Asset return expectations under an alien invasion

Posted by Cam Hui -
Publication note:  There will be no mid-week update next week. The regular publication schedule will resume next weekend.

 

 

Is ET here?

The holidays are a great time to decompress and think about big picture topics. This year, I focus on the limitations of modeling techniques for long-term asset returns and the risk of discontinuous exogenous events. In case you missed it, there have been numerous stories emerging in the press about unknown flying objects in the New Jersey area (see this NY Times account as one of many examples). The sightings expanded to other parts of the U.S., and they have been spotted in other countries as far away as Iran, Chile, Japan, and the Philippines.

 

 

While I am a subscriber to Occam’s Razor, which can be paraphrased as the simplest explanation is the most satisfactory, and these UFOs are of terrestrial origin, it’s a worthwhile exercise to consider asset return expectations under the scenario of an extra-terrestrial alien invasion.

 

 

Conventional thinking

Let’s begin with a story of conventional thinking. Once upon a time, there was a country whose economy dominated the world so much that its stock market grew from one of several promising emerging market economies to over half of global capitalization over the course of a century. The success of its equity market led scholars to study it intensely and some used the history of that country’s market to form long-term return expectations, both on an absolute basis and relative to fixed income instruments. After all, we have over 100 years of history, right?

 

 

That’s when the aliens invaded.

 

 

The catastrophic scenario

I don’t know what happens next, but I can sketch out some scenarios, starting with a catastrophic disruption.

Here is the history of another catastrophic disruption. Did you know that the Russian stock market beat the U.S. market during the latter half of the 19th and early 20th Century?
 

 

This study represented 52 years of history. Is that enough to form long-term return expectations? Anyone who bet on Russia after 52 years of outperformance would have been disappointed.What happened next was the Russian Revolution. Asset holders would have been far more concerned about their own survival than the value of their portfolios.
 

 

 

A benign scenario

Now consider a more benign and less disruptive scenario of what may happen when a culture with an advanced technology meets one that’s less advanced. Human history is full of cases of how agrarian societies dominate hunter-gather societies and how industrialized societies dominate agrarian societies, and so on.

 

Here is how the earnings estimates of the Magnificent Seven have changed over the years. Estimate revisions have shown an upward bias over the years.
 

 

By contrast, here is the same analysis for the rest of the S&P 500, or S&P 493. The evolution of estimates are mostly flat to down. The stark difference between the Magnificent Seven and the rest of the S&P 500 illustrates the dominant power of new technology.
 

 

This doesn’t mean that the stock prices of the weaker markets fall, though prolonged underperformance may be evident. U.S. equities have steadily beaten other developed markets since the GFC (all returns are in USD). It is therefore no surprise that Mario Draghi’s report on European competitiveness focuses on the steps that Europe should take to re-ignite growth.

 

 

Call this the Three Body Problem alien invasion scenario. The aliens have a technological edge, and the vanguard has arrived, but the main invasion force won’t be here for a very long time.
 

 

Deceptive assumptions

In conclusion, my story about an alien invasion is a way of opening the door to a discussion about rate of return studies. Standard assumptions about returns to bonds and equity risk premiums are useful only up to a point. But consider how the assumption of a 2% real return to equities holds up in real life. Even if there was no inflation, $100 invested in equity or equity-like instruments at the time of Augustus Caesar would have a real inflation-adjusted wealth with 19 zeros, and nominal wealth a multiple of that figure. For some context, anyone with that level of net worth could pay off the annual U.S. federal deficit with the interest income from a single day. What happened in between were a lot of discontinuous exogenous events that destroyed wealth. That’s why diversification matters, as insurance against events such as wars and revolutions (though extra-terrestrial alien invasions may not apply).

 

3 thoughts on “Asset return expectations under an alien invasion”

  1. I have often done that calculation using the rule of 72 with various % yields. Since 2% doubles in about 36years, simplify the math with a doubling every 33.3 years. So in 2000 years you have 60 doublings. 10 doubles is 1000, and 20 is 1 million…yeah the math is impressive…a copper penny would be worth a fortune. So obviously something besides the taxman breaks the chain. Call it the invisible hand of human stupidity. It also makes me wonder about hodling gold or silver, although as a hodler myself I have to say that hiding the stuff keeps it out of the taxman’s hands.
    Aside from the taxman and bandits aka taxmen, and hun invasions etc, a lot would be lost to counter party risk which the hodlers say is avoided by gold. True to a certain degree, but there is a counter party nobody mentions, the buyer. What is your gold worth if there are no buyers at any price? This is what worries me.
    With fiat if there is a collapse they can print unlimited amounts to hold things together as the debt looms over us all, but they cannot make us buyers.
    Wall Street is focused on its making money short term, it’s human nature to do that. When Russia was having its problems pre-revolution the market was doing well it seems. It was ignoring the revolt that was going on, it had to because as we know, it turned out to be a very real problem.
    When one considers what is going on with people eating 6 million $ bananas, with Fartcoin, with anything that has quantum in it, with the Buffet measure at all time highs, we are near a top. However at 24,000 feet one is much higher than most places on earth 99.99?% higher, but the top of Everest is still a trek.
    What if after the crash, enough people get wiped out that there are no buyers, like from 1930 to 1955?
    People will always buy food, so if you buy something related to that, means there will be a future buyer provided there are still people, but even agro stocks did not do well in Russia 1917.
    Buffet is heading for the exits, is he right? Should this be ignored? Getting out early in a melt up does not look cool after a few months, but likely looks great after a few years.
    When the break at the top happens and is clear enough get out if not out already. Do not be like Lot’s wife looking back at the peak hoping to get back there before getting out. Biblical reference for a bubble of biblical proportions.

  2. Clearly the most ominous sign of economic problems ahead is the performance of ITB the Homebuilders ETF. It has crashed. Take a look.

    The yield curve rise is a theory for stock values but in housing it drives the 30 year mortgage in the real economy. The outlook for long-term bonds in a MAGA world could be toxic. If investors shun buying them, and I wouldn’t own them, the housing industry has a big problem. That is a big sector of the economy and historically the first to fall in a recession.

    1. ITB is in a correction, not yet a bear but bears watching…incidental pun..We are in strange times. Normally a rise in rates makes for home prices to fall, but not this time because of those hodling their sub3 fixed 30 year. Hence supply on the market is lower than it should be, this gives homebuilders a tailwind. Seasonally this is a bad time for home sales, so they could bounce back. NAIL looks worse. But in a melt up the warning signs get ignored. LEN and TOL are still in an uptrend but there still remains an awful lot of downside. Face saving is important, not just for the Chinese, but for almost everyone. They will do like Japan did when they are forced to, then the yield on whatever bonds they hold gets passed back to the treasury which reduces the interest cost of the federal debt. We’ll get there eventually. Even if they don’t buy them directly from the treasury , with a wink or a nod, they can buy them on the secondary market. Look at the charts, try and time some options and shoot for some 20 baggers which even if 4 out of 5 fail you end up with a 4 bagger
      . We are heading for some insane volatility which options might be a good bet if a small bit of ones portfolio.

Comments are closed.