April 2, 2019 – Canadian yield curve inverts. Is this bad for Canadian stocks?
LYFT goes public. Now what?
Apple expands its services offering. Why are they getting into TV, finance, gaming and news?
Schwab slashes financial advisor fee to $30 per month. Is this changing the game?
Brexit update. Will this unmitigated disaster ever end?
A discussion on various stock market timing signals including CAPE, dividend yield, Baltic Dry index, market cap to GDP and the yield curve.
Welcome investors to the Absolute Return Podcast. Your source for stock market analysis, global macro musings and hedge fund investment strategies. Your hosts Julian Klymochko and Michael Kesslering aim to bring you the knowledge and analysis you need to become a more intelligent and wealthier investor. This episode is brought to you by accelerate financial technologies. Accelerate because performance matters. Find out more at www.Accelerateshares.Com.
Julian: Welcome ladies and gentlemen to the Absolute Return Podcast Episode 7. Today is March 29th, 2019, I am your host Julian Klymochko.
Michael: And I’m Michael Kesslering.
Julian: We’re really excited to chat about a bunch of things this week. We’ll talk about various stock market timing signals including CAPE, dividend yield, the Baltic dry index, market cap to GDP and the yield curve. We’ll give you an update on Brexit, which is an unmitigated disaster. We’re pretty excited to talk about that. Big news in the financial advisor space with Schwab launching a $30 per month subscription service. In technology, Apple expanded its services offering with tv, finance, gaming and news offerings. Ride-hailing firm Lyft goes public and lastly, we’ll chat about the Canadian yield inverting as it recently followed its U.S brethren.
What we mean by the Canadian yield curve inverting that refers to the 10-year Canadian government bond that yield dipped below that of the 3-month Canadian treasury bill yield. So that is the inverted yield curve and it’s a pretty big deal. Because there are numerous implications for this. First, I want to chat about why this happened. Well we are going to look at two things. Number one we look at the front end of the curve. The short-dated paper being the three-month treasury bill yield and that typically follows what the Bank of Canada is setting as its benchmark rate. So, over the past number of years the bank of Canada has been hiking off credit crisis low interest rates and so that has brought up short term yields. Then on the back end looking at the 10-year bond, what has brought that down and it’s come down pretty dramatically. I remember back in November it was north of 2.5 percent and now this week I believe it’s in the 1.54% range. So that’s firmly below inflation. Which means a negative real yield for 10 years. But in any event, they say that the yield curve is the best economist out there. It has numerous market implications, right?
Michael: Yeah yeah and so I guess in terms of being the best economist out there I just first wanted to point out kind of its spotty track record is that, so it has successfully signaled a recession in the early 1990s. But then gave false positives of recessions in 1986 and 2000, where they actually didn’t show up. As well inverted in 2006 which was well ahead of the 2008 crisis.
Julian: And this is Canada, right?
Michael: Yes, yes this is focused on Canada and also failed to predict the recession in 2015. So, I think it just kind of highlights the importance of testing whether it be a macro factor or more of a micro factor across different geographies and locations as the yield curve inversion at using it as a factor for predictive value has worked out in the U.S, but not so much in Canada, Japan, certain areas of Europe. So, I was just wondering you know do you think there’s any systemic or you know economic reason that it hasn’t had the predictive power that it’s had in the U.S, in Canada and abroad.
Julian: It’s tough to say certainly there’s some unique dynamics in different markets. You know Japan has had very very low interest rates for a very long time at a very flat yield curve. So, an inversion really doesn’t mean nearly as much over there as it does here and that’s a much more I’d consider a manipulated market. The Bank of Japan really loading up on bonds, JGB’s or Japanese government bonds. Another thing I wanted to talk about is what this means for interest rate levels at the bank of Canada and so I indicated over the past few years they’ve been on this rate hiking cycle. But what an inverted yield curve does it takes all of that right off the table. Like no central bank would hike rates into an inverted yield curve and what some economists are now predicting, I saw one calling for three rate hikes, two to three rate hikes in the next 12 to 18 months. Certainly, the market is starting to price that in. Certainly not pricing in any rate increases this year and so if you are say looking for a mortgage, keep that in mind that we might start seeing interest rates come down. You might be able to benefit from a variable rate mortgage if the Bank of Canada cuts their target rate by you know 0.75 percent, which would be three rate cuts. You can see a dramatic decline in your mortgage rate on your house.
