2 Scholarly Papers And The Implications For Your Portfolio

Two recent white papers take different approaches, yet lead to a similar conclusion.

Photo by Scott Graham on Unsplash

Recently, I published my Q3 2023 Personal Portfolio & Asset Location Update.

In that article, I included the following comment.

If you look closely at that right hand column, you will likely start to notice a clear theme. I have begun moving cash to bonds, including those longer-term bonds that fell so hard in Q3. I hope to return fairly shortly with another outlook article explaining my thoughts in greater detail.

This was not the first time I have recently broached this topic with readers. In this article, I featured the “jaws” that had begun to open between the behavior of long-term treasuries and the Nasdaq index, which typically tend to mirror each other. And in this article, I put several related data points together to share my view of where we stood right now with respect to the balance between various asset classes.

For any investor, the challenge is to be forward-looking. The fact that asset classes have behaved a certain way in the past does not necessarily mean that they will continue to do so. Especially may this be the case when the last few years were actually quite uncommon from a historical perspective.

Related to this, in this article I will feature what I believe to be some significant work from two investment professionals who are certainly a lot smarter than I am. I will offer links so you can dig into the original works themselves, if you have the time and interest. For the rest of my readers, I will attempt to briefly summarize the high points such that you can at least discern the general picture.

Howard Marks - Sea Change

The first section comes from two recent papers by Howard Marks, of Oaktree Capital Management. The first was entitled Sea Change, and published in December, 2022. The second was a follow-up to the original article, originally sent to Oaktree clients on May 30, 2023 and released to the rest of us just a few days ago.

Basically, here is a bullet-point summary of the original article.

• In late 2008, the Federal Reserve took the fed funds rate to zero for the first time ever to rescue the economy from the effects of the Global Financial Crisis (GFC).

• Since that didn’t cause inflation to rise from its sub-2% level, the Fed felt comfortable maintaining both low interest rates and quantitative easing (QE) for some 13 years.

• This led to en extended period of “easy money.” Businesses, even flawed businesses, were able to obtain financing and avoid default and bankruptcy.

• This also made the 2009-21 period a great time for asset owners. Low interest rates led to surging corporate profits and a lower cost of capital. On the part of investors, TINA (there is no alternative) and FOMO (fear of missing out) drove investors into stocks at ever-increasing prices and valuations. In contrast, bargain hunters and lenders (think, also, of savers as lenders) got the short end of the stick, so to speak.

• Then came COVID. Relief measures, fiscal stimulus, and supply-chain issues resulted in too much money chasing too few goods, the classic combination for rising inflation.

• Ultimately, this caused the Fed to embark on the fastest tightening cycle in four decades, while simultaneously ending QE.

• For a variety of reasons, it does not appear that ultra-low or declining interest rates will become the norm in the decade ahead.

• In turn, this basically results in everything being flipped on its head, thus the expression “sea change” chosen as the title of the article. Times will likely be tougher ahead; for corporate margins and profits, for asset appreciation, for borrowing costs, and in the case of marginal businesses even to stave off default and bankruptcy. (Author’s Note: As I write this, Rite Aid just declared bankruptcy, faced with a $4 billion debt load and rising interest costs.)

In his more recent follow-up article, Marks goes on to “put flesh on these bones,” as he puts it, and shares insights he believes are relevant today.

First off, he notes that, unless one has been working for roughly 43 years and therefore over 65 years old, one has not had much experience with an environment in which interest rates were not declining and/or ultra-low. He uses the metaphor of a moving walkway at an airport. Compared to people walking beside the walkway, it seems like you are effortlessly moving faster, in turn feeling like this was completely “normal.” When one comes off the walkway, however, much greater effort is required to simply keep up.

Similarly, as opposed to a truly free market that efficiently allocates resources, we have had a period of Fed activism, a financial equivalent to the effect of that moving walkway. Marks notes that, for investors who bought assets on borrowed money, these conditions were a double bonanza.

Related to that, he notes his surprise that the Fed left such conditions in place as long as they did. Marks comments that setting interest rates at zero is an emergency measure, not a measure that should have been left in place as long as it was. He finds it hard to believe that the Fed does not now believe this was a mistake, one not to be repeated.

Importantly, this distorted the behavior of both the market and its participants. Risks were borne that otherwise would not have been accepted. In terms of why the markets may have still held up as well as they have, Marks observes that stock market participants tend to be optimists, always believing that someone will buy their shares for yet higher prices, and that optimists tend to surrender their optimism only grudgingly.

In summary, we have had an extended period in which ultra-low interest rates have benefited assets and those who owned them via equities, simultaneously hurting savers and those who owned debt instruments, such as bonds.

However, Marks believes that the tide has now clearly turned. Building on the themes laid out in Sea Change, as summarized in my bullet points above, Marks believes that investors today can get equity-like returns from investments in credit.

As an example, he points out that in early 2022, high yields bonds only yielded about 4%, not exactly a compelling return. Today, they yield more than 8%. A well-constructed portfolio, even allowing for some measure of default, could meet the needs of an investor requiring a 6% return.

Marks reminds investors of a significant difference between the returns of bonds and stocks. While stock returns are at the whim of Mr. Market, the bulk of returns from bonds are contractual returns. To be specific, Marks is referring to the fact that, when owning stocks, nothing is actually promised to the investor. Even dividend-paying stocks can cut such dividends during difficult times. In contrast, bondholders actually hold a contract, where the borrower promised to pay interest every six months, and your money back at the end. In the case of bankruptcy, bondholders have first claim to a company’s assets, before any stockholder will be satisfied.

In conclusion, Marks suggests that credit investors can access returns today that:

• Are highly competitive with historical returns on equities

• Exceed many investors’ required returns

• Are much less uncertain than equity returns.

As a result, Marks suggests that significant reallocations of capital towards credit are warranted.

Michael Smolyansky - Federal Reserve Research Paper

Real longer-run stock returns [for the U.S. stock market] in the future are likely to be no higher than about 2 percent, the rate of GDP growth.

This is the dramatic conclusion of a recently-released paper by Michael Smolyansky, published under the Economic Research section of the Federal Reserve website.

I previously wrote a lengthy and detailed article on Seeking Alpha summarizing this paper. Due to SA’s exclusivity agreement, I can only share the gist of it here, supported by the link to the original article I provided above. Readers who have the time and interest can also head directly to Smolyansky’s original work, also linked above.

The author begins by featuring that, from 1989 to 2019, the S&P 500 index grew at an impressive real rate of 5.5 percent per year, excluding dividends. Over this same period, the rate of U.S. real GDP growth was 2.5 percent. Over that roughly 30-year span, then, the real return from U.S. stocks outpaced GDP growth by some 3 percent, or more than twice the rate of GDP growth.

The question becomes; What accounts for this enormous discrepancy, and is it sustainable?

Here is the crux of Smolyansky’s novel contribution to the discussion. Rather than attempting to reword it in any fashion, let me simply quote a key snippet his explanation.

My central finding is that the 30-year period prior to the pandemic was exceptional. During these years, both interest rates and corporate tax rates declined substantially.

Simply put, Smolansky states unequivocally that his outlook for stock price growth is bleak.

He believes that an optimistic outlook is that interest and corporate tax rates remain close to their 2019 levels. In this scenario, corporate profits could only grow by as much as EBIT. He further questions whether current stock pricing reflects an understanding of what he lays out in his analysis, and whether it can continue.

Lastly, and perhaps most importantly, he states the belief that the risks to his forecast are, if anything, to the downside.

Again, please bear in mind that, due to my exclusivity arrangement with Seeking Alpha, I had to greatly condense what I shared here. Please, if you are at all intrigued by Smolyansky’s work, take the time to read either my linked article or the original work itself.

Summary and Conclusion

While both of the above articles came at the challenge from different perspectives, I couldn’t help but be struck by the concept that the underlying conclusions are remarkably similar.

Basically, these boil down to: Don’t make the assumption that the behavior of the related asset classes over the past few years is any indication of how they will continue to behave. Essentially, both analyses posit relatively muted returns in stocks for the foreseeable future.

As I freely admit in my Q3 2023 portfolio review, I may have been a little bit early to the party in terms of moving an allocation into bonds, particularly longer-term bonds.

However, one must always remember the concept of risk vs. reward. Let me close this article with a tweet thread from Jurrien Timmer of Fidelity. While the entire thread is meaningful, it was the second tweet that really caught my eye.

As I continue to contemplate how to put the roughly 30% cash in my portfolio to work as time moves forward, a lot of my thinking relates to the dilemma posed in the last 3 tweets in the thread above. It’s great getting that 5% money market return right this minute, but Timmer accurately captures the bigger challenge.

OK, that’s all for today. I hope that this article has given you much to think about, in the unique context of your personal situation. As always, I welcome comments, discussion, and even critique in the comments section below.

Finally, if you have friends, family, coworkers, or anyone else whom you believe could benefit from my work, I would be honored if you would share it.