Gyroscopic Investing

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I've had some of the same thoughts about the modern stock market's ability to allow someone to diversify much more than in the past, and therefore each stock on its own doesn't have to offer such tremendous return on investment.  The risk of owning VTI today and the risk of buying into an oil company in 1860 are quite a bit different.

Good write up.

Clive wrote: The studies I've made for a range of stock styles indicate that 80+ years ago typically 6% real (after inflation) share ownership gains were a common average. Projected forward in time that real gain progressively becomes smaller, up to the most recent decade where shares marginally lagged inflation overall on average. The average for all such samples works out to around 3.5% - but that shouldn't be taken as a long term guideline as the overall slope is downwards.

Stocks reflect underlying businesses that grow their revenues and profits.  While interest rates, the level of economic activity, and demographic trends (and so forth) reflect which businesses do the best and how fast they all grow, having a long-term real growth rate of "several percent a year" is probably going to continue over the long run (as measured in decades and centuries, assuming we have capitalism as the economic system).  Note that I'm ignoring potential "black swan" events (e.g., world wars, world pandemics, peak resources, whatever) that might alter this rate temporarily or permanently.

What changes over time is the valuation investors place on business profits (http://www.multpl.com/).  For the S&P 500 in the United States, the PE ratio has varied from a low of 5 to a high of 45, with 15 as the average.  I remember investors placing a PE of around 100 on the Japanese stock market at its peak in 1990.

Market valuation is the sum of all fears and greeds of investors.  Valuation is usually based on some rational metric (i.e., a publicly-traded business typically has a PE of 15, versus a PE of, say, 3 or 5 for a privately-owned business because privately-held businesses are much less liquid in terms of finding buyers and sellers for transferring ownership).  But sometimes valuation gets crazy due to excessive investor pessimism or optimism (e.g., tulipmania in Holland in the 1600s, the stagflation of the 1970s, the dot-com craze in the United States in the 1990s, the global real estate bubble in the 2000s).  Emotional-based valuation will never change because it's based on human emotion, which generally does not change for the population as a whole over the generations.

The beauty of the Permanent Portfolio is that the typical retail investor does not have to be skilled at picking stocks or riding trends or picking the winning asset classes in advance.  All they have to do is have the intestinal fortitude to follow the rules: invest in the four asset classes in equal amounts and then rebalance when called to do so.  The process is mechanical and requires no specialized investment skills.

Clive wrote: If you have a bunch of assets that each generally provide inflation pacing gains over the mid to longer term, but that zigzag relative to each other over the interim, then you can exploit those motions by reducing from current leaders to add to current laggards using a constant value (or weighting) approach such as used by the PP. So doing will result in an above inflation reward over the mid to longer term assuming each of the individuals achieve inflation gains over the total period.

This is the basis of Modern Portfolio Theory (http://en.wikipedia.org/wiki/Modern_portfolio_theory): invest in classes of assets that are minimally correlated with each other and let the zigs of the different asset classes cancel out the zags.  Rebalance periodically to lock in the gains.  This technique depends on "reversion to the mean" where the hot asset classes of the latest decade become the laggards in the next decade, and the laggards become the leaders in the next decade.  While asset correlation is not fixed (it changes over time), the skilled asset allocator can usually get somewhat better returns than the non-allocator (http://en.wikipedia.org/wiki/Asset_allocation).  Also remember the old joke that the only thing that goes up in a bear market is correlation because all asset classes go down when investors get scared and rush for the exits at the same time.

A cool-headed Permanent Portfolio investor, of course, is immune from this irrational rush-for-the-exits behavior.  So is a skilled value investor who knows how to buy undervalued assets when their market has overcorrected and sell overvalued assets when their market is overpriced.

Clive,

I believe what you are seeing here is that investors are willing to pay less and less for equities as they become more informed.  Said another way, as technology and education have improved over time, the investor has become more knowledgeable about the fair value of equities and is less likely to overpay.

A simple example is auto shopping.  Prior to Consumer Reports and Edmunds, for example, the consumer had no reference point for the true cost of an auto and how much they could negotiate the sales price downward.  Now consumers are fully armed with detailed cost information and can make informed purchase decisions.  

I tend to doubt that equities will trend towards delivering a return equal to the rate of inflation.  I believe there are too many irrational buyers and sellers in the marketplace and no amount of information will change their behavior.  Industries and companies fall out of favor for a variety of reasons, and not all of them are fundamental.  Intelligent analysts will identify and take advantage of these situations to make a buck.

Clive wrote: Some years ago, can't recall exactly when, the US decided a taxation policy that favoured retention of earnings over paying out dividends. The UK in contrast continued with higher dividend payout rates.

My guess is those extra retained amounts just get wasted (big bonuses, failed expansions etc.).

This is a very interesting thought, and it does seem to make sense to me, although at the end of the day, many of these companies UK/US are all competing globally, so I would imagine this "waste" factor would be very minimal or non-existent. 

Another issue that may be working to reduce stock returns is the moral hazard introduced into corporate governance by the rise of diversified passive investment. Diverting corporate profits from shareholder's pockets is easier when many shareholders are disinterested in the details of the business and do not shop for relative value when contemplating stock purchases. I guess the marginal pricing of stocks is a powerful force that tend to offset the passive investor effect. Still it would be interesting to look at the history of beta. If beta increased with the proportion of assets in passive index funds, that would imply that the power of marginal pricing in price discovery has been undermined by passive investment strategies.

Cowboy,

I've often wondered about that... if too many investors become index investors, then who's there to make sure the company's even try to earn a profit?

moda0306 wrote: ... if too many investors become index investors, then who's there to make sure the company's even try to earn a profit?

I think the market handles this.  If indexing becomes so widespread that securities start getting mispriced, investors will sense this and some will go back to active trading.  When active management doesn't seem worth the cost, some investors move back into indexes.  Some of this happens indirectly with performance chasers flowing between active and passive mutual funds.  Human nature being what it is, I doubt we'll ever come close enough to 100% in either camp to have serious problems.