There is one problem that is very definitely coming our way that I really don’t think we can Muddle Through and where even the middle-of-the-road scenarios are terrible, and that’s the public pension crisis. I really see no way it can end well. It’s going to hurt just about everyone.
One way to use information on stock valuations and interest rates in a systematic way is to estimate the break-even level of valuation that would have to exist at given points in the future, in order for stocks to outperform or underperform bonds over various horizons. Investors presently face a dismal menu of expected returns regardless of their choice. Indeed, in order for expected S&P 500 total returns to outperform even the lowly return on Treasury bonds in the years ahead, investors now require market valuations to remain above historical norms for the next 22 years.The good news is that this menu is likely to improve substantially over the completion of the current market cycle. The problem is that current valuation extremes present a hostile combination of weak prospective return and steep risk.
During the first quarter of 2017, the stock market (as measured by the S&P 500 Index) enjoyed a 6.07% total return. The gains reflect (1) the steady, persistent, non-inflationary economic recovery that has characterized the post-2008 period and (2) investor enthusiasm for President Trump’s pro-business, pro-growth policies.
Today, in what will be the first of at least two and possibly more letters focusing on pensions, we’ll begin to examine that angst in more detail. The mounting problems of US and European pension systems are massive on a scale that is nearly incomprehensible.
One of the benefits of historically-informed investing is that it allows various investment perspectives to be evaluated from the standpoint of evidence rather than verbal argument. That’s particularly important during periods like today, when much of financial commentary on Wall Street can be filed into a folder labeled “it’s hard to argue with your logic, if only your facts were actually true.”
While it might sound obvious, we find it important to remember that knowing about the past only helps you place bets on the future to the extent that the future is like the past.
Put simply, investors are in an echo chamber here, where their optimism about economic outcomes is largely driven by optimism about the stock market, and optimism about the stock market is driven by optimism about economic outcomes. Given the deterioration in correlations between “soft” survey-based economic measures and subsequent economic and financial outcomes, investors should be placing a premium on measures that are reliably informative. On that front, hard economic data, labor force constraints, factors influencing productivity (particularly gross domestic investment and the position of the current account balance in the economic cycle), reliable valuation measures, and market internals should be high on that list.
Yes, active management has had its collective head beaten bloody for the past few years; and the proclivity for passive investing may persist a lot longer than any of us imagine, driving markets higher than many of us believe possible; but I think the stampede into passive investment is going to end up painfully, at the bottom of a cliff, for many investors.
Without a surge in monetary growth, fiscal policy alone doesn’t indicate inflation.