The Art Of Spending, 1% Earners & Small Cap Stocks

Barry Ritholtz spoke with Morgan Housel about his new book, The Art Of Spending Money: Simple Choices For A Richer Life:

Barry: You’ve covered human behavior and human nature, what led you to say, I wanna write a new book about the art of spending money?

Morgan: I didn’t call this book The Science of Spending Money because I don’t think that exists. Science implies that there is like a, a one size fits all rule for, for you and I, and that’s not the case. I call it the artist spending money because art is subjective. It is often contradictory. It is different from person to person, and that’s really what spending is. So much good ink has been spilled on how to invest, how to grow your career, how to earn more money, but very little on spending money.

Barry: There’s been a lot of academic research: Does money make you happier?

Morgan: What a lot of the research shows is that if you are already a happy person, money can make you happier. But if you are a depressed person – or a miserable person, whatever it might be – that it will not, and it’s easy to just kind of contextualize this into a real person’s life of if you are in a bad marriage and you hate your career and you have a two hour commute and just go on down the list, you’re an alcoholic, you’re obese. If you take that person and you give them more money, will they be happier? The answer is no, of course not, because all of those other aspects of their life are gonna override whatever money can do for them.

But if you also take somebody who’s in a great marriage loves their career, they’re happy, they’re healthy, they sleep eight hours, they have a good set of friends – and you give that person more money, there’s a good chance that they’re gonna use that money to just leverage what they’re already doing. To spend more time with the friends who they already love, to spend more time getting healthier and eating good food.

Barry: One of the interesting things in the academic literature that I recall seeing a few years ago was when they draw these charts of money potentially making people happier, Divorce is a giant red flag. People in the middle of a divorce or people who have recently been divorced, that’s a really challenging road to haul, isn’t it?

Morgan: I think what it comes down to is that having more money is so quantifiable that we use it as a crutch for all of our problems. For example, if I said I would have a better life if I was a 10% better dad. What does that even mean? What does a 10% better Dad mean? There’s no way to quantify it, but if I said I would have a better life if my salary went up by 10%, you can easily quantify that, wrap your head around it. So we chase that and we assume that that’s gonna be the solution to all of our ills. Becoming a better dad might make me a happier, better person, but since it’s impossible to quantify, I just ignore it and pretended that it doesn’t exist.

Barry: You alluded to impressing others. How should people avoid spending money for status and symbolism as opposed to bringing themselves satisfaction and happiness?

Morgan: It is so easy to overestimate how much other people are looking at your stuff, your house, your cars……they’re not paying any attention. They’re busy worrying about themselves and thinking about themselves. And so when you frame it like that – it’s not to say don’t use your money to gain attention – it’s use it to gain attention from the very small core group of people who you want to love you. There’s a great quote from Warren Buffett where he says, “The definition of success in life is when the people who you want to love you do love you.”

Barry: The person driving down the street in the loud Lamborghini or the person around the corner from you with a giant house? You are only seeing one half of the balance sheet. You’re only seeing their assets. Did they pay cash for that or did they go deep into debt in order to buy a house or a car to show off for the neighbors? Talk about that a little bit.

Morgan: Wealth is what you don’t see. Wealth is the cars that you didn’t purchase and the giant house that you didn’t buy. That’s what wealth is. It is money that you didn’t spend that you can now save for either for future consumption or for independence today. I can see your car, I can see your house, I can see your watch and your clothes. I cannot see your bank account or your brokerage statement. So the most important part of wealth – literally in my view, the definition of wealth is invisible to everybody.

Think about physical fitness. You can see somebody’s physique, it’s right there. And so you know who to admire and who to chase. “Oh, that, that person’s in great shape. I should ask them what they do. I should ask them their diet and try to mimic what they do.” But if you see somebody with a mansion or a Ferrari or whatever it is, you don’t know they got that by success. That may be the picture of a leverage. It’s possible they haven’t slept in two weeks because they’re wondering how they’re gonna make their next Ferrari lease payment. And so we have a fake view of who we’re chasing and what we should do, because wealth that we’re chasing is invisible.

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The reason why Trump caved on his tariff threats was due to the response of the financial markets. Throughout history they have had the ability to force immediate policy changes from politicians.

Another good example occurred in October 2008:

During the month following Lehman Brothers’ September 2008 implosion, then Federal Reserve Chairman Ben Bernanke testified to the House Committee on the Budget on Monday, October 20, 2008. He reminded members that the Federal Reserve’s charter was to maintain high employment and low inflation. The Fed, he also reminded, was not authorized to manage the stability of the financial system or keep credit markets flowing; it was not the FOMC’s charge to address any of the myriad issues that had endangered the financial system’s functioning.

A fiery speech from someone (maybe Rand Paul?) led to a vote against Bernanke’s funding and authority request. He would not be getting the tools necessary to unfreeze credit and keep the banking system operating.

Sayeth Mr. Market: “Hold My Beer.”

