This week we look ahead at the year 2010 and what events might materialize.
Upon reviewing these predictions, I realize these have a somewhat bearish slant. It’s my view that the big theme of 2010 will be a reminder that things are difficult out there, something of a reality check for the economy and markets. It will be a reversal from the theme of 2009, which has been “things aren’t as bad as we thought in the pit of the crisis.” Crisis, of course, was the theme of 2008.
Most of these predictions tend to revolve around this reality check for the markets, so if I’ve got that wrong, I’m in big trouble from the start.
As most of you folks know, the type of trading we do in our own funds is very short term in nature. We like being able to go to cash at a moment’s notice. While we remain cautious as ever, our current trading portfolio does have a mildly bullish bias. Stay tuned to The Draconian throughout the year and I’ll let you all know if that stance changes and if we start looking for more areas to aggressively short.
Now, allow me put my Nostradamus hat on and we’ll get straight to it:
1) No serious inflation materializes and the U.S. Dollar hangs in there.
Loyal readers are already aware of our stance on the inflation debate. Sure, it could be a problem some day. But not for a while, a lot longer than most expect. We’ve been banging the anti-inflation drum, warning investors not to bet too heavily on significant inflation for a while now and I’m glad to see the rest of the industry finally talking sense about inflation.
Back in November, we discussed one of the biggest threats to the markets being a policy change and subsequent rally in the Dollar. I didn’t think that would materialize so quickly after sounding that warning bell, but lo, that’s exactly what happened in December and suddenly betting on the Dollar and against significant inflation is the trendy prediction for 2010. Since we launched The Draconian last summer a big theme of this newsletter has been to keep a stockpile of Dollars handy for these very reasons.
For the record, I do believe we’ll get some expansion in the Consumer Price Index. Betting against that would be silly. Annual drops in the CPI very rarely happen, and usually only do so during awful, extreme environments. It probably won’t surprise you to learn that since we got off the gold standard, the only time the CPI ever went negative for a year was after the recent financial crisis. The Fed’s not joking around when it says one of its policy goals is to “manage” inflation. It does a better job at this than you might realize. No way does the CPI exceed modest 1-2% growth over the next year.
With that, I think we see the Dollar firm up a little. We’ll be discussing this much greater detail in the coming weeks, but for now, I think people will be surprised at the relative strength the ol’ Greenback shows in 2010. Last year everybody seemed to convince themselves that with all this money printing and government stimulus that the Dollar was facing certain doom. I didn’t agree then and don’t agree now. Inflating our way out of all this debt is a viable solution, but not when we need to keep borrowing a trillion dollars a year to support a decade of projected budget deficits.
There are too many other deflationary headwinds at present as well. Real estate is still a drag. Wages are going down. Monetary velocity is still low. Retailers have zero pricing power as consumers are still reluctant to consume unless a supersale or government incentive is attached. The job market still looks bleak. The CRB commodities index has been stalling out. The bond market is still forecasting minimal inflation. And don’t forget that Japan has been printing Yen like madmen for decades now and their currency has actually gone up! I think that reports of the death of the U.S. Dollar are being exaggerated.
In 2010 we will all be reminded that runaway inflation is farther away than we thought. Like our friend the Chupacabra, it will remain a spooky story we tell ourselves late at night.
I think by next December it might even be the case that hardly anybody is talking about dollar weakness.
2) The stock market disappoints. Big time.
To quantify this, all I’ll say is that I think the market ends the year lower than it began. Even still, that qualifies as a very contrarian forecast right now.
I know that the brilliant John Hussman put the odds of a “crash” at 80% in 2010 based on a Bayes’ Law interpretation. But I’m reluctant to agree for semantic reasons. I think there is virtually no chance of a repeat of what we saw after Lehman went down; that’s my definition of a “crash”. That said, I do think the S&P finishes lower this year, possibly even down double digits. I think the odds of witnessing a single drawdown of 20% or more at some point in the year is probably higher than any time since the 1970’s. If that, coupled with continued economic and credit problems qualifies as a “crash”, then yes, I do agree with Mr. Hussman.
On a side note, if you don’t already follow his weekly commentary here, it’s time for you to start. I am awed by his intelligence, economic acumen, and writing ability.
That chart looks pretty familiar, huh? It looks a lot like what we’ve seen in the last couple of years, doesn’t it?
A lot of investors are completely baffled and mystified by the gigantic rally in 2009, but it’s pretty much exactly what the market did back in 1930.
As you can see, the next leg of that chart is pretty ugly – the Dow would go on to lose roughly 90% of its value. I don’t think that will happen today, but with all the economic mess that still needs sorting out I have a hard time believing that the market soldiers on to new highs from here.
I’ll now ask a question: do you think that the market and the economy will be better than it was in the 1930’s but worse than it was in the 1970’s? That’s certainly the political consensus with all the “it’s the worst [whatever] since The Great Depression” rhetoric. I’d say it’s also public consensus, and it’s probably the reality of the matter as well. Not as bad as the 30’s but worse than the 70’s.
Sounds reasonable to me.
If so, the above chart is the worst-case scenario, and the below chart is the best-case:
On top of that, bearish sentiment at present is the lowest it has been in a long time, lower even than the summer of 2007 when everything in the world was hunky dory. You probably already know that bearish sentiment correlates very well with market action, often bottoming at market peaks, and peaking at market bottoms.
What we see this year is really anybody’s guess, but I think the market will disappoint. Regardless of what happens in 2010, you can see why I’m so skeptical that today is the beginning of the next great bull market for equities.
3) Real Estate falls further.
But then stabilizes. Maaaybe. Earlier this summer, amidst the enthusiasm of the homebuyer tax credit (which can’t keep getting extended forever), I said that there was still more downside in real estate and I think that’s what we see in the first part of 2010. If you haven’t read Some Straight Talk on Housing, give it a look, especially if you’re thinking about buying a new home.
