Category: Financials

Mwaniki Talking About Money

Time To Ditch The 60/40 Rule

By: Jussi Askola

Summary

  • The 60/40 rule is a common yardstick that investors to rely on in constructing their portfolios.
  • It says you should put 60% of your portfolio in stocks and 40% in bonds.
  • The problem is that it isn’t suited to the realities of today’s market.
  • In this article we propose an alternative to investing according to the 60/40 rule.
  • Looking for a portfolio of ideas like this one? Members of High Yield Landlord get exclusive access to our model portfolio. Get started today »

The 60/40 rule is an approach to investing that worked well in the past. If you’re not familiar with it, it says that you should put 60% of your money in stocks and 40% in bonds. And rebalance every year so that the weightings always are at 60/40. The stocks increase your expected return while the bonds provide income and reduce volatility.

By all accounts, the 60/40 portfolio has a good track record. According to Schroders, it provided better returns from 1988 to 2018 than stocks or bonds alone:

By rebalancing, you would have achieved better returns with a 60/40 portfolio than with stocks – the higher return asset – alone!

So as we’ve seen so far, the 60/40 portfolio with rebalancing boosted total returns over the last 30 years. It undeniably lowers risk, by getting bonds into the mix. And on top of that, the lower volatility means you’ll have a less stressful experience over the course of your life.

That all sounds good on the surface. But there’s just one problem. 

In 2020, both assets in the typical 60/40 portfolio have serious problems with them. Stocks are extremely overvalued and volatile, and bonds yield next to nothing.

Past performance does not predict future performance. And there are good reasons to think that a 60/40 portfolio might do much worse over the next 30 years as it did over the last 30.

In this article, we make the case that you should avoid investing by the 60/40 rule and buy real assets instead. We’ll start by reviewing the flaws with stocks and bonds and move on to why real assets are superior today.

Stocks are Overvalued

According to the Wall Street Journal, the S&P 500 (SPYhad a 41 P/E ratio as of Dec. 11.

That’s more than double the historical average.

Historically, stocks tend to fall back to the point where their P/E ratio is at about the mean. That would imply they have a long way to fall.

source

That doesn’t guarantee that stocks are going to be losers over the next 10 or 20 years. But the higher they rise relative to earnings, the riskier they become.

To be sure, corporate earnings have soared over the last decade. But look at what made that possible. We’ve seen continuously low interest rates, culminating in near zero interest rates today.

Low interest rates stimulate spending, which drives corporate earnings higher. But now that interest rates are near zero, where do we go from here? The only option left is negative interest rates, and central banks are reluctant to go there.

So there are few monetary policy options left to stimulate the economy. This is why Ray Dalio recently forecast a “lost decade” with 0% returns, and Jeremy Grantham forecast negative returns.

There’s just a lot of risk factors impacting stocks right now. So far this year, we’ve seen mostly a positive trajectory with extreme volatility in between. But you never know when a new crash will occur that will take a decade to recover from.

Bonds Have Next to No Yield

Now that we’ve reviewed the problems with stocks, we can move on to the second asset class in the 60/40 portfolio: Bonds.

In a traditional 60/40 portfolio, bonds provide the safety and return smoothing component of the portfolio. They return less than stocks but they have more stable, and dependable returns. Having bonds in your portfolio in the first place reduces volatility. If you rebalance, they can even boost total return.

The problem is that today, bonds have so little yield that they’re almost pointless. As of this writing, the 10-year Treasury yield was 0.91%. That doesn’t keep up with inflation most years. Of course, you could up your yield by getting into a junk bond ETF. But that dramatically increases your risk, which defeats the purpose of having bonds in your portfolio in the first place.

Consider the SPDR Bloomberg Barclays High Yield Bond ETF (JNK). This year it went on a wild ride, dropping 22% at one point. And its price is barely up (2.47%) over five years.

Chart

Sure, it has yield. But from a total return perspective, it hasn’t done well. And in the meantime, it has delivered a fairly volatile ride this year. So such a high risk bond play isn’t going to smooth out your portfolio.

So, on the one hand, we’ve got the genuinely “safe” bonds that have no yield. On the other hand, we have high-yield bonds which are very risky – going against the whole thesis of holding them in your 60/40 portfolio. So what’s an investor to do?

Here’s What We Are Buying Instead

Having established the flaws with stocks and bonds in today’s market, it’s time to dive into what we recommend as an alternative:

Real assets. 

Real assets are assets with a real, physical substance that often produce substantial cash flows.

They include:

  • Apartment buildings.
  • Warehouses.
  • Railroads.
  • Hospitals.
  • Farmland.
  • Timberland.
  • And more.

