Attractive global returns for the patient investor

We talked about earnings yield in Where should I invest?. When it comes to stocks and stock markets, the Shiller PE ratio (also called the CAPE ratio) is a good way to measure earnings yield:

Estimate of earnings yield = (100 / Shiller PE ratio) %

Higher the CAPE ratio, lower the earnings yield. For a long-term investor, higher earnings yield is obviously more attractive. In a number of works published in the 80s and 90s, e.g., Stock prices, earnings, and expected dividends, researchers illustrated that high stock market earnings yield is generally followed by good market performance and vice versa.

One point worth noting is that Shiller PE is not very good for predicting short-term returns or for timing market crashes. The predictive ability improves when the forecasting period is longer, e.g. 5 or 10 years. This has been demonstrated, e.g., in the paper Dividend yields and expected stock returnsA high Shiller PE (low earnings yield) generally means that a country’s stock market is overpriced, and investing in that country will probably lead to disappointing results eventually. However, it does not guarantee that the country’s stock market will do badly next month or next year. A richly valued stock market can continue to become more richly valued for several years, eventually turning into a stock bubble before it crashes. This happened in the late 90’s when the US stock market became heavily overpriced, a phenomenon attributed to irrational exuberance.

Investing in a basket of countries with low Shiller PE ratios generally leads to higher returns, a result demonstrated convincingly in a number of publications, e.g., the paper Global Value. Conversely, countries with high Shiller PE ratios exhibit poor returns over the subsequent 10-year period.

Shiller PEs and other country stock market valuation metrics are posted quarterly on Star Capital. They recently posted an update showing that performance of stocks in different countries corresponded well with their Shiller PE based predictions in 2016. Russia, the country with the lowest Shiller PE posted returns of 37% (in ruble) and 58% (in US dollar) in 2016. Russia doesn’t sound like a safe place to invest. And that’s generally true of countries with low Shiller PE ratios. CAPE ratios in the neighborhood of 5 signal extreme distress or significant risk factors. Risk factors include the risk that foreign investors may lose all their money or that a country’s currency may go to zero. However, such terrible outcomes are rare enough that investing in a diversified basket of cheap countries produces high returns with high probability in the subsequent 5-year period. While it is no doubt daunting to invest in such countries, I remind myself that historical studies take into account periods of far greater uncertainty than today, including World Wars where most countries were direct or indirect participants.

As of the day of this posting, the US stock market is quite expensive with a Shiller PE of around 28. This is just under double the historic mean and median of around 16. However, this doesn’t mean that a market crash is imminent. I’ve provided one reason above – that overvaluation is a poor market timing instrument. There’s also another reason having to do with opportunity cost, an idea labeled as the equity risk premium. The Shiller PE corresponds to a 10-year average earnings yield for stocks, and I find it helpful to compare this with the 10-year treasury rate. Since stocks carry much more risk than treasuries, it is reasonable to expect that the earnings yield of stocks will be higher than the treasury yield to compensate for the higher risk, the difference of the two being the equity risk premium. In 1929 before the great depression, and in the late 1990’s before the dot-com bust, the 10-year earnings yield of stocks  went lower than the 10-year treasury’s yield, signaling extreme overvaluation. The US stock market has an earnings yield of 100/28 or about 3.6% now. This is clearly still higher than the yield of the 10-year treasury, currently at 2.4%. The difference gives us a roughly calculated equity risk premium of 1.2%, low by historical standards but still positive. In other words, high stock valuation is being supported by low interest rates. If the Fed were to raise rates rapidly, stocks would start to look less attractive, but we’re not there yet.

A note for those who follow the SciPre portfolio: Many countries in the SciPre portfolio have low Shiller PE ratios. Their undervaluation is an important factor contributing towards their inclusion in the portfolio.

SciPre Portfolio : Jan 1, 2017

Here’s what the SciPre portfolio looks like as of 1/1/2017.