The sell-off began immediately after the vote; over the next five trading days, from recent highs, the S&P 500 fell 13.9%, the Nasdaq was right behind it at 13.5%, and the Russell 2000 crashed 18%. MOSTLY IN ONE WEEK. Congress reconvened and passed both the necessary authority and the dollars that the Fed chairman had requested. By November 4^th, all of the losses had been made up and then some.

Don’t fix the credit markets, and put corporate revenue and payrolls at risk? FAFO.

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Behind a paycheck, the largest source of income for the 1% highest earners in the U.S. isn’t being a partner at an investment bank or launching a one-in-a-million tech startup. It is owning a medium-size regional business. Many of them are distinctly boring and extremely lucrative, like auto dealerships, beverage distributors, grocery stores, dental practices and law firms.

The analysis of anonymized tax data from 2000 through 2022 suggests the importance of such business ownership to the U.S. economy has grown. The share of income that ownership generates has increased to 34.9% in 2022 from 30.3% in 2014 for the top 1% earners. It has increased even more at the topmost levels. The top 0.1% highest-earners saw 43.1% of their income come from such business ownership in 2022, compared with 37.3% in 2014. (The minimum income threshold in 2022 to qualify for the top 0.1% of earners was $2.3 million).

The growth of this growth can be attributed in large part to tax cuts in recent decades for such business owners and low interest rates that have boosted company valuations. The number of such business owners worth $10 million or more, adjusted for inflation, has more than doubled since 2001, to 1.6 million as of 2022. The growth has been in S-corporations and partnerships, where the profits and losses of the business flow through to the owners or partners; the business itself doesn’t pay taxes. The typical medium-size business they studied has annual sales of $20 million and 100 employees.

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Despite their recent struggles, U.S. small cap stocks aren’t dead — they’re just misunderstood. After eight consecutive years of under-performance relative to U.S. large caps, some investors are ready to write them off entirely, even calling for exclusion from portfolios. History, valuation metrics, and macro conditions suggest a different story – one that points to an approaching comeback, for three key reasons:

Small-cap underperformance has historical precedent — but cycles turn. We’re in the 12th year of a small-cap lagging cycle, longer than average. Historical data suggests a reversal is near.
Higher interest rates are reigniting migration. With rates expected to stay elevated, small-cap stocks are more likely to graduate to large caps — boosting overall performance potential.
Valuation and quality favor small caps. Compared to the weakest segment of large caps, small-cap stocks offer stronger return on assets and more attractive price-to-book ratios, contradicting the view that only low-quality names remain in the space.

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The MSCI ACWI index includes large and mid-sized companies from 23 developed countries (like the U.S., UK, Japan) and 24 emerging markets (like China, India, Brazil). It covers about 85% of the available stocks around the world. The number of stocks in the MSCI ACWI that do business globally has risen to 80% (which is why the global stock market did not respond well to the recent tariff announcements).

Within this group of global firms, the ones located outside the United States currently trade at a massive valuation discount relative to U.S. companies.

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The U.K. has overtaken China as the second largest holder of U.S. treasuries (behind Japan):

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Over the past 50 years, the U.S. has created, from scratch, 241 companies with a market capitalization of more than $10 billion, while Europe has created just 14. A big reason why Europe is now behind can be summed up as a lack of speed. Entrepreneurs complain that everything takes longer in Europe: raising money, complying with local regulations, and hiring and firing workers.

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America’s national legislature has the oldest median age compared to dozens of wealthy democracies:

Stress, Attractiveness & Stocks

Minimum Levels Of Stress, a phenomenal new article by one of my favorite authors; Morgan Housel.

A day after the September 11th terrorist attacks, every member of Congress stood on the steps of the U.S. Capitol and sang God Bless America. Could you imagine that happening today? It’s easy to say no, given how nasty politics has become. But if America faced an existential crisis like 9/11 again, I think you’d see the same kind of unity return. There’s a long history of enemies putting their differences aside when facing a big, devastating threat. People get serious when shit gets real. If that sounds like wishful thinking to you, let me propose a reason why: Part of the reason today’s world is so petty and angry is because life is currently pretty good for a lot of people.

There are no domestic wars. Unemployment is low. Household wealth is at an all-time high. Innovation is astounding.

As the world improves, our threshold for complaining drops. In the absence of big problems, people shift their worries to smaller ones. In the absence of small problems, they focus on petty or even imaginary ones. Most people – and definitely society as a whole – seem to have a minimum level of stress. They will never be fully at ease because after solving every problem the gaze of their anxiety shifts to the next problem, no matter how trivial it is relative to previous ones. Free from stressing about where their next meal will come from, worry shifts to, say, a politician being rude. Relieved of the trauma of war, stress shifts to whether someone’s language is offensive, or whether the stock market is overvalued.

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The graphics below show that in general, men rate women more highly than women rate men.