Foreclosures are getting worse, not better, and will keep getting worse and not better, especially as a gigantic wave of mortgage resets is set to wash over the market in 2010. All the homebuyer tax credit did was just push back the date at which housing finds a bottom and, for better or worse, that date now coincides with this new round of mortgage resets.
Rate pressures are also likely to rise as the government scales back its Fannie/Freddie purchase program and ratchets the Fed Funds rate upward. Higher rates mean higher monthly mortgage payments which means that buyers can’t pay as much money for a house. That’s the cruel and simple calculus of the matter. I don’t expect dramatic rate pressure, but whatever pressure we do see will be a drag on home prices.
If you’re the sort of person who needs a chart for convincing, check these out.
The blue line is the actual Case-Shiller home price index and the red line is the value predicted by inflation + real wealth expansion. Over the long-run, by definition, housing cannot appreciate more than the inflation rate + any real gains in wealth. Over the short-run, home prices can be dramatically influenced by speculative factors and expansions/contractions in credit or changing lending standards.
I also submit the next chart for your consideration, where we relate a buyer’s income to the price of a house:
There’s a very good reason for this metric to remain relatively constant over time and oscillate around a historical mean. By definition, an individual cannot indefinitely pay more for a house than he can afford nor will lenders lend what they don’t expect will be paid back. This metric will obviously fluctuate as things like interest rates and lending standards rise and fall.
Over the long run, however, both of these charts are highly mean-reverting.
At the end of 3Q09, home prices were still roughly 7-9% above their historical norms according to these metrics.
You can also see that these two metrics can overshoot in either direction. Assuming that the economic path before the U.S. and her people is a rough one, home prices might have another 10-15%+ to fall. It gets worse if you live in one of the key bubble states, like us here in Nevada. It also gets worse if you start making assumptions about lending standards becoming more strict and household incomes actually falling a bit. To me that sounds reasonable, but who knows.
This is all consistent with what we wrote last summer.
4) Hedge funds return to prominence (of sorts).
Basically, they outperform the markets and the world of traditional investments this year.
Asset flows into hedge fund strategies has been picking up serious steam, with the industry now back above $2 trillion in assets. Keep in mind that the consensus view was that hedge funds would be a disaster in 2009, with up to half of the industry either blowing up or closing down. A lot of funds did shut their doors last year, but as a whole, the industry surprised the world with remarkable resilience and even responsibility.
These guys have solved their problems the old fashioned way: the good ones survived and the bad ones failed. I haven’t heard of a single hedge fund bailout so far, and I’m much more comfortable making long-term bets on any industry where actual merit is the arbiter of success.
Yes, there are still problems in hedge fund land right now, but most of that is traced to legacy positions that are still illiquid. The dominant theme in 2009 was a renewed emphasis on investor-friendly policies. Pretty much every hedge fund I know did everything they could to increase their transparency, liquidity, accountability, and proper alignment of incentives. In essence, they’ve done everything the banking system and government hasn’t. This is no longer the mysterious, elitist, exclusive industry it once was. These talented capitalists have rebuilt their industry around giving investors what they want. This is the wonderful side effect of unfettered competition and minimal government mingling.
Over the long run, I want to bet on industries like that. And that do this:
Hedge funds had their own credit-related problems during the financial crisis – they had some painful deleveraging like everybody else. But this year people remember that these things are superior ways to invest, especially during standard bear markets. The really sophisticated investors never forgot that lesson anyway, and they’re now actively reallocating to the sector. That trend will continue through 2010, and through the next decade hedge funds will be the place to be.
You guys all know we’re biased, because our business is managing a family of hedge funds. We run this kind of business and have essentially all of our personal investment net worth invested in the funds that we manage because we believe that over the next ten or twenty years, the blue line in the chart above continues to outperform the red one.
Send me or Kyle (Kyle@DracoFund.com) an email if you have any questions or want to learn more about how and why to get access to some alternative strategies. We’re also happy to talk to you about how you can implement some alternative strategies in your own portfolio – this is the goal of Draco Trade School.
5) The Democrats lose their stranglehold on American politics.
Unless, of course, the Republicans bungle it again.
When Obama & the Democrats took office in such decisive, dramatic fashion, I thought that they had wrapped a tidy ribbon around what would become a new era of political dominance. At the time, I thought that the Republican party had suffered too much permanent damage from the baggage of the Bush administration, an administration which, beyond the tax cuts, demonstrated so many un-Republican characteristics. Many of the folks that I know that voted Bush in 2004 had begun in 2007-2008 to feel a frustrated sense of betrayal. (Anybody wonder why John McCain, a man who had frequently, loudly, and publicly clashed with the Bush administration was chosen to be the Republican candidate?) I thought the Republican party would need to completely reinvent themselves to ever regain the power they lost in 2008.
But now I am not so sure. I’m astonished at how quickly Obama’s approval rating has slid, and approval ratings for the Senate and Congress are bouncing around all-time lows. I expected that Obama and his gang would play the “blame the previous administration” card for a while, as any savvy gamesman would suggest. But there wound up being a lot less juice in that strategy than I initially thought. It seems as though more and more people today are blaming the current administration for our economic woes in addition to administrations past.
I think my perspective here is fairly neutral. As a lifelong registered libertarian, I haven’t once voted for a major-party presidential candidate since graduating high school. I have equal contempt (and hope) for both parties.
But deep down I am just a tired, political cynic. These two parties are far more similar than most partisans would be comfortable admitting, and all the effort we expend to bifurcate ourselves is wasteful and inefficient. I’ve found that for the most part, Americans want the same basic things.
I also know too much about incentives and how improperly aligned they are in a democratic system. The wonderful thing about America is that we can literally vote ourselves what we wish, and these politicians are keenly aware of that. They make decisions that help them keep their jobs, which are not always decisions that are responsible. America is a candy store where the kids call the shots. This, more than the idealistic partisanship of modern politics, is why I’m such a cynic.
This year, get ready for more partisanship and more selling out.
The Democrats will try and make the current economy seem great, or at the very least, on the road to a better place. The extent to which reality confirms this political spin doctoring will be what determines their fate this November.
The Republicans, naturally, will fight the perception of recovery tooth and nail, though I’m not entirely sure this will be the best long-term strategy for them. Fear is a powerful manipulator, and to their credit, few administrations in history wielded that power more effectively than Bush & Co. But now is a time when people (voters) are responding to optimism coupled with results. We all have enough fear at present.
Increasing numbers of people seem to be demanding more fiscal responsibility from our government, but in truth, we are far less concerned about responsible public policy than with feeling safe and confident. Truly responsible public policy would mean forcing sacrifices on the American people that would incite riots. As kids calling the shots in the candy store, the idea of “sacrifice” is unfortunately a foreign concept to most of us.
Rather than act as responsible parents and make tough decisions, politicians will chicken out and resort to the delivery of bread & circuses and the promise of more stimulus. That’s been working pretty well in Japan for a decade or two, and there’s no reason to think it won’t keep working over here. This November, we’ll vote for whomever makes us feel better about our future, and any real data that confirms this will circled, highlighted, and underscored in bold.
Right now, that’s jobs. As I’ve written before, there is nothing more valuable today than a steady, reliable job. A job that pays $40,000 per year might not seem like anything special, but that’s a million dollar asset when you consider how much capital you’d need to reliably generate an equivalent amount of passive cash flow.
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Click here to read part two.
I hope you enjoyed Kelsey’s newsletter last week about the job market and how it has shaped the psychology of today’s new graduates. Based on the web traffic and feedback we’ve received so far, it looks like you did! If you missed it, you can read that again here. I think that you younger readers will find it matches your own thoughts and feelings, and I’m curious to hear you older readers’ reaction to it. What were you all thinking and feeling in the years after graduation?
I love talking to students and graduates today. If for no other reason than they are so different from me, and collectively, so different from my generation. I was at UCLA in the heart of the dot-com explosion, studying both economics and computer programming. It seemed like every other business student was also a day trader and every other computer science student was launching a new web portal. Upon graduation, we were all heading off to lucrative jobs at tech startups, investment banks, or Big 5 consulting firms. Not only did we feel like we had the ability to conquer the world, but we believed it was our inherent right.
My generation, Gen X (born 1961-1981), is very different from Kelsey’s. Broadly speaking, we are very individualistic, highly pragmatic, and feel relatively little sense of community. There is good reason for this, of course, as we we were born during the cultural revolution, a time when sovereign influence was disintegrating and institutions were being torn down by our rebellious parents and elder cousins. Their cultural rebellion had good reason, as these Baby Boomers were children during the 1950’s, reacting to a time when conformity and safety were social virtues above all others. The mood of the 1950’s was no surprise either, given the instability of the Great Depression and WWII. And so it goes back through time…
Today’s grads are contending with their own issues, products of today’s environment. Things are different now. Allow me to quote a recent post over at Brazen Careerist:
Salary negotiations are over. In most polls, if you ask Gen Y what they care about when choosing a place to work, the top three things will be, in varying orders: flexibility, interesting work, and likable co-workers.
Gen Y doesn’t consider salary to be a huge factor in choosing a place to work because Gen Y knows that salary data is public. The days when a company can screw you by underpaying you are over. Anyone can go to a place like Payscale and find out what other people in a similar geographic location are getting paid for a similar job.
As I reflect on my college experience, salary was unquestionably one of the most important factors in job selection and would frequently sway my cohorts from accepting one position over another. The most intrepid of us would play employers off each other to secure the best signing package. What was most important to us was an environment where we had the freedom and opportunity to advance and receive appropriate financial compensation for it. It’s no wonder so many Gen X-ers left their jobs at investment banks or retail brokerages and went out and started a hedge fund!
Kelsey mentioned the binary poll we conducted, where today’s grads seemed generally less interested in salary and excess consumption than they were with a sense of community, safety, and flexibility. I can almost guarantee you that the results from my college cohorts would be flip-flopped.
And I love how Kelsey mentioned that her cohorts want to make their employers proud. It’s a subtle difference, but I’d say that my graduating class was much more interesting in trying to impress our employers. Of course, in return for dazzling them with our individual merit, we expected compensation or we would simply move somewhere else.
For curious minds
As the stepson of an educational psychologist, I have spent a large portion of my life in an environment cultivated around the understanding of human behavior. I’ve consumed a fair amount of academic research on the topic of generational psychology over the years but am by no means an experienced voice. The undisputed authorities here are Neil Howe and the late William Strauss. I’ve mentioned before that their book, The Fourth Turning, changed my life and literally reshaped how I view the world. I know that book is held in such high esteem today because of the jaw-dropping accuracy of the predictions they made back in 1997, but beyond that, they weave the most fascinating tapestry of American history I’ve ever encountered.
Here’s an excerpt of an outstanding interview with Neil Howe if you’re too cheap to buy his book – contact me at Feedback@TheDraconian.com if you’d like a PDF of the whole thing, about 17 pages. It’s a great introduction to the topic and contains some interesting predictions for the era that has only begun to unfold.
You might wonder if this is all just intellectual masturbation (a vice I’ll readily cop to). What relevance could all this quasi-philosophical mumbo-jumbo have to the world of investing, and why should someone like me spend any time at all studying something so seemingly unrelated as generational psychology? Well, this stuff has oodles of practical merit. Generational psychology is nothing more than the investigation and identification of patterns and trends throughout history, which also happens to be the exact business of trading and investing.
As traders and investors, we study the past to find patterns and trends and then we use these in our efforts to divine the future. Some patterns are broad, some are very specific. Some are obvious, others are subtle. I am obsessed with the identification of patterns – wherever in nature they occur – for their raw utility.
Also keep in mind that psychology is a big driver of the markets. I’m of the belief that more investors can be more successful if they develop an understanding of certain psychological fundamentals. Markets have functioned in very different ways throughout history, and an understanding of the individuals and generations who drive them is one key to understanding how these markets work.
Don’t be afraid to use all sorts of seemingly-strange tools when it comes to building a framework for investment analysis.
On health reform
It looks like all that healthcare reform we’ve been hearing so much about is finally here. Is this really a big deal for the American people or is this a bunch of political spin wrapped around another clunky anti-climax? Listening to partisan Democrats and Republicans talk about it just makes my ears hurt, so I tried reading through the actual bill myself over on OpenCongress.org. But that made my eyes hurt.
So I pressed mute and closed my eyes and calmly tried to think about a few theoretical principles.
At its simplest level, in any situation involving insurance, the interests of the insurance provider and insured consumer are set in direct opposition. Insurers are hoping that I will pay premiums and not get sick; I have made a bet that I will get sick and my policy will pay out more than my premiums. The only possible way I can assess a massive piece of legislation like this is to call on the markets for help. Insurance stocks have been rallying sharply in December on the expected passage of this legislation, as clear an indicator as any that this legislation makes them better off. Naturally, I am concerned because if they are made better off, it necessarily means that I (or more specifically, the insured public as a whole) is made financially worse off.
Obviously, there are many more factors to consider beyond the strict dollars and cents of the matter, most of which are difficult or impossible to quantify. I’m having difficulty enough with step one of this analysis, so I’ll take it slow. In the meantime, I would really enjoy hearing your feedback on this issue. This will be a big investment topic starting right now and extending through 2010. I am specifically most curious to hear from Democrats who are really excited about this legislation because it’s their argument I feel I understand the least. Most polls right now show a majority of Americans opposing this bill, so if you hate it and want to tell me why, I’m certainly interested in listening.
Feedback@TheDraconian.com is the place to do it.
Market recap & possible red flags
We cautioned back in November about not getting too heavily caught up in gold. We’ve always liked gold and continue to like it over the long run, but have warned about getting too crazy with it because of its vulnerability should we see any Dollar strength. Since the summer I’ve been writing about the importance of keeping your cash balances high, and times like this are exactly why. The Dollar is rallying and gold has pulled way back.
The market has totally stalled out here in December. Usually this is a somewhat busy time for portfolio managers as they do their year-end rebalancing. Not all, but many of the fund managers I know that were having a decent 2009 banked what profits they had in November and have just shifted into cruise control, coasting until January.
You’ll definitely want to tune in next week for our “10 Predictions for 2010,” but after that we’ll take a closer look at a bunch of red flags that have been popping up lately. Amidst the noise of the holidays, some of these items may have gone unnoticed.
This mess in Dubai is a big, big deal. At the very least, it should serve as a reminder that we aren’t anywhere close to resolving the global credit problems. And Greece is possibly an even bigger bogeyman. Their debt now hangs tenuously above junk status, with Spain, Portugal, and Italy all finding themselves in a potentially similar boat. Those problems may seem isolated because they’re on the other side of the world, and maybe they’ll stay an arm’s length away. But there are plenty of domestic credit-related potholes, especially the blizzard of mortgage resets that is set to blow through in 2010 and 2011.
Did you know that Citigroup is down almost 40% since August? 40%!! Both Wells Fargo and Bank of America recently pulled back around 20% and financials as a whole (as measured by the XLF) were recently off over 10%. These banks stocks are down because when investors look on the horizon they see dark clouds. Can’t you see them too?
Sierra Storms
One of my favorite things about living here in the Sierras is watching the winter storms creep over the mountains. My office faces west with a nice view of Mt. Rose and I love seeing those clouds pile up and spill down through the valley. Sometimes it looks ominous, but feeling the temperature and barometric pressure drop always gets me excited with thoughts of snow.
When storms are barreling towards us, we Northern Nevadans know what to do. We run by Wal-Mart after work and make sure we have everything we need to get us through the weekend. We check the heater and dig our jackets out of the closet. We get our snow shovels ready on the porch. Maybe we even stop at the video store or queue up some Netflix to keep us busy while we wait for the storm to pass.
Investors should be doing the same thing with their portfolios right now. Make sure you are truly diversified. Keep plenty of dollars at the ready or hide some in near-term treasuries. Buy some TIPS to guard against longer term inflation. Own a diverse basket of inexpensive equities – get some dividend stocks or write some calls on the stocks you own to boost your yield. Grab a short fund if you want a hedge or something that doesn’t correlate. Look at high-quality corporate debt. Pick up some gold or some foreign currencies. If you’re a high net worth investor, get access to some alternative strategies.
People, the clouds are piling up.
How bad is this storm going to be? Will this be a blizzard or are we in for just a light dusting of snow?
I have no idea. The markets and the weather are equally fickle beasts. But the Law of the Sierras is better safe than sorry. This is a lesson that all of us here are intimately familiar with, as we live it every winter. We have deep respect for Mother Nature and the power she wields. Storms are easy to deal with if you’re properly prepared; getting caught off-guard on Donner Pass in the middle of a blizzard is where it gets a little scary.
Be prudent and stay warm, my friends.
EDITOR’S NOTE: This week we feature a special newsletter from Kelsey Joyce aka “The Draconienne”. Those of you who are investors have probably chatted with Kelsey at some point on the phone as she juggles all of our administrative needs. She’s a key part of our team.
Not enough credit is given to generational psychology and the way it shapes economics, politics, and culture. Kelsey is on the leading edge of the Millennial Generation, children who were born during the prosperous late 80’s and 90’s, and are now coming of age during a time of crisis and turmoil. Collectively, they are very different from the prior generation, Gen X, and even more different from the Baby Boomers before them. I know this newsletter goes out to a lot of Boomers (and their predecessors, The Silent), so hopefully you folks will find the perspective fresh and interesting.
She’s here today to talk about the challenges this generation now faces in the job market. It’s commentary straight from ground zero, and I think you’ll enjoy it.
A Foot in the Door
May 16, 2009 snuck up on me, and before I knew it I was sitting alongside fellow University of Nevada, Reno graduates. Graduation day crept up before many graduates were, or even got the opportunity to be, prepared.
Despite the excitement and optimism in the air, many students’ attitudes toward graduating were not so. Graduating means it’s time to make a decision: continue the expensive path towards a higher level of education, or enter the frightening job market and try to make something of oneself. Conversations of graduates’ plans streamed up and down the isles as we waited to receive our diplomas. An overwhelming amount of “I don’t knows” and “I’ve been looking for a job for months” were what these hardworking students had to answer. According to the National Association of Colleges and Employers (NACE) that’s what nearly 80% of recent college graduates who are actively looking for a job had to answer. The thought of ‘not knowing’ led to a tremendous amount of stress and fear upon graduates. This created a sense of nervousness and skepticism, which actually lingered in the air on graduation day.
I said that many gradates didn’t get the opportunity to get prepared, and by this I mean that desirable jobs simply weren’t seeking applicants, and if they were, interviews were rarely given. Consequently, the opportunity to prove oneself was out of the picture. According to the NACE, employers say they will hire 22% fewer college graduates this year than last year. At the same time, colleges are expected to see record numbers of graduates in 2009.
A core of resilience
Despite the fact that there are limited jobs available, we graduates never gave up. We aren’t graduates that tried once, got turned down and didn’t pick ourselves back up again. We tried relentlessly, but not one employer gave many of us graduates the opportunity. Collectively my generation has an abundance of pride, and it takes a great deal of discouragement and failed attempts for one to admit that they graduated and now work at Macy’s or Olive Garden. Actually, it wasn’t until graduates couldn’t financially survive that they surrendered to working as a hostess after dedicating so much time and effort throughout college.
Perhaps we, the Millennial Generation, felt too entitled to a decent job with benefits upon graduation and that’s why it is so hard to settle for less. Perhaps the realization that our dream jobs are not even open to applicants is what brought on the fear and anxiety. That feeling of entitlement quickly vanished as the job market began to crash, and more graduates prepared themselves to fail rather than succeed in finding this so called ‘deserved’ job.
There were many reasons why May 16th brought graduates uneasiness: our desire to be a part of a team and the subsequent fear of being left behind, not being able to meet the requirements employers demand, and the idea of being out in the ‘real world’ without being able to provide for oneself. These fears now place two choices in front of us: more school or enter the workforce, each of which place great financial burdens on young individuals (especially if the job received is not financially up to ones expectations).
What we’re all thinking
Here’s a little insight as to what is going on in most graduates minds – I say “most” because I need to point out that, although the number is low, there are those who did find and receive a job that they enjoy and also receive adequate pay in order to make ends meet. According to Mimi Collins, director of communications for the NACE, a very small number of the class of 2009 college graduates did have jobs secured by the time they graduated and hiring rates were expected to drop even lower. So there is a good chance these fears will apply to 2010 graduates as well. For the sake of explaining the general feelings graduates experience, I will focus on those who did not find a job with benefits and a suitable income by the time graduation crept up. After all, they are the overwhelming majority.
First of all, I think it is safe to say that it is extremely important to Millennials to not only make something of oneself, but to be part of a team, whether that team is a business or some other formal organization. Collectively, we don’t have the desire to individually enter a job of choice, climb up the totem poll, and make oneself rich. To us it is more than that. Yes, everyone strives for the lifestyle in which they do not have to worry about finances. Yes, we all want to be able to afford the trips, and the homes we have always dreamed of. Our generation of graduates may enter the workforce individually, but the prize is not to succeed individually, but rather to be part of the team that succeeds and reaches all these goals with the help of one another.
It is belonging to something bigger than each of us alone that we yearn for.
Millennials get gratification not only by feeling as though they are a part of a team, but that we are helping the whole to succeed. So what does this create in new graduates minds? A constant fear that we are going to be left behind, that we aren’t going to be a part of something bigger than ourselves. This fear becomes much more real when one cannot seem to find an opportunity to become a part of a team or an employer that will offer a chance to prove oneself. According to the United States Department of Labor unemployment among college graduates had increased tremendously due to the economic recession, with the number of unemployed graduates with a bachelor’s degree increasing by 136 percent since 2007. This has resulted in more than 2.2 million college graduates in the United States that are currently unemployed. That’s 2.2 million college graduates that are living this fear daily and countless others that are frightened, and doing everything possible to not become part of this statistic.
These millions of graduates haven’t been given that opportunity to be a part of a team. And as many are trying to pay off college loans, newly graduated individuals do not have what it takes financially to create their own team. This is difficult because positive, entrepreneurial spirit is something the Millennials are recognized for. Many of us graduates would love to build our own organizations; we just need to get some experience and cash flow before this is possible.
All we need is a foot in the door.
The paradox of new hires
Employers are obviously aware of the economic conditions and how many people are desperate for a job. Therefore, they are demanding a candidate of true quality, as I believe they should regardless of economic times. But today more than ever, employers are requiring an additional qualification which does leave us graduates fearful: experience.
Many employers’ definition of a ‘quality’ employee is changing and a higher level of experience is becoming a mandatory part of that equation. There are two different types of employers who emphasize two different qualities: one emphasizes experience above all else, while the other emphasizes character. And it’s the overwhelming amount of employers who value experience over character that worry graduates.
Every job lists the qualifications required. Fair enough. Where today’s graduates have a hard time believing this is fair is when the requirements will in no way be relaxed in order to allow a high-character, hard-working new grad to get their foot in the door. We hear, “your application will not be reviewed if the following qualifications are not met in full.” These words are not only discouraging, but they’re plastered on almost every job posting! Newly graduated individuals who decide to enter the workforce obviously do not have “two years prior experience.” We perhaps have a little, but two years is usually the standard, and how is one to get these two years if everyone requires it before starting?
On the other hand there is the employer who values character, and is willing to give the employee the experience and train them where needed. This is the type of employer every current graduate hopes to find. Not only do I, as a current graduate, like to see these types of employers, but I do think these employers have a better chance at getting the desired “quality” employee that they’re seeking. Seeking this type of employee can result in finding an employee who is not stuck with bad habits picked up from another job, but one who can be trained and molded in the exact way the employer would like them to be. Our generation is resilient but also adaptable. As an employer, when teaching new employees how a job should be done, I imagine it to be a whole lot easier with an employee willing to learn rather than a stubborn (though more experienced) employee locked in their old ways.
Employers should take advantage of the qualities they can find in Millennials: our eagerness, our “be the best you can be” attitude, our ability to skillfully multitask, our “I’ll look it up” as opposed to “I don’t know” approach to problem solving, and our desire to receive guidance and instruction.
Once we are given the opportunity, we are out to make our employers proud.
But sadly, most employers demand the experience and would rather the “sure” bet on one who already knows how to do the job, instead of taking a chance on someone who could be, and wants to be, a more valuable long-term asset to the team.
The financial burden
The biggest fear of all is graduating and being sent out into the “real world” with the thought that you are unable to provide for yourself.
First of all, it is necessary to determine what is important to us graduating Millennials. Jeff recently spoke to a group of students at UNR. He opened the presentation with two scenarios that both he and I believed might describe some general values of students nearing graduation. Students were asked to choose which scenario they would like to find themselves in a few years after graduation:
|
Scenario A
|
Scenario B
|
| Modest house in average part of town (significant equity) |
Nice house in wealthy part of town (little or no equity) |
| Stable, if boring job. |
Lucrative, if risky job. |
| 5-year old Toyota Camry (paid off) |
Brand new BMW 335xi (leased) |
| Aggressively paying down student loans |
Meeting student loan payments |
| Income: $4,000/month |
Income: $10,000/month |
| Expenses: $3,000/month |
Expenses: $10,000/month |
When I, as a new graduate, looked at these two scenarios it did not take long to respond that I would much rather be living scenario A. Apparently my values are in line with about ¾ of students at UNR, because that’s how they responded too.
This data is a fair generalization of the values of Millennials: most of us are not expecting, or wanting to lead an extravagant lifestyle straight out of college. When one approaches graduation, ‘providing for oneself’ brings many expenses to mind: housing, food, car, gas, phone, utilities, car insurance, health insurance, etc. In addition to these expenses, one will factor in a little fun money, student loans, as well as amounts one wishes to save (if values are in line with scenario A).
In each scenario, it is assumed that one is provided with some sort of health insurance plan from their employer. Presently, this is not the case with many jobs. Generally, graduates get dropped from their parents’ health plan at graduation date. Because of its large cost and importance, I would say health insurance is a main stressor that hangs over graduates heads (especially because many new graduates incomes are not even what scenario A suggests). A report that came out last year by the Commonwealth Fund shows that 34% of college graduates will spend time in which they are uninsured in their first year following graduation. Two-thirds of these young college graduates who do not have health insurance had gone and will go without needed medical care because it costs too much. Talk about living life with only the bare minimums!
This, once again, proves that the majority of Millennials are not looking to lead extravagant lifestyles. Even essentials are being bypassed. The above list of expenses I mentioned includes necessary costs (beside ‘fun money’ which many would argue actually is). Even this frugal lifestyle is hard to budget with the wages many graduates are receiving, and the thought of not being able to provide oneself with these bare minimum essentials is terrifying. But stepping up to face this fear is part of what our generation is all about.
Our important choice
The bottom line is that graduates today have to make the choice to either enter the workforce in rough times, or continue school. All of these factors are constantly in our thoughts, but the bitter truth is that either choice puts up a startling financial burden on young individuals.
For graduates that do decide to enter the workforce today, their wages are permanently impacted. Lisa Kahn, a Yale School of Management Economist, explains the long-lasting loss in wages that individuals encounter when they graduate from college during a recession as this. Kahn found that with each percentage point the unemployment rate rises, graduates of that time earn 7% to 8% less during their first year of employment. Economic research shows that this negative effect continues for up to 15 years! These unfortunate graduates still earn 4% to 5% less by their 12th year out of college, and 2% less in their 18th year out. I mentioned earlier that employers say they will hire 22% fewer college graduates, but they are also paying those they do hire less. Between 2002 and 2007 the inflation-adjusted hourly wage for men ages 25 to 35 with bachelor’s degrees fell 4.5%. For the typical woman, inflation-adjusted wages fell 4.8%. Now, deep in the recession, the average starting salary for graduates who do receive jobs has dropped another 2.2% from this time last year, according to NACE.
On the other hand, many gradates are deciding to continue school and enter a graduate program. According to the most recent numbers from the Council of Graduate Schools, Graduate applications were up 8% nationwide. Schools such as Northwestern University and Harvard are currently tracking double-digit increases. According to Kahn’s further research, college graduates who went to graduate school instead of the job market during the early ’80s recession didn’t suffer the same wage losses. Therefore, it seems a good decision for graduates of this recession to continue school.
From a current graduate’s standpoint, additional school requires a lot of money that most of us do not have. The thought of entering or going further into debt often does not seem like a wise choice. In addition, the thought of now having to completely provide for oneself does not make this option look any better. When someone of a common graduates’ age adds up the costs I spoke of earlier (without much income) it often seems impossible to continue graduate school directly after graduating with a bachelors. For many, this financial burden is one that cannot be taken on right away.
With all of these thoughts constantly running around and stomping through our minds, we were forced to face graduation and make a decision; ready or not. Without knowing we have a secure job or even the opportunity to get one, many graduates threw their hats in the air with more of a “here goes nothing,” rather than a “confident to conquer” attitude.
Getting your foot in the door can change it all and our generation is as determined as ever to make this happen.
Here at The Draconian, a lot of our commentary is relevant for traders because we’re traders ourselves. That’s not to say we don’t understand long term investing, because we have to do plenty of that as well. Trading is a tough business, but odds are it probably isn’t your business, so there’s a good chance that long term investing strategies are of more relevance for somebody like you.
If you consider yourself a long term investor, then what you’re doing is making an investment today based on some kind of guess about what you think it’ll be worth far in the future. What should you expect? If you’re making an investment today, what will it be worth in 2020?
