During the 1992 Presidential contest between George H. W. Bush and Bill Clinton, Clinton’s campaign manager, James Carville, wanted to keep his campaign staff focused on Bush’s biggest weakness: the US economy had fallen into recession. Carville therefore posted a sign at campaign headquarters reading, “It’s the economy, stupid.”(1)
I want to talk about investing, not politics, but the idea is the same. For investors to be successful over long periods of time, they need only beat inflation net of all their costs: fees, trading costs, taxes, spending, and so on. No matter how high investors’ nominal returns might be, if those returns don’t beat inflation, capital is being destroyed.
Investors understand this truth perfectly well when inflation is very high. High inflation tends to be devastating to both equity and fixed income markets, which means that during those periods (the mid-to-late 1970s, for example), investors lose a great deal of ground to inflation, getting significantly poorer every year.
But for some reason investors lose sight of the inflation issue when inflation is very low. Instead of focusing on Job #1 – outperforming inflation – they worry about all sorts of other things, like chasing yield and chasing returns.
Consider the yield-chasing phenomenon. Investors fled traditional fixed income assets because they saw that the Fed was busy driving rates down. So what has happened to fixed income returns? Intermediate bonds produced a total return of about 5% per annum over the past five years, while inflation has hovered around 1%. That’s a terrific real return, but many investors missed out on it entirely because bond yields seemed too low to bother with.
Return-chasing behavior is, in a way, even more mystifying. Over the past five years a well-designed, well-managed, globally diversified investment portfolio will have returned between 5% and 7%, depending on the exact makeup of the portfolio, the investor’s objectives and so on. That may not seem very high, but inflation was only about 1% over that period.
The reason many investors are unhappy with that return can be summarized simply: the S&P 500 was the best-returning asset class in the world, up 11%. The sensible response to this is, “So what?” Intelligently-designed investment portfolios don’t attempt to load up on whatever asset happens to be hot at the moment. In this case, unfortunately, the S&P is extremely familiar to US investors, and so it’s top-of-mind for them. If the best-returning asset class had been Turkish real estate, nobody would have cared.
Even so, investors are falling prey to what the behavioral finance guys call “framing” problems. If a thoughtful investment advisor points out to you that you just beat inflation by 4% per annum, that doesn’t sound bad at all. But if Jim Cramer is constantly screaming about how great the S&P has done, suddenly your 5% doesn’t look that great.
But Cramer is wrong. In the first place, beating inflation by 4% per year is pretty damn good and we should be happy with it. If we’re not, we need to remember that the explanation for our attitude can be summed up in a nasty four-letter word: grēd.
Of course, most of us have a grēdy bone in our bodies somewhere – otherwise, free markets wouldn’t work. And that bone may be shouting, “Hey, let’s make hay while the sun shines! There will be times when we can’t beat inflation, so let’s build up a really big head start!”
Which brings us to the second problem with Mr. Cramer: we’ve just clobbered inflation with a portfolio that is pretty much bulletproof (i.e., globally diversified), while the S&P is pretty much a fat target.
We’ve actually seen this movie before, twice. In the late 1990s, the Fed provided far too much liquidity to the economy, with the result that stocks shot upwards spectacularly. This was called the Tech Boom, and it was followed by the infamous Tech Bust that devastated portfolios.
Then, in the early 2000s, worried about the Tech Bust and 9/11, the Fed again supplied too much liquidity to the economy, with the result that risk disappeared. This was followed by the Financial Crisis that further devastated portfolios.
Then, in late 2008 and afterward, worried about the recession and the market collapse, the Fed supplied too much liquidity to the market yet again (these guys are real slow learners), with the result that stocks shot up a third time. What do you think is likely to happen going forward? Some people think that “it’s different this time,” but I hope those people are seriously hedged.
There is one alarming note about how successful diversified portfolios have been in beating inflation in recent years: we’ve been too successful. Globally diversified portfolios that have compounded at 5% to 7% don’t fit into a world where global GDP growth is 3% and US GDP growth is 2.5%. What has happened is that central banker policies have brought returns forward, that is, the returns we should have earned over a fifteen year period have in fact been earned over half that time.
What that suggests is that forward-looking returns for diversified portfolios are likely to be much lower. If inflation stays low, of course, that might not be a terrible outcome. But if inflation breaks out, there are few things worse than low-returning portfolios in an era of high inflation.
For investors who are gazing covetously at the high gains achieved by US large cap stocks, the best antidote to yield-chasing and return-chasing behavior is to keep our eyes firmly focused on how well our capital is doing relative to our real enemy: inflation.
(1) Actually, the sign read, “The economy, stupid,” but that’s not the way it went down in history.
Next up: Getting Rich in a Poor Market
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Please note that this post is intended to provide interested persons with an insight on the capital markets and is not intended to promote any manager or firm, nor does it intend to advertise their performance. All opinions expressed are those of Gregory Curtis and do not necessarily represent the views of Greycourt & Co., Inc., the wealth management firm with which he is associated. The information in this report is not intended to address the needs of any particular investor.