The future belongs to the left, not the right

For the time being, rightwingers are thriving, but their rise is self-limiting

Wolfgang Münchau

US congresswoman Alexandria Ocasio-Cortez has proposed a 70 per cent tax rate on high earners. Such a policy could cause collateral damage but from the perspective of the radical left, collateral damage is a promise, not a threat © Reuters

Matteo Renzi, Italy’s former prime minister, is getting ready to form his own centrist political movement, very much like French president Emmanuel Macron’s La République en Marche. A new centrist group in the UK has also brought excitement, albeit for different reasons. Liberal pro-Europeans are certainly not going down without a fight.

But the odds are not looking good for many of them. Liberal democracy is in decline for a reason. Liberal regimes have proved incapable of solving problems that arose directly from liberal policies like tax cuts, fiscal consolidation and deregulation: persistent financial instability and its economic consequences; a rise in insecurity among lower income earners, aggravated by technological change and open immigration policies; and policy co-ordination failures, for example in the crackdown on global tax avoidance.

When the financial crisis struck, continental European governments did not take full control of their banking systems, crack down hard enough on bonuses, or impose financial transaction taxes. They did not raise income and corporate taxes to counter-balance cuts in public sector spending. They did not tighten immigration policies.

The usual economic statistics do not capture how the lives of people on lower incomes have changed over the last two decades. Stagnating real disposable incomes matter, but so does lower job security and reduced access to credit markets and mortgages.

I expect the pushback against liberalism to come in stages. We are in stage one — the Trumpian anti-immigration phase. Immigration carries net economic benefits, especially over the long term. But there are losers from it, too, both actual and imagined. Chancellor Angela Merkel’s decision to open Germany’s borders to 1m refugees in 2015 was justified on ethical grounds, and I am sure will bring long-term benefits. But it turned into a crisis because she did not prepare her country politically.

The euro, too, was a liberal fair-weather construction. Once crisis struck, politicians did the minimum they needed to ensure its survival, but they failed to solve the underlying problems, which nowadays express themselves as imbalances that do not self-correct. Without a single safe asset and a genuine banking union, the eurozone will remain prone to financial crises.

Liberal democracy has been successful at breaking down trade barriers, protecting human rights and fostering open societies. But the inability to manage the social and economic consequences of such policies has rendered liberal regimes inherently unstable.

For now, the right is thriving on the anti-immigration backlash. But its rise is self-limiting for two reasons. First, rightwing policies are not succeeding even on their own narrow terms. A wall along the border with Mexico will not stem US immigration flows any more than the re-nationalisation of immigration policies would in Europe. And second, I suspect that immigration will soon be superseded by other issues — such as the impact of artificial intelligence on middle-class livelihoods; rising levels of poverty; and economic dislocation stemming from climate change.

This is a political environment that favours the radical left over the radical right. The right is not interested in poverty and its parties are full of climate-change deniers. Some of the rightwing populists may speak the language of the working classes, but the left is more likely to deliver.

The killer policy of the left will be the 70 per cent tax rate proposed by freshman US congresswoman Alexandria Ocasio-Cortez. It is not the number that matters, but the determination to reverse a 30-year trend towards lower taxation of very high incomes and profits. There would be collateral damage from such a policy for sure. But from the perspective of the radical left, collateral damage is a promise, not a threat.

What about the radical centre? Mr Macron has demonstrated that grassroots liberalism can succeed as an electoral strategy. But there are factors specific to the French electoral system that favoured Mr Macron’s victory in 2017. And it is too early to pass judgment on whether his actual policies will deliver what his voters wanted. Italy is also a candidate for a Macron-style revolution, but that could not by itself solve the country’s deep-rooted problems.

The economic and social impact of liberal policies varies across countries. Germany has so far avoided the downward spiral because of its unique position inside the eurozone and its still relatively strong industrial base. But wait until the irresistible force of the electric self-driving car hits the immovable object of diesel drivers.

We have entered an age that will favour radicalism over moderation, and the left over the right. It is not going to be the age of Donald Trump.

