The Next Four Years

Finally.  We have a winner.

After an unfathomably long campaign season, a relentless barrage of attack ads, and political narratives so bizarre and contrived it makes one think that the U.S. has turned into a nation of zombified crazies, this thing is finally over.  I, for one, am happy I don’t have to “check” every “fact” anymore.  What does it say about our sociopolitical system when nobody can even agree oninformation?

In any case, our national nightmare has drawn to a close.

All hail the new king.

His name is Nate Silver.

After today, he will be known as the guy that went 50 for 50 in 2012.

If his name is unfamiliar to you, go watch this video or this one, which is quite funny.  In fact, watch them on mute.  You’ll see what I mean.  He’s a straight-up nerd.  One of my people.


I’ve been linking to FiveThirtyEight Blog for a while now.  During the 2010 election I found it something of a novelty – huh, here’s this guy who has a real life statistical model for predicting election outcomes.  Cool.  It spoke to me immediately.  And between Nate’s blog at the NY Times, RealClearPolitics’ awesome polling aggregation, and Gallup’s survey data on issues, I’ve felt like I had everything I need to understand whatever’s happening in today’s politics.

The neat thing about these sources for political insight is that they are each entirely data-driven.  There’s no spin, just numbers and percentages.  To me, it feels like coming home.

Allow me to explain: I’m a huge baseball fan.  And what’s worse is that I’m the most insufferable kind of baseball fan.  I’m the kind of guy who geeks out over strange statistics like WAR and wOBA and UZR/150.  True story: I tried to explain Wins Above Replacement to Mrs. Concord once on a drive and she fell asleep.

This all began back when I was in college and I started reading this obscure columnist at ESPN named Rob Neyer.  He, of course, led me immediately to the great Bill James, and like a lot of us who discovered Bill James in the 90′s, our lives would never be the same.  As a kid who grew up memorizing statistics on the backs of baseball cards, I thought metrics like batting average and RBIs mattered.  When I learned about newer, better ways of quantifying performance, I felt like somebody had personally handed me a treasure map.  It would be essential on my lifelong quest for seeking outvalue.

That discovery carried over into other interests and endeavors.   Sure, it’s kept me from getting swept away by glossy narratives like Miguel Cabrera’s triple crown (viva the real MVP, Mike Trout!).  But more importantly, it’s helped me become a more successful investor and an understanding of advanced statistical analysis been essential at enabling me to follow politics without going utterly, batshit insane.

Anyway, your mileage may vary.  Statistics and percentages get my blood pumping but they put Mrs. Concord to sleep.  She prefers a good story, and that’s OK too.  She is way more fun at parties than I am.

Before we move along to some economic analysis, you need to understand that all of this stuff carries an important, final caveat:

These models are not infallible.  When you are dealing with statistical models you are dealing withspheres of probability.  Probability is a slippery, misunderstood thing.  The next election is going to roll around and this time the entire world is going to want to know what is going to happen and if itdoesn’t happen that way they will get angry and confused.  They’ll think these models are stupid, when in reality, it was just a case of the actual outcome differing from the most probable outcome.

In fact, it was finance that taught me that lesson.  I watched a whole bunch of fancy Wall Street quant funds run by particle physicists blow themselves to pieces in 2007 and 2008.  A lot of them thought that applying gaussian distributions to the world of finance was a good idea and learned the hard way that it was a very bad idea.   Apparently, they’d never read When Genius Failed.  They’re a humbler bunch these days, especially since many of them haven’t made much money in the last few years.  They manage risk differently.

The Next Market Cycle

Part of me wonders if the action of the last two days is a “sell the news” type of situation.  Investors have been buying the rumor all summer long, and now that the Obama victory finally happened, it seems like everyone is selling the news together.

After hours S&P futures immediately sold off after the Obama victory became apparent.  Gold rallied.  It seems to suggest a new round of market volatility.  The Dow dropped over 300 points yesterday.

If you’ve been following this VIX, you noticed that this didn’t start with the election.  Volatility has been slowly trending higher since mid-September.

I’d be very surprised if this volatility didn’t persist through the next several months.  See, the dirtiest secret of all is that Obama is powerless to repair the economy, every bit as powerless Mitt Romney would have been.  Sorry, everybody.  And now that we know who’ll be at the helm for the next 4 years, everybody is waking up from the campaign haze and realizing that the economy still faces a major slog and none of these magic policies are going to move the needle much.

