Dear friends,

It’s summer time, an especially blessed and cursed interval for those of us who teach. On the one hand, we’re mostly freed from the day-to-day obligation to be in the classroom. Some of us write, some travel, some undertake “such other duties as may from time to time be assigned” by our colleges. On the other hand, we hear the clock ticking. All year long, as we try to face down a stack of 32 variably-literate essays at 11 p.m. Sunday night, we think “if I can just make it to summer, I’ll recharge and it’ll be great!” About the first thing we notice when summer does arrive, is that summer is almost spent.

Nuts.

To The Wall Street Journal: I get it now! I promise never to display another illicit barber pole.

Now will you stop?

Mayhap the editors of the WSJ.com have Calvin Coolidge (one of my predecessors as director of debate at the University of Massachusetts, by the way) tattooed upon their heinies?

Nothing in the world can take the place of persistence. Talent will not; nothing is more common than unsuccessful men with talent. Genius will not; unrewarded genius is almost a proverb. Education will not; the world is full of educated derelicts. Persistence and determination alone are omnipotent. The slogan Press On! has solved and always will solve the problems of the human race.

Calvin Coolidge. The quotation appears on the cover of his 1933 memorial service but archivists can’t find evidence of him actually saying it.

Admittedly that would be an awfully painful experience but there are few better explanations for their incredible persistence in sharing the same damned story with me, three times a week, every week for months. What story? Here’s a snip from my inbox:

Conversations

That story first ran at the beginning of May. The gist of it is, if you own a hair salon or similar establishment, you can’t simply plunk a red, white and blue striped pole in front of your establishment. Without a licensed barber on staff, you can’t even have a picture of a striped pole in your window. Barbers are ratting-out hairdressers at an incredible rate over these violations.

Got it. The illicit pole has been taken down from the Observer’s world headquarters. (Actually we have neither pole nor headquarters, but I’m getting desperate for some peace, so I’ll play along.) We promise not to reproduce its tri-color likeness in these pages again.

To the New York Post: No. He’s not saying stocks will go up 50%.

The headline is certainly eye-catching:

If only it were true.

The esteemed economist in question is Robert Shiller, creator of the Shiller CAPE index which tries to generate more-reliable estimates of stock market valuations by factoring the economic cycle into earnings estimates; that’s the Cyclically Adjusted part of the Cyclically Adjusted Price-to-Earnings (CAPE) index.

The quotation from Shiller is this: “I would say, have some stocks in your portfolio. It could go up 50 percent from here. That’s what it did around 2000 — after it reached this level, it went up another 50 percent.”

Have some stocks in your portfolio?  That is, don’t abandon the market completely. Does that sound like a guy saying the stock market will rise 50%?  Uhhh … no. That’s a guy saying “I’m not in the business of calling market tops. The market’s expensive but it could still go up before the final blow-off.” In a late June interview, he said, “People should be cautious now. We have a high market. That doesn’t mean I would avoid it altogether.”

You get a better sense of the esteemed economist’s current thought if you simply follow him on Twitter. His current passion is the role of narrative in economics; that is, the stories we tell ourselves – and the stories others suck us with – are far more powerful forces than rational calculus and data. He noted, for example,

Trump’s example and admonition to “think big and live large” (Trump and McIver, 2004) appears to provide inspiration to many of his admirers, and that might well be expected, along with his stimulative tax policy, to boost consumption demand as well as entrepreneurial zeal. Many people might take the Trump story as a script for themselves, and thus spend freely and raise their risk tolerance.

He lays it out in his newest book Phishing for Phools: The Economics of Manipulation and Deception (2016) and his 2017 presidential address to the American Economic Association.

To the Quad City Times: Really, a subscription is a contract.

In our March issue, I warned folks about an apparently widespread scam perpetrated by cash-strapped newspapers. In pursuit of a bit of additional revenue, the papers were turning 52 week subscriptions into 46 week subscriptions after the fact, then looking for an early renewal at a new, higher rate. Chip and I found several newspapers pursuing such “accelerated” terms, and urged you to check your own subscriptions to be safe.

I wrote the editor, publisher and circulation director of the Times, but received no reply. So, I filed a complaint with the Iowa Attorney General’s office.

Three days later, the publisher of the Times called me at home to apologize for the three month delay in responding and to promise that my original expiration date would be restored. She did allow that they’d received a call from the Attorney General’s office but wouldn’t commit to restoring the terms of other subscribers who were in the same position as me. Their reasoning is that a paid subscription isn’t a contract, hence they’re not bound by the dictates of contract law.

Since these agreements are often referred-to as “individual subscription contracts,” this seems like a novel legal position.

To the Wall Street Journal: Thanks!

In an era when much financial journalism is reduced to pandering for clicks and the sort of press release journalism that takes everything they hear at face value, the work of the folks at The Wall Street Journal really stands out. I’ve been endlessly impressed with the thorough, thoughtful and quiet way in which their financial reporters have kept the issues of risk, valuation and market stability at the forefront. They haven’t been screaming about it, but they have very faithfully found and explained news (whether about the occasional deceptiveness of the VIX or implications of tightening spreads in the face of loosening monetary policy) that strikes me as important for another not willing to assume we’ve reached some sort of “permanently high plateau” or a “new normal” where riskless 10% returns are baked in. To Jason, Justin, Chris & Co., sincere thanks. You’re good.

In particular, Jason Zweig continues to do really important, thoughtful work. His recent two-part report on the shrinking number of stocks (the small- and micro-cap universe is contracting sharply, which greatly increases the challenges that managers face) was surprising and interesting. And I was delighted by his column looking at our friend and too-occasional contributor Sam Lee’s take on being both a prudent investor and a bold speculator. I’m slightly stunned with Sam’s grasp of the implications of cryptocurrencies (Ethereum, in particular) and with Jason’s ability to walk us through the tale. It’s well worth reading.

Etherium prices

Now if only they could find an editorial staff that wasn’t so firmly stuck in the 16^th century, I might even be willing to read those last four pages of the front section again.

And to you all: Thanks!

The Observer’s audience continues to be large, cheerful and growing. We’re up about 22% in readership over last June, for example, and the early months of the year saw about 34,000 readers a month drop by. Those numbers always drift down in summer as folks, sensibly enough, find better ways to spend their time.

We remain dedicated to helping folks, investors and managers alike, as best we can as often as we can. If you’d like to support that effort, we’d be grateful. You’d got three options: direct support through a tax-deductible cash gift (at $100 or more, we’d be happy to express our thanks by sharing access to MFO Premium with you), indirectly by using MFO’s link to Amazon (we receive a rebate of something like 5% of the value of anything you buy), or psychically by sharing your thoughts, kudos, questions, leads and suggestions with us. It’s always good to know that folks find something we’ve written useful enough to respond to.

Details about the first two options are laid out under the Support Us tab at the top of the page.

Thanks, especially, to the folks who’ve already committed and who, in several cases, have set up recurring monthly donations through PayPal; Brian, Greg, Deb, and Jonathan – You’re the best! Many thanks also, to those who sent donations this month, Hjalmar, Marc and John. We appreciate your help more than you know.

Enjoy the sum- sum- summertime, and we’ll see you again in August!

I wonder, occasionally, about a world dominated by self-driving cars, sometimes called “autonomous vehicles.” GM announced in June that they’ve piloted 180 autonomous vehicles and that they’ve got the capability to begin mass production of them. For now, they’re committing $600,000,000 a year to the development.

Last year, Goldman Sachs projected that, between driver-assistance technology and autonomous vehicles, the market will grow from about $3 billion in 2015 to $96 billion in 2025 and $290 billion in 2035. One key is convincing regulators to allow vehicles that are designed with no driver controls at all, basically it would just be a comfortable chair and a computer screen in a rolling box, and to convince people to get into them.

There are three likely advantages to such devices: they would simplify our lives, they would save money and they would save lives.