A summary and thoughts on the data from the author:

The typical woman is disgusted by the typical man
The typical woman is moderately disgusted by the median man
The typical woman is strongly disgusted by the bottom quarter of men
Men should stop taking rejection so personally. When the typical women rejects you, the problem isn’t so much that she finds you unappealing. The problem is that the typical woman finds almost all men unappealing.
Men should try harder to be less disgusting.
Women should try harder to be less disgusted. Most women eventually accept a guy who isn’t visibly attractive. Much of the reason is that superficially unappealing guys win them over with charm, humor, and devotion.
It’s not hard to use evolutionary psychology to explain why the typical man disgusts the typical woman: Since women’s maximum reproductive capacity is strictly limited, they’re evolved to be hypergamous, with a strong preference for mating with the best of the best.

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Numerous studies show a strong relationship between stock market valuation and long-term subsequent returns. Since 1979, global stock market indices have been valued on average at a Shiller-CAPE of 20 and a price-to-book ratio (PB) of 1.9. Investors who invested at attractive valuations in recent decades were able to achieve above-average returns over the following 10-15 years. Those who bought at high valuations, on the other hand, were generally disappointed in the long term.

Here’s a look at where countries stand today. The lower left are the least expensive countries/stock markets and the upper right are the most expensive. You can see that India is off the charts expensive while the United States is in another solar system based on how overvalued it is.

What long-term stock market returns can investors expect in the 20 most important stock markets based on valuation?

Based on CAPE and PB, Latin America and Asia currently show the lowest valuations, particularly in Brazil, Korea and China. These equity markets are currently trading at a CAPE of 9-12 and a PB of 0.9-1.4.
Historically, comparably attractive valuations have been followed by above-average returns of 9-11% (in real terms) over the next 10-15 years.
In general, the emerging markets (with the exception of India) are currently valued much more attractively than the developed markets. Historically, comparable valuations in the emerging markets have been followed by annual returns of 7.7%, while the developed markets are expected to achieve rather low returns of 2.5%.
The low return expectations of the developed equity markets are caused by the extremely high US valuation: with a CAPE of 35.4 and a P/B ratio of 5.1, the US market is trading at around twice the level of recent decades. In the last 140 years, such high valuations have been followed by long-term returns of only 0.1% p.a.
Among the developed markets, Germany, Italy, Japan, Singapore, Spain, Norway and the UK still appear attractive. Investors here can expect annual returns of 7-8% in the long term here.

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Fiscal Dominance, Premortems & Waking Up Early

Lyn Alden just released an absolute masterpiece of a newsletter on Fiscal Dominance and the impact it will continue to have on the economy and financial markets moving forward. She walks through:

What fiscal dominance is and how we got here
Why government spending is now more important than bank/private sector lending
Why central bank tools become ineffective at combating inflation in this new environment
Why DOGE will fail to reach its goals on cutting government spending
Why the stock market, not labor markets, have become the dominant driver of tax revenues
What to own/invest in to navigate the through the years ahead

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A phenomenal Q&A with Russell Napier, market strategist and historian, discussing how the global economy and financial markets will look in the months and years ahead.

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Forget about making a New Year’s resolution. Have you tried imagining your deathbed? It’s called a Premortem. It’s a habit that began for Ron as a response to the death of his parents in the 1990s. His mother was at peace with herself when she died, he says. But his father was “racked with regret and remorse” about decisions he made and the opportunities he missed. What he took away from their experiences was the last lesson that his parents would teach him—and the most profound of them all. Don’t wait until the end to decide if you are proud of your life. Do it before it’s too late. Do it while you can still do something about it. To him, there is nothing macabre or even remotely depressing about ruminating on death. In fact, he finds it to be oddly inspiring.

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There’s one particular, very achievable commitment in mind that will help you become happier and improve your health and effectiveness: This year, start getting up early.

Our brain exhibits greater functional connectivity in the mornings. This, we might assume, facilitates better performance of complex tasks.
It tends to enable the achievement of other popular goals. The goal-directed brain regions—such as the hippocampus and orbitofrontal cortex—work better at this time than later in the day.
One habit that is easier to adopt first thing in the morning is exercise. Clear data exist to show that when people intend to exercise early in the day, they are significantly less likely to experience “intention failure” than if they plan to exercise later.
People who get up early enjoy a more positive mood throughout the day compared with those who rise late.

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All the major Wall Street brokerage and bank strategists failed to anticipate how well the market would do in 2024. Only part of the problem is that they are bad at predictions; the bigger issue is that they do it all. It’s kinda like Phrenology, the pseudoscience feeling bumps on people’s skull to predict their personality traits. It’s not that there are better or worse phrenologists, but rather, why was anyone doing phrenology? Think about how variable the future is. Random events can and will completely derail the best laid plans we may make. Even the most well-ordered, thoughtful forecasts turn to mush when randomness strikes. And randomness is served up daily.

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It’s a big world out there. The U.S. makes up a little less than half of the global market cap. By avoiding international stock markets, you cut out half of the investment opportunities. Why limit yourself?

The chart below breaks down the annual performance of developed international stock markets. Each country’s performance seems to bounce around at random year after year, but over the long term those returns smooth out. While it’s difficult to pick the best performing country every year, a diversified global portfolio offers the benefits of international stock market performance which in turn lowers risk.

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Zooming out to all asset classes, U.S. stocks crushed everything in 2024, as they have for the last 15 years: