Mostly Voices [0:00]

A foolish consistency is the hobgoblin of little minds, adored by little statesmen and philosophers and divines. If a man does not keep pace with his companions, perhaps it is because he hears a different drummer. A different drummer.

Mostly Mary [0:21]

And now, coming to you from dead center on your dial, welcome to Risk Parity Radio, where we explore alternatives and asset allocations for the do-it-yourself investor. Broadcasting to you now from the comfort of his easy chair, here is your host, Frank Vasquez.

Mostly Uncle Frank [0:36]

Thank you, Mary, and welcome to Risk Parity Radio. If you are new here and wonder what we are talking about, you may wish to go back and listen to some of the foundational episodes for this program. Yeah, baby, yeah! And the basic foundational episodes are episodes 1, 3, 5, 7, and 9. Some of our listeners, including Karen and Chris, have identified additional episodes that you may consider foundational. And those are episodes 12, 14, 16, 19, 21, 56, 82, and 184. And you probably should check those out too because we have the The finest podcast audience available.

Mostly Voices [1:28]

Top drawer, really top drawer.

Mostly Uncle Frank [1:30]

Along with a host named after a hot dog.

Mostly Voices [1:34]

Lighten up, Francis.

Mostly Uncle Frank [1:38]

But now onward to episode 238.

Mostly Voices [1:44]

Today on Risk Parity Radio, it's time for the grand unveiling of money.

Mostly Uncle Frank [1:51]

Which means we will be doing our weekly portfolio reviews of the seven sample portfolios you can find at www.riskparityradio.com. .com on the portfolio's page. But before we get to that, I'm intrigued by this.

Mostly Voices [2:03]

How you say, emails?

Mostly Uncle Frank [2:07]

And we're just gonna do two emails today because these are fairly weighty topics to talk about.

Mostly Voices [2:15]

You can't handle the dogs and cats living together.

Mostly Uncle Frank [2:19]

First off, we have an email from Justin, our friend over at Risk Parity Chronicles.

Mostly Voices [2:26]

Young America, yes sir.

Mostly Mary [2:29]

And Justin writes, Frank, just listened to episode 223. Thought it was a nice way to do an asynchronous back and forth. One question, and I don't know if I was misunderstanding Big Earn's argument or it got lost in translation from one format to the other, or else if there was an inconsistency in Big Earn's thoughts. But how could CAPE ratios matter in the aggregate? How could withdrawals depend on CAPE ratios when you begin withdrawals, but then not matter for individual equities? If someone says CAPE matters for portfolios, isn't that an acknowledgement that valuations matter and that the value factor should work? Justin.

Mostly Uncle Frank [3:08]

Well, you've hit upon one of the most hotly debated topics in personal finance and portfolio construction. and crystal ball forecasting. My name is Sonia.

Mostly Voices [3:20]

I'm going to be showing you the crystal ball and how to use it or how I use it.

Mostly Uncle Frank [3:27]

Which is what can we actually use CAPE ratios for, if anything? Now, the crystal ball has been used since ancient times.

Mostly Voices [3:35]

It's used for scrying, healing and meditation.

Mostly Uncle Frank [3:40]

For those of you who don't know what we're talking about, we're talking about the observed relationship between historical PE ratios generally of an entire market in a country to future returns in that same market and country. And these were all the rage back in around 2010 when people thought that they had had this or found this incredibly useful tool for predicting future market returns. And so at that time around 2011, a lot of very well-known and intelligent people in finance thought that they could use that to show that the decade of the 2010s was going to be a rough one for the stock market because the CAPE ratio was still historically pretty high. And those predictions turned out to be laughably wrong. Wrong! And so by the mid-2010s, the same people were talking about, well, what went wrong? Right?

Mostly Voices [4:39]

Wrong!