Today, I invest about 50% of my net worth in real assets that are resistant to recessions. While some real assets get killed in recessions (e.g. hotels), others are very stable. It’s that latter category I’m focused on. Some of the biggest sub-sectors in my real asset portfolio include:

Apartment communities in business-friendly Sun Belt states:

Waller Creekside on 51st Austin, TX | Welcome Home

source

Service-oriented net lease properties with 10-year leases or longer. Our tenants are major chains such as Taco Bell (QSR): 

source

Healthcare facilities that are set to profit off the aging population.

source

Warehouses that are leased to Amazon (AMZN) and other rapidly-growing e-commerce companies.

source

These real assets allow us to enjoy many of the features you can’t get with most stocks and bonds today. These include:

  • High yield. My portfolio is made up of assets that yield 5%-8% and have regular dividend increases.
  • Predictable cash flow. The assets I own are backed by long-term leases that ensure revenue stability.
  • Upside potential. Most of the assets in my portfolio are trading at their highest yield spreads in a decade. They have 30%-50% upside as yield spreads return to normal.

How Do I Invest in Real Assets?

After having worked in private equity and bought real assets directly in the private market, I have today shifted my focus to the REIT market. 

If you’re used to investing in stocks, then REITs (VNQ) are by far the easiest way to get into real assets. You can buy and sell them through your brokerage account just like stocks, and they’re backed by portfolios of real assets.

Over the past 20 years leading to the recent crisis, REITs easily outperformed the 60/40 portfolio strategy and most other asset classes: 

Today, REITs look poised for another decade of outperformance. After falling in the COVID-19 market crash, many REITs are trading at substantial discounts to fair value, and as a result, yields are higher and the potential upside is greater than usual.

Of course, sometimes assets go down for a good reason. Yet many high-quality REITs remain down even despite not being greatly affected by the crisis. 

Take the example of W.P Carey (WPC). It owns mainly industrial properties that are in great demand and enjoy >10-year leases with high credit tenants. Throughout the whole year, WPC has collected nearly 100% of its rents and has kept buying new properties to grow the cash flow. It also has a strong BBB-rated balance sheet and plenty of liquidity. By all accounts, things are going well for the business, and it has even increased the dividend in 2020, continuing its 20-year-plus track record of dividend growth. 

Yet it’s down 23%, so you can invest in WPC’s real assets, lock in a 6% yield, and enjoy ~30% upside as the REIT returns to a fair valuation. 

High yield. Significant upside. And lower risk. That’s nearly impossible to find in the stock and bond market today. 

WPC-owned distribution center that is leased to Advance Auto Parts (AAP):

source 

Bottom Line: You Need to Adapt Your Portfolio

A 60/40 portfolio has performed well over the last 30 years, but now bonds yield close to nothing, and stocks are overvalued. 

What are your other options?

If like me, you want to earn income and position yourself for double-digit total returns, then nothing beats real assets in today’s market.

As more investors come to the same conclusion, we expect a lot more capital to rotate toward real assets. The time to act is now while others are still fearful, valuations are low, and yields are high. 

Using Human Intelligence To Chart Your Financial Future

Nov. 11, 2020 3:14 PM ETAAPL, AMZN, ARKK.

Summary

  • Human intelligence is an under-appreciated ingredient in investing strategies and tactics.
  • The Federal Reserve has generally said that virus control is the factor that will help move the economy toward its potential, simple common sense.
  • Identify an investment theme or two that you can follow, a micro-focus, and monitor the forces impacting the macro-economy.
  • Build trust in your competencies by using your own “intelligence.”
Acacia tree

Human intelligence is behind everything, including artificial intelligence, machine learning, and the internet of things. We invest in technology as if it’s got a mind of its own but neglect what’s behind it. The intangible is becoming more tangible and also elusive in some ways. There’s an investment thesis building here, I promise.

We find ourselves at an inflection point in the world of human activity and in what to invest our time, attention and money. Human capital is increasingly valued in some sectors and industries more than others, except when management or leadership recognizes that the people it employs are the very essence of its model, like goods and services-oriented firms or those selling essentials like Walmart (WMT). Then you have the firms like Amazon (AMZN) and Alibaba (BABA) that use technology really well to scale for “essential” services and products. In a research paper about the valuations of firms with more intangible capital on their balance sheets, the study showed how the market and economy are evolving to include more of the FAANGs as highly valued firms, and why, which includes:

Apple (AAPL)

Alphabet and Google (NASDAQ:GOOG) (GOOGL)

Netflix (NFLX)

Facebook (FB)

The pandemic rewarded many of these firms for a period. Monday, Nov. 9 some of the more traditional firms were back in favor – oil and gas, airlines, and others battered by the pandemic. I’ve written about this since early February that COVID-19’s grip would continue to plague the economy until it was better contained and confidence restored. This current new normal is reflected in the Dallas Federal Reserve’s Index. The trend lines run to Oct. 17 and we know that cases have been rising in all states since that time. The Federal Reserve has generally said that virus control is the factor that will help move the economy toward its potential. It’s just common sense. I’ve participated in several Fed webcasts and read the assessments by various leaders.

Currently, epidemiologists and economics are co-mingling more in the mainstream of academia, trying to determine what pandemic economics look like and might reveal in the months and years ahead. The news by Pfizer (PFE) of their vaccine’s efficacy of 90% created the thrust behind the markets move early in the week as well as the election being called. The safety of their vaccine is now under review.

No lack of themes

Another investment theme is obviously climate change and sustainability, encapsulated by ESG (environmental, social and governance) actions by firms. All of the big investment houses are packaging ETFs and funds to appeal to the growing market for investments that help people and planet. That universe of types of firms is growing as are funds flows. Blackrock (BLK), Calvert and others like the American Century funds are increasing their offerings.

Morningstar noted:

Sustainable funds represented about 10% of all flows into U.S. stock and bond funds for the quarter (9/30/20). It wasn’t so long ago when that percentage was routinely below 1%. In September, sustainable funds comprised 24% of the $12.7 billion in net flows of U.S. stock and bond funds. Granted, September was a bad month for overall fund flows, but sustainable funds appear to be on a secular growth path that hasn’t experienced the same ups and downs.

My point is that we are not lacking in firms, funds and assets in which to invest as the ESG world shows. Note also that these funds can overlap each other’s holdings with other funds owned in a portfolio or 401(k). Duplication and thus concentration is an issue. We also witness “the market” being traded increasingly by algorithmic programs and momentum. What’s a human to do in this investment world of AI, the possibilities of technology, and behavioral economics?

Do-it-yourself themes

The pandemic has been like one of those apocalyptic series or movies where advanced technology and the basics of living are smashed together in an odd contrast to each other. Think TravelersInterstellarRevolution, and so forth. Our workforce is reflecting that as are our politics depending on what world of work you occupy to some extent. The big picture, macro, is a challenge to identify and yet, this is the very thing we require as a compass, particularly in the case of investing at this time. I believe human intelligence is the answer. It’s reflected in many a life sciences firm, ESG-leading firms, technology firms and yes, even oil and gas firms as they try to navigate an energy transition that is undoubtedly happening. British Petroleum (BP), Occidental Petroleum (OXY), Shell (NYSE:RDS.A)(NYSE:RDS.B), Enbridge (ENB) and others are finding unique paths within their scope of operations, asset mix and competencies.

No computer program will necessarily be able to identify “the future” though complexity science-types might disagree. The futurist’s impetus usually starts with a person having an idea or vision about the future. I believe we must use our human intelligence for this – sharpening our wits, focus and awareness. Inherent in operating from the theater of human intelligence is intuition, thought, and analysis that a computer or a Google search cannot truly penetrate. This is why analyzing data and finding inferences, data analytics, is a skill that’s in demand, the human side of the equation that finds meaning. Yes, I’ve been researching bitcoin investments of late. I listened to Raoul Pal’s “greatest trade” video endorsing the future of bitcoin. I’m currently intrigued by the Ark funds (ARKK)(ARKW) to name a couple of their funds.

I probably spend more time thinking about investing than investing, until I’m clearheaded about why I’m willing to bank on a stock or fund. Sometimes that does not materialize as success for many reasons – a sector falls out of favor, a black swan event or some other unforeseen circumstance. However, the portfolios I do have had held up from diversification and not acting (holding) as much as thinking (strategizing). Not pulling the trigger has been as equally important as pulling the trigger.

The best advice I can offer is to identify an investment theme or two (and/or their firms) that you can follow, a micro-focus, and monitor the forces impacting the movements of relevant firms and what is happening in the macro-economy. This will offer both risk mitigation and the ability to observe opportunities. The rest of one’s actions are about risk tolerance and investment horizon. Then, whether pandemic or not, there’s some forward movement or strategic plan when one’s timing is right based on your own human intelligence. The trust you build using your intelligence creates confidence for future decision making – your own human capital.

How Many Stocks Do You Need To Be Diversified?

By Logan Kane

Summary

  • Research shows that the typical investor has fewer than 5 stocks in their portfolio. This is not an effective way to diversify.
  • Why awareness of mean-variance optimization is better than shooting from the hip with your portfolio, and why owning more positions helps you let winners run.
  • Some interesting implications regarding owning your employers’ stock, short selling, and ETF vs stock investing.

Growing up, when the weather was too cold for golf, I would come home from school and watch Jim Cramer on TV. Cramer was a lot of my early education in the stock market, and his crazy sound effects and viewer call-ins appealed to my adolescent brain on winter days in Missouri. One of the first things I learned from Cramer was that you needed at least 5 stocks to be diversified. To the typical investor who owns fewer than 5 stocks, this is an improvement. However, years later, when I dug into the statistics of the stock market, I found that even owning 5-10 stocks causes you to take too much uncompensated risk. Furthermore, due to the nature of the distribution of stock returns, starting with high concentration will force you to make risk management decisions over time that cause headaches. I’ve found from my research that if you choose to invest in individual stocks, you should aim for 20-25 positions, meaning an initial max concentration of 5 percent in any one company. This gets your non-diversifiable risk to the point where if you’re good at picking stocks, you will know that you’re not just getting lucky.

The Problem With Concentrating Risk In Your Best Ideas

A common line from ex-investment bankers and hedge fund managers is that they like to concentrate their portfolio in their best ideas. However, if you look at the statistics of all the professional investors who do this, the group loses on average to more diversified investors. That’s to say nothing of non-professionals who concentrate risk. I found an excellent report from the research team at S&P which should be required reading for anyone picking stocks. Here’s what they had to say.

