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Seeking Magnified Returns via Alternative Investments

Seeking Magnified Returns via Alternative Investments

Where to Find Reliable, Risk-Adjusted Returns on investments…

  • Peer-To-Peer Lending
  • Short-Term Construction Lending
  • Life Settlements
  • Merger Arbitrage

Most of us are familiar with the famous fictional private detective, Sherlock Holmes, created by British author, Sir Arthur Conan Doyle. In the stories, Holmes was known as a “consulting detective”, tactically tapped by his clients (often Scotland Yard) for his proficiency with observation, forensic analysis, and logical reasoning, to help solve tough cases.

One of Sherlock’s famous phrases was “whenever you have eliminated the impossible, whatever remains, however improbable, must be the truth”.  We at Three Bell suggest that while making solid risk-adjusted returns in the public markets is not necessarily impossible, it is becoming more and more improbable. As such we are looking elsewhere for opportunity. Much like Holmes, we apply many of the same principals and skillsets to assist our clients in navigating the changing (and at present, challenging) financial markets.

Last month, we discussed how the public stock and bond markets are fully priced and adding alternative investments to your portfolio can reduce volatility, increase returns, and mitigate downside risk.

In this edition of “Cutting through the Noise”, we examine alternative investments to overvalued public market investments.  Although its anything but, ‘Elementary, my Dear readers’, we believe these alternatives provide clues to where to find higher returns with lower risk. Let’s dive in!


Holmes was famous for his use of deductive reasoning to take seemingly disparate facts, and use them to formulate a complete picture of what had actually occurred. Following Holmes’ example, in order to understand where certain alternative investments fit into a well-diversified portfolio, we must first understand where the sum total of all of the world’s investable assets are deployed.

By limiting investment choices to stocks and bonds, we eliminate options in two-thirds (~66%) of the investment world.

Take a look at the chart below. What we can deduce is that public markets (stocks and bonds) actually represent a comparatively small portion of the overall investable universe…and, as we discussed in our last article are the most overvalued cross-section at that.

Domestic equities and bonds - fraction of investables
Source: Oliver Wyman

The vast majority of the public market investment universe (stocks and bonds) is confined to the first four ‘colored blocks’ above, and represents just $159T out of a total $437T of investable assets. By limiting investment choices to stocks and bonds, we eliminate options in two-thirds (~66%) of the investment world.

However, almost all of that remaining $300T can be accessed through some form of private offering, typically through a hedge fund framework, that can blend nicely with a public market portfolio. On that note, let’s take a look at some of the specific alternative investment strategies Three Bell is currently leveraging on behalf of our clients to help mitigate the volatility of the broader stock and bond markets, as part of a well-diversified portfolio.

…many new private credit markets [sic] can offer disproportionate returns to those available in the public fixed income market.


Our last edition of “Cutting through the Noise – Think Alternative(ly)” broadly discussed alternatives as an asset class. However, there are a wide variety of investments that fall within that category and generate returns in vastly different ways.

Credit Market Niches’

The financial crisis of 2008-09, which was first and foremost a credit crisis fueled by defaulting subprime mortgages, resulted in many changes to the banking sector. The sum total of these changes was a substantial pullback from banks offering certain types of financial products, and a “back to basics” mandate. The net response to these changes is many new private credit markets that can offer disproportionate returns to those available in the public fixed income market.

Peer-To-Peer Lending Funds

A specific niche type of lending platform that has gained significant traction since the Financial Crisis is peer-to-peer (P2P) lending. This category looks to serve the individual loan market that does not want to borrow through unsecured, revolving credit (eg credit cards).

Lenders (in our case, a hedge fund) extend credit, often at rates similar to credit cards, but allow borrowers to amortize that debt from the outset, enabling borrowers to see the light at the end of the tunnel and thereby dramatically reduce instances of default. These lenders can then pass along high returns to their investors because they operate much more efficiently than the big banks.

One such hedge fund utilizes a complex algorithm that evaluates and weighs over 1200 different unique data points for each loan, then uses a high-speed trading conduit into the lending platforms to purchase the best loans within 40 milliseconds. This pretty much leaves the little guy out of the equation, but does offer an excellent risk-return profile to investors in such funds.

What do we like about this alternative investment?

  • Consistent, high single digit, low double digit returns since inception (currently annualizing at approximately 12% net of fees)
  • Little to no correlation with the stock or bond markets
  • Maximum loan size is $30K and most are 3-year loans, which means a fund investing tens of millions of dollars is going to own a LOT of loans that are paying off in a relatively short period of time
  • Personal loan deficiencies consistently remain lower than other loan types, including auto loans, mortgages, and credit cards. Supporting data illustrates this further.
  • 9% of investors in this market segment have made money in personal lending over the past 10 years.
  • Default rates through the Financial Crisis needed to be 70% more severe before investors would have lost ANY money in this asset class (see chart below)
Source: Federal Reserve via Theorem Marketplace Lending Fund

Short-Term Construction Lending Funds

Traditional banks lost their shorts in the Financial Crisis, partly because they had loaned money to real estate developers who walked away from unfinished projects, forcing the banks to repossess the properties. Worse, global Basel III commercial banking regulations written after the Financial Crisis prohibited the banks from holding the assets until they recovered their value, and banks were thus forced to liquidate in a fire sale, locking in substantial losses.

Due to those regulations, many traditional banks exited the short-term construction lending sphere, which left a void of capital for real estate developers that needed to borrow money to build their properties. Enter private real estate debt funds…

There are many high return business models that lend themselves well to the private, hedge fund format.

Because of the scarcity of capital for real estate projects, hedge funds that effectively analyze and pick high quality, low risk projects, can charge double-digit interest rates on what are typically relatively short term loans (1-3 years), and are then cashed out of the project entirely when the development is complete and the debt is refinanced with a traditional bank and long-term debt.

What do we like about this alternative investment?

  • High annual interest rates of approximately 12% net of fees
  • No property depreciation risk since not buying the asset, just loaning funds
  • Short term loan duration of 1-3 years
  • Senior secured debt gets paid off first in the event of default
  • Maximum 70% LTV established at time of investment
  • Ability to repossess property at a very low cost and hold that property or develop it to maximize investor returns (thus eliminating need for fire sales)
  • Little to no correlation with the larger stock or bond markets

Special Situations

There are many high return business models that lend themselves well to the private, hedge fund format.  These opportunities vary in their reliance on the underlying stock and bond markets, but one variable remains the same… the overall correlation to the public markets is historically very low.

Life Settlement Funds

A life settlement is the transfer of ownership and beneficiary rights of an unwanted or unneeded life insurance policy in exchange for a cash settlement. The seller of the policy no longer has the responsibility of paying future premiums.  In exchange, buyers (investors) profit based on the difference between the face value of the policy (death benefit) and the aggregate of the acquisition price, plus accumulated premium costs.

The typical returns for investors in these policies have been 10-18% per year with very little volatility, as seen in the graph below.

Carlisle Life Settlements IRR
Source: Carlisle Management Company

The life settlements industry, and returns thereon, are expected to continue to grow due to 1) projected increases in the US senior population and a resulting larger pool of policyholders potentially looking to sell, and 2) the large gap between the current size of the life settlement market (under $20B) and the value of the individual policies that lapse or are surrendered each year (over $640B).

Voluntary Life Insurance Terminations and US Population age
Source: Carlisle Management Company

What do we like about this alternative investment?

  • There is little to no correlation to the larger stock and bond markets
  • Returns are well into the high teens every year since inception
  • Returns are very stable and experience very little volatility
  • The underlying policies are with investment grade carriers
  • Returns are almost all long-term capital gains making it very tax efficient

Merger Arbitrage Funds

Merger arbitrage entails investment in event-driven situations such as leveraged buyouts, mergers, and hostile takeovers. Because of the risk that a merger will not close, the target company’s stock will typically sell at a discount to the deal price. This pricing discrepancy or “spread” is a merger arbitrage fund’s potential profit.

There are a variety of reasons why a merger might fail, creating this opportunity, including government antitrust rulings, financing failures, and shareholder rejections. However, with proper position selection, a merger arbitrage fund can largely immunize itself against stock market fluctuations. This is due to the fact that the fund isolates its exposure to the compression of the spread between only two stock prices, the acquiring company and the target company. Thus price movements at the market level become largely irrelevant.

What do we like about this alternative investment?

  • Returns for the fund we utilize have annualized at approximately 28% since inception, net of fees
  • Low-interest rates and a sluggish economy should lead to increased M&A activity
  • At 170 announced deals, there are a lot of potential mergers to address
  • The Dodd-Frank Bill forced many investment banks out of merger arbitrage, lessening competition
  • Arbitrage spreads tend to be positively correlated to overall interest rate levels (profit tends to increase along with interest rates in a rising rate environment)
  • Fund strategy isolates returns from larger stock market fluctuations, reducing correlation and providing true diversification


Based on an extensive examination of all the clues presently available, we deduce that the public markets offer more risk than return. That said, no one can predict the market, and there is always the possibility that it pushes inexorably higher.

In response to this upsidedown risk-return paradigm, we do not suggest investors retreat to the unacceptably low-interest rates available in money funds.  Rather, we can utilize certain alternative investments to continue to produce stable returns by investing in funds whose underlying assets and strategies are not tied to the stock and bond markets.

Through the use of alternative investments, in concert with stock and bonds, our intention is not to predict the market, but rather prepare for all outcomes.



Three Bell Capital (“Three Bell”) is a registered investment adviser with the Securities Exchange Commission. The information provided by Three Bell (or any portion thereof) may not be copied or distributed without Three Bell’s prior written approval. All statements are current as of the date written and does not constitute an offer or solicitation to any person in any jurisdiction in which such offer or solicitation is not authorized or to any person to whom it would be unlawful to make such offer or solicitation.

This information was produced by and the opinions expressed are those of Three Bell as of the date of writing and are subject to change. Any research is based on Three Bell proprietary research and analysis of global markets and investing. The information and/or analysis presented have been compiled or arrived at from sources believed to be reliable, however Three Bell does not make any representation as their accuracy or completeness and does not accept liability for any loss arising from the use hereof. Some internally generated information may be considered theoretical in nature and is subject to inherent limitations associated therein. There are no material changes to the conditions, objectives or investment strategies of the model portfolios for the period portrayed. Any sectors or allocations referenced may or may not be represented in portfolios of clients of Three Bell, and do not represent all of the securities purchased, sold or recommended for client accounts.

Think Alternative(ly)… Invest Different

Think Alternative(ly)… Invest Different

By: Bill Martin
Senior Managing Director and Investment Strategist

With both stock and bond markets priced for perfection, it is time to look for asset classes that can provide true diversification to lower risk and increase returns.


Apple, Inc. taught us the power and promise available through embracing change, if we only learn to ‘Think Different’.  We believe that has never been more appropriate and applicable than right now for the financial markets.  In an homage to that timeless Apple precept, we encourage investors to look beyond the typical herd mentality for answers and find “alternative” sources of excess returns.  With the bond market offering record low yields and the stock market trading at record high earnings multiple valuations, we try to answer the question… what’s an individual investor to do?

We’ve all heard it our entire investing lives:  diversification is the key to stable, long-term investment returns.  OK, great, but diversification into what exactly?  It’s entirely possible to diversify into a terrible investment and in so doing, do yourself a disservice.  Logically, diversification into just “different” investments, in and of itself, is not going to help investment returns, particularly in the event of a substantial market correction.

Historically, for many investors, diversification has meant spreading assets across different segments of the stock market, with a portion of the allocation going to smaller more nimble growth-oriented companies, some to larger more established value-oriented companies, and then splitting that up across both domestic and international exposure.  The resulting pie chart shows a wonderfully diverse array of colored pie wedges, creating the illusion that we have accomplished our diversification objectives (at least graphically).

The only way to achieve this “true diversification” is through an asset class broadly referred to as “alternative investments.”

However, when markets experience severe declines, the returns of these various sectors tend to homogenize and drop at the same rate.  This is what we refer to as “correlation.”  During the Great Recession, even if you had all of your fixed income allocation in US Treasuries you still experienced a drawdown of -20% or more.  That number was closer to -40-50% if you were 100% in stocks and bonds that did not contain Treasuries… no matter if you were in US or International, investment grade corporates, or high yield bonds.

So, when we think about true diversification, and the benefits we are supposed to realize from that concept, we must find investments that are not correlated to the larger stock and bond markets, and are capable of generating positive returns regardless of any form of precipitous correction, market decline or increase in interest rates.

The only way to achieve this “true diversification” is through an asset class broadly referred to as “alternative investments.”  By using alternative investments, it is possible to design an “all-weather” investment portfolio where each individual component of the allocation is making money in a way which is both divorced from the broader stock and bond markets, and at the same time different from the other investments within the portfolio.

In this edition of Cutting Through the Noise, we investigate how to use alternative investments as a key component to portfolio construction to achieve stable non-correlated, long-term returns, and why it is particularly important to do so now given where we are in the current market cycle.

Low Expected Returns for Stocks and Bonds and the Need for Diversification

In order to understand the importance of incorporating alternatives into your portfolio, we must first understand the current challenges of the two traditional primary asset classes:  stocks and bonds.  As you will see below, neither are poised for outsized gains, and instead both are set to experience significant headwinds.

Bond Market Headwinds

In the fixed income world, we earn the interest income from the bonds we hold, plus or minus any increase or decrease in the underlying value of the bond holdings.  The biggest driver of increases or decreases of bond prices are interest rates, namely, what is the present interest rate vs the rates when the bonds we hold were issued.

As interest rates rise, the price of a bond portfolio tends to depreciate, and vice versa.  This is because in a rising interest rate environment, new bonds are being issued which pay higher coupon rates than those that are held in the current portfolio.  Thus, if those bonds were to be liquidated in that environment, they would need to be discounted to account for the lower coupon payments.

So, where are we in this cycle?  Gradually lower and lower interest rates due to global Central Bank bond buying programs (“Quantitative Easing”) has driven interest rates to levels previously not seen.  From this level (see chart below),

there is more risk than return available in the bond market.

Based on the chart above, we believe that its more likely interest rates will rise from where they are now… versus fall.  If this is in fact accurate, the best case is for bond investors to earn the income associated with the bond coupon and hold those bonds to maturity to eliminate interest rate risk and resulting pricing fluctuations.  This puts returns anywhere between 2-5%, depending on how much credit risk an investor is willing to accept.

Stock Market Headwinds

As a result of these artificially suppressed interest rates, investors have sought higher returns elsewhere and have correspondingly pushed stock prices to near historical high valuation multiples – particularly when considering the low level of economic growth in the underlying economy.

In order to understand where the headwinds exist in the stock market, we need to start with the general understanding that the more an investor pays for earnings, the lower their expected return.  We have a nice chart that illustrates that point below.

Both the bond and stock markets are much more likely to decline than provide historical levels of return going forward. 

Time to get outside of the box…

The market is currently trading at earnings multiples that are higher than any other time in our history, except for a few months in 2000.  As such, we believe P/E multiples are unlikely to expand much further and are instead much more likely to contract.

This, coupled with muted GDP (around 2%), means that earnings growth is also likely to be muted which creates overwhelming risks to the downside for the stock market.  Historically, the 10 years after the stock market trades at these levels, the result is a paltry 1% annual growth (see our CAPE blog for more in depth analysis).

Key Takeaway

Both the bond and stock markets are much more likely to decline than provide historical levels of return going forward.  Interest rates are more likely to rise than fall dramatically hurting bonds, and earnings multiples are more likely to revert to the mean and compress hurting stocks.

As a result, we believe traditional portfolios that have relied solely on these two asset classes for diversification and returns are, at best, going to suffer mediocre returns for the foreseeable future, and at worst (particularly in the case of the stock market) suffer severe declines in asset values.

Time to get outside of the box…

What are Alternative Investments and What Do They Do?

The intent of considering alternative investments is to maximize the odds of increasing our total investment return profile, while reducing the risks that are stacked against us if we invest only in the public stock and bond markets.

The chart below illustrates some of the high level key differences between alternative and traditional investments:

The alternative investment category opens up a broad universe of options that are often times overlooked, which if properly deployed can create correspondingly superior risk/return opportunities. 

We are all very familiar with the “Traditional” row on the top of the chart – buy stocks and bonds and hope they go UP…that is what is meant by “Market Direction Sensitive” in the last column in the top row above.

In the “Alternatives” row on the lower part of the chart we see options beyond just stocks and bonds which, very generally, include all asset classes other than long stocks, bonds, and cash. Specifically, Alternatives include funds that trade long/short equity, real estate, private equity, life settlements, venture capital, commodities, merger arbitrage, specialized debt, and much, much more.

The alternative investment category opens up a broad universe of options that are often times overlooked, which if properly deployed can create correspondingly superior risk/return opportunities.

The triangle chart below provides a conceptual framework that illustrates the potential benefits of combining various alternative investments.  Specifically, alternative investment portfolios should include an intelligent combination of fund strategies that generate outsized uncorrelated returns, deliver inflation protection, and provide hedged downside protection thru “true diversification.”

…many hear the term “hedge fund” and pre-judge in the negative, either because of historical underperformance or because they have heard hedge funds are all “risky.” 

Impact of Alternatives on Portfolio Returns

We wouldn’t be looking at this important asset class if it didn’t deliver demonstrable benefits.  However, we must start with a caveat:  most alternatives are packaged as “hedge funds” and most hedge funds have lagged the broader stock market recently.  As such, many hear the term “hedge fund” and pre-judge in the negative, either because of historical underperformance or because they have heard hedge funds are all “risky.”

“… alternatives have shown the ability to both lower risk AND increase return.”

To that we have three comments:

  1. Returns are time period dependent. As such, many hedge funds did their jobs well and looked dominant vs index funds and ETFs leading up to and through the financial crisis.  They “hedged” against negative returns.  That’s what they do.  Now that the market has run to historically high valuations (see above), would you rather stay almost entirely in long only stocks and bonds or consider diversifying to hedge some of the downside?


  1. There are many types of hedge funds, ranging from “conservative” to “aggressive” and everything in between, and many of them do not simply “hedge” stock or bond market risk. In fact, some of them are completely off the grid, don’t have anything to do with stocks or bonds, and can perform well regardless of what the broader stock or bond markets do.


  1. Keep an open mind as we avoid driving through the rearview mirror. Investing is not easy and the truest long term successful strategy is to be contrarian.  Many alternatives and hedge strategies are built to capitalize on this phenomenon.

We have two very important graphs to examine below.  The key take-away is that alternatives have shown the ability to both lower risk and increase return.  This is despite following a record bull market run facilitated by the world’s central bankers.  History suggests that the risk-return benefits of alternatives will be even higher in the intermediate future.

The first graph shows the risk and return for a typical “balanced” 60% stock and 40% bond portfolio.  The stock portion is invested 2/3 domestically and 1/3 internationally.  The return of that balanced portfolio has been 7.94% with an annualized volatility of 8.81%.  This portfolio is said to have a simplified Sharpe ratio (return/volatility) of .90.

This simplified Sharpe ratio is an efficiency evaluation metric to indicate how much return your portfolio gets per unit of risk.  The benefit of lower volatility is that it will typically help investors from selling at the wrong time.  It is always important to keep that number as low as possible.

The next graph below shows the benefit of allocating 50% of the portfolio to Alternatives, while keeping the remaining 50% in the 60/40 stock bond mix cited above.  The return increases to 9.33%, while risk declines to 7.28.  This configuration delivers a 1.28 Sharpe ratio, or a 42.4% increase in efficiency.  Greater returns, less risk.  Check!

“… investors often end up taking more risk by going into riskier market segments like high yield bonds or emerging market equities at just the wrong time.  At market peaks, these segments actually add risk rather than reduce risk.  We call this Di-worse-ification.”

These graphs clearly illustrate the benefit of adding alternatives into a portfolio otherwise comprised entirely of stocks and bonds.  The alternative investments into which we are currently deploying capital should have an even more dramatic positive effect, as they have higher expected returns with lower downside risk than the examples used in the above graphs.

Summary: Utilize Alternative Investments to Provide True Portfolio Diversification, NOT Di-worse-ification!

As we began by postulating, most investors seek to diversify their return patterns by going into more and different public market sectors.  While this can be helpful, investors often end up taking more risk by going into riskier market segments like high yield bonds or emerging market equities at just the wrong time.

At market peaks, these segments actually add risk rather than reduce risk.  We call this phenomenon, “Di-worse-ification”: the act of unknowingly constructing a highly correlated portfolio.  The dangers of diworseification are highest at low levels of interest rates, tight credit spreads and elevated earnings multiples.  Strike 1, 2 and 3.

We want to highlight the benefits of including completely different asset classes with different return drivers, such as some of the broad categories mentioned in the segments above.  The potential benefits and opportunities of including alternative assets have never been greater.

With the stock and bond markets both priced for near perfection, the greatest risk is that stock and bond markets continue to trade together. This means higher interest rates will bring lower bond prices.  Higher rates will also bring commensurately lower earnings multiples and lower stock prices.  In that event, diversification into traditional asset classes will not mitigate risk or stem investment losses.

That said, we see plenty of opportunity to reduce an investor’s risk profile, while increasing potential returns. Investors need to expand their selection universe to include new ‘alternatives’. This month we introduced the benefits of including alternatives in a well-diversified portfolio. Next month we will dig deeper into specific alternative investment opportunities.


Let’s Get Ready to Ruummbllllle!

Let’s Get Ready to Ruummbllllle!

By: Bill Martin
Senior Managing Director And Investment Strategist

Active investing is under siege by a proliferation of passive investments. Must there be only one winner in this fight?

In last month’s edition of Cutting Through the Noise, we took a good look under the hood of passive investment vehicles, and concluded that, while they have a number of positive attributes such as low cost, broad based market exposure, and tax efficiency, there are also growing and often unseen potential perils that should not be ignored.

In this month’s blog, we are going to examine some of the positive attributes of active management, and illustrate why continuing to tactically allocate to certain active managers in concert with passive investments, is a sound investment strategy, particularly in light of where the market is currently trading.

