Practical analysis for investment professionals
26 January 2018

Weekend Reads for Investors: Grumpy and Gloomy Edition

As I write this edition of Weekend Reads, I have not seen the sun for many days now and it is the middle of my least-liked season: winter.

For those of you in the Southern Hemisphere, enjoy that sun! Nonetheless, the weather seems to match my mood.

What am I grumpy about exactly? Mostly the performance of the stock market. It has me worried. I just cannot find data to support the liftoff in share prices. Further, the equity risk premium, based on how I calculate it, is close to turning negative. The last time that occurred? Just prior to the Great Recession.

But my friends who joke about “perma-bears” and investment prognosticators who have called “seven of the last two bear markets” have reason to point their fingers at me. Count me among those in the “Just Don’t Get It” category.

All of that said, I do not think the stories below are gloomy. In fact, there is a candidate for 2018 Story of the Year among the environmental, social, and governance (ESG) selections.

Investing

Not that it matters given the rocketing equity prices over the last year, but mounting data demonstrate that not all is well. For example, China is still struggling to control its shadow banking industry, which jeopardizes their economy due to a misallocation of capital. How large an issue is this? Hard to say, because — duh! — the activity is taking place in the shadows.

Meanwhile, the World Bank believes that global economic growth has peaked. Importantly, it does not think this is a cyclical phenomenon. Re-read that sentence. The World Bank believes this is not a cyclical development but a systemic one.

Economics

Want a bit of an investment secret? Demographics, though an obvious source of economics and investing information, is often overlooked. This is because so many investors are passive — so data of any kind just doesn’t matter. Or they’re active but are short-term traders or index-huggers despite your protests.

But if you still endeavor to earn alpha by understanding the world well and then placing capital based on that understanding, demographics are worth paying attention to. For example, aside from the United States, all of the world’s top economies have shrinking populations, with Japan leading the descent. As a consequence, many Japanese banks are downsizing in order to survive. Indeed, I read a report earlier this month about Japan’s government paying women to have babies as a way of arresting the population decline.

How investment managers, corporations, and governments manage themselves in a shrinking world will be a major story of the next 25–30 years.

Something that I suspect but cannot confirm with full substantive data: Both China and Russia are building financial architecture and infrastructure, think oil pipelines, to move the world off the petrodollar and propel the renminbi and the ruble to reserve currency status.

To that end, and this could just be trade-talk bluster meant to warn the US executive branch to pipe down its rhetoric, but Chinese officials said they may slow their purchases of US Treasuries or halt them altogether.

Fintech

I promised in my last edition of Weekend Reads that I would take up the mantle and continuously cover fintech. Something to watch in this space is the disintermediation of traditional investment banking roles. While crypto-this and crypto-that have sucked the air out of many fintech conversations, to me, such developments are also long-run game changers. Just ask Spotify, which is foregoing traditional investment banks for its forthcoming IPO. Hmmmm!

A friend in the big data analytics space sent me this outstanding summary of viability predictions about major new technologies that have techno-fools drooling. This is a nice reality check from someone qualified to weigh in on such matters.

Behavioral Finance

Admittedly the following story is not so much about behavioral finance as it is about the power of meditation and human creativity. Why? The piece details how neuroscientists mapping the human mind have found a statistically significant connection between brain interconnectivity and intelligence quotient (IQ). This is a claim that I made in Meditation Guide for Investment Professionals. The original article — I LOVE primary source data — is also worth a read.

Environment, Social, and Governance (ESG)

Did you know researchers have used data and smarts to determine good locations for future solar farms? While on the subject of ESG, in the “G” for governance category, a UBS analyst claimed he was fired because he issued overly bearish reports, and a court agreed with him. What a shock. “What, you mean there is pressure on the sell-side to hype?” Say it isn’t so. Kudos to the analyst for standing by his independently derived opinions. Well done.

Oh wait, more ESG! Many in the ESG community have long believed that insurance companies will be among the first businesses to acknowledge that climate change is real. After all, insurance firms pay attention to data so that they can properly underwrite risks. Lo and behold, insurers are going cold on the coal industry.

Last, this candidate for 2018 Story of the Year 2018 details BlackRock’s recent call to businesses to contribute to society or risk losing its support. Wow! Prediction: This is not the last time we will see activist asset owners get serious about global issues.

Fun Stuff

In keeping with this month’s theme, I didn’t feature a “Fun Stuff’” article. If you have read something fun in the last month, paste the link in the comments section!

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images/whitemay

About the Author(s)
Jason Voss, CFA

Jason Voss, CFA, tirelessly focuses on improving the ability of investors to better serve end clients. He is the author of the Foreword Reviews Business Book of the Year Finalist, The Intuitive Investor. Previously, Jason was a portfolio manager at Davis Selected Advisers, L.P., where he co-managed the Davis Appreciation and Income Fund to noteworthy returns. He holds a BA in economics and an MBA in finance and accounting from the University of Colorado.

Ethics Statement

My statement of ethics is very simple, really: I treat others as I would like to be treated. In my opinion, all systems of ethics distill to this simple statement. If you believe I have deviated from this standard, I would love to hear from you: jason@jasonapollovoss.com

13 thoughts on “Weekend Reads for Investors: Grumpy and Gloomy Edition”

  1. Todd Meier says:

    In fairness to readers, please disclose how you estimate the equity risk premium, “based on how I calculate it.” (How did this get past the editors?)

    1. Hi Todd,

      I have previously published how I calculate the Equity Risk Premium, both here on Enterprising Investor, as well as in an article for the Financial Times. In the future I will provide a link to either one of those two articles.

      For convenience, here is how I calculate it:

      Earnings yield (here, I use the inverse of the monthly Shiller CAPE ratio) – the monthly 10-year US Treasury rate = equity risk premium

      These figures currently are as follows:

      Monthly Shiller CAPE as of 1 January 2018 = 32.47
      Earnings yield = 1 / 32.47 = 0.030797659
      Monthly 10-year US treasury rate as of 1 January 2018 = 0.0256, so that subtracted from the earnings yield is my calculation for the equity risk premium = 0.005197659

      Less interesting than the current level is the current level as compared to the time series. The last time that it was at or less than 52 basis points was the month of June 2008 when it stood at 0.36%. The last month in which it was actually negative was December 2007 when it stood at -25 basis points. You may recall that was the market peak just prior to the Great Recession.

      Hope that helps!

      Jason

  2. Joanne Ott says:

    Jason,
    This is very interesting – the grumpy conundrum is concerning to say the least as to the trending equity risk premium and considering global economic growth may have peaked. Thanks for your analysis. I am curious about a couple of things:
    1 – The impact of perceived increase in share-buybacks – It seems the market is now factoring in higher CF as a result of lower taxes. Certainly this is proportionately adjusted in the CAPE calculation, yet what about the dividend yield (I don’t think companies lower their dividend payouts?) and impact on the equity risk premium? (Admittedly I’m not up to snuff on the literature).
    2- Adaptive Market Hypothesis – the evolving AMH suggests that there are periods where risk/reward relations don’t follow the norm – of which currently the author of the AMH we are in such a period (I don’t think he is suggesting that the market isn’t overpriced, yet risk/reward relationships are not the norm). Do you have an opinion on this in relation to the current equity risk premium falling in negative territory? Just curious and appreciate your insights.

    1. Hi Joanne,

      Thank you for your comments and questions, of course : ) I will try my best to answer your questions.

      1) A perceived increase in share buybacks in a rising market ought to concern investors. Why? Because there is no way that if the share price keeps rising that the most recent share buybacks are executed with the same economics as older share buybacks; after all, the company is paying a higher price and for the same economic engine (i.e. the company). Furthermore, it is disconcerting to me that the market has certainly rewarded businesses with high amounts of stock buybacks by bidding up the share price. Yes, it makes sense from a mechanical point of view. But if a business’s best idea about how to invest capital, and its highest and best use of that capital is not a great new product idea, but instead, is to pay a higher price for their shares than they did two years ago, well then I think you can make a case that the company is destroying capital. Ouch!

      Next, because dividends are paid out of earnings you can think of the earnings yield (the inverse of the P/E) as being the maximum dividend yield that a company should pay. Now obviously they could borrow money in order to increase the dividend beyond earnings.

      2) I am familiar with Andrew Lo’s AMH. I tend not to think of securities prices as following a mathematical theory. The reason is because of the high degree of free will displayed by markets and by individuals’ psychologies. Theories are best when they describe systems with low free will. The theories of physics are powerful because they describe systems with almost no free-will. Psychology, by contrast, has many different typologies describing many varied personality types and with different treatments for each. There is no overarching theory of psychology because of the high degree of free will displayed by people. Markets, to my mind, on this continuum I just described, are further into the free-will zone. So that Lo’s AMH acknowledges that securities prices can be overvalued for periods of time is not so interesting to me. Last point on theories of market prices…they need to be able to take inputs and make meaningful predictions. That they describe phenomena is interesting, but not practically useful. Perhaps Lo would have an opinion about the markets relative to the equity risk premium, but my mind just does not use theories like EMH or AMH to try and understand.

      Last point on this…in a comment above I showed my calculation for the equity risk premium at the current level. It is NOT negative based on that calculation. Instead I cautioned that it was negative previously and that the last time it was as low as this was just before the Great Recession.

      Hope that helps!

      Jason

  3. Jean-Francois BOUILLY says:

    It was a pleasure to listen to you in Paris (as well as a good meditation!). There are so many ways to compute the ex ante equity risk premium, and I just like the simplicity of your approach (simplest is often the best).
    To answer to Joanne, I am always sceptical when “This time is different …” I might also have called for a bear market every year but at least I was right in 2000 (as well as 1989 for Japan but that’s another story…)

    1. Hello Jean-Francois,

      I am so glad that you enjoyed the meditation presentation – thank you for coming out to see it!

      I am also pleased to read that you like the calculation for the equity risk premium. Though independently created by me, I have since discovered that others calculate it very similarly. There is a CFA Institute Research Foundation monograph (look for it on cfapubs.org) that discussed multiple ways of calculating the figure. One of the major ways to calculate it is very similar to what I described above in the comment.

      Also, last, I am always skeptical to hear the “this time it is different.” One thing not mentioned in the comments here about the equity risk premium is that I think a case CAN be made that the earnings yield should be permanently lower (P/Es higher) because of the free flow of information facilitated by the internet. This means that markets are likely more efficient at pricing to the degree that the percentage of the market participation is done by active managers. Passive investors don’t give a damn about price, they just blindly throw money in no matter the prices. This is a countervailing force to the efficiency. I am not quite sure where we are in that tug-of-war: efficiency vs. passive, but I think it likely that the earnings yield is probably lower right now and justified by better information flow.

      That said, I do NOT think that in 2008 the situation was any different, and in my comparison above I was using the current ERP vs. one from 2008. So I think the comparison that it is high right now is a fair one.

      Big smiles,

      Jason

      1. Joanne Ott says:

        Thanks Jason. Good information. I understand your point that assuming better efficiency and free-flow of info may result in justifying a higher PE multiple – yet your comment about level of active vs passive makes me even more curious. I read recently the amount of ETFs is greater than the underlying assets held. In your opinion, what are the implications of this on the multiple or equity risk premium? Inflate the premium?

        1. Hi Joanne,

          My comment was not about active vs. passive investing, it was about the degree of free-will involved in the different sciences. However, regarding your question about ETFs…hmmmm, I had not seen that data, but would love to see it. It is strong evidence of the irrationality of investors, and in this case, passive investors since they blindly sink money into ETFs. Also, parenthetically, it makes me wonder about the mechanics of how such a thing is possible. In any case, any blind bid for an asset divorced from a sense of the underlying and fundamental value would tend to raise the P/E all other things equal. Said else, if the earnings level is the same but there are more bids for those earnings than previously you would expect the price paid for those earnings to rise. This, in turn, because of how I calculate the equity risk premium, would tend to lower the premium.

          Yours, in service,

          Jason

  4. TTeck See says:

    Hi Jason:

    thank you for your comments.

    did you once review a FAJ article that discussed the utility of analyzing financial statements because of the recognition rules of accounting standards for intangibles (research and development vs. acquired intangibles)?

    i have visited the FAJ issues back to 2 issues in 2017 (the last year of bimonthly issues?) but have not located the article. i wonder if the article has implications for the measurement of economic growth.

    1. Hello,

      Thank you for your question. I have never had anything published in the Financial Analysts Journal, so it could not have been me. Here on Enterprising Investor I have published several pieces on accounting. I also wrote an article for a Swiss accountancy journal that you may have read.

      With smiles,

      Jason

  5. De SShi says:

    Hi Jason:

    Your reply to Joanne’s questions as well as Jean-Francois’, and Todd’s, remind me of the many forecasting questions like CFA LA’s superforecasting question “What will be the end-of-day closing value for the euro against the U.S. dollar on 15 February 2018?” (See here https://www.gjopen.com/questions/416-what-will-be-the-end-of-day-closing-value-for-the-euro-against-the-u-s-dollar-on-15-february-2018 )

    what does it take to migrate your discussion with Joanne, Jean-Francois and Todd on to Superforecasting’s https://www.gjopen.com/questions page? but before you answer, you might like to re-phrase the question (see CFA LA’s question syntax) so that comments and forecasts and forecast updates, have a way objectively aligning addressing and focusing on the question.

    do you need CFA Inst’s approval to post such discussions outside of the CFA online universe of web pages? (did CFA LA need to obtain such permission?) or can or is it desirable to host the question on CFA Inst website? is there anyone in CFA Inst monitoring Superforecasting’s website to see if CFA Inst should participate in such expectation formation activity? what is CFA’s Inst’s policy on “such things”?

    i apologize for burdening you with such questions, seeing your replies to the three i think that the wider CFA community would benefit from your ERP discussions.

    1. Hi,

      Thanks for your comments. I am a fan of the work encapsulated in “Superforecasting.” As for more extended coverage from CFA Institute…maybe. This type of work has broad application to many jobs in finance and, in my opinion, should be a part of how we help our Members to improve themselves. For what it is worth, you may enjoy a tome I co-authored called, The Investment Idea Generation Guide, that shifts the emphasis from forecasting to scenario thinking when contemplating and anticipating the future.

      Yours, in service,

      Jason

  6. De SShi says:

    Hi Jason:

    Thank you for the referral to Investment Idea Generation Guide. I have clicked next page up to the end and indeed it is worthy of serious study. Thanks again.

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