(Quick programming note. I’m going to experiment with a shorter letter. Nobody has complained about the length besides Yinh. The rest of you are too polite. Not going to overthink it. We’ll see how it goes.)
The rally in the markets for the past 2 weeks has many scratching their heads. It must be especially dissonant for business owners and landlords who see the market and their own P/Ls as 2 trains headed in opposite directions.
For the visually inclined:
Sure estimating forward earnings right now is like using binoculars to study the moon, but the point remains. The market despite being lower than it was in early February may actually be equally or even more expensive as a discount of future cash flows.
Let’s remember that stocks were up 30% in 2019 despite earnings being flat. Pure multiple expansion. Mocha Joe plays the buy-stocks-then-fall-into-a-coma-game:
So I’ll add 3 comments to this in descending levels of conviction.
1) The market is actually more expensive than the Credit Suisse chart suggests
Why? The implied volatility is much higher than it was last summer. If you are willing to pay the same multiple for an asset whose volatility has doubled you are willing to accept a lower geometric return. I know many people want to shut down when they hear “geometric return”. The more you are exposed to it, the more intuitive it becomes. Internalize these bits:
- When talking about compounding quantities like investment returns, geometric returns are what you care about.
- An expected geometric return allows you to compare assets of different volatilities (without resorting to Sharpe ratios). By pulling in the notion of volatility it is more obvious that this market is more expensive than the June 2019 market.
- For the formula people, geometric returns = arithmetic returns – σ² / 2. Returns are dragged down in proportion to volatility squared.
- The easiest way to remember why compounding is so heavily impaired by volatility is to recall that you need to return 50% to make up for a 33% loss. So to make up a loss you need to return Loss / (1 – Loss). This reality means your wealth-growing process hates volatility.
I’ve explained this in more depth and with different types of examples in The Volatility Drain. (Link)
2) The market appears willing to pull earnings from ever further into the future
Perhaps this is a form of inflation. Perhaps the “Fed Put” looms larger in investor discount rates as every market crisis is deemed inseparable from a human crisis. To use a computer science analogy it’s like the Fed response has become the “greedy algorithm” which chooses immediate gratification at every node in the search tree.
Either way, I’ve said this before: I wish I could buy call options struck on the P/E ratio not the SP500. (Link)
For savers who hang out in cash looking for bargains, this is what financial repression looks like. A city without a single dive bar. You can pay up for bottle service, velvet ropes, and bad music. Or stay home.
3) Gun to my head: the next 10% in the market is higher.
First, nobody is putting a gun to my head, so this is a no-skin-in-the-game guess. Not investment advice. But sentiment seems to think that this rally is stupid and makes no sense a la Mocha Joe reasoning. This means the “stupid price” is making a lot of people look stupid. And since markets like to maximize the area of stupidity under the curve, the integral is largest if we rip even higher. I’m only using second-order reasoning but since the market can go either up or down it might be just as effective as 4th, 6th, 8th or any even number order reasoning.
The Money Angle
With all the market chaos, a bunch of friends, most of them outside the field of finance, have dove into a Whatsapp chat devoted to money strategies. The chat is aptly named “Early Retirement Inc”. This is a smart group of people with good careers. The nature of public money discourse seems to revolve around what stocks are going to do or even worse what single stocks are going to do. This means everyone, even smart people, are breathing polluted air.
I’m gonna take a stab over the next couple weeks at a healthier approach. A lot of financial advisors read this so I’m sure I’ll be corrected. But if you want to get the right answer to something, you publically say something obviously wrong. Let’s see what happens.
The Retirement Problem
You work for 40-50 years but you live for 20 to 30 years more. The problem you must solve: don’t run out of money. Retirement finance is a vast field filled with overly precise mathematical treatments of “safe withdrawal rates” and investment allocation “glide paths” (think a target-date fund that is aggressive when you are young and conservative as you age). William Sharpe who won the Nobel Prize for the CAPM model called it the hardest problem in finance.
I’m not going to bore you with all that. I’m also not going to bore you with my soapbox rant about how destructive I think the whole vision of retirement is as portrayed by Charles Schwab commercials. The fact that it takes a moment to figure out if it’s a financial commercial or a Viagra ad is enough of hint that drugs are being sold in both cases.
Instead, I will encourage you to walk through an exercise that identifies the most important levers of the problem. I’ve put together a Moontower Retirement Model that you can make a copy of and play with your own numbers. I built it years ago and because of back and forth in my Whatsapp chat had a chance to dust it off and improve it. The model’s value is not in its output. “Hardest problem in finance”, remember?. It’s laden with assumptions and simplifications. It also spits out a path without confidence intervals. You can’t get away from the shortcomings. But if you have never worked through something like this, you are going to think about money in a much more enlightened way afterward.
Here’s the Moontower Retirement Model
(Please don’t hesitate to ask questions, point out errors and so forth. I’d like to enhance it over time.)
Here’s a screenshot of the input screen:
You will have fun trying to estimate numbers for your household income and expenses and if not it may alert you to get a grasp on these things.
Once you have some reasonable assumptions start tinkering with:
1) Inflation and investment return rates
Inflation is applied to pay and expenses evenly. Investment returns are applied to your entire net worth. Since net worth includes cash, homes, and stocks try to estimate a decent weighted-average return.
2) Retirement Age
Every year you delay retirement has a double impact. You increase savings that can grow AND you don’t withdraw return-generating assets.
A dollar saved is another source of big swings. You not only reduce the expense but you reduce the compounding of that expense. Or you can say that a dollar saved is also extra dollars in the future due to compounding. This is the most interesting lever because it’s high impact and insofar as you can control your expenses, it’s the lever you can steer the best. In contrast to, say, inflation. Good luck understanding inflation nevermind controlling it.
Don’t focus on the specific numbers as if you saw your future. You didn’t. This exercise has immense value despite that.
- A well done Twitter thread “over-analyzing” how certain comedic bits hit the mark. (Link)
- Some friends and family are referencing vivid dreams in this time of Covid. Well this is really a thing. (Link)
- I’ve mentioned Air BnB Experiences before as a cool way to try something new in your city or get a true local experience in a city you are visiting. Since all of that is on hold, they just launched “Online Experiences”. This is also a neat channel for people who want to try on a side hustle. (Link)
- Steve found this crazy story in the always amusing “Am I The A**Hole” subreddit. (Link)
- Last week I enjoyed sharing the clip The Drawing Advice That Changed My Life. Many of you appreciated it too. Ben found an analogy in his own life to the video. In his daughter’s lessons, the piano drills was “drawing the ibis” but the singing that she’s discovering by being forced to do piano drills every day is the “social commentary” from the video. I encourage watching the clip if you haven’t. For posterity, the 4 tips at the end:
- “Action comes before motivation”. Not the other way around.
- “Quantity leads to quality”. In other words, you suck when you start. How else would you expect it to be?
- “Don’t let thinking be a form of procrastination”. Thinking is not doing. I say it all the time: you can’t introspect your way forward. Thinking feels like doing but it’s not.
- “Constraints lead to creativity”. Too much freedom will actually stop you from being creative. This rhymes with necessity being the mother of invention. A guitar teacher once encouraged me to do nothing but use one string. Masters like Clapton and Hendrix got infinite mileage out of a 5 note scale.
From my actual life
In the spirit of not letting a crisis go to waste, we directed our energy towards, ugh, being productive. Instead of gallivanting around Napa or going for a boozy brunch like overpaid 26-year-olds we coordinated homeschool Zoom calls, guided math problems, did our taxes, and evena family workout. At night, John came by with a great bottle of sake. Don’t worry he went straight to the backyard and we all kept our distance. It was, in fact, a “good” Friday.
- The Peloton app has a free 90-day trial. We don’t have the bike but their upbeat trainers will guide you through different types of workouts from strength to yoga to cardio and more. The app is well-laid out so you can easily filter the live schedule or you can just do old videos. Plenty of 10-minute workouts too.
- Ozarks season 3 was so good I couldn’t help but watch on a weeknight. Jason Bateman is the director. Talent clusters in unfair ways.
- Thanks to Vincent, we started watching Succession. From the first episode, we were drawn in. It’s supposed to be a Murdoch-esque tale of corporate intrigue. The characters are quirky in a way that makes for a unique mix of drama and humor. It’s an HBO show but also available on Hulu and Amazon.
By the way, I haven’t watched this much TV since Kirk Cameron was considered a sex symbol. You are either too young to get that reference or I just gave you a collective sense of what a “coyote morning” feels like. You’re welcome either way.