Best of The Long View 2022: Investing
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Last week, we ran the “best of” our interviews with financial planners, advisors, and retirement researchers over the past year. On this week’s episode, we’ll feature some of our favorite clips from interviews we’ve done with portfolio managers and investment specialists.
“Jeremy Grantham: The U.S. Market Is in a Super Bubble,” The Long View podcast, Morningstar.com, Feb. 8, 2022.
“Mary Childs: The Rise and Fall of the Bond King,” The Long View podcast, Morningstar.com, April 19, 2022.
“Cliff Asness: Value Stocks Still Look Like a Bargain,” The Long View podcast, Morningstar.com, May 31, 2022.
“Andrew Lo: Finding the Perfect Portfolio—a ‘Never-Ending Journey,’” The Long View podcast, Morningstar.com, Feb. 1, 2022.
“Eric Balchunas: Assessing Jack Bogle’s Monumental Legacy,” The Long View podcast, Morningstar.com, May 24, 2022.
“Wesley Gray: Perspectives on Market Efficiency, Investor Behavior, and ETFs,” The Long View podcast, Morningstar.com, Nov. 29, 2022.
“Sarah Ketterer: ‘Forget Value, Think Valuation,’” The Long View podcast, Morningstar.com, Sept. 6, 2022.
“Michael Santoli: Navigating Through a Foggy Market Outlook,” The Long View podcast, Morningstar.com, Aug. 9, 2022.
“Jim Grant: ‘Rising Interest Rates Are the Kryptonite of Financial Assets,’” The Long View podcast, Morningstar.com, May 3, 2022.
“Morgan Housel: No One Hires a Luck Manager,” The Long View podcast, Morningstar.com, May 22, 2019.
“Morgan Housel: ‘Little Rules About Big Things,’” The Long View podcast, Morningstar.com, Nov. 1, 2022.
Jeff Ptak: Hi, and welcome to The Long View. I’m Jeff Ptak, chief ratings officer for Morningstar Research Services.
Christine Benz: And I’m Christine Benz, director of personal finance and retirement planning for Morningstar.
Ptak: Last week, we ran the “best of” our interviews with financial planners, advisors, and retirement researchers over the past year. On this week’s episode, we’ll feature some of our favorite clips from interviews we’ve done with portfolio managers and investment specialists.
We started the year discussing the markets with legendary strategist and investor Jeremy Grantham. Jeremy is famous for his research into market bubbles. But what’s less well known is that he played a role in the development of index funds. We asked him about what led him to conclude indexing would be a useful innovation, and whether he sees anything today that could prove just as revolutionary as indexing has been.
Benz: I wanted to ask about indexing, switching gears a little bit, your name turned up in Robin Wigglesworth’s book about the rise of index investing. People might be surprised to learn that you played a role in the development of index funds. Can you talk about what led you to conclude that it would be a useful innovation? And is there anything today that you think could prove to be just as revolutionary as indexing has been?
Jeremy Grantham: In 1971, Dean LeBaron and I were asked to go and sit on the back row at Harvard Business School for a summer course for pension fund offices. And the case is picking a manager, and it was Morgan Guaranty Trust, so called then, JPMorgan. It was the new guy on the block, T. Rowe Price, who were introducing growth, imagine that; how novel. And a crazy little startup locally, which was a made-up name standing in for our firm Batterymarch, which was started—I was a cofounder of eight years before GMO. And at the end of the case, they said, as they often do, we’ve got these two guys visiting, have you any questions for them, have they any points? And my point, which came up as we studied the case was, I was surprised that no one suggested giving their money to the gentleman from Standard & Poor’s because of the four bits of data there, the three companies and the S&P, the best bet looked to be the Standard & Poor’s. And our reason for doing it was it’s a zero-sum game.
So, we were very happy that Batterymarch picked Mayo and me to run a portfolio and try and beat everybody. But we knew that in total, people who played the game would pay almost 2% in those days with high commissions to play the game. And the guys at the bar watching this, the indexes, if they owned everything, would make nothing. So, we’d make minus two, and they would make nothing, and they would beat us by definition. The zero-sum-game argument was completely sufficient reason to do indexing. It was not, however, the reason for our competitors at Wells Fargo. They were doing it first of all, because Samsonite, the luggage company, came in and said do it. But secondly, because the market was efficient, which it was not. Had the market been efficient back then, it too was a completely sufficient reason to do indexing. If the market is efficient, you should index. But the market was gloriously inefficient. And to prove it, Batterymarch, in the eight years we were there, won by 6 points a year without any extra risk. And then, for the first nine years at GMO we won by 8% a year with no damages. So, it was a gloriously inefficient market back in the day, but it was still a zero-sum game. So, the players still by definition underperformed by the cost of playing the game.
