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The Time To Hedge Is Now! Just Do Not Rely On Gold To Help

Summary Overview of strategy series and why I hedge. Why not gold? The profits I plan to take now, and what I am doing with other unrealized gains and losses. Some new positions to consider. Discussion of risk involved in this hedge strategy. Back to Update on Bond Hedge Strategy Overview If you are new to this series, you will likely find it useful to refer back to the original articles, all of which are listed with links in this Instablog . It may be more difficult to follow the logic without reading Parts I, II and IV. In the Part I of this series, I provided an overview of a strategy to protect an equity portfolio from heavy losses in a market crash. In Part II, I provided more explanation of how the strategy works and gave the first two candidate companies to choose from as part of a diversified basket using put option contracts. I also provided an explanation of the candidate selection process and an example of how it can help grow both capital and income over the long term. Part III provided a basic tutorial on options. Part IV explained my process for selecting options, and Part V explained why I do not use ETFs for hedging. Parts VI through IX primarily provide additional candidates for use in the strategy. Part X explains my rules that guide my exit strategy. All of the above articles include varying views that I consider to be worthy of contemplation regarding possible triggers that could lead to another sizeable market correction. I want to make it very clear that I am NOT predicting a market crash. I merely like to take some of the pain out of the downside to make it easier to stick to my investing plan: select superior companies that have sustainable advantages, consistently rising dividends and excellent long-term growth prospects. Then, I like to hold onto to those investments unless the fundamental reasons for which I bought them in the first place changes. Investing long-term works! Why I Hedge If the market (and your portfolio) drops by 50 percent, you will need to double your assets from the new lower level just to get back to even. I prefer to avoid such pain, both financial and emotional. If the market drops by 50 percent and I only lose 20 percent (but keep collecting my dividends all the while), I only need a gain of 25 percent to get back to even. That is much easier to accomplish than doubling a portfolio, and takes less time. Trust me, I have done it both ways, and losing less puts me way ahead of the crowd when the dust settles. I view insurance, like hedging, as a necessary evil to avoid significant financial setbacks. From my point of view, those who do not hedge are trying to time the market, in my humble opinion. They intend to sell when the market turns, but always buy the dips. While buying the dips is a sound strategy, it does not work well when the “dip” evolves into a full-blown bear market. At that point, the eternal bull finds himself catching the proverbial rain of falling knives as his/her portfolio tanks. Then, panic sets in, and the typical investor sells when they should be getting ready to buy. Why Not Gold? Gold can be a great hedge against inflation and in times of crisis, especially if the crisis is expected to lead to inflation. Notice the theme of inflation? Currently, we are in a deflationary economic environment. If you do not believe that by now, I probably cannot convince you otherwise, but I will try just the same. Trillions of dollars, yen, euro, and many other currencies have been created around the world via quantitative easing, yet almost no inflation exists. During and since the Great Recession, many governments around the globe injected trillions more into their respective economies to stimulate growth, yet growth has been anemic. Interest rates are at historically low levels (some yields have even turned negative) due to, once again, central bank intervention and lack of demand for loans; still, inflation and growth in most economically developed countries remain well below expectations. The world has never before experienced the level of coordination between central banks with such accommodative policies, all focused on an attempt to create inflation. Yet, all efforts are failing. Without all the record-setting central bank and government interventions, the global economy would be experiencing deflation. How could it be otherwise? If that is not true, then why are central banks trying so hard (and failing) to create inflation? I respectfully submit that I believe much of the developed world economy is in a deflationary economic environment. But why is that so? Many will argue that demographics is the culprit leading to reduced demand. Others will contend that too many companies have built more capacity than is needed to meet current demand, even though demand continues to rise. In other words, demand just is not rising fast enough to absorb the excess supply flooding the globe. I suggest we are suffering a little from both: sluggish demand due to changing demographics and excess supply and capacity in many industries that overbuilt infrastructure to accommodate the expected continuation of growth by China and other emerging markets. The growth slowed and created excess supplies in a lot of areas; most notably, energy, minerals and maritime transportation. At the same time, large portions of developed nation populations are aging, retiring from the workforce and spending less. At the same time, younger people entering the workforce are finding fewer good-paying jobs available, while many are saddled with large student loans that will eat into