I want to post a bit more about my personal economic philosophy – specifically why I’ve spent years teaching myself how to be a speculator.
This goes back to the early 2000s, when I started having disposable income as a result of my engineering career. I was fortunate enough to get through school with no debt, so the question became where to invest my money. And nearly everyone advised me to do one of two things: buy a house, or invest in stocks. Mostly buy a house, since the stock market had taken a pummeling from the .com bust and 9/11 a lot of people were newly gun-shy. You might wonder why I was polling people about what to do with my money, but at the time I had little background in finance, and was looking for any advice I could get. On the basis of said advice, I started researching buying house.
What I found was concerning – housing prices were, I felt, uncomfortably high. My dad’s house, which he bought for about for $200,000 (inflation adjusted to current day dollars) in 1981, had recently been appraised at $675,000. I have no idea if he could actually have sold it for that, but there was a least a reasonable chance. Other than some minor re-model and repair nothing had been done to radically increase the value of the house since it was built in the 60’s. A little basic math showed that such a house was effectively out of my price range – a 30 year fixed mortgage would have been somewhere between $4,000 and $4,500 per month depending on down payment. Realistically, even on my $80K per year salary that was impossible. Someone would have written the mortgage, but I never could have paid it.
At that point I asked what I consider the first worthwhile economic question of my adult life: Why is my dad’s modest 40 year old home out of my price range even though I have a better job than he did when he bought it – a job well above the median household income for the area? I felt due diligence required that I answer that question before buying a home. And my efforts to answer it re-directed my life.
My first line of investigation was to ask what had happened to housing prices since 1980. Thankfully, two men that I now consider economic luminaries had devoted a good portion of their careers to answering that question – Karl Case and Robert Shiller. Case’s major breakthrough was to develop a method for tracking repeat sales of the same home. This, combined with seasonal corrections and adjustments for inflation, allowed the creation of a very robust index of housing prices. A chart of the Case-Shiller index can be seen here:
Note that I was investigating this in late 2002 or early 2003, so the later part of the chart wasn’t there. Based on what I saw, I made 3 observations:
- The price of houses has never really gone down, even in bad economies (eg the early 90s mini-recession)
- My dad’s house was not unique – the effect was nation-wide
- Housing price movement was not random but rather smooth
- Some force was driving a continual increase in prices
- Whatever was driving the price increase, it was speeding up
At some level this argued for buying a house NOW-NOW-NOW before prices got even higher. But the last three bullets were intriguing – here was a observable machine, moving via as-yet-unseen forces, asking to be understood. And no true engineer can something like that go. At least I couldn’t – it needed to be taken apart and understood, just like the VCR 😉
In terms of candidates for the invisible force driving housing prices, I found two promising ones:
- Population growth
- House flipping
I’ll address population growth first. It made sense that existing houses would become more valuable as long as the population was growing. Since houses are built first in the most desirable locations, it stood to reason that existing houses would go up in price as long as the population grew. So what’s up with US population growth? The answer is most clearly shown via this chart:
In brief, I would describe US demographics as follows:
- comparatively small pre-war generations, now dying
- a huge boom of births in 1945-1960, with the earliest of them starting to die from mid-life diseases like heart disease
- post boom, a higher number of births than pre-war but fewer than the boom
In other words, one can rationally assume that US population growth will continue as long as larger post-war generations are replacing pre-war generations. But the population will actually start to shrink when the baby boomers start to die. This was a sobering thing to see – my would-be house purchase had about 5-10 years of positive demographics going its way, but then the next 10-20 looked ugly. In other words, one driver of the perpetual increase in housing prices was about to come to an end.
The other driver, house flipping, was easier to understand – popular culture, and cable TV in particular, was fueling a boom in short term real estate speculation. This explained how I could be living in a metro area where a sub-median house was unaffordable with a super-median income. Simply put, the buyers were not local people intending to live in the houses, but people intending to flip them. This made buying suddenly seem profoundly unattractive.
Seeing two major headwinds working against a housing speculation, I made the decision not to buy a house at all, at any price point, in any location. This decision encountered substantial resistance from family members who in large part made their fortune by buying houses during the 70s and 80s, and I understood their position and that they were trying to help me. But it seemed clear to me that the demographics which made them rich had the equal ability to make me poor. That, and the flipping thing had to blow over eventually, right? What made this decision easier was that I was offered a very attractive lease on a nice house. Now, I would look at this lease and how little it cost compared to interest on the housing price and make observations on the cost of capital vs. its utility. But at the time I wasn’t that sophisticated. I just knew the rent was stupid-cheap and I could live for $1,500 per month in a place it would cost me $4,000 per month to buy. Sign me up.
The decision not to buy, plus said decrease in my rent, increased my available cash dramatically. No question I had to start doing something with it. But what? If real estate was out, in my limited view the other choice was stocks. But stocks had just had a bumpy ride – the bursting of the .com bubble, and subsequent 9/11 mini-recession were fresh in my mind. None the less, stocks bore looking into – some people said they were now cheap. Reprising the housing investigation, my immediate question was what the changing US demographics had to say about the price of stocks, or really investment securities in general.