And so, that’s why we did it. And I wrote my one article for the Journal of Portfolio Management saying but you can’t fool all of the people all of the time, which was basically saying how long can you hide that simple truth? And the answer was pretty darn well, for a long time. Decades came and decades went, and it wasn’t until about 2010 that indexing really got the bit between its teeth. It was 3% or 4% of the total and now it’s 35, and you tell me, but it’s finally begun to move. It’s begun to move because of the simple truth: It is a zero-sum game, and the players will always lose to the indexes. And you get into some interesting end-games philosophy as you approach 100%, but that we can leave for another century.
Second part of the question was, is there anything to compare with that? And the answer is no. That’s a simple truth, and it will somewhat inherit the earth, and it’s exciting to try and beat the index, and smart people, very smart people, always will.
Ptak: Pimco bond manager, Bill Gross, was a larger-than-life figure whose accomplishments and contradictions seemed to defy easy description. But author and journalist Mary Childs managed to tell the story of Gross’ improbable rise and notorious fall in all its fullness in her excellent book, The Bond King. We asked Mary why it took Gross coming along for the total return style of bond investing to really catch on.
Benz: Let’s talk about that popularization of total return as a bond strategy. It seems odd that the concept of trading bonds for total return, income plus capital appreciation, didn’t really take off until the 1970s. You discuss Bill Gross literally clipping coupons early in his career. Why did it take that long for bond trading to catch on?
Mary Childs: It’s such a good question because it seems so wild to us now that this would not be a market, would not be an asset class, which I would say just illustrates the influence of Bill Gross and his cohort. But I think it was partially that insurance companies and other financial institutions had a prescribed need for—they had a very specific need for bonds. Bonds filled this specific purpose of being an exact and predictable flow of money so you could just match it against incoming liabilities, and you would feel great about this schedule that you had. I don’t know, that’s comforting, right? And you can sleep at night. And the idea of trading those away and losing that beautiful matching little ladder that you built, that’s so sad. Why would you do that? Why would you add risk into this thing that’s working perfectly? So, obviously, to some extent, we always resist change as a people, as a society, whatever. But in another sense, we may be resisted change here because it was working. It was low risk. It was steady-Eddie. We all felt good about that. And it was fine. So, I think it seems obvious to us now. But at the time, I think they had a system that was working and good. And the urgent need for trading bonds came in when inflation really started messing things up.
Ptak: In May, we sat down for a live interview with AQR founder, Cliff Asness, at the annual Morningstar Investment Conference. Cliff is a quantitative researcher extraordinaire and a prolific writer. There was lots to discuss, including the cheapness of value, the case for ESG, and the outlook for bonds. But we took the opportunity to pick Cliff’s brain about how retirees should approach asset allocation given the punishing market conditions of the past year.
Benz: I want to follow up on Jeff’s earlier question about life stage and retirement in particular. This specific environment of stock markets selloff, rising bond yields, high inflation. You touched on the implications for retirees, but I want to delve into that a little bit more. You mentioned the role of alternatives, potentially. What other strategies should pre-retirees and new retirees be thinking about in what seems in a lot of ways like a catastrophic environment?
Cliff Asness: I think for the average retiree—and this might be an unpopular answer—they want to do less, not more. The key, which is easy to say after the fact, is to have thought about these kinds of things. What we’re going through now, is not unprecedented, by any means, particularly for markets. It’s certainly an ugly period. But there have been far worse periods. So not to be obnoxious about it, but if you’re knocked off your plan by this period, your plan was not a good plan. So, most of this stuff is about work upfront, reasonable scenarios of what we might have to live through. And knowing I’ll stick with it through that scenario. That’s way harder than it sounds. I’m sure you’ve experienced this many times. You could show people, what if you’re down this much? And they’re looking at the long-term graph, and any long-term graph of a gain, the wiggles in between you look at you go, “That wouldn’t have bothered me at all.” Because you see where it ends up—that wiggle was down 27%. And by definition, a fair amount of people got out at the bottom.
Coming up with worst cases you can tolerate, it’s a little bit of method acting. There’s no quantitative way to do it with certainty. Sometimes people look at the worst case that has ever happened. That is certainly worth looking at and I’ll always look at that. You know that’s not a perfect estimator of a worst case. Because this is another terrible English sentence, but I’m going to say it anyway: The worst case was not the worst case until it happened. Therefore, if you were using that model, you did not anticipate the worst case. So worst cases are a little bit of art. You can’t go way too far the other way, because then you’re paralyzed to do nothing. If I invest in stocks, what if they lose 100% in a day? I have to be willing to bear that. You’re probably not going to invest enough in stocks if that’s your work. So, there’s art not science, but setting up a portfolio that is reasonable and including—and this sounds like lecturing—but including some of these alternatives. Again, they certainly don’t have to be AQR’s; there are other ones that are long and short, trying to make money from maybe a risk premium or behavioral aspect that’s not just the market going up. Trend-following, which, on average, makes money, but seems to do particularly well in tough times.
