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“The Dominant Risk For Wall Street” May Be Manifesting In Small Caps

A good deal of attention has already been paid to the growing divergence between small cap and large cap stocks so far this year. The former have seen a small decline while the latter have risen about 8%. But I’ve seen very little commentary regarding WHY this might be happening. Of the many divergences the market has seen recently I think this one may be the most significant as the small caps could be the “canary in the coal mine” for the broader market.

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It all comes back to what I have argued amounts to a bubble in corporate profit margins. Jeremy Grantham has used a 2-standard deviation event as one benchmark for a bubble. Using that definition, it’s hard to argue that profit margins are not currently in a bubble.

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Warren Buffett also weighed in on unsustainably high margins back in 1999:

In my opinion, you have to be wildly optimistic to believe that corporate profits as a percent of GDP can, for any sustained period, hold much above 6%. One thing keeping the percentage down will be competition, which is alive and well. In addition, there’s a public-policy point: If corporate investors, in aggregate, are going to eat an ever-growing portion of the American economic pie, some other group will have to settle for a smaller portion. That would justifiably raise political problems—and in my view a major reslicing of the pie just isn’t going to happen.

Note that margins are now nearly twice the 6% level that Buffett considered a long-term upper threshold. Now I haven’t heard him say anything about current levels of profit margins (and I’d love for somebody to ask!) but I think his logic is still valid. At some point, the pendulum will have to swing the other way and profits will revert to some extent.

Like the price divergence between small and large caps, the forces behind the scenes here have also been the subject of much ink. It’s that 99% versus the 1% thing. You see over the past few years as the economy has slowly recovered in the wake of the financial crisis companies have seen their revenues grow but have been reluctant to add to their employee base. The result is that a larger and larger portion of these revenues fall to the bottom line. This goes on for a period of five years and, voila! Record profit margins. The 1% (owners of these companies) celebrate while the 99% stagnate.

Until now…

There are signs recently that this dynamic is shifting. After all, you can only milk your current employee base so much before they become overextended and your product or service suffers or you can’t meet the growing demand, etc. At some point in the recovery or expansion process you have to start adding employees AND paying your current employees a little better in order to retain them.

And it’s beginning to look like this is exactly what’s starting to happen. As the BLS reported a couple of weeks ago, job openings are improving pretty dramatically. July saw a 22% gain year-over-year. And as we learned today, real wage growth spiked in August by the largest amount in years.

This is fantastic news for the 99%. It looks like more jobs and better pay are finally on the way. And it’s exactly the result the FOMC, with their albeit super-blunt tools, have been trying so hard to create. As Pimco’s Paul McCulley writes:

But as Martin Luther King intoned long ago, the arc of the universe does bend toward justice. And as I wrote in July, I think it will do so with the Fed letting the recovery/expansion rip for a long time, fostering real wage gains for Main Street. This implies that the dominant risk for Wall Street is not bursting bubbles, but rather a long slow grind down in profit’s share of GDP/national income.

But do bubbles usually unwind in a “long slow grind down”? Maybe. But sometimes they burst. Either way, this is not so good for the 1% and those record-high profit margins. And we’re seeing this happen already in what area of the market? You guessed it – the small caps and “middle market” companies. Sober Look reports:

While over 50% of [middle market] companies are seeing revenue growth, the fact that over 50% are experiencing EBITDA declines suggests margin compression. For the sixth consecutive quarter, more middle market companies experienced EBITDA declines than gains.

It’s been six consecutive quarters now that these smaller companies have experienced, “margin compression.” UBS recently confirmed this data noting the recent plunge in EBIT margins at small cap companies.

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Chart via Business Insider

Make no mistake, this epic stock market rally has been built on the back of this profits boom. It’s been the source of much of the earnings growth we’ve seen and inspired investors to bid valuations to what has historically been rarified air. Should profits decline it would mean already extended valuations are even more inflated than they currently appear and would remove a major underpinning of the bull market.

