How To Beat The Market By Being ‘Fearful When Others Are Greedy’

This is the second post in a 3-part series that began with “How To Time The Market Like Warren Buffett.”

‘Be fearful when others are greedy and be greedy only when others are fearful.’ -Warren Buffett, 1986 Berkshire Hathaway Chairman’s Letter

This has to be Warren Buffett’s most famous quote. For investors, however, of all of his copious advice it has to be the most difficult to put into practice.

How, exactly, do we know when ‘others are greedy or fearful’? And how, exactly, should we be ‘fearful or greedy’ in response?

In my recent post, “How To Time The Market Like Warren Buffett,” I tried to get at how Buffett uses fundamentals, or valuations, to determine whether he should be fearful or greedy. Essentially, he just buys whatever offers the better prospective return. When it’s stocks, that’s what he buys. When, on rare occasion, bonds offer a better return he buys them instead. This is one way he has managed to generate market-beating returns over long periods of time.

But, surprisingly enough, fundamentals aren’t the best way to judge the prospective returns of stocks. Investor sentiment is actually much more predictive than even Buffett’s favorite measure of valuations (total market capitalization-to-GNP).

Philosophical Economics ran a post back in December titled, “The Single Greatest Predictor Of Future Stock Market Returns,” in which they found that household allocation to equities was correlated to future returns in the stock market by greater than 90%. I ran the same correlation and found that while market cap-to-GDP had an 83% negative correlation to 10-year returns in the stock market, this measure had a 94% negative correlation.

Ultimately, what investors are actually doing with their money – acting out of fear or greed – is a much better predictor of future returns than even the best measure of value. But how do we use this information as a contrary indicator? How do we put it into practice?

It’s simple: we do just what we did with the fundamental measure. We create a forecasting model that suggests what stocks are likely to return over coming decade based upon investors’ allocation to stocks. Then we compare that to the yield on the 10-year Treasury bond. Whichever offers the better prospective return should be bought.

Screen Shot 2014-08-18 at 9.54.17 AMSo I went back once again and looked at what would have happened if an investor had followed this model only looking at it once a year at year end, starting back in 1950. (Again, I know this is cheating; our investor obviously didn’t have access to all of this then future data back in 1950. Still, it’s a fun exercise so get over yourself.)

Screen Shot 2014-08-18 at 9.38.40 AMLike the valuation timing model, this one also significantly outperformed a simply buy-and-hold approach. Yet it didn’t differ much from the valuation model. It ourperformed during the internet bubble because it kept our hypothetical investor in stocks for two years longer than the valuation model. But it underperformed during the financial crisis because it didn’t get our investor out of stocks while the valuation model did.

Another major difference between the two is that our valuation model got our hypothetical investor out of stocks at the end of 2012 and so she missed last year’s huge gains. The sentiment model kept her in stocks and that’s really the main difference between the performance of the two up to this point.

The bottom line is both of these models, due to their exceptional predictive ability, allow an investor to determine not only when but how to be fearful and greedy: simply own stocks when they offer the better prospective return, otherwise own bonds.

I should emphasize again that this model is merely for educational purposes. It doesn’t factor in transaction costs or taxes (which could be huge) so it’s not in any way a recommendation for you to use with your investments. But it’s definitely something to consider when evaluating investment opportunities on a broad basis or deciding where to put new money to work.

There’s one more way to dramatically enhance even these terrific results and in part three of this series I’ll reveal how. I’ll also soon put up a page on this site that regularly updates these models and compares their prospective returns to the yield on the 10-year treasury so we can keep tabs on it. Stay tuned.


King Midas And The Media

I tweeted this yesterday because Buffett invests for the full cycle. His outperformance usually comes during bear markets (for a variety of reasons including the quality of the companies he’s invested in, the “margin of safety” he demands from his purchases and the fact that he keeps some significant powder dry to take advantage “fear”).

During bull markets he just hopes to keep pace but during the final euphoric phase of bull runs he tends to lag (again for similar reasons including his focus is on larger, more established companies rather than the young, high-flyers that typically soar during these periods; the “margin of safety” he demands is simply not available when valuations are stretched and his growing cash position becomes a performance anchor).

