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A Conversation

Imagine a financial adviser* approached you with an investment opportunity** without telling you specifically what it was. And right up front he tells you it’s likely to generate a zero to negative return over the coming decade. What would you say?

I imagine any investor with any common sense would respond by saying something like, “why in hell would I want to own something that will generate a zero to negative return over 10 years?!

And the adviser would likely respond with: “Well the outlook for other asset classes over the next 10 years is no more attractive than it is for this one.”

Common sense investor: “Well if it’s going to return zero or less wouldn’t even a savings account do better? Why not just own safe fixed income instruments? We can ladder them so we don’t have too much interest rate risk or opportunity cost. And it’s plain to see that plenty of asset classes offer returns better than zero over the coming decade. Why not just own them?”

Adviser: “There seems a reasonable likelihood that inflation will accelerate at some point over the next decade, and this asset class is a good hedge against inflation.”

Investor: “Okay. If runaway inflation is the only reason to own it wouldn’t TIPS or precious metals provide a better hedge considering this asset class’s extremely unattractive valuation?”

Adviser: “I have learned the hard way that market timing is very difficult and is generally a terrible idea. It’s better to just own this asset class all the time regardless of its prospective return.”

Investor: “Okay. So you’re saying you’re not confident in your ‘prospective return?'”

Adviser: “No. We’re confident. We have a variety of valuation measures that are highly correlated to the future 10-year returns of this asset class and they all say the same thing: that it’s very highly likely to return zero or less over that time frame.”

Investor: “So you’re saying that you have proven valuation measures that have been highly accurate in forecasting the return of this asset class for decades but you don’t think they’re very useful.”

Adviser: “That’s right.”

Investor: “Gotcha. I’ve got an even better deal for you. How about I sell YOU an investment that returns nothing over the next 10 years? That’s better than negative right? I’ll take the money and put it into risk-free treasuries, keep the difference between what they pay me and what I pay you (nothing) and then pay you your initial investment back at the end. How much would you like to buy?”

Adviser: “Only my employer (major bank) and the Fed can play that game, I’m afraid.”

*Thanks to Henry Blodgett for playing the “adviser.”

**US Equities

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It Pays To “Think Different” About Apple’s Stock Price

About 10 months ago I wrote that I thought Apple was worth $114 to $128 per share (split adjusted). That day the stock closed at $72. Today it closed at $116, 60% higher. So this morning I sold it. Here’s why:

Fundamentally, the company has gone from being very undervalued to fairly valued in a very short period of time. (Note: Carl Icahn, who is a lot smarter than I am, says the company is worth $200 per share. I just don’t know how much of this is salesmanship/optimism and how much is cautious analysis.)

I know, I know, Apple is firing on all cylinders and will probably continue to do so. iPhone 6 is selling like hotcakes even before we get into the holiday shopping season. New products are in the pipeline and Apple Pay will probably be huge for the company.

But how much of this optimism is already baked in to the current valuation? At 5 or 6x cash flow, almost none of this was priced in. At nearly twice that valuation today I’m not so sure. Ultimately, at the current price I no longer have a margin of safety. Should the company stumble, and I’m not saying they will, there’s no reason the stock couldn’t go back to the $80-95 level (where I’d probably buy it back).

Screen Shot 2014-11-21 at 12.18.53 PMAnd this is where fundamentals and sentiment get blurred. Clearly, investors don’t quite love the stock as much as they did during the summer of 2012 (will any stock be that loved ever again?) but they no longer think Samsung is going to eat the company’s lunch. So I wouldn’t say sentiment is super-frothy but a 60% run in 10 months tend to inspire at least a little euphoria and StockTwits sentiment has reflected that for some time. 90% of the messages on the site tagged with Apple’s ticker are bullish. That’s a pretty crowded trade.

As for the long-term trend, clearly it’s still bullish. But there are some signs that it may be getting exhausted. DeMark Sequential sell signals are now triggering on multiple time frames. A daily 13 sell signal registered at today’s open while another 9 sell setup triggered a couple of days ago. All this means is we are seeing a cluster of trend exhaustion signals currently:

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The weekly sell signal won’t trigger until the Monday after Thanksgiving but this time frame gives us a good look at the action over the past couple of years. The stock famously peaked in the summer of 2012 before losing roughly half its value into the spring of 2013. The stock has since rallied back and broken out above that prior high (taking the major indexes with it). A simple 1.618 Fibonacci extension projects a target of roughly $122.