Michael: Now do you think there’s a possibility of three rate cuts without a recession?
Julian: It’s tough to say. A lot of it depends on what they’re doing at the fed. Bank of Canada policy typically follows what they’re doing in the U.S and the reason they do that, it’s really to try to manage the currency. They don’t want the loonie to rally too hard. Which would be you know pretty punishing on the economy. Another big variable is the price of oil. Now the price of oil, WTI and Brent have been doing well. But a lot of the pricing that Canadian producers receive has been at a big discount. So that’s been tough for the Canadian economy as well. Alberta recently had you know forced production cuts. Which really affected the Q4 economic numbers. So, seeing a lot of slowdown in the economic numbers in Canada and if we look outside the country and you’re seeing something similar globally. I mean pretty poor numbers coming out of China and Europe. So, everything is pretty much one system. So, one country can’t be looked at in a vacuum. You really need to take a global perspective what’s going on in Europe, what’s going on in Asia. Because those really affect what’s going on in Canada and the U.S. from a central bank perspective, from an economic perspective and lastly from a stock market perspective.
Big IPO hitting the market today with Lyft going public on the Nasdaq, it is popping what 8% on its first day, It started the day off quite a bit higher probably around 15,16 percent but sort of declining into the end of the day. I should mention that it was priced off a $72 IPO price and this was actually up-sized, or the range was increased. They initially went out at $62 to $68 per share and then just two days into their roadshow, the book was entirely covered. Meaning all the money they’re raising which was over two billion dollars, there was demand after two days of marketing to investors. So certainly, a very strong IPO, a lot of demand. I want to talk about some fundamentals on the company here and so they had over two billion in revenue in 2018. This is an increase from 343 million in 2016. But should also mention that they are suffering increasing losses each year. So, on that two point one six billion in revenue in 2018, actually posted a loss of nine hundred and eleven million dollars. So nearly 1-billion-dollar negative net income into their IPO and I believe that is the largest for a start-up going public. What are your thoughts on this deal?
Michael: Yeah, I just wanted to bring up their insurance reserves actually and some good reporting from the financial times. They mentioned that on there are about two point two billion dollars’ worth of revenue in 2018, that Lyft accumulated about 430 million in insurance reserves, that’s about 20 percent. So those insurance reserves are actually placed in cost of goods sold, therefore lowering their gross margins. So that brings their gross margins to only about 42 percent. Which is substantially lower than a typical enterprise software business that people thought they might be valued similar to and so what they have been doing is burning through those reserves quite quickly. Their loss is paid out in 2018, about fifty nine percent of their insurance reserves going into the year. So why I’m bringing this up is that number one looking at the company, it’s a low gross margin business with potentially a risk asymmetry in terms of the insurance reserves in terms of whether they could be actually under reserving. Since they do have limited operational history, don’t really know if those insurance reserves will be sufficient to cover their future losses. So, it’s something to consider when looking at this company and how important insurance is to this company overall.
Julian: Yeah, I wanted to touch on two future dynamics of Lyft and these ride-sharing companies. Number one is their path to profitability both Lyft and Uber have been just burning a ton of cash and when Lyft went public in their marketing, they had zero plan to get to profitability. Which obviously as an investor is a huge concern. They’re certainly growing revenue significantly, but how are they going to convert those massive losses into profit? Especially when they’re against a voracious competitor such as Uber who now has seventy percent market share, Lyft was and always has being the underdog. They battled to a 30% market share. But in my opinion, it’s starting to become a somewhat commoditized product. It’s difficult to raise prices not because those two are in such intense competition. But you obviously also have the legacy taxi drivers, which you know could undercut any potential price increases. So that’s another interesting dynamic right there.
Michael: Yeah in terms of competition something that the founders mentioned on Bloomberg today in their interview was that they view their number one competition as car ownership. So that’s an interesting take that they have on their business. Another aspect that I was looking today is with this IPO who’s making money and so their co-founders, their stakes are worth a combined one-point four-ish billion, it may have gone down a slightly. But also, which is a lofty amount. But also, GM, general motors actually has a stake of six-point eight percent of the company which is worth about one point four billion, 1.5 billion as well. So that’s kind of interesting. But in terms of the actual IPO itself Julian how does an investment banker actually price an IPO?
Julian: Yeah there’s a lot of art that goes into it. They have to correctly gauge investor demand. They go marketing and get some feedback and see how the book of orders really builds and as you see this one they went out with an initial range, which I assume that they solicited heavy investor input previously and from that range as they booked orders they actually ended up increasing it by nearly 20 percent. But ultimately was what some of these IPO pops when you get an IPO going up twenty thirty percent or even more the first day, you got a wonder is that a poor job on the investment bankers’ side. You got two interests to balance. You want to balance the company getting the money you don’t want to sell their shares too cheaply, but you also want investors taking the risk on the stock to show a gain as well. So, you’re trying to balance those two interests. Try not to leave too much money on the table while trying not to have an IPO that tanks the first day. One aspect of these private companies is they’ve raised as you indicated a lot of money in the private markets. For example, Lyft just did around last year when they were private at fifteen billion. Now in the public markets they’re being valued at twenty-four billion. You talked about GM, well GM invested half a billion at, five and a half billion dollars round I know Carl Icahn got in this one pretty early. I think he led a round, he had about a 10x return over the years and the Japanese company Rakuten led 680 million dollar round in 2015. So, a lot of players got positioned in this one and certainly a lot of private market investors showing pretty substantial gains. But this is another IPO where we’re seeing the multi-voting shares isn’t it?
Michael: Absolutely and you know something that’s a common theme in our podcast is corporate governance and so in terms of the founders themselves, I mentioned that their stakes were within that you know one point four-billion-dollar range. But indicating that they only actually owned about 5% of the economic voting or economic interest of the company. But in terms of voting rights they actually owned 49% of the voting rights for the company. Which is although below 50% it effectively gives them control of the company.
Julian: Yeah you know my attitude – one share one vote. I believe we will see Uber coming public shortly, at least this year most likely and I think Uber is going to not do it the dual share class structure and so that’s positive. I mean the more companies that use it I believe that’s negative for capital markets. I’m always a big fan of equality within shareholders. So, we’ll see where these new startups come public at.
Michael: Absolutely and in terms of Uber its I read an interesting tweet the other day that was indicating that if Travis Kalanick, the former CEO and founder of Uber who is as a very colored history with the company, but it known as being ultra-competitive that if he still was involved in the company that likely they would have filed their S-1 last night after Lyft came out with their indicated pricing to effectively try to kill the demand the next morning when the shares started trading. Which would have been a really interesting competitive dynamic.
Julian: Yeah that would have been interesting to see. But for now, Uber has not filed yet, but will be on the lookout for that one.
Big news out of Apple this week as they showcase new offerings in tv, finance, gaming and news. So, they’re really trying to transition from an iPhone centric company to a more services-oriented company and the reason is their iPhone sales of really plateaued, I believe last quarter they reduced guidance. The markets kind of getting saturated with iPhone and each subsequent version hasn’t really had the game changing nature to get consumers to upgrade and so what they’re looking to do is capitalize on their massive billion plus device user base and earn more revenue from those devices through services such as these which offer more recurring revenue. Which investors like to see and clearly that’s much better for the company’s financials and let’s get into the details of what they’re offering.
