The Coming Mega-Bull Market?

March 2, 2014

Investor behavior has a lot to do with how markets behave, and with how investors perform.  To profit from a long mega-bull market, investors have to be willing to buy stocks and hold them through the inevitable ups and downs along the way.  Risk tolerance greatly influences their willing to do that—and risk tolerance is greatly influenced by their past experience.

From an article on risk in The Economist:

People’s financial history has a strong impact on their taste for risk. Looking at surveys of American household finances from 1960 to 2007, Ulrike Malmendier of the University of California at Berkeley and Stefan Nagel, now at the University of Michigan, found that people who experienced high returns on the stockmarket earlier in life were, years later, likelier to report a higher tolerance for risk, to own shares and to invest a bigger slice of their assets in shares.

But exposure to economic turmoil appears to dampen people’s appetite for risk irrespective of their personal financial losses. That is the conclusion of a paper by Samuli Knüpfer of London Business School and two co-authors. In the early 1990s a severe recession caused Finland’s GDP to sink by 10% and unemployment to soar from 3% to 16%. Using detailed data on tax, unemployment and military conscription, the authors were able to analyse the investment choices of those affected by Finland’s “Great Depression”. Controlling for age, education, gender and marital status, they found that those in occupations, industries and regions hit harder by unemployment were less likely to own stocks a decade later. Individuals’ personal misfortunes, however, could explain at most half of the variation in stock ownership, the authors reckon. They attribute the remainder to “changes in beliefs and preferences” that are not easily measured.

The same seems to be true for financial trauma. Luigi Guiso of the Einaudi Institute for Economics and Finance and two co-authors examined the investments of several hundred clients of a large Italian bank in 2007 and again in 2009 (ie, before and after the plunge in global stockmarkets). The authors also asked the clients about their attitudes towards risk and got them to play a game modelled on a television show in which they could either pocket a small but guaranteed prize or gamble on winning a bigger one. Risk aversion, by these measures, rose sharply after the crash, even among investors who had suffered no losses in the stockmarket. The reaction to the financial crisis, the authors conclude, looked less like a proportionate response to the losses suffered and “more like old-fashioned ‘panic’.”

I’ve bolded a couple of sections that I think are particularly interesting.  Investors who came of age in the 1930s tended to have an aversion to stocks also—an aversion that caused them to miss the next mega-bull market in the 1950s.  Today’s investors may be similarly traumatized, having just lived through two bear markets in the last decade or so.

Bull markets climb a wall of worry and today’s prospective investors are plenty worried.  Evidence of this is how quickly risk-averse bond-buying picks up during even small corrections in the stock market.  If history is any guide, investors could be overly cautious for a very long time.

Of course, I don’t know whether we’re going to have a mega-bull market for the next ten or fifteen years or not.  Anything can happen.  But it wouldn’t surprise me if the stock market does very well going forward—and it would surprise me even less if most investors miss out.

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Quote of the Week

March 2, 2014
I am a man of fixed and unbending principles, the first of which is to be flexible at all times.—-Everett Dirksen
Leave it to a politician to come up with a quote like this!  Yet flexibility is important when investing.  Relative strength can contribute to investment flexibility by showing objectively where the strongest trends are at any given time.  As trends change, your investment portfolio should change too.  Nothing is forever.

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Survivorship Bias

February 28, 2014

Everyone in the financial services industry has seen awesome-looking backtests for various return factors or trading methods, but most people don’t even know what survivorship bias is.  When I see one of those amazing backtests and I ask how they removed the survivorship bias, the usual answer is “Huh?”

A recent post by Cesar Alvarez at Alvarez Quant Trading shows just how enormous survivorship bias can be for a trend following system.  Most people with amazing backtests, when pushed, will concede there might be “some” effect from survivorship.  None of them ever think it will be this large!

Here, Mr. Alvarez describes the bias and shows the results:

Pre-inclusion bias is using today’s index constituents as your trading universe and assuming these stocks were always in the index during your testing period. For example if one were testing back to 2004, GOOG did not enter the S&P500 index until early 2006 at a price of $390. But your testing could potentially trade GOOG during the huge rise from $100 to $300.

Rules

  • It is the first trading day of the month
  • Stock is member of the S&P500 (on trading date vs as of today)
  • S&P500 closes above its 200 day moving average (with and without this rule)
  • Rank stocks by their six month returns
  • Buy the 10 best performing stocks at the close

Source: Alvarez Quant Trading

(click on image to enlarge to full size)

Mind-boggling, isn’t it?  The fantastic system that showed 30%+ returns now shows returns of less than 8%!!  (The test period, by the way, was 2004-2013.)

Unfortunately, this is the way much backtesting is done.  It’s much more trouble to acquire a database that has all of the delisted securities and all of the historical index constituents.  That’s expensive and time-consuming, but it’s the only way to get accurate results.  (Needless to say, that’s how our testing is done.  You can link to one of our white papers that additionally includes Monte Carlo testing to make the results even more robust.)  By the way, the pre-inclusion bias also shows very clearly how the index providers actually manage these indexes!