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Interestingly, that 2012 peak was accompanied by a completed monthly DeMark 9 sell setup. Last month the stock triggered a monthly 13 sell signal off of that same setup. The risk level for this monthly signal sits at roughly $121. Coincidentally, that’s also the risk level for the daily signal. So according to DeMark Sequential analysis on multiple time frames, the stock could continue to run to $121-122 to test these risk levels and complete the 1.618 Fibonacci extension on the weekly chart.

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From where I sit, however, the stock has pretty much reached fair value, sentiment has shifted positively once more with investors nurturing great expectations for the holiday season and the parabolic move over the past few weeks has triggered a flurry of sell signals. So I’m not saying this is the top. I’m just saying I’ve had my fun and the risk/reward equation no longer appeals to me.

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Dogma and Denial

“Don’t Be Trapped by Dogma – Which is Living With the Results of Other People’s Thinking” -Steve Jobs

There is a very strong and popular dogma out there that says, ‘you must own US stocks all the time no matter what.’ It’s really at the heart of the “buy and hold” mantra which is something I’ve railed against recently.

I’ve railed against it because it’s pretty plain to see that there are times when US stocks are attractive to own – the vast majority of the time, in fact. But there are also times when they really aren’t.

Right now just happens to be one of the very few times US stocks have offered investors a negative 10-year forecast return based on Warren Buffett’s favorite valuation metric (total market capitalization to GNP).

So I ask, “why in hell would you want to hold something that is likely to give you a negative return over the coming decade?”

I imagine these dogmatists would answer, “because you can’t time the market.”

To which I would answer, “On what time frame? Because it’s pretty clear that this tool is fairly good at predicting 10-year returns. (It’s about 83% negatively correlated).”

Admittedly, on a one or two year time frame it has little or no value in timing but is that your investment horizon? If so, you shouldn’t hold ANY stocks at all, US or foreign! On the other hand, if your time frame is 10 years or longer you should probably be very interested in what a measure like this has to say. And it’s not just this one. There are measures that are even more closely correlated to future 10-year returns that say essentially the same thing: stocks are extremely highly-valued/offer unusually low rates of return.

And there are plenty of other asset classes to own that offer more attractive prospective returns! Hell, the 10-year treasury bond, at a mere 2.2% yield may offer better returns than US stocks over the coming decade with FAR less risk (so long as you intend to hold to maturity). In fact, nearly ANY other country around the world offers better value/prospective returns than US stocks do right now.

So why the hang up? Why are investors (and their advisers) so stuck on dedicating the majority of their investable assets to US stocks despite the fact that they are so unattractively priced?

My best guess is they are simply in denial. They are so enamored with the returns they’ve witnessed over the past five years that they simply refuse to even entertain the possibility that stocks may serve up anything less going forward. And that’s just a shame because it’s precisely at times like these investors should question this sort of dogma, rather than near the end of a bear market when they usually finally do decide to abandon it.

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How To Handle An Environment Of “Low Returns”

First off, if you are expecting to achieve historical average rates of return from stocks or bonds from current prices please go read, “How To Time The Market Like Warren Buffett.” The bottom line is a 10-year treasury note pays you little more than 2% per year and stocks are likely to earn you even less over the next decade. So what’s a prudent investor to do? Here’s Howard Marks on your options:

How might one cope in a market that seems to be offering low returns?

  • Invest as if it’s not true. The trouble with this is that “wishing won’t make it so.” Simply put, it doesn’t make sense to expect traditional returns when elevated asset prices suggest they’re not available. I was pleased to get a letter from Peter Bernstein in response to my memo, in which he said something wonderful: “The market’s not a very accommodating machine; it won’t provide high returns just because you need them.”
  • Invest anyway — trying for acceptable relative returns under the circumstances, even if they’re not attractive in the absolute.
  • Invest anyway — ignoring short-run risk and focusing on the long run. This isn’t irrational, especially if you accept the notion that market timing and tactical asset allocation are difficult. But before taking this path, I’d suggest that you get a commitment from your investment committee or other constituents that they’ll ignore short-term losses.
  • Hold cash — but that’s tough for people who need to meet an actuarial assumption or spending rate; who want their money to be “fully employed” at all times; or who’ll be uncomfortable (or lose their jobs) if they have to watch for long as others make money they don’t.
  • Concentrate your investments in “special niches and special people,” as I’ve been droning on about for the last couple of years. But that gets harder as the size of your portfolio grows. And identifying managers with truly superior talent, discipline and staying power certainly isn’t easy.