As you can imagine, this is a highly relevant question, especially for people who would someday like to retire.
What to expect
Today we share with you a simply fantastic chart, one of my favorites to work on.
Get ready to have your mind completely blown away:
What this chart does is look first at the current Price/Earnings ratio of the stock market. PE ratios come in a variety of flavors, and for this study, I’m relating the current price to the previous decade’s average earnings to normalize things a bit. I like looking at the Price/Earnings ratio because it gauges the “value” of the stock market – it measures the price that an investor is willing to pay for $1 of corporate earnings. Since a share of stock is nothing more than a claim on a stream of future earnings, this is a popular measure of whether a stock or the market is expensive or cheap. We then relate that to actual return seen in the market over the subsequent decade.
Here’s what’s going on behind the scenes:
The data starts ten years ago in the summer of 1999 (those were the good ol’ days, weren’t they?) and looks at the PE ratio using average earnings for the previous decade. At that point in time it was a little over 40, which is pretty high. In fact it was near the all-time high. In the 90’s people were paying a lot of money for one dollar of earnings, and in the case of the dot-coms, a lot of money for zero or negative earnings. In our chart we assume that an investor bought the market at that moment in time and then we fast forward a decade to 2009 to see what they actually earned over that period.
The stock market was really, really expensive back in 1999 and someone that made an investment in the market at that point in time was punished over the next decade to the tune of about a –21% total return. Ouch! That’s also assuming that they bought and held, and didn’t buy more during market frenzies and didn’t panic-sell during declines. In reality, the average investor’s rate of return over that period is probably worse than the -21% loss in our study.
Each little dot on this scatter point plot represents a different month, every month in the 20th century in fact. We took a snapshot of how expensive or cheap the market was at each month, and then measured the actual rate of return over the next decade. I used the Dow Jones Industrial Average for this study because the data is very reliable and the Dow divisor also automatically includes returns from dividends.
As you can see, none of the decades where the total return was negative began when PE ratios were very low. For the last century, a PE ratio below 15 has pretty much always signaled a decade of, at the very least, positive future returns. Conversely, none of the great decades began when the market was very expensive – when the PE ratio was above 25, the market has never done better than double over the next ten years.
Where we are today
So is the suspense killing you? Are you just dying to know what the current ratio is for the market? Would you like to know how big your investment might grow in ten years assuming you make it today?
Today we’re at PE of about 20.4, which I’ve marked with a red line.
The mean in this entire sample is about 13.5, so a PE of 20.4 is definitely on the higher end of the historical spectrum. That’s pretty obvious from the chart, but the market today is not extremely expensive, not the way it was in 2007, 2000, or 1929. Clearly, investors who bought at those peaks were using something other than this chart to justify their purchase.
What’s interesting is that even back in March, when we were at the nadir of the black abyss and the world seemed to be coming to an end and the stock market was at a new lows, it still wasn’t a historically cheap time to buy. The PE ratio only got down to about 13. Not bad, but not cheap enough to get the real Value Hounds baying. The only song those dogs are singing today is one where the market might resume its secular bear trend and erode to new lows. Life as a hardcore value investor is difficult because the stars so rarely align in pleasing fashion, but when they do… oh boy, great fortunes are usually made.
If we look at a channel around that red line we find an average total return of around 50-75%, which is about 4-6% per year. That’s not bad either, but our data set has a bit of positive skewness thanks to the phenomenal dot-com bull market and credit bubbles that began with already-high valuations. If we look at the median of dots in the neighborhood of that line, the expected annual return is closer to zero, ranging from –0.5% to about 1% per year.
I also added a regression line, which broadly describes the data set as a whole. If you look at the value predicted by the regression line, it’s forecasting a ten-year total loss somewhere in the neighborhood of -50% based on today’s valuations. That’s an average annual rate of return for the next ten years of about –5% to -6%.
Investing is both an art and a science, and so far I’ve given you all the science. We can’t make a decision strictly on the results of a study like this, and so we must run it through our own “artistic” filters. I actually think the real story lies somewhere between those statistical conclusions, a total rate of return for the decade in stocks of about 25-50% or around 2-4% per year. I know that yields are pretty depressing right now, but you can match that with risk free U.S. Treasuries.
It won’t be a steady 2-4%/year by any stretch of the imagination. You regular readers know that our vision of the future is one where the market moves up and down, trapped for the most part in a great range. It will be a decade where, ten years from now, investors will look back and say “Oi, I should have just stayed away and avoided all that heartburn!”
I think this study reaffirms that long forecast.
Here’s the “but”
This analysis does make a few assumptions which you may or may not be comfortable with. As our custom typically dictates, I will allow you to come to these conclusions of comfort by yourself.
The first is that it assumes that earnings for the next decade will resemble the level of earnings seen on average during the last decade. If you think the next decade won’t be as profitable for corporate America as the last (one of the most profitable in history), then you’ll need to lower the denominator of our PE ratio a bit. That would mean that the market today is even more expensive than the 20.4 we calculated earlier and would lower our prospect for the next decade’s returns.
The second assumption that we make is that investors are willing to pay, on average, what they historically have for a dollar of earnings over the last century. In recent years – a generally low-yielding environment, mind you – investors have consistently exhibited willingness to pay more for a dollar of earnings than they had in the past. Should investors continue to display the above average tolerance for risk that they have since the mid-90’s, then permanently higher valuations may be justified.
You’ll also notice that the data in those charts above appears somewhat bifurcated, with two separate “curves.” That second “curve”, the series of points that appears to be shifted up and to the right, is pretty much entirely from the mid-90’s through 2007. That was a very unique period in history where valuations began at high levels and had the ten-year window terminate in 2006-2007 which was in the middle of a totally artificial bubble in risk assets that was driven almost entirely by increasing leverage and an economy that exhibited almost zero economic growth when adjusted for mortgage equity withdrawals. We covered that and more in our newsletter on the state of the housing market.
Keep in mind that that period also had a nasty bear market in the middle.
If we discard that bizarre, artificially-fueled window and take our data back even further, to 1871 this time using the S&P Composite, the story is ridiculously clear.
Behold:
Note that the S&P doesn’t include returns from dividends the way the Dow automatically does, so for this you’ll need to use your imagination and shift that whole curve to the right a little bit. But still, inside that chart is a story of staggering power that many investors have never heard before.
You might be asking, “why does this chart look like this?”
The answer is that fundamentals matter. As I said above, a share of stock is nothing more than a claim on a future stream of earnings. Fundamentals are often thrown out the window in the short run, especially in speculative environments. But over the long run, fundamentals are the only thing that matters. There is no greater fundamental investor than Warren Buffet, and this concept is the heart of his famous quote,
In the short term the market acts as a voting machine, but in the long term it acts as a weighing machine.
What WE are doing about it
As I’ve mentioned before, our real business is asset management and not professional newsletter writing (as you may have guessed!). Every single one of our currently-active trading systems is very short term in nature, with average trade durations lasting from a day or two to about 30 days into the future. Our long-term investment strategy is one where we intend to rely on short-term, skill-based tactics. This is where the bulk of our personal investment net worth is allocated, via the funds that we manage. The fact that we:
- don’t use any outside leverage to generate our returns,
- are diversified across stocks, bonds, foreign currencies, commodities futures, and options,
- and have the under-appreciated ability to convert our entire portfolio to cash with basically a few button clicks,
really helps us sleep soundly at night. Regardless of what the future looks like.
I talk about it all the time on here, and we recommend that individuals get highly diversified and stay liquid in their own investment portfolios. Get access to multiple asset classes, and multiple strategies with each asset class. Keep your cash reserves up and get some alternative strategies if you can.
As a hedge fund, we are legally restricted in the things we can say about what we actually do, and as a result it can make it a little difficult at times to give investment advice. But if it’s the sort of thing you’d like to learn more about, or if you have some questions about how to improve the diversification and sophistication of your own investment portfolio, don’t hesitate to contact us. You can always reach me with any comments or questions at Feedback@TheDraconian.com. If you have some more specific questions, you can reach Kyle Ferguson, author of Draco Trade School, directly at Kyle@DracoFund.com.
We’re nice guys, too! Old-school Nevadans with old-school Nevada values. We love talking to other people because it helps us understand the issues that are at the forefront of investors’ minds. It helps us become better traders.
Should I buy stocks now?
If you’re looking to the market as a long-term investment right here – and many of you might be, especially those of you a decade or so away from retirement – temper your expectations.
Part of me actually wants to say prepare to be disappointed. At best, today’s valuations could be considered “fair.”
Based on the historical data in this study, you’ve got a tiny chance of making significant money, a reasonable chance of actually losing money, and a most-probable outcome of fairly mediocre returns.
If you think that language is a bit wishy-washy, you’re correct. It’s because a lot of things can happen over the next 10 years, but given present valuations, some outcomes are more likely than others. It’s also because I think the stock market is a pretty wishy-washy investment right now, though probably not a terrible one for investors with sufficiently long horizons.
Being a long-term investor is a lot like playing a really, really slow game of blackjack. Assuming you’re employing basic strategy and at least some form of card counting, you want to place larger bets when the deck is in your favor and smaller bets when the deck is unfavorable. When the count is high i.e. there are lots of aces and tens in the deck, the odds of receiving a good card are high and your bet should be larger to reflect those favorable odds. So here’s some language that isn’t wishy-washy:
Avoid buying stocks when they are expensive and load up when they are cheap.
Sounds simple, right? It isn’t.
Investors were buying stocks like mad in 1929, 2000, and 2007, exactly when they should have been avoiding stocks! No investor in his right mind was considering stocks after the mess of the 1970’s or in the late 1940’s when valuations had been compressed to historic lows.
Unfortunately, the average investor is impatient and highly emotional. And so he generally makes bad decisions about his investments, displaying remarkable aptitude for doing the wrong thing at the wrong time. He’s also a greedy and fearful little bugger, Mr. Average Investor. Usually, he wants to possess more, MORE dollars! But every so often he panics and does crazy things to protect the dollars he still possesses. Within that dichotomy the seeds of his portfolio’s undoing are sowed. Whether or not it’s a good idea to make a long term investment in the stock market, buy-and-hold is a style of investing that isn’t even appropriate for his true psychological makeup.
It’s probably a subject for a separate, more philosophical piece, but we’d probably all be much better investors if we didn’t care so darn much about money.
Yikes. I think I just blew my mind.
Seeya next week, friends.
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A few brief postscripts
I know I linked above to the lousy film, 21, which was a much better book than movie. If you’re looking for a great film about gambling, check out the way-under-the-radar 1998 thriller, Croupier, from Mike Hodges and starring Clive Owen before he was Clive Owen. It’s low budget and very British, but if you a) appreciate excellent writing & filmmaking, b) enjoy film noir, and c) are fascinated by both the practical and psychological aspects of gambling, I’ll guarantee your satisfaction. It’s a favorite of mine for those exact three reasons.
If you agree or have some hate mail, lemme have it at feedback@thedraconian.com.
You also might get a kick out of knowing that our firm’s founders spent their college years in the casino, “researching” ways to beat the house. In addition to their success at blackjack, they famously broke the roulette wheel one of the local casinos. The old wooden wheel had some physical imperfections, and after months of watching and collecting data they noticed that certain numbers did in fact come up more frequently than others. The wheel’s distribution wasn’t random.
They organized a betting team, put their plan into action, made a bunch of money, and then got chased out of the casinos. We’re pretty sure that Deane & Bruce and their buddies were the reason for the entire state of Nevada pulling its wooden Roulette wheels from the casino floors.
Unlike gambling, investing is serious business. But today, nearly all of the trading and investing we do is based on the general idea of taking risk when the odds are in our favor and passing when the odds are against us. We don’t win on every trade and every investment, but over the last several decades, it’s worked out pretty well for us.
It makes for a colorful heritage, too.
