TDI Podcast: The Physics of Finance (#951)

29:09And it's way above its 10-year average, which tells you the smoothing average of the smooth index is way out of whack. Is that something that's concerning? And if so, what do you do about it? If not, why? Sure. And I would tend to look at this as the CAPE ratio would be a data point. If it were the only data point out there showing that we had this ultra-high valuation, then we could call that anomaly. Instead, it's really a confirmation. It's a confirmation of other measures of excess valuation, whether it's the valuation in relation to price in relation to assets, or assets rather, book value, whether it's the other different measures of valuation that analysts use.

29:55we're finding that all of them right now have very high values. So I think there's a recognition the market's high. In my mind, the question is whether it's high in anticipation of things happening or is it high because it's gotten very frothy, because we have a very speculative tone in the markets right now, right? It's not just in equities. We're seeing it over in the debt markets. I agree, debt markets. I was just looking at some of the performance of our debt this year. I'm like, what? I mean, I knew the numbers, but I looked again and I'm like, wow, that's unbelievable. That is literally unbelievable.

30:32The fact that we've earned eight and a half percent on our debt, for example, for this client this year on on on the international side, it has been outstanding. But the bigger question is, I think when we look at this, is that if in fact we have powers, beings, institutions that don't care about valuations. For example, you have an announcement by X company that they're going to do a$6 billion,$7 billion,$10 billion,$2 billion buyback. And the reason for that is to buy back shares to help their earnings on an EPS basis, right? And on top of that, to hold up the stock because the options exercises that are going on by the insiders need to have stocks that are, you know, need to have buyers of them and being held up.

31:33And they don't really care about the timing nor the valuation. And because of the share shrinkage, because the share shrinkage and the number of companies, there is a fascinating story on the amount of actual companies that are in the market. The amount of actual stocks that you can buy has shrunk dramatically over the last 20 years. And the share count has shrunk dramatically, not in totality because new companies come out, but on a company-by-company basis. I mean, they keep on shrinking it. And that being the case, they're goosing their EPS. There's another data point for you. Is that something that is in your radar?

32:12Oh, let's see. It's certainly something to consider. I think the goal, though, is to recognize, or one of the aspects is to recognize, that just because we're reducing the available stocks, that may reduce the supply available to investors. And therefore, it may bid up prices out of scarcity. Yep. But what that doesn't change is the fact that those investments, because of their price in relation to their earnings and their growth and earnings, are setting up for below average returns or well below average returns. So I guess if I'm an investor and I hear, gosh, market's high valuation, I'm looking for, does that necessarily mean that I'm going to have below average returns?

32:56Because historically, high values led to below average returns. Below average values led to above average returns. Because if you pay less for something, a stream of earnings, you get a better return than if you pay a whole lot more for it. I just don't know necessarily if with all the confusion, chaos, central bank tinkering, buybacks, sovereign wealth funds, I just don't know if price discovery is even a thing right now. I don't mean to sound all dour about it. No, no. I think what you're describing when you say price discovery, what I hear there is, is the market functioning normally to recognize that it's buying something in relation to a future return?

33:40Right. That's what I mean. Instead, it's really buying it more in relation to momentum or scarcity. I mean, we've seen, but that then misaligns a fundamental relationship, the relationship of the return for investors coming out of a company, the fundamental return of the earnings in relation to the price they're paying. Right. Right. It's distorted by the fact that their current price of their investment is going up, despite the fact that it's getting well beyond the reach of those earnings. Right. But interestingly, we're seeing the same thing happening in the housing market today. Well, how's the house price?

34:16Well, how's the house prices? I was just talking about that before. House prices. It's not, you know, this whole notion or it's misguided notion that housing that people are not able to buy houses because interest rates are too high. No, hello, they can't buy houses because prices are absurd. And people, as it drives down into payment, right? Because at the end of the day, people don't buy homes on price, they buy it on payment. And what happened four or five years ago, when mortgage rates went down to 3%, the value of the house that they could afford to pay to still keep a low payment was very high.

