Bogleheads on Investing- Episode 40 transcript

Dr. Ed Yardeni is the President of Yardeni Research, Inc., a provider of global investment strategies and asset-allocation analyses and recommendations for institutional investors. In this podcast, we discuss his new book, In Praise of Profits, review economic activity from 2021, and look ahead to 2022. 

Dr. Yardeni earned his PhD in economics from Yale University in 1976, a master’s degree in international relations from Yale, and completed his undergraduate studies magna cum laude at Cornell University. He previously served as the Chief Investment Strategist and Chief Economist of several Wall Street firms and asset managers and was an economist with the Federal Reserve Bank of New York, held positions at the Federal Reserve Board of Governors, the US Treasury Department in Washington, D.C., and taught at Columbia University’s Graduate School of Business.

Dr. Yardeni is frequently quoted in the financial press, including The Wall Street Journal, the Financial Times, The New York Times, The Washington Post, and Barron’s. He was dubbed “Wall Street Seer” in a recent Barron’s cover story. He also appears frequently on CNBC, Bloomberg Television, and Fox Business. 

Episode 040- guest Ed Yardeni

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Rick Ferri, December 1, 2021

Rick Ferri: Welcome everyone to the 40th edition of Bogleheads on Investing. Today we’re welcoming back Dr Ed Yardeni.  Dr Yardeni is the president of Yardeni Research Incorporated, and in this episode we’ll be talking about his new book, In Praise of Profits.  We’ll also be looking back at 2021 and looking forward to 2022.

Hi everyone, my name is Rick Ferry, and I’m the host of Bogleheads on Investing. This episode, as with all episodes, is brought to you by the John C Bogle Center for Financial Literacy, a 501(c)3 nonprofit organization; go to boglecenter.net.  Your tax-deductible contributions are greatly appreciated.

Today we’re welcoming back our special guest Dr. Ed Yardeni. Dr Yardeni is the president of Yardeni Research, a provider of global investment strategy and asset allocation analysis and recommendations to institutional investors. Dr. Yardini earned his PhD in economics from Yale university in 1976, having completed his doctoral dissertation under Nobel laureate James Tobin.

He previously received his master’s in international relations from Yale and completed his undergraduate studies magna cum laude at Cornell university. Prior to opening his own firm in 2007 Dr. Yardeni was a chief investment strategist and a chief economist at several Wall Street firms and asset management firms. He was also an economist at the FederalReserve Bank of New York, and he held positions at the Federal ReserveBoard of Governors and the US treasury department in Washington DC.

He also taught at Columbia University’s graduate school of business. Dr. Yardeni is frequently quoted in the financial press, including the Wall Street Journal, the Financial Times, the New York Times, and most recently in a cover story for Barons when he was dubbed the Wall Street Seer.

Today we’ll be discussing Dr. Yardeni’s newest book, In Praise of Profits. We’ll also be talking about the economy, where we’ve been and where he thinks we may be going. So with no further ado, let me introduce Ed Yardeni. Welcome to the podcast Ed.

Ed Yardini: Thank you very much.

Rick Ferri: Ed thank you for joining us today.  You’ve published a couple more books since I talked with you last. The latest book that you wrote I found very interesting. It’s called In Praise of Profits. This book is just the latest in a series of topical studies that you’ve done, starting with The Yield Curve,Stock Buybacks, Fed Watching–two books on Fed watching — and also S&P Earnings, Valuation and the Pandemic. And this all followed your original book Predicting the Markets: A Professional Autobiography. So I want to specifically focus on this book though, because I found it very interesting. It’s really something that I think has been bothering me as an investor, and I think clearly has been bothering you also. It’s about profits. We’ve had a lot of discussion in the media and I can’t get too political in this podcast but there’s a difference of opinion, if you will, about profits and where we should be going as a nation. And what you intend to do with the book is to clear that up, at least from your view as an economist. So with that, could you tell us what the main idea of the book was?

Ed Yardeni: Sure. I’ve observed over the years that profits tend to be the driver of economic prosperity. I mean it’s really pretty simple and straightforward to see, to observe, that it’s profitable companies that expand. They hire more workers; they expand their capacity so they’re ordering more goods, capital equipment and so on. Whereas companies that are not doing so well or are actually losing money, have to retrench. They have to cut back employment; they have to try to sell off some of their assets. 

And the more profitable companies we have, the better the overall economy is going to do. The better overall society will do, because again it’s profitable firms that hire people. And that’s the

name of the game when we’re talking about economic prosperity. We’re not rooting for companies themselves to be prosperous and no one else will be prosperous. And obviously companies can’t be prosperous if their customers aren’t prosperous. So this is sort of a defense of what I call entrepreneurial capitalism, which I think needs to be distinguished always from crony capitalism.

There’s aspects of capitalism that I certainly don’t agree with, don’t favor and I criticize in the book. But on the other hand, the entrepreneurial capitalism often gets kind of wrapped up into that conversation and gets misrepresented as based on greed and selfishness and exploitation of workers. And the reality is that’s not the reality of our economy.

