Economic & Investing Tipping Point




In bestselling author Macolm Gladwell's debut book, "The Tipping Point: How Little Things Can Make a Big Difference", he defines a tipping point as "the moment of critical mass, the threshold, the boiling point."  The tipping point is that magic moment when an idea, trend, or social behavior crosses a threshold, tips, and spreads like wildfire.  Just as a single sick person can start a flu epidemic, this human phenomenon can give rise to a rapid adoption of new technologies or trends like cryptocurrencies such as Bitcoin.

Mohamed El-Erian, chief economic adviser at insurance and financial services firm Allianz, parent company of PIMCO asset management, believes the world will converge on an economic and investing tipping point in the next two years.  He expects a fundamental shift in the global economy that will either result in a powerful economic boom or in renewed economic tremors which will shake financial markets.  While at PIMCO, a team led by El Erian and "Bond King" Bill Gross developed the concept of "New Normal" in early 2009 to describe their concept of a novel economic reality of slow growth and super low interest rates that they expected to emerge in the aftermath of the global financial crisis in 2008/09.  The New Normal economic concept is broadly accepted today.  With El Erian now forecasting an end to the New Normal and a foreboding economic crossroad ahead, the remainder of this feature article will summarize his views and consider its implications on portfolio construction and the current global investment opportunity set.

The following are the most relevant excerpts on this crossroad theme from an interview with El Erian covered in a blog post at Value Walk.

"Rather than seeing the New Normal continuing I think the world is nearing a tipping point.  We are heading toward a T-junction which has three fundamental implications: One is, that the road we’re on is going to end.  The second message is that what comes afterwards is very different from what we’ve had.  And the third message is that it can be one of two things.  So it’s a bimodal distribution with two modes: really good or really bad.  We either tip into high and inclusive growth or we tip into recession with renewed financial instability."

"I think within the next two years we are going to tip one way or the other.  The probabilities are pretty equal and that’s what makes it very hard for decision making."

When asked "What will define the direction in which we are going to tip?" El Erian replied:

"The major difference will be what the politicians do. It’s not an economic question, it’s a political question.  When you grow an economy slowly and in a non-inclusive way, the politics of anger take over and you get improbable outcomes like Brexit, the election of President Trump in the US or the difficulties chancellor Merkel is having in coming up with a new coalition.  The list is long.  Sometimes the politics of anger result in growth reform candidates likes President Macron in France, sometimes they result in a very disruptive outcome like Brexit.  But the politics of anger starts dominating which means that the political establishment becomes less secure."

"This anti-establishment-movement is like a technological disruption: It shakes the system to a better or to a worse equilibrium.  In the case of Macron, what you see is a shake to a better equilibrium. In the case of President Trump, we are starting to see congress take on measures that it hasn’t been able to take on for a very long time."

The last thought provoking comment from the interview related to the question, "What’s your take on the financial markets after an exceptionally good year?"

"Markets have been conditioned to buy every dip, regardless of how elevated asset prices are and regardless of how decoupled asset prices are from fundamentals.  That can continue for a while.  It takes a lot to derail this market because that strategy to keep buying the dips is very simple and it has been very profitable repeatedly – and there is nothing that markets like more than a simple strategy that is repeatedly profitable.  But when it stops, there’s an air pocket that comes afterwards."


Hussman Margin Adjusted CAPE


We'd like to put an exclamation point on El Erian's final point by referencing the chart above from John Hussman's market commentary dated January 15, 2018 entitled "When Speculation Has No Limits."

This chart displays Hussman's Margin-Adjusted CAPE, which improves the correlation of the Shiller cyclically-adjusted P/E (now at 34.4 times) with subsequent total returns by accounting for variation in the embedded profit margins (assumes currently high corporate profit margins will experience mean reversion to historical lower averages).  Hussman's Margin-Adjusted CAPE is at 45 times and is now beyond both the 1929 and 2000 extremes, placing current market valuations at the richest level in U.S. history.  If the aftermaths of the 1929 and 2000 bull markets are any guide, we are in for one doozy of an air pocket.

From a portfolio construction and risk management standpoint, these obscene domestic equity valuations have led Servant Financial to seek relative values across global asset classes and adopt a bar bell approach with client portfolios.  As the chart of expected 10 year real returns and volatility from Research Affiliates below graphically depicts, this risk bar bell includes an overweight allocation to higher expected returning emerging market equities (6.0% real return and 22.6% volatility) and developed international EAFE equities (4.4% real return and 18.0% volatility) while underweighting U.S. large cap equities (0.2% real return and 14.6% volatility).  To dampen the volatility of our international equity overweights and reduce overall portfolio risk levels below strategic levels, we are overweight high quality domestic fixed income securities and cash while aggressively managing portfolio duration and interest rate risk - U.S. bond aggregate (0.5% real return and 3.7% volatility) and U.S. Treasury intermediate (0.5% real return and 3.5% volatility).  As we articulated a year ago in the January 2017 post "Omne Trium Perfectum,"  we have assembled a diversified portfolio of inflation hedges to provide a Third Pillar to traditional client allocations to stocks and bonds.   This potential inflationary backdrop with the incoming Trump administration led us to research various asset classes that provide protection as inflation hedges - U.S. Treasury Inflation Protection Securities (TIPs), commodities, real estate investment trusts (REITs), floating rate senior bank loans (where interest rates are reset every 30 to 60 days), emerging market equities, debt (local and U.S. dollar based), and currencies.  Many of these Third Pillar securities have been added to client portfolios and will benefit if the road ahead leads to a powerful economic boom.


