Dr. Horace "Woody" Brock is the founder Strategic Economic Decisions, an economic research and consulting service. He earned his B.A., M.B.A., and M.S. from Harvard University, and his M.A. and Ph.D. from Princeton University). He was elected an Andrew Mellon Foundation Bicentennial Fellow in 1976. Dr. Brock studied under Kenneth J. Arrow, Professor of Economics, and John C. Harsanyi, Professor of Economics, University of California, Berkeley, both winners of the Nobel Prize in Economics. His recently published book, American Gridlock, is available on Amazon.com or via the link below. For more information, follow Dr. Brock on Twitter (@HWoodyBrock) and on Facebook (www.facebook.com/AmericanGridlock).
The following is a lightly edited transcript of a talk given by Dr. Brock at the Portfolio Construction Forum, held in Sydney, Australia, from August 21-23. A video of this talk is available here.
”Outside the box” is not about being deliberately different; it’s about understanding how the new environment we live in requires that we act differently if we are going to gain our objectives and our goals.
Using backwards induction
I will start off with some basic principles to help people answer the question, “What do I do with my money?” I’m going to talk as if it’s my money that we’re talking about. That makes it more personal, but the rules are pretty general.
In thinking this way I’m going to be using a kind of logic that isn’t that familiar to most people. It’s known in mathematics and game theory as “backwards induction,” and it’s a very powerful way of straightening out or trying to make sense of things. It asks, “What are your final goals with your money? What is it that you want out of your money?” Then, “What do you do to get it?”
It’s the reverse of saying that when you’re 70 years old, you should be 65% in bonds, 25% in stocks and the rest in cash. A traditional rule like that comes out of thin air. There are times when that’s a very good allocation, there are times when it’s bad, but by working backwards from what I actually want – which is not about returns at all ironically – we can perhaps do a little bit better job.
This logic was also used by two quite famous people. One was the great model and fashion designer Coco Chanel, who got it right, as did Franco Modigliani, the MIT and Chicago professor who would receive a Nobel Prize for his work – for his efforts to understand “what do I do with my money over my lifetime?” and “why?”
This is just glorified common sense, like all good logic, but the analysis proceeds from first principles. It does not proceed from what is traditional or what other people are doing.
Coco Chanel famously said when she lost her lawsuit to retain the rights to Chanel No. 5, as I recall, that she had only one desire in life, and that was to remain in her suite of rooms at the Ritz Hotel in Paris. It was on the Place Vendome, where you can now rent her rooms – the Chanel suite – for I think around $25,000 a night. She wanted her living standards maintained.
Do you think when you’re 70 years old you give a damn about your quarterly performance? Up 4.9999%, down 9.6%, up 14.1% or down 3.5%? By the time you’re 40, 50 or 60, you’re so used to seeing these up and down returns – how your portfolio has done – that it really doesn’t have anything to do at all with what matters to you, which is not being thrown out of your suite at the Ritz, or in my case a wonderful house I happen to have on the coast of Massachusetts north of Boston. Chanel wanted to keep her rooms at the Ritz regardless of inflation, deflation, the stock market, this or that. I want to keep my house.
As Modigliani would say – it’s part of your life cycle objective or planning structure. Your goal when you’re 40 is very different from when you’re 65. Facing retirement, what you want is to maintain a living standard that permits you to survive. Inflation or deflation will come one way or the other. You need what we call a “robust” strategy to maintain a lifestyle.
Income volatility is what matters
If that’s what I care about, then, as an extension of that, what I really care about is not at all the performance of the value of my portfolio, but rather the income stream it makes possible. That’s the thing that will keep me in or out of my suite in the Ritz, or my house in Gloucester, Massachusetts. I want to know about the performance of my income.
Suppose you buy Nestle, 3M, John Deere, a lot of very good, global companies of the kind I believe in right now. Do you think that the volatility of their dividends has anything to do with the volatility of the stock market? Well, when I’m 65 or 70, I don’t care about the stock market.