Concentrating portfolios, in other words, makes it more likely that good managers will look bad, more likely that bad managers will look good, and more likely that asset owners’ decisions will be informed by luck rather than skill.

In fact, there are clear conflicts of interest when highly educated (often clever but not always highly intelligent) fund managers concentrate their holdings. If they get lucky, investor money pours in, and if they don’t, they get another job at another fund somewhere. I’d conservatively say that 90 percent of the alpha in the stock market goes to 10 percent of the participants. If you’re not in the 10 percent, your best bet is to be lucky, which concentrating makes more likely.

The below graph makes this point clear. If you have an edge in the markets, it will show, and the more independent outcomes you have, the better you’re likely to do, luck be damned.

Source: Standard & Poors

Another immediate consequence and the one that you’ll typically see in the literature is that portfolios that are less diversified almost always have higher amounts of risk, as defined by standard deviation.

Source: Standard and Poors

You can compare the dispersion–or volatility of the typical single stock–to the volatility of the S&P 500 index (SPY). This is a historical graph but single stock volatility has been as high as 2000 and 2008 were in 2020. As such, a lack of diversification is a significant risk management problem in bear markets. The obvious corollary is that the fewer stocks you own, the greater the risk you bear.

One other issue is the extreme right tail in the distribution of individual stock returns. The median stock returns less than 5 percent, around a third return negative over the long run, and about 1 in 7 stocks return more than 20 percent annually. This general pattern holds true across different countries and indices. I’ve previously written about this, what researchers refer to as the “capitalism distribution.” What’s interesting about this also is that research shows the proper approach is to let your winners run and cut your losers, which is harder to pull off if you start with a less diversified portfolio.

If you start holdings at 10-20 percent and they grow massively, let’s say you bought Apple (AAPL) when the iPod came out, you start to have a problem. Your best performing stock starts to take over your portfolio. There are a few Seeking Alpha members who have shared their experience of their portfolio becoming almost all Apple over time. The issue is that you’re strapped into a roller coaster of a stock that’s performed great from point A to point B, but you’re utterly dependent on one stock, which in the case of Apple, has dropped 80 percent once in the last 20 years, 50 percent another time, and 30+ percent two more times. For more, I wrote about this in my article titled “Apple and the Disposition Effect.

What’s the best approach with all of this in mind? If your head is spinning by reading this, the answer is ETFs. With 5-7 ETFs, you can create a set-and-forget portfolio that’s backed by research and tends to outperform your neighbors who pick stocks. If you’re brave enough, you can take the same risk as your neighbors who don’t manage risk well and get extra return on a diversified portfolio via the use of modest amounts of leverage. Do note that since you need to itemize your tax deductions to deduct margin interest, this approach is best for those with a household income of $100,000 or higher, and only if you can borrow for less than a couple of percent per year in interest. What’s more effective is that S&P or NASDAQ E-micro and E-mini futures can offer a solution at a lower price point and a lower implied interest rate, however.

Some Pointers on Portfolio Construction

1. Owning less than 10 stocks exposes you to uncompensated risk. Since investors tend to gravitate to drama and volatility anyway, I would estimate the typical retail investor portfolio has a standard deviation of somewhere between 20-25 percent in a normal year. This is much higher than the 15 percent the S&P averages. By comparison, you could use futures to leverage the S&P 500 at 1.5x, rebalance monthly, and crush the typical investor at the same 20-25 volatility threshold.

2. Mean-variance optimization strongly outperforms random stock selection and closet indexing in reducing risk. There is some fancy software out there for this, but Portfolio Visualizer offers a lot of the same functionality for free. This might mean that owning something like Walmart (WMT) or Kroger (KR) is helpful in a downturn, or if you were savvy enough, buying work from home stocks like DocuSign (DOCU) before the virus shutdowns happened. Mean-variance optimization is not always an exact science, but being aware of industry diversification and correlations in different market environments help you reduce risk.

3. Short selling gets a bad rap but is statistically effective, but with 1/3 of stocks having long-run negative returns and the companies that do so having a lot in common (losing money, high debt loads at expensive interest rates, junk credit ratings), having a few short positions among your 20-25 single stock positions tends to help your portfolio’s risk/return profile. An interesting thought experiment is to consider whether it’s easier to buy the market and short the trash out of it or to short the market and buy the best. Research shows that 63 percent of the alpha is on the short side. The same rules of diversification apply as long-only portfolios, except short selling requires additional attention with regards to risk management. Selling calls on popular stocks that are failing instead of shorting directly also improves the returns from this type of strategy, because Robinhooders have bid up call option implied volatilities to levels that are not found in reality.

4. If you work a corporate job, own as little of your employers’ stock as possible, unless you’re getting stock options. Probability distributions of all the stocks out there indicate a roughly 2 in 3 chance it will underperform the S&P 500, and if you’re VP level or above, your economic fortunes are already somewhat tied to your employers’ success. Don’t do this, even if other people do! Most people don’t make much money in the market.

