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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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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Dorsey Wright Managed Accounts

January 27, 2014


Our Systematic Relative Strength portfolios are available as managed accounts at a large and growing number of firms.

  • Wells Fargo Advisors (Global Macro available on the Masters/DMA Platforms)
  • Morgan Stanley (IMS Platform)
  • TD Ameritrade Institutional
  • UBS Financial Services (Aggressive and Core are available on the MAC Platform)
  • RBC Wealth Management (MAP Platform)
  • Raymond James (Outside Manager Platform)
  • Stifel Nicolaus
  • Kovack Securities
  • Deutsche Bank
  • Charles Schwab Institutional
  • Sterne Agee
  • Scott & Stringfellow
  • Envestnet
  • Placemark
  • Scottrade Institutional
  • Janney Montgomery Scott
  • Robert W. Baird
  • Wedbush Morgan
  • Prospera
  • Oppenheimer (Star Platform)
  • SunTrust
  • Lockwood

Different Portfolios for Different Objectives: Descriptions of our seven managed accounts strategies are shown below.  All managed accounts use relative strength as the primary investment selection factor.

Aggressive:  This Mid and Large Cap U.S. equity strategy seeks to achieve long-term capital appreciation.  It invests in securities that demonstrate powerful relative strength characteristics and requires that the securities maintain strong relative strength in order to remain in the portfolio.

Core:  This Mid and Large Cap U.S. equity strategy seeks to achieve long-term capital appreciation.  This portfolio invests in securities that demonstrate powerful relative strength characteristics and requires that the securities maintain strong relative strength in order to remain in the portfolio.  This strategy tends to have lower turnover and higher tax efficiency than our Aggressive strategy.

Growth:  This Mid and Large Cap U.S. equity strategy seeks to achieve long-term capital appreciation with some degree of risk mitigation.  This portfolio invests in securities that demonstrate powerful relative strength characteristics and requires that the securities maintain strong relative strength in order to remain in the portfolio.  This portfolio also has an equity exposure overlay that, when activated, allows the account to hold up to 50% cash if necessary.

International: This All-Cap International equity strategy seeks to achieve long-term capital appreciation through a portfolio of international companies in both developed and emerging markets.  This portfolio invests in those securities with powerful relative strength characteristics and requires that the securities maintain strong relative strength in order to remain in the portfolio.  Exposure to international markets is achieved through American Depository Receipts (ADRs).

Global Macro: This global tactical asset allocation strategy seeks to achieve meaningful risk diversification and investment returns.  The strategy invests across multiple asset classes: Domestic Equities (long & inverse), International Equities (long & inverse), Fixed Income, Real Estate, Currencies, and Commodities.  Exposure to each of these areas is achieved through exchange-traded funds (ETFs).

Balanced: This strategy includes equities from our Core strategy (see above) and high-quality U.S. fixed income in approximately a 60% equity / 40% fixed income mix.  This strategy seeks to provide long-term capital appreciation and income with moderate volatility.

Tactical Fixed Income: This strategy seeks to provide current income and strong risk-adjusted fixed income returns.   The strategy invests across multiple sectors of the fixed income market:  U.S. government bonds, investment grade corporate bonds, high yield bonds, Treasury inflation protected securities (TIPS), convertible bonds, and international bonds.  Exposure to each of these areas is achieved through exchange-traded funds (ETFs).


To receive fact sheets for any of the strategies above, please e-mail Andy Hyer at or call 626-535-0630.  Past performance is no guarantee of future returns.  An investor should carefully review our brochure and consult with their financial advisor before making any investments.

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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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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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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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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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Stock Market Sentiment Review

November 19, 2013

I’m still getting back into the swing of things after having the flu most of last week.  In the midst of my stock market reading, I was struck by an article over the weekend from Abnormal Returns, a blog you should be reading, if you aren’t already.  The editor had a selection of the blog posts that were most heavily trafficked from the prior week.  Without further ado:

  • Chilling signs of a market top.  (The Reformed Broker)
  • Ray Dalio thinks you shouldn’t bother trying to generate alpha.  (The Tell)
  • Ten laws of stock market bubbles.  (Doug Kass)
  • How to teach yourself to focus.  (The Kirk Report)
  • Are we in a bubble?  (Crossing Wall Street)
  • Josh Brown, “If the entities in control of trillions of dollars all want asset prices to be higher at the same time, what the hell else should you be positioning for?”  (The Reformed Broker)
  • Guess what stock has added the most points to the S&P 500 this year? (Businessweek)
  • Everything you need to know about stock market crashes.  (The Reformed Broker)
  • Jim O’Neil is swapping BRICs for MINTs.  (Bloomberg)
  • How to survive a market crash.  (Your Wealth Effect)


I count five of the top ten on the topic of market tops/bubbles/crashes!