Specifically, we are going to cover how:

  1. It still makes sense to use passive investment vehicles for exposure to efficient and liquid markets, such as Large Cap equities, but
  2. There are market segments such as Fixed Income, Small Cap equities, emerging markets and certain style sectors, where boutique active managers tend to outperform passive investments, particularly late in a market cycle, and
  3. Newly emerging “smart-beta” funds are helping to bridge the gap between passive and active management, and merit consideration in the construction of a balanced, all-weather portfolio.

Let’s take the first jab…

Active Vs. Passive Equities:  Judges’ Decision, Not A Knock-Out

Active management has been the undisputed champion of the mutual fund world for decades.  However, that title belt has been challenged in the past few years by the unprecedented asset flows from active to passive funds.  In fact, the estimated asset split in domestic equity funds is expected to weigh in at roughly a 50%/50% split by the end of 2017.  This is setting up as a real heavy weight fight for assets going forward.  Let’s go ringside…

In this corner, wearing the white trunks – When coupled with their recent stretch of out-performance relative to active asset managers, passive funds have taken on an almost mythical, ubiquitous and omnipotent aura – taking money from active managers in all sectors.  However, as we discussed in depth last month, the self-fulfilling nature of money shifting from active to passive investments has led to a massive, momentum-driven bubble building behind the larger index names that are creating crowded trades with the potential to dwarf the necessary price discovery elements of active management.  All of this could ultimately lead to more volatility, less liquidity, and market dislocation.

And in this corner, wearing the dark trunks – Although active managers have taken quite a few punches losing asset flows to passive investment vehicles, don’t count them out just yet.  This month, we look to provide a head to head comparison between active and passive funds within the equity and Fixed Income asset classes separately, with the intention of leaving you with a better understanding of how and where to find the best investment options within each market segment.

Oh My… What do we have here?  It looks like Vanguard, the indexing powerhouse and proselytizer, admits that active investment management deserves to have a dog in this fight.  It appears that Vanguard is getting set to roll out a fund line-up of actively managed ETF funds. Interesting.

A more fitting segue does not exist to compare historical performance of active vs. passive investment choices.

Let’s take an empirical look at how active managers have performed relative to indexes in the core space through time.

The green line represents the performance of active managers against their benchmark index.  The flat yellow line represents the average number of times when the index beat active managers, measured over a 25 year time period.  When the green line dips below the yellow line, active managers are outperforming the index, and vice versa.  Hence, from the perspective of active managers, the higher the solid green line the worse they performed relative to their benchmark.  In general, Small Cap active managers have slightly outperformed their benchmarks throughout time, while active managers in Large Cap space have moderately underperformed over this period, NET of fees.  This has not been the passive fund knock-out of active managers many may have expected.

These charts tell us two very important things:

  1. Active managers outperform their indexes a greater percentage of time in less efficient market segments. This is evidenced by the fact that Large Cap active managers only outperformed their benchmark 45% of the time, whereas Small Cap active managers outperformed by 55%, and
  2. Active managers tend to out-perform late in a cycle and well into a recession. This is indicated by the dark shaded areas on the chart where you see the green line drop precipitously and stay low until the end of the recessionary period, indicating a prolonged period of active management out-performance.

This merits careful consideration, as we believe we could be nearing the point where the market could turn south due to fears of increased interest rates or an outright recession.  If that is indeed where we are in the market cycle, rotating active managers into the allocation makes a lot of sense.

Boutique Managers Punch Above Their Weight Class

“… boutique managers looking for performance over sales and asset gathering have indeed led to long-term out-performance.”

Let’s narrow this discussion from active vs. passive funds and focus more acutely on the active “boutique manager” sub-group.  A boutique firm is one where the portfolio manager (“PM”):

  1. Has a major equity stake in the firm, often with their name on the door
  2. Specializes in a specific type of investment
  3. Does not try to cover all bases and style boxes
  4. Has the freedom to go where the markets dictate in search of value
  5. Isn’t subject to the tyranny of sales incentives that can unduly influence strategy
  6. Doesn’t not get moved off of funds to more profitable funds, after proving themselves
  7. Is heavily invested alongside shareholders, and
  8. Is more interested in raising returns than assets.

With boutique managers, the incentive structure outlined above drives long-term, multi-generational out-performance.  The ownership structure available at many boutique firms encourages an entrepreneurial risk-taking environment built around an investment-centric franchise.  This is key because it keeps good PMs in place and removes the allure for them to leave for greener pastures following short-term underperformance.

The AMG chart below graphically displays some of the benefits/characteristics of the boutique asset management structure.

Of course, all these positive attributes are meaningless if they don’t lead to superior performance.  The “Figure 9: Boutique Excess Returns:” chart below provides evidence that boutique managers looking for performance over sales and asset gathering have indeed led to long-term out-performance.

“When utilizing active managers for the Large Cap space, we lean toward managers that can ‘go anywhere’ and are not confined to a particular ‘style box’ market segment.”

This chart highlights that boutique managers generated out-performance over their stated benchmarks to the tune of 141 bps per year, on average, between 1994-2014.  Indeed, these numbers are even greater when one looks beyond the US Large/Mid Cap market segment.  This is not a surprise.  It has long been contended that Large Cap companies are over-followed by analysts, which creates a very efficient market with less opportunity to outperform due to almost complete information parity.

As such, the richest out-performance opportunities tend to lie near the market sectors with the most dispersion and least correlation.  This leads us to look to areas like Small Cap and international (especially emerging markets) when looking for active managers.

When utilizing active managers for the Large Cap space, we lean toward managers that can “go anywhere” and are not confined to a particular “style box” market segment.  These types of managers can be paired with index funds in the Large Cap space to smooth the ride for one’s investment portfolio, particularly through a down-cycle.  Examples of this type of manager include Peter Lynch, Warren Buffet, Bill Miller, and Sir John Templeton.  They are all managers that may call themselves “value” shoppers, but are bold enough to skate to where the puck is going to be (or which way the jaw is turning), as opposed to where it has been.

The boutique structure (yes, Peter Lynch was early enough at Fidelity that his Magellan fund was treated as an autonomous boutique fund) gives latitude for Buffet to buy Coke as a Value stock in the 1970’s, because he believed the intrinsic value of the brand was not yet appreciated by the market.  He was right.  The same happened for Bill Miller’s AOL play and other tech names in the 1990’s, and Peter Lynch’s financial and consumer stocks in the 1980’s.  Sir John was early to identify rapidly growing emerging markets as great values in the international markets.  Good managers just buy good companies and don’t worry about fitting them into a style box or sales deck narrative.

“Ultimately, blending active and passive managers will help mitigate ‘trend reversal risk’.”

The next chart shows the enormous payoff that can occur when one is willing to look under the hood to find a good manager and veer away from the risk-averse managers typically found at larger mutual fund complexes.  The 20 year numbers below are telling in the extreme.  The top-decile boutique manager has beaten their benchmark after fees by over 1100 bps per year!  In fact, simply using a top quartile manager led to more than 700 bps of out-performance over the illustrated period.

Ultimately, blending active and passive managers will help mitigate ‘trend reversal risk’.   This is the market risk we discussed last month, which stems from ever increasing flows into passive strategies that are creating crowded trades, driving asset prices up beyond where they likely should be, and setting the stage for a wicked reversal.

Passive vs. Active Funds: Heavyweight Vs. Middleweight

When we turn our attention from actively managed equity strategies to actively managed Fixed Income strategies, we see marked out-performance by active Fixed Income managers.  This is primarily because passive Fixed Income vehicles:

  1. Allocate a disproportionate amount to the largest debt issuers, which are currently all US Government securities, and they have abysmal yields at present and can lead to a lack of diversification
  2. Increase interest rate sensitivity because of heavy allocation to Treasuries
  3. Are forced to sell high quality performing bonds when changes to the underlying index are made that mean the fund’s holdings no longer meet the index’s inclusion criteria
  4. Usually this type of planned selling results in the worst possible trade execution and pricing on that day as a larger than normal sell volume hammers down bid prices.

Below, we see that the median active Fixed Income manager has out-performed passive investments, such as ETFs and index funds (net of fees) over almost every time period (1, 3, 5 & 7 year returns), as illustrated by 100% of the red dots being above the horizontal line marked 50. While the 10-year red dot appears to the left of the vertical 50, demonstrating under-performance vs. the underlying index, it still appears solidly above the horizontal “peer group” line, indicating better 10-year performance than the ETFs and index funds, net of fees.

“Yes, the passive investments can actually be more expensive than some of their active counterparts.”

This is an important point… ETFs and index funds appearing in many of the higher risk segments of the market (such as high yield), have such high fees and costs that they are uncompetitive with active funds and their underlying indexes.  Let that one sink in for a moment.  Yes, the passive investments can actually be more expensive than some of their active counterparts.

“Active managers will have a field day picking through the rubble and acquiring high quality bonds at a steep discount.”

The chart that follows highlights the challenges that occur within the ETF market once providers move outside highly liquid market sectors.  What you see is how certain high yield bond ETFs performed compared to their underlying indexes, after all expenses and fees.  Not that great.  On average, the ETFs under-performed across the spectrum by over -2% per year.

It is important to highlight that the opportunities for out-performance by active managers in the Fixed Income world only increase as an investor steps out of the risk curve or finds a solid, unconstrained, boutique bond manager to handle the bulk of the Fixed Income portion of their portfolio.

Lastly, the two charts below graphically display the challenges that the high yield bond ETF market will face when flows ultimately reverse.  Also, while the liquidity problems are the most pronounced in the high yield bond market, the lack of liquidity impacts all ETF markets (stocks and bonds) globally to some extent, outside of large cap stock and U.S government bond index based funds.

With that caveat out of the way, what the two graphs below display is that while money has poured into the high yield ETF bond market, the counterparties (“dealers”) that actually provide liquidity when someone sells their ETF shares, have backed away. In fact, it appears they are climbing out of the ring.  This results in the systemic erosion of the indispensable function that the active market plays in price discovery and liquidity, which we discussed in last month’s blog.  The chart on the right is the most striking example of how the ETF craze has impacted this very important function. As dealer inventories decline from above 12% to below 1%, trading volume thins considerably. It will be interesting to watch what happens when panic grips the market and everyone wants their money back at approximately the same time.  Active managers will have a field day picking through the rubble and acquiring high quality bonds at a steep discount.

There May Be a New Contender Entering the Ring: Smart Beta Funds

In the last few years, a new type of investment vehicle called “Smart Beta” has gained in popularity and aims to blend the best aspects of passive and active management.  Smart Beta funds are ETF’s that passively track an index, but instead of allocating the underlying positions according to market capitalization alone, they are weighted according to various other factors such as a company’s dividends, free cash flow, earnings, or volatility.  Smart Beta is designed to take advantage of the tax and cost efficiencies of passive investments, but select the underlying investments included in the ETF based on a stated qualitative and quantitative characteristics and data points.

In the Bloomberg chart below, we can see a traditional market cap weighted S&P 500 ETF (SPXT), compared to a Smart Beta S&P 500 ETF (SPXQUT) who’s selection criteria is based upon earnings quality, predictability, sustainability, and balance sheet strength.  The results are stunning.  One can’t help but think of Buffet’s claim that he would rather buy a wonderful company at a fair price than a decent company at a cheap price when viewing the performance of SPXQUT.

However, as compelling as Smart Beta funds can be, investors must pay particular attention to each fund’s ranking/weighting methodology.  Most Smart Beta funds, once the qualitative overlay has been applied, still rank asset weights based on market cap weights, thus making these funds more like the underlying S&P 500 index than the characteristic they are trying to exploit.  We prefer a more equal weighting format when considering Smart Beta funds (as displayed by ticker SPXQUT in the Bloomberg slide above), which more acutely focuses on getting the pure Smart Beta characteristics into the portfolio in a targeted fashion.

This is but one example of many different types of Smart Beta portfolios. Baskets of these types of examples can be utilized to shape a portfolio’s contour through an economic cycle. Smart Beta helps achieve exactly this, but in a cost effective, diversified manner.

“It is important to know which stage the fight is entering and what approaches are best at each to avoid the “rope a dope” strategy of blindly following the fund flows into index funds in all market sectors, and then getting hit with an unseen knockout blow when markets reverse.”

And Now, The Judge’s Card

Think about this…if we are indeed coming out of a period of orchestrated, Central Bank led, artificially suppressed interest rates, coincident with historically low volatility – do you necessarily want all your money in investments/funds (passive, for the most part) that have most acutely benefitted from those policies. Or, would you prefer to take some of the profits off the table, and prepare for what should prove to be a different environment as the Central Banks look to drain their own swamp of excess reserves?

We may be about to enter a new round in the fight for returns, where the recent past will not be a prologue.  It is important to know which stage the fight is entering and what approaches are best at each to avoid the “rope a dope” strategy of blindly following the fund flows into index funds in all market sectors, and then getting hit with an unseen knockout blow when markets reverse.

Bottom line, a good active, boutique manager (top 1/3) will significantly beat an index through a full market cycle, particularly on a risk-adjusted basis in a lesser efficient market sector.  The difficulty lies in finding those good managers.  The answer is not to buy a manager that has only recently out-performed, but rather to pick a manager with a good long-term track record, who may have only recently fallen out of favor, but is very likely to recover and continue along the same successful long term trajectory.

Focus your manager search on the boutique arena, particularly within more illiquid and less efficient market segments, and lean towards active management for the Fixed Income portion of your portfolio.  Doing so will help ensure your investment plan “floats like a butterfly and stings like a bee” through the full market cycle.


Better To Be Seen Than Herd:  Passive Investment Vehicles – What You Don’t Know CAN Hurt You

Better To Be Seen Than Herd: Passive Investment Vehicles – What You Don’t Know CAN Hurt You

Learn About Active vs. Passive Investment Vehicles Here.

By: Bill Martin, CFA
Senior Managing Director & Investment Strategist at Three Bell Capital

Although index and exchange-traded funds (“ETF’s”) have been around for 25+ years, money has absolutely poured into these investment vehicles (and conversely out of actively-managed funds) in the nine years following the 2008 Financial Crisis.

Many investors and investment companies that provide or allocate to these passive ETF’s and index funds, do so with an almost religious fervor, believing wholeheartedly that it is “impossible to beat the market”, so one should just “own the market” and give up on active investment strategies and vehicles entirely.

“…ETF’s are not Olympic-caliber investments. They are participation ribbons.”

The rationale for this mentality is understandably alluring. Passive investment vehicles are typically cheaper to own, highly tax efficient, and post-Financial Crisis, have generally outperformed active investments on the upside net of fees. Not only that, but the proliferation of “roboadvisors” has made it very easy for investors to create and manage their own passive investment allocations without any professional advice or assistance, further lowering costs.

So, if all it takes to be an Olympic-caliber investor is to create a set it and forget it, auto-rebalanced ETF allocation, and just let it ride for all time, why wouldn’t everyone simply do so? Because ETF’s are not Olympic-caliber investments. They are participation ribbons.

In this edition of Cutting Through the Noise, we take a good, hard, honest look at some of the serious and almost universally underappreciated potential pitfalls associated with passive investment vehicles:

  1. Market cap weighting can lead to price anomalies and a lack of price discovery which could inflame an already overvalued market,
  2. Overcrowded and undisciplined investing on the upside can lead to increased volatility on downside when the market eventually corrects, and
  3. ETF’s in particular carry a degree of structural risk that have systemic market ramifications if the stock market drops precipitously.

Let’s dive in…

How Did We Get Here?

In order to appreciate the oft-hidden flaws inherent in passive investment vehicles, you must first understand the history behind how we got here, namely why did passive investment vehicles exponentially proliferate over the last decade?

Following the Financial Crisis, stock index funds and ETFs, with their low fees and unfettered upside exposure, responded immediately and positively when the Fed and US Government brandished double-barreled fiscal and monetary bazookas and more or less forced the stock market higher with a combination of ultra-low interest rates and financial stimulus.

“This dynamic has facilitated an unprecedented $1 trillion+ transfer of assets from active to passive investment vehicles.”

By contrast, during that same time frame, active managers were exercising prudence, still reeling from the recent, dramatic and rapid drop in portfolio values. As a result, they were maintaining higher levels of cash and allocating to higher-quality, fundamentally sound securities.

The net result was that indexes led almost all active fund managers coming off the 2009 market bottom, and actively managed funds, with their comparatively higher fees and more conservative investment strategies, have yet to close the gap. This dynamic has facilitated an unprecedented $1 trillion+ transfer of assets from active to passive investment vehicles.

How quickly we forget that active management had significantly outperformed through the down market, and that sort of critical analysis and resultant positioning is rapidly becoming more and more relevant in this relatively overvalued market.  We will take a deeper look into the historical performance comparing active and passive investing styles next month.

“The active manager sells the portfolio’s holdings when money leaves their fund, which puts the most downward selling pressure on their largest and most active holdings.”

The chart below illustrates the asset flows with startling clarity, with passive vehicles (index funds and ETFs) taking in about $1.4 trillion, and active funds losing approximately $1.2 trillion over the past 10 years:

Let’s consider an example that illustrates the negative effects this transition can and has had on active managers’ ability to properly value underlying fund investments.

Assume a money manager has to pick between two nearly identical companies within the same industry. One is included in the S&P 500, while the other is not. Active managers will typically buy the cheaper company that is not in the index, because they are getting the same earnings stream with similar management quality, at a cheaper price. The company that is included in the index, however, ends up being priced substantially higher, not because its better, but because it is included in an index to which capital is being allocated.

These valuation premiums continue to expand as money leaves active management in favor of indexing. That’s the self-fulfilling nature of this trade that keeps putting pressure on active managers. The active manager sells the portfolio’s holdings when money leaves their fund, which puts the most downward selling pressure on their largest and most active holdings. Thereafter, the passive fund ploughs into a stock index that chooses investments based heavily on market capitalization.

As a result, the cheap stocks get cheaper and the rich stocks get richer. The active managers’ performance has a heavy hand of downward pressure, where fund outflows beget selling their favorite stocks, which begets losses in their stocks, which begets further fund outflows. Meanwhile, the Indexers are on the virtuous side of that trade, where fund inflows mean buying more of their favorite stocks, leading to stronger performance and the subsequent fund inflows, and so on. That is, until there’s a tipping point, and the trend reverses.

“Unlike stocks selected by active investment managers, ETF’s and index funds do not operate according to a meritocracy.”

Passive Issue #1: Market cap weighting can lead to pricing anomalies and a lack of price discovery which can inflame an already overvalued market

As investment capital has been taken directly from actively analyzed companies and given to those that happen to hold a weight in an index somewhere, there are far fewer investors kicking the tires of companies to ferret out a competitive advantage, and many more investors who’s only job is to mimic the market as a whole.

Unlike stocks selected by active investment managers, ETF’s and index funds do not operate according to a meritocracy. Active investment managers seek to fundamentally and technically analyze companies in an effort to determine if that company’s stock is more likely to rise or fall, and then make investment decisions accordingly. Makes sense, right?

The majority of ETF’s and index funds eschew analysis altogether and instead use a “market-cap weighted” method of determining what companies are included in the index or ETF, which is the exact opposite of the traditional actively-managed meritocracy that has historically driven managers’ investment decisions. A computer program is used to ensure that certain parameters (like tracking a particular index) of the fund are observed, and from there the passive investment vehicles just operate according to that protocol.

So the more indexes or ETFs that a company is included in, the more ETF investment inflows will drive the company’s market capitalization higher. As a result, passive investment vehicles invest many times more money in the largest stocks than they do in the smallest stocks. Even many of the “total market” ETFs are in fact a concentrated bet on the behemoths—out of every dollar invested, as much as 90 cents is a bet on the largest stocks, saving just a dime to spread across the thousands of small- and mid-sized stocks.

Because of passive investors’ abiding and often blind faith in the efficient market, they have ploughed money into cap-weighted indexes, which deploy money into companies based upon their market value vs. stock price, competitive advantages, economic factors, or potential for appreciation. Basically, bigger is better with no critical data analytics, investment discipline, or methodology, and that defies the very purpose of markets—allocating capital to useful ideas.

“…investors are taking way more risk than they realize, as market cap weighted passive investment vehicles are driving prices higher than they would otherwise be driven on fundamentals alone.”

Passive Issue #2: Overcrowded and undisciplined investing on the upside can lead to increased volatility on downside when the market eventually corrects

Out of the 500 companies that make up the S&P 500, the 50 largest contributors to risk were responsible for just under half of the S&P 500’s risk. That means 10% of the S&P’s companies are responsible for a whopping half of the index’s expected price fluctuations. Their extreme bias toward the largest of the large-cap stocks means that a full 20 cents of every dollar is invested in the 10 largest companies in the S&P 500.

Take a look at the chart below:

So, why should this matter? As long as the stock market keeps going up and to the right, it doesn’t. But investors are taking way more risk than they realize, as market cap weighted passive investment vehicles are driving prices higher than they would otherwise be driven on fundamentals alone.

The difficulty for passive-investing devotees is that when markets decide to become narrow-minded, undiversified, and irrational, so too do their investments. During the last two bubbles—dot com and real estate—the S&P 500 bubbled right up with markets, as both the tech and financial sectors grew to nearly a third of the index before crashing down again.

The role that the “market” or “active” participants play is important in finding a fair price for stocks. Indexes use these “fair” market based prices to find levels at which to transact for the passive money that chases index returns and crowds into the same trade.

“…it’s conceivable that ETFs could find themselves in a downward spiral.”

With the current lop-sided state of cap-weighted indexes and with these indexes receiving the lion’s share of investment, it is very difficult for an investor to simultaneously practice the principals of diversification and remain devoted to passive investing. Herding into passive investments displays a deep disregard for the very principles of diversification upon which index investing was built.

Without active managers executing diligence and fairly pricing investments, those who have piled into ETFs in the last couple of years may very well be the same fickle bunch who sold their equity holdings in the 08-09 melt down. These capital destroyers can be exceedingly dangerous, as they often rotate back into the market at a high, and are likely to sell into any potential market declines.