What I worry about even more, however, is the amount of risk that has been assumed recently based upon the expectation that profit margins will remain at these record levels indefinitely. As Sober Look recently reported, leveraged buy out valuations are at heights not seen at any other time during the past 14 years. More importantly the amount of debt in relation to targets’ EBITDA is also at a record:

Valuations

Chart via Sober Look

If EBITDA at more than half of these companies is actually declining now these multiples will soon look even more inflated than they already do and the massive amount of debt used in buying them is at risk even greater risk of becoming unsustainable than it originally appears.

Speaking of the “massive amount of debt,” It’s important to note that the volume of leveraged loans has far surpassed it’s highs of 2007…

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Chart via Dallas Fed

…and the risk controls embedded in these loans has fallen dramatically as covenant-lite’s share of overall issuance is now twice what it was prior to the financial crisis.

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Chart via Dallas Fed

So it looks as if we may have more built up risk on the debt side of things than we did prior to the financial crisis. If margins are actually beginning to revert, as the small cap/middle market is suggesting, at 2-standard deviations above their long-term average, they potentially have a very long way to fall. And with so much risk betting against this possibility the fallout could be dramatic.

Perhaps this is why spreads have finally begun to widen just a bit over the past few months in the high-yield market.

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Chart via Charlie Bilello

All in all, this is clearly a very complex system with various intermarket relationships. But we are seeing some signals that point to the fact that the Fed may be close to achieving it’s goals of increasing employment and wages. While this is good news for the labor force, it’s bad news for companies and investors because the resulting margin compression would remove the main driving force of this bull market along with causing potential problems (defaults) in the high-yield bond market. So keep your eyes on the small caps; there are big implications in that divergence everyone’s looking at.

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Seeing The Forest For The Trees

Yesterday morning I came across a piece over at Harvard Business Review titled, “To Make Better Decisions, Combine Datasets.” I began reading it and realized that’s exactly the key to investment success and what I’ve tried to do with my market timing model: combine a variety of predictive datasets to create a holistic forecasting and timing model.

The stock market is driven not just by fundamentals or sentiment or technicals alone but by all of them in concert with one another. It follows then that an investor should try to incorporate each of them into her investment process in order to maximize its effectiveness.

And this is where I think many investors get lost. They try to focus on only one of these three. Fundamentals alone may work over the long run but cheap stocks can always get much cheaper in the short-term or they could just be cheap for a very good reason (I’ve learned this lesson more than a few times). Sentiment can also be very helpful but the crowd isn’t always wrong and markets can ‘stay irrational longer than you can stay solvent.’ And, as many traders know, the ‘trend is only your friend until it comes to an end.’

What I’ve found in my 20+ years of observing and trading markets is that looking at the forest, by putting all of these together, rather than the trees alone is absolutely crucial to making good decisions. So I thought it might be fun to look at the individual components of the model to see not only what they are saying about the markets but how they might be misleading when taken on their own.

For my fundamental component I use Buffett’s favorite valuation yardstick, total market capitalization-to-GDP. On its own it has roughly an 83% negative correlation with future 10-year returns in the stock market (based on 65 years worth of data). This means higher levels for this indicator are correlated with lower future returns and vice versa. Here’s what it looks like over the past 65 years or so:

Screen Shot 2014-09-05 at 9.38.05 AMEven considering the fact that the internet bubble has pushed the average higher over the past ten or fifteen years, this measure still suggests stocks are priced significantly above their historical range. Based on its high correlation with future returns this suggests investors should expect a very low return from present levels over the next decade.

BUT… this has been the case for most of the past 20 years! An investor looking at this measure alone might have sat out a couple of major bear markets but also would have missed a couple of the most massive bull markets in history! So it’s probably not smart to use this measure in isolation. Adding other related asset classes (like bonds – we’ll come back to that) and other, unrelated indicators should help give a bit more clarity.