Asset class Ticker Allocation
Australia stock EWA 5.0%
Brazil stock EWZ 5.0%
Chile stock ECH 5.0%
Egypt stock EGPT 5.0%
Emerging Markets local bond EBND 10.0%
Emerging Markets USD bond VWOB 5%
Global value GVAL 5.0%
Gold GLD 5.0%
Gold miner stock GDX 5.0%
Greece stock GREK 5.0%
Hong Kong listed China stock FXI 5.0%
Intermediate-Term Corporate bond VCIT 5.0%
Italy stock EWI 5.0%
Nigeria stock NGE 5.0%
Poland stock EPOL 5.0%
Russia stock RSX 5.0%
South Korea stock EWY 5.0%
Spain stock EWP 5.0%
Turkey stock TUR 5.0%
Total 100.0%

First things first. I do not recommend this portfolio to anybody. Each individual’s risk appetite is specific to that individual, and one portfolio could not possibly serve all.

Second, the SciPre portfolio combines ideas of valuation and diversification across asset classes and geographical regions. I have put much thought into the design of this portfolio. However, allocations are deliberately simplified. Future posts will illustrate many of the ideas that went into this portfolio’s construction.

Finally, the tickers are usually those of ETFs that serve the mentioned asset class. I include tickers so that the perfomance of the SciPre portfolio can be tracked. I am not recommending these specific ETF products. In each asset class, there may be mutual funds and ETFs that have lower costs or more desirable features.

Disclaimer: The opinions expressed here are mine alone. I am not offering advice or recommending any product. I may own some of the asset classes and tickers mentioned above, but may not own others. Consult your financial advisor befor making financial decisions.

The SciPre portfolio

Starting Jan 1, I will post a portfolio of financial assets – stocks, bonds, mutual funds, ETFs etc. – on this blog.

The portfolio will be based on principles of global asset allocation, combined with my understanding of valuation. The portfolio will be investable. I will deliberately keep the portfolio’s composition simple.

The portfolio will be updated quarterly i.e. on April 1, July 1 and Oct 1. I may update in between these dates if markets move sharply, but this should be relatively rare.

SciPre renamed SciPre

When I started writing this blog, the name SciPre was short for Science of Prediction. But investing is very little prediction. Predicting markets, such as the timing of crashes, is extremely hard to pull off with any consistency. To quote Warren Buffett: “The only value of stock forecasters is to make fortune-tellers look good.”

Rather, investing is a lot of preparation, and in times of risk… preservation. There’s an element of prediction too, but it’s a small piece. I was on a flight last night when I decided to rename my blog from “SciPre – Science of Prediction” to “SciPre – Science of Preparation”.

Where should I invest?

Should I invest:

  • In a bank account?
  • In a home?
  • In stocks?

This question has no simple answer, but it has an answer. Moreover, it is possible to simplify the key elements of that answer. This post is about explaining how different investments can be compared. A word of caution. It is said that a little knowledge is a dangerous thing. It is not the “knowledge” that is dangerous. When a little knowledge brings with it a great deal of “confidence”, that overconfidence can cause a person to take outsized risks and ultimately bring misfortune. Bear in mind that what I say here is a deliberately simplified answer to a difficult question.

Let’s start with the bank account, as this is the simplest investment. Let’s say you put $100 into a savings account in a bank, and the bank pays a 2% interest rate. The $100 is called your principal, and the $2 you will earn in a year is the return on your principal. The chance that you will lose your principal ($100) is small. It can happen, e.g. if the bank shuts down and your account is not backed by the government, but this happens rarely. In the United States, the FDIC protects investors against loss of deposits from bank failure to a significant extent.

