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The Single Greatest Mistake Investors Make

The single greatest mistake investors make is to extrapolate recent history out into the future. They take the financial returns of the past 5 days or 5 years or even 50 years and assume the next few days or years will look just the same without any consideration for the historical context or conditions that provided for those returns.

They forget that, while ‘history may rhyme, it doesn’t repeat itself’ (Twain). Or that, “the only thing that is constant is change” (Heraclitus). These two famous quotes apply to the financial markets as much as anything.

Ignoring these truths and instead simply extrapolating is why investors are suckered into pouring money into the stock market only after a run of great performance. They believe that the recent gains are about to repeat to their great benefit when they should be thinking about what conditions allowed for those gains to take place and analyzing whether they are still relevant or not.

This is also why they are suckered into selling only after a painful decline as they did at the lows made during the financial crisis. They believe that they are about to suffer another 50% decline on top of the one they just endured when they should really be reminding themselves that change is the only guarantee in life.

I believe this is one of the biggest problems with so-called “passive” investing. It is built upon the faulty premise that it is ‘impossible to forecast’ the future returns of any asset class over any period of time so we should just own all of them all the time. My response to this is that while ‘ignorance may be bliss’ it’s not a valid investment strategy.

In his 1992 letter to Berkshire Hathaway shareholders, Warren Buffett wrote:

We’ve long felt that the only value of stock forecasters is to make fortune tellers look good. Even now, Charlie and I continue to believe that short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grown-ups who behave in the market like children. However, it is clear that stocks cannot forever overperform their underlying businesses, as they have so dramatically done for some time, and that fact makes us quite confident of our forecast that the rewards from investing in stocks over the next decade will be significantly smaller than they were in the last.

Much can be learned from this short passage. First, short-term stock market forecasts are, indeed, nearly worthless – essentially a guessing game. Second, long-term forecasts, on the other hand, can be made with ‘confidence.’ “How?” you ask.

It’s actually very simple. Rather than fixate on recent history and extrapolate it into the future you must abandon this natural tendency. And as I said earlier you also need to analyze the conditions that allowed for those returns to see whether they are still relevant to today’s market.

In Buffett’s example he’s referring to the wonderful returns equity investors experienced from 1982-1992. During that span investors roughly quadrupled their money. Over the coming decade they merely doubled their money so Buffett was right that the decade beginning in 1993 would fall far short of the return of the prior decade even it they were still very good.

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But Buffett made another prescient forecast in November 1999 when he wrote:

Today, staring fixedly back at the road they just traveled, most investors have rosy expectations. A Paine Webber and Gallup Organization survey released in July shows that the least experienced investors–those who have invested for less than five years–expect annual returns over the next ten years of 22.6%. Even those who have invested for more than 20 years are expecting 12.9%. Now, I’d like to argue that we can’t come even remotely close to that 12.9%… you need to remember that future returns are always affected by current valuations and give some thought to what you’re getting for your money in the stock market right now.

You probably already know that stock market returns from 1999 to 2009 were not very kind to investors.

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And Buffett tells us how he was so confident that this would be the case. He examined the conditions that allowed for returns to be so wonderful from 1982-1999 but were no longer present in 1999: wonderful valuations. Stocks were so cheap in 1982 that the coming decade was virtually guaranteed to be better than the decade that preceded it. (1972-1982 was another decade that was not fun for investors.) Then in 1999 valuations were so expensive that there was almost no possibility of decent returns going forward.

So let’s take a look at Buffett’s favorite valuation yardstick which he refers to on both of those prior writings. It tracks the total value of the stock market in relation to Gross National Product.

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From the chart, it’s plain to see that valuations were extremely attractive back in the early 1980’s. This is why stocks performed so well over the next 20 years. However, I find it absolutely fascinating that stock market valuations today are essentially equivalent to valuations in November 1999 when he wrote that latter passage. Yeah, go back and read that last line again. It’s a doozy and it’s absolutely fact.

This is also why the past 5 years or even the past 50 years are totally irrelevant to equity investors in today’s market. There is almost zero possibility today of achieving a return anywhere close to what those historical returns represent. So shun forecasts if you want. Plead ignorance if it makes you feel blissful. But at today’s valuations you should at least be aware of the fact that it’s exceedingly dangerous to fall into the trap of extrapolating without analyzing.

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EVERYTHING Is A Forecast

Can we please stop bashing forecasters already? There is a small but influential faction of bloggers/financial talking heads out there that love to bash everyone who doesn’t invest exactly along their prescribed investment philosophy which is usually some sort of “passive” methodology, writing off non-conformists to their style as “forecasters” (or, even worse, “active managers”).

First of all, there is no such thing as “passive investing.” Picking an asset allocation is, by definition, active investing. Second, there are problems with passive investing they just don’t want to discuss but back to the topic at hand…

Yes, I agree that most forecasts are almost worthless. Just take a look at how many analysts and market gurus were calling for higher interest rates on the long bond in 2014 (nearly all of them), for example. The only “worth” in these sorts of forecasts was in their contrarian message – buying long-dated treasuries turned out to be a great trade.

But I think it’s absolutely imperative to realize that EVERYTHING is a forecast – even a so-called “passive investment portfolio.”

If you tell me to own a total stock market fund over the next decade (or any index fund, for that matter) you are making a forecast about what sort of return you expect it to generate over that time. Clearly, you wouldn’t tell me to own this sort of fund if you believed that stocks were likely to fall 40% over the coming decade (like the San Fran Fed recently suggested may be a real possibility). No, you believe that I will likely receive a positive return, after inflation, or why take the risk of owning equities at all? It’s a forecast, plain and simple.

At the end of the day, then, trashing forecasters is simply a way of saying that THEIR forecast is not as valuable as YOURS. And if you want to make that argument then I’d like to know WHY you think yours is better rather than just bashing the other guy’s.

Ultimately, to be truly honest with individual investors and our own forecasting ability, we should be telling them that the most successful models suggest that, from current prices, they will likely receive a negative real return over the coming decade from equities. And at 1.75% on the 10-year treasury, they can’t reasonably expect anything more from that asset class. Those are forecasts based purely on facts and statistics and it’s probably the best we can do.

But you can’t play this game without making a forecast. In fact, you can’t even sit out of the game without making one because even that decision is a forecast (that cash is likely to do better than any other asset class). So, with all due respect, please STFU about it; it’s disingenuous. Stop bashing forecasters and instead tell us why you believe YOURS is so much better than anyone else’s.

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Has Demand For Stocks Dried Up?

We all spend a great deal of time analyzing valuations, technical patterns and sentiment in trying to determine if it’s a good time or bad time to buy or sell. I try to constantly tell myself, “keep it simple, stupid.” In that vein, there’s a much easier way of looking at the markets even if it means taking a very long-term view.

My friend @jesse_livermore recently wrote a terrific piece about the ultimate arbiter of market prices: supply and demand (go read it). This basic economic principle applies just as much to the financial markets as it does other prices. In fact, you can make a great case that the Fed limiting supply of Treasuries over the past few years has been a major factor in their incredible surge.

By the same token, there’s one chart that has stuck in my mind over the past year or so since it peaked. And that is the chart of total margin debt – more specifically, the chart of net credit balances in brokerage accounts:

NYSE-investor-credit-SPX-since-1980Chart via Doug Short

As you can see, we are currently witnessing the largest negative balance in brokerage accounts on record (second-most ever relative to GDP). Looking back over the past couple of decades it’s plain to see that stock prices have either benefitted or suffered from ebbs and flows in supply (stock for sale) and demand (stock for purchase).

The runup during the internet bubble benefitted from a massive amount of demand for equities fueled by rapidly expanding margin debt. Stocks peaked due, in some degree, to investors maxing out their ability to borrow and demand essentially dried up. Eventually, those shares they acquired during the bubble became supply and there was no new source of demand to soak it up. Prices were roughly cut in half.

Conversely, after the financial crisis, all the excess cash in brokerage accounts was converted to demand for equities which fueled the boom in prices during the beginning of the bull market. Then investors began to borrow and the growing margin debt once again pushed prices higher still. Now here we sit with record negative balances in brokerage accounts.

The simplest conclusion we can draw from the current levels of negative balances then is that there is currently record low potential demand for equities. In other words, the fuel for higher prices is running dry, if it hasn’t already (as I mentioned earlier margin debt levels peaked almost a year ago). Long term investors would do well to make a note of this and consider it in their long-term plans.

In the shorter-term, though, it’s probably worth noting that, on the flip side, there is also “record potential supply” for equities which can cause problems all on its own. Just take a look at what has happened recently to the price of oil. Massive new supply comes online (from the shale boom) and the price collapses about 60% in only 6 months time.

Now, I’m not saying the stock market will collapse. I’m just saying that should this potential “supply” come to market it could make for some very turbulent trading. (Another component of growing supply for equities comes from the IPO market, which last year nearly matched the record set in 2000.) And the potential for “demand” to save the day is very limited, at best.

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The Stock Market Is Just Noticing What The Bond Market Has Known For Months

…that growth is slowing, the credit cycle could have already peaked and risk appetites are waning.

Over the summer I attended a conference which featured Steen Jakobsen as one of the speakers. The one thing he said that really stuck with me is that long-term bond yields lead the economy by about 9 months. If that is true, economists are going to be dramatically lowering their expectations for growth over the coming 9 months as the 10-year treasury has seen its yield plummet over the past year (not to mention foreign yields which are now negative at maturities of up to 5 years):

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What’s more, the yield curve (the difference between the 10-year and the 2-year treasury yield) has flattened almost back to the level it saw at the very bottom of the financial crisis:

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For most of 2014, stocks completely ignored this warning from the treasury market of slowing growth. One asset class that hasn’t ignored it is the corporate bond market, specifically the riskiest sector of the corporate bond market. High-yield bonds have been sending a clear signal for months now that, after a long hiatus, risk is making a comeback and the long-benign credit markets may be shifting to something not so benign. In his conference call yesterday, Jeff Gundlach called this divergence between stocks and high-yield, ‘the most worrying signal coming out of the markets right now.’

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Most equity bulls have written off the weakness in junk bonds as a reaction to the oil crash which they believe will be contained. Junk has anywhere from 14-18% exposure to energy. However, leveraged loans have only a 4% exposure to energy and they have been just as weak, if not weaker, than junk bonds. This tells me that this growing risk aversion goes beyond just the energy sector and has implications for all risk assets, including stocks.

I guess nobody told the stock market as much until very recently. For the past few years risk appetites in the bond market (willingness to venture out on the risk curve from treasuries to riskier fixed income instruments) have been very highly correlated with stock prices – I’m talking 98% correlated… until last summer, that is. Since then, virtually all other risk assets have declined while US stocks continued to make new highs.

Screen Shot 2015-01-14 at 7.34.48 AMSo to my mind the stock market weakness over the past couple of weeks is merely a function of equities playing catch up with all other risk assets. Stocks are just starting to pay attention to these messages of slowing growth, increasing risk and waning appetites.

In the short term, my model suggests the S&P 500 should be trading closer to 1800 than 2000, based solely on bond market risk appetites which, as I said, have been very highly correlated in the past. Having said that, bond market risk appetites are a moving target. They could recover and that would change this forecast. But should we be witnessing a cyclical end to the incredible hunger for risk assets we’ve seen over the past few years (inspired by ZIRP and QE) then I imagine this is only the beginning of the process. Yield spreads certainly have plenty of room to move wider still. We’ll just have to keep our eyes peeled, I guess. And keep them trained on the bond market which will likely tell the tale.

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By Some Measures This Is The Most Overvalued Stock Market Of All Time

Not so long ago I wrote, “this is probably the second worst time to own stocks in history.” However, when you look at the market a bit differently you can make the case that this could be THE worst time ever to own stocks.

Most broad valuation measures are market capitalization-weighted simply because the major indexes are cap-weighted. The S&P 500, for example, currently trades at a price-to-earnings ratio of about 19. However, the p/e of the Russell 2000 small cap index is closer to 80!

Screen Shot 2015-01-13 at 9.28.35 AMChart via wsj.com

This disparity between the two is hidden from the valuation discussion most of the time because it usually focuses on the stock market as represented by the largest 500 companies. When you look at the broader market, though, it’s clear there’s much more to the story.

So how do we reconcile the small cap p/e that is off the charts with a large cap p/e that is elevated but not nearly as ridiculous? Looking at the median p/e (the valuation of the company in the exact middle of the pack) should do the trick. Fortunately, Jim Paulsen of Wells Capital has already gone to the trouble of putting this together:

Screen Shot 2015-01-13 at 9.32.03 AMChart via wellscap.com

There you have it: the most overvalued stock market of all time, based on median price-to-earnings. (For what it’s worth, Paulsen also demonstrates in the paper that on a price-to-cash flow basis stocks have also never been as highly priced as they are today.)

Here’s what I think you should take away from this. The first thing I think about when I see a chart like this is my potential reward versus the potential risk I’m assuming. The best possible situation would be for valuations to remain elevated for the foreseeable future. Then my gains should be roughly equivalent to corporate earnings growth, probably in the low to mid-single digits. However, in a worst case scenario, valuations return to the bargain bin and I’m facing steep losses (possibly 50% or more). All in all, I’m risking half my capital to make a single digit return.

The second thing I think about when looking at the chart above is my long-term rate of return is determined by the price I pay. If I’m fortunate enough to get a below-average price then over time I can reasonably expect an above-average return from stocks (10% per year or more). Pay a high price and I guarantee myself a mediocre return. Pay a record-high price and I’m essentially locking in one of the worst long-term returns in history (probably somewhere close to 0%).

Now I have to say that I believe price-to-earnings ratios are not the best way to value individual stocks or the broader market. There are other methods that are much more valuable for forecasting long-term returns like Warren Buffett’s favorite yardstick, total market cap-to-GNP. See “everything but the US stock market has already peaked” for my latest update on it and other indicators crucial to long-term equity performance.

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Tweet Storm: Are Mom & Pop Smarter Than Jeff Gundlach And Warren Buffett?

It’s not rocket science, folks. You just have to control your emotions, tune out Wall Street’s propaganda machine and try to see the facts for what they are.

Related:

How to time the market like Warren Buffett

Don’t buy the buy and hold line of BS

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Are Stocks On The Verge Of Another Incredible 1999-Style Surge?

Over the past few months the “blow off” camp has gotten fairly crowded. First, Jeremy Grantham said that we are very nearly in bubble in the stock market currently. However, he believes that bubbles don’t just fizzle out. They usually end in an epic move that runs faster and farther than anyone could ever imagine. Specifically, he’s looking for valuations to come fairly close to what we saw back in 1999.

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Then, a few months later, David Tepper said that because this year rhymes (of course, history never repeats) with 1998 we could see a 1999-style surge in the stock market in 2015. Today, like in the late 90’s, money is being made too easy resulting in yet another asset bubble, he says. He is also looking for valuations that reach levels close to what we saw back in 1999 (according to him, today’s p/e is a mere 16 compared to 1999’s 40 but there are much better ways to measure valuations, in my humble opinion).

Recently, Richard Russell wrote a piece in which he revealed that he believes we are are only now entering the third phase of this bull market. He reminds us that gains in the third phase are usually equal to those of both phases one and two. Stocks have roughly tripled since the 2009 low (700 to 2100) so his expectation is about 3,500 on the S&P 500, almost 70% higher than its current level.

Just this week, Jim Rogers hopped aboard the “blow off” bus by saying he believes the stock market is probably due for some sort of decline but if stocks decline to any significant degree, the Fed will turn the printing presses back on and like never before sending stocks to ridiculous heights.

So we now have at least four respected pundits predicting an amazing “blow off” run for stocks. Know that I respect each of these individuals greatly and in their own right. Rogers is a hero of mine and I have as much admiration for Grantham’s work as for anyone in the industry.

Having said that, I strongly believe that the more popular a prediction becomes the less likely it is to come to pass. And this “blow off” thesis is getting fairly popular now. More importantly I’d like to try to examine what factors would have to align for this thesis to work.

First, the credit markets, which I have been watching very closely, would have to rebound. The high-yield market has been showing signs of weakness since mid-summer last year. This makes sense as that area of the bond market has about a 14% exposure to companies directly affected by the oil crash. Leveraged loans, however, only have a 4% exposure and have been just as weak as high-yield so we can’t just write off the waning risk appetites there to the energy sector. I believe both would have to improve significantly for stocks to have any chance of a “blow off.”

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Second, the global markets would have to avoid any significant fallout from the crashes in oil and in some emerging market currencies. There is a chance, though I have no idea how to put any probability on it, that there could be significant ramifications from the sharp moves we have seen recently in these areas.

Third, because sentiment and valuations go hand-in-hand, investors would have to become even more bullish than they are today. This would mean allocating an even greater percentage of household assets to equities, a statistic that is already fairly stretched and looks to possibly be peaking. It would also mean they would have to take on even more margin debt which, in relation to GDP (or inflation-adjusted, take your pick) is already far higher than what we saw at the peak of the internet bubble.

ALANMARGINDEBTChart from CrossCurrents via CNBC

Fourth, baby boomers would have to, at the very least, maintain their current equity exposure. If this retiring generation decides at some point that they have too much exposure to equities it could create an incredible headwind for the markets. In fact, the San Francisco Fed recently suggested the S&P 500 could finish as low as 1,290 a decade from now, 40% lower than its current level.

Finally, market participants must to continue to have full faith in powers of the Fed to manage not only the stock and bond markets but the economy and the dollar, as well. This is not a given. I believe that the Fed is not as powerful as the markets currently give them credit for being. If stocks began to fall in response to some dislocation in the currency or commodity markets the Fed may be hard-pressed to create a fix. Investors should have learned this lesson in 2008 when the markets essentially ignored every effort on the part of the Fed to reign in the financial crisis.

Ultimately, a number of things have to align nearly perfectly for the stock market to see another 1999-style surge. I do, however, envision one major possible driver of an equity blow-off. Should investors, both foreign and domestic, decide that Europe, Japan and emerging markets are not the best place for their money and that the US is the right place, we could see a continued surge in the dollar and increasing demand for our investment assets.

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But what might make them move so dramatically out of those markets? I think the most likely reason would be a dislocation in one or more of them. In that case, which asset class here would most likely benefit? Risk assets, like stocks and high-yield? Or risk-free treasury bonds? I believe investors looking for a safe haven would most likely pick the latter. This is one reason I wrote a couple of months ago that treasury bonds could be about to blast off. They have already risen 10% since then but in this scenario that could be only just the beginning.

As I wrote earlier, I have tremendous respect for these guys who are looking for a “blow off” in stocks. They could very well be proven right, yet again as they have many times during their careers. All in all, however, I think there are a lot of things that need to go exactly right for a “blow off” in stocks to materialize. What’s more likely, in my mind, is that we see a “blow off” in the bond market, something almost nobody expects right now.

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