their abilities to increase spending for several years. Both ends of the demographic spectrum, especially in the U.S., point to a slowing growth in demand. And with excess supply and capacity issues, companies are less likely to invest heavily in additional plants or equipment, again leading to slowing demand. So, how do I expect the price of SPDR Gold Trust ETF (NYSEARCA: GLD ) to react during the next recession? I will use pictures (graphs) to explain my opinion. Feel free to disagree! GLD data by YCharts GLD shares hit a high of just over $100 in March 2008. By September 2008, when Lehman Brothers fell into bankruptcy, the GLD share price had fallen to $66. The initial reaction to the financial crisis was not positive. GLD data by YCharts This next chart shows us how GLD reacted to all the initial government and central bank intervention efforts. There was much speculation at the time that all that deficit spending, the near-zero interest rate policy and quantitative easing would lead to massive inflation. Of course, GLD rallied! Expectations for inflation drove demand for assets that could thrive in an inflationary environment. GLD data by YCharts The final chart shows us what happened when a majority of investors decided that inflation was not coming after all, and that central bank policies indicated that deflation was the real enemy. As of Friday, December 18, 2015, the price of GLD is at $102.04 and continues in a downtrend. Unless the next recession occurs as a result of an event that is expected to lead to inflation, I believe GLD shares will continue lower, at least after any initial reactionary rally fades and reality set in again. Deflation is still the enemy most feared by central banks, and until it is conquered, GLD will not provide the safety desired. Of course, that is only “my” opinion, and if you disagree, please feel free to follow your own convictions. I hold a few bags of silver coins that I accumulated over time since I was a teen. But the value of my silver holdings represents a very small portion of my portfolio. In case you think me a hypocrite, understand that I am not relying on my pittance of silver to save me in the next market meltdown. I confess that I do not know when inflation will return, although I do expect it to do so at some time in the future. It always does. Then, those coins will be worth something, and I could sell if I need the money or wish to convert it to cash. Right now is not a good time to do so. I invest for the very long term, so movements over the next year or two, or even five, have no impact on my long-term goals and expectations. The profits I plan to take now I want to start off this section by explaining why I intend to take profits on some positions and not on others. First, I would rather realize (sell) positions that have substantial gains already to make sure I do not lose that opportunity. I will use the proceeds from those positions to buy more hedge protection using other candidates with more future potential. But I do not like the pricing of most options available in the market today. So, I will continue to hold some of my positions with smaller gains in order to keep at least a partial hedge intact. I also intend to hold any positions with losses at current levels in case the market falls further. This provides two possible outcomes: we may need to stay protected if the market correction we are now experiencing turns into something far worse, in which case we can roll these positions later when there is a gain available; if the market rallies or remains relatively range-bound, we will allow those positions to expire worthless. Remember, this is insurance against catastrophic loss, not a short-term trading strategy. Of course, anyone who wishes to continue to hold the positions I intend to sell may also experience even higher gains, or conversely, they would risk losing most, if not all, of those gains should the market rally to new highs. All quotations used in this article are from the close on Friday, December 18, 2015. I intend to execute my sales on Monday, and may do somewhat better or worse than what could have been achieved on Friday. If the stocks of the companies I plan to sell open lower, my profit will probably be higher, and conversely, if the price of the stock goes up on Monday, I will probably realize a smaller gain. However, to stay conservative, I use the bid premiums from Friday, and the reality is that I should be able to sell for a little more than that if the market were to remain flat. The first candidate I want to mention is Men’s Wearhouse (NYSE: MW ). If you have not already taken your gains to fund next year’s hedge, I suggest you do so now. The underlying stock has already fallen from $58.28, when I first recommended buying puts in August, to a current price of $14.63. My put option contracts that expire on January 15, 2016 with a strike of $45 are currently trading with a bid of $27.10. I bought two contracts for every $100,000 of portfolio value I wanted to protect for $75 each. Those two contracts are now worth $5,420, for a gain of 3,513 percent. Do not be greedy! There is not much more potential gain left between now and the expiration. I want to use those proceeds to buy new positions with greater potential that expire mid-year in 2016. These proceeds alone should more than cover my hedge for all of 2016. Next up is Micron Technologies (NASDAQ: MU ). Those of you who have been following this series for more than a year will remember that I took some nice profits this summer on MU puts that expired in July 2015. My gains then varied, based upon when I purchased, what strike price we used and what premium we paid