The truth is, there’s no easy answer for investors faced with skimpy prospective returns and risk premiums. But there is one course of action — one classic mistake — that I most strongly feel is wrong: reaching for return.

-Howard Marks, “There They Go Again,” May 6, 2005

Clearly, investors are currently “reaching for return” like never before. I have no doubt this episode will any any differently than it has in the past. For prudent investors, however, I think the best options are currently either 3 or 4, so long as they understand all the pros and cons of each.

Choosing the third option means you should be willing to tolerate another decline of up to 50% over the next decade in an attempt to capture the low single-digit returns stocks currently offer. That’s just the simple risk/reward equation current valuations present investors with.

Choosing the fourth option means you may have to hear your friends brag about their gains for a while should the market witness another bubblicious blow off akin to the 1998-1999 episode.

Which is the lesser of the two evils for you? Neither are very appealing but that’s the name of the game when you’re playing financial market limbo.

For more Howard Marks I highly recommend you read his excellent book, “The Most Important Thing

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Overcrowded Trade Du Jour: Short Volatility

Periods of low volatility are to investors what a sweet lullaby sung by whispering nanny is to an overtired baby. It relaxes them, gets them to put their worries aside and believe that everything is going to be okay. Great for babies. Not so great for investors.

Because Mr. Market is a sadistic nanny, usually lulling investors into a sense of calm and security right at the worst time.

The few years that led up to the financial crisis were the last great period of low volatility investors witnessed. Clearly, the overwhelming sense of calm in the market (lack of fear), even through the first half of 2007, was unrealistic. You may remember that all of the gains earned during those years were quickly given back and then some during the financial crisis.

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But investors were simply doing what they do best: projecting the results of the recent past way out into the future. They were lulled into believing that volatility was no longer cyclical and that the goldilocks economy meant that it was smooth sailing as far as the eye could see.

Alas, we learned shortly thereafter that volatility AND the economy AND the credit markets were, in fact, still subject to cycles.

“Ignoring cycles and extrapolating trends is one of the most dangerous things an investor can do.” -Howard Marks

I bring this up today because volatility has once again witnessed a period of sustained depression and investors have once again been lulled into a sense of extreme complacency (if that’s even a thing).

ETFs that track the inverse performance of the VIX have become hugely popular this year. They have now attracted nearly $2 billion in assets, $800 million of that coming just in the month of September. In effect, these are bets that the current period of low volatility will last for the foreseeable future – that’s the only way they will make any money.

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Chart via FT.com

The problem is that the VIX currently stands at about 15. It’s lowest point in the past few decades is around 10. From the beginning of the year to early July when the VIX neared that 10-ish level these ETFs saw about a 35% gain (on about a 35% decline in the underlying index). Nice! Right?

Wrong. During the brief, not-even-10% correction we witnessed last month these ETFs declined nearly 50%!! Imagine what would happen if we actually saw a 20% decline… or more. These funds would be obliterated.

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I was recently listening to Tony Robbins on the Tim Ferris podcast and he shared an insight about one thing the world’s greatest investors have in common: they look for fantastic risk/reward setups. They look to risk a penny to make 25 cents. To me this looks just the opposite. It’s like risking 50 cents to make pennies. Good luck with that.

Further reading:

“Now that everyone’s a volatility seller…” – FT Alphaville

“Record short VIX notes sounding alarm to Deutsche Bank” – Bloomberg

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Wagging The Dog

Regular readers know I like to try to combine fundamentals with technicals and sentiment to form a holistic investment/trading thesis. Right now I believe that these three factors are lined up on the bears’ side in the case of small cap stocks, which have led the broader indices of late – the proverbial tail wagging dog.

First, to say valuations are stretched in the case of small cap stocks doesn’t quite tell the whole story. In fact, they may have never been more stretched than they are today. (I’d love to see a CAPE ratio for the Russell 2000 if anyone’s got that data.)

The trailing price-to-earnings ratio currently looks fairly absurd:

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Chart via WSJ.com

I would assume that the astronomical level of the p/e is due to the fact that a large number of companies have losses rather than earnings. But even if you look at price-to-revenues the stocks look extremely overvalued. WSJ reports:

As of Sept. 30, for example, stocks in the Russell 2000 traded at 1.5 times their revenue of the previous 12 months, a measure known as the price/sales ratio. That is just a hair below the highest valuation seen going back to 1994, the earliest year for which data is available. Such levels were last seen during the stock bubble of the late 1990s, according to Russell Indexes.

The index would have to fall another 15% just to return to the average price/sales ratio of the past 20 years.

A price/sales ratio of 1.5 times in the Russell 2000 doesn’t happen often, says Lori Calvasina, a U.S. equity strategist at Credit Suisse Group CSGN.VX +0.08% who specializes in small and midcap stocks. “But whenever we’ve been there, the Russell 2000 has literally never been up 12 months later, and the average decline is about 16%,” she says.

So it’s hard to make the case that small caps aren’t currently overpriced and technically, they look vulnerable on a couple of time frames.

Back when the ETF broke out above the 82.5 level at the end of 2012 I called this chart the most bullish chart I could find. I’ve been watching ever since, adding the 1.618 Fibonacci extension which has proved to be significant resistance since early spring:

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What’s most glaring about this chart is the recent selloff has seen the uptrend line that dates back to the 2009 low break. The ETF is now testing the underside of the trend line along with its 20-week moving average. So this correction is more than the typical brief pullbacks we’ve seen over the past two years.

Comparing it to the 2010 and 2011 corrections, then might give us a bit better idea of what to expect from this selloff. Notice both of those pullbacks saw the ETF make lower lows with divergences in RSI, volume and MACD histograms. Should the current selloff follow this pattern we should see a lower low made over the next few weeks.

The daily chart confirms this view. RSI (at the top of the chart) is showing another divergence/non-confirmation with the latest high made on Thursday. The index has failed to overcome its 61.8% retracement along with the other major indexes. Finally, volatility looks to have broken out and the pullback is just a test of the breakout level, suggesting we could see another surge in volatility soon. Unlike the other indexes, this relative high for the Russell comes in the context of a clear pattern of lower highs and lower lows, the definition of a downtrend:

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All of this makes a retest of last week’s lows very likely, in my opinion. It may be putting the cart before the horse, but I believe the big question after this next pullback will be whether this all amounts to a larger topping pattern for index.

Last month the index closed more than 1% below its 10-month moving average which amounts to a long-term sell signal for trend followers. Should it be unable to regain that level by at least 1% over the next few months, the most bullish time of year for the markets, I think it will be safe to assume the Russell will be faced with a new bear market lasting anywhere from roughly twelve to twenty-four months.

In fact, should the complex head and shoulders pattern in the chart above play out it would see the index decline to around the 950 area, a 21% decline which meets the definition of a bear market. But as I said, let’s see what happens over the next couple of weeks first.

Finally, sentiment toward the sector has surged. StockTwits traders are absolutely rip-snorting bullish on the Russell 2000 futures contract right now – even more bullish than they were a month ago when the major indexes were hitting all-time highs:

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Chart via StockTwits

The bottom line is these stocks are overvalued, overbought and over-owned right now. What’s more, they have led the broader indexes over the past couple of months and I believe they could very well represent a significant “canary in the coal mine” investors should pay close attention to.

See also: “The Dominant Risk For Wall Street” May Be Manifesting In Small Caps and What Does “Reduce Risk” Mean To You?

Disclosure: I currently own inverse Russell 2000 ETFs (what amount to short positions) for myself and for clients.

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Why?

I’ve been thinking about blogging and social media. Why do we do it?

There are all kinds of answers for all kinds of different folks and I’m sure they each apply to me in some degree.

Some are looking to be heard (in other words, to be listened to – aren’t we all?). Some are looking for their 15 minutes of fame. Some want to come down on one side or another of a specific issue and be right, damn it!

I’m guilty of all of these things, as I said, to some degree, but none of them are the main reasons I do this.

First and foremost, I blog and tweet and such because it helps me flesh out my own ideas. A lot of the time I’m just thinking out loud and typing it. There’s something about writing things down AND in a public way where you can get feedback that just helps expedite or make the thinking process more efficient. I can’t explain it but it works.

Second, it helps to put things out there where they can’t be retracted in order to hold myself more accountable. When something’s not put out there permanently it’s really easy to either totally forget about it or to change the way we remember it over time. A blog post or a tweet brings it right back into the present and makes it impossible to misremember or deny.

Finally, one of the best feelings I can get in my business is helping someone learn something that makes a dramatic impact in their lives – even if it comes from my own horrible mistake! It’s why I do this here and on social media and why I teach a class at the local community college. It’s just very rewarding.

But at the end of the day, this whole thing, the blog, social media and even my class is really just for me. It helps me be a better thinker and a better investor – so I’ll keep doing it.

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