Featured, Investing, Posts

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.’

Screen Shot 2014-03-06 at 7.36.34 AM
Investing, Posts

On The Corporate Profits Bubble…

I recently wrote an article on the topic for Business Insider. Here’s an excerpt:

[blockquote2]After the internet bubble, the Federal Reserve came up with a great definition of a bubble. They posited that a bubble is formed when investors, “extrapolate recent price action [or economic action] far into the future.” I believe this is exactly what they are doing today: extrapolating record high profit margins far into the future in order to justify current valuations. And just as Mr. Buffett posited back in 1999, they are likely to be greatly disappointed.[/blockquote2]

Read the full story at BusinessInsider.com

Sailing Yacht Kokomo III - Underway at Sea
Investing, Markets, Posts

What Does “Reduce Risk” Mean To You?

[blockquote2]There will be an agreement in whatever variety of actions, so they be each honest and natural in their hour. For of one will, the actions will be harmonious, however unlike they seem. These varieties are lost sight of at a little distance, at a little height of thought. One tendency unites them all. The voyage of the best ship is a zigzag line of a hundred tacks. See the line from a sufficient distance, and it straightens itself to the average tendency. -Ralph Waldo Emerson, Self-Reliance[/blockquote2]

That is one of my favorite quotes. I contradict myself all the time. I tell individual investors to fire their financial advisers and put their money into index funds. Then I turn around and talk about how this style of investing is growing in popularity and it really worries me. I write about how investors shouldn’t try to time the market and then I write about how the stock market is very risky right now and they should “reduce exposure.”

My point in all of this is to simply think out loud and ultimately all of these winding roads (or differing tacks) lead to one place: a deeper understanding of the markets and my own abilities and limitations so that my investment process is constantly improving. That’s one of my main goals in writing this blog. Like a sculptor I keep adding a bit here or removing a bit there in an effort to refine but the work will never be done.

The other main goal in doing this is helping individual investors learn how to best invest their own money. In that regard, I get asked a LOT what does “reduce exposure” mean to me? I can’t tell you that. Everybody’s circle of competence is unique to their own experiences and skills. What I can tell you is whatever “reduce exposure” means to you make sure it’s well within your own skills to implement.

To be clear, I don’t think it’s ever a good idea to give up on stocks completely. If you own index funds “reducing your exposure” means just that – take your ideal allocation down a bit. So if you would normally put 60% of your portfolio in stocks maybe you reduce that to 50%. That leaves you room to take it back to 60% when stocks once again become fairly valued, as they surely will at some point in the future. Should they become significantly undervalued you’ll be in a position to increase that to 70%. That seems totally prudent to me.

Beyond that there are some really good opportunities out there in the market even if they are few and far between. Warren Buffett recently wrote, “in the 54 years we have worked together, we have never forgone an attractive purchase because of the macro or political environment.” Just because stocks are generally overvalued doesn’t mean you should give up looking for opportunities.

Speaking of Mr. Buffett, he’s another one prone to contradicting himself. The quote above comes from his latest letter to Berkshire Hathaway shareholders in which he advises:

[blockquote2]Forming macro opinions or listening to the macro or market predictions of others is a waste of time. Indeed, it is dangerous because it may blur your vision of the facts that are truly important. (When I hear TV commentators glibly opine on what the market will do next, I am reminded of Mickey Mantle’s scathing comment: “You don’t know how easy this game is until you get into that broadcasting booth.”)[/blockquote2]

Clearly he hopes investors don’t remember the times in recent history in which he made macro market predictions. Most recently he advised “Buy American. I am.” in October of 2008 writing:

[blockquote2]Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.[/blockquote2]

In other words, “it’s time to buy stocks.” And before that in November of 1999:

[blockquote2]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… This talk of 17-year periods makes me think–incongruously, I admit–of 17-year locusts. What could a current brood of these critters, scheduled to take flight in 2016, expect to encounter? I see them entering a world in which the public is less euphoric about stocks than it is now. Naturally, investors will be feeling disappointment–but only because they started out expecting too much.[/blockquote2]

For a guy who eschews macro predictions. He sure is good at making them.

Investing, Markets, Posts

Bitcoin, Warren Buffett And Bubble Psychology

You may not have a heard of Bitcoin but to finance nerds like me it’s been a fascinating story to watch over the past few months. So what is Bitcoin? In the words of CoinDesk, the self-proclaimed “voice of digital currency,” Bitcoin is:

[blockquote2]Bitcoin is a form of digital currency, created and held electronically. No one controls it. Bitcoins aren’t printed, like dollars or euros – they’re produced by lots of people running computers all around the world, using software that solves mathematical problems. It’s the first example of a growing category of money known as cryptocurrency.[/blockquote2]

But what’s a “cryptocurrency”? According to Wikipedia:

[blockquote2]Fundamentally, cryptocurrencies are specifications regarding the use of currency which seek to incorporate principles of cryptography to implement a distributed, decentralized and secure information economy… Within cryptocurrency systems, the safety, integrity, and balance of all ledgers is ensured by a swarm of mutually distrustful parties, referred to as miners, who are, for the most part, general members of the public, actively protecting the network by maintaining a high hash-rate difficulty for their chance at receiving a randomly distributed small fee. Subverting the underlying security of a cryptocurrency is mathematically possible, but the cost may be unfeasibly high… Most cryptocurrencies are designed to gradually introduce new units of currency, placing an ultimate cap on the total amount of currency that will ever be in circulation. This is done both to mimic the scarcity (and value) of precious metals and to avoid hyperinflation.As a result, such cryptocurrencies tend to experience hyperdeflation as they grow in popularity and the amount of the currency in circulation approaches this finite cap.[/blockquote2]

Got that? Great. Then get out there and join the Bitcoin gold rush!

But I won’t be joining you because there is no way in hell I’m going to begin to understand all that. In the words of Warren Buffett, it’s just not within my personal “circle of competence.” I’m just not capable of analyzing it and understanding whether my money will be safe in it.

And I bet there are only a handful of people on the planet that actually can. Which means 99% of the people trading it right now have no real investment reason for owning it and are just speculating that prices are going higher… just like they did in internet stocks in 1999 and in real estate in 2005.

Oh… and in 1711 in South Seas stock:

Screen-Shot-2014-02-24-at-9.58.05-PMvia Meb Faber


It’s Time To Play Defense In The Stock Market – What’s Your Game Plan?

A few years ago I was coaching my son’s flag football team. I’m no football buff; this was a group of first and second grade kids who were just starting to learn the game. The parks & rec department was short on coaches so I volunteered.

Anyhow, it was late in a midseason game and we were ahead by a touchdown, with a decent chance of getting our first “W” of the year (I told you I’m not a football buff). The other team had the ball at midfield and the clock was running down. I called the kids into a huddle and before I could say a word, one of my first grade boys, clearly pumped up by the situation, interjected, “c’mon guys! Defense wins championships!”

I don’t know where little 6-year Beau learned it but he didn’t know how right he was. I tweeted one of my favorite investing quotes today: “The most important rule of trading is to play great defense, not great offense.” I pulled it from an interview with Paul Tudor Jones in Jack Schwager’s fantastic book “Market Wizards.”

But what does ‘playing defense’ mean in terms of investing? I think it means something different to everyone and should depend entirely on your personal investment philosophy and plan.

For Paul Tudor Jones it means getting out of losing trades as soon as possible. In the words of Jesse Livermore, another famous trader, “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. When a stock moves below a mental-stop, sell it immediately.” This is how traders “play defense” in the markets.

For investors it works a bit differently. For Warren Buffett, “playing defense” means ensuring he has a “margin of safety” every time he commits capital and raising cash when stocks generally get too expensive. These fit with his two rules of investing: Rule #1 – Never lose money. Rule #2 – Never forget rule number one.

For individual investors it can mean a variety of things and I can only make one recommendation in this regard: whatever “defense” means to you, whether you are more of a trader or more of an investor, be sure it is within your abilities to implement. Don’t try short selling just because you’re nervous about stocks going lower. Don’t start trying to time the market if you’re not PTJ or Warren Buffett.

For most, I think the best way to “play defense” is to simply adhere to a plan of regular rebalancing. When stocks go up and bonds go down you sell a little of the former and buy a little of the latter to keep your desired allocations in tact. This way you are guaranteed to “buy low and sell high” while most investors are doing just the opposite.

For more information about rebalancing and building an investment game plan read my e-book, “FIRE Wall Street.”


Is It Time To Buy Stocks Yet?

INDIVIDUAL INVESTOR: Is it time to buy stocks yet?

ME: Actually, I’ve been saying for a while now, ‘please don’t buy anymore stocks,’ and I haven’t changed my mind yet.

II: Why?

ME: Because stocks are extremely overvalued and the potential downside is significant (30-60%).

II: How do you know?

