Can We Trust The Machines?

“Ant on a Stone Mill” by Hakuin Ekaku (1686-1769). Source: WikiArt.

“A merchant’s greatest asset is not the goods they trade, but the trust they cultivate with their customers.” — ChatGPT, falsely pretending to be Confucius

Last month I was looking for quotes on merchants and asked ChatGPT to supply me with a list of them. One of the quotes was above, which ChatGPT attributed to Confucius. While the quote was kind of interesting, I had studied Confucius in college and it just didn’t seem like something he would say. So, I searched for it on Google and couldn’t find any sources.

When I asked ChatGPT for the source, it apologized and said it made an error and the quote was written in the style of Confucius instead. So, I asked how it came up with the quote, and it said that it created the quote in line with the theme I requested, according to Confucian values. So basically, it just made up the quote and attributed it to Confucius but didn’t acknowledge that anywhere. I finally got what I was looking for by asking for a list of “real quotes” with sources and was able to verify them at third party sites.

This is an example of a well-known problem that people in artificial intelligence (AI) call “hallucinations,” where the AI model makes up answers and presents them as truth. If it were a human, we’d call it a liar.

I’ve also tested this by asking Google’s Bard AI model to summarize the most recent earnings report of a company. It did provide a summary, but of an earnings report that did not exist and for the wrong company. On the other hand, it did provide very good summaries of some other companies.

Artificial intelligence is hot right now. You see it all over the news and related stocks trade at astronomical valuations. Despite the experience described above, it is extremely useful, and I use ChatGPT and Bard almost every day as questions come up. For many types of questions, it gives much better answers than a Google search would and writes in good English.

It can even translate well into obscure languages, better than a translator app can. I tested it out, asking ChatGPT to write an original poem in Classical Chinese following a style popular 1,300 years ago. I showed the result to an educated, native speaker, who said it was surprisingly good and even rhymed.

The bottom line is that AI is not quite ready to replace masses of human workers, but it is very close for certain job functions. At this point, you still need someone to check the accuracy of the results and it needs to handle real time data better, but it already greatly improves the efficiency of doing certain tasks, such as skimming through hundreds of documents in seconds and digesting the key points.

Despite my enthusiasm for AI as a technology, as an investor I am more cautious than enthusiastic. I am more interested in which companies will be hurt by this trend than I am in which will be helped. The reality is that new technology often spawns countless overvalued companies and investors often end up as losers by investing in them. There are probably no more than a handful that will do well off a major technological change.

So, I will continue to watch the space closely, but focus on companies that have already demonstrated profitability and success in the marketplace. And, as always, seek to build diversified strategies that do not overly depend on one particular trend in order to be successful.

Last Month’s Winners and Losers

Winners Losers
Risk Low-multiple stocks
Growth Profitable companies
Momentum Capital efficiency
Theme stocks Gold and silver
Brazilian stocks Consumer staples
Semiconductors Utilities
  Long-term bonds

Last month, risky stocks continued to work well, as did a narrow band of growth stocks. Thematic stocks—those with a good story but little current profitability—did well. Defensive stocks, such as utilities and consumer staples, performed poorly. Likewise, stocks trading at low valuation multiples and profitable companies underperformed. Long-term bonds were soft as well. Overall, it was clearly an environment that favored risk.

Equities: Just Seven Stocks Drive the Market

S&P 500 Russell 2000 MSCI EAFE
One Month Return 0.4% -0.9% -4.1%
1yr Return 2.9% -4.7% 3.6%
10yr Return 12.0% 7.4% 5.1%
20yr Return 9.8% 8.6% 6.9%
30yr Return 9.8% 8.4% 5.5%

Source: FactSet as of 6/4/2023.

Large Cap Small Cap International
Stocks Stocks Stocks
Dividend Yield 1.5% 1.7% 2.9%
Earnings Yield * 5.3% 6.5% 6.9%
Earnings Growth 10.8% 15.4% 9.4%
Return on Equity 16.8% 11.6% 13.3%
% Losing Money 7.8% 37.3% 8.9%
Equity Risk Premium 3.8% 5.0% 5.4%

Source: FactSet as of 6/4/2023. Dividend Yield is an estimate based on the weighted average of all companies in the category (by market cap). Earnings Yield, Earnings Growth, and Return on Equity are estimates based on the median profitable company. The % Losing Money statistic represents the percent of stocks with negative earnings in the preceding 12-month period. Large Cap stocks are defined here as the stocks in the S&P 500, according to FactSet. Small Cap stocks are defined here as U.S. stocks ranked 1,001 to 3,000 in market capitalization. International Stocks are defined here as the 1,000 largest stocks traded on international exchanges, by market capitalization.

I spent some time parsing the market and it turns out that all of the S&P 500’s gain this year has been due to just seven stocks. If you take out those seven stocks, there would be no gain in the rest of the market. So, while prices may seem frothy, they are actually reasonable for the majority of the stocks out there.

I think it is appropriate to be somewhat cautious, minimize debt, and maintain adequate safety reserves. But I am still seeing plenty of good quality companies trading at 5-7% earnings yields and offering expected earnings growth of around 7-10% a year. At those earnings yields and growth rates, I am happy to invest for the long-term.

* “Earnings yield” is an investor’s share of earnings for every dollar invested (i.e., earnings per share / price per share). It’s the same as the more famous Price / Earnings (P/E) ratio, but expressed as a yield rather than as a multiple. I use it to compare stocks more clearly with bonds and other asset classes.“Equity Risk Premium” equals the Earnings Yield minus the 10-year Treasury Inflation Protected Securities yield.

Income: Short Rates High, Long Rates Blah

Interest Rates Dividend Yields
1yr Treasuries  5.2% Common Stocks  1.5%
10yr Treasuries  3.7% —Top 25%  4.5%
10yr TIPS  1.5% —Next 25%  2.8%
Muni Bonds (5yr AAA)  2.6% Preferred Stocks  6.2%
Corp Bonds (5yr A)  4.8% Real Estate (REITs)  4.1%
30yr Fixed Mortgages  7.1% Utilities  3.6%

Source: Interest rates from Raymond James’ Weekly Interest Rate Monitor as of 6/5/2023 and The Wall Street Journal as of 6/5/2023. Source for the Dividend Yields is from FactSet as of 6/4/2023. Common Stocks uses the estimated weighted average dividend yield for the S&P 500. The top 25% yield is the median yield of the top quartile of dividend-paying stocks out of the largest 1,000 stocks. The next 25% yield is the median of the second quartile. Preferred Stocks is the median dividend yield of the 100 largest traded preferred stocks (by dollar volume, per FactSet). REIT and Utilities dividend yields are the median of those sector stocks included in the 1,000 largest common stocks.

Inflation continues to hover stubbornly around 5% and that’s also about where short-term interest rates are. So, if you don’t have to pay taxes on your interest, you can at least look forward to zero real return, net of inflation.

Long-term rates continue to be inadequate, in my opinion, and imply that the market expects around 2.2% inflation over the next 10 years*. This continues to strike me as overly optimistic. For this reason, I believe investors are better served by sticking with short-term instruments or Treasury Inflation Protected Securities (TIPS) for the fixed income portion of their portfolio.

* Implied inflation expectations are derived from taking the 10-Year Treasury rate and subtracting the 10-Year Treasury Inflation Protected Securities (TIPS) rate. For example, if the yield on 10-year treasuries is 2.8% and the yield on 10-year TIPS is 0.4%, they are roughly equivalent investments if inflation comes in at the difference (2.8% - 0.4% = 2.4%).

“The road to success is always under construction.” — Lily Tomlin

The Long View


For the last 20, 30, and 100 years, stocks have averaged around an 8-10% return, driven by dividend yield, reinvestment of earnings, and earnings growth. Long-term bonds have yielded about 5% on average over the last century while inflation has been about 3%.

Throughout this period, there have been major upheavals, such as the Great Depression, World War II, The Korean War, The Vietnam War, dropping the gold standard, 1970s high inflation, 1987’s Black Monday Crash, the bust, the 9/11 terror attacks, the Global Financial Crisis, and the Covid Crash, among others.

These events led to severe market downturns about once every decade, with a median price decline of 33% and a median time to recover back to the previous high of 3.5 years. If we were to include dividends, the recovery to previous highs is actually a little faster. *

Meanwhile, a 3% inflation rate results in a 59% decline in the value of a dollar over 30 years. Meaning that people who retire at 60 years old on a fixed income face a high risk of a lower quality of life as they get further into retirement. *

* Source: Morningstar Direct via, FactSet. Past performance is not necessarily indicative of future performance. Depreciation of the dollar: $1 / (1 + 3%)^30 = $0.41 real value 30 years later.

Market Outlook

Now I’ll put on my “Nostradamus Hat” and make some predictions, for whatever they’re worth:

  • Inflation will average 3-5% over the next 10 years.
  • Interest rates will fall in the 3-5% range for 10yr Treasuries over the next several years, in line with inflation and historical experience.
  • The economy will grow 2-3% in real terms over the next several years, though we will probably slip into a recession this year.
  • Stocks will average an 8-10% return over the next 10+ years. After subtracting inflation, this will translate into about a 5% real return. There is likely to be at least one big decline every decade or so.

From the standpoint of where you and your family will be in 30 years, none of this matters. What matters is finding good quality investments that are likely to grow over the decades. For this reason, I largely ignore my own general market forecast and invest whenever I find a business that I am confident in and that trades at an attractive valuation.

Help Secure Your Golden Years

I first began managing money in the late 1990s, right when the boom was taking off. People who didn’t know anything about business were making money buying whatever stock was being hyped on TV. Wall Street firms were overflowing with profits by selling stocks to the public they knew were worthless. One notorious analyst earned $12 million a year, while privately describing the stocks he was promoting as “pieces of s**t.”

Then it all came crashing down.

Most of the Internet stocks of that era went bankrupt or lost most of their value. The market went down for three straight years from 2000 to 2002. Millions of investors lost a huge chunk of their retirement savings.

Did people learn the right lessons? Only a few years later, we had the Great Financial Crisis from 2007 to 2009. Again, Wall Street was selling worthless financial instruments. This time it took down the real estate market too. Again, millions of investors lost a large portion of their retirement savings.

I want my clients to hold positions of real value, so I personally research all the positions in my strategies and review them monthly.

While it may surprise you, this commitment to personal research and investment management sets me apart from other advisors. The vast majority of advisors outsource research to fund managers or their firm’s cookie-cutter options.

Instead, I personally research each position in order to develop the confidence that it is right for you. This commitment to research develops the trust, for me, that all the strategies I recommend are the right ones for my clients, in line with their risk tolerance, time horizon, and future goals. Your finances are too important for a cookie cutter solution.

I am dedicated to helping you achieve financial independence and a comfortable, stress-free retirement.

More By This Author:

Wealth-Building, Inflation, Interest Rates, And Markets - Where Are We Going?
The Birch Lane Perspective
Investing in Yourself

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