Trend-following came under a lot of fire for four or five years. And surprisingly, now is back in vogue. I don’t know if I’m ever in vogue. That’s way too hip a word for me. But what we should all strive for, is to like or dislike. Someone can disagree with me, but like or dislike things like uncorrelated alternatives, trend-following, as much after a five-year bull market as we do after a one-year bear. If you haven’t, and you’ve had a portfolio that has none of these things, and you took too much risk, I’m not looking saying, “You screwed up, it’s over.”
There is always more time. One lesson is, a lot of us look at things and just go, “I missed it.” And so often, that’s not the case—things keep going for longer than you think. Again, I’m talking my book here, but the value trade, you can feel like you missed it, because it’s up a ton. But it’s still priced at 1999-2000 level. I think it would have been better, of course, to have this all in place beforehand. But if you’ve not thought through what you can stick with, you do have to make a change—that’s painful because you’re not getting that back. But if there are diversifying alternatives, we can’t predict those very well ourselves just because they’ve worked for a while or not worked for a while. We think they should just be in the portfolio.
There’s still time to do that, but the time to do that is all the time. Not now. I’m not really good on the what should investors do right now, except in the sense that I go, “I’ll answer that, but it’s also what I’d say they should always do. With that, sell everything.”
Ptak: Asset allocation was also the topic of our discussion with eminent researcher and author, Dr. Andrew Lo, who joined us to discuss a book he’d written on the topic. That book, called In Pursuit of the Perfect Portfolio, traces the history of investing in finance all the way back to the Neolithic era. During our interview, we asked Dr. Lo about Nobel winner Harry Markowitz and Modern Portfolio Theory’s unlikely beginning, which happened at a time when there was scant academic interest in portfolio management.
Benz: As you explained in the book, there had been little academic interest in portfolio management until Markowitz came along. Now there are whole journals devoted to the topic. But back then, the disinterest reflected attitudes toward the stock market, which was perceived as a bit of a backwater, right?
Dr. Andrew Lo: Absolutely. It’s really quite a stunning change, because when Markowitz started applying these principles, nobody had any interest in portfolio optimization. And today, I don’t imagine there’s a financial analyst out there who doesn’t know of mean-variance analysis. A very interesting story that Harry tells is at his thesis defense, when Milton Friedman, who was on his thesis committee, half-jokingly said, “Well, we can’t really give him a Ph.D. in economics, because, of course, this isn’t really economics, it’s just math.” And Harry Markowitz I think had the last laugh, when, as part of his Nobel acceptance speech, he mentioned this story. And he said that, “Well, at that time, Friedman was right. It wasn’t economics or finance. But now, it is.”
Ptak: In one afternoon—I think you recount this in the book—Markowitz had worked out the two major inputs to what became Modern Portfolio Theory: correlation and the notion of mean-variance optimization, as well as the notion of an efficient frontier. Can you talk about how those discoveries changed portfolio construction, maybe by contrasting with how it had been done up to that point?
Dr. Lo: This is really quite a stunning achievement, and it’s one that most people aren’t aware of, because they just take for granted that we now think about correlation, diversification, and portfolio construction the way we’ve always done it. But, in fact, prior to Markowitz, the way that people thought about investments was really from the perspective of the portfolio manager, the culture, and the personalities involved. They were often called gunslingers. Because these were larger-than-life celebrities that were able to pick stocks in much the way that certain art experts are able to pick the very best pieces of art. And so, that’s the way that the investment industry operated until, I would say, the 1960s and ‘70s, well past the first decade after Markowitz’s publication.
But something happened in that process, which is that portfolio managers began to see a different way of constructing portfolios, not by picking the best stocks, but rather by creating a combination of securities that had good properties overall. And correlation was a key feature. What you wanted to do was to put together a collection of securities that were not all highly correlated, not highly related. And the reason for that is you wanted to make sure that you had good diversification, not putting all your eggs in the same basket. And by managing the correlation, you’re able to produce a portfolio that had better returns, lower risk, and therefore over time, would grow into a much larger nest egg than the traditional stock-picking approach. That was a combination of Markowitz and Sharpe and all of the other luminaries that had ultimately taken this academic idea, a rather dry set of mathematics, and really turned it into something practical and genuinely useful.
Ptak: In our interview with Bloomberg’s Eric Balchunas, we discussed the life and professional accomplishments of another monumental investing figure, Jack Bogle, the founder of The Vanguard Group. Bogle was the subject of Eric’s excellent book, The Bogle Effect, which traces the arc of Bogle’s ascent to lead what would eventually become the world’s largest fund manager. We were interested in Bogle’s early years and some of the experiences and events that shaped his worldview and career direction.
