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How the BLS Methodology for Wireless Plans Exaggerated a Small Effect

NOTE: The following article appeared in our quarterly inflation outlook, distributed one week ago to clients. We thought it might be interesting to a more general audience.


…The deceleration in medical care inflation is not the queerest change in price inflation we have seen in the last quarter. The prize there clearly goes to inflation in wireless telephone services. In the March CPI (released in April), core inflation overall declined -0.12% – the biggest monthly drop since 1982. But a large part of the blame for that curious result, which was more than a quarter percent below expectations, fell on the single category of wireless telephone services.

The chart above shows the year/year change in wireless telephone services inflation. The current y/y rate is nearly -13%, but that isn’t the striking part. Wireless telephony is generally in a state of deflation. But the one-month change of 7%, in a category that constitutes 2.2% or so of consumption in core categories, trimmed one-sixth of a percentage point from the core number. The 7% single-month decline is completely unprecedented and happened because of the way that the BLS samples wireless telephone plans and how it accounts for the value of changes in the components of these plans. In short, the BLS method severely exaggerated a small effect.

How the BLS Methodology for Wireless Plans Exaggerated a Small Effect

In sampling wireless telephone plans the BLS does not take into account the fact that, unlike with many products, telephone plans are consumed continuously but at a pre-set price that is different for each consumer based on the plan that consumer previously bought. If you go to the store and buy Pop-Tarts, the price you pay is the same as the price that everyone else pays. So, the BLS can easily figure out how much of the average person’s consumption consists of Pop-Tarts, and track the price of Pop-Tarts, and arrive at a good estimate of how the cost of the average person’s consumption basket changed as a result of changes in the price of Pop-Tarts. Moreover, if the size of the box of Pop-Tarts changes, or if Pop-Tarts are replaced by Pop-Tasties (which, let us suppose, are like Pop-Tarts but are sold by a different company and are slightly different), the BLS analyst can make an intelligent substitution based either on comparing the price of Tarts and Tosties when they overlapped, or by comparing the characteristics of Tarts and Tosties and adjusting the price series for Toaster Pastries to reflect the new items on sale.

Contrariwise, with wireless telephony only people taking out new contracts are paying the new prices. However, the BLS doesn’t have a way to survey consumers generally to find out what the average consumer is currently paying and what the average plan looks like. Instead, they survey various sales outlets (most of this is done online) and see what plans are being offered to consumers. They adjust the price of the wireless telephony series based on changes in these plans over time…but notice that this will tend to exaggerate moves, since it effectively implies that everyone rolls over their wireless contracts every month into a new plan.

Ordinarily, this is not a crucial problem; in March, however, a number of carriers introduced unlimited data plans. Although the BLS doesn’t specifically evaluate the price per gigabyte of data, they effectively do something similar when they compare the old plan offered (which had some amount of data at a fixed price) to the new plan offered (which has unlimited data). “Infinity gigabytes” is clearly a lot better than “four gigabytes,” but it is difficult to say how much better when most people will not immediately consume dramatically more data when moving to the new plan.

So in March, the BLS series for wireless telephony had two problems. First, the introduction of a number of new wireless data plans caused the quality of the sampled plans to look much better for a similar price. Second, and more importantly: even though the price wars in telecom didn’t affect very many people – only those who were changing their plans that month – the BLS methodology acted as if the average consumer moved to the new plan, and that greatly exaggerated the effect. In short, the BLS series for wireless telephone services vastly overstated the deflation experienced this quarter – but the tradeoff is that it will understate the inflation experienced in the future, as users gradually migrate to unlimited data plans.

Categories: Causes of Inflation

Summary of My Post-CPI Tweets (May 2017)

May 12, 2017 4 comments

Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guy or sign up for email updates to my occasional articles here. Investors with interests in this area be sure to stop by Enduring Investments. Plus…buy my book about money and inflation. The title of the book is What’s Wrong with Money? The Biggest Bubble of All; order from Amazon here.

This month, I am making sure to include my comments before the actual number, since my suspicions about the upside risk were exquisitely wrong. This is why you shouldn’t put a lot of weight on monthly figures, folks!

