By Brian Nelson, CFA—
The wind is at our backs.
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The Federal Reserve, Treasury, and regulatory bodies of the U.S. may have no choice but to keep U.S. markets moving higher. The likelihood of the S&P 500 reaching 2,000 ever again seems remote, and I would not be surprised to see 5,000 on the S&P 500 before we see 2,500-3,000, if the latter may be in the cards. The S&P 500 is trading at ~4,100 at the time of this writing.
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The high end of our fair value range on the S&P 500 remains just shy of 4,000, but I foresee a massive shift in long-term capital out of traditional bonds into equities this decade (and markets to remain overpriced for some time). Bond yields are paltry and will likely stay that way for some time, requiring advisors to rethink their asset mixes.
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Capitalism Is Hanging On By A Thread
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The stock market looks to be the place to be long term, as it has always been. With all the tools at the disposal of government officials, economic collapse (as in the Great Depression) may no longer be even a minor probability in the decades to come–unlike in the past with the capitalistic mindset that governed the Federal Reserve before the “Lehman collapse.” See Image.
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We saw temporary Great Depression-like numbers during the COVID-19 meltdown last year, as we had predicted concurrent with our expectations of the market’s melt-up, but the economic pain was neither prolonged nor substantial. Today, we are in a state of controlled capitalism, holding on to the last shred of free markets that we can, if we can.
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Under a pure capitalistic system, our financial structure would have failed almost certainly with the fall of Lehman in 2008, and we would have had a massive eradication of wealth at the top.
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Years later, with COVID-19, restaurant owners, airlines, and customer-facing enterprises would have gone under, facilitating another massive wealth transfer from owners to workers and new entrepreneurs when the recovery from COVID-19 ensued.
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Instead, during the Great Financial Crisis, homeowners were thrown out of their houses, while the banks were bailed out. During COVID-19, businesses that recklessly bought back stock prior to the crisis stayed intact, while workers suffered again.
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Government officials saved the “whole” by making the wealthy even more wealthy. A 20% return on $10,000 is $2,000, but a 20% return on $10,000,000 is $2 million. Wealth inequality has widened.
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Many students are struggling to pay off their student loans. Watching Operation Varsity Blues: The College Admissions Scandal on Netflix made my stomach churn.
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It made me think that the donations made to universities to put their names on buildings may not truly be a form of philanthropy. It may be the worst sign of vanity. Damian Lewis’ character Bobby Axelrod in Billions may have shown us the real reasons for this type of “philanthropy.” Ego.
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As we all know, the ultra-rich have been very, very lucky to have stayed that way the past two decades. In the capitalistic system that built this country, new financial entities would have risen from the ashes of those that should have fallen during the Great Financial Crisis.
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Most of the restaurant chains and luxury and leisure entities should have failed during COVID-19, paving the way for new leaders and new faces. I feel the coming generation may be completely fed up with this, and this is why we’re seeing Reddit revolutions, capital uprisings, and crypto creation.
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I’ve never met Jamie Dimon, but in an alternate history, Jamie is not the billionaire that he is today, but rather a banker that lost it all during the Great Financial Crisis, like many did during the Great Crash of 1929. Many of the index fund promoters would have lost so much capital during COVID-19, too, if capitalism was allowed to “work.”
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We have very few captains of industry anymore – those that truly built companies from the ground up.
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The Path of Least Resistance Is Higher
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Where am I going with this?
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Well, in my opinion, only the rarest of the rarest black swan event may take the markets down in a meaningfully painful way for one to consider underweighting equities this day and age. To a very large degree, we’ve substantially limited the risks of sustained economic collapse, much like we have eradicated polio and how we’re working to do the same with COVID-19.
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It may seem the markets are rigged to work for the rich (and that might not be wrong), but this is the chess game we’re all playing. The Fed and Treasury are chess pieces that one has to account for in one’s analysis, just like economic growth and earnings expansion. It may not be fair that the hedge fund that bet on a huge decline prior to COVID-19 still lost money when the Fed and Treasury bailed everyone out again.
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But that’s how it works.
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I headed up the valuation infrastructure during most of the Great Financial Crisis at Morningstar. I knew what the Fed and Treasury did. I knew they would do it again during the COVID-19 meltdown. We were on the right side of the “trade” in 2020 at Valuentum because we knew the game we were playing. I think it would be terrible to be “right,” and the Fed and Treasury destroy your thesis.
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But you have to understand that you must account for all the chess pieces, not just the ones you want.
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Sometimes, I still wonder why the Fed and Treasury let CEO Dick Fuld’s Lehman fail, but I don’t think government officials at the time truly wanted to throw in the towel on capitalism. They wanted to hold on to it dearly even just a dozen years ago, but when the markets tanked that September day in 2008, U.S. finance changed for all time.
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Fed Chairman Alan Greenspan showed us how we can create a massive housing bubble after the dot-com bubble, and after the burst, how we’d still all be better for it. The precedent had been set. With any economic problem, the Federal Reserve and Treasury will throw everything it can at it, and I mean everything. We’ll be better off…eventually.
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After about 20 years in this business, I feel confident that, if needed, the Fed and Treasury would even go so far as to purchase stocks outright–even in a more deliberate manner than when the banks were nationalized, in part, during the Great Financial Crisis. No policy measure is off the table. Absolutely nothing.
