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Monday, December 18, 2023

2023-12-18

***** denotes well-worth reading in full at source (even if excerpted extensively here)


Economic and Market Fare:

Hussman: The Secret Life of Fed Pivots

....... We’ve abandoned our reliance on speculative limits, but the combination of valuations and market internals remains central to our discipline. When neither is favorable, a “trap door” opens. That combination doesn’t require a market collapse, but it does permit one, because it brings risk-aversion into a market that’s not priced for risk. As I wrote at the 2000 bubble peak, “This is a lesson best learned before a crash rather than after one.” ........

As I detailed in The Structural Drivers of Investment Returns, once we know the starting valuation of the market and dividend yield of the S&P 500, the arithmetic of returns dictates that there are really only two factors that will determine future investment returns: a) the growth rate g of whatever fundamental we’ve chosen, and b) the valuation multiple V at the end of our investment horizon T. That’s true for any fundamental we choose. It’s just arithmetic.

Average annual total return = (1+g) x (V_future / V_today)^(1/T) – 1 + average dividend yield

The more predictability there is around those two factors – long-term growth and ending valuations – the more reliable the valuation measure. That’s exactly why it’s preferable to use fundamentals with smooth and predictable long-term growth rates, and to use a denominator that’s representative and proportional to the very, very, very long-term stream of cash flows that companies will deliver to investors over time.

Arithmetic is the greatest long-term adversary of rich valuations. Consider, for example, that nominal GDP, corporate gross value-added, and S&P 500 revenues have all grown by only about 4.5% annually over the past 10, 20, and 30 years. This includes all the technological innovation of the “new economy” in recent decades. For S&P 500 revenues, it also includes the cumulative benefit of stock buybacks. While earnings have grown faster than 4.5%, primarily due to depressed post-GFC wage growth and low interest costs born of a decade of zero-interest rate policy, elevated profit margins must now be sustained forever in order for earnings growth to keep pace with revenue growth. Meanwhile, the S&P 500 price/revenue ratio is presently at 2.6, higher than any multiple observed in U.S. history prior to September 2020. Finally, the dividend yield of the S&P 500 is presently just 1.5% even though dividends are close to the highest fraction of revenues in history.

The easy part, but the hard reality, is arithmetic. Assuming that today’s extreme price/revenue ratio maintains a “permanently high plateau” (the same proposition Irving Fisher infamously offered at the 1929 peak), a continued 4.5% growth rate in revenues would be accompanied by the same 4.5% growth rate in prices. Add a 1.5% dividend yield, and a permanently high plateau would be expected to produce 6% annual long-term total returns for the S&P 500.

The problem is that the historical norm of the S&P 500 price/revenue ratio has been not 2.6, but only about 1.0. The ratio got down to 1.16 at the 2002 market low, 0.66 at the 2009 low, and a still elevated 1.59 at the low of the pandemic selloff in early 2020. Let’s assume that a decade from now, the ratio stands no lower than that 2020 trough of 1.59. In that event, continued 4.5% revenue growth coupled with a 1.5% average dividend yield implies average annual 10-year S&P 500 total returns of just (1.045)*(1.59/2.60)^(1/10)-1+0.015 = 1.0% annually for a decade. Should the price/revenue ratio touch its historical norm of 1.0, the estimated 10-year outcome would be a loss of about -3.5% annually.

That basic arithmetic is why elevated valuations tend to produce “long, interesting trips to nowhere” for investors. Amid the excitement of Fed pivots and record highs, it may be lost on investors that the S&P 500 lagged Treasury bonds from August 1929 to July 1950, December 1968 to December 1987, and March 1998 to March 2020. That’s 62 years out of a 91-year period, all from valuation levels less extreme than we observe at present.

These long, interesting trips to nowhere can be measured from varying starting points, but the defining feature is that they begin at points of elevated valuations and end at points, often well over a decade later, of depressed valuations. Relative to risk-free Treasury bills, for example, the S&P 500 lagged T-bills from 1929 to 1947, 1966 to 1985, and 2000 to 2013. That’s 50 years out of an 84-year period. Lagging T-bills. Still, it should not be lost on investors that most of this underperformance is compressed into a few years following extreme valuations. It’s the initial collapses from extreme valuations like today’s that do the most damage.

At present, we estimate that a decline to the 1650 level on the S&P 500 (a 65% loss) would be needed to restore historically run-of-the-mill S&P 500 expected returns of 10% annually. A level of 1800 (a 62% loss) would bring our estimates of expected returns to a typical 5% risk-premium over and above current 10-year Treasury yields. A decline to about 2750 on the S&P 500 (a 42% loss) would bring our estimates of 10-year S&P 500 total returns merely in line with the prevailing 4% yield on 10-year Treasury bonds. None of these figures are forecasts, but they do represent historically consistent estimates of the potential market losses that would be needed to restore pedestrian levels of long-term expected return. I realize that estimating potential market losses of 42-65% may seem preposterous, but as I wrote in March 2000, “If you understand values and market history, you know we’re not joking.” ..........










Should we be teaching Neoclassical Economics to undergraduates?

“Because of this, we must teach it, but only to discredit it, make students aware of what is wrong, and what is disconnected from how markets operate. So, there is a distinction to be made between how markets do not follow the laws of neoclassical economics, and how the world is dominated by its practice: policy wonks, politicians, bankers and professors prefer to ‘rebuke the line for touching’. It is this wisdom and this distinction that we must teach our students.”

.............

Perhaps a more accurate description is John King’s conclusion that,

“Mainstream macroeconomic theory is wrong, and it has pernicious consequences when used as the basis for economic policy.”

Of course, this echoes Keynes’s own statement, in the opening paragraph of The General Theory, when he wrote:

“The characteristics of the special case assumed by the classical theory happen not to be those of the economic society in which we actually live, with the result that its teaching is misleading and disastrous if we attempt to apply it to the facts of experience.”

Disastrous, indeed. The result is all too obvious, as Keynes also reminds us, in an essay written in 1930. Referring to the “nightmare”, Keynes writes:

“We have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand. The result is that our possibilities of wealth may run to waste for a time — perhaps for a long time.” ......








Vid of the Week:




Charts:
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(not just) for the ESG crowd:


......... It is commonly reported that we are on a trajectory to reach about 2.9°C of warming by the end of the century, but it is rarely explained that this only takes account of humanity’s direct effects. Natural feedbacks would long since have kicked in that would drive heating much higher. We are really on a trajectory to apocalypse. ..........




Last time, I expressed extreme disappointment that fossil fuel executives had any role in leading the climate meeting COP28. This is a classic example of putting the the fox in charge of the hen house. The issue is easily summed up:
It’s difficult to get a man to understand something when his salary depends on not understanding it.

Upton Sinclair
Setting aside economic self-interest and other human foibles, it is clear from the comments that the science is not as clear to everyone as it is to me. That’s fair; I’ve followed this subject for half a lifetime, and it is closely related to my own field.

Stars are fusion reactors surrounded by big balls of gas; understanding how they work was a major triumph of 20th century astrophysics. We understand these things. Planetary atmospheres are also balls of gas; there is some rich physics there but the problem is in many ways simpler when they aren’t acting as the container for a giant fusion reactor. We understand these things. The atmospheres of Venus and Mars come up when teaching Astronomy 101, these planets represent opposite extremes of climate change run amok. From that perspective, Earth is a nice problem to have. We understand these things.

It is easy to get distracted by irrelevant details. No climate model is ever perfect, but that doesn’t mean we don’t understand what’s going on. The issue is basic physics, which has been understood for well over a century. Not only is the physics incredibly clear; so too is the need to take collective action to ameliorate the effects of climate change. The latter has itself been clear since 1990+ at least.


An interview with Navroz Dubash on COP28, the history of international climate diplomacy, and the developmentalist turn in climate politics



Geopolitical Fare:




These theoretical megastructures represent one way an advanced civilization might harvest energy from stars.





Pics of the Week:

Cosmic dust, microscopic syrup, a flying gecko and more.


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