Category Archives: Macro

The Case Against 100% US Stock Indexing

liberty

Why not buy a US market cap weighted index and forget about it?

In my post on gold, I catalogued all of my disagreements with the perma-bears. In this post, I am going to talk about my disagreements with the perma-bulls who advocate owning nearly 100% US stock market cap weighted indexes.

100% US stocks is the preferred asset allocation of most FIRE bloggers. It’s the mantra repeated often in the financial independence blogosphere. Warren Buffett recommends a similar allocation, 90% US stocks and 10% treasuries.

I don’t think this is the optimal approach. I think investors should embrace stabilizing asset classes, global diversification, and moving away from market cap weighting.

USA: The Place to Be

I love the United States of America. I don’t find Lee Greenwood cheesy. I particularly love small towns in America. The traditional town square, modest homes with an America flag flapping in the breeze, the churches, the little communities. I listen to Ronald Reagan’s “shining city on a hill” speech and I find it inspiring.

Perhaps my perception is a fantasy about a world that doesn’t really exist anymore. Perhaps I’ve had pro-America propaganda fed into my brain since birth. Whatever.

Perhaps I’m blinded by patriotism and have been indoctrinated, but I think there is more to it than that. I don’t think it’s an accident that the United States became the world’s top superpower in the 20th century. I don’t think it’s just because of abundant natural resources and two oceans protecting us from invasion.

The United States has one of the best economic systems in the world. Our founders crafted a document that created a framework which was pretty hard to screw up. It has a number of safeguards built into it that maintain a certain economic and political framework that is very hard to untangle.

The testament to that framework is the results. There isn’t any country on Earth with standards of living that are as high and widespread as ours. The US ranks 10th in per capita income throughout the world, but that’s across 327 million people. Countries with higher levels of per capita income (like Switzerland, Luxembourg, Qatar), have much smaller populations.

For all of the complaining about our very legitimate problems, this is still the best place on Earth. Unequal distribution of wealth? At least we have wealth to distribute. Keep in mind that an income of $32,400 – a very average income in the United States – places a person in the top 1% of incomes globally. An average American lives better than 99% of the human beings on Earth. Keep in mind that half of the planet lives on less than $5.50 per day.

We have it pretty good, problems aside. Not only that, but for all of the whining about our infrastructure, it’s some of the finest in the world. When was the last time you had to drive on a dirt road? Or pay off a police officer because the country is completely corrupt?

The magnificence of this country seems entirely lost in our political conversation. We tend to dwell on our problems, rather than our strengths and how good we have it.

The Extraordinary Performance of US Markets

The long term performance of our capital markets reflects the soundness of the American economic model. Since 1871, the US has delivered a 9.07% nominal return, 6.87% real. There isn’t a country that comes close over a long enough time frame.

Since 1970, US stocks have crushed it. US stocks have delivered a 10.57% real return since 1970, or 6.41% real. The rest of the world delivered a 8.65% return, or 4.65% real.

returns

Since 2010, international investing has been an outright disaster. US stocks delivered a real return of 11.49% and the rest of the world delivered 3.32%. For perspective, the US bond market has returned 3.68% since 2010. This decade, you would have been better off buying a total bond market fund instead of buying international stocks.

2010

The US is indeed a wonderful economy. US investors never had to worry about the markets going to zero, which happened to other countries in the 20th century. Corporate governance is also strong. While there are the occasional frauds, we can reliably believe that companies will stay on the up and up. Those who stray will be prosecuted. The SEC will limit most, but not all, frauds.

We also have the largest military in the world, which helps play a role in protecting the interests of US markets. There is something to be said for having fleets of aircraft carriers, drones, and nuclear weapons looking out for our interests.

A US stock investor is investing in the best performing stock market in the world. Not only that, but they’re investing in some of the best and most profitable companies in the world. Berkshire Hathaway. Google. Amazon.

The US is also diversified, with representation in every economic sector and industry. This compares favorably to other countries, which are often concentrated in a single industry or sector. Take Australia, for instance, which is concentrated in financials and natural resources.

Meanwhile, compared to alternative asset classes, like bonds, US stocks have dramatically outperformed.

bonds

An investor looking at all of this data comes to a simple conclusion: why own anything else besides US stocks? They outperform every other asset class and they outperform the rest of the world. There are clear reasons behind this. There is an equity risk premium, a theory which postulates that US stocks outperform because they’re more volatile. Meanwhile, there are plenty of political reasons to think that the US stock market will continue to outperform.