from 397% to 878% . Now I hold MU puts that expire in January with varying gains. The contracts that I bought in April and May with strikes of $20 and $18, respectively, will now yield returns of 1,012 and 945 percent. I could capture a little more, but why risk it? I paid $49 each for four contracts in April for each $100,000 I wanted to protect, for a total of $196. I want to sell these now at the current bid premium of $545 each, or $2,180 total. I will also sell the five contracts purchased in May at $33 each (total hedge cost of $165) for $345 each, or a total of $1,725. These two positions will give me back a total of $3,905 (for each $200,000 I was protecting with two positions) that I can now use to hedge into 2016. My proceeds from this hedge will also be enough to cover most, if not all, of my 2016 hedge costs. I still have more profitable MU positions purchased with lower strike prices, and will continue to hold those to expiration to maintain some protection, should the market fall further before January 15th. My third sales will be of my April purchase of puts on Seagate Technologies (NASDAQ: STX ) that expire in January 2016 with a strike price of $38. I bought three contracts for each $100,000 of portfolio value I wanted to protect for a cost of $58 per contract (total $174), and will sell for the current bid of $390 per contract (total $1,170), for a gain of 572 percent. I will address what I intend to do with my other STX positions in the next section. Sotheby’s (NYSE: BID ) has been good to me this year! I made purchases in May and June of BID put contracts for January expiration with strikes of $35 and a purchase in August at $31. The gains on each are 789, 1,500 and 645 percent, respectively on those positions. The total cost of those three positions (each of which was designed to protect $100,000 of portfolio value) was $445. The total proceeds will be $4,430. Again, these proceeds could cover my hedge expenses for 2016, so now I have plenty to fund my strategy into the future. The final positions I plan to sell now are those I bought during June and August in Williams-Sonoma (NYSE: WSM ). I made one purchase of one put contract for January 2016 of WSM with a strike price of $70 in June for $90, and plan to sell it at the current price of $1,090, for a gain of 474 percent. I made two purchases in August – one put with a strike of $72.50 for a premium of $180, and one with a strike of $70 for $190. The current bid on the $72.50 strike contract is $1230, while the other contract is bid at $1,090. The total cost of both contracts was $370, and the total proceeds will approximate $2,320, for a gain of 527 percent. So, what if you did not make the purchases listed above? I will explain what I plan to do about those position in the next section. What I am doing with other unrealized profits and losses First, for those positions with little or no value, I plan to hold those to expiration. If some still have more than $5 of value on the last day, I will sell those positions as long as I can net more in proceeds than the cost of commissions on the sales. Since I have all the gains that I need to fund the next year of hedging, I intend to hold all other positions until near expiration to maintain at least partial protection from further market volatility. I will use the same selling strategy as mentioned in the above paragraph at expiration or during the week leading up to it. But for those who hold positions with small gains that missed out on the big gains listed in the section above, you will need to decide whether to hold on in case equities fall further or to sell some positions to help offset the cost of your 2016 hedge positions. Last year, I only took profits on one position (Terex (NYSE: TEX )) and could offset only a portion of the strategy costs. Do not forget that hedging is a form of insurance, and insurance is rarely free. I got lucky in 2015 and hope I can get more new positions in place before I might need them in 2016. Some new positions to consider I am not recommending or making any outright purchases at this time. However, there are some positions I would like if the premiums come back down enough to meet my criteria. I do not know if we will have a Santa Claus rally this year. It happens during the latter half of December about 72 percent of the time. I would not mind one this year (or any year, for that matter). It would provide more opportunity to position my portfolio for 2016. The bottom line is that I try to keep the cost of my strategy low and also try not to pay too much for the positions I want. However, as we move further along this path, I am willing to pay a little more for a higher strike price than I was at the beginning of the series. This is only my third attempt to use this strategy, and the first in which I am trying to be fully hedged. I hope we are all learning together and getting better as we grow in experience. It has worked for me in the past, but on a smaller scale. So far, I am happy with the outcomes and hope to keep improving the results in the future. Do not forget that I usually buy multiple positions in each candidate that I use, and you should, too, unless you get in at a particularly good premium and strike. I add positions as I find I can do better than what I already own in order to improve my overall hedge. Sometimes, I may buy only half or a third of the position I intend to own in the first purchase. As we get deeper into this bull market (if it still is a bull), I try to stay closer to fully hedged as much as possible. Here is the list of what I would buy next, and the premiums at which I would make the purchases. I may get in if the premium gets