Rick Ferri: Ed, you touched on right away on the difference between entrepreneurial capitalism and crony capitalism. And I’d like you to dig into that a little bit more. I mean what is the difference?

Ed Yardeni: In a word, lobbyists. I have to keep it real simple. I am an entrepreneurial capitalist. I do pretty well. I’ve got a small company. I’ve got employees, but I’m not doing so well where I have extra money to hire lawyers and lobbyists to work with politicians in Washington to try to protect my business.

Rick Ferri: That’s what it really gets down to, correct?

Ed Yardeni: Yeah politics. Yeah I mean I don’t get involved in politics. I get involved in trying to satisfy my customers whereas crony capitalists have done so well that they forget that it was  entrepreneurial capitalism that gave them their success and their wealth. And it was their focus on their customers that made them successful. And it’s sad when entrepreneurial capitalists do so well that they morph into crony capitalists by relying more and more on the government to create regulatory impediments to competitors to compete with them, to put them out of business even. 

Rick Ferri: Now would some of that be in defense of retaining jobs?

Ed Yardeni: Well that always is the excuse, right? Is the reason that the government needs to subsidize my business, or the reason the government needs to protect my business from both domestic and foreign competition is because if the government doesn’t do that then I’m going to have to shut down, and all these people that I employ will lose their jobs. I mean that’s a valid concern, but if we let that determine who the winners are and who the losers are then it’s not going to be the customers that make that decision. It’s going to be politicians and companies that interact through lobbyists that will decide who succeeds and who doesn’t. And that’s fundamentally to the detriment of who I’m trying to satisfy and make as well off as possible, and that’s consumers. Sometimes it’s better to let the market make the decisions even if it’s painful because the ultimate result is good for consumers, and good for even the employees that may lose jobs and find them with companies that are better managed and better aimed at satisfying their customers.

Rick Ferri: More sustainable perhaps?

Ed Yardeni: Yeah.

Rick Ferri: What I took away from your book, and I hadn’t really realized this: huge number of S-Corps, sole proprietors, partnerships relative to C-Corp. And the breakdown of national income between these large C-Corps,well not not all of them are large, to S-Corps and solo practitioners. So could you elaborate on that?

Ed Yardeni: Yeah. Well in corporate profits the data that comes out with GDP, that’s the corporate profits of both C corporations and S corporations. C corporations tend to be large but not always, there’s plenty of small C corporations, but they’re owned by their shareholders and they pay out dividends, and they’re taxed twice. They’re taxed on their profits and then the shareholders are taxed on their dividends. S corporations are so-called pass-through entities, and what that means is that they’re owned by fewer shareholders– which is one of the requirements– and if they pass the IRS requirements for filing as corporations as pass-throughs, then their profits show up in the national income accounts, but their profits are then paid out as dividends to their small number of shareholders, and then the shareholders pay their personal income taxes on those dividends. So that they’re pass-throughs and there are quite a few of them.

And there’s even more sole proprietorships that are owned by only one person and also are pass-throughs. Whatever profit they have is passed through to the proprietor they don’t have to  any corporate tax, they just pay personal income tax on proprietor’s income. And then there’s partnerships, which are also included in the data.

And when you add them all together you find out that pass-throughs including S-Corps and proprietorships and partnerships; pass-throughs account for more than half of payroll employment in the United States and they’ve been growing very rapidly, which is an indication to me that a lot of people are entrepreneurial in their — in spirit and in action. A lot of people have decided they don’t want to work for somebody else. They want to have their own company and they start their own company. And as long as they succeed at some point they probably need to hire people.

The old days, the United Kingdom was often described as a nation of retailers, of small shops, of shopkeepers. We really have continued to evolve into a nation of proprietorships and S-corporations and partnerships. Those are all entrepreneurs. Very few of them are in a position where they can go hire lobbyists and get political about their business.

Rick Ferri: So as these entrepreneurs are successful and they start to grow, and they start hiring people and some of them become publicly traded companies, it seems like at that point they tend to become villainized in many ways because of this thing called income inequality. In other words, the people who grew that company and went public– and yes they became wealthy as a result– somehow don’t deserve that wealth, and that wealth needs to be shared with the quote-unquote stakeholders, as opposed to the shareholders. Can you talk about the difference between stakeholders and shareholders?

Ed Yardeni: Well, first with regards to the income inequality issue, a lot of the income inequality we see in our society has a lot to do with demography. Frankly, simply with age. I mean young people don’t earn very much and older people tend to earn a lot more. And that kind of makes sense. That that’s the way it should be because young people aren’t experienced. They may be very well educated, but they aren’t particularly experienced, particularly in the business that they eventually wind up joining. And older people have more skin in the game, that they develop more. So it’s true that there’s income inequality, but a lot of it’s related to where you are at in the age profile.