This is where my college economics classes came in handy – if anything gets beat into the students in ECON 101, it’s that price results from the meeting of supply and demand. So where does the supply of stock come from? Where does the demand come from? I posited the following theory:
- The supply of investment securities is proportional to the working population. As people enter the workforce, form firms, and create demand for goods with their new income the real value of the economy increases. Clearly factors like employment rate and worker productivity matter too, but on a multi-year time frame, those move back and forth and are noise.
- The demand for investment securities is proportional to the % of the working population late in their careers. As a successful career progresses, the worker will accumulate securities either themselves or in a pension fund. The maximum point of security ownership will be at retirement. Past that point, ownership will drop as securities are sold to fund retirement living, and eventually death liquidates the portfolio.
Obviously I’ve grossly simplified here. This model explains stocks and corporate bonds better than it does Treasury bonds, for instance. But I fundamentally believe it is correct and will try to convince you of that fact in a minute.
Assume for sake of argument I’m right. If so, what does it have to say about the effects of the US baby boom? Well, it says that the boomers would first contribute to the supply of securities as they entered the workforce – roughly 20 years after their birth. If we put the start of the boom at 1945, that would mean in 1965 the supply of securities would start growing radically. But the boomers would have no effect on the demand for securities until midway though their careers – say they would start substantial stock accumulation in 1980 when the oldest were 35. What prediction would this make about stock prices? Starting in 1965 we would expect a growing supply of stock with no new demand and thus depressed prices. By 1980 ever single boomer is in the labor market and supply is fixed. But demand is then variable – as the boomers age and acquire investments, the price of stocks should rise. This should continue until the boomers hit retirement, at which point price should hit a maxima from which it never returns in this cycle. When will the boomers hit retirement? The very first ones would hit early retirement (age 55) in 2000. The last boomer should hit late retirement (age 65) in 2025. So we’ve got a set of predictions here:
- stock market local maxima in 1965
- stocks decline from 1965 to 1980
- stock market local minima in 1980
- Stocks rise from 1980 to 2000
- stock market local maxima in 2000
- stocks drop from 2000 to 2025
Now all but the last of these aren’t true “predictions” in the scientific sense since they’re about past events, but look at this chart of inflation-adjusted stock prices:
As my boss has been know to say when he makes some mathematical discovery, “Hot damn – that works!”. The relationship between the model and reality is uncanny. Now, you could argue I massaged the model to fudge the dates a bit. I didn’t – those are the same dates I have written in an old spiral notebook from when I first thought this through without knowing what the result would be. But you’d certainly be excused for thinking that. I’m not trying to convince you of my powers as an oracle here. But what I am telling you is that I personally believe this model will drive stock (and bond) prices thorough at least 2020. And that means stocks are likely going more down than up.
Now what does that mean for my prospects as an investor? Basically, that they suck, at least for the next 10 to 15 years. Any investment I make today will be facing unfortunate headwinds for a decade at least. That doesn’t mean I might not pick winners – certainly some firms will enjoy spectacular success regardless of the boarder market. But the odds will be against me. Now, I realize that I’m risking over-generalization here. I’ve got an economic model, and it fits 3 to 4 major data points in the last 40 years. Deciding my financial behavior on the basis that that model is definitely true has some risk associated with it. But I do believe the model is in fact correct, and by avoiding investment in all forms I’ve placed my bet. We’ll see how it turns out.
Now, if real estate and investment in general are both likely to be dogs due to demographics, what’s left? I can see only two other non-consumer things to do with my money: horde or speculate. Of the two, speculation seems more attractive if nothing else because hording is provably insufficient. Suppose I had started saving in age 25 and intended to retire at 65 and live to 90. So I would work 40 years and be retired for 25 – 8 years of work for every 5 years of retirement. That means, assuming I could break even with respect to inflation, I would need to save just over 38% of my income to enjoy the same lifestyle in retirement that I did while working. Realistically that’s not going to happen, especially if I intend to raise a family. So hording is out – without the returns presented by investment, it just doesn’t leave enough money to live decently.
What’s left is speculation. I truly believe that the best chance I have to enjoy a high quality of life for my entire life lies in successful speculation, and that’s where my intellectual efforts and capital have been directed ever since I came to that conclusion. If there were a less effort intensive option, I might well take it – I’m not a particularly hard worker by nature. But I don’t see any other good options. Now it’s very possible I’m wrong – certainly it’s happened before. But the events I’m seen since conceiving my theory (namely the 2007 crash and subsequent anemic recovery) suggest to me that my model is pretty much spot on, and investment regardless of vehicle is going to be an ugly scene for a while. At least until the last act of the baby boom plays out. So it’s either acknowledge I won’t be able to retire with a decent lifestyle, or buckle down to the difficult task of learning to be a winning speculator. I chose the latter.
That’s why I’m a speculator rather than an investor.