RA Asset Allocation 1-22-18


We need to do more work on this topic, but we initially think this is an appropriate way to respond to El Erian's economic intersection theory and expected bimodal economic distribution of high and inclusive growth or recessionary conditions and renewed financial instability.  In a continued global synchronized growth scenario, we would expect emerging and developed international equities and Third Pillar inflation hedges to outperform U.S. equities.  Both developing and developed international equities outperformed U.S. equities in 2017.  Meanwhile, in a recessionary scenario we would expect the overweight to high, quality domestic corporates and U.S. treasuries to provide much needed ballast in a recessionary induced market correction.  Developing and developed international equities would arguably outperform domestic equities in a recession given their substantial valuation discounts.


Minack CAPE Comp


In the case that the foregoing analysis was insufficient justification for exploring unconventional portfolio construction approaches in these unusual times, we've included the following forward thinking investment analysis by Jeremy Grantham entitled "Investing in A World of Overpriced Assets", part 2 of this linked GMO quarterly letter to add further credence.  Grantham's analysis of liquid securities markets concludes it is time to overweight emerging market (EM) equities.  

The synopsis of his investment analysis and recommendation is as follows:

"To concentrate the mind, I fantasize about managing Stalin’s pension fund where the penalty for failing to deliver 4.5% real per year over 10 years is death.  I believe only a very large investment in EM equities will give an excellent chance of survival."

"Since February 2016, EM equities have already moved 11% relative to the US.  But their three earlier moves since 1968 were at least 3.6x the developed world markets!  Absolutely, at around 16x Shiller P/E, EM equities can keep you alive."

"Exhibit 3 (chart above), from Minack and Associates in Sydney, suggests that GMO’s forecast may still be understating the opportunities in EM equities.  It plots the straightforward measure of Shiller P/E (price over 10 years of average real earnings after inflation).  My using an outside source is deliberate: to cross-reference and also to suggest that GMO’s estimates, in the interests of safety, are conservative.  Note that at the recent low in February 2016 (Point 1), the multiple on EM equities was lower than after the crash in 2009! Remarkable.  Meanwhile (Point 2), the multiple on the US had gone from 12 to 22, an almost 100-percentage-point spread in favor of the US in just 7 years.  The Emerging index had sold at 38x in late 2007 (Point 3), a very substantial premium (52%) by any standard over the 25x of the US index.  It had sold again at a premium as recently as 2011 after the crash.  And early last year, the US was at a 120% premium the other way.  When you see the absolute and relative volatility of these three indices in Exhibit 3, doesn’t it suggest money to be made and pain to be avoided, even with less than perfect predictive power?  It certainly indicates an old-fashioned level of extreme market inefficiency at the asset class level."

"Be brave.  It is only at extreme times like this that asset allocation can earn its keep with non-traditional behavior.  I believe a conventional diversified approach is nearly certain to fail."

The data and analysis of each of the foregoing experts - El Erian, Hussman, Research Affiliates, and Grantham - point to very hazardous conditions and a potential economic conflagration ahead.  They have all signaled in different ways an economic and investing tipping point ahead the likes of which we have never seen before.  Proceed with caution.  Look for alternative routes and unconventional methods to preserve your financial wellbeing.

ETF Trends And Smart Beta



Today's investment world has seen a proliferation of index strategies and Exchange Traded Funds (ETFs).  The investment objective of most ETFs is to replicate the returns of a particular index before fees and expenses using a fund investment approach commonly known as passive index management.  The world's largest ETF is the SPDR S&P 500 ETF (symbol SPY).  According to, SPY has $270 billion of assets under management (AUM). The asset management fee for SPY is 0.095%, or 9.5 basis points, or equivalent to annual management fee income of $257 million for its owner State Street Global Advisors.  SPY is nearly twice as large as the next largest ETF, the iShares S&P 500 ETF (IVV), with $142 billion of AUM.  Vanguard offers a third ETF that tracks the S&P 500 that is ranked 5th in size at $84 billion in AUM.  These three S&P 500 cap-weighted ETFs account for approximately 17% of the $3 trillion domestic ETF market.

The S&P 500 index is owned by Standard and Poor's and is widely regarded as the single best gauge of large capitalization U.S. equities.  The index includes 500 leading companies, and because it is capitalization weighted (larger companies have greater index weight) it captures approximately 80% coverage of the available domestic stock market capitalization.  Companies within each major industrial sector are represented in the index.  The total market capitalization of the S&P 500 companies is about $22.6 trillion.  Over $7.8 trillion (or 35% of the S&P 500's market capitalization) is benchmarked to the S&P 500 index.  Passive index mutual funds and ETF assets comprise approximately $2.2 trillion (10% of market capitalization) of this total.

CNBC reports that U.S. ETFs took in $0.5 trillion in the twelve months ended May, 2017.  A Bloomberg ETF analyst interviewed for this CNBC article noted that investment advisors and institutions have been actively switching their asset allocations to ETFs due a perception of enhanced liquidity and an overall lower cost of investment management.  The Bloomberg analyst cited this cost factor as "the mother of all trends."  The cost of investment management is an important consideration in an investment process but should not be the sole factor.  Investors should also consider diversification benefits and expected returns relative to the risks for any investment strategy whether it's passive or active.

Another important trend cited in the article was that while ETFs saw net inflows of about $466 billion in the past twelve months through May, 2017, active mutual funds faced $350 billion in net outflows according to Bloomberg data.  Passive index mutual funds also saw net inflows of about $200 billion in the same period - a winner in the passive versus active mutual fund race, but still a laggard relative to passive ETFs and their continued market share gains.

Investors appear to be moving to passive investment strategies en masse.  This trend was affirmed in a global study of the ETF industry by EY entitled "Reshaping Around The Future - Global ETF Research 2017".  The article concluded:

The growth of the ETF industry continues to defy superlatives. Global ETF assets, which totaled just $417 billion in 2005, had reached $4.4 trillion by the end of September 2017 — a cumulative average growth rate (CAGR) of around 21%.

It seems that almost every trend that has shaped investment markets in recent years has worked in favor of ETFs.  This includes global themes such as the shift to self-directed retirement saving; economic factors such as low yields; regulatory efforts around suitability and value for money; technological developments such as digital distribution; and investment themes such as the “shift to passive.”

Supported by these factors, we expect the ETF industry to continue its rapid global expansion, outgrowing the wider asset management industry.  The prevailing conditions remain favorable, and the industry retains its many innovative characteristics.





As the above chart depicts, 89% of $298 billion of net cash inflows into U.S. equity ETFs year-to-date through August 31, 2017 has flowed into traditional beta (market) ETFs, or capitalization weighted ETFs.  The ETF industry has become a $4.4 trillion mammoth by providing investors with more efficient access to capital markets.  This "mother of all trends" toward lower cost passive strategies will certainly provide investors with a lower cost of portfolio ownership, but it's important to also periodically evaluate what you actually own.  Worries are growing among behavioral finance and other experts that by simply buying the SPY ETF, investors are pursuing a lemming-like crowd behavior which may have unintended consequences.  Investors who automatically pour their lifesavings into ETFs that simply buy an entire market, like SPY ETF, may not pause periodically to prudently evaluate relative valuations and risks.  I don't believe simply following the conventional wisdom of the crowd while wearing valuation and risk blinders is a prudent investment management approach.

Passive investors pursuing traditional passive capitalization weighted investment strategies may be sleepwalking their way toward another stock market bubble without recognizing the growing dangers.  Richard Thaler, Nobel prize winning behavioral economics professor, recently cautioned investors about this potential risk: “We seem to be living in the riskiest moment of our lives, and yet the stock market seems to be napping. I admit to not understanding it.”

A growing small minority of investors are moving away from these traditional market capitalization-based indices like the S&P 500 to alternative strategies, known as smart beta.  Many are doing so in search of differentiated sources of excess return, or alpha, and for portfolio risk mitigation.  As depicted in the chart above, smart beta (7.6%) and active ETFs (3.1%) represent only about 11% of the net cash inflows to U.S. equity ETFs.

Smart beta is a rather new term in modern investment parlance.  Smart beta is a broad term for rules-based investment strategies that avoid the conventional market capitalization weightings that have often been criticized as fueling valuation extremes by systematically overweighting overvalued stocks and underweighting undervalued ones.  Among the best known alternatives to market cap weighting are the fundamentally weighted indices developed by Research Affiliates (RA).  RA ranks their index constituents by financial factors like book value, dividends, sales, and cash flow.  Other RA smart beta indices are based on other factors such as momentum, volatility, or equal weighting.  RA provides the following straightforward definition: "Smart beta strategies are designed to add value by systematically selecting, weighting, and rebalancing portfolio holdings on the basis of factors or characteristics other than market capitalization.(emphasis added)"

Smart beta strategies attempt to deliver a better risk and return trade-off than conventional market capitalization weighted indices by using these alternative weighting regimes.  Smart beta strategies offer the potential for better-than-market returns along with the traditional benefits of cap weighted passive index strategies of broad diversification, transparency, rules-based methodologies, and lower cost.

RA describes their process as follows:

Smart beta is a rules-based portfolio construction process.  Traditional index-linked strategies rely on price to decide which stocks to invest in and how much of each to hold.  But the stock market is not always efficient, so stock prices don’t always accurately reflect a company’s economic footprint.  Smart beta strategies seek to exploit these market inefficiencies by anchoring on factors other than price.  In other words, smart beta strategies break the link between price and portfolio weight in an effort to deliver better-than-market returns.

The stock picker for smart beta strategies is generally a rules-based algorithm or computer program.