down close to my buy price, and you will need to make such decisions for yourself. I really get frustrated when I miss buying a position over a nickel or dime on the premium. It is not worth the risk of being unhedged. Symbol Current Price Target Price Strike Price Ask Prem. Buy At Prem. Possible % Gain Tot. Est. $ Hedge % Cost of Portfolio RCL $95.90 $22 $75 $2.58 $1.80 2,844 $5,120 0.180% MAS $27.88 $10 $25 $1.35 $0.80 1,775 $4,260 0.240% GT $31.87 $8 $27 $1.30 $0.85 2,135 $3,630 0.170% KMX $53.49 $16 $50 $3.90 $2.50 1,260 $3,150 0.250% ADSK $59.52 $24 $50 $2.43 $1.75 1,633 $4,900 0.300% SIX $52.58 $20 $45 $1.65 $1.25 1,900 $4,750 0.250% To protect one-eighth of a $100,000 equity portfolio, I would need the following number of contracts to provide the estimated hedge protection shown above. The total cost of the above positions would be about 1.39 percent of my portfolio to hedge 75 percent of 100,000 value. Royal Caribbean Cruise Lines 1 Masco 3 Goodyear Tire & Rubber 2 CarMax 1 Autodesk 2 Six Flags Entertainment 2 Please note that each position is designed to protect only 1/8th portion of a portfolio value of $100,000 against a market drop of 30 percent or more. The number of contracts provides total estimated gain shown in the first table if the stock price hits my target price. For additional explanation of the strategy, I refer you to the first article in the series (follow the link in the first paragraph of the article), which contains a detailed explanation of the strategy and how it works. I expect the stocks listed above to fall precipitously during a recession, as each has a history of doing so during past recessions, and many have fallen much further than the overall market during the last two meaningful market swoons. Discussion of risk involved in this hedge strategy If an investor decides to employ this hedge strategy, each individual needs to do some additional due diligence to identify which candidates they wish to use and which contracts are best suited to their respective risk tolerance. I do not always choose the option contract with the highest possible gain or the lowest cost. I should also point out that in many cases, I will own several different contracts with different strikes on one company. I do so because as the strike rises the hedge kicks in sooner, but I buy a mix to keep the overall cost down. To accomplish this I generally add new positions at the new strikes over time, especially when the stock is near its recent high. My goal is to commit approximately two percent (but up to three percent, if necessary) of my portfolio value to this hedge per year. If we need to roll positions before expiration, there may be additional costs involved, so I try to hold down costs for each round that is necessary. My expectation is that this represents the last time we should need to roll positions before we see the benefit of this strategy work more fully. We have been fortunate enough this past year to have ample gains to cover our hedge costs for the next year. In the previous year, we were able to reduce the cost to below one percent due to gains taken. Thus, over the full 20 months since I began writing this series, our total cost to hedge has turned out to be less than one percent. I want to discuss risk for a moment now. Obviously, if the market continues higher beyond January 2016, all of our old January expiration option contracts that we have open could expire worthless. I have never found insurance offered for free. We could lose all of our initial premiums paid plus commissions, except for those gains we have already collected. If I expected that to happen, I would not be using the strategy myself. But it is one of the potential outcomes, and readers should be aware of it. I have already begun to initiate another round of put options for expiration beyond January 2016, using up to two percent of my portfolio (fully offset this year by realized gains) to hedge for another year. The longer the bulls maintain control of the market, the more the insurance is likely to cost me. But I will not be worrying about the next crash. Peace of mind has a cost. I just like to keep it as low as possible. Because of the uncertainty in terms of how much longer this bull market can be sustained and the potential risk versus reward potential of hedging versus not hedging, it is my preference to risk a small percentage of my principal (perhaps as much as two percent per year) to ensure against losing a much larger portion of my capital (30 to 50 percent). But this is a decision that each investor needs to make for themselves. I do not commit more than three percent of my portfolio value to an initial hedge strategy position, and have never committed more than ten percent to such a strategy in total before a major market downturn has occurred. The ten percent rule may come into play when a bull market continues much longer than expected (like five years instead of 18 months). And when the bull continues for longer than is supported by the fundamentals, the bear that follows is usually deeper than it otherwise would have been. In other words, at this point I would expect the next bear market to be more like the last two, especially if the market continues higher through all of 2016. Anything is possible, but if I am right, protecting a portfolio becomes ever more important as the bull market continues. As always, I welcome comments and will try to address any concerns or questions either in the comments section or in a future article as soon as I can. The great thing about Seeking Alpha is that we can agree to disagree and, through respectful discussion, learn from each other’s experience and knowledge.

The Deep Value Investing Philosophy During The Fed’s Ongoing War On Deflation

The definition of inflation is a general increase in the price levels for goods and services. Deflation is simply the opposite of inflation, where prices are declinin g, not rising. The Federal Reserve (Fed) is of the belief that targeting inflation at a rate of two percent is the optimal level for keeping the United States (U.S.) economy chugging along. Let’s compartmentalize for a moment whether the Fed is even measuring the true rate of inflation correctly. Taken from the Fed’s website , “Having at least a small level of inflation makes it less likely that the economy will experience harmful deflation if economic conditions weaken.” Former Federal Reserve Chairman Ben Bernanke had a religious devotion to the “inflation good, deflation bad” mentality as indicated by his academic work. Bernanke’s collection of research papers blame the Fed in the 1930s for not increasing the money supply to fight off deflation so as to avoid the Great Depression. Determined not to repeat the same mistake during the crisis in 2008, Bernanke aggressively implemented a quantitative easing program while simultaneously hammering interest rates to the floor. No monetary tool at the Fed remained idle in order to avoid deflation and the perceived risk that falling prices result in a collapsing economy. Looking at deflation from more of a bird’s eye view rather than simply looking at Bernanke’s favorite example of the 1930s Great Depression, a different conclusion might be reached regarding falling prices’ perceived linkage to a contracting economy. A previous study showed no connection between deflation and a depressed state in the overall economy. The study looked at more than 100 years of economic data spread out over 17 different countries. No correlation existed between deflation and a contracting economy across all international markets , including the U.S. Even when the microscope was put over the 1929-1934 deflationary period, half of the countries in the study experienced economic growth despite collapsing prices. There does not appear to be compelling evidence that the Fed adds value to the economy by targeting a particular inflation rate in order to avoid the scourge of deflation. As I mentioned in a previous blog , successful entrepreneurs focus on their own individual businesses. Monitoring macroeconomic variables as they do at the Fed is not a productive use of an entrepreneur’s time. Individual investors should have the same mentality when it comes to their portfolios. Rather than guessing the future rate of inflation and what effect it might have on financial assets, investors should focus on the minutiae of which stocks and bonds are of good value to purchase. Sliding the macroeconomic textbooks in a drawer and focusing on what stocks trade at a price point below some measure of intrinsic value is the behavior pattern of successful investors. One de minimis estimate of intrinsic value applied to a stock is its net current asset value calculation. The chart below shows the average annual return following the rigorous value investing criterion of purchasing only stocks trading below net current asset value. The performance results are independent of Fed policy and do not require an investor to have an opinion on the future rate of inflation. *Net Current Asset Value Portfolio has no more than a five percent weighting in any one stock. Dividends and transaction fees are included in all of the calculations. During years where few stocks could be found, funds remained idle in U.S. Treasury Bills. That subset of the Fed hierarchy who serve on the Federal Reserve Open Market Committee (FOMC) spend their days analyzing changes in various macroeconomic indicators, looking for clues as to the direction in which the overall economy might be headed. The FOMC is the primary decision-maker as to where short-term interest rates should be targeted. As already mentioned, its attempt at targeting the inflation rate is not consistent with statistical evidence in terms of stimulating the overall economy. Pushing interest rates to the floor in order to target a two percent inflation rate has resulted in retirees’ receiving little to no interest on their savings. This zero interest rate policy (ZIRP) has been in effect by the FOMC over the past 84 months. Unfortunately, an individual investor cannot control the behavior of the masterminds at the FOMC, but he or she can control what stocks to include in a portfolio. As indicated on the chart, embracing a deep value investing philosophy by purchasing only stocks trading below net current asset value outperforms the broad market average over the long term. This holds true both before and after the FOMC scrapes its targeted interest rate off of the floor. It is a peculiar financial world we currently live in. The FOMC pores over the changes in food, clothing, and energy prices purchased by consumers. These prices are manipulated by the Fed, forced to move in a direction that may be in conflict with where Mr. Market feels they should be headed. Over the past seven years, entrepreneurs in this country have been manipulated into misallocating resources via the forced feeding of ZIRP soup by the FOMC. Because of their low interest rate policy, the Fed’s mandate of seeking long-run employment and price stability has morphed into an orgy of enticing reckless speculation with regard to overpriced stocks. Getting paid to manipulate interest rates and blocking a clear view of honest price discovery in stocks seems to be a waste of taxpayer money and a major irritation to investors who embrace a strict value investing philosophy.

Past Vs. Prologue: Cutting Through The Noise Of Investment Returns

Fortunately for investors, there is good information on stock returns which can be used to provide guidance for return expectations. Less fortunately, the translation of that information varies considerably which creates a lot of “noise” that investors must cut through in order to make good investment decisions. Comparing the work of Dimson Marsh and Staunton to that of Jeremy Siegel reveals different approaches and different conclusions. In any endeavor, history can serve as a useful guide to what might happen in the future. The good news for investors is that studies of historic investment returns are far more detailed and accessible than they used to be. Triumph of the Optimists by Dimson, Marsh and Staunton is one of the most useful and should be a core part of any serious investment curriculum, but there are others. The bad news for investors is that even when good information can be attained, its translation into investment advice and portfolio strategy can vary substantially. Much like background noise and poor connection quality can make it hard to understand a person on the other end of a phone call, so too can “noise” interfere with the quality of the signal investors receive in the form of advice. This phenomenon is readily apparent in regards to establishing appropriate guidelines for expected investment returns. For starters, the quality of underlying data regarding returns is fairly good – which is often not the case with investment research. It encompasses long periods of time and multiple geographic markets. The Dimson Marsh and Staunton (DMS) study (see [ here ] for our book review) encompasses returns between 1900 and 2000 for 16 different countries. Jeremy Siegel also conducted a study of stock returns focusing on just the US but dating back to 1802 which he popularized in his book, Stocks for the Long Run . The studies are similar for the depth of their research and for the fact that both found US stocks providing a real return of 6.7% over their study periods. The path of these research efforts diverges when it comes to interpreting the results for the purpose of establishing expectations, however. DMS focuses on analyzing the patterns they see in the historical returns and normalizing them as the basis for making a sensible forecast. One of the key points they highlight is that valuations have changed considerably over their study period and this provided a one-time, unsustainable boost to returns. They report, “Since 1900, there has also been a dramatic change in the valuation basis for equity markets. The price/dividend ratio (the reciprocal of the dividend yield) is much higher now than it was in 1900. After adjusting for the difference, they conclude that the ex ante risk premium for US stocks is 1.7% lower than the historical premium. “Our assertion in this book … is that the equity premium is markedly lower than many people suggest.” Indeed, this outlook is very consistent with Dimson’s recent assessment in the Economist [ here ] that “the likely future long-term real return on a balanced portfolio of equities and bonds will be 2-2.5%.” A second finding from DMS is that the unusually strong returns in the second half of the twentieth century appear to be statistical flukes and unlikely to be repeated. They note, “This was a period [the latter half of the twentieth century] when most things turned out better than expected. There was no third world war, the Cuban Missile Crisis was defused, the Berlin Wall fell, and the Cold War ended. There was unprecedented growth in productivity and efficiency, improvements in management and corporate guidance, and extensive technological change. Corporate cash flows grew faster than expected, and in all likelihood the equity risk premium fell, further boosting stock prices. In short, it was the triumph of the optimists.” In other words, the phrase for their book title, Triumph of the Optimists , is intended to be a mild warning in regards to expectations. They conclude their study by highlighting, “Statistical logic tells us that future expectations must lie below today’s optimists’ dreams. We can hope for, but we cannot expect, the optimists to triumph in the future. Future returns from equities are likely to be lower than those achieved in recent decades … experience should teach us realism, not optimism.” Siegel, by contrast, take a very different approach when establishing expectations for future returns by highlighting the constancy of stock return through history. As he often does, he started and ended his November presentation at the CFA Institute’s Equity Research and Valuation Conference [ here ] with a graph showing the returns to stocks, bonds, bills, gold, and the dollar. The chart shows stocks on a nearly linear upward trajectory with the returns for all of the other assets on considerably less attractive paths. Although he stops short of proclaiming 6.7% as his expected return for stocks, he clearly relishes in the moniker “Siegel’s constant” being applied to his findings. By leaving the graph of historical stock returns on the screen at the end of the presentation, he leaves a strong visual impression, and implied message, that past is prologue. Siegel also takes a very different approach to the subject of valuation. For one, he prefers using price/earnings (PE) as an indicator, despite the fact that just like with returns, one year’s worth of earnings can be hugely unrepresentative. To his credit, he does discuss Shiller’s cyclically adjusted price to earnings ratio (CAPE) which actually does a very good job of indicating future returns. However, after noting that the conventional CAPE methodology forecasts only 2% real returns for stocks, he moves on to describing how he believes the CAPE metric should be adjusted. His conclusion is that with certain adjustments, current valuation metrics point to expected returns to stocks very much in line with the long term average of 6.7% So we have two very different takes on essentially the same data set of stock returns. Siegel is bullish in finding stocks right on track to continue their long run record of 6.7% real returns – which is well above the returns of other asset classes. DMS, while also recognizing the historical superiority of stocks, are considerably more cautious in their expectations for future returns. Both perspectives are well informed views by respected academics. Unfortunately, this conflict creates even more of a challenge for conscientious investors trying to establish an appropriate portfolio strategy. How should investors cut through the noise? In an important sense, we enjoy having multiple sides to debates like this because it forces us to understand the positions very clearly and to disentangle what can be very subtle issues and assumptions. The case of return expectations is an excellent example because both views seem quite plausible. We begin our investigation, as we often do, by searching for inconsistencies and differences in underlying assumptions. One key assumption Siegel makes is that although stocks can deviate materially over the short term, those deviations become progressively smaller over longer periods. This is an important tenet in his thesis “stocks for the long run” but one that is not uncontroversial. Zvi Bodie, another noted academic, argues that Siegel’s view understates the long run risk of stocks. He describes in his paper “The long run risk of stock market investing: Is equity investing hazardous to your client’s wealth?” in the Financial Analysts Journal [ here ] that, “Economic uncertainty, especially, is magnified with time. What is the worst thing that can happen over the next 5 years compared with over the next 10,15,20,30, or 100 years? In 100 years’ time, a myriad of catastrophic things could happen.” This is an issue we highlighted in the blog post “Spring Cleaning” [ here ] where we noted that this observation is common in fields outside of economics and is a key factor in engineering (long term) infrastructure projects. Two other academics, Lubos Pastor and Robert Stambaugh, also addressed this issue in a paper entitled “Are stock really less volatile in the long run?” [ here ]. They acknowledge that “Conventional wisdom views stock returns as less volatile over longer investment horizons.” However, they also report that “stocks are actually more volatile over long horizons from an investor’s perspective.” They go on to explain: “Investors condition on available information but realize their knowledge is limited in two key respects. First, even after observing 206 years of data (1802-2007), investors do not know the values of the parameters of the return-generating process, especially the parameters related to the conditional expected return. Second, investors recognize that observable “predictors” used to forecast returns deliver only an imperfect proxy for the conditional expected return, whether or not the parameter values are known. When viewed from this perspective, the return variance per year at a 50-year horizon is at least 1.3 times higher than the variance at a 1-year horizon.” In other words, the future is uncertain and hard to predict. Indeed, an important element of their findings is that they explicitly call out the difference between assessing variance after the fact, or ex post , and assessing variance in the future, or ex ante . In contrast to Siegel, the notion that the future is inherently less certain permeates the language of DMS. This is evidenced when they say, “downside risk is always present,” and “because of the power of compound interest rates, the very worst that could happen to an equity investor worsens as the investment horizon is lengthened.” When DMS “examine the range of risk premia that can be anticipated over various future time horizons,” they find that “There is clearly a substantial probability of achieving a negative risk premium, even over long investment horizons.” Another subject that Siegel treats very differently than DMS is valuation. It is interesting to note that while Siegel sees fit to examine 200 years of stock returns, he uses only the current year’s price/earnings as his primary valuation metric. Using a single year’s worth of earnings makes his analysis vulnerable to being incredibly unrepresentative of the longer term and in doing so, seemingly antithetical to his effort to capture the big picture revealed by an extensive history. He does also consider a more robust