So, number one, they’re offering the apple card which is there a foray into credit and financial services. They actually teamed up with Goldman to offer a digital credit card that’s supposedly much cheaper than any other offerings out there. Then they’re offering Apple news, $9.99 per month monthly service that gives you access to 300 plus magazines. Apple arcade, which is a gaming subscription service and on this one they’re actually going to have exclusive games and one of the biggest ones is their Apple tv app. So tv plus, which they’re going to have I believe a lot of exclusive content. I think that they’re going to invest 1 billion annually in producing content. But I mean that really pales in comparison to what Netflix and HBO are investing into their offerings and I really wanted to comment that the online content scripted original and series market seems to really become saturated. There were 496 series in 2018, which is massive growth. It grew 40% since 2014 in terms of the number of streaming shows. If you talk to people, there’s pretty much just too many options out there and too many shows that no one is watching, and you got Netflix, who’s just producing a ton of original content. You got HBO, now Disney coming out with a streaming app as well. So, what are your thoughts on this whole dynamic and what Apple’s up to, think they can compete?
Michael: Yeah so, your comment on Netflix and what their spending is they spent 12 billion on content in 2018 and they plan to spend 15 billion in 2019. Now Apple they have a cash balance of 120 billion dollars? They have a massive cash hoard. So, they have no problem with spending that amount of money. But the issue I guess is whether they have the organizational willpower to do so. Being a cash cow business, their business lines right now are just generating a ton of free cash flow. But with that in mind basically competing with Netflix, because they have a lower subscriber base is that if they’re going to bid on similar shows as Netflix and similar you know talent, they will have to pay you know the same or more as Netflix. The issue being is that they by definition having a lower user base if they’re charging a similar amount for the services, they’ll have a lower break-even or a higher break-even cost and so as a company if they’re losing money on a number of these shows you know shareholders may react poorly to that to not be able to see the long-term strategic necessity of paying up for content. So that’s something to keep in mind here.
Julian: The thing about Apple is they just have a massive built-in competitive advantage. Because everyone uses their devices right. So, if they want to get into a business and look at all the business models they effectively invented. They invented the podcast. So, thank you Apple. They also invented effectively invented streaming, streaming music as well. So, they can really get into these markets and dominate. So, we’ll see how they do, and I wouldn’t bet against them and they still have the iPhone cash cow. Which provides a tremendous amount of free cash flow annually and they have been utilizing a substantial portion of that free cash flow to buy back stock and issue a dividend. So, if they can invest in growth initiatives as well, I think shareholders would be fairly you know receptive to that. As long as it fits within a balanced capital allocation program and it seems like if that really is the case a billion dollars a year isn’t that significant when it comes to Apple obviously.
Michael: Absolutely and then in terms of sentiment I found it interesting with the Apple card is that just looking at the sentiment is that the public seems to be more worried about apple having more information on their customers than they are about Goldman Sachs having more information on customers. Which is a far cry from how the public perceived the large investment banks post-crisis as opposed to now.
Julian: Oh yes, the vampire squid. Well we’ll see how all this plays out. I think Apple’s on to something here. I went and bet against them and they’re likely to be tremendously successful in my opinion. So, we’re pretty excited about these services and I’ll likely subscribe to all them and then see how they go. Interesting news and financial planning.
