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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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Don’t Buy The Buy-And-Hold Line Of BS

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

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

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

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

Buffett Indicator Annotated

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

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

Screen Shot 2014-08-05 at 9.29.02 AM

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

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ATTN: DUMB MONEY – The Smart Money Is Selling To You (Yet Again)

Near major turning points in the stock market there is always the fascinating dichotomy of smart money doing one thing and dumb money doing the exact opposite. And by smart money I’m not talking about analysts or brokers or newsletter writers, hardly; I’m talking about corporate insiders. As for the dumb money, I’m talking about Joe Retail trader, your average Wall Street sucker. Without fail the smart money is buying at market bottoms while dumb money is selling and vice versa.

To take off on a brief tangent, for those of you offended by the term “dumb money” know that, in the words of Warren Buffett “when ‘dumb money’ acknowledges is limitations, it ceases to be dumb.” The trouble is that most dumb money doesn’t ever acknowledge the fact that market timing is outside of its abilities. It continues to think it’s smart and buy high and sell low and regard itself as merely unlucky. End of tangent.

Recent sentiment surveys show that investors haven’t been this net bullish in a very long time. This is valuable to us as a contrarian indicator but these are still just surveys. They reveal what people are saying they’re doing with their money. Looking at what investors are actually doing with their money the picture becomes downright scary.

Right now we are witnessing the most extreme example of this dichotomy between smart and dumb money that has ever been recorded. Rydex traders now have nearly 8 times a much money in bullish funds as bearish ones. This is an all-time high:

sentiment_05via SentimenTrader

At the same time, “in-the-know insiders,” corporate officers and directors, have never been more bearish on their own shares. Marketwatch reports:

[blockquote2]Corporate officers and directors in recent weeks have sold an average of six shares of their company’s stock for every one that they bought. That is more than double the average adjusted ratio since 1990, which is when Seyhun’s data begin…. The current message of the insider data “is as pessimistic as I’ve ever seen over the last 25 years,” he says. What makes this development so ominous, he adds, is that, while no indicator is perfect, his research has shown that “the adjusted insider ratio does a better job predicting year-ahead returns than almost all of the better-known indicators that are popular on Wall Street.” There have been two prior occasions when the adjusted insider ratio got almost as bearish as it is today — early 2007 and early 2011. The first came a half a year before the beginning of the worst bear market since the 1930s. While the market didn’t fall as much following the second of these two instances, the May-October decline in 2011 did satisfy — based on intraday levels of the S&P 500 index — the semiofficial definition of a bear market as a 20% drop.[/blockquote2]

When the smart money talks, I listen. And if there’s any dumb money out there reading this I hope this helps you ‘cease to be dumb.’

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