In the book, you trace Bogle’s life career and long arc. So, I wanted to focus for a moment on the early stages of his life and career. Bogle, he came from what had been a wealthy family, but he didn’t lead a life of privilege as a young person. How do you think those early life experiences set him on his future course?
Eric Balchunas: I think they were pivotal. I think a couple of things maybe later were equally as pivotal. But obviously, your childhood is major. First of all, he was always working. He was a scholarship kid. He had a taste or a sniff of the Great Depression. I always tell people, like especially my mom and my family, I would say, “Visiting Jack Bogle was like hanging out with my grandfather, not my father.” He was not a boomer. He was a World War II-type guy. He had the same sense of humor. The office had pictures of warships and stuff, just like my grandfather. And that generation was very thrifty generally. They had just seen things that the rest of us haven’t. And I think he had enough of that that was a nice core for him. And obviously, working off of scholarships, he had to work, doing all kinds of jobs, including setting bowling pins. And in my life, as I’ve met people who had to work through college, they tend to be the most successful people. That’s a really good ethic to begin with.
So, I think thriftiness was important. Obviously, that paid dividends later. And in fact, I do think there was some genetics at work though. His great grandfather was a populist fighter of insurance companies. And Bogle lists some of his great grandfather’s speeches in one of his books. And it’s fascinating how similar their language is. His great grandfather was the one who said, “Gentlemen, cut your costs.” He just copied it. So, there was some genetics at play, I believe, and of course, obviously, the environmental aspects that I said as well. And I think his father was not a great achiever; he didn’t achieve a lot and had trouble holding down a job. And I think that also probably sparked Bogle to want to make something of himself.
Benz: The academic thesis that Bogle wrote when he was a Princeton undergraduate was eerily prescient. Can you talk about the main thrust of the argument he made in that thesis?
Balchunas: It really is something how the seeds of Vanguard are in there. Basically, he wrote this thesis that says something along the lines of future growth can be maximized by reducing sales charges and management fees. Funds can make no claim to superiority over the market averages. And the principal role of the investment company should be to serve its shareholders. That’s pretty good. That definitely gives some credence to the way Bogle wrote the rest of his life, because circumstance definitely played a big part, but Bogle would put himself as the hero. And some people will push back against that, and there’s definitely some truth there. But those core statements are pretty much the foundation of Vanguard.
A lot of things had to happen first, but they’re right there. And one interesting tidbit about the Princeton thesis—two of them. One is, he was looking for an idea for the thesis in the library at Princeton. He didn’t know what he was going to write about. And he picked up Fortune. And there was an article on mutual funds in that magazine. And it was deep in the magazine, and it wasn’t on the cover. You had to be curious to get it. I think his curiosity and reading a lot helped him a lot in his life. In addition, I looked at what was on the cover of other magazines at the same time and Time magazine at the time had Conrad Hilton on the cover. So, I do imagine what if he picked up Time instead? It’s interesting how two different paths—he maybe had been a low-cost hotel guy. But the other thing that’s interesting is Michael Lewis—I interviewed him for the book—and Michael Lewis has a binder he keeps. And when I told him this, he goes, “Wow. I got to print that out because I have a binder that I keep of Princeton thesis that have changed the world.” I’m not sure if he is planning to write a book about it. But the atom bomb was first devised in a Princeton thesis; Teach for America. And there’s this history of Princeton thesis having a lot of things that were seeded right there that became actual major accomplishments or events or ideas that formed.
Ptak: Entering this year, there’d been lots of debate about whether value investing had lost its mojo. We wondered why value was in such a funk to begin with, and whether its recent outperformance was a good portent of things to come or just a head-fake. We put those questions to the Alpha Architect founder, Wes Gray, recently.
Benz: We want to switch over to discuss some of the factors, and that’s where a lot of your research has centered. Starting with the value factor, value stocks were in a huge slump until recently. Why did that slump happen and what might it portend for those who are considering allocating to value after its recent strong run, or its relatively strong run, I should say?
Wesley Gray: As you guys are aware, there’s thousands of research papers talking about why value exists in the first place, or the value premium, which is just simply buying cheap stocks over the long haul tends to outperform the market and expensive stocks. And two theories boil down to, this cheapness proxies for higher risk, and in general, higher risk should lead to higher return. And I’m a partial buyer of that. But there’s also this idea of just bad behavior. People throw the baby out with the bathwater. So, if you’re buying these cheap companies that no one likes, well, they probably have terrible stories, they’ve probably got terrible short-term narratives in performance. And what happens is, the market throws the baby out with the bathwater, and eventually, there’s a sentiment shift somewhere, someway along the way where they’re like, wait a second, these stocks shouldn’t be 5 P/E, they should be 10 P/E. And when you get that expectation shift due to this behavioral mispricing, that’s where value a lot of times goes on its big runs. And so, that’s just the theoretical foundations for why does value exist in the first place? Mispricing due to sentiment issues and then arguably, some element of risk. We’re not going to talk about risk because it just is what it is. If things are riskier, they should get higher expected returns if you believe in the efficient-market hypothesis at all.