The stock market [S&P 500 index] was at 850 when my father died in 1966. In 1981, inflation was 14% and it was the worst stock market in history – worse than the 1930s in real returns. The market then went from 850 to 1,200 by the year 2000. =
I know all about what we call cycles of valuation in P/E ratios. In the year 2000, the American market was 34 times earnings. It was 8 times when Dad died. For P/Es, the average in 20 countries over a hundred years is 14.8. Undoubtedly, justice happened; the P/E has fallen from 30-something in 2012 back to a P/E today of 14 or 15, depending how you measure it. I knew that; I didn’t buy stocks. You made so much money in stocks in the previous few decades that only a fool would imagine that you were going to continue to make that money with valuations at record-high levels.
But this is basic stuff. What’s not basic is how Coco keeps her suite and I keep my house. How do you maintain living standards? It may not be possible. If there’s a civil war – you can’t.
My objective is the stability of income to keep me living the way I’m used to, which means that you look at the volatility of dividends and streams of income and not at the value of the portfolio. It’s not that the latter isn’t interesting; it’s that none of you ever receive information about the standard deviation of your income stream, which is what you should care about. You only care about whether your portfolio is up or down.
By 70, you don’t care, because it’s not the point. You’re not trying to get rich quick with a big stock market gain and live off that and pay your rent at the Ritz.
Should you worry about inflation?
At a more practical level, let’s talk about what you might do today. We live in a world where inflation is possible, because we’ve been supposedly printing money so much that many people – gold bugs – expect inflation.
Where is it? Inflation should have come by now. It has to come eventually!
Of course, this notion is completely false, like most of the things you read. The United States never prints money. We have $100 bills. Weimar Germany had ten-million dollar bills – so did Zimbabwe. They printed money; we never do. When we monetize our debt; we pay for it by issuing primary dealers credits to their reserve account with the Fed, and we have masses of new bank reserves. That is the liability of the Fed that has exploded – not cash or money.
Now somebody says, “Well all those new liabilities, all these bank reserves we’ve created, well that can turn into cash when Tom, Dick and Harry go into the bank and borrow ten times more than the reserves the bank has.”
Well, the Fed has new ways of seeing that, actually, you can’t lend out those reserves. Not only that – if you haven’t noticed, in Japan and America, people who are over-indebted don’t want more debt. It doesn’t matter that we have one and a half trillion dollars of excess reserves sitting on the shelf. They are basically of no importance to inflation at all. Just look at the data.
Deflation, on the other hand – “Oh that could never happen, we’re printing money” – is more of a threat, as only Ben Bernanke seems to understand. The most important commodity, which no commodity trader seems to understand, has nothing to do with nickel or oil or rare earth prices, because in a service economy the only really important commodity is labor. Labor has been deflating. Bernanke understands the most serious threat is deflation, if the middle class is in debt.
If you don’t have any debt, and you have a general deflation of 30%, then the price of bread goes down 30% and my income goes down 30%. I eat the same amount of bread, and Coco stays in her room. Everything is fine with deflation, or inflation for that matter. But when you have a massive amount of debt, that doesn’t change with deflation. I still owe that million dollars, and my wages drop 30%. That’s not a sovereign debt problem; that’s civil war, because we’ll all revolt against one another.
Investing to protect against inflation and deflation
Coco wants insurance against both inflation and deflation. Corporate bonds don’t do that. TIPS don’t do that. Dividend streams, from 3M and Nestle – global companies that are doing very well in the new world – do that.
Dividends protect you during inflation and deflation. Gold does not. Real estate is wonderful, except that it’s all about leverage, and real estate in bad times causes more bankruptcies than everything else put together times ten.
If government bonds are paying 2%, what kind of dividend yield can I get by investing in dividend-paying companies? Here, the good news for the investor is that the market has everything backwards, which is not unusual. I’m not a contrarian, but this just an elementary observation. We’ve been, at least in the US, pouring money into bond funds – it’s safe to be in bonds.