How does the bank account above compare with a home? Just as we can put $100 into a bank and earn interest, we can similarly buy a home and earn rent. A two-bedroom, one-bathroom apartment in San Francisco could cost $1 million to buy and $40,000 a year to rent. The rent-to-price ratio is therefore $40,000/$1,000,000 = 4%. If I had a million dollars in cash, I could buy such an apartment and earn a 4% return in the form of rent. This basic idea is simple. Now, let’s get into the weeds. Unlike a bank account, where the principal is fixed, the value of a home can change. Home values usually increase over time, but sometimes they fall like they did when the US housing bubble burst. There are maintenance costs and a variety of taxes (and some tax benefits) associated with homes. Homes are also illiquid, meaning it is not always easy to buy or sell a home.

How about stocks? A stock or a share represents partial ownership of a company. If a company has one million shares, and each share is worth $10, then the company is worth $10 million, which is called the company’s market capitalization. If this company earns $1 million in a year, then the earnings per share is $1 million / 1 million shares = $1/share. The ratio of earnings to price is called the earnings yield. In this case, it is $1/$10 = 10%. Stocks carry many risks, including the risk of going down to zero, and prices that fluctuate daily. Besides, even though the share in this example has an earnings yield of 10%, that 10% is not paid back to the shareholder. Some part of it (or none of it) may be paid out in the form of a dividend to the shareholder. In the example above, if the company chooses to pay 20% of its earnings (20 cents per share) to shareholders, then it has a dividend yield of just 2%. Some investors attach more importance to the dividend yield, which is what they are being paid “now”, than the earnings yield which is reinvested in the company. This example is over-simplified, but it illustrates the idea that money earns return when invested in a business.

The annual interest rate in a bank account, the rent-to-price ratio of a home, and the earnings yield of a share represent the same idea for different investments – the idea of return on investment.

Going back to what I said about a little knowledge, it would be dangerous if the message you take away is that one can compare a bank account, a home and a share of a company based on their return on investment alone. The risks are totally different, so such a comparison would not be apples-to-apples. That said, I find it helpful to compare investments using their long-term expected return, which is what one might reasonably expect if holding the investment for many years. This isn’t easy to calculate, but great minds (including some Nobel laureates) have worked on it, so it’s at least partially understood. I’ll talk more about this idea in later posts.

Be happy. Be wealthy.

Happiness is too complex a subject to cover in a blog post. But pursuing wealth without understanding its link to happiness can be harmful. I define happiness as a state of being that every human being aspires to. Since human aspirations are varied, everyone’s happiness is also a little different. Yet, as there are threads that bind humanity, so are there themes that are common to happiness. The question: “How can we be happy?” is so fundamental that it has absorbed the minds of philosophers for ages.

Before I repeat the conclusions of some of my favorite philosophers, let’s consider the four squares below.happiness-four-squares

The squares say ‘Health’, ‘Love’, ‘Respect’ and ‘Wealth’. Each square offers an example of a human need.

  • Can a person who is very sick be happy?
  • How about someone who lacks love, who has no close friends or family?
  • Can a person who does not have the respect of others, and is treated as unimportant, be happy?
  • Finally, can a person in extreme poverty be happy?

I consider Buddha to be one of the greatest philosophers of all time. He lived around 500BC; in short, a long time ago. Buddha was born a prince. He married, had a son, yet the sight of suffering led him to relinquish his princely life and seek higher understanding. His quest brought him to the conclusion that the cause of sorrow is unfulfillment of human desire, and therefore detachment is the way to happiness.

Being an applied mathematician, I think of Buddha’s conclusion as an asymptotic result, meaning something that is true at the extreme limit of self-control. At that limit, excruciating pain of a terminal disease, complete loss of family and friends, and extreme poverty would all fail to lower a person’s spirits. Most of us are not so strong. Buddhism acknowledges this too. Regardless of whether the ultimate goal (of Buddhahood) is actually reachable, one can make progress towards it. This was the state of our understanding of happiness circa 500BC (if not earlier).