I personally believe that this recent issue we’ve had with value stocks, and now, we’re obviously seeing this thing turn, is it was just the classic sentiment problem. Winding back the tape about a year, year and a half from now, obviously people always have a hard time remembering this. But if you could wind the tape back a year, year and a half from now, everyone said value is dead, why would you want to own energy, why would you want to own any of this stuff? These are fuddy-duddy, loser companies. It was literally a broken record from the exact same stories I used to hear back in ‘99—internet has taken over everything, tech is everything, and so on. And what happens is, even if value companies, which at that time and as we’re seeing right now, are coming out with better and expected earnings, better fundamentals, you’d expect a shift in valuation—you didn’t. The way it would happen is, Zillow would come out with worse earnings, worse revenue, and it would just go up higher. And I can’t explain that except with sentiment. And I don’t know when or how sentiment shifts occur. I think that’s an interesting question. But now that all of a sudden sentiment has shifted and everyone is like, “Wait a second. Actually, let’s do focus on cash flow, let’s do focus on fundamentals, let’s focus on gravity”—it matters. All of a sudden, people are like, these value stocks are actually making money. They’re real businesses. They actually send out dividends. We should probably boost their valuations a little bit and let’s go bomb out all these “Ponzi schemes” we’re buying where they say that we’re going to have revenue, they say we’re going to have earnings 30 years from now. But really, what they do is they just lose money all the time. And I think you’ve seen that shift. And that’s why I think you’ve seen this break where all of a sudden growth is down 70%, 80% and how value is starting to move in the right direction. So, I think it’s nothing new under the sun. If you have horizon, you know this research, it’s just welcome to the value trade. It’s finally, the sentiment is here and now you’re starting to get the relative outperformance.
Ptak: Do you think value stocks are still cheap enough compared with other types of stocks to confer access returns? I think that you all have done research in this area, AQR as well. What does it look like?
Gray: Yes. It’s counterintuitive to a lot of people that obviously they haven’t studied this their whole lives, they don’t look at the time series on it. Just because something all of a sudden starts working a little bit, it doesn’t mean it’s dead. So, value in particular right now, obviously, it’s had strong relative performance compared with overpriced, no-earning-type companies. So, obviously, the fundamentals are moving even faster and stronger than the prices. You can have relative outperformance, so the value stock was a P/E of 5 and now maybe it’s a P/E of 6, but that earnings has raised so much faster even than the P that you could still have this relativeness where the relative cheapness of value stocks versus growth stocks is still huge. And that’s exactly what we find, where right now, even though value has “crushed” growth, because they’ve fundamentally been doing so much better, so their earnings—or however you want to assess their fundamentals—versus the growth stocks, it’s been growing faster than the growth, the relative spread or the relative cheapness of value versus the rest of the market is still at nosebleed 90%-plus type ratios. And again, when you say “historically,” you always want to take it with a grain of salt. But anytime you have a spread that’s in the 90-percentile range, which you have right now, so the valuation on cheap loser stocks versus the broad market or the fancy growth stocks is at 90%-plus levels, that’s an edged bet. I don’t know if it’s going to happen next year, or next three years, or next five years, or next 10 years. But in general, when you have an edged bet and something is at the extremes of the spread, that’s usually a good long-term place to shift your capital, because they win. Lower price is usually the higher expected returns. But timing is everything. And I’m not going to tell you that now is the time because it could be five years from now where it flips. But it’s definitely elevated in the spread.
Ptak: Sarah Ketterer, the CEO of Causeway Capital Management and manager of Causeway International Value Fund, has seen a market cycle or two over the course of her multidecade career running money. Given that experience, we sought Sarah’s insights into the macroeconomic picture, inflation specifically. Though Sarah is a bottom-up stock-picker, not a top-down strategist, she nevertheless had a very prescient take on the state of inflation and its implications on monetary policy at the time we asked her in the late summer.
Benz: In your most recent commentary, you stated, “We believe equity markets have yet to discount the full economic impact of the interest-rate increases and monetary liquidity reduction needed to shrink inflation.” Inflation seems to be easing. Does that change your view?
