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A Brief @Twitter Timeline Of My 11-Month Correction Beard

Late last September I made a vow:

I had been making the case here and on Twitter that the bull market was long in the tooth and there were many signs that could be waning.

At the same time, stocks, which normally have a 10% correction once per year, hadn’t had one since 2011.

Within days my wife sent me this:

But, in just 3 weeks after my initial pledge the stock market fell about 9%…

…until the Fed came to the rescue:

Then the Santa Claus rally took over.

E*Trade called me out, on my birthday, no less.

Then the heat on the beard intensified.

As the stock market made new highs, the beard trolling got pretty loud.

And as the beard grew longer and longer, the media began to take note…

…as did the most creative of technicians.

Then this past Monday the market finally cracked.

To be clear…

…I was just trying to make a point…

…and have a bit of fun in the process.

Mission accomplished.

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Druck Backs Up The Truck And Loads Up On Gold

Back in April I wrote a post titled, “how to trade like Stan Druckenmiller, George Soros and Jim Rogers.” It centered on a quote from Druck that really gets at the key to his incredible success in the markets:

The first thing I heard when I got in the business, not from my mentor, was bulls make money, bears make money, and pigs get slaughtered. I’m here to tell you I was a pig. And I strongly believe the only way to make long-term returns in our business that are superior is by being a pig. I think diversification and all the stuff they’re teaching at business school today is probably the most misguided concept everywhere. And if you look at all the great investors that are as different as Warren Buffett, Carl Icahn, Ken Langone, they tend to be very, very concentrated bets. They see something, they bet it, and they bet the ranch on it. And that’s kind of the way my philosophy evolved, which was if you see – only maybe one or two times a year do you see something that really, really excites you… The mistake I’d say 98% of money managers and individuals make is they feel like they got to be playing in a bunch of stuff. And if you really see it, put all your eggs in one basket and then watch the basket very carefully. -Stan Druckenmiller

The way Druck generated 30% average annual returns over a period of decades was by being a pig, by putting all his eggs in one basket and watching it very carefully. Considering he may be the most successful money manager alive, you may be curious to learn what Druck is buying today.

Well, you’re in luck! Druck’s latest 13F filing shows that he is currently backing up the truck and loading up on gold. In the second quarter, he bought over $300 million worth making it his single largest position. He now has more than 20% of his portfolio allocated to the SPDR Gold Trust (GLD). This position is more than twice as large as his next largest holding.

Clearly, Druck feels (as I do) that it’s time to get greedy in the gold market.

UPDATE: I just noticed that Stan also bought a sizable position in Newmont Mining, as well. What a pig. 

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One Of The Single Largest Buyers Of Equities In The World Could Now Turn Seller As A Consequence Of The Oil Crash

For months now it’s been popular to consider the oil crash contained, that is to suggest that it has no repercussions outside the energy industry. However, equity investors should take note that one of the single largest buyers of equities in the world may now become a net seller simply due to the oil price crash.

Due to its massive North Sea oil reserves (the busiest drilling site on the planet), Norway has prospered greatly over the past few decades. This has allowed the nation, despite its relatively small population, to build one of the largest sovereign wealth funds in the world. So large, in fact, that the fund now owns 1% of all the equities around the world (including nearly 2% of European equities, making it the largest holder there).

The oil crash has not been kind to Norway. And in order to maintain its spending to prop up it flagging economy, some believe the country may be forced to dip into its sovereign wealth fund. In other words, the fund has gone from being one of the largest buyers of equities in the world to possibly a net seller. Bloomberg reports:

If the government has to withdraw money from its $875 billion sovereign wealth fund, it will be a historical step. It’s either that, or heavily rein in fiscal spending at a time when the country needs it most. The state’s spending could start to outstrip income from oil, which it pours into its wealth fund for future generations.

To his credit, Marc Faber outlined this possibility at the Barron’s Roundtable back in January:

…sovereign wealth funds rose to $6.8 trillion as of September 2014, from $3.2 trillion in 2007. Of that growth, 59% came from oil, gas, and related revenue. As oil prices fall, what will happen to the growth of sovereign wealth funds, which have been buying financial assets around the world? Their funding is going to evaporate, and they might be forced to sell.

Clearly, there are larger repercussions of the oil crash than many currently believe. One of these is that oil-dependent nations, some of the most powerful players in the markets, have already been forced to halt their buying of equities. Considering their buying has been one of the major factors behind the powerful bull market over the past few years this is nothing to sneeze at. What’s more, these massive funds may even be forced into becoming net sellers.

Considering the demographic headwinds facing our stock market right now along with the already extreme positioning of margin traders, it’s hard to imagine any other source of demand being able to make up for the loss of these massive buyers…  or even to just soak up the supply should they become net sellers.

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The Warren Buffett Way To Avoiding Major Bear Markets

A year ago, I wrote a post called, “how to time the market like Warren Buffett,” in which I proposed a very simple market timing method inspired by this passage from the Oracle of Omaha’s 1992 letter to shareholders:

The investment shown… to be the cheapest is the one that the investor should purchase.…  Moreover, though the value equation has usually shown equities to be cheaper than bonds, that result is not inevitable: When bonds are calculated to be the more attractive investment, they should be bought.

The idea is very simple and intuitive: When reliable measures forecast that stocks will outperform bonds, buy them. However, when, on rare occasion, they forecast that bonds will outperform stocks then they should be favored. But how to forecast equity returns? Simple. Just use Buffett’s favorite valuation yardstick, market cap-to-GNP. Right now this measure shows stocks to be about as highly valued as they were back in November 1999.

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What makes this measure most valuable, though, is its forecasting accuracy – which may be what makes it Buffett’s favorite. Below is the 10-year forecast implied by this measure (blue line) against the actual 10-year return for the S&P 500. Notice the red line tracks the blue fairly closely but can overshoot in both directions, overestimating returns during the 1973-74 bear market and understating returns during the dotcom bubble.

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The next chart overlays the 10-year treasury bond yield (red line) against the 10-year forecast for stocks (blue line). The majority of the time this comparison suggests stocks are the better investment. There are few occasions, however, when bonds offer the better opportunity. Today is one of those occasions.

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In my original post, I demonstrated just how attractive it would have been to follow this methodology. Since 1962, an investor who simply had bought stocks when they were more attractive and then switched to bonds when they became more attractive outperformed a buy-and-hold approach and dramatically so (mainly by sitting out a significant portion of the last two major bear markets).

What I think is most remarkable about the chart above right now is, at 3.05% (stocks’ forecast return of -1.07% minus a 10-year bond yield of 1.98%), it is signaling one of the largest spreads between forward returns on record. There are only a handful of quarters over the past fifty years that offered investors a better opportunity to switch from stocks to bonds. In fact, the last time the spread was this wide was during the second and third quarters of 2007, just prior to the financial crisis that led to a 50% drop in the stock market.

Now this doesn’t mean you should sell all of your stocks and run for the hills. Everyone has their own personal investment goals and risk tolerance and that should be paramount in their individual process. A practical way to implement this would be to simply underweight stocks and overweight bonds based on today’s reading. Or if you’re making significant new contributions to your account, maybe you just put those in bonds for now until stocks offer a more attractive opportunity. In fact, that’s probably how Buffett would do it. And though I doubt he uses these measures exactly this way, this sort of process has worked well for him for quite a long time.

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Am I Bearish Or Are You Just WAY Too Bullish?

Yesterday I found myself reading GMO’s latest quarterly letter and thinking, ‘wow, I’m fairly bearish but Jeremy Grantham just sounds like a grumpy old man!’ Until I came upon this passage:

…you may think that I am particularly pessimistic. It is not true: It is all of you who are optimistic! Not only does our species have a strong predisposition to be optimistic (or bullish) – it is probably a useful survival characteristic – but we are particularly good at listening to agreeable data and avoiding unpleasant data that does not jibe with our beliefs or philosophies. Facts, whether backed by 97% of scientists as is the case with man-made climate change, or 99.9% as is the case with evolution, do not count for nearly as much as we used to believe. For that matter, we do a terrible job of planning for the long term, particularly in postponing gratification, and we are wickedly bad at dealing with the implications of compound math. All of this makes it easy for us to forget about the previously painful market busts; facilitates our pushing stocks and markets on occasion to levels that make no mathematical sense; and allows us, regrettably, to ignore the logic of finite resources and a deteriorating climate until the consequences are pushed up our short-term noses.

It immediately made me think of one of my favorite songs from The Who:

The shares crash, hopes are dashed.
People forget,
Forget they’re hiding,
Behind an Eminence Front,
Eminence Front – it’s a put on.

We are only a few years removed from one of the worst financial crashes in our history and investors have already put it out of their minds. Most importantly they have forgotten perhaps the greatest lesson of that time: overpay for a security and you are essentially taking much greater risk with the prospect of much reduced reward.

Right now, stocks as a whole present very little in the way of potential reward. According to Grantham’s firm, investors should probably expect to lose money over the coming seven years in real terms (after inflation). Other measures (explained below), very highly correlated to future 10-year returns for stocks, suggest investors are likely to earn very little or no compensation at all over the coming decade for the risk they are assuming in owning stocks.

In trying to quantify that risk, Grantham’s firm suggests that investors are now risking about a 40% drawdown in order to earn less than the risk-free rate of return. I have also demonstrated recently that margin debt in relation to GDP has been highly correlated to future 3-year returns in stocks for some time now. The message we can glean from record high margin debt levels is that a 60% decline over the next three years is a real possibility. Know that I’m not predicting this outcome; I’m just sharing what the statistics say is a likely outcome based on this one measure.

Screen Shot 2015-07-29 at 10.04.43 AMThis horrible risk/reward equation is simply a function of extremely high valuations. As Warren Buffett likes to say, “the price you pay determines your rate of return.” Pay a high price and get a low return and vice versa. Additionally, if you can manage to buy something cheap enough to build in a “margin of safety,” your downside is limited. However, when you pay a high price you leave yourself open to a large potential downside.

Speaking of Buffett, his valuation yardstick (Market Cap-to-GNP) shows stocks are currently valued just as high as they were back in November 1999, just a few months shy of the very top of the dotcom bubble. Investors should look at this chart and remember what the risk/reward equation back then meant for the coming decade. For those that don’t remember, it meant a couple of massive drawdowns on your way to earning very close to no return at all. (Specifically, this measure now forecasts a -1% return per year over the coming decade.)

fredgraph-2Instead, investors today choose to hide behind an “eminence front.” They ignore these facts simply because they are unpleasant to think about. Despite the horrible risk/reward prospects of owning equities today, they have now put nearly as much money to work in the market as they did back in 1999. (This measure is even more highly correlated to future 10-year returns. It now forecasts about a 2.5% return per year over the coming decade.)

fredgraphIt’s truly an astounding phenomenon that investors, after experiencing the very painful consequences of buying high – not just once but twice over the past 15 years, can once again be so enamored with paying such high prices yet again. Amazingly, they are as eager as ever to take on incredible risk with very little possibility of reward. It proves that “rational expectations” are merely the imaginings of academics and have no place in real world money management. It also validates Grantham’s view that it’s not him who is pessimistic; it’s investors who are too optimistic.

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