Let us start with a simple idea, which also happens to be validated by the data: stock market returns and corporate profits over the long term have the same growth rate.
In the left hand chart below, the S&P 500 index is shown as a blue line, while corporate profits, as recorded in the US national accounts, are denoted with a red line. The black line in the bottom panel reflects the ratio between stock performance and corporate profits. The next thing I do is compute the trend of the ratio and its standard deviation. It is quickly apparent that the trend is on the mean, which implies that the stock market is a mean-reverting variable against corporate profits. What is also clear is that when the ratio rises to 125, US equities are 25% or more above their long term average (vs profits). Hence, shares should be sold. When the stock market is 25% below the long term trend, at 75, equities should be bought. Today the ratio stands pretty much at 125.
To be sure, I have hardly broken new ground with this observation, but I would beg the reader’s patience to stay with me. On the basis of logic, when one variable is dependent on another, and when they both have the same long-term growth rate, there should be a fairly high correlation between their shorter term variations. As such, two year variations of the US stock market should be highly correlated with two year variations in US corporate profits. And indeed, chart below shows that in the 1950-77 period, this is what happened.
In these years the correlation between corporate profits and the stock market’s two-year rate of change was about 0.7. Hence, the variation of corporate profits “explained” about half of the variation in stock prices. Equity prices led by about three months the “published” economic data, which itself is available with a three month lag. Hence for most of this 27 year period the stock market led the economy by about six months. Again this is hardly revelatory and, indeed, it is why stock market readings are included in most leading indicators. The interesting point is that after 1978 everything changed. The correlation between the two-year rates of change for profits and share prices, which had been 0.7, fell to almost zero.
The year the world went mad
I’ll wager this is the first time such a non-relationship between profits and share prices has developed over such a lengthy time horizon. The funny thing is that even though the short-term linkage between profits and stock prices has broken down, the long-term relationship remains intact (the first chart)
The chart below shows this strange behavior of stock markets since 1978. At some point in each cycle equity prices have massively diverged from fundamentals as measured by the evolution of corporate profits. On each occasion market participants have convinced themselves for a decent period of time “this time it is different.”
To be slightly less generous; for approaching 40 years investors have believed fairy tale after fairy tale, namely that:
- Inflation could not be brought under control
- Stock market declines could be “insured” against
- The end of the cold war changed all the rules
- A “new economy” was appearing
- A “financial revolution” was redefining risk management
- Central bank policies could break the link between share prices and profits
On each occasion, however, the “overvalued” stock market eventually crashed down to a level that was justified by the evolution of corporate profits. Hence, despite these violent boom-bust cycles, the long term relationship between profits and prices was maintained.
These developments have had a big impact on the finance industry. Active managers, a.k.a return-to-the-mean fellows, underperformed for most of the period, which is not surprising as it is hard to run a rational investment policy when the lunatics have taken over the asylum. Instead, the indexers won the battle. This has had consequences because indexing is a pernicious mix of socialism and momentum buying, which leads to huge misallocations of capital (see How Indexation Killed Growth). Moreover, the link from this capital misallocation to reduced structural growth and lower productivity is clear.
Still, a not unreasonable response to these observations might be that if active managers have underperformed and exchange traded funds are flawed by design, what should the savvy investor do?
Portfolio construction in a time of magic
In recent years I have offered advice on effective portfolio construction advice to deal with these very strange times. It can be summarized thus:
When profits return back to earth the adjustment will almost certainly be violent. Hence investors need to make decisive asset allocation switches. As we have been living through a disinflationary period since the mid-1980s bonds and equities have been negatively correlated. In such an environment investors should only be 100% invested in equities when shares are grotesquely undervalued (75 or below on the S&P 500 vs profits ratio from the first chart). When bonds get severely overvalued, as was the case during 2012, then the usual risk management strategy would be to move 100% into equities. For those intervening periods (75 to 125 on the first chart) the solution is to be 50% in equities and 50% in bonds. When the ratio starts to move above 120-125, investors should systematically reduce their equity position—together with corporate bonds—to a bare minimum. They should respond by upping positions in long- and medium-dated government bonds.
In an “ideal world” the portfolio should be loaded 100% in equities right after the latest “this time is different” meme has been shattered, but before the new one has bedded down. The position in bonds should be edged back to 100% at the point that the new meme is generally accepted as a God-given truth. As already noted, the in-between periods should see a 50:50 split between the two assets. As we sit on our rule’s 125 threshold, it is clear that a move fully into government bonds is justified. As such, I consider the practical part of this note to be done and dusted. However, I have purposely left the obvious question unanswered:
Why on earth did the attitude of investors change so much from the late 1970s onward to make investing incompetence a key skillset that for most of the cycle was rewarded? To be honest I am dipping into the realm of conjecture and I am quite happy to change my views in response to a better explanation. Still, here goes.
My answer to the “why” question
Keynes famously said that most politicians slavishly follow rules devised by long dead economists without ever realizing it. This is true. But sitting just above the economists are the philosophers and Keynes’s comment may apply even more to their unseen influence.
My contention is that up until 1978 human affairs were managed according to a set of rules essentially grounded in a scientific frame of mind developed in Europe over the previous ten centuries. This mindset was based on two central ideas:
1) That the world (created by God with an idea in mind) was “real” and understandable at the same time (the core of Aristotle’s belief).
2) That the role of humanity was thus to decipher that reality, and to teach what was discovered to the next generation, the core of the Christian (or Jewish) beliefs.
The first one to codify this insight was St Augustine in his book City of God written in 426AD. Generation after generation was then inculcated with these basic principles, which, until recently, changed little and can be thought of as the bedrock of modern civilization.
One consequence of this world view was that the fellows who managed money for a living tended to be a fairly robust bunch of individuals. They had been taught that reality was a hard, gritty thing and their duty was to understand and respond in a rational way. Certainly the generation managing money in the 1950-77 period had experienced the Great Depression, World War II, the Korean War and the Cold War. As a result, they knew that the front line is not a good place to develop theories on the best way to deploy foot soldiers. Put simply, they understood from experioence that if something is not broken, there is no need to spend a lot of money and effort fixing it. Or if a new theory is shown by experiment not to work, there is no point trying it again and again. Their role, as they saw it, was to understand what worked in the real world, and to adapt their actions. At their core, they were all disciples of Aristotle and children of the Christian (or Jewish) faiths even if they did not know it.
But then things started to change. In France, from 1950 onward, a series of “philosophers” (Jacques Derrida, Michel Foucault, Jean-Paul Sartre, Claude Lévi-Strauss, Pierre Bourdieu etc...) emerged who had spent their time during the German occupation of France doing nothing that could be described as courageous; they developed theories such as existentialism and post-structuralism, whose main goal was to show that there was no such thing as reality.
Reality, for them, was a myth created by elites to keep the masses in their chains. And if reality does not exist then the corollary is that “truth” also cannot exist. Hence, as a matter of general principle things really can be different, over-and-over again.
Their mantra was “relativism”, which was anchored to three fundamental principles:
1) The victim must be guilty and the criminal innocent, as a judicial system is always under the control of the hated “bourgeoisie”.
2) The role of a proper education is thus not to teach students how the real world works but to show that a voodoo explanation of the universe is as good as anything proposed by Albert Einstein or Isaac Newton.
3) As a result, there is no such thing as personal accomplishment based on merit.
These ideas had a huge influence worldwide, but especially in US universities where many tenured professors embraced them with gusto. Such luminaries educated students in the simple notion that reality does not exist. The apogee of this transition was 1968 when the “revolt” against “old” notions of reality culminated with slogans such as “it is forbidden to forbid”. This was an impressive contradiction and showed that society was moving from a rational basis to an irrational one.
And guess what; these students scrubbed up, got with the new materialism and started to arrive in Wall Street jobs in and around the late 1970s, just at the time when the breakdown between profits and share prices started to occur. A non-scientific mind, not grounded in scientific method and experimentation, was taking over from a rational mind. And irrational minds can truly believe time-after-time, that this time really is “different”.
In a sense we have replaced the “scientific” mind which started to emerge in the 12th century in Europe with William of Ockham, Peter Abelard, Thomas Aquinas, Francis Bacon, Thomas Beckett and Desiderius Erasmus with one grounded in a “magical” way of thinking. Worst of all, it was introduced by lunatic French intellectuals. As a Pope once said: “No heresy is dangerous as long as it has not reached France”.
The result is that in one generation, we have moved back nine centuries in intellectual terms. These theories have destroyed educational systems all over the Western world, which means that a “return to the mean” is just not possible. Whole generations have been lost.
Back to the market
Fortunately, it is not actually possible to wish away the relationship linking stock prices with corporate profits. So every five or seven years, the latest “this time is different” dream crashes on the rocks of temporal reality. The problem with this inherent instability is the support it provides to those at the extreme end of the spectrum who will argue that capitalism is a bad thing. Alas, for the clergy overseeing this mysticism, the problem is with reality and not anything to do with their theories (creeds) which cannot, of course, be proven wrong. And this according to Karl Popper is the essence of a magical frame of mind.
These days the cycles are being truncated as even before the collapse has run its course, the lunatics have started to prepare the ground for the next “this time is different” meme. See for example the success that Thomas Piketty has had in persuading everyone that the problem is capital itself or solutions to low growth such as the banning of cash as a pesky medium of exchange that results in unreasonably high liquidity preference.
I am partly cheered by my hope that the Confucian frame of mind has thus far resisted these stupidities. But my bigger reason for thinking that the world can break out of its intellectual deadend is a hope that diffuse knowledge spread not by a high priest class, but true believers of freedom over the internet, will supplant the established universities.
That, of course, does not fix the problem as even if new, more rational, generations are educated, positions of power across the western world will continue to be held by those of the new mystical class. To conclude, consider Mark Twain’s great existential interrogation: “Sometimes I wonder whether the world is being run by smart people who are putting us on or by imbeciles who really mean it.”
Sadly, we are currently in a world run by the latter group. But it will not last forever. And this, at least, is the good news.