Markets tend to top out when investors are feeling euphoric, not when they are tremendously concerned about the downside.  In my opinion, investors are still quite nervous—and fairly far from euphoric right now.

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The Top Ten Ways to Sabotage Your Portfolio

November 4, 2013

Good portfolio management is difficult, while poor portfolio management is almost effortless!  In the spirit of David Letterman’s Top Ten list, here is my contribution to the genre of things to avoid, with a special nod to our brand of investing.  I made a version of this presentation originally at a 1996 Dorsey Wright Broker Institute.



1. BE ARROGANT.  Assume your competition is lazy and stupid.  Don’t do your homework  and don’t bother with a game plan.  Panic if things don’t go well.

2. WHEN A SECTOR OR THE MARKET REVERSES UP, WAIT UNTIL YOU FEEL COMFORTABLE TO BUY.  This is an ideal method for catching stocks 10 points higher.

3. BE AFRAID TO BUY STRONG STOCKS.  This way you can avoid the big long-term relative strength winners.

4. SELL A STOCK ONLY BECAUSE IT HAS GONE UP.  This is an excellent way to cut your profits short.  (If you can’t stand prosperity, trim if you must, but don’t sell it all.)


6. TRY TO BOTTOMFISH A STOCK IN A DOWNTREND.  Instead, jump off a building and try to stop 5 floors before you hit the ground.  Ouch.

7. BUY A STOCK ONLY BECAUSE IT’S A GOOD VALUE.  There are two problems with this.  1) It can stay a good value by not moving for the next decade, or worse 2) it can become an even better value by dropping another 10 points.

8. HOLD ON TO LOSING STOCKS AND HOPE THEY COME BACK.  An outstanding way to let your losses run.  Combined with cutting your profits short, over time you can construct a diversified portfolio of losers and register it with the Kennel Club.

9. PURSUE PERFECTION.  There are two diseases.  1) Hunting for the perfect method.  Trying a new “system” each week will not get you to your goal.  It requires remaining focused on one method,  maintaining consistency and discipline, and making incremental improvements.  2) Waiting for the perfect trade.  The sector is right, the market is supporting higher prices, the chart is good—try to buy it a point cheaper and miss it entirely.  Doh.  Better to be approximately right than precisely wrong.

10. MAKE INVESTMENT DECISIONS BASED ON A MAGAZINE COVER, MEDIA ARTICLES, OR PUNDITS.  Take investment advice from a journalist or a hedge fund manager talking his book!  Get fully engaged with your emotions of fear and greed!  This is the method of choice for those interested in the fastest route to the poorhouse.

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Stocks for the Long Run

September 20, 2013

Unlike certain authors, I am not promoting some agenda about where stocks will be at some future date!  Instead, I am just including a couple of excerpts from a paper by luminaries David Blanchett, Michael Finke, and Wade Pfau that suggests that stocks are the right investment for the long run—based on historical research.  Their findings are actually fairly broad and call market efficiency into question.

We find strong historical evidence to support the notion that a higher allocation to equities is optimal for investors with longer time horizons, and that the time diversification effect is relatively consistent across countries and that it persists for different levels of risk aversion.

When they examine optimal equity weightings in a portfolio by time horizon, the findings are rather striking.  Here’s a reproduction of one of their figures from the paper:

Source: SSRN/Blanchett, Finke, Pfau  (click to enlarge)

They describe the findings very simply:

Figure 1 also demonstrates how to interpret the results we include later in Tables 2 and 3. In Figure 1 we note an intercept (α) of 45.02% (which we will assume is 45% for simplicity purposes) and a slope (β) of .0299 (which for simplicity purposes we will assume is .03). Therefore the optimal historical allocation to equities for an investor with a 5 year holding period would be 60% stocks, which would be determined by: 45% + 5(3%) = 60%.

In other words, if your holding period is 15-20 years or longer, the optimal portfolio is 100% stocks!

Reality, of course, can be different from statistical probability, but their point is that it makes sense to own a greater percentage of stocks the longer your time horizon is.  The equity risk premium—the little extra boost in returns you tend to get from owning stocks—is both persistent and decently high, enough to make owning stocks a good long-term bet.

