Open Letter to the Next President, Part 4
By John Mauldin
For the past three weeks I’ve been discussing the economic realities the new president will face when he or she takes office next January, using the device of an “open letter to the next president.” Mostly, we’ve been dealing with the economic realities that other countries face and with how difficult the global economic climate is going to be during the next president’s first four years. I briefly outlined last week the stark reality of what will happen to the deficit and national debt in the next four years, and I offered a chart of what would happen if (as I think likely) we have a recession within four years. The deficit would immediately blow out to $1 trillion. That figure is before any stimulus and in all likelihood does not include the significant amounts that will have to be spent on unemployment reserves, etc.

Just to refresh your memory, let me reproduce the two key graphs. The first shows that entitlements, defense, and interest will consume all tax revenue by 2019. Thus, any spending beyond those three items will require the United States to borrow money and continue to grow its soon-to-be $20 trillion debt.
This second chart shows what will happen if we have a recession in 2018 and if lost tax revenue is roughly what it was during past recessions (in terms of a percentage of overall spending). The deficit would quickly rise to $1.3 trillion a year and according to current CBO projections would not fall below $1 trillion over the following 10 years. Even at low interest rates, net interest expenses become bigger than defense spending during that period. And I should point out that the chart below does not increase net interest expense in line with what will be a much larger rise in debt. If anything, the chart below understates the amount of net interest that will accrue.
Today we are going to look at what the next president might do in response to recession – and possibly even to prevent a recession. I actually think a positive path can be found, but following it will take an enormous political effort and a big shift in the current environment of noncooperation.

In trying to outline how we might proceed, I am reminded of a story about a small Baptist church in a rural area of Eastern Kentucky. The preacher decided to talk to his congregation about the evils of sin. He started out by declaring that he was against the sin of lying, the sin of adultery, the sin of theft, and the particularly pernicious sins that accompany dancing. As he was warming to his topic, he was getting a steady chorus of amens from the assembled, which of course stoked his enthusiasm.

So he decided to get to one of the real big sins on his list. He announced that he was against the sin of making and drinking moonshine. At which point five members of the congregation, including two of his deacons, stood up and started to walk out. Somewhat baffled, he asked, “Where are you gentlemen going?”

“Well, pastor,” drawled one fellow as he walked out the door, “it seems to me that you done stopped preachin’ and gone to meddlin’.”

(For my non-US readers who might be scratching their heads at this, the mountainous areas of the Southeastern US are famous for their “nonregulated” (read illegal) “moonshine” liquor production. In certain areas, the production of moonshine was widespread during prohibition and continues today. Those of us of a certain age can remember sipping such illegal contraband from fruit jars. For my French and European readers, think of your countries’ “Eau de Vie” (for my US readers, that’s “water of life,” and it’s every bit as potent as moonshine. Both can be used either as a beverage or as paint thinner. Back to the main plot.)

This letter is definitely going to fall into the category of meddlin’. I can pretty much
guarantee that no matter where on the political spectrum you fall or which economic philosophical camp you pitch your tent in, the policies that I’m going to recommend to the next president will horrify you. You will think that these are unbelievably bad choices. And the irony is that in some cases I’m even going to agree with you. But hard choices are what we have come to. We have a divided nation that’s not going to be any less divided after the coming election, and no one is going to get what they want.

An Open Letter to the Next President, Part 4

Dear Mr. or Ms. Future President,

Last week we looked at what will happen to the budget deficit and national debt if we enter into a recession during your first term in office. I think you will agree that the picture looks ugly. As it happens, a whole host of economic analysts are worried about just that possibility. Their concern is summed up by this statement from Bill Gross:
The reality is this. Central bank polices consisting of QE’s and negative/artificially low interest rates must successfully reflate global economies or else. They are running out of time. To me, in the U.S. for instance, that means nominal GDP growth rates of 4–5% by 2017 – or else.
They are now at 3.0%. In Euroland 2–3% – or else. In Japan 1–2% – or else. In China 5–6% – or else. Or else what? Or else markets and the capitalistic business models based upon them and priced for them will begin to go south.
Capital gains and the expectations for future gains will become Giant Pandas – very rare and sort of inefficient at reproduction. I’m not saying this will happen.
I’m saying that developed and emerging economies are flying at stall speed, and they’ve got to bump up nominal GDP growth rates or else.
You, as the next president, can help get GDP moving again. But let’s be clear, if we slog along in the same general direction, entrusting our national future to the same general policies we follow today, there will be a recession on your watch. If you wait until there’s a recession and then hope the Federal Reserve will do something to pull us out of a nosedive, it will already be too late. The good news is that there are policies you can enact during your first 100 days in office to radically alter the growth path of the United States. The bad news is that those policies are going to be politically difficult to effect and you are going to have to spend a great deal of the new political capital you have to do so. But it will be the most important thing you do in your first term. (If, on the other hand, you don’t act decisively, it may be your only term.)

It is not news to you that there is political gridlock in Washington. Republicans and Democrats in Congress don’t agree on the economic policies I’m going to suggest.
There are entrenched ideas on both sides of the aisle about the best way forward; and, to be generous, those ideas are mutually exclusive. Your problem is that you need to balance the budget. One side wants to do it by cutting spending, and the other side wants to do it by raising taxes and spending even more. The country seems to want a great deal more healthcare but doesn’t want to actually pay for it.
How can you satisfy both Republicans and Democrats while at the same time creating a few million jobs in the very short term to forestall a recession?