Mr. Alvarez concludes:

People often write about systems they have developed using the current Nasdaq 100 or S&P 500 stocks and have tested back for 5 to 10 years. Looking at this table shows that one should completely ignore those results.

When looking at backtested results, it often pays to be skeptical and to ask some questions about survivorship bias.

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Quote of the Week

February 28, 2014

Markets will be permanently efficient when investors are permanently objective and unemotional.  In other words, never.—-Howard Marks, Oaktree Capital

This quotation is taken from a much longer think-piece about the role of luck in investing that I first saw on Advisor Perspectives.  Mr. Marks points out that while markets are often structurally fairly efficient, they are often quite inefficient on a cyclical basis when investors freak out.  Highly recommended reading.

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How Not to be a Terrible Investor

February 27, 2014

Morgan Housel at Motley Fool has a wonderful article on how investors can learn from failure.  He sets the tone with a few different quotes and anecdotes that point out that a lot of being a success is just avoiding really dumb mistakes.

At a conference years ago, a young teen asked Charlie Munger how to succeed in life. “Don’t do cocaine, don’t race trains to the track, and avoid all AIDS situations,” Munger said. Which is to say: Success is less about making great decisions and more about avoiding really bad ones.

People focus on role models; it is more effective to find antimodels—people you don’t want to resemble when you grow up.    Nassim Taleb

I’ve added the emphasis, but Mr. Housel makes a good point.  Learning from failure is equally important as learning from success.  In fact, he argues it may be more important.

If it were up to me, I would replace every book called How to Invest Like Warren Buffett with a one called How to Not Invest Like Lehman Brothers, Long-Term Capital Management, and Jesse Livermore. There are so many lessons to learn from these failed investors about situations most of us will face, like how quickly debt can ruin you. I’m a fan of learning from Buffett, but the truth is most of us can’t devote as much time to investing as he can. The biggest risk you face as an investor isn’t that you’ll fail to be Warren Buffett; it’s that you’ll end up as Lehman Brothers.

But there’s no rule that says you have to learn by failing yourself. It is far better to learn vicariously from other people’s mistakes than suffer through them on your own.

That’s his thesis in a nutshell.  He offers three tidbits from his study of investing failures.  I’ve quoted him in full here because I think his context is important (and the writing is really good).

1. The overwhelming majority of financial problems are caused by debt, impatience, and insecurity. People want to fit in and impress other people, and they want it right now. So they borrow money to live a lifestyle they can’t afford. Then they hit the inevitable speed bump, and they find themselves over their heads and out of control. That simple story sums up most financial problems in the world. Stop trying to impress people who don’t care about you anyways, spend less than you earn, and invest the rest for the long run. You’ll beat 99% of people financially.

2. Complexity kills. You can make a lot of money in finance, so the industry attracted some really brilliant people. Those brilliant people naturally tried to make finance more like their native fields of physics, math, and engineering, so finance has grown exponentially more complex in the last two decades. For most, that’s been a disservice. I think the evidence is overwhelming that simple investments like index funds and common stocks will demolish complicated ones like derivatives and leveraged ETFs. There are two big stories in the news this morning: One is about how the University of California system is losing more than $100 million on a complicated interest rate swap trade. The other is about how Warren Buffett quintupled his money buying a farm in Nebraska. Simple investments usually win.

3. So does panic. In his book Deep Survival, Laurence Gonzalez chronicles how some people managed to survive plane crashes, getting stranded on boats, and being stuck in blizzards while their peers perished. The common denominator is simple: The survivors didn’t panic. It’s the same in investing. I’ve seen people make a lifetime of good financial decisions only to blow it all during a market panic like we saw in 2008. Any financial decision you make with an elevated heart rate is probably going to be one you’ll regret. Napoleon’s definition of a military genius was “the man who can do the average thing when all those around him are going crazy.” It’s the same in investing.

I think these are really good points.  It’s true that uncontrolled leverage accompanies most real blowups.  Having patience in the investing process is indeed necessary; we’ve written about that a lot here too.  The panic, impatience, and insecurity he references are really all behavioral issues—and it just points out that having your head on straight is incredibly important to investment success.  How successful you are in your profession or how much higher math you know is immaterial.  As Adam Smith (George Goodman) wrote, “If you don’t know who you are, the stock market is an expensive place to find out.” 

Mr. Housel’s point on complexity could be a book in itself.  Successful investing just entails owning productive assets—the equity and debt of successful enterprises—acquired at a reasonable price.  Whether you own the equity directly, like Warren Buffett and his farm, or in security form is immaterial.  An enterprise can be a company—or even a country—but it’s got to be successful.

