Maybe It Really Is Different This Time! (Part 2)

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During his recent interview with Tobias, Joshua Brown, CEO of Ritholtz Wealth Management, and author at The Reformed Broker Blog, discussed how maybe it really is different this time for investors. It’s a comprehensive and interesting discussion so we broke it down into two parts. This is Part 2 below. You can read Part 1 here:

Joshua Brown: Well I took a stab at it. And my answer to that question is that it is conceivable that the microchip and the invention of software, like these things becoming household, in the early 80s, was a line of demarkation that people in the future will point back at and say, “That was the moment that everything changed. And it took a really long time though for it to take over the economy but once it did it never went back.” I feel like that’s… Look, dude. You and I, we could be like partners in an investment firm in 1930 and we could be making these really big bets on blacksmiths and fuckin’ work shoes. Like that could be us! And I don’t think they ever got a redemption moment, you know the people that were doing that. And the automobile fundamentally changed the economy. Why are we so inconceivable, that software is doing that now?

Tobias Carlisle: It’s not inconceivable, I agree with you 100% and I would say that the demarkation point is not just the computer, I think it’s the, and it’s not even the first dot, it’s the Internet or the web. And in those network effects finally being built up properly until you get to the point now where it becomes winner take all. The only thing that I would say to that though, this is the only saving grace for value. That the better risk adjuster-

Joshua Brown: You’ve said this before.

Tobias Carlisle: Well this is the only saving grace for value. The risk reward, if you’re wrong, value’s already dead. So you’re already dead. If you’re right-

Joshua Brown: I don’t know about that.

Tobias Carlisle: If you’re right the pay off is huge.

Joshua Brown: Stock that’s fallen from 60 to 20? Has lost two thirds of its value.

Tobias Carlisle: Right.

Joshua Brown: But from 20 to 10 it loses another half of its value.

Tobias Carlisle: Right.

Joshua Brown: Like I don’t know that your jump, I understand what you’re saying. You’re saying like, you’re jumping out a basement window at this point because valuations have already come down so much. I don’t know. You have had historically, like, entire industries where stocks have gone to zero. And I think there are people saying something similar to what you were saying about steel stocks in the 90s, and they just, they went to zero and there aren’t any left. It’s US steel.

Tobias Carlisle: Maybe a few.

Joshua Brown: I mean, that pre-date that time or they went through reorganization to get them back?

Tobias Carlisle: That’s fair, that’s fair.

Joshua Brown: You know what I’m saying? Like people, you forget Bethlehem Steel, how huge and important that company was in America. And somebody that grew up in the 50s and 60s and watched them build the interstate highway system, and then like in the 90s have that be a three dollar stock? It’s like inconceivable. And then you had activists come along, like “Guys, come file a 13D, here’s how we’re going to revitalize”… It didn’t work, they all went to zero. And the same with most publicly traded coal companies. And so it’s like, I don’t know, is retail, steel? Is retail, coal? Because when you do the screens evaluation, you find a lot of retailers in there. And I don’t really know what they’re going to do about it. And you know, like to me like that’s, I don’t have the answer but I think I know that that is the right question. Is what if everything is permanently changed, and you know, I think it’s people are worried about it.

Tobias Carlisle: I think that’s exactly the right question but I think that that is the question that I mean, all value investors are asking that question. And if they’re not then they’re not going to be in the game for very long. Buffett himself has said that retailers are a bad business because there’s always some new concept that comes along that just steals all the value from the, whatever the. So the department store killed whatever came before that and then you needed your department store to be near to like a, a tram. The tram, where people got off the tram, because if it wasn’t then people just weren’t going to walk past whatever was the local thing-

Joshua Brown: Right.

Tobias Carlisle: And Amazon’s the new version of that like it has to be accessible from your desktop because no one’s going to walk to the tram stop anymore.

Joshua Brown: So Buffett, really not a value investor.

Tobias Carlisle: Right.

Joshua Brown: I think he’s a growth at a reasonable price investor.

Tobias Carlisle: I agree.

Joshua Brown: And when you look at what Tad and Todd are buying, they’re not interested in any of these value stocks. They’re buying Visa, MasterCard-

Tobias Carlisle: Well those are value stocks, potentially.

Joshua Brown: Oh, well. But these are the top momentum stocks in America. Visa’s gone up like 1000% over the last five-

Tobias Carlisle: But-

Joshua Brown: They’re buying momentum stocks. I mean, they’re not buying it because they’re momentum stocks. I understand, they like the credit card companies, they like the MOAT. I understand that. I’m just saying like that’s what they’re… These guys are buying stocks that are, in no way shape or form are cheap. Like, by any statistical definition of cheap. You could say they’re cheap on, what their earnings might be two years from now or whatever-

Tobias Carlisle: Right.

Joshua Brown: But that would be stretching-

Tobias Carlisle: Right.

Joshua Brown: The definition of value.

