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How To Handle An Environment Of “Low Returns”

First off, if you are expecting to achieve historical average rates of return from stocks or bonds from current prices please go read, “How To Time The Market Like Warren Buffett.” The bottom line is a 10-year treasury note pays you little more than 2% per year and stocks are likely to earn you even less over the next decade. So what’s a prudent investor to do? Here’s Howard Marks on your options:

How might one cope in a market that seems to be offering low returns?

  • Invest as if it’s not true. The trouble with this is that “wishing won’t make it so.” Simply put, it doesn’t make sense to expect traditional returns when elevated asset prices suggest they’re not available. I was pleased to get a letter from Peter Bernstein in response to my memo, in which he said something wonderful: “The market’s not a very accommodating machine; it won’t provide high returns just because you need them.”
  • Invest anyway — trying for acceptable relative returns under the circumstances, even if they’re not attractive in the absolute.
  • Invest anyway — ignoring short-run risk and focusing on the long run. This isn’t irrational, especially if you accept the notion that market timing and tactical asset allocation are difficult. But before taking this path, I’d suggest that you get a commitment from your investment committee or other constituents that they’ll ignore short-term losses.
  • Hold cash — but that’s tough for people who need to meet an actuarial assumption or spending rate; who want their money to be “fully employed” at all times; or who’ll be uncomfortable (or lose their jobs) if they have to watch for long as others make money they don’t.
  • Concentrate your investments in “special niches and special people,” as I’ve been droning on about for the last couple of years. But that gets harder as the size of your portfolio grows. And identifying managers with truly superior talent, discipline and staying power certainly isn’t easy.

The truth is, there’s no easy answer for investors faced with skimpy prospective returns and risk premiums. But there is one course of action — one classic mistake — that I most strongly feel is wrong: reaching for return.

-Howard Marks, “There They Go Again,” May 6, 2005

Clearly, investors are currently “reaching for return” like never before. I have no doubt this episode will any any differently than it has in the past. For prudent investors, however, I think the best options are currently either 3 or 4, so long as they understand all the pros and cons of each.

Choosing the third option means you should be willing to tolerate another decline of up to 50% over the next decade in an attempt to capture the low single-digit returns stocks currently offer. That’s just the simple risk/reward equation current valuations present investors with.

Choosing the fourth option means you may have to hear your friends brag about their gains for a while should the market witness another bubblicious blow off akin to the 1998-1999 episode.

Which is the lesser of the two evils for you? Neither are very appealing but that’s the name of the game when you’re playing financial market limbo.

For more Howard Marks I highly recommend you read his excellent book, “The Most Important Thing

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The Worst Trade Of My Life

“The only thing to do when a person is wrong is to be right, by ceasing to be wrong. Cut your losses quickly, without hesitation. Don’t waste time.” -Jesse Livermore

This morning I closed out the worst trade of my life. Corinthian Colleges stock price is up about 100% this week on news that its creditors aren’t going to immediately force them into bankruptcy. But that doesn’t even come close to making up for the losses I’ve suffered over the past three years.

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It began back in 2011 when I first started buying the stock. At the time, it looked cheap because the for-profit industry was facing two major challenges that hurt Corinthian even more than most of its competitors. First, the industry was heading into what appeared to me to be a cyclical downturn as the economy began to improve and those who were out of work became less interested in learning new skills or burnishing their resumes. Second, the federal government was unhappy with the industry’s business practices and started devising and implementing more regulatory restraints for the companies.

What I totally miscalculated was that it’s probably a secular decline, not a cyclical one, for the industry. AND the government was fully prepared to put a company like Corinthian out of business. To make things worse, the stock price tried to tell me this for three years and I just wouldn’t listen.

“The inability to read a tape and spot trends is also why so many in the relative-value space who rely solely on fundamentals have been annihilated in the past decade.” -Paul Tudor Jones

Guilty as charged, Paul. What I’ve learned – the hard way – from all of this: What the best traders and investors in the world perhaps do best is admit when they’re wrong and take a loss quickly.

Warren Buffett’s recent Tesco trade is a great example of this. A few weeks ago it was revealed that the company, the largest grocery store operator in the UK, is now being investigated for accounting fraud. Buffett began dumping his shares almost immediately, roughly a quarter-million of them, in fact, calling the investment a, “huge mistake.”

Buffett’s speed and decisiveness in cutting this loss should be an inspiration to investors. In fact, I believe that even if you don’t have the greatest possible investment or trading process to begin with (just a decent one), if you have a terrific plan for selling that involves cutting losses quickly and ruthlessly, you can generate alpha (outperformance) solely that way (by losing less when markets fall). That’s how critical it is.

Moreover, it doesn’t need to be based solely on fundamental developments as Buffett’s sale seems to be. The trend in Corinthian over the past three years was plain as day. In fact, while I owned it, it rarely spent any time at all above its 200-day moving average. Outside of late 2011, early 2012 it didn’t really ever make any higher highs and higher lows. The trend over the past two years was almost screaming, “this stock is a loser! Get out while you can!!”

The bottom line is this: We all will make mistakes in the markets. What separates the best from the rest is how they deal with them and then how they learn from them and adapt their methods going forward. This was the worst trade of my life. I’ll never forget it because, although it had to literally beat me over the head, this lesson has now been lodged firmly in my brain.

So if you learn anything at all from Jesse Livermore, Paul Tudor Jones, Warren Buffett or from my painful mistake, I hope it’s this: Recognize when you’ve made a mistake and sell immediately. And pay attention to the trend. If it doesn’t validate your thesis, move on to your next idea.

“There is no better test of a man’s integrity than his behavior when he is wrong.” ―Marvin Williams

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Two Similes

A couple more thoughts on “The New Wolves of Wall Street“:

  • The main reason for using index funds is to reduce costs. If that’s the case then why add a high-cost advisory fee on top? Doesn’t that defeat the entire purpose?! If asking your stock broker if you need to trade something is like asking the barber if you need a haircut (to steal a Buffett line), then an adviser pitching index funds with a fat advisory fee is like a barber telling a bald guy, “okay, you can shave at home but keep the regular checks coming, okay?”
  • Many of these advisers will say that just because they’re using index funds doesn’t mean they’re not providing valuable advice. It’s true that some are but some will argue that you pay them to close the “behavior gap.” In other words, “you pay me to protect you from yourself.” To me this sounds a lot like, “I’m the wiseguy who provides protection in this neighborhood. If you don’t pay me how can I keep you safe?”
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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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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.

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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 SentimenTrader.com where Jason regularly publishes some superb work.

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How To Time The Market Like Warren Buffett

This is the first in a 3-part series on market timing – read part 2 here.

“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.

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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.

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