Complexity doesn’t help with this evaluation.  In fact, complexity often obscures the whole point of the exercise.

This is actually one place where I think relative strength can be very helpful in the investment process.  Relative strength is incredibly simple and relative strength is a pretty good signaling mechanism for what is successful.  Importantly, it’s also adaptive: when something is no longer successful, relative strength can signal that too.  Sears was once the king of retailing.  Upstart princes like K-Mart in its day, and Wal-Mart and Costco later, put an end to its dominance.  Once, homes were lit with candles and heated with fuel oil.  Now, electricity is much more common—but tomorrow it may be something different.  No asset is forever, not even Warren Buffett’s farmland.  When the soil is depleted, that farm will become a lead anchor too.  Systematic application of relative strength, whether it’s being used within an asset class or across asset classes, can be a very useful tool to assess long-term success of an enterprise.

Most investing problems boil down to behavioral issues.  Impatience and panic are a couple of the most costly.  Avoiding complexity is a different dimension that Mr. Housel brings up, and one that I think should be included in the discussion.  There are plenty of millionaires that have been created through owning businesses, securities, or real estate.  I can’t think of many interest rate swap millionaires (unless you count the people selling them).  Staying calm and keeping things simple might be the way to go.  And if the positive prescription doesn’t do it for you, the best way to be a good investor may be to avoid being a terrible investor!

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The Growing Case Against ETFs

February 21, 2014

That’s the title of a Marketwatch article by mutual fund columnist Chuck Jaffe.  I have to admit that usually I like his columns.  But columns like this make me nuts!  (See also The $ Value of Patience for an earlier rant on a similar topic.)

Here’s the thesis in a nutshell:

…safe driving comes down to a mix of equipment and personnel.

The same can be said for mutual funds and exchange-traded funds, and while there is growing consensus that ETFs are the better vehicle, there’s growing evidence that the people using them may not be so skilled behind the wheel.

The article goes on to point out that newsletters with model portfolios of mutual funds and ETFs have disparate results.

Over the last 12 months, the average model portfolio of traditional funds—as tracked by Hulbert Financial Digest—was up 20.9%, a full three points better than the average ETF portfolio put together by the same advisers and newsletter editors. The discrepancy narrows to two full percentage points over the last decade, and Hulbert noted he was only looking at advisers who run portfolios on both sides of the aisle.

Hulbert posited that if you give one manager both vehicles, the advantages of the better structure should show up in performance.

It didn’t.

Hulbert—who noted that the performance differences are “persistent” — speculated “that ETFs’ advantages are encouraging counterproductive behavior.” Effectively, he bought into Bogle’s argument and suggested that if you give an investor a trading vehicle, they will trade it more often.

Does it make any sense to blame the vehicle for the poor driving?  (Not to mention that DALBAR data make it abundantly clear that mutual fund drivers frequently put themselves in the ditch.)  Would it make sense to run a headline like “The Growing Case Against Stocks” because stocks can be traded?

Mutual funds, ETFs, and other investment products exist to fulfill specific needs.  Obviously not every product is right for every investor, but there are thousands of good products that will help investors meet their goals.  When that doesn’t happen, it’s usually investor behavior that’s to blame.  (And you’re not under any obligation to invest in a particular product.  If you don’t understand it, or you get the sinking feeling that your advisor doesn’t either, you should probably run the other way.)

Investors engage in counterproductive behavior all the time, period.  It’s not a matter of encouraging it or not.  It happens in every investment vehicle and the problem is almost always the driver.  In fact, advisors that can help manage counterproductive investor behavior are worth their weight in gold.   We’re not going to solve problems involving investor behavior by blaming the product.

A certain amount of common sense has to be applied to investing, just like it does in any other sphere of life.  I know that people try to sue McDonald’s for “making” them fat or put a cup of coffee between their legs and then sue the drive-thru that served it when they get burned, but whose responsibility is that really?  We all know the answer to that.

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The Power of Buying Pullbacks

February 5, 2014

Buying pullbacks is a time-tested way to boost returns.  From time to time, we’ve discussed the utility in buying pullbacks in the market.  Buying the dips—instead of panicking and selling—is essentially doing the opposite of how most investors conduct their affairs.  In the past, much of that discussion has involved identification of market pullbacks using various oversold indicators.  (See, for example, Lowest Average Cost Wins.)  In a recent article in Financial Planning, Craig Israelsen proposes another good method for buying pullbacks.

The gist of his method is as follows:

The basic rule for investment success is as old as the hills: Buy low, sell high. But actually doing it can be surprisingly difficult.

Selling a stock or fund that has been performing well is tough. The temptation to ride the rocket just a little longer is very strong. So let’s focus on the other element: Buy low.

I propose a disciplined investment approach that measures performance against an annual account value target. If the goal is not met, the account is supplemented with additional investment dollars to bring it up to the goal. (For this exercise, I capped supplemental investment at $5,000, in acknowledgement that investors don’t have endlessly deep pockets.)