Nonetheless, for many of us, the loss of control would give real pause. Few are entirely comfortable with the prospect that a machine would make and execute potentially life-and-death decisions for us.  Experts foresee two particularly vexing, perhaps fatal, problems:

1. The vehicles cannot react well to circumstances their programmers couldn’t foresee. Tests in Australia, for instance, show that autonomous vehicles are entirely flummoxed by kangaroos. In India drivers have so little regard for the rules of the road that the test vehicles are virtually paralyzed. I’m perversely curious, given the number of huge gaping sinkhole stories of late, of whether programmers will take “sudden conversion of the road into an abyss” into account.
2. Vehicles from different manufacturers must have coordinated responses, otherwise one vehicle might “misunderstand” the likely response of the other (your Ford thinks “surely it will brake” while their Chevy thinks “oh God, accelerate!”), triggering an avoidable crash.

(A separate, fascinating question would be how autonomous vehicles will react in a no-win emergency; if you’re going to either hit and kill a single pedestrian or slam into a school bus, potentially injuring many children, which will your car choose?)

My shortest summary of the self-driving future is this: things will be smoother and more efficient so long as nothing unforeseeable happens; at that point, all bets may be off.

Which raises this question:

Are we already in a self-driving stock market?

Three quick thoughts.

1. There’s reason for concern.

   Economic growth is sluggish. The stock market has been driven higher for a decade by ultra-low interest rates that discouraged investing in “risk-free” bonds and made it irresistible to borrow money to leverage a stock portfolio; that policy is now being reversed. As the Wall Street Journal recently noted, the Fed has a terrible record for managing such tightening cycles; overshoot and overreaction are far more common than a quiet drop in pressure. And stock valuations are high. If you squint just right you can claim that they’re only at 15 year highs, otherwise you describe it as one of the three highest levels in a century.

   Bill Gross, bright though eccentric, argues this is “the second most crisis-laden” period since 1971 as much because there’s no plausible upside story as because of the downside risk. (Okay, if you want to be skeptical about Gross’s judgment, go to the 1:25 mark of the embedded video interview. He makes his claim then appears to have an “absence seizure” where he freezes for four seconds with his eyes bulging out; his neck moves a tiny bit so I don’t think the video froze, I think Gross did. I’d see a doctor.) In the same week, the chair of the San Francisco Federal Reserve Bank described the stock market as “running on fumes.” BofA Merrill Lynch’s “multi-asset fragility indicator” has been flashing red for months; Joe Ciolli of Business Insider quotes a BAML note to investors: “Markets today are prone to ‘flash crashes’ and tantrums …Rising fragility shows cracks emerging.”

2. There’s precious little evidence of concern.

   The markets set, then broke, three record highs in June and did so with record low levels of volatility. (“Volatility has disappeared from the stock market,” notes the WSJ’s Justin Lahart, “If you think stocks are dull, look at the economy,” 6/27/2017.). Record numbers of fund managers now describe stocks as overvalued and 80% of them recognize that the US market is the world’s most overvalued.

   And still it rises. Why?

3. Perhaps because robots don’t feel concern.

   More money is entrusted to self-driving vehicles than ever before.

   Quant hedge funds are approaching a trillion in assets, which is multiplied by the funds’ ability to use leverage to multiply their bets. John Detrixhe, who has the painfully trendy “Future of Finance”, beat at Quartz.com reports:

   the buzz around quants is so intense that investment managers may feel pressured to adopt some sort of algorithmic strategy, or else risk raising less money, [Michael DePalma of Phase Capital] said. Computer-driven hedge funds have doubled their assets under management, to $932 billion, following eight straight years of inflows since 2009, according to data-tracking firm HFR. (“Even the most cutting-edge quant funds rely on old-school human intuition,” 6/28/2017)

   Passive ETFs contribute another $3 trillion, and rising. Since most are indiscriminate buyers, that is, they buy both the best and the worst components of their indexes with equal aplomb, they tend to provide an increasingly important prop to the market. The Wall Street Journal’s Chris Dietrich writes:

   Booming demand for passive investments is making ETFs an increasingly crucial driver of share prices, helping to extend the long US stock rally even as valuations become richer and other large buyers pare back. ETFs bought $98 billion in US stocks during the first three months of this year, on pace to surpass their total purchases for 2015 and 2016 combined…surging demand for ETFs this year had to an unprecedented extent helped fuel the latest leg higher for the eight-year stock-market rally. (“ETF buyers propel stock market’s surge,” 6/29/2017)

   “The risk,” according to Michael O’Rourke, chief market strategist at Jones Trading Institutional Services, is that when the wind changes direction, “the blind buyers [might] turn to blind sellers.” Cliff Asness, pointing to the market experience in 2007, allows that “a quant quake” could happen again.

