Mean Markets and Lizard Brains Read online

  FIGURE 6.5 The Dollar’s Decline

  Source: Federal Reserve

  A main motivation for my prediction that the dollar would decline is the large and (then) growing U.S. current account deficit. The current account deficit is still large, but may have stopped growing (Figure 6.6).

  FIGURE 6.6 U.S. Current Account Deficit Is Large, but Not Growing

  Source: Bureau of Economic Analysis

  What’s Next?

  The U.S. current account deficit will switch to a surplus. There are two paths to this surplus: one is actual poverty and the second is perceived poverty. We are seeing the road to actual poverty in $1.50 euro, $1,000 gold, and $100+ oil. U.S. consumers have much lower purchasing power than we did a few years ago. We can afford to buy much less, and this is working to reduce our current account deficit.

  There is, however, an alternate path to the end of American profligacy. Instead of real poverty, it is possible that Americans will simply wake up to the fact that we are not as rich as we think we are. The combination of a weak housing market and a change in zeitgeist to a more frugal outlook could lead to the end of the current account deficit without any further decline in the U.S. dollar.

  This alternate path seems likely for two reasons. First, the dollar appears to be undervalued by traditional measures. Second, there appears to be a broad, popular expectation of further dollar declines. The lizard brain is generally wrong, so if we all “know” the dollar will fall, it will not. In summary, I remain convinced that the U.S. current account deficit will end, but less convinced that this enormous change in the global economy requires further declines in the U.S. dollar.

  PART THREE

  Applying Science and Art to Bonds, Stocks, and Real Estate

  In Part Three, we evaluate the prospects for bonds, stocks, and real estate. In Part One, we learned that markets are far from rational. Thus, we cannot rely upon the world to ensure that prices are fair. In Part Two, we examined the macroeconomic forces driving investments.

  In this section, we evaluate investments using the science of irrationality, including our understanding of the lizard brain, and the art of macroeconomics.

  With these two complementary tools, we turn our attention to the most important financial investments. In Chapter 7, we examine bonds, and ask if interest rates are going to rise substantially. In Chapter 8, we evaluate the stock market. Has the bull market in stocks returned, or is the early twenty-first century stock market rally a trap? In Chapter 9, we evaluate real estate and ask if there is a housing bubble.

  In The Meaning of Life, the Monty Python comedians start by asking, “What’s it all about?” In answer, the movie provides humorous perspectives on ponderous subjects including birth, conflict, old age, and death, and concludes with:

  Well, that’s the end of the film. Now, here’s the meaning of life. . . . Well, it’s nothing very special. Uh, try and be nice to people, avoid eating fat, read a good book every now and then, get some walking in, and try and live together in peace and harmony with people of all creeds and nations.

  After a tumultuous film, “be nice to people” might seem a bit obvious. Similarly, the “sell long-term bonds” advice in this section might appear modest. After brain scans, chimpanzee productivity, and seashell arbitrage, can’t the new science of irrationality say more? Absolutely. The final two chapters of this book provide novel and surprising advice on how to outsmart the lizard brain. This innovative “logic of the lizard” approach builds on the clear evaluations of bonds, stocks, and houses of this section.

  chapter seven

  BONDS Are They Only for Wimps?

  U.S. History Has Favored the Bold

  “Bonds are for wimps!” So declared Harvard Professor Greg Mankiw in 1993 when I was a Ph.D. student in his macroeconomics class. Professor Mankiw is not only a world-class researcher, but also a great communicator. I found him to be an excellent teacher, and his ability to make economics interesting has allowed him to write several best-selling textbooks.

  When Professor Mankiw said, “Bonds are for wimps,” I don’t think he was making an investment recommendation. Rather he was being a great teacher by using colorful phrasing instead of using the technical term “the equity premium puzzle.”1

  The academic research on the equity premium puzzle examines the money that has been made in U.S. stocks and U.S bonds. What was the conclusion of this research as of 1993? Bond investing had provided safe, but unspectacular, returns. Over the history of the United States, those investors willing to take a flyer on risky stocks would have made much more money than bond investors, even when adjusting for the more volatile nature of stocks. With the benefit of hindsight, therefore, only the extremely timid (a.k.a. the wimps) ought to have chosen U.S. bonds over U.S. stocks.2

  Warning: Past performance is no guarantee of future returns. Every mutual fund has such a disclaimer. All of the research summarized by Professor Mankiw examined the past. In 1993, it was true that throughout the past, U.S. bonds had been worse investments than U.S. stocks.

  Obviously, investors ought to care about the future not the past. Accordingly, this chapter analyzes the outlook for bonds, not just past performance.

  Before starting on our bond journey, a few preliminaries are required. First, we’re going to look at only U.S. government bonds. The bond universe encompasses many other bonds including junk bonds, municipal bonds, and many more. Why do we only cover government bonds? Because of the story of the goat.

  Two men go to a car junkyard looking for spare parts for a classic vehicle. The junkyard is large, so the owner suggests that the men look around to see if they can find a junked car with the needed parts. Interestingly, the owner warns the men to look out for his pet goat.

  During their walk through the junkyard, the men pass a hole in the ground. One of them kicks a pebble into the hole and both are surprised that they do not hear the pebble hit bottom.

  As might be predicted, the men forget their spare parts mission and begin throwing larger and larger items into the apparently bottomless hole. After some minutes, and still unable to hear anything hit bottom, they heave a transmission into the hole. Soon afterwards, a goat runs up to the side of the hole, pauses, and then jumps into the hole. Shaken by the goat’s apparent suicide, the men return to the junkyard owner.

  “Did you find your parts?” the owner inquires. Without mentioning the items they had thrown in the hole, the men tell the owner about the goat that jumped to his death. The owner says, “That’s funny, but it couldn’t have been my goat, as mine was securely tethered to a transmission.”

  In the bond world, U.S. government bonds are like the car transmission while all other bonds are the goat. If U.S. government bonds sink in value, they will drag all other bonds down with them. There might be some delay while the other bonds teeter on the edge, and some goats may have longer ropes than others. Nevertheless, if U.S. government bonds decline in value, so will all other U.S. bonds.

  What about the possibility that bond prices will soar? As we will see, that is not possible. In the current environment, bond prices can either fall or perhaps rise modestly. The first message in this chapter is: U.S. government bonds will measure the speed and length of any decline in the bond market. Thus, we keep our eye fixed on these bonds.

  The second message is: Bond prices move in the opposite direction of interest rates. In other words, rising interest rates are bad for bond owners.

  Why are rising interest rates bad for bondholders? This can be confusing, and the reason for the confusion is as follows. Is it better to earn 4% or 8% on a bond? The answer is obvious; the 8% bond is better. So rising interest rates might seem good for bondholders. The answer is exactly the opposite: Rising interest rates are bad for bond owners. Falling interest rates are good for bond owners.

  The potential confusion is resolved by clearly separating today’s bond prices from future returns on bonds. My friend Chris (the MIT rocket scientist we met earlier) and I recentl
y had a similar revelation in a nonfinancial situation. Chris is a great athlete and better than I at every sporting activity we have played, at least until recently. A frigid Boston winter forced us indoors, and we decided to begin playing racquetball. Because I had played a lot of racquetball previously, I soundly beat Chris during our first match.

  After the drubbing, Chris was a bit morose, especially given his history of outrunning and outplaying me in a variety of sports. I said, “Losing badly was the best possible outcome for you.” When he asked me to explain, I said that he had nowhere to go but up. As we continued to play each other in a series of matches, Chris performed steadily better. Our first match was a short-term defeat for Chris, but set him up for months of steady progress. The worse he did in the initial match, the better his prospects for improvement.

  A similar situation exists for bonds, especially government bonds. The lower a government bond’s current value, the more it will grow until maturity. An old joke asks, what’s the difference between men and bonds? The answer is that bonds eventually mature. Not only do all U.S. government bonds mature, they mature exactly on schedule and at a price of exactly $100. Thus, the lower the current price of a U.S. government bond, the more gains to the eventual price at maturity of $100. Lower bond prices mean higher future returns. Similarly, higher bond prices mean lower future returns.

  When interest rates go up, bond prices go down. When interest rates go down, bond prices go up.

  Another way to look at bonds is to divide current owners from possible buyers in the future. If, for example, home prices were to plummet, that would be bad for current homeowners but good for future buyers. Similarly, a drop in bond prices is bad for current bond owners, but good for future bond buyers.

  The decision to invest in bonds rests upon a prediction about the direction of interest rates. Buyers of bonds are betting that interest rates will remain stable or decline. Those who believe interest rates will rise should avoid owning bonds. Accordingly, the mission of this chapter is to examine the future of U.S. interest rates.

  Revenge of the Bond Wimps

  In 1993, Professor Mankiw said bonds were for wimps because the economic research suggested that brave investors ought to, buy stocks.

  While bonds may be for wimps, those wimps who bought bonds in 1993 had very good outcomes—perhaps better than if they had bought stocks. In the time since the “bonds are for wimps” statement, the total amount earned from buying U.S. Treasury bonds has been almost the same as from buying stocks. Furthermore, those who bought bonds knew that the U.S. federal government would pay them back. Stock owners took big risks, which included two consecutive years of serious stock market declines.

  In recent decades, bonds have been the profitable tortoises to the profligate hares of the stock market. In fact, the good years to have bought bonds started in the early 1980s, more than 10 years before Professor Mankiw said bonds were for wimps. Interest rates over the last 20-plus years have seen a persistent and powerful decline (see Figure 7.1). Accordingly, bond owners have been handsomely rewarded for more than 20 years.

  I remember reading a magazine article in the early 1980s that suggested buying what it labeled the Reagan bonds. These were long-term U.S. government bonds with interest rates significantly above 10%. I took note of the argument neither because I believed it nor because I was going to buy the Reagan bonds. I took note because the article seemed so ridiculous.

  Consistent with the theme of this book, bonds were a great buy at precisely the time they were hated. In the late 1970s and early 1980s, the hot investment themes were real assets, including gold, jewels, land, and impressionist paintings. In a time of inflation, everyone knew that bonds were for idiots (and probably wimpy idiots at that).

  FIGURE 7.1 20+ Years of Declining Interest Rates and Rising Bond Prices

  Source: Federal Reserve

  Over the last 20 years—since the time that bonds were hated—bond investors have had the best of all imaginable investment worlds. They have enjoyed high returns and low risk. Fantastic. Is this trend likely to continue?

  The Mother of All Deficits: Eating Up the World’s Savings?

  In an episode of The Simpsons our hero Homer Simpson is sent to hell. His somewhat innovative torture is to be forced to eat donuts until it becomes excruciating. Accordingly, the devil’s workers collect all the donuts in the world, which they stuff one after another into Homer’s mouth. Far from being unhappy, however, Homer eats every donut in the world and still wants more.

  There is a similar specter haunting the bond market; it is the voracious U.S. federal budget deficit. If, like Homer Simpson, the U.S. government eats up all the available credit, what will be left for homeowners and businesses? If there is not enough money to be borrowed at low interest rates, then large budget deficits might cause interest rates to rise.

  There are indeed reasons to be afraid of the U.S. budget deficit as it is forcing the U.S. government to borrow an additional billion and half dollars a day. Former U.S. Senator Dirksen (who died in 1969) is reported to have said: “A billion here, a billion there, and pretty soon you’re talking real money.” While there is no written evidence that the senator actually made this statement, $1.5 billion a day (including weekends) is definitely real money.

  The problem with large deficits is that they eat up the supply of credit or “crowd out” private investments. Here’s how James Tobin, Yale professor and winner of the Nobel Prize in Economics, described the problem:

  The key issue is “crowding out.” Funding the Federal debt and paying interest on it absorbs private saving that otherwise could be channeled to investments that will benefit Americans in the future—homes; new plants and modern equipment; education and research; schools, sewers, roads provided by state and local governments; and income-earning properties in foreign nations.3

  How much will budget deficits crowd out private investments? Figure 7.2 shows budget projections as calculated by the Congressional Budget Office (CBO). We are so accustomed to deficits that most economists chart the size of the overspending. Thus, the “deficit” that is a negative number is usually shown as a positive.

  I think the CBO assumptions are somewhat optimistic, particularly with regard to future spending. Nevertheless, the CBO picture of the future is about as accurate as is available. It estimates that the U.S. federal government deficit will be large and will not shrink for many years to come.

  Whenever you read deficit projections, you should ask, “how do these projections account for Social Security?” During the 2000 presidential campaign, Vice President Al Gore talked about putting the Social Security savings into a “lockbox.”4 This was such a theme of his campaign that he was mocked for his lockbox on Saturday Night Live. While the lockbox comedy skit was funny, the topic is deadly serious. When President Bush predicts that the deficit will be cut in half by 2008, he is using Social Security surpluses to cover other expenses.

  FIGURE 7.2 $500 Billion Deficits for as Far as the Eye Can See

  Source: Congressional Budget Office

  Because Social Security currently has a surplus, combining it with other accounts makes the deficit look smaller. Since the Social Security funds will be spent in future years, I prefer to work with the “on-budget” figures. In other words, Figure 7.2 shows the deficit as if the Social Security funds were in a lockbox.

  Given that the federal government is likely to be running large deficits indefinitely, these large deficits will put upward pressure on interest rates. To understand how much, we need to put these figures into the proper perspective.

  The U.S. Annual Budget Deficit and Cumulative Debt in Historical Perspective

  While the U.S. budget deficit seems likely to be large for the foreseeable future, the situation doesn’t look particularly grim in comparison with other times in U.S. history.

  There is a story of a snail who was walking through New York’s Central Park. A tortoise attacked the poor snail and stole his money. When the po
lice asked the victim what had happened, he said, “I don’t know, officer, it all happened so fast.”

  Like the speed of slow-moving creatures, most things are relative. Accordingly, the U.S. financial position should be compared with the size of the overall economy (GDP). Using this comparison, the current fiscal position is not as bad as at previous extremes in U.S. history. Figure 7.3 shows total U.S. federal government debt as a percentage of the overall size of the economy for a few selected years.