  • Step right up ladies and gents. The CPI circus is about to commence.
  • Last month’s circus crazier than usual, including an unprecedented (and inexplicable) 11+% drop in wireless telecom services. [Editor’s note: it was only 7%. I corrected this in a later tweet]
  • This caused more diversion in core and median CPI. Median (better measure) remains steady at 2.5%.

  • PPI y’day was broadly strong. I don’t pay much attention to PPI but it does create upside risk.
  • Also note that European inflation saw a drop and then big jump from the early Easter. Not sure we have an analog but…
  • Point is that consensus is for 0.17% or so. There’s a lot of upside risk to that number I think.
  • Over next few months, core will rise regardless as we drop off 0.18, 0.21, 0.15, and 0.13. Easy hurdles.
  • Wow! Core only 0.1% again! Even a low 0.1%…0.07%.
  • I cannot WAIT to get a look at the breakdown.
  • ..Medical Care ebbed from 3.5% y/y to 3.0% y/y, wanna look inside that one. Recreation and yes, communication also soft.
  • Core drops to 1.89% y/y. Lowest since late 2015. Of course, remember that median is a better measure – we’ll see that later.
  • [I retweeted this, look at Matthew’s yellow line here]

  • Wireless telecom services fell another 1.7%. Incidentally I earlier said 11% m/m was last mo…it was only 7% m/m, the 11% decline was y/y.
  • so wireless telecom services now down 12.9% y/y, 9.9% over the last 3 months. This really warrants explanation from BLS.
  • In Medical Care, Medical Drugs fell to 2.62% from 3.97% y/y. Professional svcs, which is twice the weight, fell to 1.58% from 2.50%.
  • Health insurance fell to 2.72% vs 3.34%. Lowest since 2015.
  • Medical decel seems implausible but remember is a rate of change measure. So rising from high level, but at slower rate, is lower CPI.
  • Let’s get to housing. Primary rents 3.84% vs 3.88%. OER fell to 3.39% from 3.49%, that’s a big drop for 25% of the index.
  • So overall, Housing rose from 3.1% to 3.2%, but that’s on the strength of a 1% rise in household energy y/y.
  • This is OER. The decline is actually welcome – it had been running well ahead of even our optimistic models.

  • Core goods steady at -0.6% y/y. So the deceleration in last two months is all from core services, from 3.1% to 2.9% to 2.7%.
  • I don’t see that slowdown in core services as sustainable unless housing rolls over…
  • …and I don’t see that happening while home prices keep rising at 6-7% as they have been.
  • Weakness in services outside of housing s/b taken with grain of salt though…a lot of that is wireless services!
  • But doing core-less-housing-and-wireless is cheating. We take out housing to look @ the wiggly stuff. Can’t also take out wiggly stuff.
  • OK, four-pieces CPI look. From most-wiggly to least. They tell the story. Food & Energy:

  • Core goods (about 19% of CPI)

  • Core services less rent-of-shelter (26% of CPI). <<BOOM>>

  • And Rent of Shelter (33.3%)

  • And within core services less ROS, a lot of that is wireless but medical care ebbing is also in there. That’s the story of this month.
  • On Median…I have 0.13% m/m, but the median category is an OER piece and the BLS seasonally adjusts those.
  • But my best guess on median is 0.13%, dropping y/y to 2.4%.
  • Maybe I’m wrong and inflation pressures are ebbing after all. You know who else is thinking that? Janet Yellen.
  • Forgot to tweet this chart earlier.

  • Also interesting. Core<median b/c of big weight in left tail. But also starting to be more weight in general left of mode.

  • Last routine chart: the weight of categories inflating faster than 3% is still almost half. It’s that left tail draggin’ stuff down.

It was easy to ignore last month’s negative core print. It was obviously tied to a ridiculous (and still not explained by the BLS) plummet in the price of wireless telecommunications services. A 7% fall, nationwide, in one month, that no one seems to have noticed, is something the BLS really needs to comment on (my best guess is that some data plans got uncapped, and the BLS assumed a large increase in the data taken at zero dollars and therefore a big drop in the price per gig. That’s effectively a hedonic adjustment, and a not unreasonable one if you really saw a dramatic increase in data being taken. Since I have yet to talk to anyone who saw anything that resembled this huge effect, I remain skeptical.) But in any event, it was easy to ignore March’s number released in April.

Now we have two months in a row, and while wireless telecom contributed this month as well, there was also softness in medical care and in owner’s equivalent rent. That’s harder to ignore. And while median CPI was steady after last month’s debacle, it should downtick today.

I don’t think inflation is done rising; I think this is just a pause. But as I said above, I am sure that the decline in core CPI and core PCE will not go unremarked at the next FOMC meeting – the one where they are supposed to hike rates again. I think we’ll learn a lot about the stomach the Fed has for continuing the rate normalization regime by whether they go through with the next hike.

Categories: CPI, Tweet Summary

Bond Vigilantes Still Slumber

I read an article recently that noted the 65-75bp rise in Treasury yields over the last year or so, and sought to explain, through a labyrinthine line of reasoning/model, that most of the rise was due to the “reflationary” trade, with the Fed hopelessly behind the curve. The model the author used depicted inflation expectations as being fairly directly tied to the rise in inflation outcomes that we’ve seen: headline inflation has risen from below 1% at the middle of last year to 2.4% year-over-year ended last month.

This approach was, at one time, fairly standard. Since there was no way to directly observe inflation expectations, people measured real rates by taking current interest rates and subtracting trailing 1-year inflation, reasoning that recent inflation is a good proxy for expectations. Indeed, you will still see some economists and bloggers referring to the “recent decline in real rates” that has happened since headline inflation has risen about 250bps since mid-2015 (see chart, source Bloomberg) while 10-year rates are approximately unchanged over the same time horizon.

With this framework, economists would say that real interest rates have fallen precipitously and are now roughly zero, whereas two years ago they were over 2%.

Of course, that old way of doing things is nonsense today. Because past inflation is highly influenced by changes in energy prices (oil prices bottomed in early 2016), trailing inflation is in fact a pretty poor measure of longer-term inflation expectations, and we no longer need to rely on this method because we can directly observe real interest rates, and to some extent market measures of inflation expectations.[1] Here are the current levels, along with 1-year and 2-year changes, in real rates and inflation over the last one and two years (source: Bloomberg; Enduring Investments calculations):

So what has really happened to longer-term real rates and inflation expectations? Over the last two years, 10-year real yields have risen about 27bps, with roughly unchanged 10-year inflation expectations, producing a 25bp rise in nominal interest rates. Over the last year, those numbers are +38bps and +27bps, leading to a 65bp rise in 10-year nominal yields.

Those figures give the central bank tremendous credit for not being behind the curve. Over the last two years, core and median inflation has risen 0.3% while 10-year expectations have been stable. Over the last year, core inflation has fallen a bit (though that has a lot to do with the quirky plunge in telecom prices last month, which should be reversed this month) while median has risen about 10bps. Still, there’s no panic at all in inflation markets. Real yields have risen only 16-65bps over the last two years, despite 75bps of rate hikes.

The Fed very probably is well behind the curve, but the market doesn’t think so. The bond vigilantes haven’t even begun to light their torches yet.

[1] Since market nominal interest rates are lower than they would be if the Fed had not bought a few trillion in securities, breakevens and inflation swaps are probably lower than true inflation expectations would be if the market was freely trading, but since at some point market rates will begin to anticipate the unwind of the Fed’s balance sheet we can’t really say for sure.

Categories: Federal Reserve, TIPS

Pre-Existing Conditions and Fire Insurance

When it comes to health care, I continue to be amazed at the utter nonsense that gets tossed about when the discussion comes to insuring pre-existing conditions. The problem seems to be that no one who understands insurance has anything to say about health care legislation, because the question of why you may not want to guarantee issuance of insurance at a given rate no matter what pre-existing conditions the patient has is really not hard to understand. Consider this little vignette:

Caller: Hi, I’d like to buy some home insurance, please.

Agent: Sure, I’d be happy to help with that.

Caller: Does the insurance cover loss from fire?

Agent: Of course. That’s just one of many coverages you get with our insurance. Can you tell me a little bit about your house?

Caller: It’s three bedrooms, two baths. Worth about $300,000. What will the insurance cost me?

Agent: It depends on a few more pieces of information I have to gather from you, but about <pause> $800 per year.

Caller: That sounds great. Sign me up. Do you need my credit card?

Agent (laughing): Just a moment, sir! I need to get more information to give you an accurate quote. Can you tell me about the condition of your home?

Caller: You mean, right now?

Agent: Um…yes.

Caller: It’s on fire.

Agent: Your house is on fire?

Caller: Yep. Can we speed this up a bit?

Agent: Sir, we can’t insure your house against fire if it’s already on fire!

Caller: Why not? Just because it’s a condition that existed prior to my call?

Agent: Well, yes.

Caller: That’s outrageous! I demand you issue me insurance!

Agent (after conferring with management): Sir, it turns out we can offer you insurance on your home…

Caller: See? I knew you could be reasonable.

Agent: …for $350,000.

See, here’s the thing. Insurance is based on the principle of distributing money in a pool of similar risks from insureds who don’t experience the insurable event to those who do experience the insurable event. If someone enters the pool who has already had the insurable event, it’s simply a transfer – there’s no insurance. Person A needs $100,000 in surgeries, and gets an insurance policy that costs $1,000. Where does the rest of the money come from? It doesn’t come from the insurance company, and I think perhaps people don’t understand that point (and Republicans are truly abysmal at explaining it). The rest of the money comes from other insureds. Consider this situation: rather than get private insurance, you and twenty of your fraternity brothers from college – all about the same age and health – decide to form your own mutual insurance network. Everyone agrees that if anyone gets sick, the whole group will pitch in equally to pay the medical bills of the sick person. Now, suppose one person says “can we take my mom in as well? She has early-onset dementia and was just diagnosed with lung cancer. She’d be glad to join the group and pay an equal share, because fair is fair!” Do you think it is fair that mom pays the same amount?

The insurance company makes money if the money they pay out is less than the money they take in, but they also stand to lose if they underwrite the risks poorly and pay out more than they take in. And insurance companies don’t systematically rip people off by underwriting policies super-conservatively. In fact, the evidence seems to be that insurance companies rather frequently fall prey to pressures to move more product, and underwrite policies too aggressively.

The social-justice question can be separated from the health care insurance question. If you feel that everyone should have their medical bills covered, no matter what, then create a federal umbrella program for high-risk insureds and pay for that program with taxpayer funds. That’s explicit: let the cost of health insurance cover the actual cost of health insurance, which involves conditions the risk pool doesn’t have yet, and represent the welfare or charity – because that’s what it is, of course, when others pick up the expense of those unable to pay – as exactly that. After all, the federal government offers flood insurance to landowners who can’t get insurance at a “reasonable price” because the land floods all the time; that is a similar welfare situation in which taxpayers have decided they are willing to foot the bill because it’s a social good that people live or build on the flood plain. (I’m not sure why, but that’s the import of the federal flood insurance program). So there’s precedent for the government taking over pools that are too risky for private markets.

Again, this isn’t rocket science and it isn’t hard to explain. Why doesn’t someone get on television and explain it? How about a commercial using my script?

Categories: ACA, Analogy, Good One, Insurance, Rant

Tariffs are Good for Inflation

The news of the day today – at least, from the standpoint of someone interested in inflation and inflation markets – was President Trump’s announcement of a new tariff on Canadian lumber. The new tariff, which is a response to Canada’s “alleged” subsidization of sales of lumber to the US (“alleged,” even though it is common knowledge that this occurs and has occurred for many years), ran from 3% to 24% on specific companies where the US had information on the precise subsidy they were receiving, and 20% on other Canadian lumber companies.

In related news, lumber is an important input to homebuilding. Several home price indicators were out today: the FHA House Price Index for new purchases was up 6.43% y/y, the highest level in a while (see chart, source Bloomberg).

The Case-Shiller home price index, which is a better index than the FHA index, showed the same thing (see chart, source Bloomberg). The first bump in home price growth, in 2012 and 2013, was due to a rebound to the sharp drop in home prices during the credit crisis. But this latest turn higher cannot be due to the same factor, since home prices have nearly regained all the ground that they lost in 2007-2012.

Those price increases are in the prices of existing homes, of course, but I wanted to illustrate that, even without new increases in materials costs, housing costs were continuing to rise faster than incomes and faster than prices generally. But now, the price of new homes will also rise due to this tariff (unless the market is slack and so builders have to absorb the cost increase, which seems unlikely to happen). Thus, any ebbing in core inflation that we may have been expecting as home price inflation leveled off may be delayed somewhat longer.

But the tariff hike is symptomatic of a policy that provokes deeper concern among market participants. As I’ve pointed out previously, de-globalization (aka protectionism) is a significant threat to inflation not just in the United States, but around the world. While I am not worried that most of Trump’s proposals would result in a “reflationary trade” due to strong growth – I am not convinced we have solved the demographic and productivity challenges that keep growth from being strong by prior standards, and anyway growth doesn’t cause inflation – I am very concerned that arresting globalization will. This isn’t all Trump’s fault; he is also a symptom of a sense among workers around the world that globalization may have gone too far, and with no one around who can eloquently extol the virtues of free trade, tensions were likely to rise no matter who occupied the White House. But he is certainly accelerating the process.

Not only do inflation markets understand this, it is right now one of the most-significant things affecting levels in inflation markets. Consider the chart below, which compares 10-year breakeven inflation (the difference between 10-year Treasuries and 10-year TIPS) to the frequency of “Border Adjustment Tax” as a search term in news stories on Google.

The market clearly anticipated the Trumpflation issue, but as the concern about BAT declined so did breakevens. Until today, when 10-year breakevens jumped 5-6bps on the Canadian tariff story.

At roughly 2%, breakevens appear to be discounting an expectation that the Fed will fail to achieve its price inflation target of 2% on PCE (which would be about 2.25% on CPI), and also excluding the value of any “tail outcomes” from protectionist battles. When growth flags, I expect breakevens will as well – and they are of course not as cheap as they were last year (by some 60-70bps). But from a purely clinical perspective, it is still hard to see how TIPS can be perceived as terribly rich here, at least relative to nominal Treasury bonds.

Book Review: The Mandibles (related to inflation)

April 7, 2017 1 comment

For something a little different, I wanted to write a book review today. But this is not as far removed as it seems, from my normal beat. In fact, this book could actually be a companion piece to my own book published last year, What’s Wrong with Money?: The Biggest Bubble of All. I really mean that.

The book is “The Mandibles: A Family, 2029-2047,” by Lionel Shriver. This is a terrific work of fiction, especially if you like futuristic dystopian novels. From the jacket:

In 2029, the United States is engaged in a bloodless world war that will wipe out the savings of millions of American families. Overnight, on the international currency exchange, the “almighty dollar” plummets in value, to be replaced by a new global currency, the “bancor.” In retaliation, the president declares that America will default on its loans. “Deadbeat Nation” being unable to borrow, the government prints money to cover its bills. What little remains to savers is rapidly eaten away by runaway inflation.

The Mandibles have been counting on a sizable fortune filtering down when their ninety-seven-year-old patriarch dies. Once the inheritance turns to ash, each family member must contend with disappointment, but also—as the U.S. economy spirals into dysfunction—the challenge of sheer survival.

This book was recommended to be by a friend who knows of my background in inflation – many years of study of the topic, and the fact that I founded and run a firm that’s dedicated to inflation hedging of various kinds (e.g., college tuition or healthcare, but also things like commodities and inflation-linked bond strategies). I took up the novel with some trepidation, since most treatments of inflation in fiction…heck, in non-fiction…are shallow and generally just plain obtuse. I’m including works by famous economists. So I didn’t have high hopes for this book.

I was completely wrong.

When I said that this book could be a companion book to my own (non-fiction) work, I wasn’t kidding. The author got virtually every detail right, about how the pieces fit together, about what causes inflation – including the question of how moderate and high inflation can turn into hyperinflation, a transition that has little to do with monetary policy actions and everything to do with confidence in the monetary unit. And that’s actually why my book is titled “What’s Wrong with Money…” the fact that confidence is the underlying unit (in a fiat currency) creates the potential for an outcome such as Ms. Shriver describes. It isn’t a likely outcome, but it is entirely plausible that it could work out in this way.

Ms. Shriver skillfully works current events of today into the novel, as characters occasionally recollect some old policy from the 2000s or 2010s and explain why that policy didn’t work. I was amazed at the competence with which she tackled all of these subjects.

All in all – if you like the things I write, and especially if you read my book and liked it (or even if you didn’t read it, and probably even if you didn’t like it), you will really like The Mandibles. I highly recommend it.

Categories: Book Review

Is This Bubble Smaller Than We Thought?

I haven’t written in a few weeks. It has been, generally, a fairly boring few weeks in terms of market action, with inflation breakevens oscillating in a narrow range and equities also fairly somnolent. But I can’t blame my lack of posts on a lack of interesting things to remark upon, nor on March Madness, nor on New Jersey Transit (although each of these is a very valid excuse for the general lackadaisical nature of trading in recent weeks). In my case, I plead business exigencies as we are working on a few very exciting projects, one of which I expect to be able to announce in the next week or two.

But writing a blog post/article is never far from my mind. I’ve been doing it for far too long – since the ‘90s if you count the daily letters I wrote for client distribution when I was on Wall Street – and when I haven’t written something in a while it is a bit like an itch on the sole of my foot: I am constantly being reminded about it and the only way to make it stop is to rip the shoe off and scratch. Which tickles. But I digress. What I mean to say is that I have a long list of things I’ve written down that I could write about “if I have time this afternoon,” and it’s only the lack of time that has stopped me. (Some of these are also turning into longer, white-paper type articles such as one I am writing right now estimating the cost of the “Greenspan Put.”)

Some of these ideas are good ideas, but I can’t figure out how to address my hypothesis. For example, I suspect that inflation swaps or breakevens, now that they are near fair value for this level of interest rates, have some component in them right now that could be interpreted as the probability that the Border Adjustment Tax (BAT) eventually becomes law. If the BAT is implemented, it implies higher prices, and potentially much higher depending on the competitive response of other countries. If the BAT fails, then breakevens may not set back very much, but they should decline some; if the BAT looks like it is fait accompli, then inflation quotes could move sharply higher (at least, they should). But prediction markets aren’t making book on the BAT, so I don’t have a way to test (or even illustrate) this hypothesis.

But enough about what I can’t do or won’t be doing; today I want to revisit something I wrote back in December about the stock market. In an article entitled “Add Another Uncomfortable First for Stocks,” I noted that the expected 10-year real return premium for equities over TIPS was about to go negative, something that hadn’t happened in about a decade. In fact, it did go slightly negative at the end of February, with TIPS guaranteed real return over ten years actually slightly above the expected (risky) real return of equities over that time period. At the end of March, that risk premium was back to +3bps, but it’s still roughly the same story: stocks are priced to do about as well as TIPS over the next decade, with the not-so-minor caveat that if inflation rises TIPS will do just fine but stocks will likely do quite poorly, as they historically have done when inflation has risen.

But I got to wondering whether we can say anything about the current market on the basis of how far stocks have outperformed the a priori expectations. That is, if we made a forecast and a decade goes by and stocks have shattered those expectations, does that mean that the forecast was bad or that stocks just became overvalued during that period so that some future period of underperformance of the forecast is to be expected? And, vice-versa, does an underperformance presage a future outperformance?

The first thing that we have to confess is that the way we project expected real returns will not produce something that we expect to hit the target every decade. Indeed, the misses can be huge in real dollar terms – so this is not a short-term or even a medium-term trading system. Consider the following chart (Source: Enduring Investments), which shows the difference of the actual 10-year return compared with the a priori forecast return from 10 years prior. A positive number means that stocks over the period ending on that date outperformed the a priori forecast; a negative number means they underperformed the forecast. In context: a 5% per year miss in the real return means a 63% miss on the 10-year real return. That’s huge.

What you can really see here is that stocks have – no surprise – very long ‘seasons’ of bear and bull markets where investors en masse are disappointed with their returns, or excited about their returns. But let me update this chart with an additional observation about real yields. During the period covered by this chart, there have been three distinct real yield regimes. In the 1960s and 1970s, real yields generally rose. In the late 1970s, 10-year real yields rose to around 4.25%-4.50%, and they didn’t begin falling again in earnest until the late 1980s. (This is in contrast to nominal yields, which started to fall in the early 1980s, but that was almost entirely because the premium for expected inflation was eroding). Between the late 1970s and the late 1980s, real yields were more or less stable at a high level; since the late 1980s they have been declining. In the following chart (Source: Enduring Investments), I’ve annotated these periods and you may reasonably draw the conclusion that in periods of rising interest rates, stocks underperform a priori expectations in real terms while in periods of falling real interest rates, stocks outperform those expectations.

These rolling 10-year rate-of-change figures are interesting but it is hard to see whether periods of outperformance are followed by underperformance etc. It doesn’t look like it, except in the really big macro picture where a decade of outperformance might set the stage for a decade of underperformance. I like the following look at the same data. I took the a priori 10-year real return forecast and applied it to the then-current real price level of the S&P 500 (deflated by the CPI). That produces the red line in the chart below (Source: Enduring Investments). The real price level of the S&P is in black. So the red line is the price level forecast and the black line shows where it ended up.

As I said, this is not a short-term trading model! It is interesting to me how the forecast real level of equities didn’t change much for a couple of decades – essentially, the declining market (and rising price level) saw the underperformance impounded in a higher forecast of future returns. So the “negative bubble” of the 1970s is readily visible, and the incredible cheapness of stocks in 1981 is completely apparent. But stocks were also cheap in real terms in 1976…it was a long wait if you were buying then because they were cheap. Value investing requires a lot of patience. Epic patience.

However, once equity returns finally started to outpace the a priori forecast, and the actual line caught up with the forecast line, the market leapt higher and the twin bubbles of 1999 and 2006 are also apparent here (as well as, dare I say it, the current bubble). But since the forecast line is climbing too, how bad is the current bubble? By some measures, it’s as large or nearly as large as the 1999 bubble. But if we take the difference between the black line and the red line from the prior chart, then we find that it’s possible to argue that stocks are only, perhaps, 30% overvalued and not as mispriced even as they were in 2006.

This may sound like slim solace, but if the worst we have to expect is a 30% retracement, that’s not really so terrible – especially when you realize that that’s in real terms, so if inflation is 3% per year then you’re looking at a loss of 10-15% per year for two years. That’s almost a yawner.

On the other hand, if we are entering an up cycle for real interest rates, then the downside is harder to figure. In the last bear market for real yields, stocks got 60% cheap to fair!

None of this is meant to indicate that you should make major changes in your portfolio now. If all of the evidence that stocks are rich hasn’t caused you to make alterations before now, then I wouldn’t expect this argument to do it! Rather, this is just a different rationality-check on the idea that stocks are overvalued, and my words could actually be taken as soothing by bulls. The chart shows that stocks can be overvalued, and outperform a priori expectations that incorporate valuation measures, for years, even decades. Maybe we’re back in one of those periods?

But we have to go back to the very first point I made, and that’s that if you don’t feel like betting the 30% overvaluation is going to get worse, you can lock in current real return expectations with zero risk and give up nothing but the tails – in both direction – of the equity bet. The equity premium, that is, is currently zero and stocks are additionally exposed to rising inflation. I see nothing tantalizing about stocks, other than the possibility that the downside is perhaps not as bad as I have been fearing.


Administrative Note: Our website at EnduringInvestments.com is about five years overdue for a facelift. We are currently considering how we want to change it, the look & feel we want, and the functionality we desire and require. If you have a suggestion for something you think would be helpful for us to include, please let me know. (Note that this is not a solicitation for web design services so please do not ask! We have picked a firm to do that. I’m just curious what customers and potential customers might want.)

Categories: Investing, Stock Market
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