valuation metric, the Shiller CAPE, which has one of the best records among valuation metrics for correlating with future returns (higher CAPE suggests lower future returns). However, when he finds that the current CAPE suggests future returns to stocks on the order of 2%, he deems it appropriate to adjust the earnings input to CAPE. In doing so he arrives at a CAPE ratio that suggests “very slight overvaluation” and an expected return to stocks very much in line with the historical average of 6.7%. There are at least a couple of things interesting about Siegel’s approach to valuation. For one, he does not appear to make an effort to calibrate for the fact that market valuations today are higher than they were at the beginning of the study periods. DMS explicitly address this as an issue that likely overstated historical returns relative to what can be expected in the future. Siegel makes no such valuation adjustment which means that in order to enjoy the same equity returns in the future as the past, valuations will have to continue to rise at the same rate, all else being equal. Another interesting aspect of Siegel’s approach to valuation regards the adjustment he makes to earnings for CAPE. Rather than comparing the price of the S&P 500 to the earnings of S&P 500 companies, he compares it to the profits from the entire economy. Effectively, he compares apples to oranges. John Hussman provided an excellent analysis of the “adjustment” [ here ] and James Montier at GMO has also chimed in with well- reasoned, and critical analysis of Siegel’s position [ here ] and [ here ]. In summary, we find flaws in several key aspects of Siegel’s thesis that serious challenge the credibility of his return expectations. For one, reference to any set of asset returns as a “constant” is absurd and defies underlying economic reality. In addition, the failure to clearly highlight the difference between realized historical variance and the variance of uncertain future events unnecessarily biases and complicates the assessment of return expectations. Further, Siegel’s valuation work suffers from clear inconsistencies in what Montier calls “a strange way of honestly adjusting a valuation measure.” It is also striking that Siegel does not call out the unusually strong returns in recent years and the negative impact those results may have on future returns. Specifically, the S&P 500 has returned 14.40% per year over the five years through November 2015. This is even greater than the 13.6% annual return achieved between 1982 and 1999 in what Siegel himself calls “the greatest bull market in history”, a period which he acknowledges as having generated returns more than double the longer term average. As a result, one key takeaway from this analysis is that we place more weight on the DMS work in regards to return expectations than that of Siegel. While we believe that, in general, stocks are worthy long term investments, we also believe they entail real risk, especially over horizons of less than ten or twenty years. Currently, based on the conventional CAPE ratio, we believe stock returns for the next ten to twelve years will be in the very low single digits, nearing zero. This is relevant for anyone who depends on achieving much higher returns, is retired or may be retiring shortly, or for whatever reason may need access to their investment funds in less than 30 or 40 years. We also believe that “Siegel’s constant” of 6.7% is an interesting historical occurrence, but that it says very little about the future and creates an “anchor” that can inhibit more productive intellectual inquiry. In order to calibrate that realized return of 6.7% to potential future results, we must consider how things may differ in the future. We know that the US experienced remarkable growth since 1802 and that is unlikely to repeat, at least not to the same degree. We know that productivity has recently crashed and that if it remains at current levels, it will be extremely difficult to achieve historical return levels. Demographic trends point to an aging society which is typically more averse to risk and has less demand for stocks. And debt and entitlement burdens are at record highs. Any one of these issues could depress future returns and if all of them exert pressure, future returns could be materially lower. After all, equity is only what is left after all other liabilities. Finally, this exercise also reveals one of the great challenges of investing and is symbolic of one of the industry’s major shortcomings: the almost constant need to cut through the noise. While we respect Dr. Siegel’s work, at the same time we believe that much of it used to fuel a bullish narrative at the expense of a clear discussion of issues relevant for investors. This doesn’t happen because he isn’t aware of the issues. Unfortunately, it makes things harder for investors when smart, authoritative figures produce overly ebullient outlooks that inflame the already troublesome tendency many have to extrapolate past results into the future. History can inform the future, but past is not prologue. We believe the more useful approach is that of DMS which appropriately tempers that enthusiasm with the lesson that “experience should teach us realism, not optimism”.