How the Upper Middle Class Is Really Doing

Is it more similar to the top 1 percent or the working class?

By David Leonhardt

Have upper-middle-class Americans been winners in the modern economy — or victims? That question has been the subject of a debate recently among economists, writers and others.

On one side are people who argue that the bourgeois professional class — essentially, households with incomes in the low-to-mid six figures but without major wealth — is not so different from the middle class and poor. All of these groups are grappling with slow-growing incomes, high medical costs, student debt and so on.

The only real winners in today’s economy are at the very top, according to this side of the debate. When Bernie Sanders talks about “the greed of billionaires” or Thomas Piketty writes about capital accumulation, they are making a version of this case.

On the opposing side are people who believe that the country’s defining class line is further down the economic ladder. To them, the upper middle class is on the happy side, enjoying rising incomes, longer lifespans, stable marriages and good schools. Richard Reeves’s recent book, “Dream Hoarders” made this case, as did Matthew Stewart’s well-titled Atlantic article: “The 9.9 Percent Is the New American Aristocracy.”

I think the chart above helps to resolve the debate. It shows that both sides have a point — but that it’s a mistake to divide the country into only two groups. To make grand pronouncements about the American economy, you need to talk about three groups.

The first is indeed the top 1 percent of earners, and especially the very richest. Their post-tax incomes (and wealth) have surged since 1980, rising at a much faster rate than economic growth. They are now capturing an even greater share of the economy’s bounty.

Then there are the bottom 90 percent of households, who are in the opposite position. The numbers here take into account taxes and government transfers, like Social Security, financial aid and anti-poverty benefits. Even so, the incomes of the bottom 90 percent have trailed G.D.P. Over time, their share of the economy’s bounty has shrunk.

Finally, there is the upper middle class, defined here as the 90th to 99th percentiles of the income distribution (making roughly $120,000 to $425,000 a year after tax). Their income path doesn’t look like that of either the first or second group. It’s not above the line or below it. It’s almost directly on top of it. Since 1980, the incomes of the upper middle class have been growing at almost the identical rate as the economy.

If you, dear reader, happen to be in this group, I’m not trying to dismiss your economic anxieties. I know that you may not feel rich. You probably have big mortgage payments, rising medical costs and perhaps eye-popping tuition bills.

But I’d ask you to spend a minute thinking about how much more challenging life is for the bottom 90 percent. These households aren't making six-figure incomes, and they have received only meager raises over the past few decades. They aren't receiving their fair share of the country's economic growth. No wonder so many feel frustrated.

And for too long, the country’s economic policy, even under Democrats, has blurred the distinction between the upper middle class and the actual middle class.

In the 2008 campaign, Barack Obama and Hillary Clinton both used $250,000 as the upper limit of the middle class. (Even in the New York area, $250,000 in pre-tax income puts a household in the top 10 percent.) Obama then delivered a tax cut for everyone below that cutoff. In the 2016 campaign, Clinton and Sanders used the same definition.

A better approach exists. Politicians should recognize that there are three broad income groups, not just two. The bottom 90 percent of Americans does deserve a tax cut, to lift its stagnant incomes. The top 1 percent deserves a substantial tax increase. The upper middle class deserves neither. Its taxes should remain roughly constant, just as its share of economic output has.

So here’s some good news: The 2020 Democratic candidates are moving in this direction.

Kamala Harris’s big tax cut applies only to families making less than $100,000. Elizabeth Warren’s child-care proposal delivers 99 percent of its benefits to the bottom 90 percent of earners, according to Moody’s Analytics. The housing plans from Harris and Cory Booker give all their benefits to the bottom 90 percent, according to the Center on Poverty and Social Policy. The tax cut from Sherrod Brown, who’s a potential candidate, is likewise focused on the middle class and poor.