The world we live in today is far more comfortable than Buddha’s. His world lacked electricity, running water, climate control, and modern medicine among other things. With time, our understanding of happiness has also evolved. The absence of pain or sorrow is not the same as happiness. The conclusion that we can influence (if not completely control) our happiness by changing our perception is a central idea of Positive Psychology. Evidence to support this idea has been found in psychology experiments as well as in studies on the structure and function of the human brain. The book “The Happiness Advantage” by Shawn Achor talks about some of these ideas.

Clearly, thinkers across thousands of years have concluded that our attitude greatly influences how much fulfilment we experience. Indeed, one of my favorite quotes is this one by John Milton:

The mind is its own place, and in itself can make a heaven of hell, a hell of heaven.

So then, why bother about money? One important reason is that most (if not all) of us are far from attaining the state of Buddhahood. Some desires are needs that are painful not to fulfil. If the cause of sorrow is unfulfilled desire, it helps to satisfy some needs, and have the maturity to understand that the stream of desires is endless; therefore, some of them will never be fulfilled. More importantly, our desires don’t all belong in the same league. While it may be immature to hanker after more money to keep up with one’s neighbors, the pursuit of financial security is often driven by a sense of duty towards one’s children, or a desire to not be a burden on others in old age. In the context of these goals, the pursuit of wealth is an act of responsibility as opposed to something detrimental. 

I will end with a cliché: “Money is not everything.” In this quote, I could replace “money” with any other noun (except ‘everything’), and it would still hold true. But the fact remains that poverty leads to both real and perceived deprivation, and most humans find it hard to stay positive when they are very poor. Being financially independent helps.


Presentation by Rob Arnott

Key insights from a pioneer. The conclusions that Rob shares will sound familiar to those who follow markets closely, but the presentation highlights several uncomfortable truths that we know yet find hard to embrace in our investment decisions:

A similar dichotomy between what is realistically achievable and what we believe we will achieve was also questioned in a recent blog post by Mebane Faber with an interesting title:

Institutional Investors are Delusional



Why do we get paid?

Why do we get paid?

Well, you have to do something.

True. Some work has to be done in order to get paid.

Yes, but you could win a lottery too.

Or receive a gift; inherit a fortune perhaps. That’s not quite the same as getting paid though. It’s receiving money by chance, not compensation. So let’s leave aside lotteries and inheritances.

Well then there it is. You do something, and you get paid.

Not quite. I could dig a hole in the middle of nowhere, and I wouldn’t be paid. A lot of effort goes uncompensated.

That’s because it’s useless work. The work has to be useful.

Good point. The work has to have utility. While utility is necessary, as it turns out, it isn’t sufficient for getting paid. A lot of volunteers and interns are unpaid. Sometimes, people devote their time for free to causes they care about. Other times, people would like to be paid, but they work for free anyway hoping that they will gain work experience, add something to their resume, build a good reputation etc. so that they can find work that pays. And all the while, they are working and doing something useful, but not getting paid.

Then what is it? Work experience? A good resume? Trust of others? A brand people recognize? 

It’s simple really. In order to be paid, there has to be someone on the other end who is paying.

So you have to do work that helps someone else.

Yes. When we say “useful work”, it is someone else, effectively a customer or employer of our service, who gets to decide whether the work is worth paying for. It follows that this customer should both have money to pay, and the willingness to pay. Paying customers can be people, businesses, organizations with a budget, governments etc. but they cannot be abstract entities like humanity or society.

But shouldn’t we serve humanity?

Of course we should. A giving nature, a willingness to serve, these are qualities that enrich our lives and the lives of those around us. They also lead to long-term gains in our profession. But one should not expect compensation in the short-term for generously serving abstract entities which don’t have a budget, or for serving those who lack either the means or the willingness to pay for our work. It is vital to understand this.

Okay, so we get paid for work that is useful to someone else who has money and is ready to pay.

Yes, I think that’s the answer to the question: Why do we get paid? This is an important question, one of several important questions whose answers guide us in our search for fulfilment.