Sarah Ketterer: I don’t think inflation is easing much, and we hear faint signs of any improvement in inflation. I’d say, if anything, the labor situation is still really acutely problematic for so many of our companies. I’ll mention one of our successes for clients, a company called Compass Group, and they are a catering firm globally, 60%-plus North America and another 25% or thereabouts of the revenues in Europe. They are generating plenty of free cash, but they can’t get enough labor, and the labor cost situation, they have to pass that on, and they can’t always do it. So, their only real sustainable competitive advantage is that they’re big and they have so much scale, and many of their smaller competitors are having even greater cost problems.
We’re expecting—as an organization our house view is that central banks around the world, with the exception of China’s Bank of China, the rest need to be in a tightening mode with the Fed at the head of the pack, and not just rate rises but the reduction in central bank balance sheets will lead to a lowering of the inflation rate through constraining economic growth, and China is already constrained. So, it’s going to be a bit rough the next 12 months, and we think markets are just now beginning to understand this. They did through June. It was fill up of optimism that’s happened in July and August. But it’s very clear, especially when you listen carefully to what Jerome Powell has to say, the Fed is committed to lowering inflation, and I don’t think there’s any ambiguity here that what brought markets into a buoyant state of massive multiple re-rating upward, particularly in the U.S., amplified by the expansion of monetary policy in 2020 and 2021—actually through early March of 2022—we’ll see the other side of that with the contraction. And taking liquidity out of the financial system tends to lead to lower valuations across the board, particularly for long-duration stocks where cash flow from the business are all promised far out into the future, as opposed to what we’re looking for at Causeway, which is companies generating cash today.
Ptak: There are few more astute market observers than CNBC senior markets commentator Michael Santoli, who we interviewed in August. What Christine and I particularly like about Michael is the way he distills concept in practical, easy-to-apply terms. Here’s Michael’s take on the state of corporate profit margins, a frequently debated topic that’s been in focus amid tighter monetary policy and rising inflation. Our question for Michael: Can firms sustain the higher-than-average profit margins to which investors have become accustomed?
Benz: There has been a long-running debate about the sustainability of high corporate profit margins. Some argue that it’s just a matter of time before they come down. Others believe they will remain at this higher plateau. What do you think about that?
Michael Santoli: I think it’s a nuanced issue. For one thing, the observation I’d make is, part of this long-term increase in corporate profit margins that many people cite, if you do the aggregate S&P 500 levels, is a bit of a mix issue. So, when you have these companies with somewhat structurally higher profitability, like the big growth tech companies that are now such a huge part of the index, I think just mathematically it makes the index look like it’s more profitable and it’s over-earning to a great degree. So, maybe there is a little more resilience in earnings in part for that reason. I don’t think that in general across the board the typical company is going to be able to perfectly protect margins. The good news is, you’re already seeing that to some degree. You’re seeing some margin erosion. And at the same time, as I mentioned before, with nominal growth being high enough, revenue is growing enough that there’s a bit of a cushion. And so, that aggregate profit of net income if you want to say, can still be OK, even if margins do come down. So, there is no escape from the commodity cost pressures, wage costs going up, and things like that. We may get a corporate tax-rate bump, as we know, through this newly passed package. But I don’t think there is really a waterloo on the way for corporate profitability.
I’m not going to say that somehow businesses are much better across the board than they used to be, but there has been some ability to defend margin in the last couple of cycles that, I think, has confounded the historical mean-reversion camp. I do remember, I think it was a very large buy-side well-known investor, who I think it was in the early 2010s, was saying profit margins are the most mean-reverting series in economics or something like that. And it didn’t happen, even though that was the case in prior years. Is that going to change? Are we in more of a short-cycle boom/bust scenario, the way maybe we were prior to 1990? That remains to be seen. I think there’s some plausible cases to be made for that. But right now, I think what’s interesting is that the market has rushed to seize upon the decline in commodity prices and this idea that inflation has peaked to start worrying about is aggregated growth going to be OK, not so much can companies protect their margins because of costs going up.
Ptak: There are giants and then there are giants. Jim Grant, the founder and editor of Grant’s Interest Rate Observer,looms large. His reputation staked on the trenchant macroeconomic analysis he has published for decades. We were fortunate to be able to chat with Jim last spring on a range of topics, one of them being the likely direction of interest rates. Here is Jim’s take on what history can teach us about how bond yields trend over many years and how that bodes for bonds’ diversification potential in the years ahead.
That’s a good segue to the next topic that we wanted to take up with you, which is interest rates. Bond yields are rising as you just mentioned. Bond investors are staring at losses. Do you think this is just the beginning?
Jim Grant: I’m one of the world’s leading authorities on when the next bond bear market cycle will begin. I began looking for it some time ago. But I do think it’s upon us now. Something to know about the history of the bond market, something to know of use in thinking about the present and the future is that in the past, bond yields have trended in generation-length periods. So, it’s a characteristic that you don’t see in other financial assets. You don’t see it in stocks. Real estate is another financial asset type—you don’t see it there. But interest rates, they declined for the final 35 or so years, the 19th century, that is the 1865 to 1900 or thereabouts. They went up for the next 20 years to about 1920, declined till 1946, rose from 1946 to ‘81, and declined, as I say, for 40 years subsequently.