Tobias Carlisle: But the way that they’re-

Joshua Brown: So-

Tobias Carlisle: They’re just looking at what they return on equity. They’re looking at that return in equity versus wherever else you can stick your money like, you’re basically getting virtually zero so that then makes the valuation extremely high and any discount to that is a sensible discount. That’s a value stock.

Joshua Brown: Right. Fair.

Tobias Carlisle: That’s a modern value stock like, that’s a compounded value stock. And anybody who’s done that as a value investor has done very well over the last five or 10 years.

Joshua Brown: We’ve seen, yeah. We’ve seen some of the value investors kind of move toward that approach and-

Tobias Carlisle: Right.

Joshua Brown: Those are the guys that are still in the game I guess.

Tobias Carlisle: Right.

Joshua Brown: Is it, I think the guy from like, from Oakmark, was buying Amazon or something-

Tobias Carlisle: Yeah.

Joshua Brown: Like some of these guys have changed their definition of value, so arguably like, that’s been good for their investors. But then like, if anything can be a value stock, what is a value stock? Then we end up getting into this whole debate over doctrinaire or definitions of these things that-

Tobias Carlisle: Right.

Joshua Brown: That maybe shouldn’t matter.

Tobias Carlisle: Right, nobody cares about those things.

Joshua Brown: Well, so I guess if you’re writing a rules-based strategy though you do care. Right? Like that’s, I guess that’s the difference between being discretionary versus quant screen.

Tobias Carlisle: Right.

Joshua Brown: Because if you’re a quant screen you get really mad when you hear people like, “Well I’m buying Netflix because actually if you value it based off blah, blah, blah.” And they’re like, “I can’t do that, I got the rules written already.” You know?

Tobias Carlisle: I mean I do care about it. I think it’s a central question and I think about it a lot. And the issue that I have, and this is one thing, this is a criticism of mine that I’ve had, that 10 years of value investors have been paid to become more growthy in the way that they invest. But historically that’s not been a great way to do it. So it’s either, you’ve got to make this decision and it’s an incredibly difficult decision to make. You either believe in the things that have worked in the past, and you bet that way. Or you recognize that the game has changed and you have to adapt with that game. And I don’t know what the correct answer is and so it remains to be seen.

Joshua Brown: Let me flip it on its head, let’s pretend you are the young investor. Let’s okay. So I’m a financial advisor, you’re a dentist. And I say, “Dr. Carlisle, great news. You’ve compounded at 13% over the last 10 years. So I’ve done really, really well for you.” Now you say to me, “Yeah, but did you buy cheap stocks? Or did we overpay?” “Well we overpaid.” “Well, Josh, you told me 10 years ago though that you had a discipline and that we were going to have a margin of safety because you weren’t going to chase the most expensive stocks.” And then I say, “Well, I did, but it worked out in your favor.” What do you say back to me?

Tobias Carlisle: I pre-suppose-

Joshua Brown: The money is real, you get to keep the money.

Tobias Carlisle: I pre-suppose, well-

Joshua Brown: I bullshitted, I bullshitted you but the money’s real. Now what do you tell me?

Tobias Carlisle: I am the end, I am the end consumer as well as being the manager so I’m intensely interested for a lot of different reasons in the way that these things work.

Joshua Brown: Mm-hmm (affirmative).

Tobias Carlisle: But the question is not what should I have done over the last 10 years, the question is what should I do for the next 10 years? And I-

Joshua Brown: Well, yeah but that’s going to inform. Like how you’ve spent the lat 10 years, and the lessons you’ve learned, that will color what people do over the next 10 years.

Tobias Carlisle: Absolutely.

Joshua Brown: Because of the recency bias and the availability heuristic-

Tobias Carlisle: Right.

Joshua Brown: And all of these things that screw with us. Like, you’re going to act however you act over the next 10 years, it’s going to be colored by something that you’ve just experienced. Me too. I feel like we’re human beings, it’s unavoidable.

Tobias Carlisle: Well, I try to resist it by looking at very long-term data, and I don’t know that that’s helpful. But that’s my process.

Joshua Brown: We use this example as a teaching tool, all the time. I’m sure you’ve heard it before. So there was this thing where if you were an investor from like 1917 or whatever, when they first started doing war bonds. Like if you were an investor from 1917 until 1957, so that’s like 40 something years, 40 years. If you were an investor you knew, that the best time to by stocks, was when the dividend yield of the stock market got over the yield of the 10 Year Treasury. So that was a signal that stocks are now too cheap, must be bought. And you used that and it worked like clockwork. And then you would sell stocks when that reversed. You’d say stocks are too expensive, the dividend yield is too low. And then in the late 1950s, for a variety of reasons, interest rates, you know, Eisenhower rebuilding the country and all these things, all of a sudden that just, that one day it stopped working. So one day, the dividend yield of the stock market fell below the 10 Year Treasury and it never went back. Like to this day it has never gone back.

