The Compound and Friends - What if the cost of capital never rises again? (Josh with Ben)

Episode Date: June 14, 2019

Josh's new post is about a world in which the cost of money remains cheap to free, and all of the potential disruption that would entail. Josh looks at this issue through the prism of a decade's worth of massive outperformance for growth stocks vs value stocks. Ben Carlson (A Wealth Of Common Sense) brings up some interesting points about what this would mean for savers and investors and portfolio construction in general. You can read the post, When Everything That Counts Can't Be Counted here: https://thereformedbroker.com/2019/06/13/when-everything-that-counts-cant-be-counted/ 1-click play or subscribe on your favorite podcast app   Subscribe to the mini podcast on iTunes or Spotify   Enable our Alexa skill here - "Alexa, play the Compound show!"   Talk to us about your portfolio or financial plan here: http://ritholtzwealth.com/   Obviously nothing on this channel should be considered as personalized financial advice just for you or a solicitation to buy or sell any securities. Please see this 3,000 word terms & conditions disclaimer: https://thereformedbroker.com/terms-and-conditions/ Hosted on Acast. See acast.com/privacy for more information. Learn more about your ad choices. Visit megaphone.fm/adchoices

I am on with Ben Carlson, and Ben and I are going to talk about this post I wrote. And the gist of it, and we'll link to it, but the gist of it is that value stocks have underperformed for 10 years. Capital has been so inexpensive that new companies have been able to raise money easily, come along and be extremely disruptive to incumbent businesses that have all of these physical assets like plants and facilities and employees and office space. But they've just been completely blindsided, and what that's done in the stock market is it's favored recurring revenue asset-light business models that are now the biggest market caps in the world. And it's been very negative for companies that have spent the last 50 years building up the things that appear in book value, for example. Ben, would you say I'm describing? Yeah. And your description is interesting. And I want to take it one step further because I think it's the question you asked. And you said that you went to a dinner with William Bernstein and went on the table and asked, well, what is the one thing that no one's really thinking about?

And he said, what happens if the cost of capital never rises again? This is something I've thought about before. So you put it in terms of value and growth, and I think that you're obviously right. But my question is, let's say he is right from here. What does that mean going forward? So there is precedent for this. So I looked from 1924 to 1959. The 10-year never really got out of a 2% to 4% range. So let's say the last 10 years of interest rates does sort of go forward for another few decades.

What does that mean to the economy? Wait, wait, wait. The 10-year yield was trapped between 2% and 4%. When? From 1924 to 1959. So 35-year period. That's incredible. Yeah, 35 years.

And I think the treasury market was a little easier to gain back then. People might say it is now. But so let's say something. So that's not without precedent. Let's say something like that happens. What does that mean economically to something like inflation or commodities or asset returns? So I'm taking it one step further. I think that is worth considering.

What does that mean? it one step further, I think that is worth considering. What does that mean? So what are the implications for what you could expect to get from asset classes if the 10-year yield is pinned somewhere between 2% and 3%? Yeah. And what does that potentially do to cycles? Do we get these mini booms and busts because, like you said, all these companies can fund themselves for nothing, basically. You know what's funny? I think it creates a new series of rules of thumb that people start to go by. And one of the examples that we talk about is how for like 30 years or 50 years, there was this thing in the stock market where the pros would say, anytime the yield on dividends dipped below the yield on the 10-year treasury, that was the signal that it was time to buy stocks or rather time to sell stocks because that meant stocks were

too expensive. And then in the late 50s, all of a sudden that flipped and bond yields pretty much permanently were higher than stock. And people just weren't ready for that new world. And it never went back the other way. So like we might now have these new rules of thumb that people come up with and maybe they work for a long time. And maybe a lot of the old things that we used to think were important, like the risk-free rate, etc., maybe the distortion just changes all of these existing ideas about when to invest and what. So the other question is, does a mature economy like the U.S., do investors deserve to earn a decent return on their cash? Is that something that we should rethink as well?