Long story short, his underperformance during the later stages of bull runs is something the world’s greatest investor consciously tolerates in order to be in position to take advantage of the flipside of the cycle. Still, the media loves to rib him for it – every time. So I was curious to see if it could be quantified as a contrarian indicator.

Thank you, Jason Goepfert! Jason ran a scan of headlines related to Warren Buffett ‘losing his touch’ and found:

Sure enough, spikes in these stories tended to occur near market turning points, including near the peaks in 2000 and 2008, the trough in 2002 and lesser intermediate-term corrections in 2010 and 2012.

Screen Shot 2014-08-16 at 9.23.50 AMHowever, aside from the Forbes article I tweeted yesterday we aren’t seeing much of a confluence of these sorts of stories in the media… yet. But I’m sure Jason will let us know if and when they do start to pile up.

For more of these kinds of sentiment studies check out where Jason regularly publishes some superb work.


Where’s Wall Street’s Blame In The Buy High Sell Low Game?

The chart above is making the rounds today. The dumb money can’t catch a break. Everybody’s laughing at the poor retail investor. But what I’m wondering is how many of these mutual fund investors are actually being directed by advisers? I’d wager it’s a fair number.

Yes, I know that individual investors are famous for buying high and selling low but advisers are subject to the very same biases and emotions. And their layers upon layers of fees alone can be the cause of significant underperformance.

I’ve seen advisers buy, for their clients – never with their own money, mutual funds that pay themselves fat front-end loads (upfront commissions). Then they turn around a while later and recommend selling the underperforming fund (destined to fail due to its high fee structure) to buy one just like it, paying another fat commission (aka, churning).

Where does this show up in the data and how can we blame individual investors for this sort of behavior?

Buffett Backs Up the Berkshire Truck in Q3

How To Time The Market Like Warren Buffett

“The guy’s just not going to spend the cash to spend it. [He’s] the best market timer I ever saw.” -David Rolfe on Warren Buffett

Warren Buffett likes to counsel individual investors to buy-and-hold (specifically, buy an equity index fund and hold it forever). This is a perfect example of “do as I say, not as I do,” as Buffett has successfully timed the market for decades. And with Berkshire Hathaway reporting earnings last week it was revealed that Buffett is now carrying his largest cash position ever (in stark contrast to individual investors who now hold their smallest cash positions since the height of the internet bubble). Clearly, he’s timing once again and I’m sure a few of you are wondering just how he manages to do this so successfully.

A couple of days ago I wrote “Don’t Buy The Buy-And-Hold Line of BS” arguing that valuations matter and when stocks offer literally zero return over the coming decade it’s probably not a bad idea to own something else (like bonds). Well, this really gets at the heart of Buffett’s investment philosophy:

The investment shown by the discounted-flows-of-cash calculation 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. -Warren Buffett, 1992 Berkshire Hathaway Chairman’s Letter

In other words, ‘when stocks are better value buy them. When bonds are the better value buy them.’ Couldn’t be simpler; could it? But how does Buffett calculate “value?” In the quote above he references “discounted-flows-of-cash,” a very complicated valuation model that relies on many assumptions that can cause all sorts of problems. I think there’s actually a much easier way to look at it.

Back in 1999, when he decided to market-time the internet bubble (well done, sir), Buffett hinted at his process telling Fortune, “I think it’s very hard to come up with a persuasive case that equities will over the next 17 years perform anything like–anything like–they’ve performed in the past 17.” So what tool does he use to make a “persuasive case?” A couple years later, once again via Fortune, he revealed it: the ratio of total stock market capitalization-to-GNP (or GDP), calling it, “probably the best single measure of where valuations stand at any given moment.”

Okay, but HOW does he use it? Here’s my best guess:

John Hussman has done some work with this indicator and found that it is very closely correlated to future returns in the stock market. In other words, this indicator is very good a predicting future returns for stocks over the coming decade.

When Buffett said in 1999 that the next 17 years were very unlikely to look like the prior 17, he meant that the starting valuation in 1982 was so attractive (based on his favorite yardstick, market cap-to-GDP, which stood at 0.333) it virtually guaranteed wonderful returns over the coming decade. Conversely, the starting valuation in 1999 was so unattractive (based on the same yardstick reading of 1.536, or 4.5 times higher than the 1982 reading) it virtually guaranteed horrible returns.