Bloomberg Smart Beta flows


Today, smart beta strategies are far from mainstream.  Inflows to smart beta ETFs represent a small minority of the current annual pace of $0.5 trillion in cash flows into ETFs.  Nevertheless, flows to smart beta ETFs have been growing rapidly over the past several years just as volatility has begun to wane as the chart above from Bloomberg depicts.  Year to date cash flows to smart beta strategies approximate $3.5 billion.

Servant Financial model portfolios currently employ select smart beta ETFs - VanEck Vectors Morningstar Wide Moat ETF (MOAT), WisdomTree International Hedged Quality Dividend Growth ETF (IHDG), iShares Edge MSCI Minimum Volatility Emerging Markets ETF (EEMV), and VanEck Vectors Morningstar International Moat ETF (MOTI).  The MOAT ETF has been in portfolios the longest.  When we evaluated MOAT, we looked at the underlying index's historical performance track record relative to the S&P 500.  For example for the 10 year period ended November 30, 2017, the MOAT index (includes performance prior to MOAT ETF launch in April, 2012) produced an annualized return of 13.1% compared to 8.3% return for the S&P 500 Index.  We saw that MOAT had historically generated excess returns compared to the S&P 500 and that the related tracking error or variability of its returns relative to the S&P 500 seemed acceptable.

This fundamental approach used to evaluate MOAT is essentially the research process that RA has been applying on a grander scale and more research intensive manner to the various smart beta strategies and factors it follows.  RA tracks seven broad strategies - value, income, low volatility, quality, momentum, multi-factor, and size - and eight factors across large and small caps - value (price to book), value composite, momentum, illiquidity, low beta, gross profitability, investment and size.  You can learn more at their Smart Beta Interactive website.

Just like stocks, bonds, sectors and countries, smart beta strategies can become cheap or expensive over time.  RA measures the relative valuations of their seven strategies versus market benchmarks to estimate how cheap or expensive a strategy is.  Their relative valuation for equities is fundamentally based on the Shiller CAPE approach that RA applies to major equity asset classes that we've reviewed in previous newsletters.  RA has found, like the Hussman Funds, that when relative valuation is low compared to its own history, that strategy is positioned to outperform.  When valuation is high, it is likely to disappoint.

Much like RA's development of expected returns for each major asset class, the firm estimates a) an annualized expected excess return over the market benchmark (net of transaction costs) and b) the annualized expected tracking error relative to the benchmark for each smart beta strategy.  The Smart Beta Interactive site transparently provides all this data to allow investors to conduct an informed return to risk evaluation of each strategy.

Since we're already a proponent of quality based smart beta strategies with the domestic and international moat ETFs, we were curious to review RA's interactive data on quality.  RA's quality simulation selects companies from the U.S. Large and Mid Cap universe based on a quality score.  The quality score combines high return on equity with low debt to equity and low earnings variability.  Stocks are weighted by market cap times quality score and are rebalanced semi-annually.  The following chart depicts the wealth growth of the quality strategy against the benchmark.  Since 1968, this quality strategy has grown wealth approximately 1.8 times the benchmark. 


RA Quality


On a forward-looking basis, the quality strategy is the most attractive of the smart beta strategies based on expected risk-adjusted returns.  RA's expected annualized excess return over the benchmark is 3.59% for quality (net of trading costs of 3.26%) with an expected tracking error of 3.7%.  This equates to an extraordinary information ratio of 0.97 (excess return over tracking error).

We also looked a RA's high dividend smart beta simulation given broad interest among investors for high yielding dividend strategies to replace fixed income securities and Servant's use of dividend-based IHDG in portfolio models.  RA's high dividend simulation selects 100 stocks by dividend yield from the U.S. Large, Mid and Small Cap universe, after applying screens for dividend growth and dividend coverage.  Stocks are weighted by indicated dividend yield and rebalanced annually.

Since 1968, RA's high dividend simulation has grown wealth over the benchmark at 2.2 times versus 1.8 times for quality.  On a forward-looking basis, the high dividend strategy is less attractive on risk-adjusted return basis as compared to quality.  RA's expected annualized excess return over the benchmark is larger at 4.50% (net of trading costs of 3.81%), but the expected tracking error is more than double at 8.6%.  This equates to an information ratio that is almost half that of quality of 0.52 (excess return over tracking error).

We've provided this update on the ETF industry and an introduction to smart beta strategies in an effort to keep investors abreast of the strong undercurrents that passive investment strategies may be having on traditional capitalization weighted market indices.  We continue to believe that market valuations are rich and are regularly evaluating relative values across asset classes and strategies.  For example as we've written about previously, we see relatively attractive risk-adjusted returns in emerging market equites and debt, developed international equities, and the domestic biotechnology and healthcare sectors.  We've recently spent research time on a multi-asset dividend yield portfolio model, and reinsurance and insurance sector fundamentals in light of the heavy catastrophe losses in 2017.