Ro Khanna, a Silicon Valley congressman who co-wrote Brown’s tax plan, has a useful way of thinking about this. “Our priority has to be the working poor and those struggling to make it into the middle class,” Khanna told me. “What do the upper middle class care most about in my district? They want a pluralistic America that is engaged with the world and embraces technology and future industries. What they don’t want is a backlash to diversity, a backlash to globalization, a backlash to technology.”

The upper middle class doesn’t deserve the blame for our economic problems. But it doesn’t deserve much government help, either.

Central Banks Worldwide Are Lifting Stocks. Is the Stability Masking Trouble Ahead?

By Randall W. Forsyth 

Central Banks Worldwide Are Lifting Stocks. Is the Stability Masking Trouble Ahead?
Central Banks Worldwide Are Lifting Stocks. Is the Stability Masking Trouble Ahead?
Photograph by Peter King/Fox Photos/Getty Images

“Don’t fight the Fed” was a market mantra from another era. If the U.S. central bank was raising interest rates, the stock market would inevitably be fighting an uphill battle. In that case, the better part of valor would be to get out of stocks and other risky assets and take cover in cash.

Now, the Federal Reserve and virtually every other central bank on the planet appear to be keenly watching asset prices, given their increasingly tight connection to the real economy. That may not have been their stated intent, but that has been the effect of a marked shift away from restraint this year.

The Dow Jones Industrial Average notched its ninth straight weekly advance, for a cumulative gain of 16% over the span, the longest winning streak since May 1995, according to our colleagues at Dow Jones Market Data. The rise has put the blue-chip gauge within just 3% of its record close on Oct. 3.

The advance has also been global. The Shanghai Composite Index scored its seventh straight weekly gain, totaling 12.4% during the period. The Nikkei 225 ended its sixth winning week in the past seven and is up nearly 12% from its December low. And the Stoxx Europe 600 had its seventh up week in the past eight, ending up 12.6% from its Dec. 27 low.

Minutes of the Jan. 29-30 meeting of the Federal Open Market Committee confirmed that the U.S. central bank was not oblivious to the growing danger to the economy posed by the slide in risky assets. The policy-setting panel confirmed earlier statements attesting to its patience in raising interest rates and flexibility in shrinking its balance sheet, which is another form of policy tightening.

While the Fed’s shift so far has only been rhetorical, the effect has been to add $5.1 trillion to the wealth of investors in U.S. stocks since the market’s Christmas Eve low, according to Wilshire Associates’ reckoning.

At the same time, the People’s Bank of China has engaged in a number of easing moves. Cornerstone Macro, led by veteran strategist Nancy Lazar, wrote in a client note that the central bank’s actions have boosted shares of U.S. companies with the most sales to China, including A.O. Smith (ticker: AOS), Expeditors International of Washington(EXPD), Boeing(BA), and TransDigm Group (TDG). Reports that U.S. and Chinese trade negotiators are moving toward a deal that would forestall a threatened increase in U.S. tariffs on Chinese goods would clearly be another plus for trade, and continued gains in stock prices.

In essence, central banks have tamped down the risk in the markets, which is evidenced by the decline in volatility measures. As a result, the VIX—the so-called equity fear gauge, measuring the volatility of S&P 500 index options—fell for the ninth straight week, to 13.51, less than half its late 2018 peak before it began its slide into somnolence. Nor has that been confined to equities. The MOVE index of Treasury market volatility has also declined by nearly a third since December as expectations of Fed rate hikes have all but disappeared.

Indeed, traders continue to bet actively on future rate cuts in the market for options on Eurodollar futures, according to Chicago futures brokers R.J. O’Brien & Associates.

The steady rise in stock prices and diminution of risk perceptions make for an opportune time for hot, young companies to make their initial public equity offerings. Last week, Pinterest, the social-media site, submitted a confidential filing to the Securities and Exchange Commission to go public, following ride-sharing company Lyft’s filing in December. Waiting in the wings to go public are other so-called unicorns, notably Uber, the biggest ride-sharing service, and Slack, the messaging service for offices. As with the rush to the debt market noted here last week, the IPO window now seems to be opening.