So I believe Buffett very clearly understands the predictive ability of his favorite yardstick. And he uses it to time the market by comparing future stock returns to future bond returns, as he said in the quote from the 1992 letter above. Stay with me here.

I ran the numbers on Buffett’s yardstick and its predictive ability myself, using the data from FRED and Robert Shiller covering the years from 1950 to 2013, and found it to be negatively correlated (low values correlate with better 10-year returns and vice versa) by over 80%. I then created a forecasting model based on the data. This tells us what stock market future annualized returns should be over the coming decade based upon the current reading of the yardstick.

We can then take this number and simply compare it to the current yield on the 10-year Treasury note to see which offers the best return over the coming decade, just as Buffett prescribes. When stocks offer a better return, they should be bought. Conversely, when the 10-year treasury offers a better return it should be bought. Simple. As Buffett says, most of the time stocks are more attractive – but not always:

Screen Shot 2014-08-07 at 10.29.14 AM

So I went back and looked at what would have happened if someone had followed this model, only looking at it once a year at year-end, starting back in 1950. (I know this is cheating; our investor obviously didn’t have access to all of this then future data back in 1950. Still, it’s a fun exercise so get over yourself.)

They would have been fully invested in stocks from 1950 to 1981 at which point they would have switched into treasuries for only a year. They would have owned stocks again from that point until 1996 when bonds offered the greater prospective return. They would have stayed out of stocks for nearly the next decade (through the rise and fall of the internet bubble) and only sold their bonds in January 2003 when they would have bought stocks again. But they only owned stocks for two years before switching into bonds again in 2005. They didn’t buy stocks again until January 2009, after the heart of the financial crisis had already passed and stocks were once again attractively valued relative to bonds. Once again they sold their stocks and bought treasuries at the end of 2012 and still hold those treasuries today.

And how did she do? Even after missing the massive gains of the internet bubble and those we saw in stocks last year, this hypothetical Warren Buffett-wannabe-market-timer, was way ahead of the game. Her $1,000 grew to roughly $1.15 million today compared to $720k for the buy-and-hold investor and a mere $32k for the all-bonds guy. And all she did was buy stocks when they were more attractive; otherwise she bought bonds. Simple.

Screen Shot 2014-08-07 at 8.20.55 AM

Now this model is merely for educational purposes. It doesn’t factor in transaction costs or taxes (which could be huge) so it’s not in any way a recommendation for you to use with your investments. But it’s definitely something to consider when evaluating investment opportunities on a broad basis or deciding where to put new money to work.

I’ll soon put up a page on this site that regularly updates Buffett’s favorite yardstick and compares its prospective return to the yield on the 10-year treasury so we can keep tabs on it. Stay tuned.


Don’t Buy The Buy-And-Hold Line Of BS

“Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.” – Peter Lynch

This quote has been making the rounds since the market’s 2% decline last Thursday. It’s a great quote; I’m a huge Peter Lynch fan. I’ve read each of his books at least twice and recommend them enthusiastically.

However, I think there’s an important point to be made here. Peter Lynch managed money professionally from 1977 to 1990 putting up an amazing track record: 29% average annual returns. No doubt this places him in a very elite class of the most skilled investors ever. But he also had a massive tailwind to work with as the stock market was very attractively valued during his entire career.

Below is a chart of the total stock market value relative to GDP (via Doug Short). I’ve circled the area that represents Lynch’s career in red:

Buffett Indicator Annotated

Over the past couple of decades there was maybe only a single month, at the very bottom of the financial crisis, during which stock market valuations neared the levels that Peter Lynch had to work with. And even then those levels, of about 60% market cap to GDP – that we considered cheap, during his career represented the month just before the 1987 crash!

Considering what investors have gone through since Lynch retired, the aftermath of the internet bubble, housing bubble and financial crisis, I think it would be very difficult to make the case that they lost far more money over the past couple of decades trying to sidestep these debacles than the money lost by those who didn’t sidestep them.

Screen Shot 2014-08-05 at 9.29.02 AM

When Treasury Bonds far outperform stocks over a 15 year period, I’d say sidestepping the madness of these markets has paid off fairly well. And considering the fact that stocks are now, once again overvalued to the point that an investor can expect roughly a 0% return over the coming decade, I’d say it will probably pay to sidestep it once again.

Investing, Markets, Weekly Reports

On The Stock/Bond Conundrum

Professional investors typically look at the stock market as playing Curly to the bond market’s Moe. (I don’t know who Larry is… Currencies? Commodities?) Behavioral finance teaches us that neither of them are very rational over the short run and can, at times, get pretty zany. But the bond market is typically a bit wiser than the stock market and at times it likes to slap the stock market around when it gets wise. Maybe it’s because the bond market has things like “vigilantes” (or used to) that keep it a bit more honest. Who really knows?

Right now traders can’t stop talking about the divergence between the two. Bonds are saying the economy looks punk (as the yield curve continues to flatten) and stocks are saying everything looks hunky dory (as they surge to new highs). So who’s right? Is Moe about to do the eye poke on Curly or will Curly get the block in along with the last laugh.

I’ll just say that I don’t know; I’m not an economist and I wouldn’t trust those guys to know either. But I do have at least a clue.

First quarter GDP would suggest that the bond market has it right but, as we all know, markets are forward-looking, discounting mechanisms. So the continued weakness in yields would suggest that bonds see the Q1 contraction as more then just a blip while stocks are saying, “it’s not so bad.

And we’ve recently heard from a couple of market watchers I do trust who have come down on the side of the bond market. Stephanie Pomboy gave a terrific interview to Barron’s over the weekend:

The No. 1 thing is that investors generally have underestimated the impact that QE [quantitative easing] has had on the economy and the degree to which it has supported growth. As a consequence, they have underestimated the cost the tapering [of monthly Treasury bond purchases by the Fed] would have, and that is starting to come into focus. People will realize that the economy really has not achieved any self-sustaining momentum and that it requires continued stimulus. I liken it to a car on a flat road that has no momentum. When you take your foot off the gas, the car just stops moving. That’s essentially what the Fed is doing…. I expect to see Treasury yields trading in a range from 2% to 3%, basically how it’s been for the past several years. You want to sell at 2% and buy at 3%. I wouldn’t be surprised to see rates fall below 2%, as investor perceptions about the economy meet with reality and they realize that the Fed still has a lot of work to do.

Is it just a coincidence that the Fed began to taper in January and the economy began to contract at the very same time? Maybe. But it’s worth making a note of especially due to the fact that each time QE has ended in the past it’s led to problems that have forced the Fed into a new round of QE. Different this time?

Jeff Gundlach, another whose work I greatly admire, seems to agree with Stephanie. A couple of weeks ago he predicted we would see “one of the biggest short covering scrambles of all time” in the bond market that would send the 10-year yield below 2% and perhaps even below the 1.5% level tagged back in 2012. The recent economic slowing would have to at least continue if not accelerate for something like this to occur.

To be sure, this is THE contrarian call right now. A recent poll of 72 economists found none of them see a contraction in our future. To me, this is the sort of consensus that Bob Dylan sang about:

“Half of the people can be part right all of the time
Some of the people can be all right part of the time
But all of the people can’t be all right all of the time” [emphasis mine]
I think Abraham Lincoln said that
“I’ll let you be in my dreams if I can be in yours”
I said that.

And I wouldn’t be surprised to see Curly get slapped upside the head yet again.

Investing, Markets

The Calm Before The Storm

It seems like volatility always dies down in the summertime as traders retreat to the Hamptons and focus more on sunscreen than stock screens. And you’re not supposed to short a dull market but…

When volatility gets as low as it has recently I take it as a sign of dangerous complacency, especially with the growing potential risks to stocks right now. Bianco research recently noted that over the past 25 years there has only been one other period where volatility has been as low as it is today: July 2007. This marked the beginning of a volatility pick up that ultimately peaked manifold higher during the height of the financial crisis.

Normally, low volatility is no reason in and of itself to become worried about stocks. In fact, low volatility is typically bullish. However, when complacency reaches an extreme like this it does suggest that investors are usually in for some sort of ‘surprise’ that sends volatility higher. And there’s a very good argument to be made that prolonged periods of low volatility actually create more extreme, pent-up volatility.

It works like this: A stock market that goes months and months without anything more than mild pullbacks lulls investors into a sense of security or confidence that stocks just don’t go down anymore. They extrapolate the recent benign price action far out into the future; they start believing things like the “great moderation” line of bullshit. This causes them to become overconfident and over-commit to stocks. When a pullback greater than just a few percent finally happens these investors are surprised by the ‘extreme volatility’ (which is really just normal volatility that has been dormant) and they reduce the undue exposure they put on when they believed volatility was dead. Add this to the normal selling that occurs during and you get a greater than average sell off. Multiply all of these effects (to account for record low vol) from the beginning and that’s how you get a crash like we saw subsequent to the record low vol mid-2007.

Now there were all sorts of other issues that compounded to create the worst financial panic in a few generations and that’s not about to happen again. But history does look like it could be rhyming in some ways right now.

Any major dude will tell you” about not just the record low vol but also that record high margin debt has finally and ominously begun to reverse. A few months ago Jeff Gundlach warned that we could expect a double digit decline once this happened. And @jlyonsfundmgmt shared a great chart the other day showing the correlation between margin debt and the peaks of the past few bubbles.

I know: Correlation ≠ causation. Still, it makes a great deal of sense to me that margin debt is greatly responsible for blowing up an equity bubble in the first place and when it peaks it’s a good sign that the bubble has run out of fuel.

And we’ve seen some canaries croaking in this coal mine over the past couple of months. Biotech stocks, MoMos and the Russell 2000 have all taken it on the chin lately even while the major indexes have hovered near their all-time highs.

As for the latter, @ukarlewitz noted late last week in his excellent “Weekly Market Summary” that, “RUT [Russell 2000] recently ended a streak of more than 360 days above its 200-dma, its longest ever. Every prior instance when a long streak in RUT ended has led to SPX also breaking its 200-dma in the weeks ahead.” That level lies >5% below its current number but there’s a good chance stocks could fall at least twice that much. Again @ukarlewitz:

At more than 5 years, the current bull market (defined as a gain uninterrupted by a drawdown of more than 20% on a closing basis) is both longer and more powerful (on an inflation-adjusted basis) than either the one from 1982-87 or 2002-07. It is, in fact, longer than every bull market in the past century except the ones ending in 1929 and 2000. In other words, this exceptionally long advance without a 10% correction is occurring at the point where virtually every bull market has already ended.

No. This doesn’t mean stocks are about to fall 20%+. But with record low vol over this span how many investors are prepared for such a scenario?

There are also divergences galore. Toddo, calls our attention to the weakness in the banks along with the small caps in contrast to the majors. Maybe more important is what the smart money is doing. We haven’t seen a divergence this large between “emotional buying” and rational buying since… you guessed it. Yep, 2007.

Another noteworthy divergence/canary can be seen in junk bonds. Risk appetites there have also begun to reverse and this is typically a prelude to equity risk appetites reversing as well. So what to junk bond investors see that equity investors don’t?

Maybe it’s that the latest episode of “reaching for yield” is about to come home to roost.

Maybe it’s the weakness in retail. TJX, HD, WFM, BBY, PETM and others have all disappointed investors over the past couple of weeks and we all know consumers make up 70% of the economy.

Maybe it’s the bursting of the bubble in profit margins.

Maybe it’s the bursting of the housing bubble in China.

Or maybe it’s just the fact that this cycle has run its course and is about to swing the other direction. Who knows?

In any case, I’d argue that the record low vol shows investors aren’t looking ahead as much as looking behind and reminiscing at how good things have been over the past five years or so. They’re expecting more of the same even though it’s mathematically impossible. But people love to believe things even when they know they’re not true. And you know what? According to the Fed, this is the very definition of a bubble.

It might not be your father’s bubble but just because we haven’t matched the p/e’s achieved during the internet bubble doesn’t mean that we aren’t ridiculously overvalued today. And it’s increasingly likely this is just the calm before the storm.