Very simply, the clients will “buy low” in years when the account value is below the target. If, however, the target goal is met at year’s end, the clients get to do a fist pump and treat themselves to a fancy dinner or other reward.

One benefit of this suggested strategy is that it is based on a specific performance benchmark rather than on an arbitrary market index (such as the S&P 500) that may not reflect the attributes of the portfolio being used by the investor.

In the article, he benchmarks a diversified portfolio against an 8% target and shows how it would have performed over a 15-year contribution period.  In years when the portfolio return exceeds 8%, no additional contributions are made.  In years when the portfolio return falls short of 8%, new money is added.  As he points out:

It’s worth noting that the added value produced by this buy-low strategy did not rely on clever market timing in advance of a big run-up in the performance of the portfolio. It simply engages a dollar cost averaging protocol – but only on the downside, which is where the real value of dollar cost averaging resides.

Very smart!  (I added the bold.)  It’s a form of dollar-cost averaging, but only kicks in when you can buy “shares” of your portfolio below trend.  He used an 8% target for purposes of the article, but an investor could use any reasonable number.  In fact, there might be substantial value in using a higher number like 15%.  (You could also use a different time frame, like monthly, if that fit the client’s contribution schedule better.)  Obviously you wouldn’t expect a 15% portfolio return every year, but it would get clients in the habit of making contributions to their account in most years.  Great years like 2013 would result in the fancy dinner reward, while lousy market years would result in maximum contributions—hopefully near relative lows where they would do the most good.

This is an immensely practical method for getting clients to contribute toward some kind of goal return—and his 15-year test shows good results.  In six of the 15 years, portfolio results were below the yardstick and additional contributions were made totalling $13,802.  Making those additional investments added an extra $12,501 to what the balance would have been otherwise, resulting in a 7.7% boost in the portfolio total.  Looked at another way, over time you ended up with nearly a 100% return on the extra money added in poor years.

Of course, Israelsen points out that although his proposed method is extremely simple, client psychology may still make it challenging to implement.  Clients are naturally resistant to committing money to an underperforming market or during a period of time when there is significant uncertainty.  Still, this is one of the better proposals I have seen on how to motivate clients to save, to invest at reasonable times, and to focus on a return goal rather than on how they might be doing relative to “the market.”  You might consider adding this method to your repertoire.

Buy pullbacks and use the rollercoaster ride of the market to your advantage.

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Quote of the Week

February 4, 2014

The elements of good trading are: (1) cutting losses, (2) cutting losses, and (3) cutting losses. If you can follow these three rules, you may have a chance.—-Ed Seykota

Although this sounds tongue-in-cheek (and probably is to some extent), it’s also true.  Almost nothing is more ruinous than being risk-seeking with respect to losses, yet that is the way most individual investors behave.  According to research, individual investors tend to take profits quickly and let their losses run—no doubt hoping for a recovery.  While this may be enjoyable for one’s ego, it is a poor way to handle a portfolio.  With enough transactions, the unwitting investor finds himself holding a diversified portfolio of losing positions!

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Is Sector Rotation a Crowded Trade?

January 16, 2014

As sector ETFs have proliferated, more and more investors have been attracted to sector rotation and tactical asset allocation strategies using ETFs, whether self-managed or implemented by an advisor.  Mark Hulbert commented on sector rotation strategies in a recent article on Marketwatch that highlighted newsletters using Fidelity sector funds.  All of the newsletters had good returns, but there was one surprising twist:

…you might think that these advisers each recommended more or less the same basket of funds. But you would be wrong. In fact, more often than not, each of these advisers has tended to recommend funds that are not recommended by any other of the top five sector strategies.

That’s amazing, since there are only 44 actively managed Fidelity sector funds and these advisers’ model portfolios hold an average of between five and 10 funds each.

This suggests that there is more than one way of playing the sector rotation game, which is good news. If there were only one profitable sector strategy, it would quickly become so overused as to stop working.

This is even true among those advisers who recommend sectors based on their relative strength or momentum. Because there are so many ways of defining these characteristics, two different sector momentum strategies will often end up recommending two different Fidelity sector funds.

Another way of appreciating the divergent recommendations of these top performing advisers is this: Of the 44 actively managed sector funds that Fidelity currently offers, no fewer than 22 are recommended by at least one of these top five advisers. That’s one of every two, on average, which hardly seems very selective on the advisers’ part.

Amazing, isn’t it?  It just shows that there are many ways to skin a cat.

Even with a very limited menu of Fidelity sector funds, there was surprisingly little overlap.  Imagine how little overlap there would be within the ETF universe, which is much, much larger!  In short, you can safely pursue a sector rotation strategy (and, by extension, tactical asset allocation) with little concern that everyone else will be plowing into the same ETFs.

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Quote of the Week

January 7, 2014

The term bubble should indicate a price that no reasonable future outcome can justify.—-Clifford Asness, AQR Capital

Valuation gurus come to different conclusions about this market, but most do not think stocks are in a bubble.  The consensus is that stocks are slightly above long-term average valuations.  Whether those valuations turn out to be reasonable or not will depend on future earnings, but bubble does not seem to describe the current situation, at least by the definition proposed by Mr. Asness.  The “bubble” word, it seems, is mainly used to scare people—or to compensate for missing the market last year.  The trend is your friend, until it ends.

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The 1%

January 6, 2014

“The 1%” phrase has been used a lot to decry income inequality, but I’m using it here in an entirely different context.  I’m thinking about the 1% in relation to a recent article by Motley Fool’s Morgan Housel.  Here’s an excerpt from his article:

Building wealth over a lifetime doesn’t require a lifetime of superior skill. It requires pretty mediocre skills — basic arithmetic and a grasp of investing fundamentals — practiced consistently throughout your entire lifetime, especially during times of mania and panic.  Most of what matters as a long-term investor is how you behave during the 1% of the time everyone else is losing their cool.

That puts a little different spin on it.  Maybe your behavior during 1% of the time is how you get to be part of the 1%.  (The bold in Mr. Housel’s quotation above is mine.)

In his article, Housel demonstrates how consistency—in this case, dollar-cost averaging—beats a couple of risk avoiders who try to miss recessions.  We’ve harped on having some kind of systematic investment process here, so consistency is certainly a big part of success.

But also consider what might happen if you can capitalize on those periods of panic and add to your holdings.  Imagine that kind of program practiced consistently over a lifetime!  Warren Buffett’s article in the New York Times, “Buy American.  I Am.” from October 2008 comes to mind.  Here is a brief excerpt of Mr. Buffett’s thinking during the financial crisis:

THE financial world is a mess, both in the United States and abroad. Its problems, moreover, have been leaking into the general economy, and the leaks are now turning into a gusher. In the near term, unemployment will rise, business activity will falter and headlines will continue to be scary.

So … I’ve been buying American stocks.

If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities.

A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now.

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.

Gee, I wonder how that worked out for him?  It’s no mystery why Warren Buffett has $60 billion—he is as skilled a psychological arbitrageur as there is and he has been at it for a very long time.

As Mr. Housel points out, even with mediocre investing skills, just consistency can go a long way toward building wealth—and the ability to be greedy when others are fearful has the potential to compound success.

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Investor Behavior

January 6, 2014

Marshall Jaffe, in a recent article for ThinkAdvisor, made an outstanding observation:

In a world where almost nothing can be predicted with any accuracy, investor behavior is one of the rare exceptions. You can take it to the bank that investors will continue to be driven by impatience, social conformity, conventional wisdom, fear, greed and a confusion of volatility with risk. By standing apart and being driven solely by the facts, the value investor can take advantage of the opportunities caused by those behaviors—and be in the optimal position to create and preserve wealth.

His article was focused on value investing, but I think it is equally applicable to relative strength investing.  In fact, maybe even more so, as value investors often differ about what they consider a good value, while relative strength is just a mathematical calculation with little room for interpretation.

Mr. Jaffe’s main point—that investors are driven by all sorts of irrational and incorrect cognitive forces—is quite valid.  Dozens of studies point it out and there is a shocking lack of studies (i.e., none!) that show the average investor to be a patient, independent thinker devoid of fear and greed.

What’s the best way to take advantage of this observation about investor behavior?  I think salvation may lie in using a systematic investment process.  If you start with an investment methodology likely to outperform over time, like relative strength or value, and construct a rules-based systematic process to follow for entry and exit, you’ve got a decent chance to avoid some of the cognitive errors that will assail everyone else.

Of course, you will construct your rules during a period of calm and contemplation—but that’s never when rules are difficult to apply!  The real test is sticking to your rules during the periods of fear and greed that occur routinely in financial markets.  Devising the rules may be relatively simple, but following them in trying circumstances never is!  As with most things, the harder it is to do, the bigger the potential payoff usually is.

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Equity as the Way to Wealth

January 3, 2014

According to a recent Gallup Poll, most Americans don’t think much of the stock market as a way to build wealth.  I find that quite distressing, and not just because stocks are my business.  Stocks are equity—and equity is ownership.  If things are being done right, the owner should end up making more than the employee as the business grows.  I’ve reproduced a table from Gallup’s article below.

Source: Gallup  (click on image to enlarge)

You can see that only 37% felt that the stock market was a good way to build wealth—and only 50% among investors with more than $100,000 in assets.

Perhaps investors will reconsider after reading an article from the Wall Street Journal, here republished on Yahoo! Finance.  In the article, they asked 40 prominent people about the best financial advice they’d ever received.  (Obviously you should read the whole thing!)  Two of the comments that struck me most are below:

Charles Schwab, chairman of Charles Schwab Corp.

A friend said to me, Chuck, you’re better off being an owner. Go out and start your own business.

Richard Sylla, professor of the history of financial institutions and markets at New York University

The best financial advice I ever received was advice that I also provided, both to myself and to Edith, my wife. It was more than 40 years ago when I was a young professor of economics and she was a young professor of the history of science. I based the advice on what were then relatively new developments in modern finance theory and empirical findings that supported the theory.

The advice was to stash every penny of our university retirement contributions in the stock market.

As new professors we were offered a retirement plan with TIAA-CREF in which our own pretax contributions would be matched by the university. Contributions were made with before-tax dollars, and they would accumulate untaxed until retirement, when they could be withdrawn with ordinary income taxes due on the withdrawals.

We could put all of the contributions into fixed income or all of it into equities, or something in between. Conventional wisdom said to do 50-50, or if one could not stomach the ups and downs of the stock market, to put 100% into bonds, with their “guaranteed return.”

Only a fool would opt for 100% stocks and be at the mercies of fickle Wall Street. What made the decision to be a fool easy was that in those paternalistic days the university and TIAA-CREF told us that we couldn’t touch the money until we retired, presumably about four decades later when we hit 65.

Aware of modern finance theory’s findings that long-term returns on stocks should be higher than returns on fixed-income investments because stocks were riskier—people had to be compensated to bear greater risk—I concluded that the foolishly sensible thing to do was to put all the money that couldn’t be touched for 40 years into equities.

At the time (the early 1970s) the Dow was under 1000. Now it is around 16000. I’m now a well-compensated professor, but when I retire in a couple of years and have to take minimum required distributions from my retirement accounts, I’m pretty sure my income will be higher than it is now. Edith retired recently, and that is what she has discovered.

Not everyone has the means to start their own business, but they can participate in thousands of existing great businesses through the stock market!  Richard Sylla’s story is fascinating in that he put 100% of his retirement assets into stocks and has seen them grow 16-fold!  I’m sure he had to deal with plenty of volatility along the way, but it is remarkable how effective equity can be in creating wealth.  His wife discovered that her income in retirement—taking the required minimum distribution!—was greater than when she was working!  (The italics in the quote above are mine.)

Equity is ownership, and ownership of productive assets is the way to wealth.

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Quote of the Week

January 2, 2014

Never argue with stupid people; they will drag you down to their level and then beat you with experience.—-Mark Twain

We’ve all been there.  With some clients, sometimes it’s just not worth the fight to educate them about financial markets!  Make this your year to find those clients with whom you see eye-to-eye and make something good happen!

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Quote of the Week

December 23, 2013

Mine is not to reason why, mine is just to sell and buy.—-Steve Robbins, DWA Message Board

Steve posted this in response to a thread discussing various monetary and fundamental worries in the current market.  His response indicates his confidence that if a particular market worry manifests itself, it will be reflected in securities prices and can be responded to appropriately at that time.  This is a healthy attitude (I think) because it avoids many of the cognitive biases that harm performance and focuses just on the actual trend in the marketplace.  The trend is your friend, until it ends.  The time to act is when the trend ends—not before, based on your worries.

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The Simplicity of Relative Strength

December 16, 2013

One of the ongoing difficulties for investors is finding some kind of simple method for investing.  Relative strength is just such a simple method.  Even simple methods, however, have to be applied!

Tadas Viskanta from Abnormal Returns writes:

…having a plan, even a sub-optimal one, that you can stick to is preferable to having no plan at all. The ongoing challenge for advisors and investors alike is to find a plan that they will not abandon at the first sign of trouble.

That’s an important point.  If you can’t follow a method because it is too complex and if you bail in panic during the first downturn, you’re not going to succeed with any method.

Abnormal Returns revisited this theme recently, in connection with a discussion about systems versus optimization.  Mr. Viskanta pulled a quote from Scott Adams:

Optimizing is often the strategy of people who have specific goals and feel the need to do everything in their power to achieve them. Simplifying is generally the strategy of people who view the world in terms of systems. The best systems are simple, and for good reason. Complicated systems have more opportunities for failure. Human nature is such that we’re good at following simple systems and not so good at following complicated systems.

This has a great deal of applicability to the investing process.  Simple systems are generally more robust than complex systems, and relative strength is about as simple as you can get.  Relative strength is not an optimized system—like most simple systems, it will make plenty of mistakes but its simplicity makes it robust.  (I would note that Modern Portfolio Theory relies on mean variance optimization to construct the “ideal” portfolio.  Optimized systems are both complicated and fragile.)

In practice, complicated systems tend to blow up.  Robust systems are generally more resilient to failure, but will certainly struggle from time to time.

Human nature, I think, makes it difficult to follow any system, whether simple or complex, so discipline is also required.  Investors will improve their chances for success with a simple, robust methodology and the discipline to stick with it.

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50+ Years of Corporate Profits

December 9, 2013

If you are obsessed with the Fed’s balance sheet, Congress, Nouriel Roubini, or any of the many other doomsayers, you might want to print out this chart of corporate profits to refer to from time to time.  Corporate profits continue to climb.

Since this chart is done on a logarithmic scale, it suggests that corporate profits are rising at a pretty steady constant percentage rate.  I’m sure the composition of corporate profits has changed—which companies are producing them—over time, but American business seems to be remarkably resilient.

Source: St. Louis Fed  (click on image to enlarge)

There have been plenty of periods where corporate profits have declined or been stagnant.  There have been a few periods where corporate profits grew at sustained high rates.  Both have tended to regress toward the mean.  If you take out all of the zigs and zags, you can see that corporate profits have continued to grow at a pretty steady underlying rate.  There’s lots of year-to-year variability, but it’s a somewhat more hopeful view than a constant “sky is falling” outlook.

Keep in mind that when you buy stock, you are buying a share of the corporate profits too.  If corporate profits continue to rise over time, share prices should participate as well.

In the long run, the optimists tend to win.

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Quote of the Week

December 9, 2013

The best investors in the world have more of an edge in psychology than in  finance.—-Morgan Housel, Motley Fool

 

This is so true!  Most investing problems are behavioral, so having an edge in psychology is very meaningful.  You will tend to do well if you are more disciplined (less panicky) and more patient than your competition.  This quote is from a longer article that I saw featured on Business Insider.  You can read the whole list here.

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Real Returns on Bonds

December 6, 2013

First Trust’s Bob Carey had a blog post of couple of months ago that examined the real return on bonds.  (I encourage you to read the whole post because he also had some interesting comments.)  Bonds, I think, are a pretty good diversifier because they can often reduce overall portfolio volatility.  But there’s not much real return—return after inflation—in bonds right now.

Source: First Trust  (click on image to enlarge)

In 2011, in fact, you have evidence of a bond bubble.  Even in the TIPs market, expected real returns were negative for a period of time.  When investors are willing to buy an asset expecting to lose purchasing power, well, that seems a little crazy.  Right now, expected real returns are still quite low.

If inflation drops from here, maybe things will work out.  If the stock market has a significant decline, holding bonds might turn out to be the better alternative.  But if real returns go back to their historic norms, there may be more turmoil ahead in the bond market.  There’s no way to know what will happen going forward, of course, but it’s probably a good idea to know where you stand relative to history.

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Quote of the Week

December 4, 2013

Most of what is taught about investing in school is theoretical nonsense. There are very few rich professors.—-Morgan Housel, Motley Fool

 

Very true.  And some of the rich professors are ones who threw off the shackles of academia and went into the money management business!  If mean variance optimization worked at all, lots of finance professors would be loaded.  This quote is from a longer article that I saw featured on Business Insider.  You can read the whole list here.

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Fuel for a New Bull Market?

December 3, 2013

Lots of economists have talked about the deleveraging of the consumer and how it has slowed down the economy.  Consumers are reducing their debt loads, perhaps because they are uncertain about the future.  When consumers feel more confident, they often borrow to buy consumer goods, homes, or to invest in businesses.

Even more important than the debt itself is usually the ability of the consumer to service the debt.  The ability to borrow is often fuel for a bull market—at the least, those two data series often move in tandem.

Did you realize that consumer debt service is now as low as before the huge bull market starting in the 1980s?  This chart, from the Fed, is the household financial obligations ratio.  It’s a ratio of financial obligations to disposable personal income.  Financial obligations consist of payments on mortgage debt, consumer debt, auto leases, rental housing, plus homeowner’s insurance and property taxes.

Are you surprised we are at 1982 levels?

(click on image to enlarge)

Periods when the consumer was adding leverage, from 1982-1987, from 1994-2000, and from 2003-2007 were outstanding for the stock market.

Right now, with debt service at a relatively low level, the consumer has the capacity to take on more debt.  That’s a lot of fuel for a new bull market.  We will have to see going forward whether the consumer has the confidence or propensity to take on more debt.  If re-leveraging does start to happen, the stock market could be much better than most expect.

HT: The Bonddad Blog

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Stock Market at All-Time Highs

December 2, 2013

“I can’t buy now—the stock market is at all-time highs.”  I’ve heard that, or some version of it, from multiple clients in the last few weeks.  I understand where clients are coming from.  Their past experience involves waiting too long to buy and then getting walloped.  That’s because clients often wait for the bubble phase to invest.  Not only is the stock market at all-time highs, but valuations tend to be stretched as well.

Here’s the thing: buying at all-time highs really doesn’t contain much information about whether you are making an investing mistake or not.

For proof, I will turn to a nice piece in Advisor Perspectives penned by Alliance Bernstein.  Here’s what they have to say:

With the US stock market repeatedly reaching all-time highs in recent weeks, many investors are becoming leery of investing in stocks. Focusing on the market’s level is a mistake, in our view. It’s market valuation, not level, that matters.

Since 1900, the S&P 500  Index has been close to (within 5%) of its prior peak almost half the time. There’s a simple reason for this. The stock market goes up over time, along with the economy and corporate earnings.

Fear of investing at market peaks is understandable. In the short term, there’s always the risk that other investors will decide to take gains, or that geopolitical, economic or company-specific news will trigger a market pullback.

But for longer-term investors, market level has no predictive power. Market valuation—not market level—is what historically has mattered to future returns.

They have a nice graphic to show that investing near the high—or not near the high—is inconsequential.  They show that future returns are much more correlated to valuation.

Source: Advisor Perspective  (click on image to enlarge)

I’m no fundamental analyst, but commentators from Warren Buffett to Ed Yardeni to Howard Marks have suggested that valuations are reasonable, although slightly higher than average.  There’s obviously no guarantee that stocks will go up, but you are probably not tap dancing on a landmine.  Or let’s put it this way: if the stock market goes down from here, it won’t be because we are at all-time highs.  The trend is your friend until it ends.

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Warren Buffett and Charlie Munger’s Best Advice

November 26, 2013

…talk about the best advice they have even gotten in a short piece from Fortune.  I think it clarifies the difference between a blind value investor and an investor who is looking for good companies (not coincidentally, many of those good companies have good relative strength).  Warren Buffett and Charlie Munger have made a fortune implementing this advice.

Buffett: I had been oriented toward cheap securities. Charlie said that was the wrong way to look at it. I had learned it from Ben Graham, a hero of mine. [Charlie] said that the way to make really big money over time is to invest in a good business and stick to it and then maybe add more good businesses to it. That was a big, big, big change for me. I didn’t make it immediately and would lapse back. But it had a huge effect on my results. He was dead right.

Munger: I have a habit in life. I observe what works and what doesn’t and why.

I highlighted the fun parts.  Buffett started out as a Ben Graham value investor.  Then Charlie wised him up.

Valuation has its place, obviously.  All things being equal, it’s better to buy cheaply than to pay up.  But Charlie Munger had observed that good businesses tended to keep on going.  The same thing is typically true of strong stocks—and most often those are the stocks of strong businesses.

Buy strong businesses and stick with them as long as they remain strong.

Source: CNN/Money (click on image to enlarge)

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Quote of the Week

November 25, 2013

At the top of the list of economic theories based on clearly false assumptions is that of Rational Expectations, in which humans are assumed to be machines programmed with rational responses. Although we all know – even economists – that this assumption does not fit the real world, it does allow for relatively simple conclusions, whereas the assumption of complicated, inconsistent, and emotional humanity does not. The folly of Rational Expectations resulted in five, six, or seven decades of economic mainstream work being largely thrown away. It did leave us, though, with perhaps the most laughable of all assumption-based theories, the Efficient Market Hypothesis (EMH).—-Jeremy Grantham, GMO

On the other hand, technical analysis assumes that investors are emotional and selectively irrational.  I know what makes more sense to me.

HT to The Big Picture

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Option Income Isn’t Really Income

November 22, 2013

Fans of the free lunch will disappointed to find out that option income isn’t really income—it’s just part of the total return stream of an option income strategy.  There’s nothing wrong with option income, but a buy-write strategy is just a way to slightly reduce the volatility of an equity portfolio by trading away some of the potential upside.  I get concerned when I see articles promoting it as a way to generate extra income, especially when the trade-off is not fully explained.

According to a recent story in the Wall Street Journal, investors are increasingly turning to option income.

So far this year more than $3.4 billion in options contracts have changed hands on U.S. exchanges, according to the Options Industry Council in Chicago. That’s almost as much as 2008’s full-year volume and is on pace to be the second-best year in options trading history. The all-time record came in 2011 with $4.6 billion in contracts changing hands.

A buy-write strategy to generate option income might make sense if it is part of a total-return strategy.  All too often, investors have the wrong idea.

How big of a dent can it make on a portfolio’s long-term prospects? A lot, says Philip Guziec, a Morningstar analyst who studies various options strategies. He recently looked at six years worth of performance data through April 2010 using the CBOE S&P 500 BuyWrite Index, which follows a strategy of selling call options on the S&P 500 Index every month and reinvesting premiums.

During that period, a covered-call strategy where premiums were reinvested would have increased the portfolio’s return by around 19%. By contrast, spending each month’s options payments resulted in reducing the options portfolio’s value by more than 50%, according to Mr. Guziec.

“Too many people sell covered calls to generate extra income to live on, not realizing how severely that type of a strategy can eat into a portfolio’s upside over time,” he says.

Many investors would be shocked to learn that their portfolio could take a 50% haircut in only six years if they spent the option income!  As always, the bottom line is total return.

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