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Real Asset Strategies: Timing Isn’t Everything, but…


Real assets are coming off of a horrendous year relative to diversified stocks. Meanwhile, inflation is expected to stay low indefinitely. So why in the world should anyone own real assets now?

In 2013, real assets—defined as equal parts commodity futures, real estate investment trusts (REITs) and natural resource stocks—experienced their third worst year versus the S&P 500 Index since 1970. An economic slowdown in China and a rise in US bond yields created headwinds for commodity and REIT prices, respectively. Market participants seem to have concluded that there’s barely any chance that inflation will pick up.

Nonetheless, we think there are three reasons why investors should consider an allocation to real assets:

First, making a strategic allocation to real assets can guard against macroeconomic environments in which stocks and bonds decline simultaneously. We don’t recommend making tactical bets on inflation, because inflation is notoriously hard to predict.

Second, the fact that forecasters predict little chance of an inflation spike is irrelevant—or even bullish for inflation-related assets—because they have such a poor track record of forecasting inflation. Since 1950, actual inflation was, on average, 1.5% above or below the forecasts of just one year earlier—and was sometimes off by more than 5% (Display 1).


When monetary policy is changing—as it will over the next couple of years—the misses tend to come in waves. If inflation surprises forecasters on the upside by, say, the 1.5% historical average over the next few years, the US Federal Reserve will face a dilemma. If it tightens policy faster than expected, it could choke off the stuttering recovery. If it leaves policy loose, it could risk a much larger inflation outbreak.

In either environment, real assets should outperform diversified stocks; in the second environment, real assets should also outperform bonds. Investors should be prepared for at least the possibility of such outcomes.

Third, real assets have bounced back strongly after past periods of extreme underperformance. There were only two years, 1975 and 1998, when real assets underperformed the S&P 500 by more than they did in 2013. Real assets’ underperformance in 1975 reflected the collapse in inflation following the first 1970s spike. Their underperformance in 1998 reflected the market perception during the tech bubble that real assets were “old economy” investments. However, real assets outperformed the S&P 500 by more than 30% over the three years following 1975 and 1998, and by more than 65% over the next five years (Display 2).


Today, the rubber band of relative valuations and performance between real assets and broader markets is tightly stretched. We think that makes now an interesting time to consider implementing a strategic allocation to real assets.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams. MSCI makes no express or implied warranties or representations, and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed or produced by MSCI.

Jon Ruff is Lead Portfolio Manager and Director of Research for Real Asset Strategies at AllianceBernstein (NYSE:AB).

Podcast Appearance With Michael Covel

I joined Michael Covel on his awesome Podcast this week.  I’m usually listening to other people on his podcast while I workout so it was weird being the guest.  But this was a really fun interview.  The podcast format is so much better than the standard media interview which is brief and doesn’t allow for such an open exchange.  We touched on a ton of topics here:

  • How I got started blogging and writing.
  • The importance of investing in yourself and thinking like an entrepreneur.
  • Why the word “pragmatic” has become so important to me.
  • Why the US government isn’t bankrupt.
  • The importance of understanding behavioral finance.
  • The importance of learning from your mistakes.
  • Myths about the Fed and central banks.
  • Dr. Laurie Santos and her findings on how monkeys act just like we do with money.
  • The importance of understanding quantifiable risk.
  • Learning to think in a macro sense.

This was a fun interview.  I hope you enjoy.  Listen here.  

Richard Bernstein: 5 Signs This Rally is Still Hated (Which is Bullish)

The most hated bull market in history is set to continue according to Richard Bernstein of RBA.  He offers up 5 signs as evidence that this continues to be a market that will climb the wall of worry:

“Investors never fully embraced the bull market and remain very uncertain despite that the bull market is more than five years old. Consider the following:

1)  Credit Suisse data shows that US pension funds have their lowest equity allocations in more than 30 years.
2)  BofAML’s “Sell Side Indicator” highlights that Wall Street strategists continue to underweight equities in their recommendations.
3)  ISI’s hedge fund survey suggests that hedge funds are neutrally positioned.
4)  ICI mutual fund flows have been negative for US equity funds for more than two months.
5)  As mentioned, S&P 500® high beta stocks are selling at their cheapest relative valuations in nearly 30 years.”

Read his latest note here.

Yahoo Finance Appearance: Why the Big Picture Matters More than Ever

I was on Yahoo Finance yesterday with Michael Santoli discussing the release of my new book and in the interview he asked me about some of the key points I make:

  • Most importantly, the macro picture matters more than it ever has.  The world is more interconnected and intertwined than it’s ever been.  Understanding what happens at the local level doesn’t guarantee success.  You have to understand the big picture.  You have to understand the global macro picture, central banking, how the monetary system works.  Succeeding in what I call “the new macro world” relies on an in-depth understanding of the macro picture.  While the financial crisis has faded, this fact is likely to become increasingly prevalent in the coming years as the world only becomes smaller.


  • I kind of bumbled through this one in the video (ah, the fun of not knowing precisely what you’re going to discuss on TV!), but my basic point was simple –  “Stocks for the long run” doesn’t apply in the way we’re often told.  Our portfolios aren’t just made up of money that can afford to sit in accounts for 50 years.  Much of it is made up of savings that could need to be tapped for life’s big events – buying the new home, going to school, paying for children, getting married, retirement, emergencies, etc.  Our financial lives don’t stop when we retire.  They are a series of events that require planning, stability and “stocks for the long run” often implies that we can simply afford to “ride out” all of the ups and downs of the stock market.  I don’t think it’s quite so simple.


  • Why a home isn’t actually a great investment.  When thinking about financial assets you have to calculate your real real return.  That is the after tax, after tax fees and after inflation return.  And homes are an extremely expensive financial asset.  When we calculate the real, real return of housing over the long-term the returns are essentially in-line with inflation.  Housing isn’t year as good of an investment as many think.

Watch the full interview here:


How to Never Lose an Inflation Debate

I liked this line by Paul Krugman in a recent story referring to how the inflation story is like a game of musical chairs:

“So it’s always the 70s, if not Weimar, and if the numbers say otherwise, they must be cooked.”

That’s basically right.  But just in case you’re having any trouble winning inflation debates lately you might want to come armed with this flow chart just so you can be certain that you don’t get bamboozled by someone with the facts.  I hope you find it helpful:


Investment Plans Are Always Forecasts

I don’t often disagree with the very smart Carl Richards, but I did take issue with a piece that was sent to me titled “investment plans and forecasts don’t mix”.  Carl says it’s silly to construct a forecast of any type or listen to anyone who makes forecasts.  Now, I think it’s important to be very clear about this point so that when we construct portfolios we know precisely what we’re doing.  And make no mistake – when you construct a portfolio you are ALWAYS making a forecast whether you use someone else’s forecast or your own implicit forecast.

First, let me say that there’s a lot to like about the concept of “passive investing”.  The idea that you should reduce fees and take your behavioral biases out of the equation are two of the most important things any investor can do.  But the concept of passive investing is often sold using the mantra that it’s “forecast free”.  This is simply wrong.  Here’s why.

When you take a position in the market you are always making a forecast of some type.  If you’re a long only equity owner who uses a buy and hold portfolio then you are making an ultra bullish forecast about stocks over the long-term.  If you implement a multi-asset class portfolio with some hedging involved then you’re almost certainly taking an equity bias which results in a bullish forecast (though probably less bullish than the long only equity portfolio).  Your portfolio is almost guaranteed to have a directional bias and that means that it has a specific forecast tilt built into it.  This means you’re making a specific bet on a specific economic/market trend which means you are indeed making a forecast about the future.

It’s very important to be clear about this.  There is no such thing as constructing a portfolio without some directional bias.  Even a perfectly hedged portfolio has a slightly negative after friction bias.  But most of us construct portfolios with a long equity bias which means we are implicitly bullish on stocks and the economy.  And so our forecast, whether we know it or not, is actually a bullish one.  This is generally a very good bet, but you should know what you’re doing when you’re constructing a portfolio of any type.  Going into it saying “I don’t make forecasts” is a dangerously naive view of the world and could expose you to unforeseen risks.

It’s okay to make forecasts.  It’s okay to make very bullish forecasts.  And it’s often dangerous to listen to pundit forecasts because it could lead you to shift your portfolio like a hot potato.  But know what you’re doing before you do it so your portfolio can actually be designed in a manner consistent with your personal needs and goals.  Go into the portfolio construction process with your eyes wide open or you might find yourself in a bad place one day not knowing how you got there.