We've also seen firsthand that these systematic passive cap weighted money flows are creating significant inefficiencies in capital markets that nimble, contrarian investors are exploiting.  Through our family office investment consulting engagement, we've witnessed active hedge fund managers hunting in inefficient pockets of the markets create extraordinary levels of excess returns, or alpha, in 2017 - a small cap technology focused manager posting mid-30% net returns and an international small cap manager posting mid-20% net returns.  The iShares Russell 2000 Small-cap ETF (IWM) has produced a total return on a year-to-date basis of 15.1%.

We also conducted some initial research and development with an emerging investment platform that systematically screens market indices for industries/sectors subject to technological dislocation.  I would broadly categorize this emerging platform as a "smart beta" strategy.

We will continue to evaluate the relative value of smart beta and other investment strategies to provide clients with more attractive risk-adjusted returns.

Extreme Financial Games



A hedge fund that I oversee for my family office client had the following energizing comment in the fund's most recent quarterly letter:

There is no secret sauce for successful investing beyond a proven process and humility.

Certainly a number of hedge fund managers have been humbled recently by persistent underperformance against the S&P 500 as this unmanaged index marches ever higher.  For example, the Dow Jones Credit Suisse Long-Short Hedge Fund Index has gained only 4.3% year-to-date through September 30, 2017 compared to a total return of 14.1% for the S&P 500.  Despite the generally exorbitant compensation in the industry, I have some empathy for hedge fund managers that have consistently underperformed the S&P 500 because they've employed a risk mitigation, hedging discipline of shorting richly valued stocks (a bet that a stock price will go down) with flawed or failing business models and/or inferior management.  You lose money shorting a stock if it rises in price for speculative, technical, or other reasons despite its rich valuation and perceived poor fundamentals.  This year a broad swath of hedge fund managers' egos have been left dazed and confused by the irrationality of today's markets.

I believe the hedge fund manager's reference above to a "proven process" is a reference to the proving grounds of a sustainable investment approach of performance measured over a full market cycle - both bull and bear phases.  The rigor and discipline of an investment process is only truly tested in a period of bearish market volatility and declining prices.  Like great women and men, it is in the trial that an investor is made.  Just like precious metals in a furnace it takes intense heat and pressure to reveal the inherent beauty and shine of an investment process.

Since its founding in 2005, Servant Financial's primary investment objective has been to take a risk aware approach to preserve client capital and maintain the real value of portfolios while growing capital over the long-term.  Our investment strategy provides for the essential tenets of a fiduciary driven approach by providing broad diversification, low transaction costs, low portfolio turnover, and tax efficiency.

We achieve these investment objectives through risk-based asset allocation and a core passive index strategy.  We overlay active management elements through a relative value discipline among asset classes and employing select active fund and stock selections.

As we've written about frequently in the past, investors have generally been penalized for taking a global, broadly diversified investment approach.  Simply stated, with the benefit of hindsight investors would have significantly outperformed by being solely long U.S. equities over the last eight years.  This issue was explored in a recent article from PIMCO entitled "Are Diversifying Assets Up Next In The Return-Seeking Cycle?".  The article cites some stark comparisons of performance across asset classes:

Since the lows of the global financial crisis in March 2009, U.S. stocks (proxied by the S&P 500) have returned 270%, or 16.8% annualized, outpacing every other major market over that period.  Contributing to that outperformance were highly differentiated returns among asset classes, particularly in the three calendar years following the “taper tantrum” sparked by comments from then-Fed Chairman Ben Bernanke.  Starting in 2013 and through 2015, the S&P 500 Index gained 52% cumulatively, whereas core bonds returned 4% (proxied by the Bloomberg Barclays U.S. Aggregate Bond Index) and an equally weighted basket of diversifying assets actually lost value, returning −12%.  In other words, diversifiers lagged U.S. stocks by 64% for the 2013–2015 period.

Futurist and inventor Elon Musk's statement that "There's a one in billions chance we're in base reality" immediately came to mind.  In summary, Elon took game theory to the next level when he stated that he believes we are living in some advanced civilization's computer simulation.  Essentially, the world in which we live is the ultimate in fake news and our markets are a form of entertainment called extreme financial games.  When one looks at this issue through the lens of valuation, I think there is something to be said for Musk's argument that U.S. equity markets are some form of computer simulated entertainment.  

Within this realm of extreme financial gaming, Servant's investment process has been dynamic and interactive and has consistently included forward-looking expected return inputs to supplement the longstanding investment advisory practice of using past returns to forecast future returns.  Research Affiliates recently posted an article entitled, "The Most Dangerous (and Ubiquitous) Shortcut in Financial Planning" - using historical returns to forecast the future is the shortcut methodology.  I'm unsure who is the puppet master in this extreme financial game, but I'd like to use the rest of this feature article to update investors on S&P 500 valuations and expected future returns by summarizing the work of three investment research firms that we religiously follow that use forwarding-looking return forecast models.

The first research firm expected return forecasts we'll look at are from GMO.  GMO is a global investment leader with expertise in managing multi-asset class strategies as well as focused strategies in a number of specific asset classes.  GMO's investment approach seeks to identify asset classes and securities where investors are paid to take risk and utilizes a long-term investment horizon, a belief in the power of mean reversion, discipline, conviction, and a commitment to research (emphasis added).  As we've covered in the past, mean reversion is a key assumption in GMO's asset class forecasts. GMO assumes asset class valuations will revert to their historical mean valuation levels over a 7 year forecast period.  For the S&P 500 this approach implies that GMO expects that the current Shiller price to earnings (PE) of ratio 31.3 times at the 100th percentile of its historical valuation range would revert to approximately the 50th percentile over the next 7 years.  In other words, the lower valuation multiple applied to the S&P 500 over time is expected to result in mark to market valuation losses by GMO.

GMO recently published their 7-year asset class real return forecasts as of September 30, 2017.  As you can see from the chart below, GMO expects that investors will lose money over the next 7 years on a real basis (after inflation) for all asset classes except emerging market equities (+2.4%), emerging market debt (+0.4%), and cash (+0.1%).  U.S. large cap (-4.1%) is expected to be the worst performer over this forecast period.


GMO Asset Class 7Yr 9-30-17


The next body of valuation research we will look at is from Research Affiliates.  Research Affiliates is a global leader in smart beta and asset allocation.  Dedicated to creating value for investors, Research Affiliates seeks to significantly impact the global investment community through their insights and product innovations.  The scatter plot below shows Research Affiliates' 10-Year expectations of risk and real return for portfolios and asset classes.  Follow this link above to Research Affiliates' website where you can click each of the individual dots, or make selections from portfolio and asset lists to get more information about each portfolio or asset class.  The portfolios connected by the dashed line below represent efficient, highest return per unit of risk, portfolios.  These efficient portfolios are governed by a set of diversification standards which can be seen by clicking the "Efficient" label in the portfolio list at their website.

These expected returns are based on a set of routines which model both expected cash flows and changes in asset prices (reversion to the mean), and not by extrapolating returns of the past (pervasive short-cut approach used by most financial advisors).  You can learn more about Research Affiliates methodology for valuing assets here.

In general, I would characterize Research Affiliates' methodology as a more robust version of GMO's basic methodology described above.  Note that Research Affiliates projection period is 10 years versus GMO's 7 year forecast period.  There are obviously other significant differences in assumptions and methodology as you'll note for example that Research Affiliates has projected a 10 year real return for emerging market equities of 6.3% with volatility of 22.9% compared to GMO's 7 year expected real return of 2.4%.


\Margin Adj CAPE vs. Act S&P 12yr


The third and final research firm's work we'll look at is Hussman Funds.  Hussman Funds was founded by John Hussman, an economist, stock market analyst, and mutual fund owner.  He publishes a weekly market commentary and is broadly known for his public criticism of the U.S. Treasury and the Federal Reserve policies and for predicting the 2008-2009 U.S. Recession.  He has written extensively about the extreme valuations of the S&P 500 and other asset classes precipitated by Fed monetary policies and, not surprisingly, is predicting another market crash and financial crisis.  

Like GMO and Research Affiliates, Hussman has performed extensive investment research and valuation analysis. In his latest weekly commentary dated October 9, 2017 is entitled "Why Market Valuations are Not Justified by Low Interest Rates."  Hussman describes how his team has back tested some 15 different valuation approaches and determined the methodologies that have the highest correlation and predictive value for future expected returns.  One of his favorite methodologies is Margin-adjusted CAPE (cyclically adjusted price earnings/Shiller PE).  Hussman's introduction to this method is as follows:

The chart below is based on (Hussman's) margin-adjusted variant of Robert Shiller’s cyclically-adjusted PE (CAPE). Specifically, the CAPE (calculated here as the ratio of the S&P 500 to the 10-year smoothing of inflation-adjusted earnings) is multiplied at each point in time by a factor equal to the 10-year smoothing of corporate after-tax profits to GDP, divided by the historical norm of 5.4%. The resulting measure is similar to the S&P 500 price/revenue multiple, the ratio of market capitalization to corporate gross value-added, and other measures that share a correlation near 90% or higher with actual subsequent 10-12 year S&P 500 total returns in market cycles across history.

As expected, the (log) margin-adjusted CAPE acts as a “sufficient statistic” for actual subsequent S&P 500 total returns, particularly on horizons of 10-12 years (which is the point where deviations from historically normal valuations most reliably damp out). Also as expected, adding additional information about interest rates (green) does virtually nothing to improve the reliability of the resulting projections; a result that can be understood from our earlier valuation examples. If anything, low interest rates actually worsen expected future market returns here. If extreme valuations were not enough, depressed interest rates suggest the likelihood of below-average economic growth as well.

As you can tell by the green and blue lines in the bottom right corner, Hussman expects negative nominal returns for the S&P 500 over his 12 year forecast period.


Margin Adj CAPE vs. Act S&P 12yr


The last and perhaps most telling chart on current extreme valuations below is Hussman's margin-adjusted Shiller PE.  Since the current profit margins of the S&P 500 are well above the historical norm of 5.4%, Hussman estimates the Margin-adjusted Shiller PE is something like 44 times today or significantly in excess of the 40 times for the 1929 market bubble, the bubble of 2000 at 41 times, and the current Shiller PE of 31.3 (without making an adjustment to normalize margins).