My sentiment measure tracks the percent of household financial assets invested in equities. Believe it or not this measure is even more highly negatively correlated with future returns than Buffett’s valuation measure above (closer to 90% – hat tip, Jesse Livermore). Here’s what it looks like over the same time frame:

Screen Shot 2014-09-04 at 12.54.35 PMIt’s also currently sitting significantly above its long run average suggesting returns should be far below average going forward. As I mentioned this is a better forecasting mechanism than the fundamental measure but even if the incredible euphoria of the internet bubble got you out of the stock market you may not have gotten back in over the past 15 years because we haven’t seen anything like the pessimism witnessed at the 1982 low.

Finally, I’ve added a third component to the model, inspired by Doug Short: a simple trend regression model based on Robert Shiller’s data going back nearly 150 years. With a negative correlation of roughly 74%, it’s not quite as effective at forecasting future returns as these other two but I think adding it, as a third independent component based on a very long-term trend, helps to make the model more robust. So here’s what the S&P 500 looks like relative to a regression trend line over the full time period:

Screen Shot 2014-09-04 at 1.01.27 PMOnce again this indicator shows the stock market to be trading very close to the top of its historical range. Still, like the fundamental model this one might have had you sitting out of the stock market for perhaps the past 20 years!

So even though we have three independent models we need a way to put them together and then to put them into some sort of context. What I’ve done is used each indicator individually to create a 10-year forecasting model. Then I’ve simply averaged them together each quarter. All told, the combination results in a correlation to future 10-year returns of about 90%. Here’s a chart of the model’s forecast returns as compared to actual 10-year returns for the stock market:

Screen Shot 2014-09-04 at 1.05.21 PMWhere the model is farthest off the mark (where you see the yellow line far above the blue line) is in the late 80’s early 90’s. Stocks surged further and faster during the internet bubble than the model forecast they would. Removing those years, the model’s correlation value rises to about 94%.

So we know what the individual readings look like. What’s the model saying about future returns from here? As the chart below shows, the model forecasts a return of just 1.2% per year over the next decade:

Screen Shot 2014-09-04 at 1.10.16 PMTo add some context, in addition to the 10-year forecast I’ve put the yield of the 10-year treasury note on the chart, as well. Investors don’t look at potential returns in a vacuum; they compare potential returns of different opportunities, many times looking at the “risk-free” rate of treasury notes in the process. This next chart shows the difference between the model’s forecast return and the yield on the 10-year treasury note:

Screen Shot 2014-09-04 at 1.17.48 PMWhen the blue line is above zero, stocks offer the better return; when it’s below, bonds do. And as I’ve shown before in “How To Time The Market Like Warren Buffett” this timing model works very well. Just buy whatever asset class is more attractive – trading only once per year – and you’ll kill a buy-and-hold approach.

I think this alone is validation of a multi-disciplinary approach. But adding one more super-simple component makes it that much more effective: before we go and sell our stocks because bonds are more attractive, we want to make sure we don’t sell too early in a bull market or buy to early in a bear market. As the chart above shows this model would have had you sell your stocks and shift into bonds all the way back in April of 1996 and then miss all the gains of the next 3 1/2 years.

Adding a very simple trend-following approach solves this problem (hat tip, Meb Faber). Rather than sell right when bonds become more attractive it’s much more advantageous to wait for the trend to end. And as a representation of the trend, we can simply use a 10-month moving average. Below is a chart of the S&P 500 and this moving average:

Screen Shot 2014-09-04 at 1.23.36 PMTo be clear we’re not trend followers all the time with this model. We buy-and-hold until the model tells us that stocks are not attractively priced and then we become pure trend followers. Once the model tells us stocks have become less attractive than bonds we wait for the S&P 500 to close at least 1% below its 10-month moving average at which point we sell our stocks and sit in cash, buy bonds or even short stocks (the latter generates the best returns over the period studied).

Should the index at any point close back above its 10-month moving average by at least 1% we buy stocks again. Like I said, so long as stocks are less attractive than bonds we are pure trend followers. Only when the model suggests stocks are once again more attractively priced than bonds AND the trend has turned up (as indicated by a monthly close above the 10-ma) do we buy stocks and abandon trend-following for buy-and-hold.