Conclusion

There are a thousand ways to make a buck in the financial markets, but one of the most popular approaches is one of the least effective. Owning a poorly diversified portfolio has a cost, and the larger the size of your portfolio compared with your income, the greater this cost is. If you want to play around with $5,000, be my guest, but if you have a sizable portfolio, it pays to professionally manage risk. If you’re good at portfolio management, embrace the opportunity to invest money in a higher number of stocks to improve the probability of having one or more long-term 10x winners in your portfolio. Be conservative with your portfolio construction so you have the flexibility to let winners run and cut losses, and the rest will take care of itself. Lastly, ETFs and futures offer the most bang for the buck, allowing for you to focus on leveraging and risk management for the same level of volatility, which is a far more exact science than picking stocks.

Did you enjoy this article? Follow me for future research updates!

Disclosure: I am/we are long SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

The Fed Model And The Money Illusion

Larry Swedroe profile picture.

Larry Swedroe

Summary

  • The Fed Model has been used by many investors to judge whether stocks are under or overvalued.
  • However, understanding how valuations are impacted by changes in real and nominal interest rates exposes the flaws in using that metric.
  • The Fed Model should not have any predictive value, and the evidence from research shows this to be the case.

There are well-dressed foolish ideas just as there are well-dressed fools. – Nicolas Chamfort

Magic, or conjuring, is the art of entertaining an audience by performing illusions that baffle and amaze, often by giving the impression that something impossible has been achieved, as if the performer had supernatural powers. Practitioners of this art are called magicians, conjurors or illusionists. Specifically, optical illusions are tricks that fool your eyes. Most magic tricks that fall into the category of optical illusions work by fooling both the brain and the eyes together at the same time.

Fortunately, most optical illusions don’t cost the participants anything, except perhaps some embarrassment at being fooled. However, basing investment strategies on illusions can lead investors to make all kinds of mistakes.

There are many illusions in the world of investing. The process known as data mining – torturing the data until it confesses – creates many of them. Unfortunately, identifying patterns that worked in the past doesn’t necessarily provide you with any useful information about stock price movements in the future. As Andrew Lo, a finance professor at MIT, points out:

“Given enough time, enough attempts, and enough imagination, almost any pattern can be teased out of any data set.”1

The stock and bond markets are filled with wrongheaded data mining. David Leinweber, of First Quadrant Corp., famously illustrated this point with what he called “stupid data miner tricks.” Leinweber sifted through a United Nations CD-ROM and discovered the single best predictor of the S&P 500 Index had been butter production in Bangladesh.2 His example is a perfect illustration that the mere existence of a correlation doesn’t necessarily give it predictive value. Some logical reason for the correlation to exist is required for it to have credibility. For example, there is a strong and logical correlation between the level of economic activity and the level of interest rates. As economic activity increases, the demand for money, and, therefore, its price (interest rates), also increases.

An illusion with great potential for creating investment mistakes is known as the “money illusion.” The reason it has such potential for creating mistakes is it relates to one of the most popular indicators used by investors to determine if the market is under- or overvalued, what is known as The Fed Model.

The Fed Model

In 1997, in his monetary policy report to Congress, Federal Reserve Chairman Alan Greenspan indicated that changes in the ratio of prices in the S&P 500 to consensus estimates of earnings over the coming 12 months have often been inversely related to changes in long-term Treasury yields.3 Following this report, Edward Yardeni, at the time a market strategist for Morgan Grenfell, speculated that the Federal Reserve was using a model to determine if the market was fairly valued – how attractive stocks were priced relative to bonds. The model, despite no acknowledgment of its use by the Fed, became known as the Fed Model.

Using the “logic” that bonds and stocks are competing instruments, the model uses the yield on the 10-year Treasury bond to calculate “fair value,” comparing that rate to the E/P ratio (the inverse of the popular price-to-earnings, or P/E, ratio). For example, if the yield on the 10-year Treasury were 4 percent, fair value would be an E/P of 4 percent, or a P/E of 25. If the P/E is greater (lower) than 25, the market is considered overvalued (undervalued). If the same bond were yielding 5 percent, fair value would be a P/E of 20. The logic is that higher interest rates create more competition for stocks, and this should be reflected in valuations. Thus, lower interest rates justify higher valuations, and vice versa.

For a long time after Yardeni coined the phrase, it seemed almost impossible to watch CNBC for more than a few days without hearing about the market relative to “fair value.” The Fed Model as a valuation tool had become “conventional wisdom.” However, conventional wisdom is often wrong. There are two major problems with the Fed Model. The first relates to how the model is used by many investors. Yardeni speculated that the Federal Reserve used the model to compare the valuation of stocks relative to bonds as competing instruments. The model says nothing about absolute expected returns. Thus, stocks, using the Fed Model, might be priced under fair value relative to bonds, and they can have either high or low expected returns. The expected return of stocks is not determined by their relative value to bonds. Instead, the expected real return is determined by the current dividend yield plus the expected real growth in dividends. To get the estimated nominal return, we would add estimated inflation. This is a critical point that seems to be lost on many investors. The result is that investors who believe low interest rates justify a high valuation for stocks without the high valuation impacting expected returns are likely to be disappointed (and perhaps, not have enough funds with which to live comfortably in retirement). The reality is when P/Es are high, expected returns are low and vice versa, regardless of the level of interest rates.

