Footnotes – June 2024

Footnotes will be a monthly publication which follows our “First Friday” webinar presentations each month.  The goal of the Footnotes publication is to summarize our “First Friday” presentation’s most important data points, which will make it easier for The Abernathy Group Family Office members to make intelligent decisions based on facts and data – as opposed to potentially conflicted opinions – from the mainstream media.

Click here to view the corresponding First Friday Video

Commentary from the June “First-Friday” meeting:

June’s “First Friday” meeting discussed the prevalence of illusions.  Illusions combined with clever narratives frequently charm the best of us.  And when you mix market appreciation with narratives focusing solely on the positives, realities surrender to perceptions. 

Over the course of history, prosperity has discouraged demanding work.  Lax behavior goes unpunished.  Eventually this behavior leads to the downfall of every great civilization.i  And while this discussion is not insinuating America’s decline, it focuses on the “recency-bias” created by prosperity, and the lack of due diligence and critical thinking prosperity encourages. 

“Recency-bias” creates the convincing narrative that events taking place most recently are likely to continue into the future.  “Recency-bias” completely ignores the lessons of history.  “Recency-bias” combined with overconfidence and the siren-song of convincing narratives most often creates regrettable investments.  These persuasive narratives focus on the short-term positives while ignoring the realities of history which include the full cycle – not just the recent past. 

We discuss the fact that prosperity tends to create lax behavior.  Lax behavior frequently leads to lazy due diligence, which leads to decisions based on the information which is easiest to acquire, NOT the information which is most relevant to your decision.  Eventually, lax behavior and the fear of missing out (“FOMO”) overwhelms reason and logic.  Regrettable decisions often follow. 

How does an intelligent investor overcome the Siren-song of prosperity, “FOMO,” and the narratives constantly repeated by the talking heads in the press?ii 

Focus on signals, ignore noise.  Concentrate on leading indicators, ignore lagging indicators.  When the future is uncertain – increase diversification, reduce your risks.

As a short reminder to each Family Office member, The Abernathy Group Family Office has now had 12+ “First Friday” webinars.  All of them are available on our website and “YouTube” Channel if you would like to go back and see how we have interpreted the economic signals, while doing our best to cancel the noise over the last year plus. Our goal: to help our Family Office members save time and make intelligent decisions by ignoring information with little predictive power and focusing on data with the highest probability of telling us what is to come.

Today, we are going to discuss why investors are surprised so often. 

What are illusions and how do we guard against false certainty? 

What are today’s identifiable illusions and why do illusions often create a siren-song of prosperity, while simultaneously increasing the probability of disappointment to come?

And of course, we will end with our best ideas about tactics each investor can take to reduce and at times avoid the disappointment which follows surprises. 

Slide 2

As everyone knows Illusions are all around us.  Most of the time illusions are created by those trying to sell us a product or service.  And in those instances, our guard is up.  We are aware of the biased conversation created to highlight benefits and eliminate negatives. 

Yet equally often, illusions are the second order effect of herd mentality or confirmation bias.  Many times, illusions are convincing because they are repeated so often the public starts to believe the illusion.  The illusion eventually becomes the narrative.

In an effort to keep our comments shorter than normal today, let’s focus on the influence illusions may be having on a declining U.S. economy, an overvalued stock market, and rampant speculation… all of which tend to end badly. 

Slide 3

Today, the stock market is valued at 21 X earnings and paying a 1.2% dividend. 

Is this a reasonable valuation based on all of the information available regarding our world and our economy?

Many of us on this call are investors in real estate.  Let’s use a real estate investment to estimate a fair value for the stock market today, as most of us can easily relate to real estate investing. 

How many of us would buy a property with a 1.2% rental return each year, when rental income is typically 5-7% of purchase price? 

Ok.  Maybe that’s not fair.  Let’s refocus our comments on the stock market for the time being. 

So, how many of you believe buying a stock with a 1.2% yield offers a high probability of that investment delivering a reasonable return of 9% per year over the next 5 + years? 

Most of you might say, well the yield is only one dimension of return.  You are not including the expected appreciation in the underlying value of the asset delivering a 1.2% current return, so the 1.2% current return is on top of the appreciation. 

And that is a fair response. 

However, if, upon further diligence you found out that the asset’s current price relative to average historical valuations, was in the 90th percentile – meaning – in 90% of the cases over history, financial assets were valued at lower levels (and receiving higher returns).  And what if you then found out that last year, the assets earnings increased only 5% – yet the assets current price increased by 30%? 

*Current prices in today’s markets imply earnings must increase at over 10% per year for the next 5 years – to justify current prices.  (Note: history clearly shows the market’s earnings have increased at less than 3%/year on average over the last 100 years).  Would that change your interest in investing in an asset planning pay you 1.2% over the next 12 months? 

Our belief: the market’s expectations of earnings growth of 10-12% or more, over the next 5 years, are unlikely to be achieved. 

The reasonable question is: Why do we believe the stock market’s earnings will not increase at 10-12% per year for the next 5 years?  The answer is simple.  Over the last 100+ years our U.S. economy (called U.S. Gross Domestic Product (GDP)) grew at just under 3% per year.  Our stock market’s earnings (which make up the majority of our nation’s GDP), grew at just a bit under 3% per year. 