A US index investor invests in all of the publicly traded companies in the country. Some will be extraordinary winners, some will be extraordinary losers. A 100% US index investor can also expect to pay low fees, and fees can be a massive drag on returns.

Buy an index fund and you’ll own your own piece of corporate America, which is always working overtime to deliver a return for you, the shareholder. There are ups and downs, but the market always recovers.

So, why not simply invest in 100% US stocks and call it a day?

Going International

While international stocks haven’t performed as well as US stocks, they can help an investor smooth out their returns during periods of time when US stocks are doing poorly.

I think this is due primarily to the unique relationship between the US dollar and the performance of the US stock market. US dollar strength tends to coincide with strong periods for US stocks.

usd

Notice the periods of time when USD is strengthening vs. other currencies: the late ’90s, the mid ’80s, the 2010’s. They’re all periods of time when US stocks are doing awesome.

Notice the periods of time when the dollar was weakening: the 1970’s, the 2000’s, the late ’80s. These were all periods of time when international stocks outperformed US stocks. Currency movements are a big part of this out-performance. It’s the interaction of the dollar with global currencies that provides an important diversification benefit.

This is best revealed when looking at returns from a decade-by-decade perspective.

decade

As you can see, international stocks tend to outperform during bad decades for US stocks. I might be wrong about my thesis about this (that it is related to currency movements), but the facts remain. International stocks can help even out returns and provide a more consistent return.

Political Risk: Millennials, The Allure of Socialism, & Political Diversification

I think international stocks also provide protection against the US embracing bad political policies. While the Constitution is strong and prevents politicians (and voters) from screwing up a good thing, it isn’t guaranteed.

Consider that 70% of Millennials say they’d vote for a socialist. Granted, this is a survey and the results are suspect,  but it largely jives with my conversations with people of my age cohort and younger.

The reality is that socialism is a guaranteed disaster and fails everywhere it’s tried in the world.

I suspect that Millennials aren’t really socialists. They are largely blinded because they have been surrounded by the fruits of capitalism their entire lives and take it for granted. It’s like the way a fish views water: it’s just the way things are. It’s hard for a fish to imagine being taken to the surface and drowning. Fully stocked grocery stores, utilities that work, a persistently growing economy, persistently improving consumer technology. That’s just the way life is from their perspective. The reality is that it is the fruit of our economic system.

With that said, I understand where Millennial socialists are coming from.

I suspect that Millennials really want to move away from a boom and bust economy. I graduated from grad school in 2006 and experienced sheer terror in 2008. I worked for a bank and was worried it was going under.

I watched people all around me pack up boxes and wonder for their future. Many of them were older and had a lot of debt. A bulk of their income went to their mortgages, as a lifetime of lifestyle creep bit them in the behind.

I was lucky enough to keep my job, but the experience shook me to the core. At the time, I was working 60-70 hours a week with no overtime. I wasn’t working like that to become the CEO of the company. I was working that way to ensure I’d stay off the lay off list because I knew that there weren’t any other jobs for the taking.

The whole experience lit a fire under me. Get the hell out of debt. Develop a bullet proof savings war chest in case I ever lose my job. I never wanted to experience that kind of desperation ever again.

Meanwhile, other Millennials graduated into that economy facing similar prospects. Many of them were in a worse situation due to student loan debt. I was lucky enough to get through college with academic scholarships, but I still had debt at the time and felt similar levels of desperation.

Facing that kind of economy in debt is enough to drive a person to think that the US economic system is broken. The fact that Millennials struggle to reach important milestones – like owning a home – further exacerbates this reality. Owning a home and having a stable job are important elements to making people feel that the “system” works. The fact that Millennials feel shortchanged in both regards makes it clear why they think the system is broken.

It’s all further exacerbated by the expectations that were instilled in Millennials when they were young. Growing up in the ’90s, we were surrounded by prosperity that we assumed was “normal” and would last forever. We walked into a storm with insanely inflated expectations of ourselves and the future.

The feeling of inadequacy is made worse by the fact that, thanks to the internet, we’re constantly exposed to our peers who are doing “better” than us. They are probably fronting to make themselves look better on social media, but it’s easier for a Millennial to feel like they’re falling behind when we look at the picture-perfect lives of our peers on social media.

If you look at your “successful” peers on social media, you see picture perfect families with nice homes and smiling children. No one is posting about the troubles they have paying the daycare bill, or the fight they had with their spouse the other night. They might have a beautiful home, but they’re actually house poor and have little disposable income after they pay the mortgage. They’re not going to post when they were passed over for a promotion at work. No one posts about the bad things in their lives. It’s all smiling faces and a front. It’s easy to look at that and feel like you’ve been left behind.

