Our past leaves us ill-equipped for the future

Tuesday, 17 January 2023 — Gold Coast, Australia

[8 min read]

Dear Reader,

The century-long rhythmic swing from under-to-over-to-under in Margin-Adjusted PE (MAPE) for the S&P 500 Index has begun its rotation to lower levels:

How far will it go?

Perhaps it could come to rest in the lows of 1932, or the all-time low during the Second World War, or maybe where it finished in 1982 after a decade of high inflation.

How long will it take to complete this cyclical rotation?

Will it be a short, sharp drop, like the one experienced in 2008/09 or could we see it grind lower over a much longer period…perhaps a decade or more?

None of us knows what pathway the greatest asset bubble in history is destined to take in its quest to restore value.

But what we do know is valuations NEVER stay on a permanently HIGH plateau or in a permanently LOW valley.

The cycle is always moving (via a saw-toothed pattern) in one direction or the other.

The latest reading of the MAPE has it resting on the same valuation latitude as the 1929 and dotcom bubble peaks. Unless this time is completely different — and valuations remain permanently high — there’s a lot more downside in our future.

If you’re at a stage in life where a Big Loss of capital and/or purchasing power would adversely impact your lifestyle, then you need to seriously factor in the prospect of what the change in valuation direction means for you.

My guess is most people have no idea what the other (far more brutal) side of this cycle is like.

Why?

Look at the last time the cycle ventured into the undervalued zone…it was in 1982…40 years ago.

The four-decade-long rotation from under-to-over valued had its setbacks in 2000–02 and 2008–09. However, thanks to central bank intervention, the recoveries were swift. The cycle regained its balance and powered on to higher highs.

If the inflation cycle has also changed from falling for 40 years to now rising, central banks won’t be able to add as much stimulatory fuel to the system.

Suppressing interest rates for years, together with excessive levels of money printing, would risk turning inflationary embers into an inferno.

The world we’ve grown up in has ill-equipped us for a future that’s shaping to be vastly different from anything we’ve experienced.

Cycles always rotate.

Some take longer than others to go full circle.
Unfortunately, far too many people fail to realise/recognise or acknowledge the rhythmic patterns that can decide the course of our lives.

The Big Loss can come in different guises

The most obvious Big Loss can come from a market crash.

However, there is a far more insidious way to suffer a Big Loss. One that comes from a combination of stagnating asset prices AND higher inflation.

From 1967–82, the US share market in nominal (NOT inflation adjusted) terms went on a jagged journey to nowhere…a US$100,000 invested in 1967 was still worth US$100,000 in 1982:

However, in inflation adjusted value, the 1967 US$100k LOST two-thirds of its buying power in over that 15-year period of asset price stagnation:

And, if you think this experience was unique to the US market only, then you’re mistaken.

Where the US market goes, the rest of us tend to follow…the All Ordinaries Index also stagnated over this period AND Australia also battled higher inflation:

If we add another zero to the US$100k, an investor with US$1 million today most likely thinks their future looks OK. But what if the next 15 years are a repeat of 1967–82?

That US$1 million will only buy what US$350k does today.

Ah, yes, you have a diversified portfolio…so all your eggs aren’t in the share market basket.

True. But have the other assets in the ‘diversified’ portfolio also been beneficiaries of the 40-year upward-trending valuation cycle?

When balanced is actually unbalanced

In my book How Much Bull can Investors Bear?, Chapter 11 was titled ‘Debunking the Myths’.

Here’s an edited version of…‘Myth #6 — Don’t put all your eggs in one basket…’

‘We‘ve all heard the saying “don’t put all your eggs in one basket”.

‘It’s one for the ages. Timeless advice. Or is it?

‘The diversification espoused by Benjamin Graham and Harry Markowitz was for an era when markets sent back reasonably reliable signals of risk versus reward.

‘Not so these days. All the market wants these days is confirmation the Fed has its back. Fundamentals count for diddly.

‘That US$8 trillion [M2 in 2018] that’s now been printed into existence since 2008 has had to go somewhere.

‘Any guesses? Try these for size.

‘Bonds. High yield securities. Shares. Property. Collectibles. Infrastructure. Private Equity. Venture capital.

‘Running in tandem with the asset price inflation (created by the rising tide of cheap and abundant money) is a derivatives market measured in the hundreds of trillions of dollars — no one knows exactly how big this weapon of mass destruction is…that’s frightening.