You are going to get Congress to compromise. That means giving each side something it wants badly enough to be willing to let the other side get something it wants and needs.
Here is what I think you could do. Let me note that numerous economists and politicians will tell you that different pieces of what I am suggesting are impractical or are philosophically just plain wrong. It’s just that they won’t agree as to which pieces are the problem. Your task is to get them to compromise so that something can actually be done.
Where to Find $1 Trillion of Free Money
When there is another recession, the Federal Reserve is going to cut rates back to 0% and will likely enter into another round of aggressive quantitative easing. (Interest rates and QE are just the tools they have left in their bag.) They will do this even though their own economists don’t think quantitative easing works all that well as far as Main Street is concerned. QE is very good at propping up stock prices, but it didn’t do much for the economy and just made the rich richer, breeding a lot of resentment.

The problem from the Federal Reserve’s standpoint is that they would like to pursue a different type of quantitative easing, but they are actually quite limited in what they can do by the Federal Reserve Act. In order for the Fed to buy other types of assets or move money more directly into the economy, Congress would have to amend that act. You may not have been paying much attention to the debate going on about the Federal Reserve, but I can tell you, there is zero appetite among the Congressional leadership to bring up anything like the Federal Reserve Act. Doing so has the potential to be a real circus. But you need Congressional leadership to do this so that you can accomplish your agenda, so you’re going to have to sit on the leadership and tell them to control their members. You need some amendments to the Federal Reserve Act.

Specifically, what you want to do is to authorize the Federal Reserve, the next time they feel they need to use quantitative easing to stimulate the economy, to be able to issue 40-year 1% bonds that can be used to repair the infrastructure of states and municipalities all across the nation. These should be projects that would be self-liquidating and capable of paying off the bonds, just as any general revenue bond issuer would, over the 40 years. No boondoggles and no bridges to nowhere. Focus on water systems, electric grids, bridges, roads, public transportation, airports – things that everybody understands as basic infrastructure. Estimates are that we need to spend about $2 trillion (on the low side) to bring our infrastructure up to date.

Understand, you don’t want to be seen as dictating policy to the Fed, which is supposed to be an independent entity. The Fed will guard that independence quite fiercely. No, you are merely giving them another tool to use. Now, they can still do QE in the same way they’ve done it in the past and never take up the new tool you’ve given them – that would be their decision – but I believe they are politically smart enough to take a hint.

Of course, that doesn’t help you right away. We all remember the last time we tried to find “shovel-ready projects” in order to do stimulus. Turned out there weren’t so many. So what can we do in the meantime?

We get creative. It turns out the Federal Reserve has added about $3 trillion to its balance sheet in the past few years. That money is sitting in US government bonds and government-guaranteed mortgage assets. As those assets are paid off, the Fed is reinvesting the money back into other bonds and mortgage assets.

So-o-o-o, when you are authorizing those new infrastructure bonds, you give the Fed the right to begin to buy them today. As soon as the commission you create to oversee the issuance of the bonds is up and running, cities, counties, and states can begin to offer their projects for immediate funding.

And those projects are going to create hundreds of thousands if not millions of jobs as they come online during the first few years of your first term. That is stimulus we can believe in, and it will help forestall a recession. Further, all those new jobs will carry salaries that will increase consumer spending in local communities and generate a wave of related private investment.

From a political standpoint, this is probably the easiest thing you will get to do. You are starting with a few trillion dollars already available to boost the economy without raising that money by taxing US citizens. What politician is not going to love that? All you are doing is taking an asset that the Federal Reserve already has and that is basically useless and turning it into a productive asset. If only the rest of my suggestions were as easy.
Making America Competitive Again
The second easiest part of my proposal is to cut the corporate tax rate. Everyone in Washington, DC, on both sides of the aisle, pretty much agrees that US corporate tax rates are too high. The reason they haven’t cut them is that politicians want to make corporate tax cuts part of a larger tax reform plan. They all feel they’re being pushed to give up something on taxes, and they want corporate taxes to be part of the deal.
Understandable, and you are going to have to offer them a bigger tax reform package, but this is the easy part.

The hard part is that you need to go farther than they are thinking of going today. You need to get bold.

Looking around the world, companies try to locate in countries that are the most tax friendly to their profits. That is why Apple, Google, and thousands of other American businesses have trillions of dollars in cash accounts overseas: if they brought the money back they would have to pay an outrageous 35% tax on it. What businessman in his right mind wants to reduce his working capital by 35%?

Further, as nearly all of you candidates have noted, too many very large corporations in the US (and many more not-so-large ones that fly beneath the radar) are allowing themselves to be “acquired” by foreign competitors, because to do so significantly reduces their taxes and benefits their shareholders. Some of you have sat on the boards of public companies, and you know that you are supposed to put the shareholders at the top of the list of people you serve. Your job is to make sure they get the maximum benefit from their investment in the company. Reducing US taxes is regrettably one way to do so.

Right now, the corporate tax rate in Ireland is 15%. The rest of Europe is pretty annoyed with Ireland for charging such a low rate, but their reaction hasn’t stopped Ireland from doing so. The country is seeing a massive benefit in terms of income and job growth, not to mention the increased travel- and housing-related income that comes with so many businesses locating in Ireland. Now, I have nothing against Ireland – the country of my forebears – but the reality is that, all things being unequal, the US would be a better place to locate your business. And the thing to do, then, is to make all things even better than equal.

Why not propose and enact a 15% US corporate tax rate? Yes you could propose 20% or 25% and it would be better than what we have, but what we want is for all of those companies that left the United States and are no longer paying taxes to decide to come back and pay us that 15% tax. And that should be 15% on every dime they make above $100,000. The tax form should be very simple. Put the amount of money you made in Box A, subtract $100,000, and pay 15% of the amount in Box B.

As a way to get politicians to go along with such a low rate, offer to enact a 10% rate on the international profits of all these companies, so that no matter where US corporations make their money, they are paying something to the US. A 10% rate isn’t going to change their investment decisions, and they are likely to just bring the money home at that point, putting it to work in our institutions and infrastructure (especially if we improve our infrastructure so that we are more competitive.)

As part of this program, you’re going to offer to get rid of all deductions. Period. End of story.
If it doesn’t fall under normal GAAP accounting guidelines as a deduction, it’s a profit and needs to be taxed. Get rid of the 3,000 or so special tax benefits for various and sundry corporations and industries. That means hedge funds don’t get carried interest, oil depletion allowances become subject to normal depreciation, new assets are written off over the useful life of the asset, and so on.

You’re dropping their taxes to a point where companies will probably be just as well off and maybe even better off without the deductions, as they will no longer need to pay their lobbyists to work so hard to wheedle special favors out of Congress.

Not only will this tax program make our companies more able to compete in an increasingly global environment, it will actually encourage them to bring a lot of their manufacturing back to the United States, thereby boosting our employment with jobs that pay well.

And I know that dropping taxes from 35% to 15% might seem like it would result in a big loss of revenue; however, if you add in my proposed 10% corporate tax on international earnings, I think there will actually be an increase in revenue. In any event, the program will be much closer to revenue-neutral than you might imagine.
Current corporate practices of maximizing deductions and squirreling money offshore really do make a difference.

The above two suggestions are the “easy” parts of the proposal. Now we have to figure out how to cut income taxes to a low personal flat rate, make sure that you get enough increased revenue to balance the budget and still be able to fund the healthcare we want, and figure out how to get the lower-income portion of the population a big boost in their take-home pay. But let’s take up those stimulating challenges next week – along with a few structural changes we’ll need in order to make sure everybody decides to hold hands and cooperate.
New York, Dallas, and Abu Dhabi
I leave on Sunday for a meeting with my Mauldin Economics partners, Olivier Garret and Ed D’Agostino. There are lots of things happening; New York is kind of a middle ground where we can all find ourselves in the same room. Then I change hotels to head towards Wall Street, where I will be on CNBC Monday afternoon, then jump over after the NYSE closing to share some libations with Art Cashin and the rest of the Friends of Fermentation. I think even Jeff Saut, chief muckety-muck of something important at Raymond James, will be there, as we are both scheduled to present the next day at Chip Romer’s Tiburon Conference. Chip brings investment industry executives together once or twice a year to talk about the state of the industry. And right now we’re talking about an industry that is in a big state of flux. I look forward to sitting with other people and learning.

Afterward, I am home for a month, where I will focus on writing my book and losing that last 10 pounds of superfluous weight prior to my conference in late May. The week before the conference I will be going to speak in Abu Dhabi. I was delighted to find out that you can actually take a direct flight from Dallas to Abu Dhabi. I started playing around a little bit and found out that there are several direct flights to the Middle East on various carriers. Dallas is a remarkably convenient town to get in and out of if you have to travel a lot.

The Strategic Investment Conference is coming along nicely. I have only a few more speaking and/or panel slots to figure out. I think we are going to maintain our tradition of making each year better than the last. If you haven’t registered yet, we are very close to sold out, as we expanded the space slightly and were able to take those who were on the waiting list. If you’re interested in coming, I suggest you get on the waiting list, as there are always people who cancel in the last few weeks. You can get on the list by clicking here.

And I know a broken headset is not a life-changing event, but yesterday the microphone I use to dictate into the computer as I write these letters finally broke. It’s not Logitech’s fault, because it lasted much longer than it should have, given the abuse I heap upon it in my travels, stuffing it into my bags. I had kinda, sorta taped it together so that I could still work, until finally I realized that I could just go to Amazon and order one and it would be here in a couple days.

I was surprised to find out that I could get the microphone delivered the same day I ordered it – for free. I have to admit that I was skeptical, even though I’ve read about Jeff Bezos working on delivery times. I wondered if a drone would appear on my balcony with my packages!

So I just clicked the button and forgot about it until I got a call from the front desk a few hours later, saying that my package had arrived. I think I know what the margin was on the inexpensive headset, so I’m not sure how Amazon can afford to deliver. It would have taken me the better part of two hours to drive to the store, find and buy the product, and get back, plus pay for the gas. I just find the whole business rather amazing. I know, it’s a bit ironic that somebody who’s writing a book on what the world will look like in 20 years can be surprised by fact that the changes he’s predicting are already happening.

By the way, I was able to get the latest, wireless version of my microphone, which was a lot cheaper than my old, tethered microphone was when I bought it. In theory I can even tap a button and shift from my computer to my iPad, listen to music, or talk on the telephone.

I wonder if I can order the new Tesla from Amazon. I’m not certain if it comes with one-day delivery….

You have a great week as we ponder whether Washington, DC, can actually break through its terminal gridlock next year. If it doesn’t, then, as Bill says, “Or else what? Or else markets and the capitalistic business models based upon them and priced for them will begin to go south.”

Your hoping we can avoid that southern drop analyst,

John Mauldin

Corporate profits are near record highs — why is that a problem?

Lawrence Summers

As the cover story in this week’s Economist highlights, the rate of profitability in the US is at a near-record-high level, as is the share of corporate revenue going to capital. The stock market is valued very highly by historical standards, as measured by Tobin’s q ratio of the market value of nonfinancial companies to the value of their tangible capital. And the ratio of the market value of equities in the corporate sector to its GDP is also unusually high.

All this might be taken as evidence that this is a time when the return on new capital investment is unusually high. The rate of profit under standard assumptions reflects the marginal productivity of capital. A high market value of corporations implies that “old capital” is highly valued and suggests a high payoff to investment in new capital.

This is an apparent problem for the secular stagnation hypothesis I have been advocating for some time. Secular stagnation is the idea that the US economy is stuck in a period of lethargic economic growth. Secular stagnation has as a central element a decline in the propensity to invest leading to chronic shortfalls of aggregate demand and difficulties in attaining real interest rates consistent with full employment.

Yet matters are more complex. For some years now, real interest rates on safe financial instruments have been low and, for the most part, declining. And business investment is either in line with cyclical conditions or a little weaker than would be predicted by cyclical conditions.

This is anomalous, as in the most straightforward economic models the real interest rate is the risk adjusted rate of return on capital. And an unusually high rate of investment would be expected to go along with a high rate of return on existing capital.

How can this anomaly be resolved? There are a number of logical possibilities. First, the riskiness associated with capital investment might have gone up and so higher rates of return could be simply compensating for higher risk rather than implying attractive investments.

There are two major problems with this story. One is that available proxies for risk have not been especially high in recent years. The chart below depicts realised stock market volatility and the Vix measure of expected volatility as implied by options. Another problem is that if capital returns have become far more uncertain, then the stocks should have become less attractive in recent years rather than more. In the last seven years, the stock market has risen to 250 per cent of its spring 2009 levels.

A second explanation could be that a heightened demand for liquidity and a shortage of Treasury instruments, perhaps created by quantitative easing programmes, has driven down bond yields, widening the spread between the rate of profit and these yields. This story does not provide a natural explanation for the relatively weak behavior of business investment. Further as Sam Hanson, Robin Greenwood, Joshua Rudolph and I pointed out in earlier work, the market is today being asked to absorb an abnormally high rather than an abnormally low level of long term Federal debt.

On top of that, if Treasuries were in short supply, one would expect that their yield would be bid down relative to market-synthesised safe instruments. Yet the so-called swap spread is actually negative and Treasury yields (vs swaps) are unusually high relative to history.

Third, it could be that higher profits do not reflect increased productivity of capital but instead reflect an increase in monopoly power. If monopoly power increased one would expect to see higher profits, lower investment as firms restricted output, and lower interest rates as the demand for capital was reduced. This is exactly what we have seen in recent years.

Is the increased monopoly power theory plausible? The Economist makes the best case I have seen for it noting that (i) many industries have become more concentrated; (ii) we are coming off a major merger wave; (iii) there is some evidence of greater profit persistence among major companies; (iv) new business formation has declined; (v) overlapping ownership of companies that compete has become more common with the rise of institutional investors; (vi) leading technology companies such as Google and Apple may be benefiting from increasing returns to scale and network effects.

The combination of the fact that only the monopoly power story can convincingly account for the divergence between the profit rate and the behavior of real interest rates and investment, along with the suggestive evidence of increases in monopoly power, makes me think that the issue of growing market power deserves increased attention from economists and especially from macroeconomists.

Business in America

The problem with profits

Big firms in the United States have never had it so good. Time for more competition

AMERICA used to be the land of opportunity and optimism. Now opportunity is seen as the preserve of the elite: two-thirds of Americans believe the economy is rigged in favour of vested interests. And optimism has turned to anger. Voters’ fury fuels the insurgencies of Donald Trump and Bernie Sanders and weakens insiders like Hillary Clinton.

The campaigns have found plenty of things to blame, from free-trade deals to the recklessness of Wall Street. But one problem with American capitalism has been overlooked: a corrosive lack of competition. The naughty secret of American firms is that life at home is much easier: their returns on equity are 40% higher in the United States than they are abroad. Aggregate domestic profits are at near-record levels relative to GDP. America is meant to be a temple of free enterprise. It isn’t.

Borne by the USA
High profits might be a sign of brilliant innovations or wise long-term investments, were it not for the fact that they are also suspiciously persistent. A very profitable American firm has an 80% chance of being that way ten years later. In the 1990s the odds were only about 50%.

Some companies are capable of sustained excellence, but most would expect to see their profits competed away. Today, incumbents find it easier to make hay for longer.

You might think that voters would be happy that their employers are thriving. But if they are not reinvested, or spent by shareholders, high profits can dampen demand. The excess cash generated domestically by American firms beyond their investment budgets is running at $800 billion a year, or 4% of GDP. The tax system encourages them to park foreign profits abroad.

Abnormally high profits can worsen inequality if they are the result of persistently high prices or depressed wages. Were America’s firms to cut prices so that their profits were at historically normal levels, consumers’ bills might be 2% lower. If steep earnings are not luring in new entrants, that may mean that firms are abusing monopoly positions, or using lobbying to stifle competition. The game may indeed be rigged.

One response to the age of hyper-profitability would be simply to wait. Creative destruction takes time: previous episodes of peak profits—for example, in the late 1960s—ended abruptly. Silicon Valley’s evangelicals believe that a new era of big data, blockchains and robots is about to munch away the fat margins of corporate America. In the past six months the earnings of listed firms have dipped a little, as cheap oil has hit energy firms and a strong dollar has hurt multinationals.

Unfortunately the signs are that incumbent firms are becoming more entrenched, not less.

Microsoft is making double the profits it did when antitrust regulators targeted the software firm in 2000. Our analysis of census data suggests that two-thirds of the economy’s 900-odd industries have become more concentrated since 1997. A tenth of the economy is at the mercy of a handful of firms—from dog food and batteries to airlines, telecoms and credit cards. A $10 trillion wave of mergers since 2008 has raised levels of concentration further. American firms involved in such deals have promised to cut costs by $150 billion or more, which would add a tenth to overall profits. Few plan to pass the gains on to consumers.

Getting bigger is not the only way to squish competitors. As the mesh of regulation has got denser since the 2007-08 financial crisis, the task of navigating bureaucratic waters has become more central to firms’ success. Lobbying spending has risen by a third in the past decade, to $3 billion. A mastery of patent rules has become essential in health care and technology, America’s two most profitable industries. And new regulations do not just fence big banks in: they keep rivals out.

Having limited working capital and fewer resources, small companies struggle with all the forms, lobbying and red tape. This is one reason why the rate of small-company creation in America has been running at its lowest levels since the 1970s. The ability of large firms to enter new markets and take on lazy incumbents has been muted by an orthodoxy among institutional investors that companies should focus on one activity and keep margins high. Warren Buffett, an investor, says he likes companies with “moats” that protect them from competition. America Inc has dug a giant defensive ditch around itself.

Most of the remedies dangled by politicians to solve America’s economic woes would make things worse. Higher taxes would deter investment. Jumps in minimum wages would discourage hiring. Protectionism would give yet more shelter to dominant firms. Better to unleash a wave of competition.

The first step is to take aim at cosseted incumbents. Modernising the antitrust apparatus would help.

Mergers that lead to high market share and too much pricing power still need to be policed.

But firms can extract rents in many ways. Copyright and patent laws should be loosened to prevent incumbents milking old discoveries. Big tech platforms such as Google and Facebook need to be watched closely: they might not be rent-extracting monopolies yet, but investors value them as if they will be one day. The role of giant fund managers with crossholdings in rival firms needs careful examination, too.

Set them free
The second step is to make life easier for startups and small firms. Concerns about the expansion of red tape and of the regulatory state must be recognised as a problem, not dismissed as the mad rambling of anti-government Tea Partiers. The burden placed on small firms by laws like Obamacare has been material. The rules shackling banks have led them to cut back on serving less profitable smaller customers. The pernicious spread of occupational licensing has stifled startups. Some 29% of professions, including hairstylists and most medical workers, require permits, up from 5% in the 1950s.

A blast of competition would mean more disruption for some: firms in the S&P 500 employ about one in ten Americans. But it would create new jobs, encourage more investment and help lower prices. Above all, it would bring about a fairer kind of capitalism. That would lift Americans’ spirits as well as their economy.

Can “Smart Beta” Get You in Trouble?

John Mauldin

I have been doing a fairly deep study of portfolio construction for the past two years, trying to figure out how to solve some of the most perplexing problems of the day: dealing with risk, volatility, performance chasing, and the ever-elusive challenge of actually figuring out where to find performance. One of the hottest topics in the literature and at conferences I attend is the concept of “smart beta.”

Smart beta is a rather elusive term in modern finance. It lacks a strict definition and is also sometimes known as advanced beta, alternative beta, or strategy indices. According to Investopedia,

Smart beta typically defines a set of investment strategies that emphasize the use of alternative index construction rules rather than simply using traditional market capitalization-based indices. Smart beta emphasizes capturing investment factors or market inefficiencies in a rules-based and transparent way. The increased popularity of smart beta is linked to a desire for portfolio risk management and diversification along factor dimensions as well as the need to enhance risk-adjusted returns above those of cap-weighted indices.

It certainly helps the popularity of smart beta ETFs and mutual funds that many of them have been on a performance tear of late. A lot of money is flowing into smart beta ETFs. At the end of the day, when I look at smart beta, it is really just another way to slice and dice the return stream in a particular portfolio. Thus you can have smart beta value funds, smart beta growth funds, smart beta momentum funds, smart beta…. There are literally multiple hundreds of smart beta funds available now.

I bring this subject up because I am at Rob Arnott’s Research Affiliates conference in Southern California (where it is much cooler than I expected). Between presentations by Nobel laureates and assorted academics, Rob offered a paper called “Can Smart Beta Get You in Trouble?” He has graciously given me permission to use a version of his much longer (and more dense paper) as this week’s Outside the Box. In the paper he examines exactly where the performance of many of the smart beta funds come from and then asks the question, “Will it persist?” Kind of like everyone is doing as they look at the latest bull market rally and wonder how long it can last. How long will the good times continue to roll?

The first version of Rob’s paper generated quite a bit of controversy, as it was interpreted by some in the industry as Rob attacking all smart beta products.

These people are being oversensitive – perhaps because the overvalued products he writes about are the ones they sell? Rob’s own Fundamental Indexes are a form of smart beta. He is just suggesting that we do a deep dive into any product we are thinking about investing in and perform what analysts call “attribution analysis.”

If there has been outperformance, why did it happen and is it likely to persist? Are there attributes of the product that are not fully valued – or that are overvalued?

And if you can do that sort of analysis, then I think you can maybe look at smart beta products that have massively underperformed and find some value nuggets here and there.

Rob has won more CFA Institute Graham & Dodd Scroll Awards than just about anyone (except some guy named Myron Scholes), which is kind of like getting an Oscar for financial analysis. I have been told that he actually told the group to stop considering his papers so that other people could win. He really is one of the smartest people in the room. I always learn something new and often mind-bending when I’m around him. His paper is not long, and it will cause you to think about where the returns come from in your portfolio. You really should read it.

Speaking of mind-bending, economics professor Cam Harvey of Duke University did a presentation this afternoon on the blockchain, which is the foundation of Bitcoin. I have been friends with Cam for many years, but it has been an online friendship. He was the first to do research and analysis of the inverted yield curve, and I’ve learned a great deal from talking and writing with him. It was a true pleasure to meet him in person this week. He actually teaches a course on blockchain technology and is probably the most knowledgeable person I’ve met on the topic. As he began to expand on the literally hundreds of ways to use this technology in our everyday lives, you could see the room come alive with questions. It was a very energizing session.

(As I have written and talked about, I think Bitcoin as a currency will fail in its current version. It has some inherent flaws in its construction. The blockchain identity technology, on the other hand, is fabulously important and one of the most fundamental new ideas to come along in years.)