I know you don’t like hearing that, not when, according to Gallup, the economy was far and away the most important issue to you in this election.  Nobody wants to hear that their man can’t do anything about the thing they care most.  To make matters worse, Obama will even have to abandon some of his campaign promises (just as Romney would have) as he’s forced to deal with the real world of policy compromise.

The secular changes I’ve been writing about for a long time on here — globalization, demographics, deleveraging — are going to have far more impact on the trajectory of our economy than any policy decisions the President may make.  Those are the things that long term investors need to pay attention to, not who wins this or the next election.

And they’re clear trends, too.  They tell you that investments that will provide solid, defensible cash flow will have a lot of value.  Energy, for example.  They tell you that growth is going to come from different sectors.  Sectors like finance that have led the way aren’t going to lead the way in this new world.  Globalization represents problems for developed economies, especially if they don’t have the capacity to innovate.  And trends like deleveraging can present long-term trouble for major currencies like the Euro and the Dollar.

As for seeking out growth, “technology,” by definition, is growth.  Unlike every other sector of the economy, the very nature of the technology sector changes over time.  20 years ago, a company like Microsoft or Intel that made computer stuff counted as tech.  Today they’re more like industrials.  There was a time when railroads were technology companies.  And there will be a time when businesses like Google and Facebook will more obviously be categorized as the consumer services that they truly are.  So if you’re looking for growth, you can do a lot worse than picking out the stuff at the leading edge of the technology curve.  Look for new businesses that solve old problems.  This strategy has worked for a long time.

Or flip that process and look for old problems in dire need of fixing and then see if you can spot something new that might solve it.  To be fair, most of that stuff gets gobbled up at the VC or private equity phase.  IPO’s these days aren’t about gathering capital, they’re about rewarding private shareholders.  That’s an important lesson that will serve you well on your quest for growth.

The Fiscal Cliff

This immediately goes to the top of the list.  It’s policy problem #1 and Congress has less than two months to figure out how to resolve it.

As it stands, on January 1, 2013 some massive spending cuts and tax increases are scheduled to go into effect.  While a rational contrarian might (correctly) say, “well isn’t that the sort of thing that hasto happen to get the budget back on track?” the problematic aspect is the immediacy of it.  Are we ready for a $600 billion hit to GDP now?  Now, when the economy is limping along at a less-than-2% rate?

Look, nobody is more on board with the idea of repairing the budget deficit and federal debt than I am.  But I’m not such a slave to fiscal ideology that I lack common sense.  What we need, and what I hope Congress will deliver, is a glide path.  We need to enact policy that doesn’t disrupt GDP too much next year, but gets the budget on a more sustainable track 10 and 20 years down the road.  (e.g. raising the retirement age to help the cost and solvency of Social Security.)

What’s more, we need to start seeing some policy that’s permanent.  Like, now.

This is incredibly important because one of the biggest reasons why economic confidence is low has to do with policy/regulatory uncertainty.  You don’t have to go too far into the world of behavioral economics before you start seeing all sorts of interesting studies on how the expectations one has for the future impacts the decisions they make in the present.  If you give someone a dollar and tell them you’ll give them another dollar next year and every year thereafter, they behave very differently than if you give them a dollar and tell them that there’s a 50% chance you’ll give them a dollar next year.  Or that you might even take back the dollar you already gave them.

Or, let’s say you give everybody a 2% reduction in their payroll tax and tell them it’s a one time thing and is only going to last for one year.  But then at the end of the year, you tell them that — surprise! — we’re going to give you a bonus year of this thing.  At the end of year two, they’ve forgotten that the payroll tax used to be 6% and think that it’s always supposed to be at 4%.  When you tell them you have to go back to 6%, they freak out because it’s an OMG TAX HIKE!!!

What’s going to happen?  Are Republicans going to compromise on tax policy?  Will the Democrats start thinking more realistically about spending and entitlement programs?  Will Obama provide the leadership and unity he promised?

I honestly don’t know.  And there’s no way to calculate the odds.

Up until this point the response to every policy issue was pretty much “well, just wait until after the election and then everything’ll get fixed.”

I’m wondering now if that’s going to happen.  We need permanent policy and we need it fast, and with all the political intransigence and aggressive campaigning this year, I’m not sure Congress is prepared for this kind of work right now.

The Other Bogeyman

The Fiscal Cliff is going to be an issue, but it’s only going to be an issue for the next couple of months.  It will resolve itself in one way or another quickly (it has to) and the unavoidable consequence will be some short-term volatility.

Remember my Three Big Points, the three most important things that every investor needs to be watching right now?