So, we have a Schwab debuting a subscription-based financial advice service for only $30 per month. So, this is perhaps a shot across a bow or even a neutron bomb on the financial advisor business. So, advisors have long stuck to a 1% of assets fee. Which for a million-dollar account is $10,000 a year for advice and some advisors certainly provide a very valuable advice. But there’s a number of financial services companies looking to undercut that, and thus far Schwab is by far the most aggressive. So certainly, big implications for advisors and just the way people handle their investments in general and so I got an example here. If we do look at an advisor portfolio and what this Schwab service does it actually gives you access to a certified financial planner. So, it’s not a robo advisor. Schwab actually has a robo advisor that is free, they don’t charge anything for it. But this service they call Schwab intelligent portfolios premium service, it actually gives you unlimited access to a sort of certified financial planner. So, it seems pretty interesting and if we look at an example on a million-dollar portfolio, the standard 1% advisor would charge $10,000 per year. Another firm betterment they have a service for what would be four thousand dollars per year, it was zero-point four percent. Vanguard at zero-point three percent or three grand. So, this Schwab fee which 30 bucks a month is $360 per year is a massive discount not just to advisors. So note that’s ninety five percent lower, but it’s even you know one tenth of their competitor’s Vanguard and Betterment. Certainly, that changes as the total assets decline. But certainly, a massive change in the financial advisor’s space and I certainly think that we’re going to see a lot more of this. If you look at the fund management space, it’s become commoditized where and you can get S&P500 ETF or these broad-based index ETFs for just point zero three, point zero five percent. So, you’ve had a lot of fee wars in that area and now we see the fee wars coming to the financial advisor’s site. So, what are your thoughts on this?
Michael: Yeah, I really see this as the ETF issuers whether they’re being forced to or just choosing to through competitive dynamics getting closer to the end customers and what I find interesting is the strategy’s pursued by these different ETF issuers. So, Vanguard and Schwab they’ve launched their own wealth management services. As you’d mentioned Schwab’s, but Vanguard advisory services they only charge 0.3% fee and that can get all the way down to just five basis points and whereas BlackRock who issues iShares, they are targeting technology services that advisers use and they’ve targeted that through acquisitions as opposed to building their own and then State Street actually has chosen not to compete at all with advisors using that as a differentiating selling point. However, their flows still trail Vanguard and Schwab and so one aspect that I did want to touch on as well is the question always comes is how is vanguard able to pursue such a low-cost strategy and yes economies of scale do matter. But the other aspect is that they actually have no profit motive that the company is effectively owned by its funds and so what that means is that they’re utilizing a mutual ownership model, which operates the company at cost. So exactly what the funds cost to produce and then uses the profit to further reduce investor fees. So, it’s really just a completely different model than these other players have, where they actually are looking to make an economic profit from the management of these funds and so I guess Julian where do you see us going from here?
Julian: Well I think of the ETF side and the asset management side those fees are rock-bottom already. You talked about believe the S&P500 ETF is three basis points. So even if those go down to 0% which maybe they will at some point, that really doesn’t move the dial much for investors when you’re talking about three one hundredths of a percent. But obviously there’s going to be massive change in the financial advisor space with a massive undercutting and big technological change from companies such as Schwab. Because I’m sure Betterment and Vanguard won’t be too far behind this. They’ll be trying to catch up here.
So, I wanted to talk about if you are an advisor what should you do about this? Well obviously, you want to protect your profit margins. You want to protect your 1% fee. So, the way to battle the it’s really just offering a superior service and there’s a number of areas you can focus on to offer a better service than Schwab can and the other firms really pushing down price. Number one could be proprietary deal flow. Perhaps you can give clients access to unique securities or initial public offerings or something else that others can’t get. The other thing is perhaps you can offer better advice. Perhaps you can put together better portfolios. You certainly can no longer rely on the commoditized portfolios that robo advisors provide like 60/40 type things such as that. So, if you can put together I’d say more advanced model portfolios that certainly could set you apart and so there’s a number of things that advisors can do. I certainly hope that they can start focusing on those growth opportunities and really staying in touch with clients and ultimately providing a higher touch service. Perhaps you can add more value on the tax side, on the estate planning side, on the insurance side. So, there’s also additional verticals that an advisor can expand to just help keep that relationship such that their client doesn’t defect to one of these Schwab type offerings. Although not coming out in Canada that I’m aware of.
Michael: Yeah and just to back up your points with some statistics is in terms of model portfolios, Bank of America advisors are actually directing 29 percent of their assets to ETF model portfolios as well as you know on a survey of advisers what you’re seeing is that advisers are only spending about 40 percent of their time on asset allocation. Now in the past that number has been a lot larger and so what that means it’s like you had said advisers just have more time to add some of those more value-add services and let the model portfolios take off some of that work and Julian what are model portfolios exactly?
