On Market Valuations and Expected Returns; Robots; Nuts to extend Lifespan!

From: aditya rana
Date: Sat, May 23, 2015 at 12:56 PM
Subject: On Market Valuations and Expected Returns; Robots; Nuts to extend Lifespan!


The abnormally low level of interest rates prevailing in the developed world underpin the inflated levels of almost all assets. However, the rich valuations imply very low long-term returns leaving investors in somewhat of a dilemma – stay out of the market and earn a zero return on cash or remain invested? Martin Barnes, Chief Economist at the venerable research firm BCA, provides a useful framework to look at this issue and make appropriate decisions. To summarise:

-For the first time in the post-WWII period, U.S. stocks and Treasuries are both very overvalued at the same time. Investors have to either accept negligible real returns on cash and government bonds, or take risk in the equity market which is overvalued by every metric besides rates.

-The real 10-year Treasury yield is more than 1.5 standard deviations below its 60 year historical average, while the Shiller P/E ratio of the stock market is almost one standard deviation above its historical average (see charts below). This is highly unusual , as historically stocks were typically cheap when bonds were expensive, and stocks were expensive when bonds were cheap.

-Despite concerns expressed about financial stability by both Yellen and Draghi, it is unlikely that central banks will shift focus from trying to boost economic activity to curbing financial excesses for at least another year.

-The Fed’s massive quantitative easing program has not resulted in a noteworthy increase in broad money supply and credit, as both the money multiplier and the velocity of money have collapsed (see chart below). This implies that each dollar of increase in bank reserves due to QE, results in less broad money due to the fall in the money multiplier and less GDP due to a fall in velocity (which is GDP divided by broad money supply).

-Monetary policy has therefore relied on less effective channels like boosting asset prices and weakening the exchange rate to support economic growth. The negative real yields have also forced investors into riskier assets and higher leverage to enhance returns.

-With the 10-year Treasury yield at 2.2% implying a real yield of 0.7%, the expected future real returns over 5 years (-0.9%) to 10 years (+0.9%) are likely to be very low (see graph and table below).

-Regarding the equity market, with a Shiller P/E of 28, which puts it in the top ten percentile historically and implies expected real returns of -1.7% (5 years) and 0.4% (10 years – see graph and table below).

-While markets “ can remain irrational longer than you can remain solvent” , and the Shiller P/E being not a good predictor of returns over the short to medium term (it reached 28 in the mid-90s but subsequently went up to 48 in 2000), the relationship over the longer-term is clear and should make long-term investors cautious.

-Though the Fed is likely to raise rates in September, the subsequent rate rises will be gradual as economic growth continues to disappoint and inflation remains well below the 2% target.

-For bond investors, the recent back-up in yields may present an attractive tactical opportunity to buy long-dated Treasuries, with yields possibly declining again, perhaps triggered by a fall in oil prices due to continued oversupply.

-For equity investors, given the benign rate outlook, markets are likely to be well supported for at least 6 to 12 months. However, equity market are vulnerable to a re-pricing of the bond market, as long rates adjust to the rise in short-term rates.

-In conclusion, short-term investors could remain invested despite overvalued markets, but “keep their running shoes beside the door” . Long-term investors who patiently wait for more attractive valuations should be rewarded over the longer run.

-Good summary of the basic environment – overvalued markets point to low returns over a 10 year horizon, but markets could stay overvalued (and even reach bubble territory as Jeremy Grantham noted last week) for a while longer. My personal view is that markets could continue to be overvalued for several more years, supported by Fed (and global central banks) policy, unless the U.S. gets a political change next year which puts pressure on the Fed to normalise rates more aggressively, as implied by a strict application of a rules based policy as espoused by the Taylor Rule (which puts the Fed Funds currently at 2%!).

Regarding the expected path of the Fed funds rate, an interesting comment from Scott Minerd, CIO of Guggenheim Partners: “Our view of the future is that the Federal Reserve will likely begin interest rate “liftoff” in September of this year, and will continue to tighten at a steady pace until it nears the terminal rate (or peak Fed funds rate) in the cycle. This will likely occur toward the end of 2017 or early 2018 in the range of 2.5 to 3 percent. Recent experience suggests that a recession typically occurs about a year after we reach the terminal rate. If this tightening cycle plays out as we suspect, the U.S, economy will face its next recession in late 2018 or early 2019.”

From a long-term perspective, as and when we move to a more aggressive rate hike policy (in response to either stronger economic growth or to deflate an asset bubble) then it is important to note that all assets which generate cash-lows, real or financial, will be vulnerable to a severe downturn in prices, as their valuation is ultimately based on a discounting of future cash-flows. This includes, stocks, long-dated government bonds, credit, bank perpetual bonds, real estate, land and art. The safe havens in that environment will be cash, treasury bills, gold and some commodities.


Came across a fascinating review of a book written by Martin Ford “ Rise of the Robots” from the research firm 13D. An excerpt:

“Ford’s book is replete with stunning examples of how quickly technology is advancing and how smart, and even curious, machines are becoming. The faster machines begin to learn, the greater their threat to all types of employment— the truck driver and surgeon alike.”

Consider Eureqa, an algorithm that uses genetic programming, a technique inspired by biological evolution to discover natural laws. The brainchild of Cornell University’s Hod Lipson and Michael Schmidt, the software was developed to uncover the “whys” behind a pendulum’s behavior. As Ford recounts: “They turned their software loose to repeatedly release the pendulum and then sift through the resulting motion data and try to figure out the mathematical equations that describe the pendulum’s behavior. The algorithm had complete control over the experiment; for each repetition, it decided how to position the pendulum for release, and it did not do this randomly—it performed an analysis and then chose the specific starting point that would likely provide the most insight into the laws underlying the pendulum’s motion. Lipson notes that the system is not a passive algorithm that sits back, watching. It asks questions. That’s curiosity.”

The program, which they later dubbed Eureqa, took only a few hours to come up with a number of physical laws describing the movement of the pendulum—including Newton’s Second Law—and it did so without any prior information or programming about the laws of physics. Eureqa achieved this insight by randomly combining mathematical building blocks into equations and then testing to see how well the equations fit the data. Equations that failed were discarded, while those that showed promise were retained and recombined in new ways until the system ultimately converged on an accurate mathematical modeling. In essence, the system is working on the principle of Darwinian natural selection.”

Nuts to extend Lifespan:

Daily nuts consumption has been long recommended in Ayurvedic texts as a core part of a healthy diet. Recent research seems to corroborate the benefits of nuts consumption in extending lifespan.

Dr. Michael Gerber, May 14, 2015:

-We’ve known that increased nut consumption has been associated with a reduced risk of major chronic diseases, such as heart disease and diabetes. But do those who eat nuts actually live longer lives? Clinical trials have shown nuts help lower cholesterol and oxidation, and improve our arterial function and blood sugar levels. Does all this translate into greater longevity?

-Researchers at Harvard examined the association between nut consumption and subsequent mortality of over 100,000 people followed for decades. In that time, tens of thousands died, but those that ate nuts every day lived significantly longer. Daily nut consumers had fewer deaths from cancer, heart disease, and respiratory disease, even after controlling for other lifestyle factors. Nut consumers lived significantly longer whether they were older or younger, fat or skinny, whether they exercised more, smoked, drank, or ate other foods that may affect mortality.

-But nuts are so filled with fat that there “may be a concern that frequent nut consumption can result in weight gain.” However, that’s not what the Harvard researchers found. In fact, other studies have associated nut consumption with a slimmer waist, less weight gain, and lower risk of obesity. If we look at all the studies put together, it’s pretty much a wash. Diets enriched with nuts do not seem to affect body weight, body mass index, or waist circumference much at all.. Hence, it appears that the incorporation of nuts (around one to two small handfuls a day) would be advisable to ensure various health benefits without the risk of body weight gain.

-How nuts do we have to go? Not much. Just a few servings a week may boost our lifespan and lower cancer rates—but it appears we have to keep it up. In the PREDIMED study, when long-time nut eaters were told to cut down on eating nuts or choose extra virgin olive oil, within five years they apparently lost much of their longevity benefit. Only the group that started out eating nuts and continued to eat at least the same amount of nuts died significantly less often.

Here’s to adding a handful of nuts to your daily diet – and keeping your running shoes in close proximity!



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