34:55And it boosted prices up significantly. Right. Right. Okay. And by the way, we talked about the fact how prices are going up because mortgage rates had gone in half from over 6 % to less than 3%. And that's a natural reaction. That's physics of finance. Now, what changed though was suddenly in the last few years, mortgage rates have gone from that below three to now six and a half. We should have found that physics would have tempered, if not caused those prices to return back to levels that were normalized with that level of payment. Yes. But it hasn't happened. Matter of fact, I think I saw a report out that one of the first reports came out that housing prices may have declined by 1.5 % or 2 % last year.

35:40Right. Now, that doesn't realign to payments at all. That does not, in fact, most of the charts are showing right now housing price to income. But what housing price to income doesn't show is the housing price to payment or the payment to income, you might say. Or the affordability of housing. And I have a chart. The National Association of Realtors put this out. And we did some calculation on that as well. but you could look at what the housing affordability index is and when it's better, when it's above or below this particular line, it's either better to buy or rent. And it's still better to rent.

36:26And that's been like that for a few years now. Because of the income stream, that takes into consideration all the things you're talking about here. Right. So I think the key message here that we're hitting on, we started talking about market valuation, stock market valuation. Now we're talking about the residential real estate market valuation. We look at the debt markets and look at the misalignments that are occurring there. So I think sort of the message is we've got this basket of misalignments that are all fundamental valuation based. And therefore, it feels frothy. It feels like there is an optimism.

37:07That's actually different than it was in 99. Let me just mention, because in 99, there was an expectation that the technology surge at the time would cause GDP to upsurge to 4%. Greenspan wrote about that at the time. So his contemporaneous view at the time was that that would cause economic growth, therefore earnings growth, et cetera, for a decade or longer, according to Greenspan, go up to 4 % real growth. So that was justification for it. I'm not seeing the same thing here today. Even AI, the Fed's saying it might add maybe a point a year over the next decade. Not even that, maybe half a point over the next decade.

37:44I mean, there's some definite productivity issues. I mean, I feel it. Sure. And I'm just a small little, you know, nothing when it comes to what the real use factor and real use cases for AI. Even if you stop, even if right now is the top tier, is the ultimate of what AI is ever going to get to right here, I find a lot of really good use for it. And in fact, just the other day, I was doing an Excel spreadsheet and there was some complexity to it that I needed to do a comparison between a few different columns that were dependent on the other column. You follow what I'm saying? And I'm like, oh, I can do this VLOOKUP.

38:23I can do this. I don't want to do this. Let me hand it off to someone in the office. I said, you know, hey, I got an idea. Let me just prompt, co-pilot and excel. And by golly, it took me about three different prompts because I had to get right what I was saying. And it gave me the full thing and created the spreadsheet with the information I needed.

38:41That's pretty cool. Yes. So, but let's also agree, or maybe not. You can disagree if you want, but I'm thinking you can agree. is that, well, go back to Greenspan. You have irrational exuberance and you have the old phrase that markets can stay irrational longer than you can stay solvent if you're going against it. But there's a lot of ways this can come out. And part of it is markets can stay at this level and earnings can grow into it. Economies can continue to push forward and it can be various factors like lower taxes, for example, is one of the reasons why margins are so good over the last five years or so.

39:27We know that, the lower tax rate on companies. But it can stay here for a while and doesn't necessarily have to end like a lot of these doomsayers in a crash. It could just be, or massive correction, it could just be just a slowdown for a little while, a little bit of a layoff for a period of time. And maybe not 20 % growth a year like someone who just entered the market thinks it has been over the last three years, but maybe 5%, 6%. And certainly over the very short run, over a handful of years or so. What happens ultimately, though, is if those margins are excessively wide, therefore the return on capital is excessively high, it will bring new entrants into the market.

40:11Right. Or the existing entrants will use that as an opportunity to build market share. It's the age-old business cycle that's gone back since business. And those competitive forces will normalize those margins over time. In the short run, they can certainly be winful profit. But in the long run, financial economics will drive those things back in line. And that, again, is what – but again, this is not a new phenomenon. We look back over the last 150 years in the stock market, and in the economy, we've seen the same thing happen over and over and over. Yep. But let's switch over because you mentioned GDP and you mentioned your particular gauge and you, you know, the way of using GDP and the, the Cleveland feds inflation now casting forecast in December is looking at CPI to increase by, you know, 3%.

41:00Right.

41:04And we don't exactly know because we don't have the data because the government was close. We're not exactly sure. Or PCE came in, they say, at the lower than expected. But it was, I mean, look, 3 % is 3%, okay? Higher than the 2%. By the way, just for those that want to keep score at home, 50 % higher, 50 % higher than where they want it to be. And they feel they can bring it down quickly, which they have not been able to. And mark my words, lowering interest rates is not going to help that cause. But is inflation stabilizing, in your opinion, or even beginning to decline? Or where are we going here?

41:43Well, I think, so two messages there. The first is the Cleveland Fed does estimate 3 % for November's report, which comes out in December next week. They did not have, the Fed, the Bureau of Labor Statistics did not produce a bottoms up number for October. Right. They did do an extrapolated number because they needed a number to be able to use for tip securities, et cetera. And the number they extrapolated was 3%. Or extrapolated equals guessed. Go ahead, continue. Exactly. Just mathematical, exactly. So this number we're going to come out with is going to capture two months worth of underlying market information.

42:26Now, all that being said, I would anticipate that we're seeing a moderation of inflation beginning to occur. But because last November, November year ago's report, inflation report for the one month of November was negative just for that month. And that month is falling out of the averages. So if we come in with even a zero level of inflation for the month of November, we will still see an increase in the reported inflation. On the year over year, on the year over year. And I got to tell you, so I'm going to take the over on the Cleveland Fed's estimate because of that. Now, Cleveland Fed has been remarkably, their now casting number has been remarkably accurate month to month.

43:10So I would give a lot of weight to that. At the same time, we have some underlying seasonal factors that would suggest that we could see a number well, when I say well over, 3-2, 3-3 between now and December's report. So November's report will probably be up a little bit. December's report will probably be up a little bit. But then the fun happens because the first quarter of 25 had some really, really high monthly inflation reports. So as those roll off into the early 26, expect that CPI is headed back down. Probably we may recover half the ground between three and two. I wouldn't be surprised if we saw two five on inflation before selling.

43:51But that's because of a technical statistical mathematical. calculation base. The fact of the matter is it's still 2.5%. It still means that if you look at a chart of prices, they will be the highest ever at that point. Right. So why is all this important? Number one, it probably explains why the Fed found the liberty to do one more cut this past week,

44:19Ed Easterling:right? Going down a quarter because they said, you know what? We may get a little heat here in the next month or two because inflation's ticking up, but you know what? They're going to look back I can see that we were wise and foresaw the decline in inflation. The second is they're also seeing a potential softness in the job market. You know, that was, to me, the big report yesterday. The whole headline is about this quarter of a point. I agree. This past week. But I think the real story under that, he thinks that they may be overstating jobs, 60 ,000 jobs a month. And that number doesn't come out.

44:47You mentioned, you know, obscurity and transparency. They're not going to revise the numbers until February. So we're going to finally find out in February whether we've been overstating jobs by hundreds of thousands cumulatively. I mean, we saw that one report that showed, I think it was ADP, that showed, was it 120 ,000 jobs lost in the small businesses in the last month? Right. That was substantial. And it's funny because you don't see it in the economy. You don't see it in the stock market. You don't see it in most metrics. I mean, look around. It's not there. But it's pockets of little things here and there that are adding up to a bigger picture.

45:28You see some layoffs from companies and AI is the excuse they're using. But the economy itself, you know, it's very hard to put together the idea that something is a problem when you have a Fed that's even talking about 2.9 to 3 % GDP number. Unemployment at 4.4 % round number. and nothing's falling off a cliff. Maybe it's a slow motion, but it doesn't look horrible as of yet. And so the chances of the recession, right now the poly betting markets view of recession in 26 has now dropped below 30%. And that's probably even only that high because of the exogenous risk that there's all this, that government shutdown took away a lot of good data.

46:19In a sense, Fed is going to be doing some revisions to this payroll number, jobs number, but that won't happen until February. This inflation numbers, the reports that come out each month, the 12-month report that comes out every month is showing some statistical anomalies that will look a much different picture in four months than it does today. Matter of fact, you mentioned that only takes us two and a half. And that's part of the reason that the St. Louis Fed publishes two numbers that we watch closely. One is the three-year expected inflation rate. And they're saying that that number right now is 2.4%.

46:55So even if we get down to 2.5, it sort of says we're going to stay up in the mid twos for the next three years on average. Um, even more discouraging though, is the five year, five year forward, which is the average for the five years that starts in five years. Right. So that's the back half of the next 10 years. And even that's only 2.2. They're still not getting us back to the 2 % target. Yeah. Even though they say they will, because they have to maintain that status of that. We'll get there. Right. And the big tie back in of all of this to the first part of our conversation is that the P.E.

47:30ratio has typically had a strong relationship to the inflation rate. As inflation goes higher, that causes bond yields to go higher. That causes P.E. ratios to go lower. So higher inflation is bad for valuation. Lower stable inflation is good for that's when we get our best P.E.s. So the fact that we're staying elevated, I mean, it's not like it's not like the market's anticipated we're headed back to one and a half, which is where we were just, you know, five years ago, seven years ago. But again, but again, you still still with that. It's a good environment. Everything's good right now. You know, if the economy is not good, the lowering interest rates, that's good for the stock market.

48:07If GDP comes at a good number, that's good for the stock market. If unemployment comes in at 4.5 percent, that's good. If it comes in at 3.9, that's good. Everybody is looking at everything being good. And the fact is, there's a couple of small pockets of issues that are going on, you know, but everybody's trying to see the future. One of the reasons has been, at least I'm thinking, that there's, again, back to this whole controlled chaos and this artificiality of this transparency, which is really

48:39saying projections that are not actually happening, but nobody checking on it. For example, you know, we know things like, you know, we hear these great pieces of information of things that are going to be happening, but we never, you know, the video chips being sold to China. But then China's like, no, we're not doing that. We're not buying that. You know, we hear things like Sam Altman, Oracle. These players have been boosting and touting. They know there's no ramifications of this. It used to be that, look, I'm not going to, how am I going to give you a two-year outlook? Most companies can't give an outlook past a quarter.

49:20That's the only visibility they have. Maybe six months, maybe, maybe, if they are established. Meanwhile, Sam Altman is saying he's going to spend a trillion and a half dollars over the next 10 years doing XYZ. It's like, wait, dude, you haven't even made any profit yet. How are you going to get all this money? But nobody was looking at that. And I think that continues to be what the investors are. There's a gigantic, here's the point. There's a gigantic carrot that just will not go away. Because I think investors are resigned to the fact, and this is good actually, that we're not looking, this is actually not bad.

50:00We're not looking at today or tomorrow. We're looking five years from now, 10 years from now. Does it really matter if there's a little bit of a correction and overvaluation and a little bit of bubbly right now? I get in now. If it's going to be higher later, what's the difference? I'll get a couple extra points. Maybe that's nice. But it doesn't really matter. Well, we can replay that scenario by thinking about asking ourselves the same thing in the late 90s. But it took 10 years to get it all back, but you got it back in a lot more. Well, not all of it. I'm talking about index-wise. with the subsequent 10 or 15 years providing a mid-single digits return.

50:37I get it. I get it. So you're right. Let's see. I guess, and people often say, the nice thing about stocks, if you stay invested long enough, you'll make money. But you may not make as much money as you can make in alternatives, alternative investments like bonds or otherwise, real estate, a variety of investments that people use. The second is that timing is important, too. because for a lot of investors, those going into retirement or those that are in retirement, having that 15-year dearth before you recover while you're taking capital out can have a significant impact on their ultimate success, investment success.

51:19You brought up just now alternative investments. There's a lot of different definitions of that, but private equity, private credit, clearly we define as alternatives, right? Yeah. And when I threw out alternatives, I realized at that moment that I didn't want to imply the capital A alternatives. I was really thinking about alternatives like bonds. Alternatives to stocks. Alternatives to stocks. Alternatives to stocks, exactly. But you're right. There is a broad marketplace out there of alternative investments that are packaged and available to a broad base of investors. What is your thinking or research or at least your insight into what's going on right now with some of the private credit?

51:58Private equity put aside, there's some issues there that I'm hearing bubbling up to, buying things at valuations that are dumb. And some people trying to cash out and not getting out. You know, some of the players trying to do the round trip where private equity usually does. But private credit, it seems to me that there is an insatiable appetite for debt. which I don't know where it exactly comes from, but it's from a lot of places. Private credit has had its little issues lately with Yieldstreet, with Blue Owl, a few others out there. And we're starting to see little, I don't know if it's canaries in the coal mine or if it's just aberrations of bad firms doing poor deals.