Anyway, while I completely understand where Millennials are coming from in thinking that the system is broken, they are still completely wrong in their politics. They’re especially wrong because they fail to realize how fortunate they are to simply be born in America. As mentioned earlier, simply being lucky enough to be born in America virtually guarantees you’re going to be in the top 1% of incomes globally.

Even if they don’t really want socialism (I suspect they just want a stronger welfare state, less debt, and an economy that isn’t so boom and bust), I think they are voting for people that do actually want socialism and want to undo the entire system that made our way of life possible.

Warts and all, it’s still the best system in the world. Blowing it up isn’t going to make life any better.

This is another reason to own international stocks. If the US does something insane like go socialist, the rest of the world won’t. Just like every company in an index doesn’t succeed, every country in the world doesn’t always succeed. Own all of the countries and you get some important diversification in case something in one country goes wrong.

If you’re going to own a lot of different companies, why not own a lot of different countries for the same reason?

Owning international stocks isn’t just about creating more consistent returns. It’s also about diversifying political risk against the possibility that the US economic system – which has worked so well for so long – could be upended by bad politics and an angry electorate.

I hope the US remain the premier world economy. I think it probably will stay at the top. But what if I’m wrong? That’s why I own international stocks. If the US goes down the wrong path, I don’t think that the entire world will follow. Diversification among countries is just as important as diversification among companies.

Bonds aren’t a waste of time

I wrote about owning bonds in my post, are bonds for losers?

While stocks are virtually guaranteed to outperform bonds over the long term, bonds can help contain drawdowns. Most people underestimate their capacity for financial pain and bonds can help limit that pain.

On the surface, going 100% stocks is the way to go. Since 1871, stocks have offered a real return of 6.87%. Bonds offered a return of 2.51%. 60/40 offered a 5.54% return. Why not go for the higher returns and just go all-in on US stocks?

The drawback of owning 100% stocks is that they can undergo truly horrific drawdowns that can take years to recover from. US stocks were flat in real terms from 2000-2012. 12 years of sideways markets is rough. From 1964 to 1981 (17 years), US stocks only delivered a real return of 1.32% from 1929 to 1948 (19 years).

Can your long term investing plan sustain multiple decades of flat real returns?

It’s easy to look at a long term chart of US stocks, or a long-term CAGR, and brush off these drawdowns. Living through them is a completely different matter.

In the early 2000s, US stocks suffered a 44% drawdown. From 2007-2009, stocks suffered a 50% drawdown. Imagine you had a 100% stock portfolio. Also, imagine you had a significant amount of money saved up, like $500,000. A 50% loss is $250,000. That’s a decent house in most parts of the country. Would you have been able to “stay the course” in the face of those kinds of losses? I think most people are kidding themselves if they think they will behave rationally in those situations.

For most people, I think the answer is no. Just imagine what it’s like to experience these kind of drawdowns:

EPhLPwhX4AAUr2N

These kind of severe drawdowns can make a person behave irrationally. A big part of the problem is that these drawdowns aren’t just numbers on a brokerage statement. Markets are reacting to very real and very bad circumstances in the real world.

After a nasty drawdown, it’s easy to get caught up in the mentality that the economy is ending and something is fundamentally wrong.

In 1929-32, it looked like the US was unraveling at the seams. We went from the ’20s, a time in which anything seemed possible (imagine starting a decade without plumbing or electricity and ending it with a stock market boom), to soup lines and hobo villages.

In the 1973-74, there was a widespread feeling that the post-World-War II prosperity was unraveling. The country was running out of oil. The decade prior was a political horror show: the assassinations of JFK, Martin Luther King, Robert Kennedy. Protests in the streets. Dead students at Kent State. We lost a war for the first time in history and lost 50,000 of our young men. Our President was unmasked as a corrupt man who resigned from office instead of face impeachment. Double digit inflation further eroded our standards of living. They called it malaise and it was a widespread feeling that America’s best days were behind us.

The early 2000’s debacle was marked by a feeling that the ’90s was nothing but a bubble economy and we were now going to pay a price. The turn of the millennium and the late ’90s was associated with extraordinary optimism about the future. We had a glorious party and now we were hungover. Add to that the experience of 9/11, this feeling became particularly palpable.

We all remember 2008, but at that moment, it felt like the entire economic system was falling apart.