The second problem with the Fed Model, leading to a false conclusion, is it fails to consider that inflation impacts corporate earnings differently than it does the return on fixed income instruments. Over the long term, the nominal growth rate of corporate earnings has been in line with the nominal growth rate of the economy. Similarly, the real growth rate of corporate earnings has been in line with the real growth of the economy.4Thus, in the long term, the real growth rate of earnings is not impacted by inflation. On the other hand, the yield to maturity on a 10-year bond is a nominal return – to get the real return you must subtract inflation. The error of comparing a number that isn’t impacted by inflation to one that is leads to what is called the “money illusion.” Let’s see why it’s an illusion.

We begin by assuming the real yield on a 10-year TIPS (treasury inflation-protected security) is 2 percent. If the expected long-term rate of inflation were 3 percent, a 10-year Treasury bond would be expected to yield 5 percent (the 2 percent real yield on TIPS plus the 3 percent expected rate of inflation). According to the Fed Model, that would mean a fair value for stocks at a P/E of 20 (E/P of 5 percent). Let’s now change our assumption to a long-term expected rate of inflation of 2 percent. This would cause the yield on the 10-year bond to fall from 5 to 4 percent, causing the fair value P/E to rise to 25. However, this makes no sense. Inflation doesn’t impact the real rate of return demanded by equity investors. Therefore, it shouldn’t impact valuations. In addition, as stated above, over the long term, there is a very strong relationship between nominal earnings growth and inflation. In this case, a long-term expected inflation rate of 2 percent, instead of 3 percent, would be expected to lower the growth of nominal earnings by 1 percent, but have no impact on real earnings growth (the only kind that matters). Because the real return on bonds is impacted by inflation, while real earnings growth is not, the Fed Model compares a number that is impacted by inflation with a number that isn’t (resulting in the money illusion).

Let’s also consider what would happen if the real interest rate component of bond prices fell. The real rate is reflective of the economic demand for funds. Thus, it’s reflective of the rate of growth of the real economy. If the real rate falls due to a slower rate of economic growth, interest rates would fall, reflecting the reduced demand for funds. Using the same example from above, if the real rate on TIPS fell from 2 percent to 1 percent, that would have the same impact on nominal rates as a 1 percent fall in expected inflation, and, thus, the same impact on the fair value P/E ratio – causing fair value to rise. However, this too does not make sense. A slower rate of real economic growth means a slower rate of real growth in corporate earnings. Thus, while the competition from lower interest rates is reduced, so will be future earnings.

Since corporate earnings grown in line with nominal GNP growth, a 1 percent lower long-term rate of growth in GNP would lead to a 1 percent lower expected growth in corporate earnings. The “benefit” of falling interest rates would be offset by the equivalent fall in future expected earnings. The reverse would be true if a stronger economy caused a rise in real interest rates. The negative effect of a higher rate of interest would be offset by a faster expected growth in earnings. The bottom line is there is no reason to believe stock valuations should change if the real return demanded by investors has not changed.

Clifford S. Asness studied the period 1881-2001. He concluded the Fed Model had no predictive power in terms of absolute stock returns – the conventional wisdom is wrong. (As we discussed, however, this is not the purpose for which Yardeni thought the Fed Model was used. Given the purpose for which the model was designed, it would have been more appropriate for Asness to study the relative performance of stocks vs. bonds given the “signal” – under/overvalued – the model was giving.) Asness also concluded that, over 10-year horizons, the E/P ratio does have strong forecasting powers. Thus, the lower the P/E ratio, the higher the expected returns to stocks, regardless of the level of interest rates, and vice versa.5

There is one other point to consider. A stronger economy, leading to higher real interest rates, should also be expected to lead to a rise in corporate earnings. A stronger economy reduces the risks of equity investing. In turn, that could lead investors to accept a lower risk premium. Thus, it is possible that higher interest rates, if caused by a stronger economy and not higher inflation, could actually justify higher valuations for stocks. The Fed Model, however, would suggest that higher interest rates mean stocks are less attractive. The reverse would be true if a weaker economy led to lower real interest rates.

Before coming to the moral of this tale, it’s worth noting that, when the COIVD-19 crisis drove the yield on 10-year Treasuries to under 1 percent, I have heard not a single reference to Fed Model. That’s because a yield below 1 percent would create a fair value P/E of more than 100! Which, of course, would not make any sense. In other words, the sharp fall in interest rates exposed the “wizard behind the curtain.” However, my guess is that if and when interest rates return to more historical levels, the Fed Model will be resurrected by the financial media. After all, they need something to try and keep your attention.

The Moral of the Tale

While gaining knowledge of how a magical illusion works has the negative effect of ruining the illusion, understanding the “magic” of financial illusions is beneficial because it should help you avoid mistakes. In the case of the money illusion, understanding how the illusion is created will prevent you from believing an environment of low (high) interest rates allows for either high (low) valuations or for high (low) future stock returns. Instead, if the current level of prices is high (a high P/E ratio), that should lead you to conclude that future returns to equities are likely to be lower than has historically been the case, and vice versa. Note that this doesn’t mean investors should either avoid equities because they are “highly valued” or increase their allocations because they have low valuations.