Ultimately what this produces is a combination buy-and-hold/trend-following model that owns stocks roughly 80% of the time and seeks to avoid major bear markets precipitated by high valuations, high levels of bullishness and prices extended far above their regression trend. It doesn’t avoid losses entirely, though.

The model didn’t recommend a move out of stocks prior to the 1987 crash which resulted in a decline of roughly 26% (its largest drawdown). It did, however manage to avoid the ’73-’74, ’00-’02 and ’08-’09 bear markets, the latter producing about a 50% decline. In fact, this is where all of the model’s outperformance is generated: in recognizing these major turning points fairly early on – essentially giving a warning signal – and then switching from buy-and-hold to trend-following when that strategy is more effective.

The next chart shows the results of three different investors. The first is a simple buy-and-hold strategy (blue line). The second goes to cash when the model indicates (red). The third, rather than going to cash, shorts the index (green):

Screen Shot 2014-09-04 at 1.50.13 PMClearly there is significant benefit to abandoning buy-and-hold for a trend-following approach when our model suggests stocks are unattractively priced. Over the period the investor who just sits out major bear markets in cash ends up with twice as much as the investor who holds through the entire decline. And the investor who gets short, in turn, fares far better still.

I truly believe these superb results, hypothetical though they be, can be attributed to the holistic nature of the model. It combines datasets that are valuable independent of one another into something greater than its parts.

As of now, the model is telling us that stocks have once again become unattractive relative to bonds. However, the uptrend is still in tact. So it’s probably valid to be bearish for fundamental, sentiment and regression reasons. But the trend is also a valid reason to be bullish – even if it is the only reason. So I’m still looking at the market through a bearish lens right now but I’ll be watching for a monthly close at least 1% below the index’s 10-month moving average for the trend to validate the fundamentals and sentiment.

For reference I’ve put up all the spreadsheets, calculations and charts I used on a public Google Drive sheet here: Market Timing Model. I’ll be updating it as new data comes in.

Finally, I need to make the same disclaimer I’ve made over and over again during this series: because this is a hypothetical model that doesn’t incorporate taxes, transaction fees, etc. it is not representative of any real returns. It is merely for educational purposes. Clearly, past performance may not be indicative of any future results.

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The Problem With Index Funds

I was glad to see on Friday someone (Yahoo! Finance Editor-in-Chief, no less) concur with my concerns over the growth of index-based investing strategies (see “One reason I’m worried about the rise of the robo-adviser“). In a piece appropriately titled, “Pride cometh before the fall: indexing edition,” Aaron Task writes:

Was ‘owning the index’ a good idea in 2000, when ~50% of the S&P 500 was in tech?

Was ‘owning the index’ a good idea in 2008, when 40% of the S&P 500 was in financials?

No, of course it wasn’t.

But that’s exactly what you did if you followed an index-based approach. So while index investing is probably better than many of the alternatives that doesn’t mean it doesn’t have its own problems. And being valuation agnostic is probably its biggest problem.

You see when you buy an index fund you put more money into the largest companies in the index and less money into the smallest, regardless of their valuations. So when investors bid tech stocks to the moon and they become the largest component of the index (as in 2000) they carry a larger weight in the index and, in turn, you end up buying a lot of them. In effect, you become greedy when others are greedy rather than becoming fearful, as Buffett would recommend (he also recommends indexing, though, so go figure).

And taken to the extreme, the growing popularity of index-based investing could possibly be the cause of yet another stock market bubble. When a growing class of buyers is willing to continue buying regardless of how high prices rise then valuations can conceivably rise infinitely (Sound familiar? Indiscriminate buying of internet stocks in 2000? Indiscriminate buying of housing in 2007?).