52:40Any insights into that at all? Yeah, well, let's see, just only insight from just from a macro standpoint. You know, all the signs are there. that there's a lot of vulnerability in that market. That, you know, it's not often until the tide goes out that you see whose boat's floating. And I think what we've not seen is a correction in that marketplace for quite a while. So again, I don't have direct insight into specific subsectors or issues other than to say that when we look at the macro factors, that's another area that's showing frothy valuations or low margins that aren't necessarily protective of the risk.

53:24So if we back off of this and look back at this conversation and if you reflect and you had to tell me, I know you're not short-term minded, but I get that. But if you had to tell me your best guess as to the next, let's give it one, three, five, one, three, five years in the future based on all this, right, about your various macro environment, the valuations, the various indicators, things you know, things you see. I mean, is there anything that is flashing a red light that's like, you know, oh, there's a problem or that you've seen before that you'll act on? Or is this more of your run-of-the-mill frothiness?

54:03And how does the outlook look over the next few years? Sure. So as the climatologist, I will answer your question about one, three, and five. Let's go to the back. For the one-year view, let me just flip it. Okay, it said heads. I'm going to go with the markets down. Let's see, three years. Looked at it again. Okay, that says it's up. Now, five years. When we start getting to five years or 10 years, I predict that investors will have well below average returns. That there will be a single digit, mid-single digits or below on a cumulative basis over that period. That this level of valuation, and I think it's a much more likely case over the next 10 than the next five.

54:44just because the momentum is so strong, we could end up seeing a few years here of continuing. I'm not sure right now if we're at 96 or we're at 99. Yeah, that makes sense. You know, the year 96 and 99. No, no, I get that. But at the same time, I think we're definitely quote unquote in the late 90s again. And that if we look out over, no matter where you were in the late 90s, if you looked then to the late 2000s, that cumulative return was consistently mid-single digits or below. And for some sectors, if you were in the more aggressive, and that's the one challenge, and I know you probably talk a lot to market analysts about this, that we have an S &P 500 that's really a small group of high-tech, high-valuation stocks and a broad market that's kind of a separate set of that.

55:33And those are kind of combined together. This is kind of an unusual level of the lack of diversification in that index, right? Yeah, 38 % of the index, I think, is the top 10. Right. Anybody who's anybody will tell you that is not diversified. And that is the potential. But at the same time, because of the way the mechanics of the market, right, and because of all those companies are the big buyback kings, and because those are the players that everybody wants to be with, with a big cash cow, et cetera, right now, Now, listen, would it take a lot to topple them? Yes and no. But, you know, because there's so much money flowing into the path of investments right now, the bigger are just getting bigger, much bigger.

56:18Right. So this is an environment. So, again, I think the forecast, we look back, I think we're going to say, yes, valuations have gotten high. We definitely needed a correction. A correction has helped to put us back on better, more solid footing. and we'll probably look at some small but significant economic challenges over the next decade. Good stuff, Ed, Ed, Ed, Ed. Tell us where people can get information on Crestmont Holdings. Crestmont Research. So it's Crestmontresearch.com. If you go online, it's Crestmont, C-R-E-S-T-M-O-N-T, research.com. It's an open access website with articles, charts, graphs, and other information that are available to investors to use as a tool, as a resource to help in their investment needs.

57:08If that particularly perks your interest, there are a couple of books out there, Unexpected Returns and Probable Outcomes, that go into more detail about this. And I welcome reader comments on any and all of those materials. Great stuff. Great stuff. Listen, you have a happy and healthy holiday, a great new year. Best to you and yours, your family, and all things that are wonderful should be coming your way. And back to you, Andrew. All the best, and I'll see you in the new year. All right, thanks. See you. You bet. That's going to wrap it up for this episode of the Disciplined Investor Podcast.

57:42Thanks for joining me this week. And we have some great things happening. We have Harry Dent coming up, Todd Trezeter in the next week or so, and next couple weeks, actually. coming up. So we're pretty excited about that. We're going to end the year with Jack Schwager. We have a great interview, I'm sure. Going to happen with him, talking about the greatest of the great investors of this age. So don't miss that. Make sure to be there. Thanks for joining me. I'll see you again real soon.

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