And it’s generally younger people that go out on their own and start companies and take some risks. And if they’re successful, then they start to hire, and if they’re very successful they start to

enjoy some significant wealth, and odds are they’re going to reinvest a good part of that wealth back into their business and hire some more people. But as they do that their companies become more valuable, their shareholders and their companies– they might even go public–which increases potentially the value of the company. I mean very few entrepreneurs are going to go public unless a Wall Street investment banker tells them that “You know, it’s your stock price is going to value your company a lot more than you realize.” And so yeah, they got wealthy and most of the wealth inequality is related to equity ownership of businesses, by sole proprietors as well as equity ownership of publicly traded companies like C-corporations.

But as you said, when we look at the notion that entrepreneurs are robber barons, which is sort of historically what entrepreneurs have been described as being — once they’ve succeeded — completely misses that their success originated from the fact that they provided goods and services that were wanted, that were needed, that were highly prized by their customers, by the consumers. It’s their customers that made them rich. They didn’t rip off their workers, they didn’t rip off their customers. I mean people like that, you know, don’t stay in business for very long, not in the free marketplace, because the consumers walk away from them and their workers walk away from them. You know, they only stay in business if they get political clout and political support.

But we have some of that, but we also have lots of entrepreneurship and what we have to understand about entrepreneurs is that they are driven by the profit motive to bring us goods and services that improve our standard of living. That’s the way they’re going to get rich. So first and foremost their top concern isn’t a selfish concern, isn’t that how am I going to get rich, it’s how am I going to satisfy enough consumers so I first will stay in business and I won’t lose everything I put into it. Then all of a sudden they say “my goodness I’ve done it and the customer is just coming in and it’s gone viral, people are talking to each other and saying you know this is a good product and suddenly I’m rich.” Now some of these people who get very rich, what do they do? They, as I said, they put it back in their business. Others get so rich that they become venture capitalists. They send some of their money to firms in Silicon Valley and say okay that’s a pretty good idea I’m going to invest in that, and so they are the wellhead of prosperity. They are the wellhead of risk-taking, and their willingness to try to come up with goods and services that increase everybody’s standard of living.

Rick Ferri: You talk in your book about upward income mobility.

Ed Yardeni:  Well, I think most Americans are aspirational. Most Americans would like to do better, and I think a lot of upward income mobility has to do with an entrepreneurial capitalist system. It provides the opportunity to have upward income mobility. Work hard, provide what your employer needs you to provide to make that their business succeed, or do that as an employer, work hard, motivate your employees and sell good products and services that consumers want and you wind up enjoying upward income mobility.

Now upward income mobility tends to occur during periods of prosperity. More people wind up making more in an economy that’s growing and prospering than one that isn’t. We actually get the worst income inequality and the worst wealth inequality during periods of prosperity when the rich are getting richer. But why are they getting richer? Well, because people are buying what they’re selling and they wind up doing extremely well. 

But again it’s like the Henry Ford insight. Henry Ford decided to raise the money he pays his workers because he wanted to make sure he had enough customers who could afford to buy his cars, and we’re well past that point in our economy, in our society, but it’s definitely in the best interest of entrepreneurs to come up with the outstanding goods and services that’ll make them prosperous and then to share the prosperity. The market kind of forces them to do that. Maybe they don’t do it completely by design or they’re not completely motivated to do that, but the market definitely forces them to share the wealth with their employees, with their shareholders, and with society at large by providing these goods and services at lower and lower prices.

Rick Ferri: When we’re listening to the news media about income inequality, what we’re not told, it appears, is that there are different ways to measure income, and just using minimum wage for example is not a great way to measure income, right. Just using income is not a great way to measure wealth, either. I know a lot of people who are multi-millionaires who are getting Affordable Care Act tax credits because their income is low and the government says if you have low income then you are in poverty or some level of poverty even though it doesn’t measure wealth. So could you talk about the problems of measuring income and the different ways of which we should be measuring it?

Ed Yardeni: Well on the progressive side, I’ve observed over the years that they do like to show that there’s data that support their position but they always seem to use the same series over and over again without recognizing the flaws in the data they’re using. And I think it’s mostly because the data supports their story and as long as it supports that story the data must be good.

But I’ve done a lot of work on income data and concluded that one series that they particularly like is one put out by the Census to measure poverty, and that is its median household income. So it’s the household in the middle, if you will. Median household income and that’s divided by the CPI. Now there’s several problems with that. For starters the census data is based on surveys. They ask people how much money income do you have, are you making. And so they’re basically asking, collecting data on an income series that is pre-tax. So it doesn’t include any of the tax credits that progressives have succeeded in putting into the tax system. Doesn’t reflect the progressiveness of the tax system, doesn’t reflect non-money sources of income like Medicaid and Medicare and food stamps.

So you’re never going to win that debate because that series is always going to show that the median household isn’t doing very well if you don’t factor in all the programs that the progressives have successfully provided. I mean in the book I try to be balanced. I try to be fair to the progressives. They’ve accomplished a great deal. I mean Social Security–nobody argues about that really anymore, and we’ve got Medicaid and Medicare. There’s a lot that they’ve accomplished. But if they don’t show that in the data that they’re using, you know they’re always going to be finding fault with the system, and so that’s one problem.