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I even believe that the Fed and Treasury would set stock prices, if they had to, just like they set interest rates. If one thinks hard about it, it’s actually not that far of a leap. The greatest risk today, in my opinion, is not being in the markets at all. The second greatest risk is pursuing a too-diversified approach to wealth creation, stretching too far to hold alternative asset classes while overweighting bonds.
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By my estimates, modern portfolio theory (MPT), as measured by a simple 60/40 stock/bond portfolio that was rebalanced by a financial advisor that charges 1% per annum did materially worse than the average active fund manager that was paid a 2% annual fee during the past 30 years or so. Let that sink in.
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Had you hired an average active stock manager in 1990 and paid 2% per year for their skills, by my estimates, you would have come out far ahead than had you hired the most brilliant quant portfolio theorist applying a 60/40 stock/bond portfolio.
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Perspective is everything.
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For long-term investors, active stock investing was by far the better option. Since the early 1990s, the SPY has crushed the Vanguard Balanced Index Fund Investor Shares (VBINX) that invests roughly 60% in stocks and 40% in bonds.
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The Concept of “Believability”
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So, what is preventing progress?
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I see a couple possible explanations. When you’re an up-and-comer, it is extremely difficult to go against Nobel prize winning work as in modern portfolio theory and the efficient markets hypothesis. I have read so many different books mostly out of fear that my views are wrong, but as I keep reading and reading, I only gain more and more conviction in my beliefs.
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Harry Markowitz, who set the stage for modern portfolio theory, didn’t have a grasp of investing, according to the writings of Peter L. Bernstein. Eugene Fama’s early work on the efficient markets hypothesis, to my knowledge, only really reveals that one shouldn’t day trade. It’s actually quite unsettling when you think about how influential Markowitz and Fama have been on finance. From Value Trap:
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“Fama’s efficient markets hypothesis presupposes that the distribution of price returns of fairly-valued, undervalued, and overvalued stocks may be independent, identically distributed in successive forward one-time periods, but this may not take into account the core component of investing. That is, it may take each stock uniquely more than one period–not successive days or weeks or months, but rather sometimes years–to be categorically reclassified as a result of both price and fair-value-estimate movements (i.e. an undervalued stock’s price advances to become fairly valued). That price returns may be independent, identically distributed in successive one-time periods across undefined sets of fairly-valued, undervalued, or overvalued stocks may not, or rather should not, translate into the view markets are efficient, or that stocks are priced correctly.”
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Ray Dalio’s Principles speak to the idea of “believability,” as defined as follows: “The most believable opinions are those of people who 1) have repeatedly and successfully accomplished the thing in question, and 2) have demonstrated that they can logically explain the cause-effect relationships behind their conclusions.”
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It’s hard to go against Nobel prize winning work such as modern portfolio theory, even when the numbers speak to substantial evidence of its failure – and what about the traditional “quant value factor” in Fama’s three-factor model? One can’t reasonably link cause and effect to a simple price-to-book ratio when one knows that big companies such as Boeing (BA), McDonald’s (MCD) and Domino’s (DPZ) have negative book equity, right?
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But Nobel prizes work magic when it comes to establishing “believability.” Markowitz’s work has “believability,” even as the concept falls short empirically. Fama’s work has “believability,” even as it makes little sense logically. Many may extrapolate the term “believability” to “inertia” as things that make little sense keep being repeated over and over and over again.
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But I wonder – for these two Nobel prize winners, I might wager that between the both of them combined, they may not have built a half dozen discounted cash flow models in their entire lives. I always found it puzzling that we believe in “quant factors” of stock returns that are derived by the very same individual that believes in random markets. It’s like asking an atheist to write the Bible.
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I remember Marty Whitman having a big issue with Fama’s Nobel prize. Shiller received his prize the same year as Fama, and Shiller is a big inefficient markets guy. These inconsistencies won’t stop the Nobel prize from being a “believability” factor in the minds of others, however.
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But you should be suspect.
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Massively Underperforming Computers in Finance
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Whitman may have recognized the prospects for the gamification of the markets a long time ago when he called Fama’s work “utter nonsense.” I’m not convinced of quant “believability,” but I will explain why others fall into the trap of quant “believability” through the context of computers.
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As I continue to study some of the most well-respected minds out there in the financial world, there are some similarities. Morningstar’s Joe Mansueto took advantage of the early age of computers when building his company. Ray Dalio did the same with Bridgewater. Those that adopted computers early on were ahead of the curve. Perhaps the fourth edition of Jim O’ Shaughnessy’s What Works on Wall Street explains as much:
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“It took the combination of fast computers and huge databases like Compustat to prove that a portfolio’s returns are essentially determined by the factors that define the portfolio. Before computers, it was almost impossible to determine what strategy guided any given portfolio. The number of underlying factors (characteristics that define a portfolio like price-to-earnings [PE] ratio, dividend yield, etc.) an investor could consider seemed endless. The best you could do was look at portfolios in the most general ways.
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Sometimes even a professional manager didn’t know which particular factors best characterized the stocks in his or her portfolio, relying more often on general descriptions and other qualitative measures. Computers changed this. We now can analyze a portfolio and see which factors, if any, separate the best-performing strategies from the mediocre. With computers, we also can test combinations of factors over long periods, showing us what to expect in the future from any given investment strategy.”
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The promise of computers was great, but in finance, it wasn’t just the computers themselves, in my opinion; it was really the public perception of computers in other fields and their impact in other fields that mattered. In the 1960s, companies would change their names to include the word “electronics” or “tronics” — Astron, Vulcatron