The nonchalance toward risk oddly has as its backdrop any number of potentially market-moving events. Fed Chairman Jerome Powell is due to testify before Congress on policy and the economic outlook, starting with the Senate Banking Committee on Tuesday and the House Financial Services panel on Wednesday. President Donald Trump also heads to Vietnam to meet North Korea Supreme Leader Kim Jong-un during the week.

The March 1 deadline to work out a trade deal arrives on Friday but is likely to be extended. Also looming is the expected report from special counsel Robert Mueller III’s investigation on Russian influence on the 2016 election. And in case you’ve forgotten, the March 29 deadline for Brexit also looms.

March Madness this year could refer to something other than college basketball, which doesn’t seem priced into the markets.

Really Bad Ideas, Part 7: Open Borders

by John Rubino

Now that we’re all free to speak our minds (maybe we should we call this the “post-political-caution world”) a lot of previously discredited ideas have re-emerged and are being tossed into the debate – apparently without much thought to, for instance, their horrendous unintended consequences.

One such idea that’s, ahem, gaining a lot of currency lately is Modern Monetary Theory (previously known as currency debasement). Another, which seems even easier to dismantle, is open borders. But the emergent democratic socialist movement apparently takes it seriously.

Here’s an excerpt from a representative article:

Progressives Should Support Open Borders — With No Apology

(Foreign Policy In Focus) – Supporting freedom of movement isn’t just the right thing to do. It’s a political winner for the left.

A genuine call for open borders is virtually absent from the debate between the White House and Capitol Hill, where the question has been not whether to militarize the border, but merely how many billions of dollars should be devoted to “border security,” or what specific physical infrastructure it should buy.

But open borders is more than an epithet for the right to attack its opponents with. It is a legitimate position, and the left should take it up as the only humane one.

Catching up with capital

For decades, critics of globalization have pointed out that the World Bank, International Monetary Fund, World Trade Organization—institutions that are shaped and dominated by the United States—have helped create a world where capital moves freely, while human beings are stuck at borders. Numerous “free trade” agreements have accelerated this trend.

As asylum seekers at the border confront metal barriers, surveillance drones and armed guards barring their entry, trucks, trains and boats bring a high volume of shipping containers into the United States each day. Ports of entry have perfected clearing these goods through customs efficiently, and policy makers have regulated (and deregulated) international commerce to make the process as easy as possible.

If only the people migrating from Central America and elsewhere were commodities instead of human beings, they would enter the United States painlessly, be handled with care by workers who are experts at transferring goods quickly and carefully, and then transported overnight to all corners of the country through extensive commercial distribution networks.

Commercial goods aren’t the only things that move freely across borders. The U.S. military carries out operations all over the world with such regularity that it’s not even considered newsworthy in the United States.

It’s bitterly ironic that Trump constantly describes migrants in the Central American Exodus as an “invasion,” when the United States has carried out so many actual invasions of that region — operations which bear great responsibility for destabilizing those societies and pushing so many people to come north in the first place.

The right to movement

Systems and governments that invest tremendously in perfecting the movement of commerce and violence across borders, while investing at similar scale to stop the movement of people, aren’t being simply hypocritical. They’re also violating a fundamental human right.

People have the right to move freely. Human migration, and migration particular to the Americas, predates the United States or its borders. Indeed, many of the people coming north from Central America are Indigenous, belonging to groups of people whose histories stretch far before that of the U.S. nation-state.

The right to freedom of movement becomes only more important as growing numbers of people become uprooted and displaced. Conflicts over control of the planet’s resources, economic policies that devastate people the world over, and climate change — which creates more disasters and makes parts of the world uninhabitable for everyday life—are all increasing.

With those dynamics, the responsibility of governments to honor people’s freedom to move only grows, too—as does that of ordinary people to defend that right.

New political possibilities

We are living in a time, not only of darkness and repression, but also political possibility.

Medicare for All, previously a marginalized demand in the United States (though existing in practice throughout much of the world) is now a central demand of mainstream liberal politics.

The slogan “Abolish ICE” — first raised by grassroots migrant justice activists and lifted up by the Democratic Socialists of America — has been brought into official U.S. politics and even carried onto Capitol Hill by Rep. Alexandria Ocasio-Cortez. The slogan has become so potent that the president and vice president have had to go out of their way to denounce it—something Trump did again in the most recent State of the Union.

Meanwhile, the majority of people in the United States oppose Trump’s wall. And three-quarters of Americans recently told pollsters they think immigration is “a good thing.”

These facts — evidence of a complicated political terrain, but one that has much promise for progressives and the left — show why supporting “border security” rather than centering the rights of migrants in the conversation about migration is not only wrong. It’s also out of step with the progressive trend in U.S. politics.

While demanding open borders may seem like a marginal position in U.S. politics now, keep in mind that “build the wall” was on the fringe until recently.

Let’s consider some of the above:

Is there actually a “fundamental human right of movement”? Or is this one of those “it would be nice if” kinds of things that conflict with other “it would be nice” things to present us with trade-offs involving difficult choices. Specifically, giving people from places without social safety nets the “right” to move unimpeded to places with social safety nets could (actually will without doubt) result in massive increases in demand for, and cost of, education, housing and health care for host country taxpayers.

Given their high cost and unpredictable timing, are open borders really “a political winner for the left”? This takes us back to our newly wide-open political debate in which everyone’s fever dreams now get equal time. In any large society there are people who believe that invading and subjugating every country that steps out of line is a great idea, that printing unlimited amounts of paper currency increases national wealth, that secret government spying programs make us “more free,” that workers produce all the value inherent in a given product while capital adds zero value (therefore if we just nationalize all the big companies and fire the capitalists…). It goes on and on, because the fringes of society host a near-infinite number of reasonable-sounding but ultimately crazy ideas.

A decade ago, most such policies were only discussed seriously in Marxism seminars and militia compounds, for good reason: The average non-ideologue can spot their fatal flaws pretty quickly.

But now these ideas’ fans only have to preface them with “in the world’s richest country we ought to be able to…” and the glow of unlimited spendable cash turns ideological sow’s ear into mainstream political silk purse.

So open borders could indeed, for a little while, attract some votes. But not for long because the fatal flaw – millions of immigrants swamping public services – will be both easy to explain and hard to defend in debates.

And if it open borders somehow survive electoral scrutiny and end up being enacted, the resulting chaos will give the policy a very short lifespan – much shorter than, say, Prohibition.

But wait, don’t a lot of libertarians also favor open borders? They do indeed, but with the explicit (maybe even gleeful) understanding that free movement of people from developing to developed world will swamp – and thus end – the latter’s social safety nets, an outcome libertarians like because welfare, Medicaid etc., are not legitimate functions of government. So in this case progressives and libertarians are natural allies only for the first phase of open borders.

The other posts in the Really Bad Ideas series are here.

No Free Lunch: Valuation Determines Return

By John Mauldin

Last week, I described the enormous challenges retirees face. One reason for that, aside from insufficient savings, is that markets haven’t delivered the returns many experts said we could plan on.

Back in the late 1990s, we were told that the long-term average return (~10%) was a reasonable long-term assumption—even if the market cooled down from the tech boom. Instead, the S&P 500 index gained about 3% annually since 1999 with total return just over half of the historical average. As a result, Baby Boomers are having to work longer and harder to retire, as well as save more of their income.

Nonetheless, hope still springs eternal for historically average returns. In this week’s letter, longtime friend Ed Easterling joins me as co-author to explore the reasons that so many analysts and product purveyors pitch such hopeful expectations. (Longtime readers will know Ed and I do this periodically.) We’ll show how the long-term average is a longshot bet in almost any market environment. Most of the time, returns over a decade or two are well-above or well-below average.

Most of all, it’s fairly predictable which side of average will occur. This has serious implications, yet there’s a lot that you can do to still achieve investment success. This is also something you will not hear from many in the investment business. “Predicting” less than historical average returns in the future is not exactly a great sales pitch. But as I think Ed and I will demonstrate, it is the most honest and accurate way to talk about potential performance of the future.

Ed founded Crestmont Research in 2001 to research and explain secular stock market cycles. You can find a treasure trove of fabulous charts and articles on cycles and market returns at his website. I’m a big fan of Ed’s work and highly recommend both of his books, especially Unexpected Returns.

No Free Lunch: Return Is Determined by Valuation

By John Mauldin and Ed Easterling

A famous Greek myth involves Orion and Scorpius, whose struggle became eternal after Zeus banished them to opposite fields of the night sky. During winter, Orion hunts in the evening. Yet when summer returns, Scorpius owns the heavens.

The stock market has its own perpetual mythologies. Every investor and financial advisor understands that “past performance is not indicative of future results.” Yet for passive stock portfolios, many embrace century-long averages of stock market performance as a reasonable assumption for future returns.

In reality, the market has periods when Orion finds a bounty of returns, and volatile, low-return periods when Scorpius rules. Investors must know whether the stock market’s season is summer or winter in order to select the best securities and strategies.

Theories and Realities

In 1952, the Journal of Finance published a paper written by Dr. Harry Markowitz titled “Portfolio Selection.” He wrote it while still a graduate student, and it introduced the concepts known today as Modern Portfolio Theory (MPT).

Markowitz likely knew that MPT posed great risk to investors should his magnum opus fall into the wrong hands. He carefully included a warning label in the first paragraph:

The process of selecting a portfolio may be divided into two stages. The first stage starts with observation and experience and ends with beliefs about the future performances of available securities. The second stage starts with the relevant beliefs about future performances and ends with the choice of portfolio. This paper is concerned with the second stage.

Unfortunately, the warning has been largely ignored. Maybe he should have been clearer:

“Do not use MPT without relevant beliefs for future performance!”

The rest of Markowitz’s paper details how risk drives return. He describes how to construct diversified portfolios that optimize returns for a desired level of risk. The level of return, however, is whatever the market delivers. That’s why the precursor stage to MPT is so important. MPT and related models have been used for many decades to build portfolios for individual and institutional investors.

Dr. Eugene Fama later amplified this idea with a paper explaining the Efficient Market Hypothesis. In summary, Fama said markets are extremely efficient at pricing stocks. As a result, after you make numerous assumptions (which basically assume away the real world), investment analysis and selection adds no further value.

Within a few years (1973), professor and economist Burton Malkiel published his literary classic: A Random Walk Down Wall Street. Across its 456 pages, Dr. Malkiel reinforces the message that the stock market follows a random path. As a result, investors are helpless and shouldn’t try to beat it.

Once those three messages went mainstream, the essential ingredients for investor helplessness were in place. Risk drives return. Markets are efficient. Returns are random. Why try? Investors should simply buy and hold. The three professors just needed a bull market to indelibly reinforce the message.

By the time the Great Secular Bull of the 1980s and 1990s ended, index mutual funds had become a highly popular form of stock ownership. Technology then made possible an even more efficient successor: the exchange traded fund (ETF).

Over these decades, millions of investors embraced passive buy-and-hold investing, believing they could simply ride the market and achieve long-term success. Investors and investment professionals became intoxicated rather than alarmed when actual performance greatly exceeded the assumed 10% long-term average return. Surveys in the early 2000s showed investors expecting 15% annual returns for years to come.

That was easy to believe at the time because conditions were perfect. The initially low and progressively rising valuation level of the stock market provided a fertile environment for buy-and-hold. But now we know what happened.

Large segments of the financial industry still believe valuation doesn’t matter. For example, mistaken notions of randomness and consistent long-term returns lead investors to expect the same long-term return from peaks like 2000 and 2007 as they expect from troughs like 2002 and 2009. Clearly, these are instances when theory and reality diverge.

Valuation Matters

Markowitz advised us to use relevant assumptions. To assess relevance and reasonableness, let’s consider a period long enough to smooth short-term fluctuations, yet not so long that an investor loses the opportunity to adjust expectations, lifestyle, savings rate, etc. For most investors, that period is a decade or two. If you are age 55 or over, 20 years starts to sound like the long run.

As previously mentioned, the stock market’s nominal long-term annualized total return has been around 10%. Total return includes capital gains as well as dividends. The century-long 10% average is also close to the average annualized return across all 110 decade-long periods since 1900 (i.e., 1900–1909, 1901–1910, etc.). Yet none of those decades delivered exactly 10%.

To assess the reasonableness of using 10% as an assumption for future annualized returns, a range is more relevant than a single value. If a high percentage of the decades fall near the average, then it would be reasonable to assume that average is relevant and has a reasonable likelihood of occurring. However, if near-average is rare, then such an assumption would be foolish.

To be generous to the analysis, let’s say 8% to 12% represent a near-average range. Although 8% and 12% deliver quite different long-term return results, our purpose here is just to assess credibility.

As shown below, only 21% of the decade-long periods since 1900 delivered annualized total return from the S&P 500 Index between 8% and 12%, and strikingly few were close to the 10% average. Only about one-third of the periods showed a compounded rate over 12%. Almost half of the periods showed less than 8% annual returns!

With almost 80% of the decade-long periods not near-average, using 10% as a relevant assumption for the next decade or two is a long-shot bet. For investors patient enough to evaluate twenty-year periods, the incidence of near-average values between 8% and 12% increases to 35%. Thus, the odds-on bet—at least two-thirds of the time—is to assume nowhere close to 10%.

Taking the analysis of decade-long periods a step further, let’s explore the effect of relative valuation on returns. Stock market valuation is most often measured with the price/earnings ratio (P/E).

Across the 110 decade-long periods, total return for the S&P 500 Index ranged from an annualized loss of almost -2% to an annualized gain of just under 20%. Even a ten-year period wasn’t enough to ensure a gain. Four of the decade-long periods delivered losses, and even more when inflation is taken into account.

The next chart divides the series into five quintiles, each with twenty-two of the decades. The first quintile includes the twenty-two periods with the lowest starting value for P/E. The second quintile has the next lowest set and the fifth quintile includes the decades starting with the highest P/E values.

The graph and table present the average value for P/E in each of the quintiles as well as the corresponding average annualized total return. As the market’s valuation level rises, the level of return realized from the stock market declines.

For example, the average P/E for the lowest twenty-two decades is 8.5 and the average compounded annualized return is 13.5%. The average P/E across the highest twenty-two periods is 26.9, with return averaging 4.8%. As beginning P/E rises, the subsequent return slides.

There is some variation and occasional outliers within these quintiles. For example, some periods start with high valuation and end with even higher valuation (e.g., 1995). In other instances (e.g., 1974), relatively low valuation was even lower ten years later. Bull market and bear market cycles run for various lengths. But when assessed in the aggregate, the relationship of valuation and subsequent return is strong. A higher valuation is strongly associated with diminished returns over the next 10­–20 years.

This is intriguing because the results are counterintuitive. It raises a question about whether either or both of the extremes might be predictable. Is there a way to know at the start of the ten-year period whether it’s likely to deliver above-average or below-average returns?

The quintiles provide a hint to the underlying cause, but don’t provide all of the answers. It also doesn’t address whether the relationship of valuation and return is simple correlation or is causal. These answers and insights could significantly impact an investor’s decision about the most appropriate investment approach. It would even provide buy-and-hold investors with a better expectation for their likely outcome.

Malkiel was right about the stock market being random, but only in the short term. The day-to-day fluctuations are responses to new information and changing investor psychology. These daily adjustments are part of the process that Fama described in his theory about market efficiency.

Both men, however, were mistaken about timing. Malkiel asserted that even long-term returns walk randomly. He seems to have thought that something random in the short run must be even harder to predict over the long run.

