exhibit A being the ridiculous amount poured into real estate. Efficient allocation theorists will have to explain away that phenomenon before they gain any credibility with their argument.

Second: as I have remarked above there has been a flight away from risk by the private sector. Whether this is rational or not is beside the point. Private sector investment has slumped. That leaves savers with nowhere to go. Except into the surge of government bonds.

So there is no ‘displacement’ of the private sector. There is no crowding out. All that is happening is that private investors are flooding into government bonds by way of both a safe haven, and by way of having no alternative.

This trend will largely self correct.

If, and when, the economy recovers, private investment opportunities will open up and cash will move from government bonds into other assets. Unless the flow of government bonds diminishes this could cause the ‘crowding out’ that the worriers are so concerned about. But that is unlikely. Why? Because a healthier economy will generate more tax revenues. This means that the end for government funding will automatically fall and thus reduce the level of reliance the government has on bond issuance. So the conflict between private sector and government sector investment needs is overblown.

As of now tax revenues have already started to climb, which is why this year’s deficit is slightly improved over last year’s.

To sum up:

Part two of my response to Carl is an effort to explain that the search for returns has to be modified to take into account the stripping away of the illusion of recent decades. We have lived through an abnormal period where we failed to account for risk adequately. Households and businesses became too leveraged. This created the illusion of high returns in nominal terms. But that was always wrong. With the implosion of the bubble and a more realistic pricing of risk we are entering, at least near term, a period of lower returns across all asset classes, as well as an unwinding of the lunacy of housing. Those two trend together throw up a great uncertainty as various asset markets take time to adjust and price risk more accurately. That adjustment period is necessarily a volatile time.

Uncertainty is the greatest single determinant of economic activity. We are living in very uncertain times. Until the economy has absorbed the lessons of the years of Reagan illusion – and we are a long way from getting that message across – we will all have to accept the consequences.

Do not expect to find, easily, a good investment opportunity just yet. Don’t forget: the so-called experts just blew through trillions of losses by way of demonstrating their inability to balance risk and return. Few of us should expect to be able to do what they failed to do.