Seth Klarman and the Fed Say the Good Times for Stock Investing Are Over

Individual investors are likely only familiar with Warren Buffett or Peter Lynch, but Seth Klarman of Baupost left behind the famous book "Margin of Safety" at the age of 34 and was designated as the next Buffett by Buffett himself. Warren Buffett has been saying for decades that instead of engaging in futile efforts based on hope, people should simply buy index funds. This is because he believed that the number of managers who can outperform the market over the long term can be counted on one hand. And Seth Klarman was one of those few managers.

He rarely appears in the media, but he appeared on CNBC. The anchor emphasized that it was a difficult feat to get him on the show. However, what he said was rather disheartening for individual investors.

• The past 15 years have been a period where everything was a bubble, driven by historically low interest rates.
• There are more and more intelligent competitors in the public market, and more information is being disclosed to the public. Therefore, the opportunities are diminishing.
• In this environment, we are focusing more on the private market to find alpha. Similarly, we are focusing more on global markets rather than just the US market.
• Of course, there are still opportunities in the public market if you look closely, but the market is becoming more efficient, so opportunities disappear more quickly than before.For example, he mentioned Meta. He said that when Meta's stock price fell below $100, it was a golden opportunity to buy. However, at that time, everyone was saying that Meta was finished.
• Regarding Warren Buffett's argument to buy index funds instead of directly investing, he acknowledged that it has advantages such as near-zero transaction costs and not underperforming the market.Therefore, for ordinary investors who cannot perform very sophisticated analysis, there is no problem with buying index funds if they can maintain a long-term perspective.
• However, the problem is that 1) most people start investing when the market is near its peak because that's when public interest in investing is high. 2) A bigger problem is that they enter near the peak and exit near the bottom. This is because most people cannot withstand the gloomy atmosphere surrounding the market when it's near the bottom. As a result, they often enter at the wrong time and exit at the wrong time, leading to failure even with index funds.Therefore, only those who can consistently invest without being swayed by emotions can succeed with index fund investing. However, due to human nature, few people possess such a temperament. Thus, whether it's active or passive investing, only a small number of people succeed in investing.

Am I truly determined to invest consistently only in index funds? The issue is that even then, the return rate will be lower than in the past. Who says so? The Fed.

What's over? The good times for corporate earnings and stock investments of the past 30 years are over. Only decline remains ahead.Who says that? Michael Smolyansky. Who is he?

He received a Ph.D. in Finance from New York University in 2015. Currently, he is a Senior Economist at the Fed.

From 1989 to 2019, for 30 years, the real return rate of the S&P 500 index was 5.5%, significantly exceeding the GDP growth rate (2.5%). Why? 1) Interest rates were low, and 2) corporate tax rates were low. However, it is highly unlikely that these rates will fall further in the future.

The proportion of interest expenses and corporate taxes to operating income, which was 52% in 1989, fell to 27% in 2019. Can it fall further from here?

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It's difficult. In December 2019, the US 10-year Treasury yield was 1.9%, whereas it was 7.9% in 1989. The effective corporate tax rate for non-financial companies was 15% in 2019, compared to 34% in 1989.

Therefore, even under the very optimistic assumption that interest rates and corporate tax rates remain at their 2019 lows, corporate earnings can only grow at the same rate as operating income.

However, looking at the figures from 1962 to 2019, the growth rate of operating income has been below the GDP growth rate (excluding the pandemic as a very exceptional case).

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Conclusion: The future real return rate of US stocks is unlikely to exceed 2%. This is one-third of the level achieved during the 30 years prior to the pandemic.

During the period from 1989 to 2019, the average annual real operating income growth rate was 2.2%, lagging behind the GDP growth rate (2.5%). However, the net income growth rate was 3.8%. This was due to the decline in interest expenses and corporate tax rates.

To reduce interest expenses, leverage needs to be lowered, which entails costs. 1) Increasing capital dilutes shareholder value, and 2) repaying debt reduces the capacity for shareholder returns. Both are detrimental to shareholders.

Wouldn't it be fine if the valuation increased even if earnings didn't? For multiple expansion, 1) the risk-free rate needs to decline, 2) the risk premium needs to decline, 3) earnings estimates need to rise, or 4) shareholder returns need to increase. However, all four of these factors reached their peak in 2019, making it highly unlikely that they will improve in the long term.

Therefore, the multiple can at best maintain the 2019 level. Interest expenses and corporate taxes can also at best remain at the 2019 level. Then, the real return rate of stocks will be the same as the operating income growth rate. And what is the operating income growth rate? At best, it's the level of GDP growth. That's why it's difficult to exceed 2% in the future. Of course, all of these are based on overly optimistic assumptions, and if even one of them breaks down, the return rate will worsen.

What's the conclusion? Positivity is not about clinging to hope but accepting reality as it is.