During a serious stock drawdown, you get the general feeling that the world is falling apart. Stock aren’t drawing down for no reason. They’re drawing down for reasons of psychology that go beyond CAGR’s and numbers on a brokerage statement. Serious drawdowns are caused by a cultural mood. The mood is going to affect the psychology of an investor.

Moments like these also increase the odds of personal struggles, like the potential loss of a job or a house, which further add to the stress of the situation.

It’s easy to see why most investors won’t behave rationally during these situations. In many cases, they’re going to wind up selling their stocks are the worst possible moment when stocks are bottoming. Bear markets start with a feeling of uneasiness towards the boom, they intensify with a general feeling of malaise, and they capitulate when the situation feels utterly hopeless. Of course, the moments when everyone feels hopeless that are the best times to buy stocks.

drawdown10k

I own bonds to smooth out the ride and keep myself behaving correctly. My age might suggest that it’s not a good idea, but I know that I won’t “stay the course” if my 401(k) balance drops 50% and I’m worried about losing my job. While most financial planners would say I’m not aggressive enough (the 401-k website usually gives me the yellow light because my investments are “too conservative”), I want to limit my drawdowns and I know bonds are the best way to accomplish that.

A 100% stock investor might simply throw in the towel completely. This is what many of them do.

When the losses are cushioned with something like a 60/40 approach, it is easier to stay the course and not give up.

The Drawbacks of Market Cap Weighting

The index fund is an extraordinary creation. It allows everyday investors like myself to access the public markets for a low fee. Fees are a tremendous drag on returns.

As far as I’m concerned, a monument should be built to Jack Bogle for creating such an amazing product for every day investors, who were previously swindled out of commissions and paid extraordinary fees to access public markets.

The theory behind market cap weighted indexes is intuitive and easy to understand. Active investors are making bets against each other, trying to outperform each other. This is a zero sum game: for every winning trade, there is someone on the other side making the wrong decision. This is why most active investors underperform. Only some of them can be winners. Add fees to the equation and it becomes even more difficult to outperform.

So, why not simply own the market cap weighted index and get the average rate of return?

There is one problem with this approach: nearly every strategy that moves away from market cap weighting outperforms over the long-run.

  1. Fundamentally weighted indexes outperform.
  2. Equally weighted indexes outperform.
  3. The 30 stocks in the Dow Jones Industrial Average outperforms market cap weighted US stocks.
  4. Completely random 30 stock portfolios outperform the market.
  5. Low volatility strategies outperform, while also containing drawdowns.
  6. Nearly every AAII stock screener outperforms the market.

Finally, all the research and data shows that a pivot towards smaller, cheaper stocks outperforms over the long run.

equities

Small value is the best performing asset class since 1972. However, it notably under-performed during the bull markets of the 2010’s and the 1990’s.

Large cap growth – one of the worst performing long term strategies – also dramatically outperformed in both the 2010’s and the 1990’s bull markets.

Why do non market cap weighted strategies outperform over the long haul and under-perform during bull markets?

I think all of these strategies (equal weight, small size, value, fundamental weight, random portfolios) outperform because they pivot away from the coolest stocks. The coolest, biggest, stocks – the leaders of a bull market – are systematically avoided by all of these strategies. This causes all of these strategies to under-perform in a rip-roaring bull market, which are led by those large cap growth stocks. Meanwhile, non market-cap-weighted strategies also avoid the inevitable horrific decline in these bull market leaders. Over the long run, they outperform.

I think value, in particular, outperforms because it is systematically buying cheap stocks and selling when they get expensive. I talk about that in this post.

Meanwhile, a market cap weighted index is going to buy more of the largest, coolest, stocks as they go up.

As a value investor, I think that the opposite strategy is the best approach.

The ’90s bubble is a good example. In 2000, the market was concentrated in a handful of bubble names. This drove your returns during the bull and made them worse during the bear. If you avoided the leaders of the ’90s bull during the early 2000’s meltdown, then you dramatically improved your long term returns.

For an extreme example of this kind of behavior, look to Japan. James Montier demonstrated that the magic formula delivered a 16.5% rate of return during Japan’s meltdown in the ’90s and 2000’s. The magic formula outperformed because it avoided the biggest stocks in that market and pivoted towards value. This likely caused the strategy to under-perform during Japan’s long bull market. Even in a market that overall was doing poorly, pivoting away from market cap weighting made it possible to earn a high rate of return.

Meanwhile, if every strategy outperforms market cap weighting, then why do most active managers under-perform?

I think the answer is simple: those active managers have the same biases of the index itself. They are going to pile into the same outperforming stocks that the index is piling into it. This is for career reasons. The best performing stocks are safe to own. If you own them and succeed, you’re a genius. If you own them and fail, well, you’re with everyone else.