‘These days a diversified fund might look something like this…a wagon wheel of supposedly uncorrelated assets.

‘In fact, what you are actually buying into is this:

‘Diversification amounts to nought if the capital behind those asset classes can be traced back to a single denominator…QE, zero interest rates and the chase for yield.

‘Central banks have floated all boats higher…with one exception. You guessed it — Cash.’

The first edition of How Much Bull can Investors Bear? was written in 2017.

The reason for making people aware of the lack of diversification in so-called Balanced portfolios — loaded with assets that were beneficiaries of the Fed’s asset pumping efforts — can be found in this excerpt from the Australian Financial Review (emphasis added):

‘Many Australians have some of their wealth invested in a balanced fund, which typically have roughly 60 per cent exposure to growth assets such as shares and property and the rest in lower-risk assets such as bonds and cash.’

A good percentage of Aussies have their superannuation and retirement savings in the default option…balanced fund.

Based on investing folklore, a professionally managed, well-diversified portfolio is considered a prudent approach to long-term wealth creation.

Unfortunately, this investing legend belongs to an era when price discovery was largely left to market forces.

Blatant asset price manipulation by central bankers has rendered this popular and widely accepted (but rarely questioned) concept obsolete…at least for now.

Perhaps, from the ruins of this bubble, we’ll see a re-emergence of a more legitimate price discovery process.

But that’s of little comfort to the problem confronting the ‘many Australians’ today.

They’re invested in portfolios that (contrary to what they’ve been led to believe) are highly concentrated in overvalued assets.

In November 2022, John Hussman published this chart on the Forecast (blue line) versus Actual (red line) per annum return (over a 12-year period) of the traditional balanced fund…60% shares, 30% US Treasury Bonds, and 10% Treasury Bills (cash).

There are periods of disconnect between the blue (forecast) and red (actual) lines — during times of market extremes — however, the red line eventually manages to entwine itself with the blue line.

The longer-term accuracy in the forecasting model (dating back to 1928) is fairly impressive:

In early 2022, the forecast annual return for the next 12 years (January 2022 to December 2033) was…MINUS 2.29%.

PLEASE NOTE…this return is BEFORE product and adviser fees are deducted.

Which means you can reduce this number by another 1–2%…giving the investor, in all up performance, a return of MINUS 3.29% to MINUS 4.29% PER ANNUM.

If we work on the ‘better’ return of MINUS 3.29% PER ANNUM over the next 12 years, here’s what that means for an investor with US$500k in the average US-balanced fund.

In late 2033, they’ll have US$334k…and, if our investor is a retiree, this number is before they’ve taken US$20–30k each year for living expenses:

Admittedly, this dire forecast is for US investors.

But, as we know, what happens in the US does NOT stay in the US.

Lacklustre performance on US markets will — to a lesser or larger degree — be exported to global markets…including Australia.

Let’s venture into optimistic territory and say Aussie ‘balanced’ funds (after the deduction of fees) manage to eke out a zero to positive 1% per annum return over the next 12 years.

Our local market ‘good news’ spells bad news for:

a) Retirees seeking a return of 6–7% per annum to (fully or partially) fund living expenses.

OR

b) Those close to retirement (next 10–15 years) looking to compound an existing balance into a much higher amount.

In 2022, the process to correct excessive valuations — in a number of asset classes — commenced.

But it’s far from finished.

Understanding the consequences of a cyclical rotation in long-term trends has never been more critical to your financial well-being.

If you haven’t already, be sure to check out my four-day strategy session with Bill Bonner on ‘Avoiding the Big Loss’. Today’s session is a good one, centred around solutions…what you can actually do about this world of pain ahead. Sign up for free here.

Regards,

Vern Gowdie,
Editor, The Daily Reckoning Australia

Dear Reader,

It’s Martin Luther King Jr Day. A holiday in the US, but not for the team, spread out between Laramie, London, Buenos Aires, and Paris.

Rain or shine, we’re on the job.

Here in France, a big storm is blowing in from the north. Temperatures are falling. Snow is expected tonight.

Yes, dear reader, winter follows summer, just as it always did. And so do markets, economies, and politics have their moods and seasons.

The Fed, hoping to redeem itself, is back on the job, too, trying to wring inflation out of the system without causing a meltdown. Despite much speculation and wishful thinking, the Fed is determined to get real rates back in positive territory. That will mean more ‘tightening’ and even lower asset prices.

Investors betting on a quick Fed ‘pivot’ may be disappointed. Says Fed governor Neel Kashkari:

‘They’re going to lose…I can tell you that.’

The S&P fell about 20% last year. The Dow, almost 10%. And the Nasdaq dropped a third of its value. More to come.

Real estate transactions are falling, too. Prices should follow soon enough.

In Wednesday’s update, investment director Tom Dyson explained that buyers of commercial properties often only put up 10% of the purchase price out of their own pockets. They borrow the rest. So, when the price goes down more than 10%, the buyer’s equity gets wiped out. And he still owes the lender.

Last year, the Greenstreet Commercial Property Index went down 13%. And that bright shooting star — the crypto market — was once worth US$3 trillion. It’s fading fast; it’s now rallied to US$939 billion; nearly a 70% loss.

Meanwhile, comes a blast of cold air from Janet Yellen. She sent a note to Congress last week, warning that the debt ceiling would begin to crack as soon as this Thursday. Not to worry, said she, the feds can delay some expenses, kite some cheques…and move money from one pocket to another to keep the bullets flying and the heat on in the Senate dining room. ‘Extraordinary measures’ they are called. Our guess is that they will become commonplace.

So far, so good.

But where’s the surprise? Things got too expensive…thanks to the Fed’s money. Now they’re getting cheaper (assets) again, thanks to the Fed.

Federal debt is still going up…with Congress ducking and dodging the issue, as normal.

So, what’s new? If that were all there were to the story, it wouldn’t be much of a story. But wait…there’s more. We are working our way through a list of things that are going bad. Big things.

The World Economic Forum (WEF) calls it a ‘polycrisis’. We’ll stick with our half-word ‘cluster’; it’s what happens when several trains…their brakes shot…come into the station at once.

Yes, there are some big locomotives rumbling and trundling down the tracks.

Which brings us to #3 on our Cluster List: Abandoning free trade, free enterprise, free speech, and equal protection under the law — the things that made the US so successful in the first place.

Why are growth rates so low? Why is productivity falling? Why have real wages fallen for 21 months in a row? Why are consumer prices rising at more than 6% per year? (A report out on the news yesterday said food prices in the Midwest were up 13% over last year.) Why is the US Government going deeper into debt, even though it already owes more than it can pay; why doesn’t it stop?

Why? Why? Why?

We learned a new word this weekend that helps explain it. Enantiodromia. Joel says it’s a word from Greek philosophers describing how ‘everything is in the process of becoming its opposite’.

How neat. Summer becomes winter. A sharp knife becomes a dull one. A young man gets old.

How far you can go with this idea, we don’t know, but it describes what is happening to the US. Once young, bright and dynamic, it is now dominated by geriatric hacks — Biden, Pelosi, McConnell et al. And the ideas that made it great have long since been replaced by ideas that will never make anywhere great. And here, we paint the picture with a brush a mile wide…slapping a coat of paint over the many details and nuances that might distract us.

‘Stuff’ is how we measure wealth. The more stuff we have, the richer we are. Of course, stuff is not everything. People go fishing…or loaf about the house. They enjoy a kind of wealth that is not necessary to measure; they get what they want.

When it comes to making stuff (including providing people with leisure time) — nothing beats a free market. Stuff (and even time) has no inherent value in itself, it’s given value only when people willingly trade their own time and stuff for it. That free trade is what gives us our economy and our wealth. Anything that gets in the way of it reduces the total output of goods and services that people want.

Which is where the deciders come in. Sometimes they want to dress up in uniforms and march to Moscow. Or inflate the currency in order to fund some cockamamie bamboozle. Or simply enjoy the superior feeling that comes from ordering other people around.

Right now, in the US circa 2023, free enterprise is a thing of the past. The deciders want un-free enterprise, un-free speech, un-free trade…and unequal protection under the law (depending on which group you are a part of).

They want to tangle us all up in red tape and regulations…rules, laws, restrictions…boondoggles, sanctions, subsidies, wars, debts, special grants and privileges, censorship, prohibitions, inflation, interdictions — thousands of them. Each of these meddles may bring them what they want…but they slow the rest of us down…and ultimately reduce the output of the stuff we want.

We get poorer.

Regards,

Bill Bonner,
For The Daily Reckoning Australia