Mostly Uncle Frank [4:43]

And What is going on here with cape ratios and why did they not predict a downturn in the time period that they were looking at it at that point in time? Now, it would take hours to go through all of the machinations people went through to explain why they didn't work and how they could work and all of those sorts of things. I will link to a nice article in the show notes by somebody who is kind of on the pro cape ratio side. Rob Arnott over at research affiliates, and the article is called Cape Fear：why Cape Naysayers Are Wrong. It was written in 2018, but it does go through all of the debates from the various people and ideas about cape ratios, what they could be used for, and what the problems of using them have been. For the more limited purpose of what we do around here, which is talking about setting up portfolios to live off in retirement, I think Michael Kitces covered it pretty well in the article that I had linked to in the show notes of episode 223 and discussed there. I will link to it again. But basically he points out that they have very little or no use in a short time frame of say less than 10 years. And they also don't have a very good use on longer time frames of over 20 years. So they end up only having some kind of predictive use in a 10 to 15 year time frame. But even that is not very useful because they're not telling you in that time frame when the stock market crash is going to occur. There's no predictive quality to a CAPE ratio in that respect. So it's no different than you or I saying that on average the stock market seems to crash about once a decade.

Mostly Voices [6:23]

Surely you can't be serious. I am serious. And don't call me Shirley.

Mostly Uncle Frank [6:26]

Knowing that really isn't all that helpful because it doesn't tell you when it's going to happen. And you may get a decade like the 2010s where it really doesn't happen until you have a pandemic.

Mostly Voices [6:38]

You can't handle the crystal ball. Or you might get multiple crashes in the same decade.

Mostly Uncle Frank [6:43]

But you've also pointed out another reason why they are pretty useless. And that is because most portfolios are not just the S&P 500 in the United States, or any other country's particular total stock market. And if you are not carrying that portfolio, your individual CAPE ratio for your stock market portfolio is going to be different by definition than the aggregate one. And so you've got an apples and oranges problem there. So if you wanted to actually use them, you would have to take the CAPE ratio for a particular portfolio and then do some long-term analysis of it, determine on what you thought was the mean, which is how this is supposed to work. That's not how any of this works. That the CAPE ratio is supposed to revert to a mean over a 10 to 15 year time period. So you're going to have a different mean, but your mean is also going to be unstable, which is what the debate has been about in that article that I just linked to. from Ravi Narasimhan, that one of the problems people discovered in trying to use CAPE ratios is that the mean is not constant. It changes over time. And so if you're dealing with an unstable mean, you have a big problem if you're using that as a basis for deciding whether the CAPE ratio is high or low. And it's through the candle that you will see the images into the crystal. But just to give you an idea of how different a CAPE ratio might be for different portfolios in different sectors, if you just look at the 10 or 11 basic sectors, and I'll link to an article in the show notes, you can check this out, that historically, for instance, the PE ratio for energy sector has been about nine, whereas for financial services it's about 17. For technology, it's 25. For consumer cyclicals, it's 31. For basic materials, it's 16. And it gets even worse than that when you start looking at the PE ratios by industry. And I'll link to another article in the show notes where they've actually done this and broken all these things out. So the PE ratio for accident and health insurance is 9.67 according to this article. For auto manufacturing, it's 21.14. For coal mining, it's 3.18. For computer software, it's 43.72. For department and specialty retail stores, it's 27.7. For environmental services, it's 25.68. For food chains, it's 12.02. For major chemicals, it's 44.04. For oil refining, and marketing, it's 18.88. For forest products, it's 11.06. For one of my favorite subsectors, property and casualty insurers, it's only 9.3. For savings institutions, it's 19.31. Specialty chemicals, it's 7.72. Transportation services, 19.98. Water supply, 29.12. Trusts accept educational, religious, and charitable. It's 10.85. So if you really wanted to know and use a CAPE ratio for anything in your portfolio in terms of your stock portfolio, you would need to go and figure out what your individual personal CAPE ratio for your portfolio is, what it has been historically, and then figure out some way to use that, knowing that the mean is changing all the time and this Methodology does not seem to work except for a limited 10 to 15 year timeframe. And all it really tells you is that you're likely to get a crash every 10 to 15 years on average. Now, people have also attempted to use this to compare one country with another saying that, well, the PE ratio of Turkey is much lower than it is in the US. So maybe that means that we should all be buying stocks in Turkey now. Now, you can also use the ball to connect to the spirit world. That doesn't make any sense either for a couple of reasons. First, the mix of industries in every country is going to be different. And so you would need to look at the thing that I was just going over for each country and figure out, well, what is the PE ratio or what should be the PE ratio based on the mix of industries in the stock market of that country that are being presented, because it's not the same as the United States or some other country. Then you would also need to consider local conditions, what people at the World Bank and IMF call country risk. What is the risk of investing in this country, given its government and other legal institutions, enforceability of contracts, capital markets, all of those sorts of things.

Mostly Voices [11:44]

Rivers and seas boiling. 40 years of darkness, earthquakes, volcanoes, the dead rising from the grave.

Mostly Uncle Frank [11:51]

Because that is also going to have an impact on what is a correct, unquote, PE or CAPE ratio for that particular country. So you can see why trying to use this as some kind of indicator to make portfolio decisions with or about is kind of a fool's errand.

Mostly Voices [12:13]

Honestly, as stupid as this stupid does.

Mostly Uncle Frank [12:18]

It actually ends up creating more questions than it answers. Forget about it. And you can see that if you go and read that Rob Arnott article where he goes over, well, this is what Jeremy Grantham says, and this is what the people at Ritholtz say, and this is what we think about it over here. There's no consistency, there's no consensus. Forget about it. What this really is, is people grasping at something with some pedigree to it and trying to turn it into a useful crystal ball.

Mostly Voices [12:54]

As you can see, I've got several here, a really big one here, which is huge.

Mostly Uncle Frank [13:02]

And that exercise has been a failure, except in hindsight. This also creates very noisy models for predicting things that end up being kind of goofy. And I'll give you an example of that in the most recent Morningstar report where they're trying to predict future returns and safe withdrawal rates. and this is largely based on the use of PE ratios for predicting purposes. So anyway, they have these wildly different predictions from 2021 to 2022. So for large cap growth stocks in 2021, their long-term prediction was 6.25% on average for the next 30 or 40 years. 2022, now they're saying it's 9.65% or 50% more. for the next 30 or 40 years. For large value, they said it was 7.97% in 2021. Now they're saying it's 8.96% for small growth, 10.17 before, 10.58 in 2022. That actually is a more reasonable differential. For small value, they said it was 10.53 in 2021, and now they're saying it's 12.4. that is indicative of a modeling problem that one year's returns are going to change your forecast for the next 30 or 40 years by a significant amount. And Michael Kitces had roundly criticized this methodology when the earlier report in 2021 came out, which we had talked about back in episodes 160 and 128. And he said the same thing that he had said back in 2016 or 2015 when he first looked at this, that you really cannot be using these sorts of things for long term predicting. It doesn't work out right. And yet we still see people every year trying to construct crystal balls based on this methodology, or saying erroneous things like, since the CAPE ratio of foreign stocks is lower than the US stocks, it must mean foreign stocks are a buy without considering the different mix of companies in those foreign stocks in terms of basic things like value and growth, and without considering the environments that those companies are operating in. In the end, this just ends up being an academic frolic and detour and does not result in good crystal ball construction.

Mostly Voices [15:39]

That's not how it works.

Mostly Uncle Frank [15:43]

So I would suggest we put those aside and focus on more useful ideas in portfolio construction. Think McFly! Think!

Mostly Voices [15:50]

And most importantly, stop trying to use those

Mostly Uncle Frank [15:54]

kind of crystal balls to do calculations of safe withdrawal rates. Think McFly! Think!

Mostly Voices [16:02]

Because even if they do work in theory, they don't work for the

Mostly Uncle Frank [16:05]

portfolio that you are holding. Unless the only portfolio you choose to hold is one that has the S&P 500 in it, and that's all. If you are holding something different, and you should be holding something different if you want to maximize your safe withdrawal rate, then you'd be using the wrong numbers to begin with by consulting the market CAPE ratio for any purpose. But I believe that's enough ranting about that. Let's move on and rant about something else now.

Mostly Voices [16:34]

You are talking about the nonsensical ravings of a lunatic mind. Second off, we have an email from Arun.

Mostly Mary [16:47]

And Arun writes, hello, Uncle Frank and Aunt Mary. I recently heard a Planet Money episode where an economist gives personal finance advice and remembered listening to a similar topic from a Ford Anything podcast. Wondering what's your take on it? Because many suggestions seem to be the opposite of what is generally followed in the personal finance community. I have given a time stamp for a few suggestions that raised my eyebrows. One, about the 15 to 25 minute time stamp where the talk is about owning 10 individual value stocks instead of total market. I'm intrigued by his idea of the Fed supporting stocks and it won't last long. Two, another suggestion to pay off even low-interest debt like a mortgage and even prepay future expenses like kids or grandkids' college fees instead of stock market investment. Three, around the 33-minute mark, compared stock market investment as casino money. Four, around the 43-minute mark, the suggestion seems to be against saving and by extension investing, I think, in autopilot. Cheers, Arun.

