TDI Podcast: The Next Phase (#973)

27:40No matter how tough it is to get, they're going to go and they're going to over subscribe to it because they don't want it going up. They're buying more than they need to make sure they have the compute. We got that. Fine. That's one story. And that is impacting the biggest of the big companies in a lot of different ways. But because it is that and we have a market cap weighted indices out there, that's a good thing. OK, fine. We hear last week from a company like, I think it was last week or the week before, Whirlpool. They come out and they talk about some horrible numbers, by the way, and their outlook is terrible.

28:18And they are saying that the war in Iran is creating a depression, recessionary mindset that they haven't seen in a very long time by their customers. People are just not buying. I don't know. It's just not buying their goods, not buying their washing machines and their dryers. And I would because I think they stink, by the way. Just got rid of all my whirlpools. That's a different discussion. But nonetheless, maybe something's there. And then finally, we see another example on the other side of a company like Shake Shack. Shake Shack came out with earnings a couple of weeks back, a week and a half back, I think it was.

28:53And what was interesting about that was if you really just take a moment, just a second, and think about it, and you think about Shake Shack, what's happening? Shake Shack is, they were down huge on their number. The lowest they've been, I think, the high of Shake Shack back about a year ago was, what, 130? Currently trading at 68. They're in the market with burgers. That's what Shake Shack does, right? Plus other things. But the market of burgers and they put tomatoes on it. All those prices are skyrocketing. Beef prices out of control, not to mention GLP-1s that are stopping people from eating a lot of this stuff.

29:31So they are in that too. So we got a weird market environment that doesn't seem to want to go down very much for anything. But yet underneath it, there's a rotation and weird things happening. I think part of it is there's a complacency that's been driven by the fact that, you know, economically, we haven't been bitten with a recession, with a real recession, in such a long time. Matter of fact, put it in perspective, the last recession technically was the two-month recession at the start of COVID. And I don't think anybody thinks that was a cathartic, a kind of a typical, you know, reset recession.

30:06Right. So what that does is it takes us back to the start of that period, which would have been essentially at the 2009, at the end of the 07-09 recession. So to put this in perspective, and I think a lot of people consider what happened in the technical two-month recession during 2020 to be, let's say, a footnote, kind of COVID-caused. If we look at the current expansion as having started in 2009 and run to present, as a matter of fact, we're now over 200 months without a recession. Put that in perspective. Without a declared recession. Without a cathartic recession. Again, I'd like to, there was a declared recession at the COVID.

30:50NBER did declare that two months, February of 2020 to April, two months, February to March, March to April as a recession period. But I would consider that from an economic standpoint, that the economy, that that was not a cathartic. It wasn't a reset. Matter of fact, if anything, ironically, that recession probably caused more dislocation than it corrected. Yeah. Well, because, you know, recessions happen because prices get out of line, profits get out of line, spending gets out of line, capital gets out, things get out of line. Labor gets too tight. And that's what drives recessions. So the last time we had one of those was the 07, 09 period.

31:30The longest recession in history, if we, again, excluding the current period, was 120 months. And then before that, 106 months. I mean, so we're nearly twice as long as the historically long recession. I'm sorry, expansion. Expansion. I was thinking, what was that? I don't remember that. I don't remember recession for 10 years. Okay. No, expansion. Exactly. Expansion. So expansion, the longest expansion in history prior to the current 10 years, round number. Yes. And I think the message there is that time does not drive a recession. Dislocations drive recessions. So I'm not suggesting that because we're long in the tooth on time, that we're due for a recession.

32:12What I'm saying is that it has been a long time. And if we look at the dislocations that are out there, some of the things you just mentioned, the magnitude of what some would consider irrational spending on creating data centers and power plants, et cetera, just to power AI. If AI doesn't turn it, an AI like.com could change life as we know it. But if it doesn't create profitability and perpetual profitability, it won't, or at least sufficient profitability, it won't have paid for, it won't justify all the expense that went into it. Yeah. You know, it's interesting. I was thinking about just the other day about this whole idea of the chip cycle.

32:52And again, a couple of weeks ago, AMD came out with their numbers and they came out with a stellar report. Just absolutely beautiful. And one of the things they talked about was, and why the stock went up so much, was that over the next three or four years, they're predicting about a 35 % increase in revenue year over year for the next X amount of years. And what's interesting about that was, and why people got so excited and off-site about it was, just in November, they were predicting about 17 % of an increase. Now, if you stop for a second and think about that, they were thinking 17 % increase year over year for a number of years, and just six months later, was that, wait, November, December, January, February, March, five months later, they're talking about how there's going to be a doubling of that number over the next four years on an annual basis.

33:46These are big numbers we're talking about now. But I find it very fascinating that people seem to forget the entire semiconductor cycle over history, which has been boom to bust, boom to bust, boom to bust, right? And you've studied it. You know it, right? Semiconductors are definitely one of the most cyclical items out there. Right. What makes us so sure that in six months from now, they're not going to have a major tweak to their numbers just as easily as they had a major tweak to their numbers? Because I think psychology is, well, you increase from 70 to 35. They may go from 35 to 50. But what happens if there's another technology, lack of money, the list goes on and on.

34:30Have you thought about that? That's a pretty interesting concept, right? Well, that and other factors that we have sort of extrapolated out, whether it's that earnings, S &P 500 earnings growth, that projected to be more than 20 % year over year. I mean, what happens when that gets revised back to something more realistic at some point? And again, it doesn't mean we won't have a year or two or three of that, but what we won't have is 10 years. What we're very unlikely to have is 10 years. Unless this time's different. That goes into a discussion at CAPE that I know you're very fond of talking about.

35:05I'd like you to do me a favor. I'd like you to spend a moment talking about, because this is something that is really in your bag of tricks, I think. The CAPE ratio, what it is, how you look at it. There's different ones to look at. CAPE 20, CAPE 10s and all that, right? It's different ones. but different periods, but basically this is the Shiller created device to figure out valuations that are really appropriate. Yes. And, and, and a big element of this is that the earnings go through a business cycle and that business cycle can be five to 10 years. And so CAPE is conservative and it uses 10 year period.

35:46And so it looks at the earnings that happened over the last 10 years, the ups and downs, put them all together, inflation adjust them, and use that as your earnings base against the current valuation level. Because what Schiller found was that at times when we have a soaring profit margin, that tends to understate PE. And then when you get the pullbacks in earnings, that tends to overstate because you've lowered the denominator in relation to valuation. So the way to normalize that, or the way that he normalizes that is by taking 10 years worth earnings, inflation adjustment present, and then use that as a denominator.

36:23And it's been a pretty good, it's not been a, it's not a trading signal in any way. Because it's so long until something moves, right? Right. So therefore, but it does tend to reflect the normalized longer term trend of relative evaluation. And so that's where the KPE is useful, is to put valuation in relative perspective. Crestmont has a different version. The Crestmont PE is based on looking at the relationship between the long-term relationship between earnings and GDP, the economy. And historically, those, Again, there's a business cycle that runs at a much more rapid pace than the economic cycle.

37:12But by looking at the normalized relationship between the two of those, it, like the CAPE, if anything, the two of them come at a normalized PE very differently. But what they do provide is they have a very high correlation between them because normalizing earnings gets out so much noise that can be distorting. The reason all this is important is that what Schiller has shown, what Crestmont has shown, is that the normalized PE is a pretty good predictor of longer-term returns. Not of short-term returns. Forward returns. Of forward returns. Right. And because if you buy things at an expensive rate today, what you can count on is you will have a lower dividend yield, that those cash dividends relative to a higher price will have a lower yield.

37:59Right? That's just math. The second thing you can count on is that when you start with high valuations, your dividend yield is lower, your likelihood of expansion of PE becomes lower at higher levels, and therefore your 5 and 10 and 20-year returns will typically be below average. And that's what history has shown. So what Schiller believes about the CAPE and what I believe about the Crestmont PE and the CAPE are that they're good indicators of what we can expect for the next decade, not necessarily what we can expect for the next few years or even five. Now, you put your name on this, so you must have a lot of strong belief and feeling that this is something that you can be proud of and something that you could actually rely on and something that when you talk about is not going to let you down.

38:42So what is it telling you exactly right now? It's telling us that we're set for a decade from this point of below average returns. Now, couldn't we say that two years ago? Oh, absolutely. And then if that's the case, just follow me here for a second. If two years ago, we believe we were going to have below average returns over the next decade, okay? Now we subtract two years, we're eight years into that part of the decade, right? And we've had above average returns over the last two years. Does that mean we get below, below average returns? And the, well, and the answer is yes, because valuations are now higher than they were a few years ago.

39:20By the way, likewise, we could have not just two years ago, you could have five or six years ago when valuations had moved up to levels that were above historical, were in relatively high levels. One would have said then that they would have been below average. I think the biggest difference is, and you can look at some of Grantham's estimates and forecasts and others for returns. they have gotten markedly more negative because at higher, higher valuations, at some point, well, something has to change at some point, or there's a reckoning evaluation back to more rational levels. But again, it doesn't mean it takes a crash to do that.

40:02What it can mean is just a kind of a choppy muddle long period of below average returns that the aggregate matter of fact let's put in perspective when the market pulled back even in coming off of 2000 we had a decade of the 2000s that was well below average returns right only when we got out into the into the 2010s and then we started to move valuations back up did we start to see returns pick up and and the reason we've seen such significant multi-ten year returns over the last few years the ends of tenure periods being so high is we now have a CAPE at 31. We now have even reported PE without doing a normalized is over 25.

40:44And historically, those numbers would be around 15 or 16.

40:53Today, it's interesting because there are a lot of beliefs and there's a lot of people that are creating predictions. We have the Tom Leaves of the world that come on and say, we're going to have a whatever the number, 7 ,800 of the S &P by the end of the year. And he's been right. And I don't know, by the way, if the markets actually would have been down if he still would have these beliefs, right? This seems to be a constant bullishness. and television and financial shows, they like it. And as a matter of fact, you see a Jeremy Siegel come on the show. When things are down and out, they bring on Jeremy Siegel because he's usually, although lately he's been a little bit less exciting in terms of being bullishness.

41:50But there's all these people doing predictions on there. But I think you often emphasize the discipline side, which is good. And that's why you're on the Discipline Investor Podcast, by the way. But what does discipline practically look like for investors in the next few years and what you would look to do as well as an investor? I think what it says is that we want to have an exposed but a relatively hedged of sorts position in the markets. Markets, whether it's bonds, stocks, et cetera. We need to recognize that there are ways to structure portfolios. And again, I'm a market climatologist. I'm not, and as people found in Unexpected Returns, the book I wrote over a decade ago, almost 15 years ago, almost 20 years ago.

42:49Time flies. Stop right there. You're going to, it can be 30 by the time you're done. Go ahead. It does. It does. So the message, I think it's that, again, we leave it to the experts to pick the way to structure portfolios, but the goal is to be able to participate in the upside at a greater rate than you participate in the downside. to recognize that there are ways to structure portfolios, ways to diversify portfolios, diversify for risk, so that if we do have those pullbacks, we do have those storms, that we still get a reasonable level of return and that we, again, remember the first rule of investing is don't lose money.

43:34Realistically, for many investors, it means lose less money because losing less money in a big downturn has a significant effect because the losses are disproportionate to gains. If you lose 10%, you got to make 11 % to make it up. But, but if you lose, um, 50, 50, that's the one I always give people. I always say, this is my, this is my baseline financial quiz for investors who just want to like let it all loose. You know what I mean? I say, if you lose 50%, how much do you have to make back to get to square one? You know what they're 50. It's a hundred. It's a hundred percent. But you know what their answer usually is, right?

44:1050. Right. Of course. Yeah. Yeah. And, and, and just like the NASDAQ investor that lost 80%. Okay. It takes 400 % to make that back. I mean, it's just, it gets disproportionate. The loss is disproportionate again. So it may not sound like a big difference, but if you, if you can control, if they're in a 20 or 30 % drawdown market, if you can contain your losses to 10%, you're well positioned with 11 % to get back to even, but the other portfolios that were just passively exposed have a long way to go. Yep. Yep. But again, I'm, I'm, I'm, I shouldn't be saying things like that to the discipline investor because obviously that's all that's a big part of what discipline is about.

44:49Well, that's, that is the funny thing is that, that, that this leads me to my next thought that I was thinking about as I'm talking to you here is when we talk about these disciplines, we talk about all the things that are going on. We talk about the news, We talk about the flim-flam trading and all that and these crazy commercials that you see. By the way, I'm pretty much off of most – I'm off of most regular news, you know, the regular news, big news station, off of that. CNBC in the morning is just killing me. I can't deal with it anymore. There's some guests here and there or background or news and all.

45:23Well, Bloomberg television, by the way, to me, if I want to know about investing issues and economy and global issues, non-politics, I just, Bloomberg's the place. It's just easy. And most people have this. And I don't know why people aren't, if that's what you want to do. The other stuff is all for entertainment, it seems to me. But my point is, when we talk about these disciplines, we talk about, you know, what people do with predictions and what this means for people. If we look at all the things that investors are looking at and what's widely accepted as the belief that's inherently ingrained with most investors today, what do you think that history will prove wrong?

46:13I think, well, I think history will prove right that there was over-optimism at this period, and it will prove that discipline is important for investing, that diversified approach is very important to investing, and I think some of that's being lost in this environment. You're talking about, you know, irrational exuberance to a degree. Well, I'm just thinking about some of the signs that are out there. You know, one thing that I came across my desk a week ago or so is the change that Standard & Poor's is proposing for IPOs. They're talking about because of some of these, you mentioned AI and all of them spending, et cetera, et cetera.

46:58Well, we know the AI companies lose a lot of money, but they have these huge valuations. And so they're looking to go public. Well, they're likely they're going to waive the rule that requires that IPOs be profitable to get into the index. And they're going to delay, they're going to accelerate the period of time from 12 months to six months that they have to wait. Well, this is what the NASDAQ is doing. The NASDAQ is appeasing SpaceX when they come out within, I want to say it's five days or something crazy, that they'll be included in the NASDAQ 100. And to me, that is, and you think about as well, how much, how concentrated the index gains have been in a short list of stocks.

47:42So we're reducing transparency. We have this ultra high concentration of effect that I think it's translated. I think most people, rather than looking at buying a basket of 500 stocks, what they're really getting is kind of half a basket of, or more than half a basket of seven stocks and a basket of 493 stocks. But there's a perception of diversification that doesn't exist because it's so concentrated in its gains. I had a guest on a couple of weeks ago that talked about this. We talked about this. I talk about this a lot. I talk about this because it's still to this day hard for me to wrap my head around.

48:24The market cap weighted index concept with all these big companies being the largest of them, right? Yes. And with people, like you said, thinking it's diverse. But he said something to me that was really, I was like, hmm, you know, that makes a lot of sense. Because we're talking about momentum investing. And we're talking about trend following. and trend following always was like this idea that I read about, Michael Cavall's book, you know, Turtle Traders and all that. I read about this and a few others out there, and I'm just like, I don't get it. Literally, I don't get it. And he said something to me.

49:00I think it was, was it Meb? I don't know. Somebody, I forgot it was the last couple of weeks. I'm not sure who it was exactly. But anyway, the idea was this, that if you want to do the ultimate trend following, or maybe it was Howard Lindzen, If you want to do the ultimate trend following, just follow an S &P 500 market cap weighted because what's happening is the larger companies are getting larger. And you're following that trend as they get larger. And technically the S &P 500, the NASDAQ 100 is the ultimate trend following tool if you think about it for the lazy trend follower. Because of the current market dynamic.

49:37Yeah, because the current market dynamic and the way of the construction of the constituents inside of that particular index. I don't know why S &P – do you know why – do you have any inkling why S &P is going to do this? Oh, I think that it's trying to include some of these major companies in the index. So you're talking about the Anthropics, the SpaceX, and OpenAI potentially? Exactly, yeah. And they're going to disband their rule. I wonder how that is going to impact, I guess, index traders it doesn't matter to, but how that's going to impact S &P benchmarking funds. That seems like a pretty drastic move on their part.

50:25Well, and the third component that they're going to waive also is normally they require that there be more than at least 10 % of the stock of the company be publicly traded. And they're going to waive that requirement too. I mean, it's, I think it's the kind of measures that if we talked about the things that S &P would be known for, for being more of a stalwart of a prudent index, right? Not a more aggressive space like we find a NASDAQ to be. But S &P, I think they're trying to be competitive. They're trying to be relevant. And they're trying to include the types of companies that I think are driving market valuations today.

51:07That could bite them in the ass pretty good though. I think absolutely. And if I was to place my bet on that, I would say it would bite their ass more than longer term. If in fact the waiving the rights, waiving the ability, see what's going to happen is that investors are going to get pretty pissed off that in the NASDAQ 100, SpaceX is going to be allowed to enter into it, especially with the current structure, if you read anything recently about the structure of how the share class are and the lack of friendliness to shareholders in this deal compared to what Elon Musk owns. What's interesting about this is if they're allowed in five days or whatever it is, some short period of time, before the lockup periods expire, the rug pull is going to be on the public markets that is going to be pulled by the insiders on this deal because you have a fully valued deal, 1.5 trillion dollars plus or minus a few trillion of this.

52:08It's a total rug pull potentially. Absolutely. You know, I think when they make that change, they're moving away from another tenant. And that is, you know, it used to be that everyone looked at as reported earnings, gap earnings, as the true earnings of a company, because that's what's really available after it's all over with to pay dividends, et cetera, right? And to retain an earnings. Sure. And it was a couple of decades ago that operating earnings became really popular. Wall Street said, you know what? Why don't we add back the non-recurring stuff since it's non-recurring? Well, I spent a couple of decades in private equity.

52:47And when we would value companies, the one thing we wouldn't do is add back all the non-recurrings because for some reason, companies seem to have more different kinds of non-recurrings the next year and different kind of non-recurring the following year. Sure. And so we need to recognize that the businesses, by definition, have a certain amount of that element. And if you add it back in belief that it is going to be suddenly going to be available perpetually to pay dividends or going to be available to retain in earnings, then it's mistaken. And I think what we just talked about here was they're going to bring companies in.

53:19They're going to have losses, but they don't believe that they're going to be perpetual losses. And so pretty soon operating earnings is going to get more and more visibility to compensate for some of these very large companies that have got very large losses. They'll make the case that as reported earnings with those big losses in there aren't relevant anymore because these are companies that are distorting the index.

53:47anyway i i think that to me it's it's it's emblematic that we might be um toward the later stage psychologically in of the kinds of things that we saw back in the 90s the things that we saw in the 20s yeah it is a a sign of frothiness when uh companies that have a decade of that century-old process decide that for the reason of competitiveness in a hyper-competitive world, that they're going to take off some of the guardrails in a sense. I think that's the key. And again, none of this pretends, and even our discussion, and I want to be really careful that as we talk about some of the risks on the horizon, that they're not, they do not appear to be on the near horizon.

54:38Yeah. At the same time, history has shown us that they don't, that a lot of times they don't appear on the far horizon. They just suddenly show up on the near horizon. Right. They just pop up. And it's often, it's often not because one thing happens, but because several things happen at the same time to cause that, you know, it's some factor, you know, because you've mentioned some things on this, discussion, and I've seen some of the articles as well, about there's certain retailers that are reporting some challenging short-term trends that are beginning to appear. Some of the things that you mentioned early off that are driving this, whether it's some of the leftover spending from four or five years ago, Inflation Reduction Act, et cetera, the big, beautiful bill.

55:25You know, there's just, I think there's a lot of, there's a lot of spending that has a very short term, I'm sorry, it has a short term, very stimulative effect. And we're probably seeing some of the effects from that right now. Crazy. Good stuff. So in closing, and let's talk about, of course, we'll have the information on Crestmont and Ed on the show notes for episode number 973 over on thedisciplineinvestor.com. So make sure to get your butts over there and check it out, by the way. But we got this inflation situation. We talked about a little bit. We talked about the practicality of valuations and looking at either the Crestmont model or the CAPE model, which both have their similarities and differences significantly, that showing both that and of your other research, whether it's any of the metrics you look at, we're seeing pretty highly elevated, which again, doesn't mean necessarily that that elevation has to, we don't have to have a crash for that elevation to come back to normal levels, but we have to see potentially, which that could do it, but it also could be just a longer period of time of just a slowdown, if you will, just slowing the process.

56:39So that's something you mentioned. But one thing you didn't talk about, I don't think was, we didn't talk about very much, was this record level of debt that is now in the markets. It's a pervasive situation that has been, I think, the propagation of debt that we've had, whether it's private credit, whether it's corporate debt, whether it's government debt, but the acceptance of utilizing not just debt, by the way, but extreme debt. But for years, Ed, we scoffed. I don't know if you were a scoffer like me, but we laughed and chuckled and looked at Greece and Italy and the pigs. Oh, my God. how they got 200 to one or two to one GDP to price to earnings or whatever particular measure we use GDP to debt or whatever, or even the GDP.

57:49I'm thinking there was like so many different things, and we would laugh. But we got to stop and look at ourselves in the mirror, don't we? Well, and I think there are two things there. First is the debt that we have out there. The question is, what did we get for it? And I think that the dilemma is that it isn't that we're looking at and seeing all kinds of productive assets as a result of it. We're looking at a lot of programs where that money went, that the money spent. And it's not necessarily paying dividends. I'm concerned about the debt, but I'm highly concerned about the trend in the increase in debt, the deficit.

58:25Yeah. The deficits that we're seeing that are appearing at national, state, and local levels and how the trend is toward raising taxes, fees, and other things to pay for that, which is just going to take – it's a vicious cycle of pulling out that purchasing power, pulling out that investment power to meet consumption needs. And I think that's the farmer eating the seed corn. That's not a good thing to do. Yeah, we call that cannibalism. Another way to look at it. You know, you could probably eat your own arm for a little while and it would be probably nutritious. But after a while, things get a little bit hairy, don't they?

59:08They do. They do. So I think that's and and unfortunately, right now, it doesn't seem that that from all sides that there's that there are there are small elements of fiscal responsibility that are trying to influence the process. But I think there's a much larger constituency that sees that has a desire to continue the spending. Yeah, good stuff. Ed Easterling, always a pleasure. Glad that you're going to be entering into, where are we now? We're getting into the rainy season yet? No, not yet, right? Oh, no, it's for Oregon? Yeah. Oh, no, actually, we're heading into dry season. So we're on the west side of Oregon.

59:52And here we're now moving from a kind of a, we've had a somewhat drier than average spring. But our summer times, people don't realize up here, summer gets very dry, almost no rain in July and August. Our fields go brown. Really? Trees stay green, but the fields go brown. And then we get the rain back again in September. And then we get most of our rain over the winter. Aside from me talking to somebody in another country, we are probably the furthest apart distance-wise. South Florida to Western Oregon. Yes, we are. I could be probably, I don't know, would it be just as close for me talking to somebody in London?

1:00:34I don't know. It's probably close. Probably we'd be close. Now, one thing we do have in common is your weather is relatively temperate, although on the warm side. Yeah. But, right? And our weather over here is also relatively temperate. We don't get a lot of days on the western side of Oregon. We don't get very many freezing days. And we don't get very many really hot days because we get the Pacific Ocean right near us. And so that brings cooler air in at night. And then during the winter, it brings warmer air in because it's coming across the ocean. You do any fishing over there? There is some fishing out here.

1:01:09A lot of good, really good fishing. What kind of, what kind of stuff is caught there? Is there yellowfin tunas? Yellowtail? A lot of tuna. You can go. You got the Pacific sailfish. Steelhead trout. Steelheads, yeah. Yeah. I was in not too far, well, far, but not too far, farther than it is for me. But for you, I was in Alaska about eight months ago and just had a great time with the halibut and the salmon. Oh, Alaska's great fishing. I've been there a couple of times. And do you camp out or do you stay in a lodge? You know me. I'm staying in a lodge. I could camp out. But at this age, at this point, I'm like, oh, I don't want to stay in a camp out.

1:01:49I'll stay in a lodge. Which, by the way, was not like a lodge. It was in between camping in a lodge. Okay. So it was great. Good stuff. And thanks for coming aboard the Disciplined Investor Podcast. We'll do it again soon. Andrew, you got it. All the best. Thanks. and another week and another great podcast guest, great discussion about what's going on around the world, especially with UBI and the things that make you go, hmm, what's going on with that? But nonetheless, we have a lot to talk about now and through the end of the year, we have a whole slew of fantastic guests that are lined up for this show.

1:02:24We have great conversations, great education, information, all the things you need to be successful in this crazy market, crazy world of investing. Stay tuned, stay here, the Disciplined Investor Podcast. I'll see you next week.

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