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Why This Correction Will Likely Lead To Another Painful Bear Market

Back in May I wrote a post arguing that the record-high levels of margin debt should make investors more cautious. Basically, there is compelling evidence to suggest that margin debt is a very good indicator of long-term fear and greed in the stock market.

When margin debt is relatively high it signals that greed is predominantly driving stock prices. Conversely, when margin debt is relatively low it indicates that fear is the predominant factor. If an investor believes it’s wise to ‘be fearful when others are greedy and greedy when others are fearful,’ as Warren Buffett suggests, then it’s probably going to be hard to find a better indicator for long-term investors looking to do so.

This also makes perfect sense from an economic viewpoint. Relatively high levels of margin debt suggest there is little potential demand left for equities and plenty of potential supply to pressure prices lower. Conversely, relatively low levels of margin debt suggest there is little potential supply and plenty of potential demand to pressure prices higher. And, in fact, this is exactly how margin debt has worked its magic on stock prices over the past 20 years.

One of the most valuable ways I have found to view margin debt levels is in relation to overall economic activity. The chart below shows that when margin debt has approached 3% of GDP in the past it’s usually been a good signal that greed has gotten out of hand. Back in April this measure hit a new record. Screen Shot 2015-08-31 at 10.13.45 AMThe reason I find this measure so valuable is that it is highly negatively correlated to 3-year returns in the stock market. When margin debt relative to the economy has gotten very high, 3-year returns have been very poor and vice versa. Right now this measure suggests the coming 3 years in the stock market could be very similar to the last two bear markets we witnessed in 2001-2002 and 2007-2008 after margin debt reached similar levels in relation to the economy.

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What’s more, in the past, when stocks’ 12-month rate-of-change has turned negative it’s usually triggered a significant reduction of margin debt. In other words, once the stock market starts declining over a year’s time record levels of margin debt, which functioned as demand to push prices higher in the past, start to become supply, which pushes prices lower going forward. This is how the last two bear markets began.Screen Shot 2015-08-31 at 10.42.30 AM

Now the stock market only needs to rise by about 3/4 of a percent today in order to maintain a positive 12-month rate-of-change. On the other hand, the longer the current correction in stocks continues the likelier we are to see it evolve into a longer-term bear market, as the massive amount of margin debt stops working in the favor of all of these “greedy” speculators and begins to work against them and they start to become more “fearful.”

And if the past couple of full market cycles are any guide, the potential supply coming to market in this scenario could make the next bear market another very painful one, at least for those who ignore the crystal clear message of margin debt relative to the economy.

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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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The Single Most Important Element To Successful Investing

Simple is good, especially when it comes to investing. In the markets, it generally pays to “keep it simple stupid.” Trying too hard to be “very intelligent” or just overcomplicating things is an all too common failure among investors. However, there are no short cuts to investing success and making things simpler than they should be can be just as much of a failure as overcomplicating things. And this is where I think many investors could be erring today.

“It is remarkable how much long term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.” -Charlie Munger

There are some very basic minimum standards to successful long-term investing that just can’t be whittled away no matter how much investors would like them to be. The most important one is simply the act of thinking. Thinking about potential risk versus potential return. Thinking about market history and long-term cycles. Thinking about the potential costs of herding and lack of liquidity. Thinking about simple supply and demand. An investment methodology that bypasses or eschews this sort of thought is not investing at all.

“What could be more advantageous in an intellectual contest – whether it be bridge, chess, or stock selection than to have opponents who have been taught that thinking is a waste of energy?” -Warren Buffett

Still, more investors than ever have now been emboldened by a 3-year trend, as strong as any ever seen in history, into believing that thinking in this sense is a waste of time. I’m mainly referring to the growing popularity of “passive investing” and “trend-following,” not in their purest sense but in how they are commonly practiced today. In many ways, they have been bastardized by those who believe they can simplify the process by removing the need to think.

“One of the things I most want to emphasize is how essential it is that one’s investment approach be intuitive and adaptive rather than be fixed and mechanistic.” –Howard Marks

Both of these disciplines were originally founded and then refined by exceptional thinking in regards to risk, costs, liquidity and managing cycles – all critical to long-term success. If your investment discipline abandons this sort of contemplation then it clearly has removed the very thing that defines “investing” in the first place and has certainly become too “fixed and mechanistic.” Investing requires thinking. Without thinking, you’re not investing. Finding a balance between overthinking and not thinking at all is the key to developing a successful investment methodology.

A couple of individual practitioners in the indexing and trend-following space who have impressed me with their thinking on the subjects are Jerry Parker and Meb Faber. If you’re interested in learning how to think about implementing an index-based, trend-following strategy you would be wise to follow them:

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Warren Buffett Sounds Like A Hypocrite Because He Just Doesn’t Think Very Highly Of You

Dan Loeb recently drew attention to the many ways in which Warren Buffett contradicts himself and it became a pretty popular little quote. It became popular, I think, because there is a great deal of truth behind it. This is especially true when it comes to Buffett’s advice on investing.

Warren Buffett famously tells us to, ‘be greedy when others are fearful and fearful when others are greedy.’ Then he tells us not to try to time the market.

He tells us to evaluate stocks and bonds and put money into whichever offers the greatest prospective return. Then he says, ‘Screw it. Just put all your money in the stock market.’

He tells us that a “margin of safety” is the most important concept in investing. Then he says, ‘Never mind all that. Just buy stocks today at the prevailing price and focus on the very long-term.’

He tells us the best returns are to be had by owning only the highest quality companies. Then he says, ‘Forget that. Just buy an index fund.’

So what the heck is going on here?

I think part of it is his evolution as an investor. He started out managing a small amount of money which allowed him to take advantage of special situations and things that just aren’t possible when you’re managing over a hundred billion dollars. Now that he is almost forced to become a closet index fund manager, he has modified his philosophy to suit his situation.

The bigger reason, though, that I believe Buffett contradicts himself like this in public is he just doesn’t think you’re capable of becoming a “superinvestor” in the first place.

It’s very difficult to be “greedy when others are fearful.” It’s just as hard to be “fearful when others are greedy.” It takes a great discipline to be able to shut out the crowd and focus on what truly matters. This is an ability most people just don’t have – which is why there is a herd mentality in the first place.

It actually doesn’t take much specialized skill at all to evaluate stocks and bonds to determine which is more attractive at any given time or to recognize opportunities that offer a “margin of safety.” It does take discipline, though, to be able to take advantage of these opportunities when the crowd is screaming, ‘you’re wrong!’

Buffett clearly believes you’re not capable of this sort of discipline. And, based on how most of you have behaved over the past 20 years (see the dot-com and real estate bubbles), he’s probably right. For this reason, he hedges all of his advice and dumbs it down so that you don’t hurt yourself too badly. In the end, Buffett sounds like a hypocrite because he just doesn’t hold a very high opinion of you.

Now if you disagree and want to learn how to be a “superinvestor” like Buffett, I suggest you start right here. And pay no attention to Buffett’s dumbed down advice… unless, of course, you prefer to run with the crowd.

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