This self-fulfilling phenomenon works in both directions, and it’s conceivable that ETFs could find themselves in a downward spiral if the confidence in overvalued markets cracks. The high valuations and concentrations of market capital in the index holdings will work against indexes, and when the market does in fact correct, the outflow from passive investment vehicles could be much more dramatic and abrupt than anything we have seen before.

Passive Issue #3: ETF’s in particular carry a degree of structural risk that have systemic market ramifications if the stock market drops precipitously

Let us turn first to the father of index investing, Vanguard founder Jack Bogle. Jack, the man who has railed against active managers for decades, recently declared that there will always be a place for active management. He pointed out here that without the role that active management plays in price discovery, passive investing in indexes and ETFs may break down at some point, “chaos” and “catastrophe” would ensue, and “markets would fail”, if passive investing strategies grew too big.

Take a moment and let that sink in. The crusader who went from the Don Quixote of the investment world to become The Don of the Index, is now waving the caution flag as the index world continues to careen out of control with new offerings under the momentum of their own growth.

To be fair, Jack seems to think we are still on relatively safe ground—blindly stuffing our cash into index funds and ETFs—until passive investing comprises approximately 75% of the entire stock market’s value. However, other market experts are less sanguine, placing the threshold closer to 50%.

In any event, as shown in the chart below, the passive world has recently passed over 30% of all financial assets and is growing quickly. At this pace, the 50% mark is easily expected to be reached within 7 years.

However, the passive investing craze has been primarily focused on the U.S. equity market with considerably less emphasis on international equity and fixed-income markets. In fact, when we look at who owns U.S. equities, as in the chart below, we find that index investors make up a very large portion of the total market. In fact, passive investments grew to 40% of all domestic equity holdings as of the end of 2016.

“…passive investing in indexes and ETFs may break down, and ‘chaos’ and ‘catastrophe’ would ensue if passive investing strategies grow too big”

And the research arm of Sanford Bernstein predicts that by next year, passive strategies will be 50% of the entire stock market. Take a look at the chart below and you can clearly see this trajectory.

It doesn’t take a PhD in applied mathematics to see that we are rapidly approaching the 50-75% range that Bogle warned could be the “catastrophic” tipping point. Although, it’s not a certainty Bogle’s threshold will be hit within the next few years, it seems clear that the warning call has evolved from “um, boss, you really might want to pay attention to this risk” to “Houston, we have a problem.”

Conclusions & Key Takeaways

Investing in Indexes like the S&P 500 and ETFs like SPY has proven to be an excellent way for most investors to get exposure to financial markets through low cost and generally tax efficient vehicles. As such, these low-cost solutions should be an important part of most investors’ financial plan.

If an ETF is well-constructed with transparent and understandable low-cost strategies that helps fill a necessary niche in a portfolio, by all means, include it. But separating the wheat from the chaff in the thousands of ETFs has become at least as important as sorting through all of the individual stocks to determine which ones to buy and sell.

However, like all things financial, one must still take care to diversify, not just by asset class, geographic region, style and market cap, but also by the type of investment vehicles and investment strategies.

This month’s blog is a clarion call to diversify beyond just the simple market cap weighted ETFs (like, SPY and AGG). ETFs have had a great run, which adds to their current popularity and future risks. Just because it is easy and appealing to buy an index does not mean they should be considered the end-all, be-all, one-stop investment shop.

Investors must consider getting exposure through active managers within certain market segments, alternative or non-correlated assets and potentially a relatively new option: smart-beta/fundamental factor funds. When money leaves the stock market (and it eventually will), and index investments are in net liquidation (and they eventually will be), the “active” market participants are likely to find better value in non-index names with similar businesses.

Next month, we will look to provide a common sense approach to mitigating some of the risks we’ve discussed in this blog and blending index investing with other sources of return to produce a reasonably cost effective approach to maximizing risk-adjusted returns.

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Navigating the Shifting Economic Winds

Navigating the Shifting Economic Winds

By: Bill Martin, CFA
Senior Managing Director & Investment Strategist at Three Bell Capital

Just as Bob Dylan grappled with life’s great questions in his 1963 hit “Blowin’ in the Wind”, we at Three Bell are asking ourselves some of the market’s big questions. For example, how many times can the prevailing winds shift before the economy will slow? The answer, my friends, is blowin’ in the wind… the answer is blowin’ in the wind.

The winds of change are howling through our political system with blustery gusts creating cross-drafts for the economy. Additionally, the risk of the occasional gale force wind from geopolitics seems to have increased. I am choosing to save all discussion of political discourse for a future blog and will focus solely on economic winds this time. Let’s just agree that there are political winds out there that are probably not fully priced into the market.

At present, the market’s momentum is being driven by short-term tailwinds related to the outlook for the President’s pro-growth policies of lower corporate and individual tax rates, the economic impact of de-regulation, and the potential for better trade deals as opposed to the negative impact of protectionism. At any particular moment, as it is now, the market may focus on the short term (next few hours, days or weeks), while at other times the market may look at long-term issues or solutions (over the next years or decades). I believe that these short-term winds are considerably less powerful than the longer term, secular winds behind the market’s success for the past 1-2 generations.

Putting aside the potential benefits from the short-term policy shifts, the major tailwinds that have driven the market to all-time highs over the last 40 years, and helped grow the economic pie, are slowly but surely turning into headwinds. It is the following three major forces that we investigate in this blog:

  • Slowing/decreasing globalization
  • Peaking/unsustainable debt levels
  • Bottomed out interest rates

This is not about tornadoes or hurricanes suddenly developing from clear skies. If you’re a golfer or a sailor, you know the wind that starts in the morning as a barely perceptible breeze and steadily builds into a stiff wind in the afternoon. Similarly, shifting economic winds will steadily build over the course of years and perhaps decades, eventually resulting in inflection points which have systemic effects on the capital markets and investment portfolios.

I do not intend to sound overly pessimistic. We humans have a great deal of input into our collective destiny, and the generally positive and indomitable human spirit coupled with new technology improvements and ongoing job training, can make adjusting to some of these newly forming headwinds more manageable.

“It is fair to question whether some leveling of the growth rate in global trade is coming from the current provincial/xenophobic environment gripping the globe or more from a lingering post-financial crisis hangover.”

Before diving into each of these developing headwinds individually, my intention is not to present a dissertation on each topic and prove unequivocally where each component has been or where each is going. Instead, I am taking a long look back at what has historically transpired, in order to develop a commonsense framework for looking forward.

With caveats out of the way…let’s erect our economic weathervane and dive into each of these headwinds!


Slowing / Decreasing Global Trade

Simply put, the US has benefitted from the effects of global trade and rising global growth. Much of this growth and benefit has accrued through providing goods and services to less developed regions. As we look back at the tail on the slope of the line in the graph below, which depicts the portion of global GDP that comes from trade, one can’t help but wonder if most of those benefits are behind us. It is fair to question whether some leveling of the growth rate in global trade is coming from the current provincial/xenophobic environment (Brexit, NAFTA withdrawal overtures, import tariffs on China, etc…) gripping the globe, or more from a lingering post-financial crisis hangover. The answer to that question will be important as we consider global trade to be more of a head, cross, or tailwind going forward.


Peaking / Unsustainable Debt Levels

We have heard about this one for years. The good news is that the US is generally in a better net debt situation than the rest of the world, on the margin. Sorry, that sounded very equivocated. The US government’s debt is in far better shape relative to the other major world economic powers. Japan, can’t buy an interest rate increase (and believe me, they’ve tried), while the Eurozone’s situation is made more precarious by the heavy debt loads of Portugal, Italy, Greece and Spain. Meanwhile, China’s creditworthiness really gets dinged if one looks through to the liabilities caused by SOE’s (State Owned Enterprises).

One also must consider that the US Dollar is still the world’s reserve currency.   Economist agree that our world reserve currency status lowers our borrowing rates because the world is eventually forced to consume in USD.  As such, there appear to be many more canaries that are flying ahead of the U.S. and they are deeper in the coal mine. Perhaps this is why the U.S. has famously earned the moniker of being the cleanest dirty shirt in the laundry or the skinniest horse at the glue factory – my apologies to my Humane Society Silicon Valley colleagues.

“There is a point at which our levels of debt, or merely level of interest rates at given debt levels, simply choke off all avenues for future government investment and growth.”

That said, the US is not out of the storm by any means, and the more troubling aspect of our debt situation is shown in the chart below. Paul Volker summarized it quite succinctly when he said… “Our current debt may be manageable at a time of unprecedentedly low interest rates. But if we let our debt grow, and interest rates normalize, the interest burden alone would choke our budget and squeeze out other essential spending”. There is a point at which our levels of debt, or merely level of interest rates at given debt levels, simply choke off all avenues for future government investment and growth. In part, this may already be limiting options for new fiscal policies to jump-start the economy in future recessions.

Lastly, check out the rate of total debt growth versus total GDP growth in the chart below. Over the past 35 years, the US has seen its total debt obligations grow at an 11% clip after inflation, while the real GDP growth rate is a much more moderate 3%. The net result is that we have not recognized a good return in our GDP growth rate, per dollar of debt. This is sobering as we believe any debt-propelled growth possibility is likely behind us. Going forward, our current high debt levels will reduce our borrowing capacity are therefore much more likely to be a headwind as opposed to a tailwind.

“Just as we mentioned that fiscal policy is constrained by high debt levels above, so too is monetary policy running low on ammunition to face the next economic slowdown.”


Bottomed Out Interest Rates

As you can see below, even though in the short term the Fed just raised interest rates by .25% last Wednesday, the level of our interest rates is still at or near historical all-time lows. This is not to imply that rates can’t go lower, as they have in Europe and Japan. Also, given the abnormally weak, current economic realities across the globe, interest rates are not likely to skyrocket any time soon. That said, the catalyst for lowering interest rates from their present levels is likely to be bad news, such as recession or anemic growth, which would add to our debt levels at an even faster rate. In such an environment, investors and consumers pull back on spending and projects, increasing the odds of a deflationary spiral. Let’s not even go there.

The main take-away from the chart above is that gradually lower and lower rates over the past 35 years have provided a very strong and consistent tailwind to the market and the economy. At current levels, it seems unlikely that interest rates will remain a tailwind going forward. It is only a matter of time before the level of interest rates turn into a full-on headwind or at the very least, a swirling wind that proves difficult to navigate.

Just as we mentioned that fiscal policy is constrained by high debt levels above, so too is monetary policy running low on ammunition to face the next economic slowdown. This is not a doomsday situation, but merely an observation that the greatest benefits of low rates are behind us. Lower rates make it easier for a company to service debt, spend more cash flow on growth related projects, buy back company stock, or pay dividends. It isn’t that those opportunities are gone, but the delta is about to change from clearly positive to neutral with a negative bias.

Lastly, low interest rates generally help stock investments look more competitive, which raises asset values and fuels consumer confidence. The key takeaway here is that much of the benefit of gradually lower interest rates has run its course.



My intention is to provide moderation and common sense to the ebullient fever of the stock market and related expectations for continued outsized gains. After repeatedly setting new record highs, the market’s valuation is now considered to be historically high (as we addressed in our 3-Part CAPE series). We believe that many of the conditions that contributed to that expensive valuation are now slowing, and likely to gradually reverse.

Gains are more difficult to come by when some of the biggest drivers of investment returns: previously increasing global trade, perpetually lower interest rates, and historically increased borrowing; reverse course and start working against the market instead of for it. The time has come for investors to start adjusting their return expectations to better reflect reality. We will continue to keep an eye on the long-term trends and update any major shifts in weather patterns as the headwinds/tailwinds narrative unfolds.

Please be clear, I am not calling for a market crash, or even a pullback necessarily. I am simply pointing out that the stock market is now running against the wind. Bob Dylan told us where to look for answers, my friends, but it’s Bob Segar’s 1980 classic, which best summarizes our view: we are now running… Against the Wind.

Here’s to getting it more right than wrong. Happy Father’s Day.

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CAPE’s Super-power Guides Investor Expectations

CAPE’s Super-power Guides Investor Expectations

Its Kryptonite is Acrophobia…

 PART 3 of 3 – Current Market Valuation

By: Bill Martin, CFA
Senior Managing Director & Investment Strategist at Three Bell Capital

Hand me my CAPE, Lois…it is time to help serious investors build reliable expectations!

  • In Part 1, we learned why the CAPE (Cyclically Adjusted Price – Earnings) model is our preferred valuation methodology.
  • In Part 2, we discussed elements of the economy that provide context to those CAPE numbers, such as Growth Adjusting our model and making allowances for low interest rates.
  • In Part 3, we now tie it all together and draw on some specific historical examples to inform our current expectations for the market’s future available returns…all given today’s environment.

Why does CAPE matter? It matters because returns vary greatly over time depending on the market’s valuation at the time of purchase. Just like buying a house in the volatile Bay Area real estate market, the price you pay has a large influence on your long-term return. Here, we quantify the relationship between the price paid for future earnings (valuation) and stock market returns.

“No magic tricks or super-hero stunts will be performed here, but we do still need our CAPE…”


 Time to Find My CAPE…

No magic tricks or super-hero stunts will be performed here, but we do still need our CAPE (the Shiller CAPE Ratio—our preferred measure of valuation for this analysis). Before we get started, I want to caution that CAPE is NOT a market-timing tool that tells us when the market is about to go up or down. In fact, valuation measures are notorious for being too fickle for meaningful insight into the market’s direction. Markets often go to extremes, and we never know the exact moment when the pendulum will shift direction. As such, valuation is rarely, if ever, a catalyst on its own for a sell-off. Nevertheless, how much we pay for earnings (CAPE) can help us estimate market return expectations looking forward. Keep in mind, a higher CAPE ratio implies greater downside risk and lower upside return potential, whereas, a lower CAPE ratio implies the opposite—the potential for less downside and more upside.

“…the price of the stock market’s earnings has been higher only 3% of the time since 1890.”


Where Are We Now?

The current Shiller CAPE level is at 30, which can be seen in the chart above, while the below graph puts context around that number. For 97% of the historical data going back to 1890, investors have assigned the market a lower valuation than today’s level. Put another way, the price of the stock market’s earnings has been higher only 3% of the time since 1890.

According to the historical record, US stocks have only been more expensive during the two most notorious bubbles: briefly in 1929 and between 1997 and 2001. Both were followed by huge crashes.

“The market’s current CAPE reading of 30 means the stock-market’s CAPE-based expected return would be a measly 1% per year above inflation for each of the next 10 years. “

In the following chart, we break out market returns (y-axis) starting from different CAPE ratios. From left to right, we see that investors who bought the market when the CAPE ratio was less than 10 (buying on the cheap in the early 1980s, for example) were rewarded with very strong annual returns for the next ten years. This is the sweet spot for generating long-term wealth.

At higher CAPE ratios, long-term returns tend to dwindle very rapidly, and an investor would have been better off taking less risk by buying bonds instead of stocks. The market’s current CAPE reading of 30 means the stock-market’s CAPE-based expected return would be a measly 1% per year above inflation for each of the next 10 years.


Different Perspectives, Same Conclusion

Another way to look at the data is to analyze the total returns that were available to investors with different time horizons who invested their money at different CAPE levels throughout history. Here again, the short and long-term returns are strongly influenced by the price paid (CAPE ratio).

“As a result, investors have tended to trail every single traditional asset class, and even trail inflation over time, which is the exact opposite of why you invest—to beat inflation and generate real wealth.”


Ignorance is Not Bliss

Apologies for the lack of subtlety, but there is nothing more important than aligning investor expectations with reasonable market expectations, based on history. Past returns are no guarantee of future results, but the point remains—when we buy stocks at high valuations, the odds are stacked against us for achieving strong returns.

When economic reality can’t meet investor expectations, investment strategies and financial plans tend to break down. If you expected 10% returns as far as the eye could see, and you got 2% instead, human nature begs you to do something different. Dashed expectations can have extremely harsh consequences for building wealth through financial planning.

The chart below highlights why it’s so important to stick to your plan. Most people have emotions, last we checked, and those emotions push people to sell at lows when the sky feels like it’s falling and to buy at highs when it feels like everything is awesome.

As a result, investors have tended to trail every single traditional asset class, and even trail inflation over time, which is the exact opposite of why you invest—to beat inflation and generate real wealth.


Know Thyself

When investors reach for more return than their internal risk tolerance can stomach, the clash between expectations and reality tends to cause problems for financial planning. Investors often take more risk than they realize, and when markets fall, they tend to sell at the wrong time, and then get back in at the wrong time after markets have already risen. The best plan is to have a diversified portfolio that meets your time horizon, your goals and your risk tolerance, so you can weather the storms and stay on track through your entire financial lifecycle.

We all know that stocks have more risk when prices are high and less risk when prices are low, but we know that on an intellectual level. Unfortunately, when we see prices and valuations fall, we feel that risk on an emotional level, which often triggers the fight or flight response. That is what makes investing so tough—the mind must prevail over heart.

That is exactly why we have analytical frameworks that help us remain objective and disciplined as we enter volatile markets. CAPE is a great starting framework for that exercise. From here, we can add our expectations for the economy that will complete a good portion of our investment playbook.


What to Expect

Reasonable and attainable return expectations are necessary for creating a well-suited financial plan and sticking to it. Adjusting for the current level of valuations (a strong headwind) and the low level of interest rates (a strong tailwind) help us to put a range around these target numbers.

A Rule of Thumb – John Bogle, the Founder of Vanguard Funds and considered the father of index investing, has a long held a general rule for building stock market expectations. Mr. Bogle has shown that stock returns can be broken down into:

Dividend Yield + Earnings Growth + P/E Multiple Expansion OR

4.2%   + 4.7%   + 0.3% = 9.2% (WOW – that has been really accurate)

If we use todays numbers we get:

2.0%   +   4.5%   –   0.5% =   6.0%   (Ugh – that is really sobering).

Notice that with our current CAPE ratio so high, we can reasonably expect it to contract through time and revert back to the mean of 16.7, hence the (-0.5%) in the equation directly above .

“In this environment, it is easy to see that investors will need to make volatility their friend. They need to re-balance into weakness in hopes of capturing long-term returns that have historically been available through simply diversifying and using a buy-and-hold strategy.“

Lastly, with a target expected return in the stock market of approximately 6%, we can hope for improved productivity to push us up closer to 8%, but need to be aware that almost any rise in interest rates will likely push that number down closer to 4%.

So, our stock market expectations are around 4-8% per annum looking out 10 years with a little higher return possibility overseas. Our bond market expectation is 3-5%, depending on how much credit risk one is willing to accept.

In this environment, it is easy to see that investors will need to make volatility their friend. They need to to re-balance into weakness in hopes of capturing long-term returns that have historically been available through simply diversifying and using a buy-and-hold strategy.

We need to put on our “objectivity” CAPE to gain the necessary superpowers to invest intelligently and without emotion. Up, Up and Away!

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Veteran Portfolio Manager Bill Martin Joins Three Bell Capital

Veteran Portfolio Manager Bill Martin Joins Three Bell Capital

We are thrilled to announce the addition of veteran institutional portfolio manager Bill Martin, CFA, to the Three Bell Capital team. Bill will help lead the Three Bell Investment Committee’s efforts to design, implement and manage client investment strategies and portfolios. Bill brings to Three Bell Capital over 30 years of experience as an institutional investor and senior portfolio manager, 27 of which were spent at American Century, one of the largest mutual fund families in the world.

While at American Century, he managed over $10 billion in investments worldwide across all asset classes including stocks, bonds, commodities, and currencies, consistently earning 5 Star Morningstar ratings, as well as numerous other professional investment accolades.

Bill attained his CFA designation in 1991.  While all investment advisors have licenses allowing them to offer investment advice, few have a CFA designation.

Bill’s 30+ years of institutional experience, coupled with his CFA, makes him an incredibly valuable addition to the Three Bell team. As an institutional money manager, he has frequently appeared on CNBC, Bloomberg TV & Radio, Fox News, BusinessWeek, New York Times, Barron’s, Wall Street Journal, Financial Times, USA Today, Los Angeles Times, and he has spoken at institutional investment conferences including Journal of Finance, Charles Schwab, Morningstar, and Pensions & Investments.

We are excited to have Bill join the Three Bell team and look forward to leveraging his expertise to continue to provide superior financial advice to our clients.

Three Bell Capital

Finding the Weigh

Valuation: Weighing Market Expectations – The Second in a Three-Part Series 

  • Last month we showed that stock market valuations are currently stretched, demonstrated with the Shiller-CAPE model based on a historical perspective.
  • Stocks now appear the most expensive in history when we adjust market valuations for economic growth and earnings potential.
  • The single, largest offsetting factor that is currently supporting such high stock prices is the low level of interest rates relative to the earnings yield (Earnings/Price) of the market.

Previously, we evaluated the market’s current and historical valuations. If you recall, the market appears pricey from the metrics provided by Robert Shiller and his Cyclically Adjusted Price/Earnings (CAPE) ratio.

Below, the graph shows more than 130 years of the CAPE ratio. The only times the ratio exceeded today’s high valuations were prior to the crash of 1929 and the during the dot-com bubble, when valuations soared much higher than today’s level. When these types of long-term measures approach their all-time extremes, it’s time for investors to get a plan that goes beyond hoping for higher prices.

Data extracted from, graph created by Altos Investments


Let’s start this month’s blog by putting some context to the CAPE, one of my preferred valuation tools. To draw insightful conclusions, valuations must be seen relative to the economic environment.

To gain perspective, I will provide a view through a couple of different lenses that suggest wildly different conclusions. If you’re anything like me, you’ll want to hear the bad news first, so we’ll start there, then make our way to the good.

The bad news, in a nutshell, is growth-adjusted valuation. Don’t fall asleep yet! There’s a kernel of wisdom in that snoozer of a word. Simply comparing P/E valuations from one period to another can be likened to mapping the earth onto a flat piece of paper—full of distortions.

In order to make the comparison “apples-to-apples” as much as possible, we must consider a couple of additional factors to adjust for different economic environments. One of the factors to consider is the economic growth trajectory that underpins the relative valuations and sentiment of a given time. In other words, investors will pay up in good times that are likely to get better, but can’t justify paying up in bad times that might get worse. The other important factor is the level of interest rates, which dictate the extent to which the stock market can compete with less risky investments, like U.S. Treasuries.



We need to add some color to our CAPE. To do so, we want to “growth-adjust” this ratio. If we can expect faster growth rates in the future, we can also justify a higher CAPE, which means paying more for future earnings. When prospects for earnings growth are high, the multiple (P/E) investors are willing to pay tends to be even higher. Let’s dive in.

Corporate earnings are a byproduct of economic activity. As such, growth in the Gross Domestic Product (GDP—our economy’s total output) and growth in earnings tend to be roughly equivalent. While it’s true that earnings growth can vastly differ from economic activity for time measured in years, in the long run, aggregate earnings growth and GDP growth are joined at the hip /move in tandem. For evidence of this relationship, turn to the charts below. The graph on the left plots the three-year average GDP growth rate and its trend since 1950. The trend line helps us understand that growth has been on a steady downtrend during the post-World War II era despite the many ups and downs of the business cycle. The graph on the right shows the close relationship between overall economic growth and corporate profits.

As you can see, GDP growth is roughly equivalent to earnings growth. This observation is the basis for our next step—adjusting CAPE for growth for the entire modern era of investing. If you know where you’ve been, you are more likely to know where you are now.

Data courtesy of St Louis Federal Reserve (NASDAQ: FRED), Bureau of Economic Analysis (BEA), and Bloomberg

Based on the chart that is above and to the left, it is fair to deduce that GDP growth and earnings growth trends are now more anemic than they were in the late 1990s, the last time valuations were this high. The following table highlights some of the key differences between the two periods.

As shown in the 720Global table above, economic growth in the late 1990s was more than double that of today, and the expected trend for growth was also more encouraging. There were plenty of good reasons to be excited in the late 1990s—high growth and productivity, low inflation, and the government actually ran a surplus, which is hard to fathom now. Today’s weak trailing 3-5-10 year annual earnings growth rates stand in sharp contrast with the growth of the roaring 90s. Additionally, government and household debt have ballooned to levels that are now constricting growth and productivity. The assets purchased with all of that debt have not offered much in return, and today’s low-interest rates reflect the current state of economic stagnation. And astonishingly, corporate earnings have barely moved an inch in the last five years, while stocks have posted strong gains over the same time frame.

Now, if we adjust the current market’s prices for the relatively low level of economic output, we clearly see that the market is the most expensive it has EVER been!



Looking forward, the standard CAPE level (as shown in the chart at the very top) needs to fall approximately 35% from current levels to reach its long-term, growth-adjusted level based on current GDP growth rates and estimates. Now, I’m not calling for that, but it is always good to know how far that teeter-totter has to fall, when you’re the one at the top.



Now, it’s time for the good news! The earnings-to-price ratio of stocks actually looks attractive relative to bonds.

Looking at low-interest rates, we begin to find justification for stretched valuations. What we see in the graph below is that interest rates are low, when compared to the level of earnings yield that an investor receives in the stock market. This “relative yield” game is important in the battle for capital between asset classes. When investors can earn a decent yield by holding a safe US Treasury bond, why not earn the easy money with very low risk? However, when investors can earn a higher yield in the stock market (based on earnings) with a chance for those earning to grow, why settle for the low yields of Treasuries? This is the key factor that Warren Buffet points to when he says stocks are not expensive.

Data extracted from, graph created by Altos Investments

Beating inflation is the name of the game in investing. As you can see in the chart above, in the 1950s and 1960s, and even in the hyper-inflationary 1970s, investors used to demand more from equity yields (Orange Line) relative to bond yields (Blue Line) due to perceived risk. That relationship has clearly changed since inflation peaked in 1980. Since then, investors typically have gotten more from their bond yields. The thinking was that there was less need for an inflation hedge (stocks), and Treasuries suddenly looked like a sure thing with really attractive, double-digit yields (Treasuries).

However, since the Federal Reserve started to manipulate short- and long-term interest rates through unprecedented measures, the relationship between stocks and bonds has all changed. As such, it appears that in this artificially suppressed interest rate environment, we have temporary, yet solid support for the stock market. If we get a sense that rates may return to more normal levels, then stock valuations would face significant headwinds.



The equity valuations of 1999, as proven after the fact, were grossly elevated. However, when considered strictly against a backdrop of economic factors, those valuations seem relatively tame versus today’s exorbitantly priced market.

Economic, demographic, and productivity trends all portend stagnation. The amount of debt that needs to be serviced stands at overwhelming levels and puts our economy at risk of rising rates. The first whiff of significant inflation could lead our international creditors to demand higher interest rates. This means that policies that rely on more debt to fuel economic growth are likely to borrow from long-term growth.

In contrast, policies that gear toward higher labor productivity and not just technological advancement are the answer for long-term economic growth. However, even the most effective policies will take a LOOOONG time before their impact is felt. The one counter-weight in this equation is the pitifully low level of interest rates, which leaves investors craving more risk and more stocks, reaching ever further for return. This condition sets the scale with the low level of interest rates on one side and the reality of expensive valuations on the other.

Next month, we will investigate the outlook for future stock returns from these valuation levels.

Here’s to getting it more right than wrong.


CUTTING THROUGH THE NOISE – A Financial Blog by Bill Martin, CFA

Come On Down, Let’s Play… Is The Price Right?

Valuation: The First in a Three-Part Series

“Price is what you pay and value is what you get.”
~ Warren Buffet

“Intelligent investing is value investing – acquiring more than you are paying for.”
~ Charlie Munger (Warren Buffet’s long-time partner at Berkshire Hathaway).

Let’s talk prices. To do so, we don’t need Bob Barker, but we will need to choose some valuation tools. There are dozens, maybe hundreds of ways to consider if an individual stock or broader stock market index is expensive or cheap vs historical pricing. All of these valuation measures have imperfections. As you can imagine, investors have their favorite valuation tools that vary by focusing on expected earnings, earnings after stripping out certain items, sales, cash flows, ect. That is what makes stock market investing more art than science. We’ll look at three useful valuation measures in this blog—the Buffet indicator, the standard P/E, and the Shiller P/E.



We can’t talk about value investing without mentioning Warren Buffet, a follower of Benjamin Graham, the father of value investing. The Buffet Indicator (below) uses the price of the broad stock market divided by the overall output (GDP – Gross Domestic Product) of the U.S. economy. This is an excellent big picture measure of what you have to pay for what you get. The Buffet Indicator’s greatest strength and greatest weakness is that the measure is not directly based on corporate earnings as reported. This measure reduces the volatility of earnings by taking the perspective that the U.S. economy’s output is the same as the U.S. economy’s earnings through time. Next month you will see how accurate that assumption is over time.

As you can see, the market appears ~20% overvalued at present vs historical levels (net of inflation). Mr. Buffet would no doubt point out that interest rates (the discounting factor for the stock market) are well below historical levels, thus leaving stocks cheap to fairly priced.



Perhaps the most common valuation ratio is a stock’s Price/Earnings, or P/E ratio. The P/E ratio is typically based on the Last Twelve Month (LTM) of earnings and the ratio captures how much an investor is paying (P) for each dollar of earnings (E). Sometimes this ratio can be inverted and quoted as an earnings yield (E/P) to better compare to the yield an investor may be able to earn on a bond.

For instance, if a stock has a price of $25 and earns $1 per year, that stock would have a P/E of 25 or an E/P yield of 4%. Taken throughout time, 25 is a very high P/E ratio; however, when compared with U.S. Treasuries at or below 2.5%, a stock with a 4% earnings yield and a chance to grow earnings over time, it may look like a decent price to pay for what you get.

One drawback to the standard P/E ratio is that often times the earnings for a company may drop to a very small number or even a negative number during a recession. During rapidly shifting times, the P/E ratio can be volatile and a source of uncertainty for value investors. A company may look even more expensive if its price drops from $25 to $10, but earnings drop from $1 to ten cents a share. Under this scenario, the P/E ratio is 100, even though the stock is down 60%. Conversely, cyclical companies may look cheap at the wrong time—at “peak” earnings just prior to an earnings recession. Since markets are often in flux, going into or out of recession, or simply weighing the odds of recession against the ends of animal spirits, the standard P/E ratio can take investors on a wild ride.

Data extracted from, graph created by Altos Investments


To reduce some of these analytical challenges of the standard P/E, we look to the Cyclically Adjusted Price to Earnings Ratio, also known as CAPE or the Shiller P/E Ratio, a measurement conceived by Robert Shiller. CAPE adjusts past company earnings by inflation and compares stock prices to the ten-year average, inflation-adjusted earnings, as opposed to the nominal earnings over just the last twelve months. CAPE is more like a movie clip, whereas the standard P/E is more like a snapshot. The net result and graph contour of the CAPE chart below is more smoothed in a fashion that is similar to the Buffet Indicator chart.

Data extracted from, graph created by Altos Investments


The charts below show the two PE measures side by side. Shiller’s measure provides a steadier read on markets and better long-term perspective for determining the aggregate market’s valuation. The CAPE Shiller model represents ten years of market information in one number that tells you how the market is priced now. It’s a valuation tool that cuts through the noise and takes a broader and deeper view of the price you pay for what you get. For these reasons, CAPE is the valuation measure that we will use in the subsequent two parts of this three-part series.

Data extracted from, graph created by Altos Investments

Robert Shiller won a Nobel Prize for Financial Economics, specifically for his work on empirical analysis on asset prices in 2013. I’m sure this ratio weighed favorably in the minds of the selection committee. His measure uses the 10-year average of earnings, but we can also vary the calculation window to more accurately capture the business cycles in a given period. In certain markets, this is a handy feature for an advisor.

The long term P/E averages for both valuation methods is about 16-17 times earnings. So, no matter how you slice it, the market is looking pricey now based strictly on a long-term historical valuation basis.

Granted, over the long term, the two measures are highly correlated and look quite similar…and that makes sense. However, the plain vanilla P/E and the CAPE can offer very different pricing perspectives during major turning points in the market and that is when investors need to have a sense of value to have conviction in their allocations.

For instance, let’s examine how each of these models handled the height of the financial crisis in 2009. In the chart below, we see that the CAPE ratio (blue line), during the sell-off in 2009 valued stocks with a P/E below 15X earnings as a bargain…a buy signal! Meanwhile, the standard P/E (red line) shows stocks were actually the most expensive in 2009….a sell signal!?!? Selling in 2009 put a lot of professional investors out to pasture. Similarly, the market’s value using the standard plain vanilla P/E veered from cheap to expensive in abrupt swings during the dot com crash, while CAPE was quicker to point out the overvaluation of the market. It is really important to get these major turning points correct to make money through full market cycles.

Data extracted from, graph created by Altos Investments

The CAPE is a fantastic tool for smoothing out the vagaries of the business cycle for cyclical stocks and stepping back to get a broader view of prices. And in recession, almost all stocks show their soft, cyclical under bellies.

Now, one word of caution (and you aren’t likely to hear this anywhere else)—I think CAPE actually underestimates the earnings power for the rapidly growing F-A-A-N-G (Facebook, Apple, Amazon, Netflix and Google) type stocks, due to its long look back over 10 years. These companies, and others like them, have become a larger and larger share of the overall market. I think this means that CAPE probably underestimates the market’s value by about 10%, but that estimate is more art than science. CAPE still cuts through the noise better than most measures.

The current CAPE reading is at a level only seen once (tech bubble) since the stock market crash of 1929. Based on only this figure, we would conclude that stocks are expensive. Robert Shiller is also calling for caution.

Next month, we will add context to valuation relative to interest rates. Some important factors we will use to provide market context are gauging and ranking market “Headwinds and Tailwinds”. Spoiler alert: at present, low interest rates provide solid support for today’s relatively high historical valuation levels, while today’s moderate growth rates and high debt levels provide a sober outlook for stocks’ long-term return potential.

Lastly in part 3, we will evaluate how stock prices perform from different valuation levels. This is the most important element of this analysis, and can mean a lot more than just winning “A NEW CAR”!


CUTTING THROUGH THE NOISE – A Financial Blog by Bill Martin, CFA

A Hawk in the Dove’s Nest

A View Into The Fed’s Inner-Sanctum

I recently had the pleasure of sitting in on a discussion with former Federal Reserve Bank President from Philadelphia, Charles Plosser. Charles spent 10 years at the Fed, before terming off in 2016.

We were hosted at a lovely home on University Avenue in Palo Alto. Charles’s visit was made possible through his tour at the Hoover Institute at Stanford University. Ten to twelve of us – venture capitalists, tech CEOs, money managers, and academics – gathered around the dining room table, chatted and asked questions. Wine was served, which helped facilitate a collegial, informal atmosphere.

“In short, the economic cure-all of cheaper and cheaper money has become the toxin that inhibits the natural order of the economic cycle.”

What followed was an insider’s view into the inner-sanctum of the Federal Reserve. Charles is known as an inflation fighting “hawk” on a Federal Reserve Board, which has been dominated by easy money bankers known as “doves”. The “doves” have more or less reigned supreme on the Fed going all the way back to Alan Greenspan’s “irrational exuberance” speech in 1996. Since that time, every crisis and mini-crisis has been met with lower interest rates and overwhelming liquidity. Our chat with Charles brought to light some of the challenges that he feels these easy money policies have fostered. In short, the economic cure-all of cheaper and cheaper money has become the toxin that inhibits the natural order of the economic cycle.

Charles Plosser earned a bachelor of engineering degree from Vanderbilt University in 1970, and Ph.D. and M.B.A. degrees from the University of Chicago in 1976 and 1972, respectively. Before joining the Philadelphia Fed, Plosser was the Dean of the William E. Simon Graduate School of Business Administration at the University of Rochester for 12 years. He also served concurrently as the school’s John M. Olin Distinguished Professor of Economics and Public Policy. Plosser was also the co-editor of the Journal of Monetary Economics for over 20 years. [source: Wikipedia]

“A business cycle without recession is like religion without sin.”

Here are my top five impressions from our discussion with Charles Plosser:

1. Charles’ specialty is the business cycle: his most memorable quote from the evening was “a business cycle without recession is like religion without sin.” Putting religion aside, Charles was pointing out that an economy needs “cleansing” that comes from a recession, to let unprofitable firms go and let leaner and more stable firms take their place. He suggests monetary policy has inhibited creative destruction. Is the appetite reduced for letting capitalism work in this way due to too much interconnectedness? Perhaps. Given the U.S. economy’s total debt is four times GDP (not counting upcoming entitlement liabilities like Medicare/Medicaid and Social Security), are there too many unpayable debts and too little solvency to let a recession happen naturally, as a normal part of the business cycle? Also, perhaps. Charles’ view is that market participants have determined that the extreme downside risks should be trimmed, while also sacrificing upside return potential. In many ways, Europe has already embraced this view of the risk and return spectrum. Charles suggests we are on a similar path.

2. Given all the extraordinary monetary policy, why has this economy struggled to reach “escape velocity?” – Charles openly wondered if the economy is growing slower than otherwise expected because human capital is not keeping up with technological advancement. As a bit of background, there are two key components of economic growth – growth in labor force and growth in productivity (measured output per unit of input). By focusing on just these two components we ask… are there more or fewer people working and are they more or less productive at their job?

Regarding the growth in the workforce, the economy is facing headwinds in the form of an aging workforce that continues to shrink through artificial intelligence and robotics, coupled with immigration challenges. All of these factors do not bode well for employment gains, thus limiting a good portion of potential economic growth.

“…long-term growth is unlikely to rise meaningfully above the slow pace of this current business cycle.”

Going to the second portion of the growth equation (productivity), Charles expressed concern that human capital is not keeping up with technological advancement. Productivity was a primary driver during the high-growth of the past 30 years. Bottom line, tech has brought both lots of positive changes along with disruption. Going deeper, tech has dramatically changed the nature of most jobs, and worker skills have simply not kept pace, as the rate of technological change continues to compound at rates that may exceed our ability to adapt from generation to generation. Given Moore’s law, the quantum leaps in technology are unlikely to slow down. As such, the full extent of tech benefits may be increasingly difficult to achieve. That means long-term growth is unlikely to rise meaningfully above the slow pace of this current business cycle.

“Tariffs are a central banker’s nightmare because tariffs encourage deflationary inflation – higher prices with lower economic output.”

3. Administration policies – Charles went to pains to keep from sharing his overall views of the new administration, but he was willing to discuss policies, as they relate to the economy. De-regulation is good… to a point. Much of Dodd-Frank, the Volker rule, and the Affordable Care Act were compromises. They should not be thrown out, but some tweaking could certainly be helpful. Tariffs are a central banker’s nightmare because tariffs encourage deflationary inflation – higher prices with lower economic output. How does the Fed set policy for that environment? Tax cuts will not solve anything without productivity increases – cuts will largely take from one pocket and put into another and/or create a need for deficit spending, which leads to higher interest rates etc. Repatriation could be a good one-time shot in the arm. He also commented that limiting immigration is bad for the economy as it limits the potential pool of skilled workers. Productivity enhancing infrastructure projects would be a plus, and this is where the focus should lie. However, those projects often take years to bring economic benefit. My sense is that an emphasis on job skills and training and re-training would be a great place to begin and end any government-led spending. He expressed that a massive infrastructure bill will most likely lead to history’s largest pork barrel and vote grab.

Classical Keynesian economics would suggest that the government fill its coffers in good times and borrows to spend in bad times, thereby creating a counter-cyclical anchor to steady the economy from damaging extremes. From this vantage point, the time for expanding fiscal policy was from 2008 to 2012. In theory, with unemployment below 5%, now is time for tax hikes in preparation for next down cycle. Charles was openly unhappy with fiscal expansion at this point of the cycle. This will complicate the Fed’s task going forward, as political uncertainty around the amount of government spending adds to the many uncertainties of the Fed’s dual mandate of stable growth and price stability.

4. In his interpretation of Fed policies to date, the Fed did not act independently during the Global Financial Crisis. The Fed did Congress’s bidding, as they became the lender of last resort to Wall Street and Detroit, choosing the winners and losers instead of letting the market decide. In short, Congress outsourced their job to the Fed.

“One problem with the path dependency of this system is that no one is ever individually proved correct or incorrect.”

BIG REVEAL – No one in the Fed knows anything that anyone in our room didn’t know. There is no special knowledge around the Fed Board Room. They observe and react. Simple as that. Got to admit, this part was a bit unsettling. I think he was attempting to point out that there are so many disparate views, from which each participant brings their own internal biases, based on their own staff’s research. One problem with the path dependency of this system is that no one is ever individually proved correct or incorrect. As such, no one knows nuttin’.

Fears for Fed’s independence – he pointed out that the Fed could be audited at any time, and that probably has the effect of making the Fed more political than otherwise.

5. An outlook for Fed policies – Charles indicated that the Fed should drain its own swamp of the reserves it created from quantitative easing (QE) operations—the Fed’s purchase of US Treasury securities intended to suppress interest rates and incent risk-taking behavior. He repeatedly referred to excess bank reserves as “kindling”. This was in reference to providing the potential accelerant in the banking system, in the form of excess reserves, to ignite inflation that could be difficult to control or ultimately distort normal economic investment relationships.

In his view, the first round of QE was necessary, and the subsequent rounds were somewhere between risky and flat out irresponsible. He believes that the use of reverse repo transactions will be a political land mine if reserves are not drained in a timely fashion. For example, how will it look if the Treasury actually pays interest to the very same banks that they bailed out, just to keep those very same reserves on the banks’ balance sheets to prevent the banks from using them to make loans? What the heck? Right!

“And therein lies the political landmine.”

CAUTION – Wonky language ahead: These reserves have been sitting idly, doing nothing for some time. Banks have not lent the money out, but treated it like a rainy day fund as they sought to repair their balance sheets by reducing leverage ratios and improving their solvency/durability. Now that the Fed has raised rates, the Fed finds itself in the awkward position of paying interest to banks on those reserves, even though these same banks worked against the Fed’s efforts by not lending when the Fed needed them to make loans to jump-start the economy… AFTER these very same banks brought the global economy to its knees in 2008. And therein lies the political landmine. My apologies for the circular reasoning and going inside baseball, but it is a big deal and it really is twisted and we will be dealing with the aftermath for YEARS.

Charles suggested the Fed should have drained reserves (or at least communicated plans to term out holdings), prior to starting to raise rates. Because they did not take these primary, incremental steps before raising rates, US monetary policy is now years ahead of Europe and Japan. As the Fed tightens and other Central Banks ease, global monetary policy is out of sync, which has implications for the value of the dollar (and thereby growth and inflation). This is not a problem until it is a problem. Charles made clear, this could be a problem.

Those of us sitting around the table gained new insight and respect for the job of a central banker. By the time we wrapped up, I’m pretty sure most of the business leaders sitting there could appreciate the difficulty of public service, and I didn’t get the sense that any of us were green with envy.

How have my views changed? The views at the Fed are more diverse than I realized. We don’t necessarily get a clear picture of the true views at the individual level.

How have my views been re-enforced? Growth will be challenged long term, almost regardless of Administration policies.

“The big takeaway is that the economy and market face more headwinds than tailwinds.”

You also get a sense that the big Super Tanker known as the US economy may have a smaller rudder than I previously understood. That’s fine for calm seas, but not for turning on a dime in rough waters. There also appears to be a respectful debate within the Fed, but that may not be the case between the Fed and Congress. They seem out of synch. As we saw, the Fed feels like it was left to do the heavy lifting, only to have Congress meddle with the economy at the wrong time. Meanwhile, some members of Congress have been quick to blame the Fed for a faltering economy or its improvisation during the crisis.

With the market priced for near perfection and the Super Tanker’s steel skeleton groaning under the heavy burden of debt, the ship’s crew will have to work like a well-oiled machine to keep this vessel sailing above water and on course.


CUTTING THROUGH THE NOISE – A Financial Blog by Bill Martin, CFA