Over the last 20 years our stock market has appreciated by over 10% per year.  How did that happen? because we had interest rates at historically low levels, financial leverage at historically elevated levels, and taxes which declined to the lowest levels in the last 60 years.  All three tailwinds supported increased earnings – thus higher asset valuations. 

However, we are unlikely to have the tailwinds of those fortunate variables over the next 20 years.  In fact, it is more likely that those tailwinds will become headwinds over the next 20 years. 

SO – with the stock market valued at more than two standard deviations above fair value, with a 1.2% dividend rate, we do not believe this to be a fertile environment for investors expecting appreciation. 

Let’s move along to the next topic – which is why investors are led along to the Siren-song of prosperity.

Slide 4

Firstly, for those of you unfamiliar with the features of a Siren song – it is a myth described as an alluring melody which convinced sailors to venture into unbecoming waters – it is remarkably similar to a mirage on land. 

However, the media is incredibly talented at creating an appealing narrative by mixing a few facts with lots of hope, and at times, fiction.  In short, all investors MUST remember the media is paid to sell advertisements, which means they want your eyeballs and attention.  The best way to get your attention is to offer alluring information (or shocking headlines).  At our firm we say Incentive Dictates Behavior™ and this fully describes the reasons media’s constant Siren-Song leads investors to believe the environment is much better than it truly is during good times, and much worse than it truly is during tough times

As an intelligent investor, it is valuable to remember expectations are probably not as good as the world expects during good times and not nearly as bad as the world expects during difficult times. 

Now – why does the Siren-Song of our current prosperity eventually lead to disappointment? 

Slide 5

The simple explanation to this question lies in the centuries of history which clearly documents the fall of all dynasties. 

As the slide shows, prosperity creates comforts which leads to lax behavior.  As citizens are more well off, they tend to spend their assets on creature comforts.  As wealth becomes more abundant, those who toiled long hours, and took the risks of innovating and starting their own companies do not want their children to have to go through the difficult periods of pain and strife their parents went through.  So, over time each successive generation reaps the illusions that rewards of entitlement lead to a better life.  Work ethics tend to dissipate.  “Shirtsleeves to shirtsleeves” in 3 generations becomes a vivid reality. 

At the same time “recency bias” (the tendency of a person to rely on the most recently available information most heavily, rather than relying on the relevant facts and data) convinces the public to believe current events will continue forever.  Over time, by consistently ignoring history, and relying on recent events, your reason becomes hostage to the current events being shouted by the talking heads, newspapers, and media – paid to sell advertisements – not to help you make intelligent decisions. 

This brings us to today: 

Is our prosperity an illusion?  Our training as analysts demands that we look at all sides of the coin, at all data, and not be swayed by recency bias, or confirmation bias, or any other bias. 

Our government has approximately 125% of its GDP in debt.  Our U.S. deficit spending over the last 2 years has averaged over 1.2 trillion per year, with almost $2 trillion in deficit spending scheduled for next year – meaning our government is donating money to our economy, which gives us the illusion of prosperity, when in reality – we are digging a hole of debt that is unsustainable.    

So as we discussed last month in our “First Friday” webinar: if there was a company for sale for $10 million that was losing $1 million per year in operating profits, yet had a rich uncle Sam, which was donating $1.5 million per year into the company, thus allowing the company to show it was offering the illusion of (non-operating) profit of $500,000 per year, would you want to buy this company for 21 times its profits (by the way, this means you will be buying the company for a bit over $10 million and losing $1 million per year… if Uncle Sam dies or decides he wants to stop funding this company with $1.5 million per year)?

(Note the U.S. economy grew at less than 3% in 2023.  Government spending in excess of U.S. revenue (defined as the budget deficit) in 2023 was almost 7%.  3% growth, with a 7% deficit spending brings the above metaphor into sharp alignment with our current U.S. economic reality.  This means without the help of our Uncle Sam; our economy would be shrinking (called a recession).

As long as our Uncle Sam continues to contribute to our economy at the trillion-dollar level, year after year, all is well.  However, the likelihood of this continuing is low, and when it stops, there will be hell to pay. 

We believe our U.S. is in a period of prosperity today.  Unfortunately, this prosperity is skin deep; an illusion being falsely inflated by fiscal spending that has no return on investment and at some point, will end. 

So how do we defend our investible net worth against an economic backdrop with a high probability of having its tailwinds of good fortune turn into headwinds, with a sword of Damocles above its head in the form of $35 trillion in debt? 

Slide 6

First, it is important for each investor to separate the signals from the noise. 

Remember signals are data which offer insight into the future.  Signals provide causal data, meaning these signals actually influence the future to come.  As an example – the inverted yield curve is causal – meaning it causes our U.S. economy to slow – it is a Signal. 

The inverted yield curve – short term rates which are higher than long-term rates – discourages borrowing.  In any economy (like the U.S.) which is dependent upon borrowing to finance growth, an inverted yield curve is meant to slow the economy.  And it has NEVER failed to slow the economy with almost a 90% chance of throwing our economy into a recessioniii – and with $35 trillion in debt, the risks are magnified significantly.

Next, intelligent investors will follow leading indicators as opposed to lagging indicators or data.  Why? because lagging indicators have little to no forecasting value.  We are – as investors – trying to find indicators and data which tell us something about the future to come, and using lagging indicators is a recipe for failure.

And the importance of diversification cannot be ignored as no indicators are infallible. 

The rule most worthy of remembering is “the more you know, the less you diversify, and the less you know, the more you diversify.”  When you combine this rule – which must be obeyed at all times, with the effort to avoid overconfidence, you will arrive at the need for broad diversification during periods of uncertainty.  *Remember each of us is wired to believe we are above average.  This coerces us to believe we are right more often than wrong – we call this overconfidence – and when you are overconfident in a market as sophisticated and as intelligent as the global capital markets – you are competing against millions of investors who are more well-armed with technology and money than you are, and they spend 70-80 hours/week on research and data analysis. 

This brings us to another topic which may offer some help. 

If our U.S. stock market is as overvalued as the data suggest, where do investors turn? 

One way to diversify is to expand your subset of investment alternatives.  Currently, non- U.S. markets offer lower valuations, and higher dividend payments of approximately 2.5%. 

Slide 7

Here is a chart which compares the current U.S. and non-U.S. valuations with the anticipated growth rates and dividend yields.  This research clearly shows U.S. stock market it overvalued and likely to deliver negative returns over the next 7 years, while non-U.S. markets are more likely to deliver appreciation/growth than U.S. markets.  Uncertainty demands diversification.  While the chart below is unlikely to be exactly correct in its predictions, until a correction takes place to bring the U.S. stock market back into an attractive valuation range for intelligent investors, investors should open their investment aperture and consider alternatives. 

The chart above shows Emerging Markets are the markets with the best risk/reward relationships and the highest dividend yields. 

While we don’t have time to go into this now, we can talk to anyone interested in the data supporting this information and the risks involved with each investment category, when your time allows.

Slide 8

I will take just another moment to point you to another study by a different company with an incredibly responsible and thoughtful analysis which details the valuations, country by country, under three different scenarios.  This table supports the notion of diversification and the notion that other markets may offer more attractive yields that the U.S. markets are currently offering. 

If anyone would like to discuss this table in more detail, let me know as the slide is terribly busy – yet in summary it says the non-U.S. markets are more alluring than the U.S. markets by a long shot. 

Slide 9

Let’s stop here and check in to take the questions I believe we have on the docket so far along with any new questions which may have come in during this discussion. 

Marissa, I saw some questions coming in… if so, can you let us know what they are?

Marissa:

Yes.  I have two questions which have come in –

The first question is –

The employment numbers came in this morning that were significantly above everyone’s expectations – which signifies a stronger U.S. economy that most thought.  What does this mean for the probability of the U.S. Federal Reserve lowering interest rates?  And as a follow on, if interest rates are not lowered, what does this tell us about the economy to come? 

Answer: The first thing to remind all of us as investors – do not rely on a single number, as the U.S. economy is incredibly complicated.  These data can easily change from month to month.  

I am not trying to dodge the question, it’s just that these monthly numbers move up and down and its more likely that the value of these numbers (which are lagging – hindsight with little information about the future) are more likely to be valuable by averaging 3 or 6 months of data, rather than 1 month’s reading.  Now that said, 280,000 jobs created was in context to an expectation of 180,000, and a whisper number from the economists of 165,000.  So, this was a major surprise, and may mean the rate cuts scheduled for July are off the table, unless something in the economy breaks and we get into some kind of trouble. 

By the way, with the U.S. Federal Reserve keeping rates higher for longer, each day the probability of something which is unpredictable happening increases.  So higher for longer rates tell us the odds are increasing that we are headed for a recession.  We believe the U.S. Federal Reserve is interested in lowering interest rates which will either help the U.S. economy avoid a recession or hopefully make the recession to come a milder recession.  With our current deficits planned for the next few years and our current total debt outstanding, the last thing the U.S. economy needs is a recession, which on average, reduces tax revenues by 4-6%, thus adding to a 6%+ deficit already planned.iv 

I hope that answers the question, and if not, give me a call and we can discuss this further. 

i Immoderate Greatness a terrific book by William Ophals. 

ii Reminder the “talking heads” and the press are NOT analysts paid to supply you with the information needed to make intelligent decisions.  They are paid to generate headlines which get your attention which sell advertisements.  They have no track record of future predictions. 

iii short rates are now higher than long rates and they have been for most of the past year.  This is concerning because past yield curve inversions have reliably predicted recessions, that is, sustained downturns in economic activity, as defined by the National Bureau of Economic Research (NBER).  (https://www.stlouisfed.org/on-the-economy/2023/sep/what-probability-recession-message-yield-spreads)

iv https://www.bloomberg.com/news/articles/2023-10-03/why-us-federal-budget-deficit-is-a-worry-again-and-will-remain-so

Click here to view the corresponding First Friday Video