Your Retirement and the Coming Financial Crises
“Predicting rain doesn’t count; you have to build Arks” – Warren Buffett
- Hundreds of billions of dollars have been plowed into U.S. equities under the logic that “there is no alternative.”
- U.S. stocks, six years into this bull market, are now more expensive than at any other time in U.S. history, except for a few months during the tech bubble.
- Global debt has increased by $57 trillion since 2007, making the global economy more fragile.
- Stock buybacks account for over half of the buying in the U.S. stock market.
- There is a mass migration from active management to passive indexing, effectively concentrating investors’ risk into “what has been doing well.”
- Being very “risk aware” and molding your portfolio so that you have a “time buffer” of lower volatility assets is extremely important for retirees.
Though it may come as a surprise to some, it is with great concern that we observe the financial markets these days. Many aspects of the market –such as overvalued stocks and massive global debt - point to a very warped world and yet, as U.S. stock prices keep rising, people’s natural caution is sedated. Risk-seeking behavior is being rewarded, luring investors, like Icarus, ever closer to the sun.
Over your life, your investment success depends on how you handle multiple full-cycles between booms and busts. The fact that a fixed amount of capital must finance an unknown but potentially long retirement makes those late in their career or in early retirement especially vulnerable to a downturn. While the comments below apply to everybody, they are particularly important to this vulnerable group.
The Two Elephants in the Room: Valuation & Debt
Given the structural problems in China, Japan and Europe as well as low bond yields, U.S. stocks are viewed as the only game in town. This has been called the T.I.N.A. (There Is No Alternative) trade, but as the saying goes “what the wise man does in the beginning the fool does in the end.”
Today, by almost any long-term metric, the U.S. stock market is at its second highest valuations ever. Below is a chart put together by Doug Short that represents the average of four valuation metrics (the higher the blue line goes, the more expensive the market):
You’ll notice that the market has never been this expensive except for a few months during the tech bubble. If you use simple arithmetic and make the non-bold forecast that over the next 10-years we’re going to have average earnings growth and end the decade with average valuations, the math implies a total return of only 1.6%1. Not very sexy considering the downside risk you’re taking. If we revert back to the highest bear market trough in history (2003), that would imply a 34% loss from current levels. If we go back to 2009 valuations, that would imply a 53% loss on U.S. stocks.
Those assuming that the last 6 years gains in U.S. stock will continue indefinitely will be sorely disappointed when they realize that trees don’t grow to the sky.
The second elephant in the room is debt. We have seen an extraordinary amount of debt growth in the world. McKinsey Global Institute released a comprehensive paper on global debt that estimates debt growth since 2007 has been $57 trillion2. Yes that is trillion with a T. Roughly $21 trillion of that has been in China alone! It’s not surprising that with that kind of spending they have been the world’s growth engine since the financial crisis.
Debt to an economy is like fat on a human body. Even when things are at their best, with too much fat you move slower than you would have otherwise. If you’re overweight, you’re more susceptible to getting sick and if you do get sick, you’re more likely to have your ailment turn into something critical. Feeding may feel better (just like spending) but it’s also the direct cause of fat.
We are seeing chronic distortions of this debt all over the world from lingering slow growth to hyperactive central bankers. Can anybody claim we live in a normal world when over 30% of Europe’s sovereign bonds trade at negative interest rates?
As stock valuations can’t grow to the sky, you simply cannot grow debt faster than an economy forever. This can last a long time but when the music stops, watch out!
Another Concern - Buybacks
Companies buying back their own stocks are over 50% of current purchases3 of S&P 500. As Warren Buffett teaches us, buybacks are only valuable when you’re purchasing shares below the “true” value of the shares. If you’re paying a higher price than the shares are intrinsically worth, you are, in effect, destroying capital. Given how expensive the market is, it is highly unlikely these purchases in aggregate are not destroying value. A Bloomberg story claims that companies in the S&P 500 are poised to spend 95% of their earnings on buybacks in 2015!4
As you can see from the chart below, buybacks have historically been a wonderful contrarian indicator and one wonders where the S&P 500 would be if this inflow drastically slowed down (as it almost always does during recessions).
The Main Counter-Argument
Interest rates are often used as a justification for higher valuations, which makes mathematical sense. If your future cash flows are discounted back at lower rates, they are worth more today. (Think about it this way, if your mortgage rate is high, you can’t afford as much house and everybody else is in the same boat, so higher rates push house prices lower and vice-versa.) Of course, any valid argument can be taken to an absurd extreme.
If we assume rates stay where they are for a full seven years, that would explain about 20% of the overvaluation (using simple D.C.F. math detailed in appendix5). If we want to be even more conservative and assume rates don’t move for 10 years, that explains about 30% of the overvaluation. In fact, by our math, an 83% overvaluation (from the first chart) would need today’s below average rates to last 23 years!5 One of the few things I'm sure of is rates will change several times between now and 2038. That seems like a pretty safe bet. While interest rates can “justify” some of the today’s valuation, the pendulum has clearly swung further than this argument can support.
Passive Management Migration
It is disheartening to see the mass migration from active to passive investing. We don’t think there is anything inherently wrong with indexing over one’s investment lifetime. In fact, the majority of people who don’t have the time, knowledge and inclination to do proper research, should be indexing. However, the timing of this migration is, in our opinion, pure performance chasing. Let me explain.
The highly respected firm G.M.O. put out a white paper called “Is Skill Dead?” What they clearly demonstrate is that much of the underperformance that active managers have suffered in the last couple of years is due to out-of-index diversification. An active manager, even if benchmarked to the S&P 500, will often hold some international stocks, some small cap stocks and almost all hold some cash (as well as some other asset classes).
During time periods where the S&P 500’s return far exceeds the returns of all the other assets classes (as has been the case recently) active managers’ performance will lag. Of course selling your active manager for an S&P 500 index is, in effect, concentrating more of your money into “what has done well.” This is pure performance chasing and likely to end in tears when investors feel 100% of the downside of what had been performing the best.
These conditions of high valuations and high debt levels were exactly what led to the financial crisis (though back then it was much more concentrated in the U.S.) Is another 50% drop probable? I don’t know. Is it possible? Absolutely. We must realize that the “good times” of the last 6 years in stocks have increased our risk not nullified it.
What You Can Do About It
First let’s start with what not to do. Do not take these arguments as a reason to sell your (presumably diversified) portfolio and go to cash. Isaac Newton famously went bankrupt when, after earning a nice return in the South Sea Bubble, sold out for cash. But then he couldn’t stand to see his friends make money as the bubble kept inflating; after all, he’s smarter than all of them right? His patience finally ran out and he reentered near the peak of the bubble with most of his money and lost it all. I call this the “whipsaw effect” and it can be disastrous.
So here is what you can do:
Be very risk aware – during the latest financial crisis almost all risk asset classes lost over 40% of their value. The proportion of your portfolio you have in risk asset classes (Stocks, REITs, etc.) will be the main determinant of your downside volatility. Be conscience that these assets can and historically have, lost over 50% of their value several times. Remember that in an average bear market you lose 30%6. You need to structure your portfolio conservatively enough that if risk assets were to take a tumble, you would have enough left in your emotional bank account to rebalance into stocks when they are much cheaper and thus a better deal. Remember that you can have good news or good valuations, but you can’t have both at the same time. Bad news is what causes good valuations.
Stay diversified – just because your something has “done well” over that last few years compared to other slices of your portfolio pie doesn’t mean you should buy more of it. In fact, most of the time, it means an asset class has increased in price faster than its value and thus it is less desirable.
Build a “time buffer” - If you are retired, you do not want to have any of your short or medium term money in stocks. Depending on how conservative you want to be, you want to hold at least 7 to 10 years of annual expenses in lower-volatility assets (cash, CD’s high quality bonds etc.) This will provide you the capital you need while you wait for risk assets to rebound.
There are advanced strategies such as using deep value managers or even hedging that can be employed but unless you’re an expert, you don’t want to go swimming in the deep end of the pool.
A lot of people upon hearing these views want to know when a reversal with stocks will come. Unfortunately, nobody can know that with any precision but like Icarus, we should be cognizant that with every wing flap that takes us closer to the sun we also get closer to a logical certainty – at a certain height, our wings will melt.
Lastly I’ll leave you with some words to ponder from Warren Buffett’s partner Charlie Munger:
“…you have to be patient. You have to wait until something comes along which, at the price you’re paying, is easy. That’s contrary to human nature, too. Just to sit there all day doing nothing but waiting…For an ordinary person, can you imagine just sitting there for five years doing nothing? It’s so contrary to human nature. You don’t feel active. You don’t feel useful, so you do something stupid.”
Sustainable retirement plan distribution strategies depend on variables that are difficult to predict including inflation, market fluctuations, taxes, interest rates, and your own life expectancy and health issues. How you meet your spending needs without depleting your retirement account rapidly is a difficult decision. Starting a retirement plan income strategy in a difficult market environment may quickly jeopardize any retirement plan income strategy. When choosing a withdrawal method, have alternative strategies ready to help meet your needs to weather a difficult investment related environment. This information is prepared for general circulation and does not have regard to any specific investment objectives. The information is an assessment of the market environment at a particular point in time and is not intended to be a forecast of future events, or a guarantee of future results. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. Statements regarding future prospects may not be realized and may differ materially from actual events or results. Past performance does not guarantee future results.
- Equation based on Dr. John Hussman’s formula:
EPS growth + (valuation now/avg valuation)1/10 + (dividend yield now + avg. dividend yield)/2
- McKinsey Global Institute – Debt and (Not Much) Deleveraging – February 2015
- Goldman Sachs forecast of 2015 – January 7th 2015
- S&P 500 Companies Spend Almost All Profits on Buybacks by Lu Wang and Callie Bost
- We assume 2% current 10-year treasury and a long-term 4.64% average. (from Robert Shiller data.)
- Bear Market Insights - Dr. John Hussman