Asset inflation and mean reversion

[carlsbadworker]

I am reading Rich’s latest article, “Shambling a tiny, halting step towards affordability”.

One of the key premise seems to be that “valuation always falls back to mean” (mean reversion). This is the bedrock of any value investing. Yet, even Jeremy Grantham GMO starts to questioning that in the past few years, that “the market can stay irrational longer than you can stay solvent”.

Here is my observations:
1. More money in the system does not always equal to higher inflation. Why? That’s because it depends on where does the money go. Here, I simplify by creating two population groups: rich and poor.
1a. If the money goes to the poor, they spend it which will cause inflation. I observe this in the minimal wage lift in California. Datassential, a company that researches and analyzes restaurant menu trends, recently found that the median price of fast food burgers has risen 26 percent in the last four years, one of the steepest price hikes across the industry. But there is no nation-wide wage inflation despite historical low unemployment rate.
1b. If the money goes to the rich, they are already maxed out in their consumer spends, so the money goes to the asset (stock, house), causing asset inflation.

2. Internet is creating wealth inequality. World bank says so and I completely agree: https://www.fastcompany.com/3055498/the-internet-is-increasing-inequality-says-the-world-bank
The Internet trend probably still has a decade left to play out (3 billion people on earth still doesn’t have Internet).

So it sounds like to me that mean reversion is not going to happen anytime soon:
i. In good time, more money being created which will push stock/housing price higher.
ii. In bad time, FED will pump more money into the system, which ends up in the hand of rich people, which will put a floor on the asset price (we are below the mean ONLY in one month in the last great recession as stocks quickly bounced back.)
iii. Fiscal policy might help but given congress is controlled by riches, tax cut always favors the top.

Will it ever be back to mean? Sure, if you have infinite time horizon, all asset bubbles will eventually collapse, but in both stocks and housing, we are not above 2-sigma level yet, it is hard to call for an asset bubble burst…at least not in U.S. (Maybe in China, but it doesn’t look like they have an asset bubble bursting soon. Tariff just basically re-allocates products through global supplier chain with little impact to the global supply and demand. i.e. China buys more soybean from Brazil while other countries (e.g. Japan) who bought soybean from Brazil now buys from the US.

Therefore, in the near future, this bull market will not end with a massive pullback. Q.E.D.

[spdrun]

It’s always different, until it’s not. The same arguments could have been used to say that the 90s/early-2000 tech bubble would never pop.

Shit unraveled in 2007-8 AFTER the Fed cut rates… a rate cut or even QE in bad times isn’t a guarantee.

[ltsddd]

I heard that refrain before with stocks (buy high and sell higher) and real estate (buy now and sell next year for a six-figure profit). I think all Piggs lived through those periods, but may be only some actually remember how drastic and sudden the sentiments shifted.

[phaster]

[quote=carlsbadworker]I am reading Rich’s latest article, “Shambling a tiny, halting step towards affordability”.

One of the key premise seems to be that “valuation always falls back to mean” (mean reversion). This is the bedrock of any value investing. Yet, even Jeremy Grantham GMO starts to questioning that in the past few years, that “the market can stay irrational longer than you can stay solvent”.

Here is my observations:
1. More money in the system does not always equal to higher inflation. Why? That’s because it depends on where does the money go. Here, I simplify by creating two population groups: rich and poor.
1a. If the money goes to the poor, they spend it which will cause inflation. I observe this in the minimal wage lift in California. Datassential, a company that researches and analyzes restaurant menu trends, recently found that the median price of fast food burgers has risen 26 percent in the last four years, one of the steepest price hikes across the industry. But there is no nation-wide wage inflation despite historical low unemployment rate.
1b. If the money goes to the rich, they are already maxed out in their consumer spends, so the money goes to the asset (stock, house), causing asset inflation.

2. Internet is creating wealth inequality. World bank says so and I completely agree: https://www.fastcompany.com/3055498/the-internet-is-increasing-inequality-says-the-world-bank
The Internet trend probably still has a decade left to play out (3 billion people on earth still doesn’t have Internet).

So it sounds like to me that mean reversion is not going to happen anytime soon:
i. In good time, more money being created which will push stock/housing price higher.
ii. In bad time, FED will pump more money into the system, which ends up in the hand of rich people, which will put a floor on the asset price (we are below the mean ONLY in one month in the last great recession as stocks quickly bounced back.)
iii. Fiscal policy might help but given congress is controlled by riches, tax cut always favors the top.

Will it ever be back to mean? Sure, if you have infinite time horizon, all asset bubbles will eventually collapse, but in both stocks and housing, we are not above 2-sigma level yet, it is hard to call for an asset bubble burst…at least not in U.S. (Maybe in China, but it doesn’t look like they have an asset bubble bursting soon. Tariff just basically re-allocates products through global supplier chain with little impact to the global supply and demand. i.e. China buys more soybean from Brazil while other countries (e.g. Japan) who bought soybean from Brazil now buys from the US.

Therefore, in the near future, this bull market will not end with a massive pullback. Q.E.D.[/quote]

soon?! 3 years, 5 years,… a decade???

given growing populations and QE from various central banks which are flooding the market(s) w/ liquidity,… this in large part explains why there has been “asset inflation”

AND as I’ve said before it is going to be interesting to see what happens to prices of various assets like RE, equities and bonds given contractual debt obligations like,…

[quote]
U.S. public pensions posted their weakest performance in three years, falling a percentage point short of their investment targets, and the prospect of rock-bottom interest rates and a trade-war induced recession could put a greater strain on state and city retirement plans.

The median U.S. public pension returned 6.2% in the fiscal year ending in June 30 after paying fees to investment managers, according to Norwalk, Connecticut-based InvestmentMetrics, which provides analytics to institutional investors. Pensions assume a median annual investment return of 7.3% to cover promised benefits.

…This has exposed them to greater volatility even as they try to climb out of a hole that’s left them with between $1.6 trillion and $4 trillion less than they need to cover all the benefits that have been promised, depending on the interest rate used to value liabilities.

That gap could get even bigger if U.S. Treasury yields, already close to all-time lows, fall further because of an escalating U.S.-China trade war or the spread of economic stagnation from Japan to Europe.

https://www.bondbuyer.com/articles/public-pensions-post-weakest-performance-in-three-years
[/quote]

basically “fractal” problems like the local multi decade 13th pension check practice, are not going going away or will fix themselves

http://www.TinyURL.com/13thcheck

so the party will continue up until the point where there is a loss of faith and confidence in the system

[Rich Toscano]

cbworker, you raise a lot of good points. But I have a couple clarifications:

1. I definitely did not say “valuation always falls back to the mean.” I dedicated several paragraphs to factors that could keep valuations elevated, and ended that section with: “The best approach is probably to allow for the possibility that valuations have permanently shifted to some degree, but not to depend on it.”

That’s not really central to your argument, but I wanted to clarify for anyone who is reading this post but didn’t read the piece I wrote.

2. Also a tangent and not related to your central point, but: I would not characterize it that Grantham is questioning mean reversion. His argument was that profit margins for US corporations may remain elevated for much longer than usual (due to monopolies, regulatory capture, etc.). That’s different than questioning mean reversion of valuations. And even more tangentially, fwiw… that viewpoint is not shared by the actual portfolio managers at GMO. (At least, not to the degree that it makes them want to have any US stock exposure).

Anyway. I think you make some good arguments and I particularly think your point 1 is valid and very important.

Where we part ways is your certainty that it will necessarily continue. I believe there are too many moving parts to know for sure. For example, there is a lot more going on than the internet. And some of the factors that have widened the income gap have already gone into reverse (a major example being globalization).

So my view is that it’s impossible to know for sure where valuations will go. But I do think you raise some good ideas.

[carlsbadworker]

Rich, thank you for the comments.

I’m not confident about my reasoning at all. That’s why I’m offering here for critique.

For examples, one of the way to separate buyers is first-time buyers v.s. investors in housing market; or trader v.s. holder in stock market. As itsdd pointed out, sentiments change, and I think it affects investors more. As a group, they tend to buy high and sell low.

Current real-estate price has already made first-time buyer hard to qualify or even if they do, nerdwallet survey shows 1/3 of them feeling less financially secure after the purchase. That would probably mean that investors are the main buyers now. The trend is very pronounced in a bubble country such as China (https://qz.com/1615596/chinas-debt-disease-is-infecting-its-housing-market/) but I don’t know where to get the corresponding data in US.

That said, I just said that massive decline (i.e. reverting back to historical median) in short-term (2-3 years) in unlikely. One of the wild card that I watch for is China. Given its global influence today, a turmoil in its economy can have severe international consequences, especially considering internal politics alone has a potential to bring turmoil in China, rather than the external factors like trade war. Xi should worry more about Hong Kong than Trump.

[Rich Toscano]

cb, you are right, I kind of misinterpreted the end of your original post there — sorry about that. I do agree that a near-term, steep pullback seems very unlikely*. Longer term, though, it’s really hard to know where valuations will go.

(* The one plausible exception case here would be if interest rates rise substantially. I know everything thinks that’s inconceivable now, but regardless… if it did happen, it would whack the market pretty hard I think.)

[phaster]

[quote=Rich Toscano]
it’s impossible to know for sure where valuations will go
[/quote]

yup,… but don’t think there cannot be smooth sailing over the long term given various debt obligations

http://www.TinyURL.com/InvestorWarning

and economic/political ideas like MMT

https://mobile.reuters.com/video/2019/08/07/mmt-a-controversial-idea-to-boost-econom?videoId=583592852

so think it is not unrealistic to expect some kind of economic turbulence in the years ahead

[Author]

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