Cam came over when the day session finished, and we began to talk about some aspects of blockchain technology. Harry Markowitz, the Nobel Prize laureate who created Modern Portfolio Theory, walked over; and after a few minutes he began to challenge Cam on the mathematical impossibility of what he thought Cam was talking about. It was fascinating watching these two genius professors talk about math and ideas, and eventually Harry got a handle on the process Cam was describing.

But I will confess a small pleasure at watching one of the greatest mathematical economists of our time wrestle with the concept of the blockchain. I have to tell you it took me a while to get my head around the concept, too, and it took Harry only five minutes. (It took me days.) Once you really grasp the blockchain, you can understand why hundreds of millions of dollars of venture capital has gone into the technology from some of the smartest VCs on the planet, and why every major bank in the world is working on some aspect of it. You are not going to wake up one morning and find your world suddenly transformed, but blockchain is going to change the workings of a myriad of financial as well as nonfinancial transactions, including the transfer of property. And yes, it will eventually change the process of how money itself works. It is a truly profound concept.

Harry was in his usual affable mood, and we sat for the better part of an hour talking about the world in general and me listening to Harry tell stories. He tells such great stories. As we slowly walked back to the room (he is 88 but still make sure to walk for 30 minutes to an hour a day), he tried to explain diversification, covariance and correlation, and why Modern Portfolio Theory will still be relevant 62 years from now. (It has been 62 years since he presented his paper establishing Modern Portfolio Theory.) Sometimes you just get to bask in the moment – walking by the ocean, taking in the phenomenal view, and realizing that I was walking with history. It doesn’t get much better than this.

You have a great week. I think I’ll just go ahead and hit the send button and wander over to the reception and see what other great moments emerge in my immediate future. You just gotta love life.

Your not necessarily the smartest beta in the room analyst,

John Mauldin, Editor
Outside the Box

Can “Smart Beta” Get You in Trouble?

By Rob Arnott, Research Affiliates

“Buy low, sell high” is easy to say and very hard to do. Emotion encourages us to hang on too long to past winners (or even buy more, far too late and far too high) and to find every excuse to avoid bargains. Bargains don’t exist in the absence of fear, and always give us plenty of reasons to shun them. We’re reluctant to sell investments that have given us joy and profit, and even more loath to buy investments that have delivered recent pain and losses. Of course, it’s easy to avoid the pain and the losses, and still buy low … all we have to do is to buy at the exact bottom! As that’s not possible for mere mortals, buying low forces us to suffer the ignominy of losses – on investments that are already loathed – until the market turns.

Of course, capitalization-weighted indexes are natural performance-chasing strategies. We wind up with peak exposure in any stock, sector, style or even country, at the top of a bubble, and minimal exposure at the bottom of a crash. It was this intuition that led us to create the Fundamental Index concept over a decade ago. We use fundamental measures of a company’s economic footprint in the economy, as an economically-meaningful anchor to contratrade against the market’s most extreme bets. In so doing, we sever the link between a stock’s price and its weight in the portfolio. No longer does indexing require us to favor whatever are the most popular and expensive stocks.

One of our proudest achievements in launching the Fundamental Index® concept is that we helped to open the door to a wide spectrum of interesting ideas, under the “Smart Beta” umbrella. Since then, so-called Smart Beta strategies are all the rage in institutional and, increasingly, in retail investment circles. And, why not?! Most of these products are sensible and systematic investment strategies, offered at low fees, ensuring that any performance benefit goes mainly to the end-investor, instead of being siphoned-off by a money manager. Ideally, investing in these disciplined strategies can help investors avoid costly investment mistakes, including the popularity-chasing inherent in traditional cap-weighted indexes.

So, why worry? Why worry, indeed?!?

The “smart beta” moniker has been redefined ever-wider, to refer to not just systematic contrarian investing, but just about any automated strategy or factor tilt that a vendor wants to describe as “Smart Beta.” Of course, if “smart beta” encompasses almost everything, the term ceases to mean anything. There are now “smart beta” products that are tilted toward value, momentum, illiquidity, small caps, low beta, profitability, growth, and ambiguous ideas like ‘quality.’ It seems like every one of these ideas has a brilliant track record over the past few years, even if live experience is absent. It’s no surprise that money managers, catering to investor demands, advocate the strategies with the best recent performance in an arms race of fabulous backtest results. How can these ideas all work? How do investors select which smart beta strategies to rely upon?

Investors, money managers and academia all look to past performance, to validate the thesis behind any smart beta strategy. If the past performance of a strategy is a sign of structural alpha systematically generated by the strategy, as vendors and their customers surely hope, then this is a great outcome! If rosy past performance comes as a result of strategy becoming loved, popular and newly expensive, then watch out! The first smart beta strategies sought to cure (even to contratrade against) performance-chasing, a behavior that is back, ironically facilitated and encouraged by a new class of smart beta beauties. This beauty parade, that brings the strategies with the best recent performance to the investor’s attention, is likely to hurt investors in the future in two ways.

First, any investor who buys a strategy with an impressive recent history expects continued success. If the rosy historical backtest came from the strategy doubling in price, relative to the broader market, it needs to double again just to match the past returns. Unfortunately, trees don’t grow to the sky. The history of the capital markets is not kind to those that rely upon soaring valuations as the basis for their future success.

Second, investors lose on the transaction costs from trading. Smart beta strategies aren’t a cure-all to consistent and reliable short-term outperformance. Their impressive long-term returns come with a fair amount of cyclicality. Each category of “smart beta” will go through thrilling periods of “buy now!” performance, giving way to periods of “what was I thinking?” results. For the performance-chaser, selling the latter and buying the former is likely to result in a substantial trading cost – a direct non-recoverable expense from investor’s wallet – with no long-term benefits to show for it (or worse).