I don't know. I'm not smart enough to answer that, but should investors in something simple as cash earn a high return on their capital? Yeah. A lot of the people that, a lot of the bears, the macro bears and the people that didn't buy equities 10 years ago and stayed out or stayed underweight. They scream about this, the Fed is punishing savers because you put money in a bank account and you can't really earn anything on your... Where does it say in the Constitution or otherwise that risk-free rate of return deserves to be a certain amount? Why do you deserve to just get paid money to take no risk at all? It would be nice if you could, but if you can't, that's not like somebody's taken something away from you that you were born deserving. Right. Yeah. You have to take some risk if

you want some reward. And to your point about the new rules of thumb, it's kind of funny that the quants all figured it out like i don't know in the last 15 to 20 years like this is how the markets work and then over the next 10 years none of what they figured out has worked which you pointed out like no fund manager is ever going to buy expensive assets and then continue to buy them as they go up which is the only strategy that has really worked out perform over the past decade or so yeah you know, maybe it was Ken Fisher. I think his first book was about price to sales. Like that was, that was his metric. And then like he gave an interview, I think he was talking to Barry and he's like, yeah, at some point I became famous for that. But at some point

I had to abandon it because it just wasn't reality anymore. So now you have probably a trillion dollars in smart beta strategies and Zweig's piece where he looked at growth not only as outperformed value over 10 years, but I think this has now gone on long enough where over 20 and 30 years, it's neck and neck. neck and neck. So much of that mythology around value wins in the end, it's gone. 30 years is an entire retirement savings period. So it's not that it won't work. It's that you're not guaranteed that that will work long term, buying the most inexpensive stocks. And so the other cyclical thing here is, again, let's say in this fantasy world of mine that interest rates just don't go up and maybe inflation is subdued, which I'm sure a lot of people from the 70s would argue with. What does that do to valuations? I mean, does that make valuations more supportive? That's very toppy to say, but is it possible that valuations should just be higher? Is it 15 PE the new bottom where the 10 PE used to be?

Yeah, something like that. If rates stay, and the thing is in those 20s to the 50s, valuation still got much lower, but that was a much different timeframe. We didn't have all these tech companies and private equity money and venture capital money to throw at these things. Yeah. And I also, so the thing that would make rates go higher is like a serious battle with inflation. I feel like technology is an anti inflation, like it's a disinflationary force. And I think everyone agrees with that. That's not like a profound statement, but like you can find examples in the things that we do pay more money for, like oil, where fracking is a technology and it might have permanently disrupted the supply-demand dynamics. And we're now producing, like Saudi Arabia, that was not something that anyone thought was possible

20 years ago. So we have to allow for these things that are technologically driven paradigm shifts. So what if we looked at borrowing that way? What if we said, it's not that nobody will ever make a bad loan again, or that we won't have credit crises, um, where all of a sudden people are terrified of all this debt, of course. But what if we said that technology has made it easier to borrow money and easier for a creditor to assess the credit worthiness of a borrower and that that has now permanently disrupted what capital should cost in – not in the markets but in the real economy? Like isn't that something that we have to consider that credit will just be permanently cheaper from here on out because we've gotten really good at borrowing and lending and knowing what's going on with the money. And getting back to Bernstein, which is the question that you started off with,

in his book, Birth of Plenty, he says that interest rates historically take a U-shaped curve. And he said even in the Roman times, they start out really high. And as the economy matures, they get much, much lower. And as you have more wealth build up in the system, interest rates should be lower. And then unfortunately, when they scream higher again to the other side of the U, that's when civilization falls apart. So maybe that's the only thing that the inflation people can hold out for is that the US just falls apart, and then we get our higher rates. Yeah. So we're like in 300 AD, The US just falls apart and then we get our higher rates?

Yeah, so we're like in 300 AD and the Germanic tribes are now daring to come across the Rhine and maybe we shouldn't be rooting for higher rates and more inflation. The Fed's trying to produce 2% or 3% inflation. Maybe we shouldn't be rooting for that. The last thing I want to get to on this topic, what is the idea of a low cost of capital mean for asset allocation? Are we thinking through enough this idea that people have historically had maybe a 5% sleeve of cash or a 15% or 20% sleeve of short-term bonds. And all of their historical calculations are embedding these assumptions that there'll be some yield on that portion of the portfolio. And so when you do like historical returns of a 60-40, some of the return came from five-year

treasuries let's say. And now that's just not in the cards for a very long time to come. I mean, that's got to have an impact on how you feel about how much of your capital in a retirement portfolio you want to be in short-term assets. Yeah, and you wonder how much that pushes people out on the risk curve. I mean, high yield is still – I mean, high yield was born in the 80s basically. It's still a relatively new asset class. And it's still growing. So does more money go into something like that where people just want yield for whatever they can get? Or do people understand that, well, okay,

I'm not going to earn much on my bonds, but they're the safe space and that's all they're going to be used for. So I think it depends on how people define that. But there's obviously more options available these days. Yeah. You know, for all of the volatility that we've had last year and a little bit this year, like spreads did not blow out between junk and high grade corporate or junk and treasuries because there's just so much money. Like nobody seriously thinks that there's this wave of defaults coming next week or next month. So the point on junk bonds, they're almost like equity. They're equity with a coupon attached that you have to make good on, but they act like equity in a portfolio. But in the real economy, again, that's another example of companies that are getting projects funded that maybe they shouldn't, and that ability to do that is more disruptive to incumbents than it's been in a long time.

So like even Tesla has $14 billion in debt and liabilities, and in a world of tighter money, they probably wouldn't have been able to do that. It would have been prohibitive for Elon to have gotten that much credit from bondholders and banks. But in this environment we're in, he might make it. well he's done at getting equity investors to buy in and how long he could extend this 10 to 15 billion dollars worth of long-term liability. So yeah, so maybe this lower cost of capital cycle is a good thing for entrepreneurs. And then we finally see like an uptick in the years ahead for IPOs that people have been reeling against. Yeah, I go both ways on this question. Like, is it good for entrepreneurs

to be able to fund anything they want and get money from Masayoshi Son at the Vision Fund and get money from Saudi Arabia and get money from China, although that's not popular recently? But is that necessarily universally good? What if they just start making business models in every single vertical of the economy that just destroys everyone's economics because they can? What if somebody says, I'm going to disrupt the dry cleaning industry and I have sovereign wealth funds from Asia that are going to give me $400 million to do it. And they're not even looking for an interest rate. They just want to be an owner in this so that if it works in 10 years, they get an equity return. So now I take that $400 million and I just come up with a way to put every dry cleaner out of business one by one by one. And I'm able to do it because nobody's looking for a return on the

money. So I don't know if that is a societal – like a good thing. And we see that in finance. People are like, all right, now my ETF costs three basis points. Oh, yeah, mine's one. Oh, yeah, mine's free. Okay, how about this? I'm going to pay you. Like is that good for jobs, for careers?

Is that going to help people pay off their college loans? I don't know if that's, like, universally good. And then take that concept and apply it to everything, food service, events, like, real estate. Like, I don't know if that's just such a great thing, even though it seems like fun for the people that own the equity. Yeah, it's almost a good thing for consumers in the short term and a bad thing for business owners and maybe the economy in the long term. It's good for the consumers now until they have nowhere to work. Right. But they have to keep dry cleaning. And then it's harder to be a consumer.

Yeah. It's like, all right, everything could be shipped to me in 15 minutes. Thank you, Amazon. But I have no place of business to go to. So now I sit home and have things shipped to me while my savings account slowly is turned over to Seattle. I don't know where this ends. Anyway, we went longer than we usually do. Ben, any final thoughts on how we should think about this? I don't know. We probably just called the tap and inflation is going to blow up higher. Ben, any final thoughts on how we should think about this? I don't know.

We probably just called the top and inflation is going to blow up higher. But I think – 10-year yielding 4% by this time next year. But I think it's something worth thinking about that maybe inflation and interest rates will be subdued and what does that mean for the markets? I honestly think that it is wholesale causing a restructuring of the equity market and in some way, shape or form the real world. I mean that's not surprising. It should. The cost of money is big and important. But like I think if this continues, we're going to see crazy things happen right before our eyes. Like I feel like we've only seen the beginning if this is the way things are going to be for a while.

Anyway, we'll see. Thanks for joining me, Ben. For anyone who wants to read my piece, go to thereformbroker.com. And if you are not yet subscribed to this pod or you've not yet enabled our skill on Alexa, I don't know what your story is. But fix that. We'll talk to you soon.