Filters are Sometimes Blinders

We saw a graph recently that tried to show how the stock market is totally disconnected with the GDP. It showed that the stock market growth was totally not correlated with GDP growth and perhaps has been negatively correlated on a decade by decade basis over the last 100 years or so.

This made me think of something that we did years ago when I was working on trying to compare performance between stockholder owned insurers to mutual insurers. Eventually we figured that it might make more sense to compare the total return on total capital of stockholder owned companies to return on capital for mutuals. The division of ownership between bondholders and stockholders is artificial and not important to this comparison.

It makes me wonder what the chart above might look like if the value of the companies is represented by the value of the stocks PLUS the value of the bonds.

Just an example of how we have sometimes been taught to filter out some very important information. It is sometimes very hard to see outside of the filters that “everyone” has been taught to use.

Explore posts in the same categories: Assumptions, People Risk


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One Comment on “Filters are Sometimes Blinders”

  1. Did a fair bit of similar work some time ago, for insurers. With so many mutuals, had to use “tangible net worth” as the only comparable to public stock companies. Results showed lagged correlation, as one might expect.

    First issue is that markets are expected to be forward looking. The decade grouping hides that.

    Second, return on (total) capital cannot diverge too far from return on equity. There are tax effects, of course, the predominant one being not the specific deductibility of interest, but in fact the pressure to RAISE debt to equity when tax rates are high. (Anyone recall the 99% junk-financed days, when Congress contemplated limiting corporate interest deductibility?)

    Finally, it turns out S&P was badly mistaken on the “duration” of equity they analyzed a few years ago. Turns out equity duration is NOT 70 years or more. Instead, there is a good fit to a model that has corporates able to pass through 80% or more of inflation, in their product pricing (with a lag of course). That yields equity duration more like two or three years. And that in turn limits any gap between RoE and RoC.

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