The Diminishing Returns of Fuel Efficiency

By Sober Look

As vehicles become more fuel efficient, the savings one obtains by further improving the mileage decline substantially. As an example, assume a driver saves $700 per year by switching from a 12 mile/gallon car to a 15 mile/gallon one. Now if that same driver has a car that gets 30 miles/gallon, she would need to switch to a 60 mile/gallon car in order to achieve the same $700 savings. In fact the incremental savings for each additional mile/gallon declines as the inverse square of a car’s fuel efficiency.

SavingsThis does not bode well for the future of alternative fuel automobiles. Saving $700 a year, as the example below shows, may not be worth paying additional few thousand dollars for a car that may be less convenient to “fill up”.

Furthermore, as traditional gasoline cars become more fuel efficient, the savings associated with switching fall off sharply. In another few years, unless gasoline prices shoot through the roof (which is not likely), alternative fuel cars (such as electric) will increasingly be more of a “luxury” item rather than a money saving form of transportation. It’s just basic math. 

EIA: – As light-duty vehicle fuel economy continues to increase because of more stringent future greenhouse gas emission and Corporate Average Fuel Economy (CAFE) standards through model year 2025, standard gasoline vehicles are expected to achieve compliance fuel economy levels of around 50 mpg for passenger cars and around 40 mpg for light-duty trucks. Diminishing returns to improved fuel economy make standard gasoline vehicles a highly fuel-efficient competitor relative to other vehicle fuel types such as diesels, hybrids, and plug-in vehicles, especially given the relatively higher vehicle prices projected for these other vehicle types.

Fuel efficiency

Answering Some Warren Buffett Questions…

Business Insider was kind enough to publish an excerpt of my new book yesterday and it prompted some questions via email and the forum.

The article is myth #1 in the investment myths chapter of the book and discusses how hard it is to replicate what Warren Buffett has built.  In essence, I argue that Buffett actually runs a multi-strategy hedge fund at Berkshire and that replicating what he does is nearly impossible for the average investor.

Some questions arose so let’s see if I can clear the air:

David writes via email:

“Cullen, I read your BI article with interest.  But I had a quibble.  You said that Buffett’s purchases of American Express and Geico were distressed debt plays and not value investing.  I don’t agree.  I think Buffett buys great businesses at a great price.  That is his strategy in a nutshell.  Whether the firm is in distress doesn’t matter or not.  Can you clarify your thought?” 

CR:  I think most people view “value investing” as using basic valuation metrics to purchase what they perceive as cheap companies relative to their intrinsic value.   Distressed debt strategies and value investing have many similarities, but I would argue that the average distressed debt strategist is engaging in something far more complex than simply looking at P/E ratios or looking for “wide moats”.   I think that what Buffett engages in is often far more sophisticated than the way it is described.  In fact, I think Buffett’s approach is often dumbed down in a manner that is dangerously misleading. There are over 2,000 mutual funds implementing some form of “value” approach.  Not one of them resembles Berkshire Hathaway even remotely.  And there are countless retail investors using what they think are “cheap” valuation metrics to buy what they perceive as “value” stocks….I just don’t think this really resembles what much of Buffett does except in a very loose way.

Trevor comments in the forum:

Do you think the massive size of Berkshire prevents bets today of material impact as compared to those in the long past?”

CR:  Ironically, I think that Buffett has become famous at a time when his firm likely can’t outperform the market by much.  And so you get a lot of investors who have bought into his past success assuming that the past performance is indicative of future returns.  But we’ve seen a clear diminishing rate of return as Berkshire has gotten larger.  Which is totally expected.  When you grow to become a $300B  firm you inevitably become such a large component of the market that you become highly correlated to the market.  So yes, I do think that Berkshire’s size is an impediment to its future potential returns.  The firm simply doesn’t have the same flexibility that it once did.  Which is fine.  But don’t go into Berkshire thinking that you’re buying some small cap growth firm or worse, that you’re buying a large cap firm with small cap growth.

Mike comments in the forum:

“Cullen – you write that the “Buffett Partnership charged 25 percent of profits exceeding 6 percent in the fund. This is a big part of how Buffett grew his wealth so quickly. He was running a hedge fund no different than today’s funds.”

NO different than today’s funds? How many hedge funds today charge ZERO AUM and don’t take profits until returns exceed 6 percent?”

CR:  Yes, Buffett’s fee structure was definitely more client friendly than your average 2 & 20 fund.  There’s no doubt about that.  But that doesn’t mean it was totally different than today’s funds.  A fee of 25% of profits over 6% is still a high fee.   Think of it like this.  Buffet knew that the stock market generated about a 10% nominal return on average.  So if his funds could match that then he’d be taking 1% on the 4% excess.  He knew he could generate a positive fee of 1% on average just for matching the index.  It’s not much different than a mutual fund that charges a 1% management fee for being a closet index fund except that it’s constructed in a much more clever way so as to give the appearance of being very client friendly.  Of course, Buffett generated returns far in excess of the market so the fee structure worked to the benefit of the clients, but that doesn’t mean it wasn’t a high fee.  It just means that Buffett made the fee worth it just as many mutual funds and hedge funds do today.

I don’t mean to sound like I am bad mouthing Buffett in the book.  I think he’s a brilliant investor.  But I think he’s a very misunderstood investor.  And as regulars will know, I think it’s important to really do a deep dive into how things actually work before assuming that you’ve understood something that might actually be much more complex than most people make it out to be….


What A Half Ironman Taught me About Investing

I did the Vineman Half Ironman this past weekend in northern California.   It’s a beautiful race that takes you through the vineyards outside Napa during a 1.2 mile swim, 56 mile bike and 13.1 mile run.  I’d never performed in a long distance event of any kind and couldn’t bike 10 miles or run 5 miles a year ago (well, I could, but not fast).  So this was a big challenge for me.  It required a huge amount of preparation, diligence and mental/physical fortitude.

I did just okay with a time of 6 hours and 9 minutes.   Not bad for a first half IM, but not great either.  But the result is not really what I enjoyed so much about the race.  Rather, I enjoyed the process of preparation, planning and the many lessons I learned along the way.  And after I finished I realized that this race really translated to investing in a perfect way.  Here’s what I learned:

  1. Process, process, process!   The most important thing was preparation.  Just like investing, planning for an endurance race is about establishing a process.  You have to create a plan and stick with it.   Last December I created a plan for every workout over the course of the next 7 months and I followed it almost perfectly. Portfolio construction is a process.  You have to create a plan and fuel your portfolio over time just like you fuel your body during an endurance race.   And you have to establish a process that you can stick with over time.
  2. Establish realistic goals.   I knew going into the race that I was an okay swimmer, okay biker and bad runner.  So I had to set realistic goals.  The biggest threat to finishing the race was setting a goal in some segment that was unrealistic.  If I’d tried to bike a 2:30 (which I easily could have) I would have burned my legs out on the run.  You have to establish realistic goals.  The same goes for investing.  Too many people implement a counter-productive strategy by setting unrealistic goals.
  3. Don’t overpay for performance.  I did some silly things during the course of my training that didn’t really help.  I bought expensive bike wheels, expensive helmets, a fancy wetsuit and tons of other gear.  In the end I probably overpaid in fees for things that didn’t contribute to my performance much.  In the investment world we often assume that strategies or managers with the fancy bells and whistles will automatically translate to better performance.  It’s just not always true.
  4. Life is a series of events inside a longer race.  The most valuable lesson was realizing that life is just a series of events inside a longer event.  Just like our financial lives, life happens all the time.  We don’t start life at 25 and end at 65.  Life happens all the time.  And if you’re not prepared for the inevitable turbulence along the way then you’ll experience hardships which actually make your financial life more difficult than is necessary.
  5. Hard work pays off.  Few things will test your mental and physical fortitude like a serious endurance race.  But if you put in the hours, learn from those around you and work really hard the effort pays off in the end.

Thoughts on “Artificial Interest Rates”

There’s been a lot of talking in the econ blogosphere about “artificially low interest rates”.   This is a concept that’s often expressed by people who are promoting the “Fed as manipulator” view of monetary policy.  And they’re basically right even if they overstep in the way they communicate the point.

I think Noah Smith’s article on Bloomberg View did a nice job explaining the key points here, but I will reiterate some of these points since they are concepts I think are important:

  • The Fed is the monopoly supplier of reserves to the banking system.  Therefore, it can always set the Fed Funds Rate.  In fact, in order to supply reserves (which are issued primarily for payment settlement) the Fed must ALWAYS force the Fed Funds Rate HIGHER from 0% where it would naturally go if the Fed did not establish a floor of some sort.  I like to think of the entire Fed System as an intervention in what would otherwise be a private clearing system.  Therefore, if you want to think of the Fed as an “artificial” construct then fine.  But we should understand that “artificial” construct as it is and not how we want it to be.
  • While the Fed Funds Rate is important it is simply one rate out of many.  Remember, banks and other credit issuers use the Fed Funds Rate as a benchmark, but that does not mean it drives the interest rate across the entire economy and across all financial assets.  It is merely one component of the spread that determines how profitable various credit instruments may or may not be.
  • I think Noah gets the description slightly wrong in his conclusion when he implies that the government creates money.  The government primarily creates “outside money” or money that serves as a facilitating form of money to “inside money”.  That is, bank deposits and other forms of inside money (money created INSIDE the private sector) dominate the medium of exchange.  And outside money (cash, coins and reserves) are really just there for facilitate the use of bank deposits (for interbank payment settlement, using the ATM, etc).  Thinking of the government as the creator of “money” can be an extremely misleading way to understand the monetary system.
  • Lastly, Noah references a Paul Krugman article which implies that there is a “natural” rate of interest in the economy where markets clear.  I just don’t think this is a very useful concept as it implies that the interest rate is some variable by which the economy can be steered by the Fed towards full employment and price stability.  I just don’t think that’s right, but that discussion will have to wait for another day.

In the end it’s all about constructing a coherent and consistent framework for understanding the monetary system.

Hoisington Investment Management – Quarterly Review and Outlook, Second Quarter 2014

The Hoisington Investment Management quarterly review and outlook Via John Mauldin Economics

Treasury Bonds Undervalued

Thirty-year treasury bonds appear to be undervalued based on the tepid growth rate of the U.S. economy. The past four quarters have recorded a nominal “top-line” GDP expansion of only 2.9%, while the bond yield remains close to 3.4%. Knut Wicksell (1851-1926) noted that the natural rate of interest, a level that does not tend to slow or accelerate economic activity, should approximate the growth rate of nominal GDP. Interest rates higher than the top-line growth rate of the economy, which is the case today, would mean that resources from the income stream of the economy would be required to pay for the higher rate of interest, thus slowing the economy. Wicksell preferred to use, not a risk free rate of interest such as thirty-year treasury bonds, but a business rate of interest such as BAA corporates.


As chart one attests, interest rates below nominal GDP growth helps to accelerate economic activity and vice versa. Currently the higher interest rates are retarding economic growth, suggesting the next move in interest rates is lower.

To put the 2.9% change in nominal GDP over the past four quarters in perspective, it is below the entry point of any post-war recession. Even adjusting for inflation the average four-quarter growth rate in real GDP for this recovery is 1.8%, well below the 4.2% average in all of the previous post-war expansions.

Fisher’s Equation of Exchange

Slow nominal growth is not surprising to those who recall the American economist Irving Fisher’s (1867-1947) equation of exchange that was formulated in 1911. Fisher stated that nominal GDP is equal to money (M) times its turnover or velocity (V), i.e., GDP=M*V. Twelve months ago money (M) was expanding about 7%, and velocity (V) was declining at about a 4% annual rate. If you assume that those trends would remain in place then nominal GDP should have expanded at about 3% over the ensuing twelve months, which is exactly what occurred. Projecting further into 2014, the evidence of a continual lackluster expansion is clear. At the end of June money was expanding at slightly above a 6% annual rate, while velocity has been declining around 3%. Thus, Fisher’s formula suggests that another twelve months of a 3% nominal growth rate is more likely than not. With inflation widely expected to rise in the 1.5% to 2.0% range, arithmetic suggests that real GDP in 2014 will expand between 1.0% and 1.5% versus the average output level of 2013. This rate of expansion will translate into a year-over-year growth rate of around 1% by the fourth quarter of 2014. This is akin to pre-recessionary conditions.

An Alternative View of Debt

The perplexing fact is that the growth rate of the economy continues to erode despite six years of cumulative deficits totaling $6.27 trillion and the Federal Reserve’s quantitative easing policy which added net $3.63 trillion of treasury and agency securities to their portfolio. Many would assume that such stimulus would be associated with a booming economic environment, not a slowing one.

Readers of our letters are familiar with our long-standing assessment that the cause of slower growth is the overly indebted economy with too much non-productive debt. Rather than repairing its balance sheet by reducing debt, the U.S. economy is starting to increase its leverage. Total debt rose to 349.3% of GDP in the first quarter, up from 343.7% in the third quarter of 2013.

It is possible to cast an increase in debt in positive terms since it suggests that banks and other financial intermediaries are now confident and are lowering credit standards for automobiles, home equity, credit cards and other types of loans. Indeed, the economy gets a temporary boost when participants become more indebted. This conclusion was the essence of the pioneering work by Eugen von Böhm-Bawerk (1851-1914) and Irving Fisher which stated that debt is an increase in current spending (economic expansion) followed by a decline in future spending (economic contraction).

In concert with this view, but pinpointing the negative aspect of debt, contemporary economic research has corroborated the views of Hyman Minsky (1919-1996) and Charles Kindleberger (1910-2003) that debt slows economic growth at higher levels when it is skewed toward the type of borrowing that will not create an income stream sufficient to repay principal and interest.

Scholarly studies using very sophisticated analytical procedures conducted in the U.S. and abroad document the deleterious effects of high debt ratios. However, the use of a balance sheet measure can be criticized in two ways. First, income plays a secondary role, and second, debt ratios are not an integral part of Keynesian economic theory.

We address these two objections by connecting the personal saving rate (PSR) which is at the core of Keynesian economic analysis, and the private debt to GDP ratio that emerges from non-Keynesian approaches. Our research indicates that both the “Non-Keynesian” private debt to GDP ratios, as well as the “Keynesian” PSR, yield equivalent analytical conclusions.

The Personal Saving Rate (PSR) and the Private Debt Linkage

The PSR and the private debt to GDP ratio should be negatively correlated over time. When the PSR rises, consumer income exceeds outlays and taxes. This means that the consumer has the funds to either acquire assets or pay down debt, thus closely linking the balance sheet and income statement. When the PSR (income statement measure) rises, savings (balance sheet measure) increases unless debt (also a balance sheet measure) declines, thus the gap between the Keynesian income statement focus and the non-Keynesian debt ratio focus is bridged.

unnamed (1)

The PSR and private debt to GDP ratio are, indeed, negatively correlated (Chart 2). The correlation should not, however, be perfect since the corporate sector is included in the private debt to GDP ratio while the PSR measures just the household sector. We used the total private sector debt ratio because the household data was not available in the years leading up to the Great Depression.

The most important conceptual point concerning the divergence of these two series relates to the matter of the forgiveness of debt by the financial sector, which will lower the private debt to GDP ratio but will not raise the PSR. The private debt to GDP ratio fell sharply from the end of the recession in mid-2009 until the fourth quarter of 2013, temporarily converging with a decline in the saving rate. As such, much of the perceived improvement in the consumer sector’s financial condition occurred from the efforts of others. The private debt to GDP ratio in the first quarter of 2014 stood at 275.4%, a drop of 52.5 percentage points below the peak during the recession. The PSR in the latest month was only 1.7 percentage points higher than in the worst month of the recession. Importantly, both measures now point in the direction of higher leverage, with the PSR showing a more significant deterioration. From the recession high of 8.1%, the PSR dropped to 4.8% in April 2014.

Historical Record

The most recently available PSR is at low levels relative to the past 114 years and well below the long-term historical average of 8.5% (Chart 3). The PSR averaged 9.4% during the first year of all 22 recessions from 1900 to the present. However this latest reading of 4.8% is about the same as in the first year of the Great Depression and slightly below the 5% reading in the first year of the Great Recession.

unnamed (2)

In Dr. Martha Olney’s (University of California, Berkeley and author of Buy Now, Pay Later) terminology, when the PSR falls households are buying now but will need to pay later. Contrarily, if the PSR rises households are improving their future purchasing power. A review of the historical record leads to two additional empirical conclusions. First, the trend in the PSR matters. A decline in the PSR when it has been falling for a prolonged period of time is more significant than a decline after it has risen. Second, the significance of any quarterly or annual PSR should be judged in terms of its long- term average.

For example, multi-year declines occurred as the economy approached both the Great Recession of 2008 and the Great Depression of 1929. In 1925 the PSR was 9.2%, but by 1929 it had declined by almost half to 4.7%. The PSR offered an equal, and possibly even better, signal as to the excesses of the 1920s than did the private debt to GDP ratio. Both the level of PSR and the trend of its direction are significant meaningful inputs.

John Maynard Keynes (1883-1946) correctly argued that the severity of the Great Depression was due to under-consumption or over-saving. What Keynes failed to note was that the under-consumption of the 1930s was due to over-spending in the second half of the 1920s. In other words, once circumstances have allowed the under-saving event to occur, the net result will be a long period of economic under-performance.

Keynes, along with his most famous American supporter, Alvin Hansen (1887-1975), argued that the U.S. economy would face something he termed “an under-employment equilibrium.” They believed the U.S. economy would return to the Great Depression after World War II ended unless the federal government ran large budget deficits to offset weakness in consumer spending. The PSR averaged 23% from 1942 through 1946, and the excessive indebtedness of the 1920s was reversed. Consumers had accumulated savings and were in a position to fuel the post WWII boom. The economy enjoyed great prosperity even though the budget deficit was virtually eliminated. The concerns about the under-employment equilibrium were entirely wrong. In Keynes’ defense, the PSR statistics cited above were not known at the time but have been painstakingly created by archival scholars since then.

Implications for 2014-2015

In previous letters we have shown that the largest economies in the world have a higher total debt to GDP today than at the time of the Great Recession in 2008. PSRs also indicate that foreign households are living further above their means than six years ago. According to the OECD, Japan’s PSR for 2014 will be 0.6%, virtually unchanged from 2008. The OECD figure is likely to turn out to be very optimistic as the full effects of the April 2014 VAT increase takes effect, and a negative PSR for the year should not be ruled out. In addition, Japan’s PSR is considerably below that of the U.S. The Eurozone PSR as a whole is estimated at 7.9%, down 1.5 percentage points from 2008. Thus, in aggregate, the U.S., Japan and Europe are all trying to solve an under-saving problem by creating more under-saving. History indicates this is not a viable path to recovery. [reference: Atif Mian and Amir Sufi,. House of Debt, University of Chicago Press 2014]

Japan confirms the experience in the United States because their PSR has declined from over 20% in the financial meltdown year of 1989 to today’s near zero level. Japan, unlike the U.S. in the 1940s, has moved further away from financial stability. Despite numerous monetary and fiscal policy maneuvers that were described as extremely powerful, the end result was that they have not been successful.

U.S. Yields Versus Global Bond Yields

Table one compares ten-year and thirty-year government bond yields in the U.S. and ten major foreign economies. Higher U.S. government bond yields reflect that domestic economic growth has been considerably better than in Europe and Japan, which in turn, mirrors that the U.S. is less indebted. However, the U.S. is now taking on more leverage, indicating that our growth prospects are likely to follow the path of Europe and Japan.

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With U.S. rates higher than those of major foreign markets, investors are provided with an additional reason to look favorably on increased investments in the long end of the U.S. treasury market. Additionally, with nominal growth slowing in response to low saving and higher debt we expect that over the next several years U.S. thirty-year bond yields could decline into the range of 1.7% to 2.3%, which is where the thirty-year yields in the Japanese and German economies, respectively, currently stand.

Van R. Hoisington
Lacy H. Hunt, Ph.D.

Ten Reasons to Stay Active in Equities

By   AllianceBernstein

It’s often hard to resist the temptation of an inexpensive, passive equity allocation. But we think you can find plenty of good reasons to go active just by looking around the markets today.

We understand the appeal of passive investing. It offers lower fees and simplicity. And many investors are skeptical about the ability of active managers to consistently beat a benchmark. Often, a passive portfolio can be a good complementary component to an active allocation, especially in large-cap developed markets.

Yet there’s also a lot of evidence supporting the benefits of an active approach. Today, we see many risks that are hard to avoid by hugging a benchmark—and opportunities that simply cannot be captured by going passive. Not every point is relevant to every investor in every market. But we can think of ten good reasons to stay active in equities today.


1. To steer clear of expensive areas—when a stock or sector becomes pricey, a benchmark will still hold it. Even after the decline in high momentum stocks this year, many Internet and biotech names aren’t cheap. An active manager can think twice about owning a stock trading at an exponential multiple to its future earnings—or decide to focus on specific companies where the disruption potential appears to justify the valuation. This applies to sectors too. US utilities trade at about 16.3 times trailing earnings—slightly below the S&P 500. But that’s a high price to pay for a sector that has delivered annualized earnings growth of 0.3% a year over the last five years—well below the broader market’s growth of 9.5%. Yet by buying the S&P 500, you would automatically be stuck with about 6% of your portfolio in utilities.

2. To manage a rising rate environment—what will happen when interest rates rise from current, historical lows? Stocks in some “safer” (income-oriented) industries like tobacco and telecom tend to have a negative sensitivity to rising rates. On the other hand, many stocks that are more cyclically exposed could do well as rising rates signal a healing economy. Active managers can fine tune their exposures accordingly.

3. To navigate political risk—there’s no such thing as an exchange-traded fund that can prepare for—or react to—an unfolding political crisis, whether in Ukraine, the Middle East or Washington. Similarly, in many emerging markets, government meddling in companies and industries poses unique challenges. An active investor can make a measured assessment of when political involvement isn’t worth the risk.

4. To deal with disintermediation—many industries face disruption because of technological change. Remember Blockbuster video or Kodak? Today, countless large, benchmark companies are facing similar threats to traditional businesses, from shoemakers in China to banks around the world. Benchmarks aren’t very good at keeping away from tomorrow’s Blockbuster.

5. To avoid bubbles—this is perhaps the classic passive flaw. In 1980, the US energy sector ballooned to 27% of the S&P 500. In 1999, the technology sector accounted for 29% of the index. Both sectors collapsed in the subsequent two years. Japanese stocks reached 44% of the MSCI World Index in 1988—more than five times more than today and a bigger weight than the US at the time. Active investors should always be on the lookout for the next market bubble—and you never know where one might pop up. For example, REITs now comprise almost 9% of the US small-cap index—toward the high end of its 10-year history.

6. To capture technological innovation—benchmarks look backwards, by definition. So they are unlikely to help you benefit from the cutting-edge companies of tomorrow that will post rapid growth with new technologies.

7. To adjust to economic recovery—every country is at a different stage of its economic cycle. In a global portfolio, a selective procyclical tilt can help focus on those companies that are best positioned to benefit from regional variations of recovery. And in a single-country or regional portfolio, an active manager can shift toward companies that appear to be in the right place at the right time of an economic rebound.

8. To find higher revenue growth—in an era where it’s becoming harder to expand profit margins, companies that can increase revenue may have an advantage. An index isn’t really able to point your portfolio toward high revenue growers that have a better chance of posting stronger earnings in a tough environment.

9. To benefit beyond the benchmark—there’s always something exciting going on just out of the benchmark. When emerging markets underperformed in a recent quarter, frontier markets—that aren’t included in typical EM indexes—held up much better. What about surging M&A activity in the pharmaceutical industry? An active US portfolio might find a way to buy a British or Swiss drugmaker that isn’t in its benchmark but could benefit from the trend.

10. To exploit less intensively researched universes—small- and mid-cap stocks are fertile ground for active managers, because these companies tend to get much less coverage by analysts. We’ve built a “mind share index” to measure the intensity of research based on the frequency that analysts publish and adjust estimates. Based on this measure, we found that large-cap companies get more than three times more attention than small-cap companies. The same concept can be applied to emerging markets. The return and diversification potential from companies in frontier markets can’t be obtained in a typical emerging markets benchmark. And frontier market indices are even more prone to the vulnerabilities of benchmarks in general, as they tend to be heavily weighted toward a few countries.

This blog was originally published on

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.