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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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l-1350
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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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dollarsigns
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It’s Going To Take A Major Bear Market Before Stocks Can Live Up To Investors’ Lofty Expectations

The Nasdaq recently set a new all-time high, 15 years after it set it’s last one. Investors who bought back then believing no price was too high to pay in order to hop on the dotcom bandwagon learned the hard way that, “the price you pay determines your rate of return.” This is an iron law of the markets. If you overpay you essentially lock in subpar returns for a long period of time.

Think about it this way. You’re buying some wholesale product to resell. Let’s just use beard oil as an example. You know you can sell the beard oil for $10 per jar. If you can buy them for $5 you can double your money every time you sell a jar. But if you pay $9 each you’re going to earn a lot less on each sale. Buying the Nasdaq in 2000 was like paying $40 per jar. Inflation (sales and earnings growth, in the case of Nas cos.) has now finally caught up so that these investors can now sell their jars of beard oil for their original cost.

Paying an incredibly high multiple of earnings for the Nasdaq back in 2000 guaranteed buyers that they would receive poor returns over the next 15 years. Even the broader market at the time was priced to disappoint investors as Warren Buffett famously wrote in Fortune back in November 1999.

What investors need to know today is that they are currently priced just as high as they were back then! The problem is they once again want their cake and to eat it, too. Despite paying an extremely high price for stocks today they also expect a high rate of return. A few recent polls show investors expecting to get 10% per year from their equity investments right now. Some are even expecting to generate twice that much and there’s just no chance it’s going to happen.

Warren Buffett’s favorite valuation measure is nearly 90% correlated to future returns in the stock market. It’s what he referred to in his November, 1999 piece when he wrote that investors were destined to be disappointed by their returns over the coming decade (now known as the lost decade). Based on how high this measure shows stocks are currently valued, it forecasts an average annual return of about -0.5% over the coming 10 years.

Screen Shot 2015-04-27 at 1.24.37 PM

Now if you want to generate a 10% return buying the major stock market indexes like the S&P 500 you’ll need to pay a much lower price. Using similar measures, it’s fair to estimate that you would have to pay about 940 on the S&P to generate a 10% forward return for the coming decade. In other words, it would take a decline of more than 50% to set up the opportunity for the stock market to provide double digit returns once again.

So if you do want to earn 10% per year on your stock market investments you should be rooting for a major bear market. Because without one you’re going to be just as disappointed as those who bought stocks back in November of 1999. Like Nobel Prize winner Bob Shiller recently said, you’ll likely wake up 20 years from now and realize your investments have gone nowhere. And during that time, there will undoubtedly be a few opportunities to buy stocks at much better valuations and thus offering much better forward returns just like we’ve seen over the past 20 years.

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johntempleton
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I’m Hearing A Lot Of Smart People Use “The Four Most Dangerous Words In Investing” These Days

Let me begin this post by saying that the three sources I quote here are among the handful of voices on social media and the financial blogosphere I respect most. This is also why I’m especially concerned about this new trend.

What worries me is that I’m now hearing the “four most dangerous words in investing” from some of the smartest guys in the game. Each of the arguments I’m going to look at represent some version of “it’s different this time” in relation to overall stock market valuation.

I’ve made the case for months now that stocks are extremely overvalued. In fact, I believe there is a very good case to be made that while we may not have another full-fledged tech bubble on our hands, the broader stock market is just as overvalued today as it was fifteen years ago, at the peak of the internet bubble.

To counter or to justify this idea, some very smart people have gotten very creative. First, Alpha Architect recently ran a post on valuations determining that, “the stock market isn’t extremely overvalued.” It’s “normalish.”

However, and they do acknowledge this in the post, they are looking at today’s valuations in relation to the history of just the past 25 years. The problem with this is that the past 25 years represent the highest valuations in the history of the stock market so, obviously, today’s valuations will look much more reasonable when framed in that light.

In acknowledging the limitation of using just the past 25 years, however, the author of the post questions whether, “market conditions 100+ years ago may be different than they are today.” In other words, ‘it’s different this time’ so those historical measures are no longer be relevant. To their credit, they recognize, “this sounds a bit like the ‘new valuation paradigm’ thinking that prevailed during the dotcom boom when valuations went crazy.” Still, they are putting it out there for less circumspect investors to rely upon.

Similarly, my friend Jesse Livermore of Philosophical Economics recently posited in a terrific piece that there are very good reasons justifying the persistent high valuations of the past 25 years.

Should the market be expensive?  “Should” is not an appropriate word to use in markets.  What matters is that there are secular, sustainable forces behind the market’s expensiveness–to name a few: low real interest rates, a lack of alternative investment opportunities (TINA), aggressive policymaker support, and improved market efficiency yielding a reduced equity risk premium (difference between equity returns and fixed income returns).  Unlike in prior eras of history, the secret of “stocks for the long run” is now well known–thoroughly studied by academics all over the world, and seared into the brain of every investor that sets foot on Wall Street.  For this reason, absent extreme levels of cyclically-induced fear, investors simply aren’t going to foolishly sell equities at bargain prices when there’s nowhere else to go–as they did, for example, in the 1940s and 1950s, when they had limited history and limited studied knowledge on which to rely.

My problem with this line of thought is that it assumes that human beings have essentially begun to outgrow the behavioral biases that have ruled them throughout a history that encompasses much longer than just the past century. We have seen “low real interest rates” and “aggressive policymaker support” in the past. See Ray Dalio’s excellent letter on 1937 as an analog for today’s economy and markets. So this argument really hinges upon, “the secret of ‘stocks for the long run’ is now… seared into the brain of every investor…. For this reason… investors simply aren’t going to foolishly sell equities at bargain prices when there’s nowhere else to go.”

In other words, we have entered a new era where human beings have fully embraced “stocks for the long run” for the long run and without reservation so cycles will be muted and valuations remain elevated for the foreseeable future. Never mind the fact that the recent history of the financial crisis may contradict this idea. I think the burden of proof for this argument lies squarely with its author. I have my doubts. In fact, this sounds strangely similar to Irving Fisher’s famous line just days before the 1929 crash, “stock prices have reached what looks like a permanently high plateau.”

Finally, Alex Gurevich wrote a fascinating think piece over the weekend on the Fed, the economy and how they relate to stocks and bonds. While I truly appreciate following Alex’s thought process (as I do both of the previous authors’), it’s his case for owning stocks that strikes me as a clear rationalization of extreme valuations:

Singularitarians (such as Ray Kurzweil)  believe that we are on the brink of explosive self-acceleration led by computers designing better computers, which design better computers even faster, and rapidly surpassing every aspect of human intelligence. Singularitarian philosophy is migrating out of the province of science fiction writers into the  mainstream, and can no longer be ignored by long horizon investors… The idea of economic singularity allows me have a clear and consistent theory of unfolding events. I can be positive on stock market without being scared of valuations.

I don’t dispute the awesome idea of singularity. It seems inevitable and inevitably beneficial for society (though some very smart people would disagree). What I dispute is the idea that singularity should justify high valuations.

As I tweeted this morning, it reminds my of Warren Buffett and Charlie Munger on the awesome innovation of air conditioning and air travel. These things were miracle innovations that dramatically improved the lives of human beings but did they justify abandoning tried and true investment methods developed over long periods of history? In retrospect, the answer is obvious. Amazing innovation is truly inspiring but it shouldn’t inspire you to overpay for a simple stream of future cash flows that have been very easy to value accurately over very long periods of time.

Ultimately, only time will tell if it is, in fact, “different this time” or if history will rhyme once again and today will only represent another stanza in the poem it’s been writing for centuries. With all due respect to these three very wise market philosophers, my money is on the latter.

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