Mostly Uncle Frank [17:56]

Arun has linked to two podcasts, which I will also link to in the show notes. One is from Afford Anything, and one is from Planet Money. And both of them are interviewing economists about personal finance issues. And the first one is of our friend, Professor Kotlikoff. Hello, Newman. who's kind of like Newman in Seinfeld when it comes to these topics. He's always got these kind of schemes and theories that apply maybe to him or this imaginary homo economicus person that exists only in academic economics, but that really don't translate well to the real world. And we first talked about this back in episode 153 where I recounted my Long history with Kotlikoff. Noman! It goes back to 2005 when I read a book from him called Spend Till the End, which recommended a portfolio of US stocks, international stocks, and TIPS, just those three things, which then performed absolutely horrible during the crisis in 2008 when TIPS went down about 10%. Hello, Noman. the same kind of sucky performance that they had last year, but for different reasons. Hello, Noman. And over the years, I've read a lot of his work, and he's a brilliant economist. Yes. But his forays into the personal finance side of it have been subpar, and for a couple of basic reasons in that he's applying assumptions that actually don't apply in the real world. Now, the main assumption that academics tend to apply to personal finance is something called consumption smoothing or optimizing consumption over time. That is the goal of what they're trying to do, optimizing consumption over a person's entire lifetime. And you might say, well, that sounds like a great idea. The problem is, as a 20-year-old, or a four-year-old, you're not going to know what your life is going to be like 20, 30, 40 years. You're not going to know about your own preferences for consumption in that time. You're not going to know if you're alive, you're not going to know if you're married or divorced. There's so much that you're not going to know that it makes this idea that you could even plot out some kind of smooth consumption over time as if you were looking back on your life and knew everything that was going to happen. in advance. And so since that assumption is clearly wrong due to the uncertainty of life, you cannot use most of what they're trying to do. It doesn't make any sense. And so almost all of their advice from academic economists is based on that faulty assumption. Now, while I'm critical of that assumption, I do think it is a worthy goal to try to smooth out consumption over at least the time period that you can reasonably predict or deal with, which is why we focus here on trying to construct portfolios that have the highest safe withdrawal rates. That is in effect trying to be able to spend the most money you can in retirement in a safe way. Now, you would think that most people were trying to do that because they are these rational, Homo economicus creatures. Hello, Newman. But it's interesting to me is in fact, that is not human nature. At least people that have been savers all their life tend to be irrational about their spending towards the end. They act as if they're not going to die, and then they end up with the most money in their portfolio at death.

Mostly Voices [21:57]

Never go in against a Sicilian when death is on the line.

Mostly Uncle Frank [22:05]

which is completely counter to what economists would assume. And gives you kind of a garbage in, garbage out quality to where they end up with a lot of their suggestions. Now the other problem I've observed at a meta level that Kotlikoff appears to have that many academics also have is they've fallen in for what is known as Laplace's demon. which is related to what I've been talking about. Laplace's demon is an idea from the 19th century, the mathematician Laplace is who it's attributed to, that if we only had enough data, we could predict the future with accuracy. And that is what people thought at that time in the Newtonian world and what many intelligent and well-educated people still think today. the only problem is that assumption is not true. And this became apparent once there started being investigation into thermodynamics in the 19th century and then later into quantum physics. But it also translates over to any kind of complex adaptive system. And this gets at the mathematics of Benoit Mandelbrot. and the work that goes on at the Santa Fe Institute. A good book to read about this on the finance side is Michael Mauboussin's More Than youn Know. And I'll also link to a little blog post I did about this in a dormant blog I have. But basically all this is saying is that this kind of Newtonian world assumed by Kotlikoff is not a good model of reality because it does not account for the concept of uncertainty. Hello, Jerry. Which is another reason why his recommendations tend to be a little bit off. Now, what I got from that Afford Anything podcast that you referenced there is that you can tell he's got very little knowledge or actual experience in portfolio construction, managing a portfolio, or selecting investments because he's laboring under some notion that he can hire some expert who can just go out and do that and beat the market with these 10 stocks or whatever. The obvious solution there is not go hire somebody to pick 10 value stocks. It's to go buy shares of Berkshire Hathaway. It's already being done for you there. It's more than 10, but Warren Buffett and Charlie Munger have done just about as good in value investing as anybody could have ever done and levered it up a bit by including some insurance company money in there. And his other recommendations have that kind of quality to it. Somebody that can explain to you how a bicycle works and the mechanics behind it, but can't actually tell you or show you how to ride the bike. That's not an improvement. So I would not be using or relying upon anything a purely academic economist has to say about these personal finance issues. because they are starting from a theoretical model that does not match the one that we actually live with. Now contrast this to the academic work that is actually useful for personal finance and portfolio construction. And that is rooted in data analysis. It's the Fama French work. It's things that come out of observing what has actually happened in markets with actual investments. without assuming a particular theoretical behavior or construct. It's a completely different kind of exercise. And most of that kind of work is actually relatively new. It's only been around during my lifetime, really, and mostly starting in around the 1980s and then sprouting in the 1990s, because this area Finance was not thought to be worthy of academic discussion or inquiry back in the day. And a lot of theoretical economists still live in that day, including some of the friends we're talking about here. Hello, Newman. But that's probably enough of me carrying on about this topic as well. If you didn't know or couldn't tell, I do have a degree in economics, but I've spent most of my legal career cross-examining economic and technical experts about things like this and poking holes in what they have to say. And it usually ends up being false assumptions or faulty assumptions at the base of the stool that they're standing on. Once you kick those out, you realize there isn't anything there, or it's not useful for the problem at hand. So some of the highlights of my legal career included cross-examining people like Barry Eichengreen and Nouriel Roubini. And I'd have to tell you, going after Kotlikov is like shooting fish in a barrel compared to cross-examining those types of people.

Mostly Voices [27:07]

Do you think anybody wants a roundhouse kick to the face while I'm wearing these bad boys?

Mostly Uncle Frank [27:11]

But I suppose this is yet another good reason why it's a good thing we don't have guests on this podcast.

Mostly Voices [27:18]

I want you to be nice. It might result in verbal unpleasantries.

Mostly Uncle Frank [27:23]

Real wrath of God type stuff. But anyway, thank you both for those interesting emails.

Mostly Voices [27:31]

Bow to your sensei. Bow to your sensei.

Mostly Uncle Frank [27:35]