By these metrics, we are clearly in an extreme financial game simulation or some other artificially created financial and market situation.  The question is are these "fake" markets of an alien origin or do they emanate from Fed monetary policies as Hussman and other market historians would vehemently argue?  My intuition is that it is Fed induced rather than E.T., the Extra-Terrestrial, playing an advanced video game.


  Margin Adjusted CAPE

The Charm And The Unknown Of Emerging Markets


Trusted Insight Logo

In last month's blog feature we ventured into new media with the introduction of to describe some thoughts on summer readings.  This month I'd like to explore the media frontier of Trusted Insight and share a video from their 2017 Alpha Investment Conference with you.

Trusted Insight (TI) is the world’s biggest network of institutional investors.  Think of it as the LinkedIn of institutional investors.  The TI network allows lead investors to syndicate investment opportunities to family offices, qualified institutional buyers, and other institutional investors across asset classes such as Venture Capital, Private Equity/Buy-out, Real Estate, Infrastructure and others.  TI also manages its own platform fund(s) and acts as syndicate lead in seed stage venture capital funds.

With over 140,000 members on the platform controlling over $18 Trillion in assets, TI is one of the fastest growing and most trusted alternative asset syndication platforms.  Each week 30,000 institutional investors engage on the TI platform.  These institutional investors are actively investing in alternative assets, primarily private equity, hedge funds, real estate and private companies.

Founded by Alex Bangash, TI started in 2010 and is venture-funded and revenue producing. Its investors were the first investors or founders of Facebook, LinkedIn, Mint,, and Blackstone, among others. The company has offices in NYC and San Francisco.

TI hosted its first annual Alpha Investment Conference in San Francisco in June.  I was fortunate enough to participate as a panel member on Reassessing The Golden Age Of Private Equity with Dale Hunt, Managing Director - Private Equity at Ascension Investment Management, Josh Stern, Director - Private Markets at Robert Wood Johnson Foundation, and Tristram Perkins, Managing Director - Neuberger Berman.  Please click on the image below to hyperlink to a 14 minute video from this panel discussion entitled The Charm and Unknown of Emerging Markets by TI.

Although the discussion is primarily targeted to institutional investors, I think it provides helpful perspectives for individual investors as well, particularly in the complex investment landscape that investors find themselves in. TI prefaced the discussion as follows: "Emerging markets take a sizable chunk of institutional capital from developed countries.  But as domestic private equity has been providing steady returns, is the risk of going into emerging markets still worthwhile?  While some warn that investors should be careful betting on emerging markets, others argue investors need a little patience and a “buy-and-build” approach.

In part three of TI’s private equity panel, investors discuss their experience and observations on emerging market investing. The panelists also answered questions from the audience."


Trusted Insights Logo


In the video, I reference a new book from Sam Zell. Please click the image below to a hyperlink to the audible site to listen to the book read by Sam. Enjoy. 


Am I Being Too Subtle?


We've also been busy over the past year or so contemplating the establishment and progression of Servant Financial over the past 12 years and going through a refresh of our branding and marketing materials to ensure proper reflection of our founding mission, values. and raison d'être.  This journey started with a new corporate logo which you see below.  Please note the heraldic shield that forms the V in Servant.  We believe investment and wealth management is a noble profession.  The assets that we manage for clients represent their dreams for the future whether it be a college education for a son or daughter, vacation home, secure retirement, or eldercare for aging parents.  At the center of the shield is a key which represents our vision of providing better client solutions through experience, passion, and integrity represented by the three rings at the bottom of the key.  The mustard plants coming forth from the key symbolize our mission to serve clients and communities with good and faithful financial advice and cultivate the growth and fulfillment of their dreams.


Servant Colored Logo


Summer Reading



The end of summer is upon us as we wind down the season over the long Labor Day weekend.  I thought it appropriate for this August newsletter to cover topics from my summer readings while vacationing in early August.  Consider it sort of like that book report we all had to prepare for the first week of school. We went to Saugatuk, MI for family vacation as we have every summer for more than a decade, but this time we took two consecutive weeks in this Cape Cod-like Midwestern retreat on Lake Michigan.  The extra week changed the pace of everything.  It was a magical trip of communing with nature, family and friends through running, kayaking, beaching, car racing, live music, dining, and, of course, reading, or in my case listening to a books on Audible.  (I found that I retain more information by hearing rather than reading.)  This is the tale of the experience as seen through the lens of my summer readings.

The odyssey began by climbing the 282 steps to the top of Mount Baldhead, or simply Mt. Baldy, above Oval Beach on Lake Michigan.  At the top of the mountain, I spied three tents of knowledge - one for Steve Case, one for Aldous Huxley, and one for Ben Bernanke.  I traveled from tent to tent soaking in each sage's wisdom.

The first tent was called Revolution after Steve Case's venture capital firm.  Steve is an American entrepreneur, investor, and businessman best known as the co-founder and former chief executive officer and chairman of America Online (AOL).  AOL was the leading company at the dawn of the consumer internet.  Steve wanted to talk to me about his new book "The Third Wave: An Entrepreneur's Vision of the Future."

Case predicts the future of the U.S. economy and describes what he calls the "Third Wave of the Internet."  AOL and other companies introduced early consumers to the Internet in the first wave.  Then search giants such as Google and companies such as Apple have led us into the second wave of the internet, the app economy.  The third wave that Steve envisions will be "the Internet of things", in which every experience, product, and service will be transacted online.  He imagines this Third Wave as being much less tech focused and more driven by centers of expertise in sector verticals.  He sees the tech geeks partnering with the industry experts to develop sector tailored tech enabled solutions.  He foresees partnerships developing in healthcare, agribusiness, manufacturing and production and other industries around existing, longstanding centers of excellence across every region of America.  These regions will have network density of expertise within sectors.  For example, in healthcare services we think of Mayo Clinic or in agribusiness with think of the Midwest and America's bread basket.  No longer will all the technological answers flow predominantly from Silicon Valley and the Bay area.  Other regions of the country will also prosper in what Steve refers to as the Rise of the Rest.  He foresees that skills around creativity and collaboration will be of critical importance in the Third Wave.  He punctuated this point with an African proverb that describes the requirements for success in the Third Wave - “If you want to go fast, go alone. If you want to go far, go together.”




I thanked Steve for sharing his wisdom and moved on to the second tent called "The Doors of Perception" hosted by Aldous Huxley.  Aldous was an English writer, novelist, and philosopher.  He is the author of nearly fifty books.  His best known work is his novel "Brave New World", set in a dystopian future while his non-fiction work "The Doors of Perception" recalls his experiences taking mescaline, a psychedelic drug.

Aldous relayed that Jim Morrison named his Los Angeles based band The Doors after Huxley's groundbreaking book.  The book itself was a reference to a quote made by poet William Blake, "If the doors of perception were cleansed, everything would appear to man as it is, infinite."  Huxley relayed that Morrison had developed an alcohol dependency that sadly led to his very early death at 27.



Aldous relayed that young Jimmy was unable to effectively process his feelings of indignation, fear and doubt.  Huxley believed that "when we bury our feelings of indignation, fear and doubt, we bury them alive."  He believes it is physically and psychologically unhealthy to bury disagreeable emotions.  We need to transform these hurts into something beautiful, virtuous, and personally fulfilling.  He says that is the way to open the doors of peace and prosperity.  He suggested that we need to practice mercy by never holding on to the bitterness.  We should be prone to forgiveness, and suppress the desire for revenge.  He recommended reading "The Paradoxical Commandments" by Dr. Kent Keith as a way to open the transformative doors of perception.  Huxley's favorite version of "The Paradoxical Commandments" was written on a wall in Saint Teresa of Calcutta's home for children entitled "Do It Anyway."

People are often unreasonable, illogical and self-centered; Forgive them anyway.

If you are kind, people may accuse you of selfish, ulterior motives; Be kind anyway.

If you are successful, you will win some false friends and some true enemies; Succeed anyway.

If you are honest and frank, people may cheat you; Be honest and frank anyway.

What you spend years building, someone could destroy overnight; Build anyway.

If you find serenity and happiness, they may be jealous; Be happy anyway.

The good you do today, people will often forget tomorrow; Do good anyway.

Give the world the best you have, and it may never be enough; Give the world the best you've got anyway.

You see, in the final analysis, it is between you and Your God. It was never between you and them anyway.

I bid Aldous adieu and headed on to the third and final tent hosted by former Fed Chairman Ben Bernanke.




Now I must tell you a few things before we relay the wisdom imparted by Bearded Ben.  First of all, Ben's tent was not a tent at all, but an orange Volkswagen vanagon.  Secondly, it was the most popular of the three sites, more popular than Case's Revolution tent, and Huxley's Doors of Perception.  There was a large crowd milling about the vanagon and the air was thick with anticipation like just before a Door's concert was about to begin.  I asked Ben what the story was with the massive crowd.  




Ben advised that he believed the people were attracted to the wisdom of his gray beard and proceeded to regale me with the history of the beard.  He advised that the Judeo-Christian tradition teaches us that God created man in His own image and that custom holds that God has a beard.  God’s beard, called Mazal, is seen as the source of all life and sustenance in creation. Mazal literally means “flow” and all fortune and goodness “flows” from God’s beard.  God's beard has thirteen knots and the untangling of these knots allows sustenance or God's mercy to flow, leading to good fortune, wisdom, and personal fulfillment.  

I was amazed at Ben's knowledge of facial hair, but had a Paul Harvey-like intuition that there was more to this story.  I commented to Ben that his gray beard was quite fashionable and perhaps "good fortune" and wisdom may flow from his beard, but surely that cannot be the sole reason for the large crowd around his VW.  I pressed him again and again until he finally confided to me that the VW vanagon came equipped with a printing press.  And, very shortly at a touch of a button "good fortune" would flow from his VW like manna from heaven.



And that is how I spent my summer vacation.

Worth Reading