When we examine the smart beta strategies and equity factors most commonly used today we see an alarming picture. We find that many of today’s popular smart beta strategies earned most of their historical performance by becoming more expensive. Sometimes over 100% of both long-term and short term performance advantage, relative to the market, is due to these strategies becoming expensive!

Figure 1 shows the recent 10 year performance of four commonly used equity “factors,” or sources of excess return, that are popular foundations for today’s smart beta strategies. These strategies typically are crafted as “long” the stocks with the desired attribute, and “short” the stocks with the undesirable opposite characteristic (e.g. long value stocks and short growth stocks). Profits are earned on the difference between the two porfolios.

In Figure 1, the blue bars are the annual returns for a long/short portfolio in each of the categories. Investors with a short memory (or following an asset manager with a short backtest) would conclude that value investing has become a fool’s errand and that investing in the most profitable companies is the way to beat the market. However, investors should pay even more attention to the orange bars. Value stocks have underperformed only because they have become cheaper and cheaper, and are now trading at a deep discount relative to growth. Meanwhile gross profitability can attribute its success solely to becoming expensive.

Figure 1

Figure 2 offers a different perspective. Over the full sample from 1967-2015, gross profitability had much more modest returns, all of which came over the last decade, and all of which can be attributed to rising valuations. Value investing, on the other hand, showed positive returns in spite of a decrease in valuation over this period, and spite of its abysmal recent decade.

Figure 2

Many of these strategies are expensive today, relative to their past valuations.
Indeed when we check the current valuations we find that today five out of these six strategies are expensive relative to their own histories. The Low Beta/Low Volatility strategies have become very popular in the last fifteen years, after the tech bubble burst and the global financial crisis. This popularity brought about massive in-flows and expensive current valuations. We cannot know whether the rising valuations created the demand for these strategies, or rising popularity created the higher valuations. Either way, new investors in these strategies may be in for a rude surprise.

Given that soaring valuations drove the performance, in the Low Beta/Low Volatility category, we know that past returns are a completely unrealistic anchor to form our expectations. Worse, the high current valuations create a headwind for future returns. The same observation applies for the Profitability strategies, attracting billions each month; they appear to derive almost all of their past success from rising valuations and appear to be quite expensive today relative to their history.

The notable exception is Value. Value strategies have underperformed Growth by a wide margin over the last decade; that underperformance has come from falling relative valuations. Of course, this recent underperformance means that investors are fleeing value-tilted strategies, in favor of the more popular (and expensive) smart beta strategies with soaring recent returns. The good news is that this has results in current bargains for the Value investor, and therefore high future expected returns, for the few who can manage to ignore the temptation of the beauty contest.

When investors buy smart beta strategies with impressive recent performance, they make two mistakes.  They set unrealistic expectations, based on artificially inflated recent performance. And, they set themselves up for awful future results, as valuations mean-revert towards historical norms.  And they incur needless trading costs swapping from recent losers (now cheap) to recent winners (now expensive). Doesn’t this sound awfully like the mistakes that investors have made for decades with traditional active management?!?

Many smart betas are popular today because of their past performance; for too many of these, a big portion of that success is purely due to rising valuations.
Beware of these smart beta gems. The next time you see a pretty backtest or impressive recent performance, do yourself a favor. Ask yourself: “Am I getting set to buy a popular strategy, that has just become massively overpriced?”

Watch out … lots of “smart beta” customers, and vendors, are about to feel awfully stupid.

Up and Down Wall Street

When the Fed’s Bullard Speaks, the Market Listens

The St. Louis Fed chief’s words can push shares up…or down, as they did last week. Also, the coming trouble in China.

By Randall W. Forsyth   

Is it a bull market or a bear market? Or maybe just a Bullard market?
That is, as in James Bullard, the president of the Federal Reserve Bank of St. Louis. Not only is he among the voters this year on the policy setting Federal Open Market Committee, he is also perhaps the most vocal member of the panel’s adjunct, the Federal Open Mouth Committee.
While many members of the FOMC (however defined) seem eager to air their views in many venues, Bullard appears to be the Fed’s version of Chuck Schumer. It’s well known in Washington that the most dangerous spot is any place between a microphone and the senior senator from New York, famous for letting nobody stand in the way of his endless quest for media exposure.
In his habit of speaking early and often, Bullard has developed a nearly unequaled ability to move markets, which was on display last week. In various appearances, he suggested that the central bank’s next interest-rate increase could come as soon as the FOMC’s meeting on April 26 and 27.
That should be a statement of the obvious, since that’s what the Fed’s solons will be gathering to decide. But it is decidedly against the odds put down in the futures market and contrary to the expectation of virtually every Fed watcher.
No press conference is scheduled following the April confab; despite Fed Chair Janet Yellen’s insistence that every meeting is live, and that a conference call with the media could be done on the spot, the suspicion remains that the panel wouldn’t move without a regular presser. More importantly, economic data remain sufficiently ambiguous to delay a rate boost.
Bullard’s point last week was that the conditions that let the FOMC make its long-awaited initial increase in its short-term interest-rate target in December—to 0.25%-0.5%, 25 basis points (a quarter-percentage point) above the near-zero level where it had been held for seven years since the dark days of the financial crisis—were present. That is, unemployment had met the Fed’s target, at just under 5%, while inflation was closing in on the central bank’s goal of 2%.
But that was far different from what the St. Louis Fed chief was saying just last month. On Feb. 17, he contended in a speech that it would be “unwise to continue a normalization strategy”—read, rate hikes—while inflation expectations were declining.
So, in five weeks, Bullard has gone from arguing to hold off on higher interest rates, as the FOMC opted to do at the March 15 and 16 meeting, to putting them on the table as soon as next month.
What has changed so radically in that span?
The market-based measure of inflation forecasts did advance. According to the St. Louis Fed’s own charting, five-year forward inflation expectations (derived from the spread on Treasury inflation protected securities, or TIPS, versus regular Treasury notes) did tick up to 172 basis points on Wednesday, when Bullard made his comments to the New York Association for Business Economics.