As everyone from Byron Wien to other observers have pointed out, the cult of equities is dying. My secretary says she hasn’t made any money in the stocks in her pension fund since 1997, adjusted for inflation. That’s where the market is today. Of course, that’s what you would have expected. All the money that people used to make was basically due the fact that the valuation of a dollar of earnings (the P/E ratio) went from 8 to 34 and is now back down to 14. Whoever expected to get rich on stocks didn’t; they went sideways for 15 years. Then they said, “Oh, I’m going to get out of stocks.”
Why own stocks now
Of course, this is the whole point – this is the very time to buy into stocks, for two reasons. If the P/E ratio is low, it will revert higher in the future. Mind you, it could still go a lot lower with the right crisis in Europe. The American stock market’s P/E ratio could go back down to nine or 10. That’s the real time to buy.
But, nonetheless, the lower the P/E ratio, the higher percentage yield you get from your dividend. The dividend doesn’t change with the value of the stock. You really want to buy those companies when the prices are down in bad times and lock in the yield. That strategy tends to do as well in inflation or deflation in the long run.
This is a very important rule of thumb. Investors have been pulling money out of equities because they haven’t – in the last 15 years – made money. That’s the very time to buy, because probably you will start to make some money. But, whether you do or not, you still get that nice 4% dividend.
It’s not a very sexy strategy. It’s pretty odd for someone at my stage in my career to realize the one thing I don’t want are those safe bonds, because most bonds are now very unsafe because of credit risks, especially municipal bonds and many – I’m afraid to say it – sovereign bonds of sovereign states.
Every analyst on the current scene seems to forget the fact that we have all of these red-ink problems, and we have all these sovereign debt problems today. But we’re going to fix it, supposedly, they say.
900,000 US baby boomers have retired. When you retire, you stop contributing to the pot, and you start to draw down your benefits. Did you know that 78.1 million more baby boomers are going to retire in the next 20 years?
One could make an argument that we haven’t begun to see the problems. This is not to mention the cities that are going bankrupt regularly, or the catastrophe of Medicare. It’s time to be involved in companies that can move to where the weather is good. Pity the governments. They can’t run away. They can’t get out of Uruguay and go to Paraguay. They can’t take their investment out of China and go to Brazil.
Governments are stuck with greying populations. Their bond yields are extremely low. As you know from elementary arithmetic, once yields go up – and, indeed, they’re going to go up – you’re going to lose half the capital on your bonds.
Bonds are a terrible investment. This is the very time to get out of bonds, but the public has been buying them like never before, saying “the cult of equities is over.”
The dangers on municipal bonds
I want to stress the point about the importance of good logic. All I’ve done so far is to say if your goal is a suite at the Ritz, then you want to do certain things that make sense in today’s environment. I will end up with a portfolio very different than what my parents had had at my age, and with very good reasons. Remember when Dad was about to retire, the idea of Detroit going bankrupt was nonsensical, much less the United States, much less Greece. What are you smoking? That could never happen.
Believe me – it’s going to happen a lot. Cities weren’t going broke then. Cities are going broke now. Meredith Whitney was quite correct in her prediction of a hundred cities going under; it could be more than that. Not now, but this is what’s in the future. That will kill muni bond prices, because people will start to get nervous, and then their bond investments will turn out to be very risky.
The final point I’m going to make here is that, in a funny way, this is Alice-in-Wonderland investing. As Alice looked into her looking glass, she saw her world upside down. What used to be safe for my parents is now risky, and vice versa.
Deficit is a dirty word
Logic can be used in other things. Let’s talk about what America ought to do to fix the problem of the past decade. I’ve discussed this in my new book, American Gridlock.
Basically, “deficit” is a dirty word, but the word “deficit” has no meaning. A country that commits $4 trillion to government spending every year, like America, has tax receipts of $3 trillion. Three from four means you’re running a one trillion dollar deficit. We borrowed from the kids and now the kids are more in debt because our debt is going up because we’re borrowing.