What index-based strategies don’t want you to know is that ‘the price you pay DETERMINES your rate of return.’ Pay too high a price and you literally guarantee yourself horrible returns. Forget owning too much of one sector within the index; was it a good time to buy stocks at all at March of 2000 or October of 2007? Hell, no. Sky-high valuations were a big reason for that. And we may have already reached that point once again (Jesse Livermore recently wrote a wonderful piece on the topic – see “Why is the Shiller CAPE so high?“).

Finally, I personally see the growing popularity of index-based investing as a good thing for individual investors over the long-term but also as a potential contrarian indicator over the intermediate-term.

Aaron again:

The pendulum has swung way too far where everyone thinks all you have to do is index and you’re going to do better [than actively managed funds].

Once the pendulum has swung so far that many investors come to believe that all you have to do is buy the index and it’s all peaches (cap gains) and cream (dividends) then it’s probably time to look out below. I just don’t know if we’re there yet.

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Mania, Part Deux

I continue to be amazed at the rampant rationalizing that is fueling this market. In my first “Mania” post, I began with a quote from professor Shiller regarding his CAPE ratio and what it currently suggests about stock market valuation:

“The United States stock market looks very expensive right now. The CAPE ratio, a stock-price measure I helped develop — is hovering at a worrisome level…. above 25, a level that has been surpassed since 1881 in only three previous periods: the years clustered around 1929, 1999 and 2007. Major market drops followed those peaks.” -Robert J. Shiller, Nobel Prize-Winning Economist and Author of “Irrational Exuberance”

Impersonating the rationalizers I mimicked the popular response: “the CAPE ratio is flawed and valuations don’t matter anyway; stocks are only worth what someone else is willing to pay.”

Lo and behold, somebody stepped up to the plate and took the rationalization to a whole new level (via CNBC):

[Charles] Dumas argues that including the Great Depression, two world wars and the Cold War into the long-run average makes it an “unduly poor comparator”. Instead, if you disregard this period, the CAPE is only 7 percent above the post-Cold War average, according to Dumas.

In other words, ‘if we take out all the bad stuff (decades and decades of market history) and focus only on the good times, the market is only 7% overvalued – AND that’s somehow bullish.’ How can this guy say this with a straight face? The whole purpose of the CAPE ratio is to adjust for cycles; it’s an acronym for “cyclically-adjusted price-to-earnings” ratio. Is he really suggesting we throw out professor Shiller’s Nobel Prize-winning work and only use a BLPE, “bubble-level price-to-earnings” ratio?

The article continues by quoting his cohort, Jack Boroudjian who writes the CAPE off as a, “strange equation.” I would literally pay money to hear these guys rationalize Buffett’s favorite yardstick right now. It’s incredibly entertaining.

Also, just off hand in my earlier piece, I mentioned the ad hominem attacks directed at John Hussman. Well Larry Swedroe subsequently jumped the shark in this regard (via ETF.com):

One investor recently asked me to comment on Hussman’s latest musings, which had made him quite nervous. Now, I knew that Hussman had been persistently bearish for quite some time, and I have been asked about his columns fairly frequently. So I went back into my files and dug up what I had written about his comments on the market from Jan. 14, 2013. It provides a great example of why he should be ignored, along with all other forecasters.

A reader asked you to comment on his “latest musings” so rather than read his “latest musings,” Larry, you went back 18 months and roughly 75 weekly reports ago. Ignore the argument put to you and resort to “genetic fallacy” to prove he’s an idiot: ‘he was wrong 18 months ago so he must be wrong today,’ is not logic. It’s simply avoiding the issue and it only makes you look like an idiot, Larry.

He continues:

As further evidence of why you should ignore market forecasts like Hussman’s, consider the following performance data on his flagship fund, Hussman Strategic Growth (HSGFX). As of Aug. 4, 2014, the fund had $1.1 billion in assets—less than 40 percent of what it had just 19 months earlier—as investors fled, unhappy with the poor performance.