So, it is a thing—as the young folks say, it is a thing in the bond market for a trend once established to persist. And it might just be that we are embarked on an upcycle in interest rates and bond yields with all that implies for valuations and mortgage rates and house prices, and so on and so on. It’s an intriguing time. It’s, as we say, in the journalism trades, great copy. But it’s also a time pregnant with risk and of course, opportunity, being two sides of the same coin. But I do think that this wonderfully, or frighteningly powerful, updraft in interest rates is the start of something, and to me, it has the feel of a reversal in trend.
Benz: Bonds have been reliable stabilizers in diversified portfolios, at least over the past 30, 40 years. They’ve diversified stocks. Can they continue to fulfill that role, even amid rising interest rates? And if not, what are the alternatives?
Grant: Well, if rates rise, and of course, it matters a great deal how fast they rise. But if rates continue to rise at a bounding pace, the 60/40 portfolio, that is 60% stocks and 40% bonds, that standby of the bull markets of the ‘80s and the ‘90s and the odds that portfolio standby is not going to work. It’s not all bad news for the bondholder when rates rise because you can reinvest coupon income at ever higher rates of return. That’s OK. But you look at your statement of mark to market base and the price of that security, of that bond, is going down. And especially, do bond prices go down when the coupons at which they were purchased are trifling. And that characterizes a great deal of bonds over many, many recent years.
You bought securities at 1.5%, at 2%, or 3%. That explains why you’ve been reading that the first quarter saw the most violent destruction of asset value in the bond market since at least the ‘70s or the ‘80s not because rates went up so much to such a high level, but rather because the rates at which prices began to fall were so low. So, a 1.5% coupon on a long-dated security can fall a lot when that 1.5% becomes 3%. And that’s kind of what happened in the first quarter. And can it continue? Yes. Would it be welcome? No.
One final word on precedent. The bond bear market that began in 1946, the one that lasted 35 years from 1946 to ‘81, that began as a tortoise would begin its race with a hare. The yield at which that bear market in bonds began in 1946 was about 2.25%. And it was not until 10 years passed that the same duration bond yielded 3.25%—10 years to get the next 100 basis points in yield higher, one percentage point higher in yield. So, history, if it were only more predictable, would empower and enrich the historians. As it is most historians don’t have two nickels to rub together. So, one must take precedent with many grains of salt. But for whatever it’s worth, the violence of this upsurge in yields is unprecedented. In the few bear market sightings we have had, there aren’t that many statistical observations, certainly not enough to make hard and fast laws. But this has been some light show on the bond market.
Ptak: There are few who write as insightfully about the choices we face and decisions we make in our personal and financial lives than Morgan Housel. Morgan was one of our first guests on the podcast back in 2019, and since that time he has written a best-selling book, The Psychology of Money. So, we were thrilled to invite him back on the podcast earlier this year to discuss the book and, in particular, his fascination with contradictions and paradoxes. It’s a theme he returns to often in his work, including a recent piece called “Little Rules About Big Things.” We asked what draws him to this subject matter and how he has found peace with the notion of not letting perfect be the enemy of good in investing and life.
I wanted to ask you about contradictions and paradoxes. You wrote a piece recently. I think, a day or two ago, I was marveling over this piece. It’s called “Little Rules About Big Things.” You wrote it in early October. We will include it in the show notes. And it’s an amazing piece. I think it’s 88, they’re not bullet points, but they’re just short little stanzas, and many of them are exploring contradictions, paradoxes in everyday life. It could be life, financial life, what have you. What is it that draws you to those sorts of things that feature so prominently in your writing?
Morgan Housel: I think one of the big things is that we tend to think of finance like there is one right answer for everyone, and if we can just find that one right answer, we’ve discovered the truth that everybody should follow. Very similar to like in physics, there is one right answer for everyone. And in math 2 + 2 = 4 no matter who you are. No matter where you’re from, how old you are, how much money you make, 2 + 2 always equals four. And in finance, it’s not anywhere near like that. We think it is. We want to pretend that it is, but it’s not. And you can take people in finance who are the same age, from the same country, who earn the same amount of money, and the right financial decision for those two people might be completely different. How much money they should save might be completely different, how they should invest their money might be completely different, because they have different personalities. And again, in math, your personality doesn’t matter. In finance, it’s everything. Your risk tolerance is everything, your social aspirations, your family dynamics, how your spouse feels about risk tolerance, to say nothing of your own risk tolerance, that’s everything. That’s not a part of it, that’s everything.
And so, the contradictions I think really bring that to light. And I think a lot of times, the biggest contradiction is, I think the majority of financial debates between people, which is what 99% of financial media is, is people debating whether X, Y, or Z is going to happen. The majority of those debates are not actually people disagreeing with each other. It’s people with different risk tolerances and different time horizons talking over one another. And people are either oblivious to the fact that other people might not have the same goals and aspirations and risk tolerances that you do, or when they understand that other people have a different risk tolerance than they do, they’re upset about it, like how could somebody else view the world differently than I do? And they almost view it as a threat to their own worldview when they discover someone else who thinks differently. And so, those contradictions are everywhere.
And by the way, they exist at the personal level, too. There are probably things that I do with my own money that contradict each other. I can’t even think of one at the top of my head, but everyone is a walking contradiction, and money is such a window into how people think about risk and reward and greed and fear, these really big topics that impact a lot of areas in life, and money is a window. The financial decisions that you make are a window into that. So, I think the contradictions are exciting to me because it is proof and a window into the fact that there is no one single right answer in this field.
Benz: Seems like you’re at peace with the notion of something being too hard to figure out and this idea of not letting the perfect be the enemy of the good. Have you thought about how you’ve gotten OK with the idea of something being good enough?
Housel: I think it’s hard to have any kind of historical view of finance and economics even in recent history of the last one to five to 10 years and not be completely humbled with other people’s ability and most likely your own ability to know what’s going to happen next, both at the individual level, like what’s going to happen in your own career—a lot of people, their ability to forecast where they will be in their career five years from now is atrocious. They have no ability to know. If they’re looking back and being honest with themselves, it was a completely blank slate in front of them. And at the broad economic level, the ability to know what’s going to happen next, is so humbling if you’re honest with yourself.
The recent example that I like is The Economist magazine, which I really admire. It’s probably the most astute financial publication that’s out there. I’ve read it for years. It’s great. Every January they publish an edition that is a review of the year ahead. So, here are the economic and investment risks that are going to impact you over the next 12 months. They do this every January. Their edition in January of 2020 did not say a single word about COVID. Of course, nobody was talking about it in January of 2020. That’s not a criticism. And their edition in January of 2022 does not have a single word about Russia, Ukraine, or energy markets. Again, because nobody was talking about it back then. I’m not criticizing them. But that ability of even literally a couple of weeks before these things completely changed the world, the most astute financial thinkers and writers are totally oblivious to it. I think it’s like that every single year that the biggest economic risk in front of you is something that nobody is talking about. It’s always like that. And you can say with so much confidence today that the biggest investing risks, the biggest economic risk over the next 12 months, over the next five years, is something that nobody is talking about right now. And you can say that because it’s always the case.
So, to me, the only practical takeaway from that humility of our inability to forecast is to have some level of good enough, good enough forecasting to where I’m like, I have no idea what’s going to happen over the next 12 months or the next five years, but maybe I have some baseline expectations of—I expect there to be market volatility, I expect there to be recessions, I expect there to be bear markets. I don’t know when they’re going to come. But that’s good enough. If I can just have a baseline expectation of what’s going to happen, that’s good enough for me. And also, I think at the personal finance level, if you don’t have a concept of enough, then no matter how much money you make, it’s never going to feel satisfactory.
And one truth in finance is that if your expectations grow faster than your income, you will never be happy with your money, and it doesn’t matter how much money you make, if it’s $10,000 a year, or $10 million a year. That’s like an iron rule of finance that has to be obeyed. And one thing that I’ve always found fascinating is that there is so much effort, almost all of the effort in the financial industry goes toward the first part of that equation, which is increasing your money, increasing your income, increasing your net worth, which is great, of course, that’s an important part. But there’s almost a complete and utter ignorance of the other part of the equation, which is keeping your expectations in check. And it should not be any surprise that a lot of people, by and large, will go through their life where, on average, over a period of time, their income will rise, their net worth will rise, and are they any happier for it? Maybe a little bit, but not nearly what you imagined you would be.
And for most people, if I said, if your net worth doubled in real terms, if your real net worth doubled from here, how would you feel about it? Most people would say, “I would feel amazed. That would be incredible. That would be such a windfall. I would be happier. We’d go on better vacations. We’d live in a better house.” But when that actually happens to people, by and large, they’re not. They’re not. And everybody knows this. What I just said is not even controversial. But the reason it takes place is because people’s expectations grow just as fast, if not faster than their income. And so, I think the only way that we can fight against that and use our money to live a better life is to put just as much effort into keeping our expectations low as goes into growing our net worth and growing our incomes.
Ptak: Thanks to all of our wonderful guests for sharing their insights over the past year. And thanks to you for listening. From all of us here at The Long View, we wish you all the best in 2023.
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