ME: Well, we only need to look at a couple of charts to understand. First, is the total value of the stock market relative to the economy, which just so happens to be Warren Buffett’s favorite valuation yardstick:

wmc140120bvia John Hussman

ME: Stocks have only been more highly valued than they are today at one point during the past 60+ years and that was at the height of the internet bubble. In the words of Mr. Buffett, at this point investors are, “playing with fire.”

II: Still, just because stocks are overvalued doesn’t mean they will fall.

ME: Of course not, they could just trade sideways while earnings grow. In fact, the chart above suggests that is exactly what should happen over the next decade: stocks are priced to return 0% over that time (right scale). This is a great visual representation of, “the price you pay determines your rate of return.” Clearly, the chart shows how accurate this valuation measure (blue line) has been at predicting the coming decade’s returns (red line).

II: That’s still different than saying stocks will go down so why do you say think there is significant downside for stocks?

ME: There’s a lot of time between now and 2024; a lot can happen in that span. And another chart suggests a lot could happen. Below is the total level of margin debt and how it also relates to GDP:

wmc140203bvia John Hussman

ME: Never before have so many stocks been purchased with borrowed money. Relative to GDP, again only one period has surpassed the current level and that was at the height of the internet bubble.

II: So?

ME: What’s troublesome about this metric is that the stock market, like all markets, is moved by basic supply and demand. Investors borrowing money to buy stocks amounts to massive demand that pushed prices higher, as we saw last year. On the flip side, however, when these investors decide (or are forced by margin calls) to sell, this massive demand all of a sudden becomes massive supply. This is why each time margin debt has surged like it has recently, stocks have lost at least one-third of their value over the next couple of years.

II: That doesn’t sound good.

ME: Right. Unless you are itching to lock in a zero-percent rate of return over the next decade, it’s probably best to wait until valuations allow for better prospective returns.

II: What valuation level is that?

ME: According to Buffett, it’s about 30-40% below current prices (70-80% of GDP versus 120% today).

II: Wait, that’s just about the same amount that you said stocks typically fall after margin debt surges like it has recently.

ME: UmmHmm.

II: How far have stocks fallen so far?

ME: 5%.

Investing, Markets

Investors Are Once Again Ignoring All The Red Flags And Setting Themselves Up For Failure

We’re currently witnessing an incredibly fascinating time in the financial markets. All kinds of people and media outlets are now talking about heightened risk in the stock market and I haven’t seen any real case made against it (just a LOT of logical fallacies). Still, investors keep pouring money in and the market keeps heading higher. It’s as if they’re laying down in front of a speeding locomotive, tying themselves to the tracks with their own greed.

Here are the 8 things we can all agree (based on their popularity in the press and lack of rebuttle) will doom investments made in the stock market today:

  1. Quantitative Easing is losing its efficacy and creating major imbalances. Ray Dalio recently argued that QE is now beginning to suffer from its own success in boosting asset prices. At the same time, the general public is realizing the whole program, by relying on the “wealth effect” to boost the economy, disproportionately benefits the rich while they see little or no benefit at all.
  2. But the Fed can’t stop or even taper QE without major repercussions in the financial markets. If QE’s greatest accomplishment has been boosting the economy via the wealth effect, it stands to reason that removing or even reducing it will have the opposite effect.
  3. Hence, the Fed is trapped. Richard Koo can’t find anyone to dispute this.
  4. Still, it can’t “print money” forever. At the current pace, the Fed is printing $1 trillion of new money every year and then spending much of that buying treasury bonds, essentially monetizing the debt. Even the Fed admits this cannot go on for long.
  5. Yet stocks are priced as though they will. Based on numerous metrics, including Warren Buffett’s favorite valuation metric, stocks are valued significantly higher than they have typically been in the past. In other words, very little risk is priced into the market at current levels.
  6. And investors are clearly optimistic about future returns. Why else would they pour record amounts of money into equity funds and use record amounts of leverage to boot?
  7. Even though they are guaranteed to be mediocre at best. Investment returns are based on the price you pay. Because prices are relatively high today future returns from current stock prices are reasonably estimated at 0-4% over the next decade.
  8. All of which means many investors are doomed to be let down. With potential “reward” in the low single digits and potential “risk” being 40-55% to the downside it seems investors have once again set themselves up for failure.

Isn’t it absolutely amazing how this happens time and time again?

Chart of the Day:

Oil has been a very good signal for stocks so far this year and it just took a pretty nasty tumble: