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Three Things I Think I Think – Weekend Edition

Here are some things I think I am thinking about:

1. Future returns are going to stink, right?  RIGHT? Reader Sam asks about Ray Dalio’s comments on future returns and why he thinks they’ll be lower. Here’s my answer:

There are a lot of factors that play into this. For instance, if GDP is lower on average then that should mean there is that much less income for corporations to earn in the economic pool. On the flip side, if there’s less income to earn there’s no reason why corporations can’t become more efficient as a whole and deserve a high premium or valuation. That’s a lot of what we’ve seen over the last 25 years as GDP has declined but corporations have become more efficient. We’ve also seen a huge drop in the household savings rate which means that the corporate sector is saving more on average.

The way Dalio is viewing the world is as if equities are a bond like instrument. So, if you look at historical returns equities are kind of like a 10% yielding 30 year bond. What we’ve seen in the last 30 years is a very high historical return on average so the assumption is that this bond has pulled returns from the future into the present which means that the average return going forward must be lower.

I am not certain that this is true. The reason why is because there are lots of other factors that could influence public equity valuations and profits. What we do know, FOR CERTAIN, is that a diversified portfolio will generate lower returns (or riskier returns) than it has in the past. This is because current bond yields are a very good predictor of future returns. So, a 50/50 stock bond portfolio is looking at something like a 6% return in all likelihood because the bond piece is yielding about 2.25% and the equity return is about 10%. That assumes stocks don’t earn a higher premium though. Either way, your diversified portfolio is either a higher risk portfolio (if it’s overweight stocks) or it’s going to generate a lower return (unless you increase your stock weighting).

Here’s a good link on understanding where corporate profits come from. If you run through the accounting you’ll find that there’s no reason why, in today’s environment, there can’t be continued profit growth if the deficit doesn’t shrink too much more or corporations start spending more.


There are also a number of fairly reliable valuation metrics that people use. I like using the aggregate of outstanding financial assets as described in this post:


That’s basically using current equity allocations as a predictor of future returns. It’s not perfect, but it’s better than most.

My Countercyclical Indexing strategy is based on (somewhat) similar thinking. Basically, as equities become a bigger piece of the overall pie you should actually be reducing your exposure to them because they make your overall portfolio riskier. Likewise, when stocks decline in value they become a smaller piece of the relative pie which reduces your portfolio’s exposure to permanent loss risk which means you should be increasing your exposure to stocks. So, in years like 2009 you’re buying and right now you’re shedding stock exposure.

2. NAIRU – make it die!  Paul Krugman has a good post on NAIRU.  In case you’re not a huge nerd, NAIRU is basically the rate of unemployment at which inflation starts to become a big problem. This is just one of the many theories that was perpetually hammered on in the 1970’s by Monetarists and other like-minded economists that has since been largely debunked.  Here’s me being crass on Twitter earlier this year about this theoretical construct:

The problem here is that there is really no empirical basis for this idea that inflation is inversely correlated to employment or that inflation necessarily becomes a problem as employment rises. In fact, the last 30 years pretty much disprove this idea completely. We’ve had pretty consistent declines in inflation whether employment was rising or falling. The rate of inflation appears to be tied to forces other than employment.  And that makes sense. Economists have oversimplified the relationship here when the complex economic system clearly has many more forces at work. It’s fun to create simplified models of the world for the purpose of theory, but when those theories don’t match reality then they become useless.  And NAIRU has become a useless construct.

3. Bank Profits Aren’t Low Because the Overnight Rate is Low!  Some people (mostly bankers) have been talking about how banks can’t earn a decent profit because the Fed has kept interest rates too low.  As if the Fed controls all the interest rates in the world!  So, get this story.  Pretend you’re a banker in the early 2000’s and interest rates are low.  Your net interest margins are pretty strong and demand for debt is through the roof as housing soars. So, you make all sorts of high risk loans at a high profit and then the Fed starts to reduce overnight rates which reduces your net interest margins a bit.  Then housing crashes and your whole leveraged business model collapses in on itself and the Fed rides in on a white horse and rescues you from your mistakes.  Your profits soar again as the Fed does all sorts of things to stabilize your industry, but your net interest margins aren’t quite as high as you’d like. So now you’re complaining that the Fed is hurting your business model.

That story would be funny if it weren’t our reality.  First, bank loans are a function of demand. If banks can’t pass on higher cost loans it’s not because the Fed’s overnight rate is too low. That’s like a commodity producer complaining that their profits are too low because the cost of a commodity is too low!  Worse, bankers blaming the Fed for their profits is a lot like the heart attack survivor who blames his doctor because he can’t run a full marathon a few years after the doctor rescued him from certain death…..

NB – On a related note, Frances Coppola has a very good post on Forbes about how interest rate policy isn’t “paying banks not to lend”.