As with self-driving cars, the question isn’t whether these things will help precipitate a crash, it’s what you should do about it.

1. Remember that the bull could end with a whimper, not a bang. Optimists, such as Fed chair Janet Yellen believe we won’t see another financial crisis in our lifetime:

   Will I say there will never, ever be another financial crisis? No, probably that would be going too far. But I do think we’re much safer and I hope that it will not be in our lifetimes and I don’t believe it will.

   The alternative to a sudden release of pressure might be a slow release: years, perhaps decades, where stocks produce formerly bond-like returns and bonds produce cash-like returns. Jim Masturzo, senior vice president for asset allocation at Rob Arnott’s Research Affiliates, a firm responsible for $200 billion in assets, says that the firm’s asset allocation research shows that a traditional 60/40 balance portfolio is likely to return about one-half of one percent a year, once inflation is accounted for, over the next decade. That estimate assume economic growth of about 2% and a dividend yield of about 2% but also a slow decline in stock market valuations.

   Jonathan Clements is both more optimistic and more pessimistic: a slow return to valuations common in the 20^th century, coupled with those same growth and dividend assumptions, could yield a market return of 3-4% for a half century.

2. Try to understand the magnitude of the risk your portfolio faces.

   In the last couple issues, we’ve walked folks through the mechanics of calculating your likely maximum portfolio drawdown, using your current portfolio and the maximum drawdown data based on funds’ performance during the 2007-09 crash. In the case of my own non-retirement portfolio, for example, I might anticipate a fall 30% and a recovery time in the range of 3-5 years.

3. Adjust your portfolio if you don’t like what you see.

   If nothing else, rebalance your stock/bond/cash allocation if you haven’t done so in the past year or so. If you’re more ambitious and have access to MFO Premium or another database that allows you to construct a correlation matrix for your portfolio; that will tell you whether your attempt at diversification is more apparent than real. That is, if several of your funds have turned out to be highly correlated during downturns or across the entire market cycle, you might ask whether you’re better served by dropping a fund or two. That would give you a simpler portfolio that’s easier to track and assess. Your most ambitious move might be to adjust your asset allocation; our occasional essays on the charms of a stock-light portfolio show that going from 60/40 stocks-to-bonds down to 40/60 reduces your maximum drawdown by about 45% while costing you about a percent a year in returns. Slightly overweighting Europe and the emerging markets, both of which are better-valued today than the US, might offset that.

4. Consider hiring an experienced chauffeur.

   Passive products excel in the sorts of steadily rising markets we’ve seen in this long bull market: with little discrimination between good and bad firms, everything rises and ETFs capture those rises efficiently. At best, they’ll capture any fall with equal efficiency. At worst, some oddity in their construction will cause them to become unhinged (as they did during the “flash crash”) or the purity of their decline will cause you to become unhinged. In either case, you’d be better served by an experienced manager who’s profited from crises before and who currently has the cash on hand to take advantage of any cracks in the system. We call those folks The Dry Powder Gang and we’ve written about them frequently.

There is, as many have noted, no such thing as passive investing. You make active decisions about what slice(s) of the market to pursue, index designers make active decisions about which companies qualify, fund issuers make active decisions about which indexes (there are now literally millions available) to track.

This might be a particularly opportune moment to assert control over your portfolio and to review the easy assumptions bred by a long bull market. If you think now about how you judge the market’s remaining upside prospects against its downside ones and how you can best preserve the gains you’ve already made, you’ll enter the fall with much better prospects.