The CPI tends to be upwardly biased. It’s widely recognized by economists that it’s upwardly biased and there are other measures that economists — particularly the Fed has endorsed the personal consumption expenditure deflator as an alternative to the CPI — and when you use that  indicator you find that real incomes have increased about one to one and a half percent per year since 1995, whereas the data series that the progressives have been promoting basically stagnated over that whole period. You’re still going to hear progressives just kind of blurt out unchallenged that the data confirms that the average family, the median family, has seen their income stagnate for decades and that all of the benefits of economic growth have gone to corporations and the wealthy, and that’s just not correct. It’s just not true. The reality is there has been no stagnation in real wages.

Rick Ferri: One thing that’s in the sights of the proposed tax bill is this idea of corporate buybacks and how stock buybacks are a bad thing and that this money should be going to the workers and the stakeholders instead of the shareholders. You wrote a whole book on this. Can you tell us some insight?

Ed Yardeni: Well we don’t really have particularly good data on buybacks. What I do see is that when we look at the S&P 500 and we look at the growth rate on a year-over-year basis in earnings per share versus the total earnings, aggregate earnings of these corporations, what we find is that it’s not much of a difference. In other words, are companies really spending hundreds of billions of dollars to buy back their shares, and on balance the S&P 500 winds up only getting a boost of about one percent per year from this buyback activity. Now the problem is that’s the macro picture. When you actually dig down and look at the S&P 500 there are in fact lots of companies that buy back their shares, and that significantly increases their earnings per share because they’re fewer shares outstanding. But then there’s also a lot of other companies where the buybacks don’t seem to be having that effect.

Well we don’t really have good data on, but we know anecdotally it exists, is companies do pay their employees for some of their compensation in stock and in stock options, and it’s not just the top three or four or five people that are part of these plans. And I think what happens is when companies like that pay out compensation in stock to avoid dilution, to avoid reducing their earnings per share because there’s more stock being issued as compensation, they turn it right around and take the money, the cash that they didn’t pay out as cash for compensation, and buy back their shares so that net doesn’t have an adverse impact on their earnings per share. And I think there’s quite a few companies that do that, so I don’t think we want to discourage companies from paying some of the compensation in stock because it does give employees skin in the game, and it does give them a benefit. I mean the reality is this: the stock market has been trending higher for years and employees who’ve been benefiting from compensation plans by getting some of their pay in stock have done extremely well and I don’t think we want to discourage that. I also don’t think that Washington should get involved in micromanaging corporate financial matters. It should really be up to corporations to deal out with that.

Having said all that, I do recognize that there is a problem of some CEOs being egregiously overpaid. So it’s again, it’s not as though I disagree with everything progressives have to say. I think they are right that there are some CEOs that are egregiously overpaid but I think it’s really up to the shareholders. Or if Congress wants to get involved in that area–they already have done that and and messed things up. It was back in Bill Clinton’s administration that Congress was very concerned about CEOs making too much money and what they did is they said, “Okay up to a million dollars in compensation for CEO is tax deductible to the corporation. Anything above that isn’t.”

So corporations started issuing stock and stock options to these CEOs who got famously rich thanks to this progressive legislative change. So beware of what you wish for. Beware of  unintended consequences when you meddle around with the economy.

Rick Ferri: But unlike stock that’s just bought back to increase earnings per share, stock that’s bought to basically get reissued to employees, this is an expense item. This doesn’t get away.

Ed Yardeni: That’s correct, it’s an expense item. Let’s just take, I don’t know, somebody’s making a hundred thousand. You give the employee ten thousand or twenty thousand in stock. So instead of paying out ten to twenty thousand dollars in cash you take that cash and go and buy the stock in the market, so that you’re not diluting earnings per share. So, absolutely, the full 100,000 is expensed from the corporate income statement.

Rick Ferri: So mostly do you think, what, half of all stock buybacks are basically expensed like it would be a salary?

Ed Yardeni: It’s hard to say. The data I’ve seen, which is very flimsy data, is something like 20-25 percent of employees get some sort of stock compensation, which is a pretty large number of people. It’s not — you can’t account for that, those kind of numbers with just a couple of the people at the top.

Rick Ferri: But overall you do know, you did see, that stock buybacks in the aggregate maybe increase earnings per share by one percent per year?

Ed Yardeni: Correct.

Rick Ferri: But what percentage of the stock market is being bought back every year, was it three, four percent?

Ed Yardeni: Something like that, yeah. I mean the market cap is huge.

Rick Ferri: So could we reasonably say then that at least half of all buybacks, maybe even more, it’s just going towards compensation that’s expensed?

Ed Yardeni: It’s a real possibility. I just don’t–I like to have the data to make my point. I mean I’d love to say that and say this insight proves my point, but I can’t really prove it with the data so at this point I’d rather just say that what I do believe is I have some data confirming the story is that something like 25 percent of working people get some participation in the compensation in a stock compensation plan.