Joshua Brown: Now if you’re one of these people though that’s like, “Well the data going back 40 years says that you sell stocks when the dividend falls below the 10 Year…” You’re still fucking waiting to buy back in. Now, nobody in 1957 or 1958 or 1959 or 1960, could have definitively said, “Things have changed permanently.” You only know that things had changed permanently with the benefit of time.

Joshua Brown: Okay, so now with all due respect to Fama, French, Markowitz, and all the theory. With all due respect, the only constant is change. And it is possible that some of these theories and formulas and frameworks and rules of thumb that we’ve constructed trillions of dollars of investing ability on top of, like it is possible that some of the underlying assumptions that we’ve just taken for granted are no longer valid. And it is also possible, I’m pointing at the microchip, the fuck do I know? It could be something that nobody’s even thinking of. It could be life expectancies, that have completely changed the idea of stock market valuation. It could be globalization, so we’ve been globalizing for centuries but like, it could be a certain tipping point in globalization where rules change. I don’t know what the answer is, I only know that we’ve got to keep it in the back of our minds.

Joshua Brown: And here’s where that’s scary for me, we’re doing a lot of modeling for clients on an individual basis. We’re doing financial plans for people. We’re showing them return assumptions for asset classes. We’re saying like, “The emerging markets, this our assumption.” S&P 500, US Small Cap, US municipal bonds. Like we’re giving people a framework for how to think about why we’re bucketing their money the way that we’re doing it and how it’s supposed to correspond with their future spending. We try to be very honest with people and say “Hey look, we’re making assumptions and the assumptions are based on history. And history will not look precisely how… The future will not look precisely how history…” And I just feel like that kind of humility, it doesn’t raise money. Like if you, if I run a TV commercial and I’m like, “Hi, I’m Josh Brown and I have no fucking idea what’s going to happen.” Like that’s not the way Wall Street operates. Wall Street operates with certainty in mind.

Joshua Brown: So there are some things that we feel pretty good about, which is that risk will ultimately be rewarded, if it’s an intelligent risk. So you say like, stocks have given you 7% real over the last 50 years, bonds have given you 2% or 3% real and that relationship should hold over the next 50 years. I think I can reasonably say that because you’re asking someone to take more risks, so they should be rewarded but A, I can’t say that over the next five years you’ll be rewarded. And so I think like, having that approach speaking with any clients and having that level of honesty, in this day and age, with this massive question that you and I are talking about hanging over our heads, like I just feel like there are certain things that we should emphasize and maybe not worry so much about. Is 2020 the year value comes back? Or is 2022 the breaking point for large cap growth? I just think that question, while it’s interesting, is so much less important, than the real question which is, “Will these asset classes do what they’re supposed to do going forward?” And maybe that’s like, the bigger, more agonizing thing to think about.

Tobias Carlisle: Do you adjust your forward projections for those different asset classes based on so, valuation? So do you think, you know, if the stock market’s expensive it’s likely that the forward return is lower?

Joshua Brown: We are more apt to use things like inflation to have like a return assumption change than something like that. We are not forecasting asset class returns based on valuation.

Tobias Carlisle: Okay.

Joshua Brown: I know that there are, I know that there are legitimate ideas about let’s take the CAPE and let’s use that, not to make a one-year forecast or a market timing call, but maybe to determine when an allocation should be higher or lower for a given asset. So like right now, if you’re like a very CAPE sensitive person, and by right now I mean like over the last eight years-

Tobias Carlisle: 20 years.

Joshua Brown: Yeah, exactly, right. So you’re saying like, “Well it’s reasonable to have less of a weight into US stocks because the 10 year outlook, when CAPE is at these levels, I don’t know if we have enough data to really do that. And that by the way, that feeds into one of the things we were talking about, like what if everything’s permanently changed?

Tobias Carlisle: What do you do in that scenario?

Joshua Brown: I think you don’t do anything, I think you stay disciplined about what you want your target weightings to be. You have volatility bands around those weightings so that you don’t get blown out of an asset flash just because there’s been near-term volatility. But you don’t screw around with your rebalancing and when the time comes to trim from something you do it, and when the time comes to add to something, you do it. And so much of that, it seems like easy and obvious, this is the stuff people will not do for themselves. They won’t do it, because you’re asking them to buy into something as it’s crashing, in the largest amount you’ve ever asked them to buy into it. And vice versa, you’re asking them to take money off the table from whatever fund or asset class makes them feel great right now. “Don’t sell my Amazon!” Right? Like this is human nature.

Joshua Brown: I think if you want a disciplined asset allocation strategy, you take your constitution seriously, meaning like what you’ve used to constitute this portfolio, you’ve done a lot of work on what you want to own, how you want to own it, why, etc. And then when it comes time to make trades for rebalancing, you do it thoughtfully but you force yourself to do it. You’re like ahead of 99% of the public, just doing that. Like literally 99% of the public cannot do that for themselves or can only do it some of the time and not reliably enough. So if you’re just willing to stick to that and say you’ll do that, you don’t have to get the CAPE ratio shit right, it becomes unnecessary over enough of a period of time.

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