  1. Real interest rates
  2. Short-term panics
  3. Corporate earnings margins

The Fiscal Cliff could count as a legit example of #2 depending on how much confidence the market has in Congress.

But #3 is approaching and could even be arriving right now.  In the third quarter we saw earnings growth flatten out a bit and now we’re going to find out whether U.S. companies will start to give back some of that growth.

Now, I get why profits are so high.  Interest rates are insanely low.  Borrowing costs for big, solid firms are almost non-existent.  Companies like Microsoft, who have as little need to borrow money as anybody and have of money under every mattress, are borrowing money right now to finance their dividend because it’s far cheaper than repatriating foreign cash and paying the taxes.  It’s a pretty wild equilibrium we’ve found ourselves in as a result of the Fed’s ZIRP and Q-Infinity programs.

Buuut, shouldn’t that not matter?  At least assuming that our markets are relatively free and that hungry companies can eventually eat some of the share?

Here’s a chart of corporate profit margins as a percentage of GDP.

Wanna know where the market could go?  OK.  Let’s run some simple math.

First, we have to make some assumptions:

Let’s assume that this is not a brand new utopia where companies have found magical new ways to be profitable in a way that they never have been before.  Let’s assume that, as it has throughout recorded economic history, these extremely profitable sectors of the economy do attract new competition and that existing competition increases.  And finally let’s assume that the federal government wants a piece of that earnings pie through higher taxation, which is totally reasonable given how desperate Uncle Sam is for new revenue, but maybe a little unreasonable seeing as how the people with the power to make that decision have been purchased by the very corporations which are generating the Super Profits.

In any case, all of those assumptions would conspire to bring earnings margins back in line towards their historical average.  For simplicity, let’s say that’s 6%, and let’s also say that it doesn’t overshoot, either, the way it would in a recession.

With current GDP at $15.8 trillion, that would suggest corporate profits of roughly $950 billion.  Corporate profits are currently running at about $1.6 trillion.  So a historical normalization would represent a 40% drop in after tax corporate earnings.

S&P earnings sit today at around $88/share.

A 40% drop would cut S&P earnings to around $52/share.

This is hardly an unreasonable conclusion to arrive at, given that $52/share is almost exactly what you get if you run a regression.

Next: what kind of multiple do you want to hang on the S&P?  20x?  15x?  10x?!

Again, because I don’t have the right answer to that question, let’s just use the 112 year average, which is 15.7 in my spreadsheet.

$52/share with a 15.7x multiple gets you an S&P of 816.


That’s a long way down.  In case you missed it, the S&P closed yesterday at 1394.

Before the financial crisis hit, the standard deviation on the S&P’s ttm P/E was 5.8.  So let’s adopt a range of outcomes from 520 to 1118 for where the S&P should theoretically be trading if corporate profits normalize.  That’s probably too wide a band, as I can’t imagine the S&P violating its 2009 or 2002 lows.  But a technical re-test of those levels is awfully tempting, especially if you have some fundamentals-based arguments to back it up.

Look, this isn’t witchcraft.  Nate Silver isn’t doing anything fancy with his political forecasting and I’m not doing anything fancy here either.  All I’m doing is using basic math and statistics to generate a sphere of probabilities and range of possible outcomes.  It’s the same thing we’ll do to forecast Miguel Cabrera’s batting average next year, and in all likelihood, it’ll really will fall somewhere inside that range.

This is why I feel comfortable predicting a secular top.  I know people have been harping on the “record profit margin” topic for a little while, but these trends take time to adjust.  The internal dynamism of the U.S. economy doesn’t re-shape itself overnight.  It takes a cycle or two.  The reason why I’m comfortable with this prediction now and wasn’t a year ago is because the latest data show that profits have finally peaked and plateaued.  S&P earnings have been going up for three straight years and now they’ve officially stopped.

Remember that all of this is still contingent on a contraction in corporate profits.  If you do notbelieve that corporate profits will contract and you are one of those Wall Street yo-yos who thought S&P earnings would get above $100 this year or next, then feel free to reject this entire exercise.

If this slowdown in profit margins is just a little hiccup that only lasts for a quarter or so, then I’ll be wrong on my call of a secular top.  No biggee.  It’ll just be one more item appended to the (very) long list of things I’ve been wrong about.  Ask Mrs. Concord about this list sometime!

Yet she loves me nonetheless.

And if I’m wrong about this call — and there’s a realistic chance I might be —  hopefully you’ll still love me too.

Source:  Cognitive Concord


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