Was this man the greatest dodgeball player of all time? Was he the GOAT?
Coming off such a dominant performance against six-year-old children, and with Billy Madison having been a fictional character, one may understandably disregard this introduction as ridiculously moronic as Adam Sandler’s first commercial success as a screenwriter.
Was Billy a great dodgeball player on a relative or absolute basis? The vast majority of the institutional investment industry, and associated regulatory regime, are squarely focused on the relative world. It lives in a Billy Madison in first grade reality, and during some periods of history, doing so has been just as ridiculous. The 18 months following the pandemic lockdowns resulted in just such a period.
The following three graphics all come from various pieces by John Hussman, who continues to write regular commentaries. Similar to comments on Lacy Hunt in my Circle of Trust piece, I believe it is important to make a distinction between someone’s analytical framework and their investment decisions.
This first graphic is one of Hussman’s models (shared in July) which is oriented to evaluate potential future 12-year returns for a portfolio of 60% US equities, 30% US Treasury bonds, and 10% US T-bills. We can see how poorly priced this allocation blend became by 2021, with the model indicative of a future 12-year return even worse than in 1929. Welcome to the world of ‘absolute,’ where Billy Madison gets his ass kicked versus professionals.
But it gets even worse, as this graphic from Hussman’s August piece suggests, the pervasiveness of overvaluation within the S&P 500 index (by market capitalization) was far worse in 2021 than in 2000. In addition, bond yields in 2000 were priced far higher than at the end of 2021, with the 5-year US Treasury yielding about 6.8% when the S&P 500 peaked in 2000, versus about 1.4% when the S&P 500 peaked earlier this year. Indeed, the 5-year yield went as low as 0.20% in August 2020 just prior to the upturn in the US inflation cycle.
This created a sort of ‘nowhere to hide’ within the conventional 60/40 portfolio mix that is so dominant within the institutional investment world. To put it bluntly, the end of 2021 was likely the worst time in history to deploy such a strategy. Even the best stock pickers are left to live in a relative world, even as the absolute world has gone to hell.
Why is this so important for individuals?
This graphic from a Hussman piece in November last year offers another perspective. It shows the trailing relative return of 3-month Treasury bills versus the S&P 500 (including dividends) from the depths of the 2008-2009 equity bear market. The ‘risk premium’ investors had enjoyed from owning stocks over ‘risk-free’ Treasury bills had been wiped out all the way back to 1995, or about 14 years!
If you were a 65-year-old new retiree in the year 2000 and pursued a 60/40 type of allocation strategy, the fixed income sleeve offered a decent cushion and helped keep future returns positive despite the carnage in large cap US stocks.
If you had sprinkled in some other market exposures such as TIPS, emerging markets, small cap value, electric utilities, REIT’s, etc., it actually was not that difficult to goose those returns up to at least mid-single digits per year, even if your retirement timing was very unlucky. As any financial planner will tell you via their Monte Carlo simulators, having a withdrawal rate on a volatile portfolio that eclipses a return stream is no bueno.
The degree of overvaluation was so pervasive entering this bear market that the ‘everything bubble’ created a far more pernicious environment. Let’s take a look at just one example from the sleepy old electric utility industry: Consolidated Edison (ED).
This chart shows Con Ed’s book value per share (bottom line) recently eclipsing 1.5!
This chart shows how relatively stable Con Ed’s dividend yield has been, which is generally a large reason why people purchase/own electric utilities - for relatively stable and growing dividends. So far so good!
Uh oh - this is a chart of Con Ed’s long-term debt, which has more than doubled over the past decade.
Revenues have grown, but nowhere near at the rate of debt, share issuance, or the dividend.
Return on tangible equity reflects this reality.
As of the close of trading yesterday, the stock traded at a P/E of over 22 times trailing 12-month earnings, at 1.76 times book value, and the projected forward 12-month dividend yield of 3.14%. The 5-year US Treasury yield closed yesterday at about 3.40%.
I have no position in Con Ed and do not follow the company’s fundamentals closely, and nothing I write is ever intended as or to be taken as individual advice. This has strictly been a simple exercise to offer just one example of living in a relative versus absolute world.
In the relative world, the ‘playbook’ calls for owning stocks in more defensive industries such as electric utilities during recessionary periods and/or equity bear markets. Perhaps stocks like Con Ed may go down less than the overall market over the duration of this cycle - yesterday’s trading saw the stock revisit near its all-time high price reached on August 19, 2022. The stock outperforming in the relative world was certainly the case during the Global Financial Crisis bear market, in which Con Ed’s price declined ‘only’ about 38% from absolute peak to trough, with the S&P 500 having dropped 57%.
Individuals do not need to conform to dogmatic industry ‘strategy.’ Yes, the dogma ‘works’ most of the time, but as the old saying goes, people cannot eat relative returns. With 1-year forward inflation swaps now pricing in about 2% CPI, and a 1-year US Treasury closing yesterday with a 3.6% yield, the era of TINA (there is no alternative) may be ending.
For those who are living off of their asset base in order to pay living expenses, I believe it may be time to consider abandoning the Billy Madison relative world.
It's All Relative
In the infamous words of Howard Cosell .....
https://www.youtube.com/watch?v=JZEIMQ42-oU