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Buy and Hold

September 9, 2013

John Rekenthaler at Morningstar launched into a spirited defense of buy and hold investing over the weekend.  His argument is essentially that since markets have bounced back since 2009, buy and hold is alive and well, and any arguments to the contrary are flawed.  Here’s an excerpt:

There never was any logic behind the “buy-and-hold is dead” argument. Might it have lucked into being useful? Not a chance. Coming off the 2008 downturn, the U.S. stock market has roared to perhaps its best four and a half years in history. It has shone in absolute terms, posting a cumulative gain of 125% since spring 2009. It has been fabulous in real terms, with inflation being almost nonexistent during that time period. It’s been terrific in relative terms, crushing bonds, cash, alternatives, and commodities, and by a more modest amount, beating most international-stock markets as well. This is The Golden Age. We have lived The Golden Age, all the while thinking it was lead.

Critics will respond that mine is a bull-market argument. That’s backward. “Buy-and-hold is dead” is the strategy that owes its existence to market results. It only appears after huge bear markets, and it only looks good after such markets. It is the oddity, while buy-and-hold is the norm.

Generally, I think Morningstar is right about a lot of things—and Rekenthaler is even right about some of the points he makes in this article.  But in broad brush, buy and hold has a lot of problems, and always has.

Here’s where Rekenthaler is indisputably correct:

  • “Buy and hold is dead” arguments always pop up in bear markets.  (By the way, that says nothing about the accuracy of the argument.)  It’s just the time that anti buy-and-holders can pitch their arguments when someone might listen.  In the same fashion, buy and hold arguments are typically made after a big recovery or in the midst of a bull market—also when people are most likely to listen.  Everyone has an axe to grind.
  • Buy and hold has looked good in the past, compared to forecasters.  As he points out in the article, it is entirely possible to get the economic forecast correct and get the stock market part completely wrong.
  • The 2008 market crash gave the S&P 500 its largest calendar year loss in 77 years.  No doubt.

The truth about buy and hold, I think, is considerably more nuanced.  Here are some things to consider.

  • The argument for buy and hold rests on hindsight bias.  Historical returns in the US markets have been among the strongest in history over very long time periods.  That’s why US investors think buy and hold works.  If buy and hold truly works, what about Germany, Argentina, or Japan at various time periods?  The Nikkei peaked in 1989.  Almost 25 years later, the market is still down significantly.  Is the argument, then, that only the US is special?  Is Mr. Rekenthaler willing to guarantee that US returns will always be positive over some time frame?  I didn’t think so.  If not, then buy and hold is not a slam dunk either.
  • Individual investors have time frames.  We only live so long.  A buy and hold retiree in 1929 or 1974 might be dead before they got their money back.  Same for a Japanese retiree in 1989.  Plenty of other equity markets around the world, due to wars or political crises, have gone to zero.  Zero.  That makes buy and hold a difficult proposition—it’s a little tough mathematically to bounce back from zero.  (In fact, the US and the UK are the only two markets that haven’t gone to zero at some point in the last 200 years.)  And plenty of individual stocks go to zero.  Does buy and hold really make sense with stocks?
  • Rejecting buy and hold does not have the logical consequence of missing returns in the market since 2009.  For example, a trend follower would be happily long the stock market as it rose to new highs.
  • Individual investors, maddeningly, have very individual tolerances for volatility in their portfolios.  Some investors panic too often, some too late, and a very few not at all.  How that works out is completely path dependent—in other words, the quality of our decision all depends on what happens subsequently in the market.  And no one knows what the market will do going forward.  You don’t know the consequences of your decision until some later date.
  • In our lifetimes, Japan.  It’s funny how buy and hold proponents either never mention Japan or try to explain it away.  “We are not Japan.”  Easy to say, but just exactly how is human nature different because there is an ocean in between?  Just how is it that we are superior?  (Because in 1989, if you go back that far, there was much hand-wringing and discussions of how the Japanese economy was superior!)

Every strategy, including buy and hold, has risks and opportunity costs.  Every transaction is a risk, as well as an implicit bet on what will happen in the future.  The outcome of that bet is not known until later.  Every transaction, you make your bet and you take your chances.  You can’t just assume buy and hold is going to work forever, nor can you assume it will stop working.  Arguments about any strategy being correct because it worked over x timeframe is just a good example of hindsight bias.  Buy and hold doesn’t promise good returns, just market returns.  Going forward, you just don’t know—nobody knows.  Yes, ambiguity is uncomfortable, but that’s the way it is.

That’s the true state of knowledge in financial markets: no one knows what will happen going forward, whether they pretend to know or not. 

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Stock Market Sentiment Surveys: AAII Edition

July 2, 2013

Greenbackd, a deep value blog, had a recent piece on the value of stock market sentiment.  Stock market sentiment surveys have been a staple of technical analysis for decades, ever since the advent of Investors Intelligence in the 1960s, so I was curious to read it.  The study that Greenbackd referenced was done by Charles Rotblut, CFA.  The excerpts from Mr. Rotblut that are cited give the impression that the results from the survey are unimpressive.  However, they showed a data table from the article.  I’ll reproduce it here and let you draw your own conclusions.

Source: Greenbackd   (click on image to enlarge)

From Greenbackd, here’s an explanation of what you are looking at:

Each week from Thursday 12:01 a.m. until Wednesday at 11:59 p.m. the AAII asks its members a simple question:

Do you feel the direction of the stock market over the next six months will be up (bullish), no change (neutral) or down (bearish)?

AAII members participate by visiting the Sentiment Survey page ( on and voting.

Bullish sentiment has averaged 38.8% over the life of the survey. Neutral sentiment has averaged 30.5% and bearish sentiment has averaged 30.6% over the life of the survey.

In order to determine whether there is a correlation between the AAII Sentiment Survey and the direction of the market, Rotblut looked at instances when bullish sentiment or bearish sentiment was one or more standard deviations away from the average. He then calculated the performance of the S&P 500 for the following 26-week (six-month) and 52-week (12-month) periods. The data for conducting this analysis is available on the Sentiment Survey spreadsheet, which not only lists the survey’s results, but also tracks weekly price data for the S&P 500 index.

There are some possible methodological problems with the survey since it is not necessarily the same investors answering the question each week (Investors Intelligence uses something close to a fixed sample of newsletter writers), but let’s see if there is any useful information embedded in their responses.

The way I looked at it, even the problematic AAII poll results were very interesting at extremes.  When there were few bulls (more than 2 standard deviations from the mean) or tons of bears (more than 3 standard deviations from the mean), the average 6-month and 12-month returns were 2x to 5x higher than normal for the 1987-2013 sample.  These extremes were rare—only 19 instances in 26 years—but very useful when they did occur.  (And it’s possible that there were really only 16 instances if they were coincident.)

Despite the methodology problems, the data shows that it is very profitable to go against the crowd at extremes.  Extremes are times when the emotions of the crowd are likely to be most powerful and tempting to follow—and most likely to be wrong.  Instead of bailing out at times when the crowd is negative, the data shows that it is better to add to your position.

HT to Abnormal Returns

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The Stock Market – Economy Disconnect

June 13, 2013

One of the most difficult things for investors to understand is the stock market – economy disconnect.  New investors almost always assume that if the economy is doing well, the stock market will perform well also.  In fact, it is usually the other way around!

Liz Ann Sonders, the market strategist at Charles Schwab & Co., has an interesting piece on this apparent disconnect.  She writes:

Remember, the stock market (as measured by the S&P 500) is one of 10 sub-indexes in the Conference Board’s Index of Leading Indicators. Many investors assume it’s the opposite—that economic growth is a leading indicator of the stock market. For a compelling visual of the relationship, see the following pair of charts, which I’ll explain below.

The most compelling part of her article follow, in the form of her charts that show the GDP growth rate and peaks and troughs in the stock market.

Source: Charles Schwab & Co.  (click on images to enlarge)

More often than not, poor economic growth corresponds with a trough in the market.  Super-heated economic growth is usually a sign that someone is about to take away the punch bowl.

In truth, there is really no disconnect if you accept that the stock market usually leads the economy.  As Ms. Sonders points out, the S&P 500 is part of the Index of Leading Indicators.  A lot of investors have trouble wrapping their heads around that concept—and it continues to cost them money.

The contrast to economic forecasting (i.e., guessing) is trend following.  The trend follower is usually fairly safe in believing that if the market is continuing up that is economy is probably ok for the time being.  When the trend becomes uncertain or tilts down, it might be time to look for clues that the economy is softening.  You’re not going to be right all the time either way, but at least you’ve got the odds on your side if you let the market lead.

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Competency Transference

June 12, 2013

From Barry Ritholz at The Big Picture comes a great article about what he calls “competency transference.”  His article was triggered by a Bloomberg story about a technology mogul who turned his $1.8 billion payoff into a bankruptcy just a few years later.  Mr. Ritholz points out that the problem is generalizable:

Be aware of what I call The Fallacy of Competency Transference. This occurs when someone successful in one field jumps in to another and fails miserably. The most widely known example is Michael Jordan, the greatest basketball player the game has ever known, deciding he was also a baseball player. He was a .200 minor league hitter.

I have had repeated conversations with Medical Doctors about this: They are extremely intelligent accomplished people who often assume they can do well in markets. (After all, they conquered what I consider a much more challenging field of medicine).

The problem they run into is that competency transference. After 4 years of college (mostly focused on pre-med courses), they spend 4 years in Medical school; another year as an Interns, then as many as 8 years in Residency. Specialized fields may require training beyond residency, tacking on another 1-3 years. This process is at least 12, and as many as 20 years (if we include Board certification).