Please take a quick peek at Wikipedia’s definition of “genetic fallacy,” Larry. Your argument clearly, “fails to assess the claim on its merit,” and relies solely on, “something or someone’s origin rather than its current meaning or context.” Oh, and also the bandwagon fallacy: ‘if people are bailing out of his fund he must be an idiot because mutual fund investors are always brilliant traders!’

If you take the time to actually read Hussman’s “latest musings” you’ll find he’s not making 1-year forecasts, as Larry would have us believe. He’s making 10-year forecasts, something even Warren Buffett does regularly to assess the future prospects of owning stocks. And Hussman uses indicators like Buffett’s favorite valuation yardstick which are very highly correlated to future 10-year returns.

I urge you to actually take a look at some of his “latest musings” and see what his indicators are saying right now:

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As the chart above clearly indicates a multitude of independent indicators (including Shiller’s CAPE and Buffett’s favorite yardstick, market cap-to-GDP), all of which are highly correlated to future returns, suggest that owning stocks over the next decade will yield close to zero annual return, one of the worst prospects in history – this based on simple math and statistics supported by nearly 80 years of data.

So rationalize it however you like. Or simply ignore it. That’s your prerogative. Just know this type of mental gymnastics only happens in the midst of a mania. And it’s just fascinating to witness.

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A Holistic Approach To Market Timing That Crushes Buy-And-Hold

This is part 3 in my market timing series that began with “How To Time The Market Like Warren Buffett”:

“…the big money… is not in reading the tape but in sizing up the entire market and its trend.” -Jesse Livermore, Reminiscences of a Stock Operator

That’s exactly what I’ve been doing with my market timing series over the past few weeks: “sizing up the entire market.” But I haven’t yet gotten to the “trend” part – which, as Jesse testifies, is absolutely critical.

Before I get to that let’s just briefly recap how we got here. I first looked at Warren Buffett’s favorite valuation yardstick to get an idea of how stocks were valued. Comparing the prospective return from stocks (as forecast by the market cap-to-GDP model) to the simple yield on the 10-year treasury note gives us a great idea of which asset class we should own at any given time: the one the offers the greater prospective return! Voila, we have a very successful market-timing model. (See “How to Time The Market Like Warren Buffett“)

Then I looked at a measure of investor sentiment as the basis of a similar model. When I wrote it, I used Buffett’s famous ‘fear and greed’ quote. Since then, however, I really think this one from Sir John Templeton is even more apt: “Help people. When people are desperately trying to sell, help them and buy. When people are enthusiastically trying to buy, help them and sell.” Anyhow, this model worked in a very similar manner to our fundamental model and both had similarly successful results. (See “How to Beat The Market By Being Fearful When Others Are Greedy“)

At the end of the day, the thing that made both of these models successful was helping our hypothetical market timer avoid major bear markets. Where they suffered was when they got our market timer out of stocks (or back into stocks) too early (something that is all too common for the fundamentally-focused investor like yours truly). This is where the trend comes in.

Inspired by the likes of Meb Faber, Cliff Asness and Michael Covel, I’ve been studying trend following for a few months now. Maybe the most common indicator of the intermediate-term trend (1-3 years) that I’ve found is the 200-day moving average. This is simply the average of the last 200 days’ closing prices. A closing price above the average signals an uptrend; a closing price below signals a downtrend.

Many studies have shown that when an investor simply adds a trend-following component to their portfolio using this indicator for the S&P 500 they can reduce drawdowns, aka losses during bear markets, and improve overall results. Depending on transaction costs and taxes, however, the benefits may be negligible. But because I prefer a more holistic approach, I decided to look at what would happen if our hypothetical market timer added this simple trend-following approach to our existing models.

Here’s how it works. Our hypothetical market timer annually (at year-end) checks the 10-year forecast returns provided by our fundamental and our sentiment models and compares them to the yield on the 10-year treasury note. If both models suggest stocks offer the best return she does nothing; she merely holds the stocks she already owns. Should one of the models, however, suggest that the 10-year treasury offers a better return she… doesn’t sell her stocks and buy bonds just yet.

This is where she becomes a trend-follower. On a monthly basis, she begins checking the S&P 500’s 10-month moving average (roughly the same as the 200-dma but easier for me to calculate with the data available) and watches for a close below that level. Should the index close below its 10-month moving average while one of our models suggest stocks are not attractive she shifts from stocks to cash. Here are the results. This strategy is in yellow, labeled “Fundy-Trend.”

Screen Shot 2014-08-26 at 11.15.03 AMSo from 1950-2014 our buy and hold investor turns $1,000 into $785k (if she can hang on through the big drawdowns). Our straight trend-following friend finishes with $690k (using the method Jeremy Siegel uses in “Stocks For The Long Run“). Our fundamental market timer finishes with $1.56 million (compared to $1.15m for our fundamental model and $1.25m for our sentiment models alone), almost twice as much as the buy and hold investor.

Not bad, eh? But what’s that green one that’s over $2.2m?! Well check this out: I also decided to see what would happen if our hypothetical market timer, instead of going to cash, decided to shift from owning stocks to getting short stocks once the trend turned down. Clearly, she kicks everyone’s ass. She makes nearly 3x as much as our buy and hold investor, 2x as much as our simple fundamental and sentiment market timers and more than 40% more than our holistic (fundamental, sentiment and trend) market timer.

Warren Buffett, Sir John Templeton and Jesse Livermore weren’t successful for no reason. They individually used fundamentals, sentiment or the trend to crush the markets. Putting them together into a simple, quantitative and holistic process yields similarly spectacular results. So don’t buy the buy and hold line of BS if it doesn’t suit you. There are systematic ways like this to protect yourself from large losses and enhance your overall returns.

Soon I’ll be putting up a page on this site to keep track of these models. But again, I’d like to emphasize that this is merely for educational purposes. It doesn’t include transaction costs or taxes which should be major considerations for real-world investing scenarios.

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Here’s Why You Can’t Be Too Bullish Or Too Bearish Right Now

If you couldn’t already tell I’ve been thinking about cognitive biases and logical fallacies a lot lately. And while I’ve been fairly bearish for quite some time now I haven’t been, “sell everything and hide your cash in the mattress bearish.” Those who are that bearish are suffering from clear biases or fallacies I’ll get to in a minute. By the same token, those who are rip-snorting bullish right now are also suffering from a similar condition.

By being overly bullish right now, you’re simply in denial over a plethora of evidence that suggests the risk/reward equation is heavily skewed toward the risk side without much potential for reward at all. But what I really think bulls are relying on most heavily right now is a little something called “recency bias” or, as the Fed likes to put it (emphasis mine):

If asset prices start to rise, the success of some investors attracts public attention that fuels the spread of enthusiasm for the market. New (often less sophisticated) investors enter the market and bid up prices. This “irrational exuberance” heightens expectations of further price increases, as investors extrapolate recent price action far into the future. – “Asset Price Bubbles” FRBSF

That’s all “recency bias” is: investors ‘extrapolating recent price action far into the future.’ In other words, Mr. Market has been flipping a coin that just keeps coming up heads (big gains) so investors begin to believe that it’s just going to be heads forever. Tails (corrections or bear markets) are a thing of the past.

Obviously, this is just faulty logic. But when BTFD becomes so ingrained into the broader market psyche it just becomes painfully clear that investors are relying on nothing but the trend. Which is fine, of course, until the trend comes to an end. Just don’t pretend there are any other reasons to be bullish aside from the trend because there just aren’t.

On the flipside, uber-bears are suffering from a similar ailment called “gambler’s fallacy.” They believe that because Mr. Market has flipped heads so many times in a row (how long have we gone without a 10% correction?) that the likelihood of him flipping tails is now much greater which is also bogus logic but something people do all the time. The likelihood of flipping heads or tails is still 50% no matter what sort of streak has come before this flip of the coin.

Despite the fact that the odds haven’t changed at all, bulls believe there’s a near 100% chance the next flip is gonna be heads once again (because it’s just persisted so long) and bears believe there’s a near 100% chance it will be tails (because the ridiculous streak of heads just can’t persist). Both are wrong. So what’s an investor to do?

To me the fundamentals, sentiment and the macro backdrop are clearly bearish right now. But I grant that these are not timing mechanisms. These are just the shade of the lens we should be looking through right now. In 2009, you wanted rose-colored glasses because all three of these indicators were flipped. Today, you want the opposite, whatever that is (brown-colored glasses?).

Still, you probably don’t want to express that view in your investments to any great degree simply because Mr. Market is still, in fact, flipping heads… for now. So don’t get me wrong; I’m bearish. Clearly. But I’d recommend waiting until Mr. Market flips a tails or two to before jumping feet first into your bear costume.

Next week I’ll post the third in my “market timing” series which will make this much more clear.

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Mania

“The United States stock market looks very expensive right now. The CAPE ratio, a stock-price measure I helped develop — is hovering at a worrisome level…. above 25, a level that has been surpassed since 1881 in only three previous periods: the years clustered around 1929, 1999 and 2007. Major market drops followed those peaks.” -Robert J. Shiller, Nobel Prize-Winning Economist and Author of “Irrational Exuberance”

Popular response: the CAPE ratio is flawed and valuations don’t matter anyway; stocks are only worth what someone else is willing to pay.

“George Soros Just Made A Huge Bet That US Stocks Might Fall” -Business Insider

Popular response: he’s not betting stocks are going lower; it’s just a hedge against his long exposure.

“Yellen’s [recent] comments suggest, and I agree, that we are in an asset bubble.” -Carl Icahn

Popular response: 1999 was a bubble; this isn’t a bubble.

Rationalize. Rationalize. Rationalize.

Time and time again investors flat out deny what’s staring them dead in the face: stocks are extremely overvalued and at risk of yet another major decline. The last time I can remember investors rationalizing bearish data points as much as they are today was during the height of the internet bubble. ‘P/E’s don’t matter any more; it’s a new economy,’ was the battle cry back then. Today it’s, ‘it’s impossible to value a stock or the market,’ and ‘this is nothing like the internet bubble.’

To an outsider, someone who has nothing to do with the markets, the logical fallacies must be painfully obvious.

Criticizing the CAPE is a classic straw man. Tobin’s Q Ratio, a valuation measure used by the Fed, along with Buffett’s favorite yardstick, total market capitazliation relative to GNP, both confirm that the stock market is extremely overvalued, using three totally unrelated valuation methods. Another thing the bulls fail to mention is that these three measures are highly correlated to future 10-year returns for stocks and suggest the potential risk at this point is far greater than the potential reward. These are just facts!

And comparing today’s market to the internet bubble is a clear Red Herring. Just because today’s market is not exactly like that of 1999 doesn’t prove that we’re not in a bubble today. In fact, it’s totally irrelevant. Today’s market should be judged on the full measure of the data available to us. And just like Shiller says, there have only been a very rare number of times stocks have been this overvalued: 1929, 1999 and 2007. These are just facts!

Then we get into the Ad Hominem attacks. ‘Shiller’s just a professor; he’s not a market practitioner so he doesn’t know what he’s talking about’ or ‘Soros and Icahn are just like all the other hedge fund big wigs out there using the media to make short-term profits; you can’t read anything into what they do or say,’ not to mention the attacks on John Hussman that completely ignore the merits of his research on its own.

I get it. It’s extremely difficult to listen to reason when the madness of the crowd is simply deafening. At the end of the day, though, it’s all just a huge sign that investors are desperate to believe, to keep hope alive that 30%-per-year profits can happen again this year and the next.

So if you didn’t know what a mania was before now, just take a look at the financial blogs and social media sites. The rationalization is everywhere. And it may be the best indicator of all that we are, indeed, in the midst of yet another bubble.

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