Monday, June 8, 2015


Peter Bernstein on risk (video) [H/T The Big Picture] (LINK)
Related book: Against the Gods: The Remarkable Story of Risk
Safal Niveshak: How to Be Happy and Get Rich (some lessons from a re-reading of Poor Charlie’s Almanack) (LINK)

Nathaniel Popper on EconTalk discussing his book, Digital Gold: Bitcoin and the Inside Story of the Misfits and Millionaires Trying to Reinvent Money (LINK)

Hussman Weekly Market Comment: Why Stocks are Not "Cheap Relative to Bonds" (LINK)
One of the constant refrains we hear at present is that while stocks may be richly valued on an absolute basis, they are “cheap relative to bonds.” At least one professor recently told students that valuations are meaningless because the P/E on cash is 100. Technically, with T-bill yields at just 0.01%, the P/E on cash is more like 10,000, but let’s not quibble. Using simple P/E ratios or inverted interest rates as a standard of value only makes sense if you have no appreciation for how securities are valued. By this kind of standard, I would advise these students to propose that their professor give them each $100 in return for a promise of a single payment of $2 next year, on the argument that the P/E of 50 is a fraction of the "P/E on cash." 
I’ll repeat what I’ve called the Iron Law of Valuation: every security is a claim on a very long-term stream of future cash flows that will be delivered into the hands of investors over time. Given that expected stream of future cash flows, the current price of the security moves opposite to the expected future return on that security. The value of a share of stock is determined by far more than current earnings, and one's estimate of value will be ill-formed if current earnings aren't a sufficient statistic for the long-term earnings trajectory. 
Moreover, market valuations, prospective equity returns, and actual realized equity returns have historically been only weakly related to the level of interest rates (even long-term interest rates). The long-term rate of return priced into stocks is far less correlated and less sensitive to interest rates than investors seem to believe (see Recognizing the Risks to Financial Stability for the record on this, particularly with regard to the "Fed Model"). 
Every valuation ratio used on Wall Street is simply an effort to approximate the Iron Law of Valuation by comparing price with some fundamental “X,” instead of explicitly modeling the long-term stream of deliverable cash flows for that investment. And here’s the central issue – if your fundamental “X” is not representative and proportional to the very, very long-term stream of cash flows that stocks are likely to deliver over time (think 50 years), valuing stocks as a ratio to X is meaningless. At the extreme, paying $100 for a one-year promise of $25 would represent a “cheap” P/E of just 4, but it would also be a ridiculous investment. Similarly, history has demonstrated cycle after cycle after cycle that paying elevated P/E multiples on record earnings is a time-tested way to lose 30-50% of your money by the time the cycle is complete. 
As for the discount rate applied to those cash flows, understand that whatever discount rate you use is also the long-term rate of return that you get if the expected cash flows actually materialize. The higher the price an investor pays for a given stream of expected cash flows today, the lower the return that an investor should expect over the long-term. As detailed below, investors have responded to zero interest rates by driving stock valuations up to the point where expected market returns over the coming decade are also zero. Given that outcome, one is quite free to say that stocks are reasonably valued “relative” to zero interest rates, but one should still expect zero 10-year returns on stocks. 
My impression is that's not how investors are thinking. Particularly at market peaks, investors seem to believe that regardless of the extent of the preceding advance, future returns remain entirely unaffected. The repeated eagerness of investors to extrapolate returns and ignore the Iron Law of Valuation has been the source of the deepest losses in history.
Book of the day (which has been the book of the day before, but some recent Tweets from Sanjay Bakshi reminded me of it yet again): The Way to Wealth: To which is added: The Whistle & The Advantages of Drunkenness