Hopefully, you are now convinced that the Fed Model should not be used to determine if the market is at fair value and that a much better predictor of future real returns is the E/P ratio.

1. Kiplinger’s Personal Finance, February 1997.

2. Wall Street Journal, April 5, 1996.

3. Humphrey-Hawkins Report, Section 2: Economic and Financial Developments in 1997 Alan Greenspan, July 22, 1997.

4. William Bernstein, “The Efficient Frontier,” (Summer 2002).

5. Clifford S. Asness, “Fight the Fed Model: The Relationship Between Stock Market Yields, Bond Market Yields, and Future Returns,” (December 2002).

Important Disclosure: The contents of this article are for information and educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. The information contained in this article is based upon third-party information and is deemed to be reliable. However, its accuracy cannot be guaranteed. Third-party information may become outdated at any time without notice. By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them. The company mentioned in this article is hypothetical.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions.

Retirement Strategy: What Does Dividend Growth Investing Actually Mean?

Regarded Solutions

There are so many different roads that an investor can use to become financially secure that, even if I actually knew them all, it would take days to list them all! I do know that there are a handful of approaches that most people choose, so I will just list them:

  • Stock picking based on the fundamentals of a company, or the technicals that many day traders use
  • Momentum trading, which means to me when a stock is on a hot streak, investors hop on for the ride
  • Day trading, which means never investing in a stock, but picking one that fits a particular trend and buying and selling within each day.
  • Following the herd investing, which to me means it happens to be a popular stock, or an IPO, or a strong sector; tends to be trend investing, not for the long term
  • Contrarian trading, which to me is going against conventional wisdom and buying stocks for large rebounds and short-term gains

I left off dividend growth investing because that is the approach I am focusing on. So I will go into more detail, in my own simple way, for folks to understand how I define it.

Dividend Growth Investing

The popularity of this long-term buy-and-hold strategy has lots of traders calling it a “cult,” and in some ways it might be! I know I wouldn’t invest any other way, and I have tried them all over the last 50 years. So I am part of the “cult.”

I believe it has been so popular for decades now due to the fact that for investors who know what they want, and focus on the rewards, the strategy has actually been shown to work.

Here is a simple definition from this website:

They are a lot of stocks on the market that are paying returns to their shareholders, called dividends. A dividend is distribution of money decided by the directors of a company, and this distribution can happen quarterly, semi-annually, annually, and sometimes even monthly … and can be paid from company earnings but also from available cash on the company accounts. 

I think that is a pretty simple explanation, but let me expand:

Some of these dividend-paying companies also have been raising their dividends over time, sometimes for years and years, and these are the stocks that I myself have focused on. Over a period of 25 to 50 consecutive years or more, these companies, through good times and bad, have never missed a payment and have increased the dividend each and every year.

Those companies are called Dividend Aristocrats and Dividend Kings. These companies tend to be quite large, have been in business for many years and have navigated all economic environments successfully, and keep paying shareholders a dividend even as the company has matured and could not be considered a “growth” stock any longer. Yes, these companies usually grow their revenues and earnings somewhat, but there are times, sometimes long periods of time, that a business has either become more difficult, has new competition, has weak management, or has made costly mistakes that impact the revenues and earnings which might, and has led to losses for a period of time. However, these particular companies find ways to continue paying and increasing its dividend every single year. Here is a chart I borrowed from an old article of mine that shows just Dividend Kings versus the S&P 500: 

See the source image

Folks who are solid divided growth investors are willing to hold these stocks for decades, and the primary focus is the income that the dividends produce. As a matter of fact, I personally know people whose only focus is growing their income stream no matter what the stock is doing in any particular period of time.

The growth of the income stream is what will create financial security over time and could lead to either an early retirement, or a very nice lifestyle from the passive dividend income alone. It is a long, boring process and even the companies are boring. Not to DGI’ers of course, but to the rest of the investing population that seek to make as much money as possible in the shortest amount of time through capital appreciation, and these folks couldn’t care less about a dividend. 

Unfortunately, most of these types of investors wind up either losing in financial distress or quitting investing, screaming that the markets are rigged. This article pretty much sums up the facts:

90% of traders fail or only 10% are really successful … Probably, typically in your life as well you’ve probably done or have been through multiple activities and it’s a process that’s a process that you jump from one thing to the next to the next until you finally find something that works for you for a longer period of time … Now if we connect this concept of hopping from one thing to the next into trading, people typically do the same thing when it comes to trading they will jump into trading stocks then they may jump into trading options without really being really good at trading stocks they will get into options then from options they may trade Forex because they weren’t really good about that or they want to try something new. …

That’s not their specialty, and that’s not their expertise, but this is what happens in the stock market – people give it a try! They hop in and out they try something else, and then eventually they don’t do it anymore. If you add all those people up then of course you’re going to see that 90% fail just like 90% of new small business owners fail as well. 

How Dividend Investing Works

Let’s keep this simple. A dividend growth investor selects the following stocks to invest in, right now (I am using 1,000 shares for this example but the math is the same if I were to use 1 share of each stock, just different income amounts):

  1. Altria (MO– 1,000 shares @ $39.53/share and the annual dividend is currently $3,440.
  2. Coca-Cola (KO– 1,000 shares @ $50.03/share and the annual dividend is currently $1,640.
  3. Johnson & Johnson (JNJ– 1,000 shares @ $148.10/share and the annual dividend is currently $4,040.
  4. Procter & Gamble (PG– 1,000 shares @ $144.39/share and the annual dividend is currently $3,160.
  5. Colgate-Palmolive (CL– 1,000 shares @ $80.31/share and the annual dividend is currently $1,760.

The one thing that these stocks have in common is that they are Dividend Kings and have an average of about 55 consecutive years of dividend growth

No, I do not advocate starting with just five stocks, by the way. I was never able to deal with much more than 20. Perhaps 10 stocks might be a decent starting point for many folks just starting out.

The annual dividend paid the shareholders with these 5,000 shares is $14,040. The last five-year growth rate of these five stocks is roughly 5.65%. That means in the last five years, shareholders have gotten a raise of about 5.65% each year on average, just by holding the shares.

If the dividends were reinvested, which younger dividend growth investors should do, the number of total shares would be significantly more, and the annual income stream would be much higher – without adding one more share with cash!

The point is that the share price at any given time does not matter for anything other than buying or selling the stocks. Since we are not selling (unless something negative happens with the dividend), the price matters only when we buy it. For argument’s sake, let’s simply assume these prices are fairly valued. If the share price drops by 25%, or increases by 25%, a true dividend growth investor will basically ignore it. It is all about the income stream and its growth, not the share price. 

If the average share price drops by 25%, it might look ugly on paper, but if the dividend growth stays the same, we are doing our job, and growing our income. I am not saying that total return does not count, but the focus is on the income stream. A loss is never incurred, nor is a gain reaped, until, or unless, we sell the shares.

What I Look At To Evaluate A Stock

Well, here is my own personal list:

  • Is it a Dividend King or Aristocrat?
  • What is the last five-year dividend growth rate average?
  • The payout ratio
  • The current cash flow, cash on hand and the balance sheet
  • Is it enough to cover the dividends and pay the debts?
  • What is its current dividend yield?
  • Are there any major problems that could impact the income stream?
  • The quarterly conference call and what management has to say publicly

Notice I didn’t say anything about the share price, its latest earnings report, or current business conditions. If a stock can continue to pay and increase the dividend, that is all I care about.

An income stream is real money and can be reinvested or used to pay expenses. A share price, if a stock is never sold, means very little to me – aside from being nice to look at!

Yes, there are times when a stock is sold. This is my list of reasons:

  1. The dividend gets cut drastically.
  2. The dividend is eliminated.
  3. The balance sheet becomes a major liability, meaning the financials are too weak to continue paying the dividend.
  4. A change in my personal circumstance that forces me to liquidate (which is what happened to me)

There are other dividend growth investors may sell shares for other reasons, like switching from one stock to another, or deciding to invest in an “opportunity” high-yield stock that carries more risk. To me, right now, that might mean Exxon Mobil (XOM) or a mortgage REIT like Annaly Capital (NLY).

I have used this approach myself in order to tweak the income stream and accept the added risks with small positions. With XOM the risks are vastly different from those of NLY, by the way.

The most important approach towards dividend growth investing are really simple:

  • It’s all about the income.
  • Know your risk tolerance and why you are investing.
  • Do your due diligence and research on a regular basis.
  • Focus on increasing the income stream, basically all the time.
  • Time in the market is vastly more important than timing the market. 

My Bottom Line

I know there are other nuances that may tweak the strategy, and many DGI’ers would argue that stocks other than Aristocrats and Kings be part of a portfolio. That is perfectly fine, but as long as the income keeps rolling in and continues to grow, the portfolio value is secondary. 

So many recent newcomers like to argue that if the share price goes down, it negates the dividend. It is my opinion, and that of most DGI’ers, that the argument is nothing more than a strawman by those folks who are not dividend growth investors – folks who might not fully understand what this approach to investing actually is.

I am not saying that DGI is the only and the best way to invest. There are numerous ways and the choice is simply up to you.Not To Bore You, But…

Knowledge is power, and many folks shy away from the investing world because that very world makes it more confusing each and every day in an effort to sell you something.

My work here will remain free to all of my followers (unless it is an Editor’s Pick! Then, the article will be openly available for only 24 hours or so.But I have no Marketplace service). My hope is that I’ll give you some of the things that took years for me to learn myself.

One final note: The only favor I ask is that you click the “Follow” button and become a real-time follower to receive emails that my articles have been published, and so I can grow my Seeking Alpha friendships. That is my personal blessing in doing this and how I can offer my experiences to as many regular folks as possible who might not otherwise receive it.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Disclaimer: The opinions and the strategies of the author are not intended to ever be a recommendation to buy or sell a security. The strategy the author used in his past worked for him, and it is for you to decide if it could benefit your financial future. Please remember to do your own research and know your risk tolerance.