Ironically, the short term is burdened with noise that the longer term filters out. Benjamin Graham, the father of value investing, described this dynamic with the metaphor: “In the short run, the market is a voting machine. But in the long run, it is a weighing machine.”

Likewise, Fama assumed that market efficiency worked at the speed of a trade. In reality, there’s a lot of information and different views about the same information to process into market prices. Market efficiency is an extended process; it’s not an immediate event. Individual stock analysis and selection are part of this efficiency process.

Stock market return is more than a single number tucked in front of a percent sign. Three components underly stock market return: earnings growth rate, dividend yield, and the change in valuation level over the period (i.e., P/E).

Earnings growth pairs with valuation change to drive capital gains or losses. If the market’s P/E remains constant, the index will rise or fall equal to changes in aggregate earnings. Likewise, if earnings don’t change, the index will increase or decrease with changes in P/E. Dividend yield is the proverbial icing on the cake that completes total return.

Above, we made a compelling case for the relationship between P/E and return. The primary determinant of whether a decade ends in the pink or green bar is the change in P/E over the respective period. P/E tends to fluctuate in a bounded range generally between 10 and 25, yet rarely below 8 or above 30.

As basic as it may sound, returns tend to be higher when P/E starts low. Likewise, losses are more likely when P/E starts high. Therefore, almost all of the periods in the below-average pink bar started with P/E above the historical average. Similarly, almost all of the periods in the above-average green bar started with a relatively low P/E.

Most importantly, changes in P/E over longer-term periods are not random. Although in the short run, investor psychology and current events push P/E above or below its fair value, the change in valuation level over the long term is driven by financial principles.

Valuation rises and falls to adjust the general level of return from stocks, which fluctuates in response to changes in the inflation rate. For example, when inflation rises, financial securities respond with lower valuation to compensate for the costly effects of inflation.

Most financial assets, especially stocks, rise toward their highest relative value (and lowest expected return) when the inflation rate is low and stable. Bond prices rise as yields fall in response to declining inflation. Stocks, as perpetual securities, react positively to low inflation. Therefore, the P/E cycle is primarily a response to the inflation cycle. Over the long run, P/E is driven by fundamentals, not by randomness.

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John here to close: P/E is even more powerful than its multiplier effect on earnings. But we’ll need to save that discussion until next week. It will lead us into a talk about market valuation (fairly priced or overvalued), implications for predicting returns (yes, it is possible), and a few thoughts on investment approach. You won’t want to miss it. I’ll have more surprising and insightful charts from Ed and Crestmont Research.

New York, Cleveland, Austin, and Dallas

Shane and I are in Cleveland as I finish this letter. We’ll fly to New York for the weekend to see a Broadway show and meet with friends, then a business meeting on Monday morning and back to Cleveland.

Dr. Rockwood removed the cataract from my left eye on Wednesday, liked what he saw the next day, and scheduled surgery for my right eye next Wednesday. I will be in Austin and Dallas the first week of April for investor meetings that I am told are already full. Then we will fly back to Puerto Rico until the end of the month, where Chicago seems to be appearing on my calendar.

We mentioned Harry Markowitz and Burt Malkiel. I have met both separately and together on more than a few occasions, primarily at Robb Arnott’s invitation. They are delightful people and deserve the accolades they have had. Harry is 91 and although moving slower, his mind is as wicked sharp as ever. It still fills me with awe to remember him lecturing me as I challenged a particular point of MPT at a conference in Florida at least 15 years ago. He drew quadratic equations in the air (I swear this is true) to explain my obvious lack of understanding. I am not sure what he said because I was simply awestruck as he was drawing those quadratic equations in reverse so that I could see them. I was so overwhelmed with even the concept of doing that, I completely lost track of what he was saying. My life has been blessed to get to meet so many people like Harry. I have learned a lot from our walks and quiet conversations overlooking pleasant venues.

Back in the real world, I have been told to avoid strenuous activity while my new eyes get settled. Which means more reading and walking. Have a great week and spend some time with friends.

Your thinking returns will be below-average in the next 10 years analyst,