Rick Ferri: Okay fair enough. But this is a target now of Washington. I mean some people in Washington have decided that stock buybacks for whatever reason are not a good thing for America.

Ed Yardeni: Yeah, they believe that the corporations should be taking that money and spending more on capital equipment and productivity and wages. They’ve often compared the amount of money that’s spent on buybacks to corporate profits and said, “My god, it’s a hundred percent. A percent of corporate profits is going to buy backs and buybacks plus dividends account for 100 percent of corporate profits.”

What they don’t seem to appreciate is a basic accounting statistic in corporate finance, and that is corporate cash flow is equal to after-tax corporate profits plus depreciation, and depreciation is huge, much bigger than corporate profits. So companies have been spending and we’ve got record capital spending going on even as we’ve had sizable buybacks. So where did all that money come from for the capital spending? And the answer is well, it’s cash flow. It’s cash flow to a large extent based on the depreciation allowance which is a essentially a tax shelter so that you can write off assets that are depreciating and have money to reinvest in newer equipment.

Rick Ferri: The proposal that went to the Senate recently said that there will be a one percent tax imposed on all corporate buybacks with some exceptions– stock that goes into an ESOP plan and a few other things– don’t you think that if that actually passed that corporations would change the way they do things as far as compensation to their employees, that 25% which is currently getting stock?

Ed Yardeni: No  it’s a piddling number. But it’s really just opening the door to Washington having more say in the way corporations manage their finances, which makes no sense whatsoever since very few politicians in Washington have ever managed a company, or should have any say in managing a company. Again it gets to the concept of shareholders versus stakeholders. Congress, I guess, views itself, or some politicians view themselves as stakeholders in every corporation in America. That somehow they have a right to meddle and to tell corporations what they should be doing with their finances, with their employment, with their capital spending, with their productivity.

But that makes no sense. That’s not the way the system’s supposed to work. It’s supposed to be a capitalistic system and shareholders should be the ones overseeing what their businesses are doing.

Rick Ferri: The name of the book called In Praise of Profits and it’s just a treasure trove of some great information about income and the measurement of income and different profits and and the uses of profits and so forth, and it just adds to your knowledge about how America works, and I think that the best thing, I guess I could just sum it up with just one line that you wrote actually in the last page of the book,and basically you said:

“Most Americans have never been better off than they are today thanks to record profits and record productivity which are fueling widespread prosperity.”

Do you want to comment on that?

Ed Yardeni: Well that line, and really, does encapsulate the whole point of the book is that you know we should praise profits rather than curse profits. ”Profits” is not a four-letter word. “Profits” really is the source of economic prosperity. The profit motive drives businesses to provide the very best goods and services at the lowest price relative to the competitors, but it’s important that they have competitors, it’s important that we don’t corrupt the system with crony capitalism, with too much politics. I mean it’s kind of too late for that it’s already happened but it’s important that we allow entrepreneurs to constantly challenge, that system to come out of nowhere with better goods and services at lower prices and say, “See, I can do this better than these big companies who’ve been established and doing it for a long time, and yet aren’t giving you the kind of quality or prices that the consumer really should have.”

So yeah the whole focus of the book is that we need to have a lot more respect for profits and a lot better understanding of the role of profits and creating the prosperity that we’ve all enjoyed and I would hope that some people would re-examine their assumptions because it’s widely believed that Americans aren’t that well-off, that their incomes have stagnated, that their standard of living is pathetic and that income inequality has gotten so bad that only a few people really are enjoying the benefits of this great country and that’s just not so.

Rick Ferri:  Well, thanks. That’s a great summary. Let’s get into the economy.

Ed Yardeni: Sure.

Rick Ferri:  And what happened in 2021, where are we now and where do you think we’re going in 2022 and let’s start with corporate profits.

Ed Yardeni: Right. The corporate profits have been remarkably strong. They’ve come back dramatically on a year-over-year basis. In the second quarter we’re up like 90 percent. That reflects the fact that they were extremely depressed during the second quarter of 2020 because of the lockdowns, but it’s really quite extraordinary, the extent to which corporate profits have made a comeback. Corporate profit margins have gone to all-time record highs and the market, the stock market anticipated that, and as you might recall there are a lot of people in the media who were kind of like looking at the stock market and said, “This is not right. I mean, why is the stock market having such a good time when the economy is doing so terribly?”

And the reality is corporate profits underneath of all that were rebounding dramatically and as corporate profits rebounded guess what, companies started to bring back their employees and started to expand again and so it’s all come together rather nicely. I think 2021 is a year where the demand shock that was created by excessively stimulated fiscal and monetary policies, created a supply disruption shock. I think that’s really what’s been happening in 2021 is it’s not that suddenly the supply chain system kind of collapsed for no good reason, it just got overwhelmed by demand.

Look people had cabin fever from the lockdowns and as soon as the lockdowns were gradually eased they went out and bought a lot of goods they couldn’t buy services so they bought a lot of goods. And then the government sent three rounds of relief checks and I think the first one was necessary, the second one not so much, and the third one I think created the demand shock that has led to the supply disruptions. Just way too much demand relative to the supply system. So the supply system has been disrupted and the result has been higher inflation.

This whole business cycle that we’ve had since we hit a bottom in the second quarter of last year, has been like a business cycle on steroids and speed. We had a horrible recession last year that only really lasted two months, which was March and April. We’ve never had a lockdown recession, and then we’ve had this extraordinary recovery to the point where we were back to where we started pre-pandemic in record GDP territory by the second quarter of of this year, and now as part of this accelerated business cycle we’re seeing something we haven’t seen for a very long time, and that’s a real pickup in inflation.

Rick Ferri: Well that gets right into my next question. Chairman Powell and others have been talking about this transitory inflation versus permanent inflation. Of course they’ve been trying to get the inflation rate up to two percent for a long time but this transient inflation seems to be pretty sticky now. Can you comment on that?

 Ed Yardeni: Yeah it’s gone from being transitory to being persistent. And the transitory story was being promoted by Fed chair Jerome Powell who said that look when you do year-over-year comparisons and you’re comparing prices in March and April this year to March and April last year, guess what?  It’s going to show a lot of inflation because prices were depressed in March/April /May /June/ July of last year, so those year-over-year comparisons are going to be distorted by what he called the base effect. But you know once you got into September/October readings you can’t, you couldn’t, make that argument anymore. And so he switched, he pivoted to a new concept, which is: well, it’s clearly supply chain disruptions that are causing a more persistent inflation than had been anticipated by him and others earlier than in 2021, and now with the pitch is, well when these supply disruptions get sorted out inflation should moderate. And that kind of makes sense. The problem is the longer that they persist and create inflationary pressures, prices, the more that those pressures then get into wages. The more there’s a risk of a wage price spiral comparable to what we had in the 1970s.

I don’t think that’s where we’re going. 1970s productivity collapsed. I see a tremendous boom in productivity in the years ahead, but for the here and now we are having unintended consequences of the Fed’s ultra easy monetary policy and the tremendous stimulus provided by the fiscal authorities that was deficit financed. All that’s created a demand shock which then created a supply shock which explains why we have an inflation problem right now. And it’s distressing because you know people are seeing their wages going up in their paychecks because workers are in high demand but at the same time a lot of those wage increases are getting offset by price increases.

Rick Ferri: When I first interviewed you, it’s been a couple of years ago, but we talked about your book Fed Watching for Fun and Profit and you came up with the four d’s for inflation: detente,disruption, demography, and debt. So first, could you explain those four and then also is there a fifth one now, called disease?

Ed Yardeni:  Well, perhaps in terms of the the 4 d’s starting in the early 1980s until we got tothe pandemic environment of seeing inflation making a comeback I was arguing that there are some major structural forces that were keeping a lid on inflation and were bringing inflation down, creating what some people described as disinflation. I  was an early disinflationist. I think it was in 1980 I wrote a piece called, On the Road to Disinflation, arguing that Paul Volcker probably would break the back of inflation and that we’d see lower inflation, not higher inflation.

And the four d’s. Detente is the first one. It’s just I need a word that starts with the d so to explain globalization. So globalization occurs during peace times. Markets become more integrated. Companies and businesses and countries trade more with each other and during peace times you get more global competition, which is fundamentally disinflationary. Then in a competitive global economy companies are under a lot of pressure to increase their productivity to offset the competitive advantage of their competitors, and so productivity is enhanced through technological disruption. So the d is in technological disruption.

And then there’s demography which is a constantly evolving story. But the way it’s been evolving in recent decades suggests that we’re not going to have very much in the way of population growth, and meanwhile populations are going to get older, more geriatric, and that that is inherently disinflationary. And finally central banks try to offset all of these disinflationary forces by encouraging people to borrow more, so they kept interest rates low, they provided very easy monetary policies, so we did in fact see a debt accumulation. But at some point that becomes a burden on growth rather than a stimulus of growth. At some point a lot of consumers have already done their borrowing, a lot of homeowners have already done their borrowing, and trying to encourage people to borrow more just doesn’t seem to work. And meanwhile, if you provide easy credit conditions you may very well create deflation because you may allow marginal companies to stay in business. Companies that should go out of business but for the fact that they can refinance their debts very cheaply as a result of ultra easy monetary policies.

I don’t know what to do with the disease concept you just introduced because it’s not clear how this is all going to play out. It certainly looks as though the pandemic has had some impact on contributing to the supply chain disruptions to the extent that port workers have been ill and couldn’t work and that certainly could be contributing to inflation rather than disinflation. So you know a lot of things changed, possibly fundamentally, possibly for a while as a result of the pandemic and right now I think we clearly have an inflation problem. But looking beyond that I  think technological innovation is going to be a source of disruption and is going to lead to more productivity, offsetting these inflationary forces.

Rick Ferri: You touched on interest rates earlier, and interest rates now are persistently low given the higher inflation rate. You were predicting, if I recall, that the 10-year Treasury should go over two percent probably even getting closer to three, if I’m not mistaken, by maybe next year. But it hasn’t. I mean it’s been persistently stuck here, it seems. Can you comment on number one, what’s going on, and number two, you still have that prediction for next year?

Ed Yardeni:  No. I mean that’s, you know I scaled it back. It just didn’t work out and so I scaled it back to well, maybe we’ll get the two. I thought we’d get to two percent by the middle of this year and we were going in the right direction there. Well we got to 1.7 percent in March, and then all of a sudden it started coming back down again for no obvious reason. Maybe the bond market had more concerns about the underlying pandemic as being fundamentally deflationary. And then bond markets really have been globalized. So now we’ve got bond yields at zero or slightly negative in Germany and Japan, so maybe they just keep buying our bonds at one and a half percent, which is why we haven’t gone to two percent. But of course the Fed also has been buying bonds like mad and I think, well, but here they’ve announced them, they’ve started to taper and yet we still don’t see the two percent handle. I think we will sometime next year but I don’t know that we’re going to see three percent. I think the Fed is going to be even more liberal next year than they were since the pandemic started, continuing to be more concerned about the labor market than inflation. And so I think there will be a couple of rate increases next year, two not three, and then I think the Fed will actually move the goal post and say that their inflation target is three percent instead of two percent.

 Rick Ferri: Interesting. The Fed has been buying a lot of Treasury Inflation Protected Securities as well. I think they own 20 percent of the market now.

Ed Yardeni: Yes they do. Why are they doing that, I don’t see any point in it whatsoever. I mean the less that they meddle in capital markets the better. So what are they doing in the TIPS market? The TIPS market could actually give us some guidance on what inflationary expectations are doing, but you can’t come to that conclusion when the Fed’s such a heavy player in that marketplace. It’s a mystery. I mean other than them believing that they’re going to buy bonds, they should buy them across the maturity spectrum and as well as in some of the esoteric bonds like the TIPS, but it makes no sense, there’s no reason for it.

Rick Ferri: Let’s go overseas for a bit and tell me what you see in Europe and then go across the Pacific and tell me what you see in China.

Ed Yardeni: Well, Europe has a demographic problem. Their populations are aging. They aren’t, their populations aren’t growing very rapidly. They’re trying to have policies that are consistent with unnationalistic policies covering all the the region of Europe or at least the Eurozone, and yet they still have a lot of nationalities. I mean they still have nation states there that don’t necessarily all agree on what policies should actually be.

And so there’s a lot of inconsistencies, a lot of tensions in the way that system is designed. They’ve got a monetary union but they don’t have a tax regime. They don’t really have a fiscal union. It’s only as a result of the pandemic that they started issuing Eurobonds for the region. I think Europe has some major issues in terms of stimulating their economy and I don’t view it as a particularly vibrant or dynamic economy. They don’t have the same kind of mix of histories that we have here. We certainly have a lot more in healthcare and a lot more in technology and finance than they do. There’s venture capital here. There’s a lot of wealthy people that reinvest their monies in new innovations. It seems to me as though we’re more innovative than the Europeans are. That’s– so by comparison to the US. I think there’s a lot of room for improvement in the way things operate in Europe.

With regards to China, China’s got a very, very serious fundamental problem also with their demography and they worsened it with the one child policy.  When we look around the world, fertility rates have collapsed below replacement just about everywhere except India and Africa, and they’ll probably go to below replacement there too because I think it’s all related to urbanization. In agricultural communities kids have an economic value. In an urban setting kids are all cost, and where are you going to put them. I mean people live in apartments. They live in small houses, maybe. And so we’ve seen fertility rates collapse and that’s particularly occurred– what’s occurred around the world– it’s occurred in China and the Chinese made that much worse with the one child policy which was only lifted in 2015 and now only this year they said okay you could have not just two children but you can have three children, but it’s too late.

Demographic damage has been done and we can see that in inflation-adjusted retail sales. Real retail sales growth which I monitor every month has plunged from about 18 percent in 2011 to zero recently. So the demography is really haunting them in terms of consumer demand. And then of course their whole property bubble seems to be ready to burst. And if it’s not going to burst, they’re going to try to manage to take the air out of it which is going to take a lot of growth out of their economy. So they’re becoming more and more dependent on exports which is becoming less and less reliable, at least exports to countries that they’re having political tensions with like the United States, like Australia and maybe some others. So I think China’s operating from a fundamentally weak demographic position and I worry about what that might imply in terms of their military aggressiveness.

Rick Ferri: Wag the dog, right? Create a diversion.

Ed Yardeni: Yeah.

Rick Ferri: Let’s get into back to the United states and let’s talk about an area that you discussed on one of your podcasts recently where you’re going to begin to focus this whole idea of productivity and where do you see us becoming more productive and you’re going to start to focus a lot on that with your research.

Ed Yardeni: Well the productivity story I think is a huge story. I think it’s the story that will make or break the decade ahead here. If this is the 1970s all over again then productivity will be collapsing during the current decade, but that’s not what I see. I see productivity having bottomed around 0.5% at an annual rate during 2015, now running around 2%, which is a significant improvement. And I think it’s going to go to 4% within the next few years, and I think the technology revolution that started in the 1990s is ongoing. I think the technologies have become more powerful, more user-friendly, cheaper, easier to implement and really lend themselves to being used in just about every business.

I tell people when you look at your stock portfolio ask yourself if every one of your stocks is a technology stock, and they look at me. “So you’re kidding, you don’t want me to put 100% of my portfolio in tech?” I said, “No, what I mean by that is you want to own tech for sure, but you want to make sure that the companies that you own that are not in tech are using tech to increase their productivity and efficiency.” So for example, these days people talk about fintech and medtech as being sub-industries within those sectors and that’s the way I’m looking at things.

The big story, really for productivity, is the big story in the demography. We’ve got very little growth in the labor force, very little growth in the population. And that’s really the key to understanding why productivity is bound to make a comeback. Companies, I think, started to realize before the pandemic that there was something wrong in the labor market. There was not enough workers, and the unemployment rate got down to three and a half percent before the pandemic. And so there’s a real shortage of workers. Pandemic hits then everything is wild for a while and now people come up with all sorts of explanations of why people haven’t been coming back to the labor market. But the reality is the underlying demography of senior baby boomers retiring and not being replaced by more younger people, but barely by being replaced by younger people, we’re seeing that the labor force growth is about 0.5 percent and the arithmetic of real GDP is very simple, it’s labor force growth plus productivity growth. So if there’s no growth in the labor force there’s no growth in real GDP unless there’s productivity growth, and I think companies are going to, are already scrambling to use technology to increase their productivity and 4 percent productivity growth would be, it would be marvelous, it would be a very bullish scenario.

Rick Ferri: I want to ask one last question: it has to do with energy. You’ve made comments recently about the potential future rise again of nuclear power and also cold fusion. You just want to touch on those and what would they mean?

Ed Yardeni: Well, I’m an economist. I’m trained as an economist and my main complaint about economists and the way economists are educated is– if you go back and look at your introductory economics 101 textbook written by Paul Samuelson you’ll see that economics is described as the science of optimally allocating scarce resources. It’s a pretty depressing concept that there’s only so much, so many resources out there and it’s up to economists to come up with systems that optimally allocate those resources.

And I can fundamentally disagree with that definition of economics. I think economics is about technology being used to overcome what appears to be scarce resources. The way we know things are scarce is through the price mechanism. When prices go up for something, well that’s there’s some scarcity there, and then some entrepreneur says, ”I know, I got an idea for how I could overcome that and come up with something better, smarter, cheaper to to deal with that scarcity.”

And it’s technological innovations that really make the difference. And I think that’s going to be a big surprise with regards to all these concerns about climate change and about fossil fuels and

so on. I’ve just been fascinated. Recently there seems to be a breakout of new technologies that may very well allow for the commercialization not of nuclear fission power but nuclear fusion or cold fusion power, and if that’s the case that would be truly miraculous because fusion generates energy without any emissions. It’s clean, it’s very, very cheap and that may be my next book– is trying to map out how something like that would impact the course of our economy, and the financial markets.

Rick Ferri: And the world.

Ed Yardeni: Absolutely, absolutely. Be a game changer.

Rick Ferri: Well thank you so much again for being our guest on Bogleheads on Investing. I really enjoyed the talk today and thank you. I really enjoy reading your information. I know your work is for mainly institutional investors, but if an individual investor wanted to follow you how would they do that?

Ed Yardeni: Well yeah, the reason it’s for institutional investors is because we spend a lot of time and money doing, giving, our very best efforts and it’s the market that is especially attuned to what we do. But individual investors are welcome to at least try it for four weeks. Go to yardeni.com and at the top of the website there’s a form to fill out a trial. Other than that I do post quite often, almost daily actually on LinkedIn and then that’s shown on Twitter as well. So I do provide quite a bit of insights that way.

I kind of view myself as having a day job which is how I feed the family and then having an evening job writing these books and providing some information on LinkedIn to the general public because I have learned a lot over the years and I’d like to share it with people and get their opinions, and maybe tweak some of my own thoughts. At this point in my life I got plans for more books.

Rick Ferri: Well thank you so much again for being our guest and hope you have happy holidays.

Ed Yardeni: You too. Best to everybody.

Rick Ferri: This concludes Bogleheads on Investing, episode number 40. Join us each month as we have a new guest and talk about a new topic. In the meantime visit Bogleheads.org and the Boglehead wiki, check out the Bogleheads’ new YouTube channel, Bogleheads Twitter, Bogleheads Facebook, and find out about your local Bogleheads chapter, and tell others about it. Thanks for listening.

Investment adviser, analyst, author and industry consultant

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