Julian: So model portfolios are custom allocations to various asset classes. Let’s say you know the traditional model portfolio is the 60/40 equities and bonds. But I don’t really think that’s sufficient and not for most to meet most investor’s needs. So model portfolio could include real estate, hedge funds, private equity all sorts of alternative strategies perhaps or more diversified global portfolio including international equities, emerging market bonds, currencies, government bonds, corporate credit, loans, high-yield. So, there are tons of asset classes that a model portfolio can incorporate, and it really depends on the client and so the main benefit of these model portfolios is it really frees up advisors’ time to focus on the client and interacting with the client, keeping that relationship beneficial for both and really working on meeting their needs. So, I believe that what advisors can do and some more value add is really just utilize these model portfolios, really ease the burden of asset allocation and focus more on client relations. Building their business and keeping clients happy.
And today is March 29, 2019 which is officially known as Independence Day for the UK or Brexit day. But as you can see that actually didn’t happen. The UK continues to remain in the EU with really no plan to leave. So, it’s just they’re mired in a dysfunctional quagmire and lawmakers really can’t agree on anything. So, what happened this week? There are actually eight different proposals on Brexit that went through parliament and British lawmakers actually voted against all of them. Which is somewhat shocking, because some of them we were actual opposites of each other. So, it seems like what we have here is just a really dysfunctional system where no one can get along. There’s really no leadership and it’s tough to see any sort of way out of this, what are your thoughts on this Mike?
Michael: Yeah I guess so Elizabeth May in her comments she you know prior to the vote she you know she issued warnings of future uncertainty and the possibility of no Brexit at all. But I guess my comment would be uncertainty has been caused by her and her colleagues and no Brexit at all. It may be favored by the country that you know at the very least it’s uncertain where the country stands on this and so do you think there’s any way forward without may calling a general election?
Julian: Who knows, no one really knows what’s going to happen here. As I said this has been a process. The initial referendum was in June 2016. So, it’s been over a thousand days and they’ve shown zero progress. The only thing that they’ve accomplished is massive international embarrassment for the country. But one positive thing to come out of this is its other countries within the EU such as Italy, Greece, France they’ve had nationalist parties that previously pitched the idea of leaving the EU. Now look at them, none of them have any interest in trying to leave the European union. Because they realize how much of an unmitigated disaster the UK has turned into and when it comes down to it they aren’t able to leave in a way that they initially pitched to voters that voted to leave. They thought they could keep all of the good and none of the bad. But it’s turning out to be pretty much the opposite and so they can’t even really come to any sort of agreement on any sort of exit from the EU.
The next key date is April 12th where they will try to either seek another extension or just have a straight up Brexit it or leave the EU without any sort of deal and no politician wants to do that. Because that would just be dive-bombing the UK economy into oblivion. No one wants to have that sort of blood on their hands. Yeah as you saw May even say she’d be willing to resign if they voted through her proposal. But thus far no luck on that one. There’s really no and no sort of outlook or insight into where any of this is going. But I believe ultimately the best way forward and the most likely, it may not be consensus. But I think ultimately they’ll end up at a second referendum. I believe the people have a right to vote again since they know how poorly it’s turned out and the leave camp were really just lied to. They were told a bunch of really just falsehoods on what would happen if they voted to leave and it certainly just hasn’t turned out that way.
Michael: Well it was taking advantage of human nature. I think people are emotional about the subject and in the original vote I think that the you know the powers that be were trying to garner a lot of those emotional factors in their favor and so though my overall view would be that you know it’s an interesting dinner party discussion, Brexit that is. But the execution of which is very difficult and really what truly matters in this situation is execution. It’s similar to running a company where you know the idea isn’t the novel concept. It’s the whole execution of the strategic business planning. That’s just something that you’re not seeing here. Yeah another really interesting aspect to consider you know the initial referendum was in 2016. So almost three years ago if you look at the demographics back then, you had older people voting to leave younger people wanting to remain and so what’s happened over the past three years is older people die off, more younger people become eligible to vote. So, the thinking now is the initial referendum was so close you know pretty much razor close fifty point something percent to forty-nine point something percent. If you were to restage that referendum, a lot of people are highly confident that the remain would win not just on the demographic changes, but also changing attitudes after they went through this whole quagmire over the past three years of really no progress being made. I think ultimately in ten years they’ll look back and remember that Brexit thing where nothing ended up happening and the UK ended up staying in the EU. But stay tuned we’ll update you on any major developments. But hopefully not too much, because this isn’t something we want to be talking about for the next three years right.
Wanted to touch on our blog post this week and we entitled the podcast Timing the Stock Market, Can You Do It. So, in our blog this week we touched on numerous stock market timing indicators. Since we’ve been talking about the inverted yield curve so much, we figured we’d touch on that in a number of other indicators that have worked historically. But most of them have gone on to not work and so the reasoning here is that in the market it’s a pari-mutuel system where traders and investors the more they you know bid something up, then odds get reflected in the price right and so if everyone is using the same indicator and everyone believes that indicator works, then it’ll certainly stop working. Because people have an effect on the outcome this the trading of the stock affects the odds, which will get rid of the effectiveness of the indicator. So, the first one I want to touch on is just the dividend yield of the S&P500 versus the bond yield of the ten-year treasury bond. So historically at least between 1928 and 1958 treasuries yielded two to five percent more consistently than the dividend yield of the S&P500. So, this went on for decades, until 1958 when the yield on the 10-year bond exceeded of the S&P500 for the first time and it effectively exceeded that and never looked back until I think around 2010. So, if you’re relying on that indicator, if you would only buy stocks when they’re yielding more than bonds the theory being that you want to have a higher income compensation to take on the greater risk of owning stocks. If you were to utilize that signal to exit stocks in 1958, that would have been a horrible decision. Because you would have missed out on a generational stock rally for the next 50 years. So that’s one indicator.
The next one and this is one that I actually really like is the Buffett indicator. So, what this does and obviously coined by Warren Buffett. It compares the total market capitalization of U.S stocks as measured by the Wilshire 5000 and it compares that to a U.S GDP. So, I want a quote Warren Buffett here. He says “if the percentage relationship falls to the 70% to 80% area, buying stocks is likely to work out well for you. If the ratio approaches 200% as it did in 1999 and part of 2000, you are playing with fire”. So, Warren Buffett ran a highly successful investment partnership when the first ever hedge funds started in the 50s and ultimately shut it down in 1969 once he couldn’t really find any very attractive investments that he could typically find relatively easy and in 1969 also what happened was that this Buffett indicator, the market cap to GDP, crossed 80% to the upside for the first time. So that really concerned him, he shut down his partnership and ultimately exited stocks. Which was quite a good timing on his part. Because there was a pretty brutal bear market and I believe 73-74 that took stocks down dramatically took his peers down pretty hard. I remember Charlie Munger had a pretty rough early 70s and took him quite a while to recoup that.
Michael: Those I believe that crash was the nifty 50 stocks which Howard Marks always discusses that crash where it was actually very high-quality stocks that were going down as an investor thought where you know invincible.
Julian: Buy at any price and I believe they ultimately bought them up to 70 times earnings, which was far too high of a valuation that they just couldn’t sustain. But if we get back to this, that stock crash actually brought the Buffett indicator back to a reasonable level. It’s around the 40 to 60 percent range for a while and didn’t cross 80 percent again until 1995. Once it went past that really never looked back, it stayed above 80 percent aside from briefly touching below that at the depths of the credit crisis in 2008-2009. But here’s another indicator that if you follow that and it was an indicator promoted by the greatest investor of all time, if you followed that then you would have been out of stocks for a long time. Since 1995 the S&P500 provided a total return of over 700 percent and the even Buffett didn’t listen to his own indicator. He was obviously running a Berkshire Hathaway and throughout that time period and that company will remain heavily invested in stocks and Berkshire’s total return 1995 to current was almost twelve hundred percent and so another timing indicator that has worked in the past but certainly has a spotty track record.
CAPE or the cyclically adjusted price to earnings ratio is another indicator. So, what this does it’s a valuation measure and it a verge is real earnings per share over a ten-year period to generate a smoother long-term earnings profile. This is one similar to the Buffett indicator that had pretty good signaling pre-1995 cape averaged 15 times. But after 1995 it exceeded 15 times and really never looked back. This was another indicator that similar to the Buffett indicator – if you listen to this one it would have kept you out of stock since 1995 say for that brief period during the credit crisis and I believe CAPE only dipped below 15 times for maybe a month or two in spring 2009 and that’s about it.
Classic – Baltic dry index, so if you’re investing throughout that credit crisis this was a pretty popular index back then. What this index measured was composite of freight shipping rates and it was regarded as a general shipping market bellwether. I don’t know if you’ve ever heard of Dr. Copper. But they say the price of copper is an economist with a PhD right and so here’s another sort of economic indicator, the Baltic dry index that people looked at for guidance as a leading indicator on where the economy and ultimately stocks are going. If we look at 2006 to 2009, up until 2008 the Baltic dry index really rallied as the market followed and then the Baltic dry index crashed during the credit crisis and brought stocks with it. Both the Baltic dry and the S&P500 rallied into 2010. But then 2010 came and the Baltic dry index really stalled out and then started a long-term decline. So many people would have taken this as a sign to get out of stocks. But if you remember stocks just continued to rally since 2010 or and are up multiples since then. Meanwhile the Baltic dry indicator remains near all-time lows. What happened there was there’s a supply side response, pretty much too many ships being built and that brought shipping supply way too high really crushing prices. So, there’s an indicator that also stopped working.
Michael: When you mentioned the Baltic dry index and looking at the actual chart of it actually reminds me of something that Derek Euale, the our head of research always says is that correlations are not static that they are constantly changing and so to kind of be wary of anybody who’s mentioning a correlation as just a singular static number is when you look at that chart it’s very clear that there’s no single correlation of those between the Baltic dry index and stocks.
Julian: Exactly. The next one, the last one we want to check out is the inverted yield curve. This has been in the news a lot. Since a week ago the yield curve in the U.S. and more recently Canada inverted and as we previously talked about in the podcast the U.S yield curve inversion has a very good historical track record at least since the 50s predicting recession and bear market. The Canadian yield curve more mixed in terms of its success has had some hit and misses. One thing I wanted to touch on is although the U.S yield curve inversion does have a good historical predictive ability in predicting recessions six to twenty-four months out, we want to look at the S&P500 returns since the yield curve inverts. Because that’s not nearly as clear and I think it’s more of a coin flip. If we look at the 12 month change after a yield curve inversion, the numbers are anywhere from negative 25% drawdown to a positive 38% return and if we average those out over eight to ten observations you get one point two percent and then 24 months after yield curve inversion, it’s also a wide range from negative twenty six percent to fifty two and a half percent to the positive averaging out at eight point six percent.
So, in conclusion our advice is not trying to time the market, there’s no reliable indicators. If there was a reliable indicator everyone would start using it, hence making it useless. Because that’s how markets function. So, the best advice here of good long-term capital allocation in addition to having a real long-term view of your investments. Don’t get spooked out of the market. You can expect a bear market in stocks you know once or twice every ten years. So, keep that in mind. Make sure you’re not too highly leveraged in the market. Make sure you hold some bonds some spare cash to capitalize on any opportunities that may come
And that’s it ladies and gents for episode 7 of the Absolute Return Podcast. Be sure to check out more episodes on www.Absolutereturnpodcast.Com, iTunes, stitcher, Spotify or wherever you listen to podcasts, make sure to give us a review as well. Cheers talk to you next week.
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