Let’s say another country has government revenues of $3 trillion and expenditures of $4 trillion. But it has no deficit that bothers the bond market or burdens its children. This is logically possible. Let’s say you have $3 trillion of tax revenues and $3 trillion of American-style spending – which is all spent on transfer payments, interest on the debt, the military.
But Country B has its fourth trillion of spending on investments in infrastructure – not the normal infrastructure, but the subset of infrastructure projects that have a high rate-of-return on capital, like the highway system and the Internet. Thomas Jefferson had to borrow to make the most important government investment in modern Western history in 400 years. He borrowed half of the $17.56 million dollars required to pay Napoleon in 1807 to buy the Louisiana Purchase.
The interstate highway system was a huge problem. “Oh, imagine the deficits that are going to result.” Wrong! It paid for itself at an 11% rate-of-return on capital. The U.S. is filled with things that need to be done. Using the mathematical theory of modern public finance, there are many hundreds of projects that we need to do that will have a positive rate-of-return on capital. That’s not an expense; that’s an investment.
Country B has no deficit because current revenues of $3 trillion fully fund its necessary unproductive $3 trillion of spending. The extra trillion was an investment picked to be profitable. We can do that.
Let’s say governments borrow, as we have in the U.S., simply to keep public workers at work – this is your Nancy Pelosi-type stimulus. It’s good to borrow money to keep them at work; they’re not fired. But not one new job was created.
Instead, let’s say you took the trillion dollars that you’re borrowing and didn’t spend it on just keeping people at work, but on new projects. You then have an accelerator-multiplier effect, as shown by a number of Nobel Prize winners and taught in Economics 101.
Let’s say I’m a huge firm, and I get a trillion dollars for 40 types of infrastructure projects. I keep 10% for a rainy day and I lend the rest out. There’s a multiplier. I borrow for building cement, barracks, drawing boards… whatever you want. The people who I hire – those 497 sub-contractors – in turn hire sub-sub-contractors, and you have your famous multiplier. Incomes jump, unemployment falls a lot.
Borrowing a trillion and spending it the right way has nothing but good implications for productivity, job growth and keeping the bond market happy. But borrowing for the wrong reasons is a failed policy. That policy is simply to keep people at work and hoping the kids will pay, and the bond market won’t notice. But now it does notice, and it has said “enough unproductive borrowing.” That’s a very different story.
Whether you’re analyzing personal decisions about what to do with your money or trying to make sense of macroeconomics, realize that the word “deficit” – which is fundamental to our prejudices about macroeconomics today – makes no sense mathematically. There is only a good or a bad deficit, depending upon whether or not that deficit raises the burden on our children or reduces it, as happens with an interstate highway.
Ending America’s lost decade
Thinking from first principles as I was trained, thinking from axioms and deriving solutions consistent with the axioms, does a lot of good, whether it’s in answering the question, “What do I do with my money?” or “What does America do to resolve its lost decade?” That story incidentally applies to all other countries, with the exception that the United States has the greatest need, along with Great Britain, to do profitable infrastructure spending. Neither the US nor Britain has basically invested in infrastructure net of depreciation in 40 years.
So we really have an opportunity to rebuild America the right way. It’ll mean borrowing, and the bond market will say “bravo,” as it has in Peru, Chile, Turkey and elsewhere. There are experts in Australia at Macquarie Bank who have forgotten much more about this than I ever knew, which is not very much.
One last point: Even though we’re outside that box, that’s not to say we’ve never been here before. The basic rules never change. Risk and return, cycles where stocks valuations go much too high and then have to go lower – that doesn’t change. What’s changed is that I’m getting old at a time when what was good for my parents is not good for me, and what they thought was safe is now risky.
It really is a world of Alice-in-Wonderland investing.
Read more articles by Robert Huebscher