They had been at 152 basis points on Feb. 17, when he cautioned against rate hikes.
That’s a mere 20-basis-point uptick over that span, and 30 basis points from the low touched on Feb. 11. Arguably, what has really changed since then has been the stock market, which rallied sharply, with the Standard & Poor’s 500 index jumping more than 12% above its February low to last week’s peak. After Bullard made his comments on Wednesday, stocks retreated in tandem with a renewed slide in crude-oil prices and a pop in the dollar, ending their five-week winning streak.
In that period, the world’s central banks all got on board with accommodative policies: Interest rates plumbed deeper into negative territory, the European Central Bank expanded its stimulus, and the Fed stepped back from its previous timetable of four rate hikes in 2016. The last suggestion helped spur the 11% correction from the end of 2015 through February, amid the ongoing slide in oil, a toxic deflationary combination.
This was far from Bullard’s first market-moving flip-flop. In October 2014, as stocks were sliding ahead of the well-advertised end of the Fed’s quantitative-easing program, Bullard suggested that the central bank could continue its bond purchases, again citing too-low inflation expectations. On the date of those comments, Oct. 16, the S&P 500 made its lows, and went on to rally some 14% to its peak last May.
The circumstantial evidence also suggests that Bullard’s comments coincided with swings in stocks as much as inflation expectations. With the S&P 500 having mostly corrected its early-year correction, if you will, and the index solidly north of 2000, the St. Louis Fed head adopted a hawkish tone. But he was distinctly dovish when the S&P 500 was in retreat in the low 1800s, most recently in February and previously in October 2014.
This doesn’t suggest that the Fed is explicitly targeting the stock market. The causality arguably runs in the other direction. Expectations of more rate hikes result in a stronger dollar; weaker prices for crude oil and other commodities; a flatter yield curve—all disinflationary indicators—and retreats in risk assets, such as high-yield bonds and equities. When rate-increase expectations subside, those markets reverse.
At this point, the federal-funds futures market is definitively pricing in only one 25-basis-point hike this year, with odds of 60% by September and 73% by December, according to Bloomberg. For April, when Bullard thinks an increase should be considered, the futures market’s probability is just 6%.

Those low odds seem justified by persistently tepid gross-domestic-product growth. The GDPNow tracking model from the Atlanta Fed was lowered last week to a real annual rate of just 1.4%, about half the estimate in early February, and no better than the revised final fourth-quarter GDP report released on Friday.
Bullard seems to be the most visible telltale of the shifting winds of Fed expectations. Investors navigating the choppy waters of the financial markets are forced to change tacks accordingly.
CHINA IS ANOTHER MARKET that has rebounded with the help of the authorities. But, according to Anne Stevenson-Yang, it amounts to a “dead-panda bounce.”
The Chinese stock market and its currency, the renminbi or yuan, have firmed in tandem with the rosier hue taken on by markets around the globe. But in the case of China’s equity and property markets, she writes in a report to clients of J Capital Research, “the root of nearly every part of the ‘rebound’ story is cash stoking an asset bubble, and that will not last long. It does suggest a degree of political panic.”
For now, the authorities are attempting to portray confidence. Curbs on margin lending and short-selling, two big culprits in last year’s market debacle, are being eased. Moreover, the yuan has been guided subtly higher by the People’s Bank of China this year, albeit against a weaker dollar, following last August’s sudden decline.
There has been a robust bounce in property speculation that Stevenson-Yang says is being likened to that of the stock market at its frenetic peak last year. Behind it is a stunning surge in government-backed lending to smaller banks and nonbank financial institutions that, in the first two months of this year, equaled almost half of China’s reported GDP for 2015, or 36 trillion renminbi—more than $5 trillion. In the past four months, lending by those institutions has exceeded all of last year’s GDP by RMB20 trillion.
“Leverage is the only idea left in the Chinese government, and is reaching truly suicidal levels,” she contends.
The financial pumping supports the “unrelenting jawboning from the top about the strength of the economy,” Stevenson-Yang continues. While she concedes that her forecast of a further weakening of the yuan—to 6.80 to the dollar versus the current 6.51—has been off the mark, she says that delaying the needed adjustments will worsen their cost and potential severity.
But capital flight—from both Communist Party elites and more modest families seeking to build wealth pools and income streams abroad, as well as attempts to acquire foreign companies, such as agribusiness giant Syngenta (HOT)—puts Chinese monetary authorities in a box. Pumping liquidity into the domestic economy further weakens the yuan. To counter that, the central bank sells dollars to meet the demand for foreign currency, which tightens domestic liquidity.
The easiest way to sort out this conflict would be to let the yuan continue to fall. That has been the biggest bet by hedge funds this year, and it has been Beijing’s aim to make the hedgies lose that wager.
But, to reiterate, burning the fingers of the yuan short sellers runs counter to the authorities’ attempt to pump liquidity into the domestic market. Which means that the effect of the Chinese authorities’ efforts to manipulate their currency has been to boost it artificially, not to drive it lower, as a certain U.S. presidential candidate insists.
Indeed, Stevenson-Yang says that Beijing may have to end the already-limited convertibility of the yuan to stanch capital flight. She claims that the $130 billion decline in currency reserves in January and February was a “manipulated number,” to the downside, a figure that, like so much of China’s data, is uncorroborated.
And when the numbers and sums no longer can be juggled, the poor panda may come back down with a thud.