What I try to explain to these highly educated, highly intelligent people is that they absolutely can achieve the same success in markets that they have as medical professionals — they just have to put the requisite time in, immersing themselves in finance (like they did in medicine) for a decade or so. It is usually around this moment that the light bulb goes off, and the cause of prior mediocre performance becomes understood.

To me, the funny thing is that competency transference mostly applies to the special case of financial markets.  For example, no successful stock market professional would ever, ever assume themselves to be a competent thoracic surgeon without the requisite training.  Nor would a medical doctor ever assume that he or she could play a professional sport  or run a nuclear submarine without the necessary skills.  (I think the Michael Jordan analogy is a poor one, since there have been numerous multi-sport athletes.  Many athletes letter in multiple sports in high school and some even play more than one in college.    Michael Jordan may have been wrong about his particular case, but it wasn’t necessarily a crazy idea.)

Nope, competency transference is mostly restricted to the idea that anyone watching CNBC can become a market maven.  (Apparently even talking heads on CNBC believe this.)  This creates no end of grief in advisor-client relationships if 1) the advisor isn’t very far up the learning curve, and 2) if the client thinks they know better.  You would have the same problem if you had a green medical doctor and you thought you knew more than the doctor did.  That is a situation that is ripe for problems!

Advisors need to work continuously to expand their skills and knowledge if they are to be of use to investors.  And investors, in general, would do well to spend their efforts vetting advisors carefully rather than assuming financial markets are a piece of cake.

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From the Archives: If You Miss the 10 Best Days

June 7, 2013

We’ve all seen numerous studies that purport to show how passive investing is the way to go because you don’t want to be out of the market for the 10 best days.  No one ever mentions that the “best days” most often occur during the declines!

It turns out that the majority of the best days and the worst days occur near one another, during the declines.  Why?  Because the market is more volatile during declines.  It is true that the market goes down 2-3x as fast as it goes up.  (World Beta has a nice post on this topic of volatility clustering, which is where this handy-dandy table comes from.)

 If You Miss the 10 Best Days

from World Beta

You can see how volatility increases and the number of days with daily moves greater than 2.5% really spikes when the market is in a downward trend.  It would seem to be a very straightforward proposition to improve your returns simply by avoiding the market when it is in a downtrend.

However, not every strategy can be improved by going to cash.  Think about the math: if your investing methodology makes enough extra money on the good days to offset the bad days, or if it can make money during a significant number of the declines, you might be better off just gritting your teeth during the declines and banking the higher returns.  Although the table above suggests it should help, a simple strategy of exiting the market (i.e., going to cash) when it is below its 200-day moving average may not always live up to its theoretical billing.

 If You Miss the 10 Best Days

 If You Miss the 10 Best Days

click to enlarge

Consider the graphs above.  (The first graph uses linear scaling; the second uses logarithmic scaling for the exact same data.)  This test uses Ken French’s database to get a long time horizon and shows the returns of two portfolios constructed with market cap above the NYSE median and in the top 1/3 for relative strength.  In other words, the two portfolios are composed of mid- and large-cap stocks with good relative strength.  The only difference between the two portfolios is that one (red line) goes to cash when it is below its 200-day moving average.  One portfolio (blue line) stays fully invested.  The fully invested portfolio turns $100 into $49,577, while the cash-raising portfolio yields only $26,550.

If you would rather forego the extra money in return for less volatility, go right ahead and make that choice.  But first stack up 93 boxes of  Diamond matches so that you can burn 23,027 $1 bills, one at a time, to represent the difference–and then make your decision.

 If You Miss the 10 Best Days

The drawdowns are less with the 200-day moving average, but it’s not like they are tame–equities will be an inherently volatile asset class as long as human emotions are involved.  There are still a couple of drawdowns that are greater than 20%.  If an investor is willing to sit through that, they might as well go for the gusto.

As surprising as it may seem, the annualized return over a long period of time is significantly higher if you just stay in the market and bite the bullet during train wrecks–and even two severe bear markets in the last decade have not allowed the 200-day moving average timer to catch up.

At the bottom of every bear market, of course, it certainly feels like it would have been a good idea (in hindsight) to have used the 200-day moving average to get out.  In the long run, though, going to cash with a high-performing, high relative strength strategy might be counterproductive.  When we looked at 10-year rolling returns, the fully invested high relative strength model has maintained an edge in returns for the last 30 years running.

 If You Miss the 10 Best Days

click to enlarge

Surprising, isn’t it?  Counterintuitive results like this are one of the reasons that we find testing so critical.  It’s  easy to fall in line with the accepted wisdom, but when it is actually put to the test, the accepted wisdom is often wrong.  (We often find that even when shown the test data, many people refuse, on principle, to believe it!  It is not in their worldview to accept that one of their cherished beliefs could be false.)  Every managed portfolio in our Systematic RS lineup has been subjected to heavy testing, both for returns and–and more importantly–for robustness.  We have a high degree of confidence that these portfolios will do well in the long run.

—-this article originally appeared 3/5/2010.  We find that many investors continue to refuse, on principle, to believe the data!  If you have a robust investment method, the idea that you can improve your returns by getting out of the market during downturns appears to be false.  (Although it could certainly look true for small specific samples.  And, to be clear, 100% invested in a volatile strategy is not the appropriate allocation for most investors.)  Volatility can generally be reduced somewhat, but returns suffer.  One of our most controversial posts ever—but the data is tough to dispute.

In more recent data, the effect can be seen in this comparison of an S&P 500 ETF and an ETN that switches between the S&P 500 and Treasury bills based on a 200-day moving average system.  The volatility has been muted a little bit, but so have the returns.

(click on image to enlarge)

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Flawless Stock Market Forecasting

May 28, 2013

One way to improve your stock market forecasts is to revise them!  Bespoke has a nice piece where they show graphically how Wall Street strategists just change their forecast when the market moves past them.  Whether the market goes up or down here is immaterial—the forecast will be changed to accommodate the market.  Investors might give credence to some of these forecasts if they didn’t know they were a moving target.  Who knew stock market forecasting was so easy?

Source: Bespoke    (click on image to enlarge)

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Stock Market Valuation

May 7, 2013

Stock market valuation is always a concern for investors.  Presumably it always helps to buy when valuation is low.  However, I’m no expert on stock market valuation.  In the past, I’ve shown some bottom-up valuations constructed by Morningstar analysts.  They suggest the market is fairly valued right now.  Another way to look at it is top-down; that is, taking the big picture view of valuations.

That’s what Ed Yardeni of Dr. Ed’s Blog does.  From a big picture perspective, there are just two main variables in stock market valuation: earnings, and the multiple you put on those earnings.  Lots of firms estimate aggregate S&P 500 earnings.  (Top-down estimates actually tend to be a little more accurate than bottom-up estimates.)  In this version, he uses the Thomson Reuters IBES estimate.  For his estimate of the appropriate multiple, he uses 20 minus the 10-year yield.  That kind of thinking makes sense.  With low interest rates, the market has typically traded at a higher multiple.  When interest rates or inflation are high, the PE multiple tends to get compressed.  He points out that other versions of this chart, like using a multiple of 20 minus CPI inflation come out in the same ballpark.

Here’s the chart from his recent article on valuation:

Source: Dr. Ed’s Blog    (click on image to enlarge)

It’s an interesting chart, is it not?  Based on earnings, it suggested the market was significantly overvalued in the late 1990s, and then fairly valued from 2002 to 2007 or so.  The market dropped appropriately in response to weak earnings during the financial crisis, but is now about 30% undervalued, not having kept up with the rapid earnings growth we’ve seen since then.  The suggestion is that if earnings hold up, current stock prices are not out of line with the past decade.

It’s well worth reading the rest of the article, as Dr. Yardeni also discusses the relative valuation of stocks versus bonds.  (The whole blog is worth reading!  He is one of the more practically grounded economists out there.)

My takeaway on this is simply that the current market may not warrant the incredible amount of hand-wringing that we’ve seen as the S&P 500 has pushed to new highs.  Given the powerful corporate earnings we’ve seen, coupled with very low interest rates, the market’s valuation may be reasonable.  Yes, it feels scary because we are in new high ground, but the data looks different than we might feel emotionally.

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Nate Silver Interview

April 17, 2013

Here’s a link to a nice Nate Silver interview at Index Universe.  Nate Silver is now a celebrity statistician due to his accurate election forecasts, although he started by doing statistics for baseball.  In the interview, he discusses some of the ways that predictions can go wrong.  In general, human beings are completely wrong about the stock market!

The typical retail investor frankly does things exactly wrong—they tend to buy at the top and sell at the bottom. Theoretically, you make this long-run average return, but a lot of people are buying at the market peaks. For many years, the Gallup Poll has periodically been asking investors whether it’s a good time to invest or not. There’s a strong historical negative correlation between when people think it’s a good time to invest and the five- or 10-year returns on the S&P 500.

Overconfidence can also kill predictions.  Other studies have found that the more confident the forecaster the worse the forecast tends to be, something that makes watching articulate bulls and bears on CNBC particularly dangerous!

It’s worth a read.

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Buyer’s Remorse

March 1, 2013

Lots of investors have avoided the stock market since 2009, only to miss out on a long run of good performance.  Now, of course, they are concerned about buying because the market is near a 52-week high.  Essentially, they are worried about buyer’s remorse—that bittersweet feeling when the market goes down right after you decided to join the party.  In practice, this usually just means they will wait even longer to get in and will thus buy at an even higher price.

While it is impossible to know what the market will do next, buyer’s remorse might not be as significant as it seems.  World Beta reprised a recent piece from Steve Sjuggerud on what happened when buying near new 52-week highs and lows:

We looked at nearly 100 years of weekly data on the S&P 500 Index, not counting dividends. You might be surprised at what we found…

After the stock market hits a 52-week high, the compound annual gain over the next year is 9.6%. That is a phenomenal outperformance over the long-term “buy and hold” return, which was 5.6% a year.

On the flip side, buying when the stock market is at or near new lows leads to terrible performance over the next 12 months… Specifically, buying anytime stocks are within 6% of their 52-week lows leads to compound annual gain of 0%. That’s correct, no gain at all 12 months later.

Using monthly data, our True Wealth Systems databases go back to 1791. The results are similar… Buying at a 12-month high and holding for 12 months beats the return of buy-and-hold. And buying at a 12-month low and holding for a year does worse than buy-and-hold. Take a look…

The same holds true for a more recent time period, this time starting in 1950…

History’s verdict is clear… You’re much better off buying at new highs than at new lows.

I find this quite interesting in light of the fact that there is no shortage of articles discussing the sky falling with the sequester, or the debt ceiling, or the Greek default, of the ongoing collapse of the Yen.  Well, you get the picture.  Maybe investors are just afflicted with crisis fatigue at this point.  In fact, PE multiples are around average right now.  There’s no telling what will happen going forward, but buyer’s remorse need not be at the top of your list of fears.

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Timeless Portfolio Lessons

February 1, 2013

The only thing new under the sun is the history you haven’t read yet.—-Mark Twain

Investors often have the conceit that they are living in a new era.  They often resort to new-fangled theories, without realizing that all of the old-fangled things are still around mainly because they’ve worked for a long time.  While circumstances often change, human nature doesn’t change much, or very quickly.  You can generally count on people to behave in similar ways every market cycle.  Most portfolio lessons are timeless.

As proof, I offer a compendium of quotations from an old New York Times article:

WHEN you check the performance of your fund portfolio after reading about the rally in stocks, you may feel as if there is  a great party going on and you weren’t invited. Perhaps a better way to look at it is that you were invited, but showed up at the wrong time or the wrong address.

It isn’t just you. Research, especially lately, shows that many investors don’t match market performance, often by a wide margin, because they are out of sync with downturns and rallies.

Christine Benz, director of personal finance at Morningstar, agrees. “It’s always hard to speak generally about what’s motivating investors,” she said, “but it’s emotions, basically,” resulting in “a pattern we see repeated over and over in market cycles.”

Those emotions are responsible not only for drawing investors in and out of the broad market at inopportune times, but also for poor allocations to its niches.

Where investors should be allocated, many professionals say, is in a broad range of assets. That will smooth overall returns and limit the likelihood of big  losses resulting from  an excessive concentration in a plunging market. It also limits the chances of panicking and selling at the bottom.

In investing, as in party-going, it’s often safer to  let someone else drive.

This is not ground-breaking stuff.  In fact, investors are probably bored to hear this sort of advice over and over—but it gets repeated because investors ignore the advice repeatedly!  This same article could be written today, or written 20 years from now.

You can increase your odds of becoming a successful investor by constructing a reasonable portfolio that is diversified by volatility, by asset class, and by complementary strategy.  Relative strength strategies, for example, complement value and low-volatility equity strategies very nicely because the excess returns tend to be uncorrelated.  Adding alternative asset classes like commodities or stodgy asset classes like bonds can often benefit a portfolio because they respond to different return drivers than stocks.

As always, the bottom line is not to get carried away with your emotions.  Although this is certainly easier said than done, a diversified portfolio and a competent advisor can help a lot.

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From the Archives: Getting Torched By Expert Opinion

January 29, 2013

Barry Ritholtz has posted a 5 minute clip of some of Ben Bernanke’s public comments between 2005-2007 on the housing market and the broader economy.  The point of me posting this is not to say that Bernanke is a complete moron because I have little doubt that he is one of the brightest financial minds in the country.  However, talk about being dead wrong!  If you relied on these opinions in order to make investment decisions, you likely got torched.  If you can’t rely on expert opinion when making investment decisions, then what options do you have?

This highlights the value of trend-following systems.   Trend following requires zero reliance on expert opinion; it simply allows the investor to adapt to whatever trends the market offers, whether or not experts expected things to play out in a given way.  With trend following, you’ll have plenty of losing trades, but you’ll also avoid sitting in losing trades for long periods of time.  Furthermore, systematic trend-following has an excellent track record (see here and here.)  Trend following allows you to cut your losses short and to hold on to your winners.  Frequently, the strongest trends end up being very different from what even the brightest experts predicted.

—-this article originally appeared 2/11/2010.  Well, heck, if you can’t trust Ben Bernanke, who can you trust?  The answer should be obvious: follow the price trend and forget about the random guessing of experts.

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From the Archives: Irrational Loss Aversion

January 22, 2013

It’s well known in behavioral finance that investors experience a loss 2-3x more intensely than a gain of the same magnitude.  This loss aversion leads investors to avoid even rational bets, according to a Reuters story on a recent study by a Cal Tech scientist.

Laboratory and field evidence suggests that people often avoid risks with losses even when they might earn a substantially larger gain, a behavioral preference termed ‘loss aversion’,” they wrote.

For instance, people will avoid gambles in which they are equally likely to either lose $10 or win $15, even though the expected value of the gamble is positive ($2.50).

The study indicates that people show fear at even the prospect of a loss.  Markets are designed to generate fear, not to mention all of the bearish commentators on CNBC.  Fear leads to poor decisions, like selling near the bottom of a correction.  Unless you are planning to electrically lesion your amygdala, the fear is going to be there–so what’s the best way to deal with it?

The course we have chosen is to make our investment models systematic.  That means the decisions are rules-based, not subject to whatever fear the portfolio managers may be experiencing at any given time.  Once in a blue moon, excessive caution pays off, but studies suggest that more errors are made being excessively cautious than overly aggressive.  A rules-based method treats risk in a even-handed, mathematical way.  In other words, take risks that historically are likely to pay off, and keep taking them regardless of your emotional state.  Given enough time, the math is likely to swing things in your favor.

—-this article originally appeared 2/10/2010.  In the two years since this was written, investors have continued to pay a high price for their fear as the market has continued to advance.  There are always scary things around the corner, but a rules-based process can often help you navigate through them.  Investors seem to have a hard time learning that scary things don’t necessarily cause markets to perform poorly.  In fact, the opposite is often true.

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Stocks and the Economy: It’s Complicated

January 15, 2013

Seeking to understand the relationship between the economy and the stock market is a rather complex undertaking.  We can certainly argue that the economy impacts corporate earnings in terms of revenues and costs.  Stock prices generally reflect investor expectations for future corporate earnings and future economic growth.  As a result, one might expect that there is a fairly direct relationship between U.S. GDP growth and U.S. stock market performance.  However, it is also generally accepted that the stock market is a leading indicator and its movements should precede U.S. economic growth.  Stocks and the economy don’t always move in lockstep.  Let’s look at some real life examples and see what conclusions can be drawn.

Consider the following chart which shows U.S. GDP growth since the early 1980s.  The shaded areas indicate U.S. recessions.

The table below shows GDP growth and stock market performance in the years following the last four recessions.

It can be observed that U.S. economic growth following the most recent recession is weaker than that of the preceding three—and yet the stock market performance was the second highest return of those shown.  In other words, the strength of U.S. economic growth has not always been a good indicator of stock market performance.  What is driving those returns then? Monetary policy?  Fiscal policy?  Globalization?  A combination of many, many different factors?

At Dorsey Wright, our investment decisions are based on relative strength models that seek to capitalize on trends.  We spend little time trying to understand the exact relationship between price movement and the various fundamental factors influencing those price returns.  After all, investors are not primarily concerned about making sure that whatever gains or losses they have in their portfolio are symbiotic with the prevailing economic and financial theories of the day.  Rather, they want to make as much money as possible given their risk management considerations.

I suspect that many investors are failing to fully take advantage of the returns in the financial markets because they correctly observe the rather weak economic growth and then incorrectly assume that the stock market must necessarily also be doing poorly.  The financial markets don’t wait for us to feel good before generating strong returns, nor do they seem to worry much about behaving in a way that fits anyone’s philosophical theories.  It’s up to us to respond and seek to profit from whatever the financial markets throw our way.  The good news for investors is that the financial markets have a long history of providing ample return (and risk) for investors who are seeking to build and manage wealth.

Source: National Bureau of Economic Research, U.S. Department of Commerce, Global Financial Data

In the table that shows subsequent three-year average GDP growth, I began measuring the three year GDP growth in the first full quarter following the end of the recession, as defined by the National Bureau of Economic Research.  S&P 500 returns are total returns, inclusive of dividends.  Past performance is no guarantee of future returns.

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