Now we are going to do something extremely fun. And the extremely fun thing we get to do now is our weekly portfolio reviews of the seven sample portfolios at www.riskparityradio.com on the portfolios page. And we are nearing the end of one of the best months for these portfolios since these experiments were started back in mid 2020. But just looking at the markets last week, the S&P 500 was up 2.47% for the week. NASDAQ was up 4.32%. Small cap value stocks represented by the fund VIoV were up 2.62%. Gold was flat or down slightly. It was down 0.01% for the week. Long-term treasury bonds represented by the fund, VGIT, were up 0.38%. REITs were up. Our representative fund, R EET, was up 3.18% for the week. Commodities were down last week. Our representative fund, PDBC, was down 1.26% for the week. Preferred shares were up. Representative fund PFF was up 1.34% for the week. And finally, managed futures represented by the fund DBMF were down slightly down 0.14% for the week. Moving to these portfolios, first one is the All Seasons. This one is a reference portfolio that is 30% in stocks and a total stock market fund, 55% in treasury bonds in intermediate and long term, and the remaining 15% divided into golden commodities. It was up 0.84% for the week. It is up 5.45% year to date, month to date and year to date, and is down 3.05% since inception in July 2020. Moving to our next one, the golden butterfly. This one is 40% in stocks divided into a total stock market fund and a small cap value fund. 40% in treasury bonds divided into long and short. and 20% in gold at GLDM. It was up 1.11% for the week. It is up 5.96% year to date and up 13. 62% since inception in July 2020. Next one is the Golden Ratio. This one's 42% in three stock funds, 26% in long-term treasuries, 16% in gold, 10% in REITs, and 6% in a money market fund. It was up 1.39% for the week. It is up 6.61% month to date and year to date. And is up 9.29% since inception in July 2020. And moving to our most complicated portfolio, the Risk Parity Ultimate, which is kind of our kitchen sink. It has 15 funds in it, I won't go through, but it was up 1.42% for the week. It is up 7.76% month to date and year to date, and is up 1.84% since inception in July 2020. Moving to our experimental portfolios. We run hideous experiments here so you don't have to. These all involve leveraged funds and are very volatile for that reason. First one is the Accelerated Permanent Portfolio. This one is 27.5% in a leveraged bond fund, TMF, 25% in a leveraged stock fund, UPRO, 25% in a preferred shares fund, PFF, and 22.5% in gold, GLDM. It was up 3.76% for the week. It is up 13.6% month to date and year to date and is down 13.41% since inception in July 2020. Moving to our next one, our most Levored and least diversified portfolio, the aggressive 5050. This is one third in a levered stock fund, UPRO, one third in a levered bond fund, TMF, and the remaining third divided into intermediate treasuries and a preferred shares fund. It was up 2.84% for the week. It is up 14.55% month to date and year to date, but is down 20.63% since inception in July 2020. Moving to our last one, which is our youngest one, it's only been around since July 2021. This is our levered golden ratio portfolio. It has 35% in a levered composite fund called NTSX, that is the S&P 500 in treasury bonds, 25% in gold, GLDM, 15% in the REIT, O, 10% each in a levered small cap fund, TNA, and a levered bond fund, TMF. and the remaining 5% divided into a volatility fund and a Bitcoin fund. It was up 1.82% for the week. It is up 9.14% month to date and year to date, and is down 16.44% since inception in July 2020. And so it's interesting as bad as 2022 was, 2023 is getting off to an incredible start. If these Portfolios kept performing this way. They would recover all their losses from 2022 in the next month and a half. I doubt that's going to be the case. But this is really a good example of why timing markets is so difficult and impossible to do consistently. I think a lot of amateur investors actually got caught by surprise and may have done something bad to their portfolios towards the end of 2022, throwing in the towel on various investments or moving to all short term bonds or something like that, or CDs. Because if you did that, you really missed out or are missing out on one of the best rallies in the past few years. And I really don't know anybody that has predicted that January was going to be so favorable. Even people that thought that 2023 was going to be a favorable year have generally thought that the better performance will come towards the end of the year, not at the beginning of the year. But this all goes to show you why we shouldn't be trying to use crystal balls in managing our portfolios.

Mostly Voices [33:59]

Fat, drunk, and stupid is no way to go through life, son.

Mostly Uncle Frank [34:03]

And should just have a plan and stick with it. Because as our Risk Parity Radio crystal ball always says about the future, we don't know. What do we know? You don't know.

Mostly Voices [34:15]

I don't know. Nobody knows.

Mostly Uncle Frank [34:18]

So we'll just thank our lucky stars that things are recovering so quickly since 2022 was pretty much the worst year in a lifetime for diversified portfolios. But now I see our signal is beginning to fade. Just one announcement. It is economy season. Economy is a conference run by my friend Diana Merriam over in Cincinnati, Ohio on the weekend of March 17th. I will link to it in the show notes. There will be a variety of personal finance speakers, most of whom are much younger than I am. thankfully, and other events including some breakout sessions where you'll be able to talk to yours truly about withdrawal strategies in a big room with a whiteboard at the University of Cincinnati there. Hope to see some of you there and I will link to that in the show notes so you can check it out. If you have comments or questions for me, Please send them to frank@riskparityradio. com that email is frank@riskparityradio.com or you can go to the website www.riskparityradio.com and put your message into the contact form and I'll get it that way. If you haven't had a chance to do it, please go to your favorite podcast provider and like, subscribe, give me some stars, a review. That would be great. Mmmkay? Thank you once again for tuning in. This is Frank Vasquez with Risk Parity Radio. Signing off.

Mostly Voices [35:59]

Hello, Newman. Hello, Newman. Hello, Newman. Hello, Newman. Good night, Newman. The Risk Parity Radio show is hosted by Frank Vasquez.

Mostly Mary [36:14]

The content provided is for entertainment and informational purposes only and does not constitute financial, investment, tax, or legal advice. Please consult with your own advisors before taking any actions based on any information you have heard here, making sure to take into account your own personal circumstances.