An outline for the next few posts

Two of my early posts (here and here) were about the path to wealth, emphasizing the importance of saving early and staying invested. My next few posts will focus on two themes.

On one hand, I will explain where wealth fits in the broader context of happiness. Happiness is a term I use loosely to describe a state of being that we aspire to. Everyone’s happiness is a little different, in the same way that we each think of God a little differently. Wealth contributes to happiness in a limited yet significant way.

On the other hand, I will focus on earning. Earning is both the source of saving, and an outcome of one’s work (profession). Since we spend much of our waking hours working, work has profound implications for happiness for reasons that are not wealth-related.

Stay tuned.


What the AAII Sentiment Survey is telling us

The American Association of Individual Investors (AAII) performs a “Sentiment Survey” each week. Its members are asked if they are feeling Bullish, Bearish or Neutral about stock market performance over the following six months.

The survey is interesting because it is a well-known contrarian indicator. This means that when a lot of investors are bullish on the survey, meaning they expect stocks to do well, stocks tend to do poorly in following months. Contrarily, when a lot of investors are bearish, meaning they expect stocks to plunge, the stock market tends to do better than average. This behavior holds on average, and the findings are discussed here.

What happens when an unusually large proportion of investors is neutral? A fairly rigorous study found that high neutral sentiment more consistently signals that stocks will do well in the following months than high bearish sentiment. As an aside, the study also found that the sentiment indicator is better at predicting rebounds than in timing crashes.

This week’s survey results are interesting for the following reason. On average, ~40% of investors are bullish, ~30% are bearish, and ~30% are neutral. This week’s readings are 17.8% bullish and 52.9% neutral. Very few investors are bullish this week: 2 standard deviations below the mean. At the same time, too many investors are neutral: 2 standard deviations above its mean. This combination of extremely low bullish sentiment and very high neutral sentiment is extremely rare. It has happened just five times in the past, or just five weeks out of the ~29 years the survey has been in existence. And all of those five weeks happened between May 1988 and March 1989, a period when memories of the rapid collapse of October 1987  (Black Monday) were still fresh in investors’ minds. The AAII has devoted a special blog post to this rare occurrence.In the months that followed this rare combination, the S&P500 did quite well. Are we set up for a repeat performance?

The question above cannot be answered with confidence based on such little data; however, the author of a study I cited above conjectures why it may be that high neutral sentiment and low bullish sentiment precede high stock market returns. I quote:

The data shows that it has been better to buy stocks when investors do not expect good short-term returns than when they expect prices to fall … In other words, Baron Rothschild’s advice of buying “when there is blood in the streets” may not be the best guidance. Rather, the time to buy may be when investors think there is a possibility of blood pouring (or more blood pouring) onto the streets or are simply uncertain about whether Mr. Market will be in a chipper or sullen mood.”

“There may be a logical reason for this. High levels of neutral sentiment suggest that while investors are not optimistic about the short-term outlook for stocks, they are not fearful of owning stocks either. This implies investors are staying engaged versus avoiding stocks. Low levels of bullish sentiment imply investors are not optimistic that prices will rise, while high levels of bearish sentiment imply investors expect stock prices to fall. The seemingly subtle difference is tied to loss aversion—an investor who is worried about falling prices will be less likely to buy stocks than one who merely doesn’t expect prices to rise over the short-term. The latter investor will be more willing to risk temporary lackluster performance if he thinks valuations are attractive enough or may be looking for signs that a market bottom has been established.

One final caveat. The near term movement of stocks is notoriously hard to predict consistently. The rewards of succeeding are so great that an enormous amount of effort and money is directed towards this endeavor. One of the blogs I follow had a post recently which talks about this difficulty using the term science envy. At the same time when the AAII sentiment indicator is suggesting that stocks will do well in the next 6-12 months, there are other indicators that are suggesting the opposite.