Active managers and institutional investors aren’t the smart money. They are most of the money and, therefore, most of the market. They’re subject to the same behavioral flaws and biases as everyone else. They discard under-performing strategies, they get excited about whatever is hot at the moment.

It’s also driven by FOMO. Most of them will probably load up on these stocks in an even more extreme way than the index itself. Not only that, but the size of most institutional investors, makes them pivot towards large caps out of of necessity.

Conclusion

I don’t think owning 100% market cap weighted US stocks is the optimal approach.

I think diversification adds a lot to a portfolio. Adding bonds can limit drawdowns. Adding international stocks helps diversify political and currency risks and leads to more consistent returns.

Pivoting away from market cap weighting limits returns during bull markets, but leads to long term out-performance by systematically avoiding the most exciting large cap names.

While indexing in 100% US stocks is likely to do fine over the long run, I think a more balanced portfolio with pivots towards value is a more optimal approach.

Of course, this depends on your perspective. Portfolios are personal. I’m someone who doesn’t experience FOMO. If other investors are outperforming me, I don’t really care. If it drives you absolutely crazy to underperform, then market cap weighting might be for you. If you don’t believe value is a factor likely to persist, you might want to own more market cap weighted indexes.

You do you, but you should go into an investment strategy with a full understanding of the risks and potential rewards.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

My thoughts on perma-bears and gold

gold

I’ve always hated gold

I have always been against owning gold.

Why did I think gold was a terrible investment? A huge reason for my gold aversion is the influence of Warren Buffett’s writings on my life and thinking. Here is what Warren has to say on the asset:

“It gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.”

In his 2011 letter, Buffett addressed the issue more in-depth:

“The second major category of investments involves assets that will never produce anything, but that are purchased in the buyer’s hope that someone else – who also knows that the assets will be forever unproductive – will pay more for them in the future. Tulips, of all things, briefly became a favorite of such buyers in the 17th century.

This type of investment requires an expanding pool of buyers, who, in turn, are enticed because they believe the buying pool will expand still further. Owners are not inspired by what the asset itself can produce – it will remain lifeless forever – but rather by the belief that others will desire it even more avidly in the future. The major asset in this category is gold, currently a huge favorite of investors who fear almost all other assets, especially paper money (of whose value, as noted, they are right to be fearful). Gold, however, has two significant shortcomings, being neither of much use nor procreative.

True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production.

Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end. What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade, that belief has proved correct. Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis. As ‘bandwagon’ investors join any party, they create their own truth — for awhile.”

To sum it up: gold has no calculable margin of safety. It produces no cash flow. The return derives from what someone else is willing to pay. It therefore ought to be categorized as speculation and not as investment.

Of course, my main aversion to gold has been my attitude towards the people who embrace it the most: the perma-bears.

The Perma Bear View of the World

Who are the perma-bears?

Perma-bears think that the Fed is an utterly corrupt institution and that they are going to lead the world to ruin. The world economy, in their view, is a debt soaked Ponzi scheme that is sure to unravel. Anyone who owns stocks or bets on a positive outcome for humanity’s future is a damned fool.

They’ve been saying this for a long time, and they are almost always wrong. However, like a stopped clock, perma-bears are occasionally right whenever we have a recession and a nasty bear market, which reliably happens once every 15 years or so.

Gold is the only asset that is beloved by perma-bears (Although, Millennial Fed hating perma bears seem to be embracing crypto).

Perma-bears hate the stock market because they think stocks are in a big bubble pumped up by the Federal Reserve. They hate bonds because they do not believe that they are truly “risk-free” assets, and the Fed has pushed yields to unusually low levels. Bonds are also in a bubble.

Stocks are in a bubble. Bonds are in a bubble. In their view, everything is in a bubble, except gold.

They also see the Federal Government’s deficits as a severe problem. They think that the US is ultimately going to deal with the debt by inflating the currency or straight up defaulting on the debt in an apocalyptic scenario that is sure to imperil the global economy.

The ultimate perma-bear book is The Creature from Jeckyl Island, which argues that the Federal Reserve is a monstrous creation that is eroding the liberty and money of Americans. It’s worth a read to get insight into the history of the Federal Reserve and the deep seated hatred of it.

You’ll often see these perma-bear types quite angry that inflation exists at all. Before the Fed, they argue, dollars were a store of value. You didn’t have to worry about the slow drip of 2% inflation eroding your wealth over time.

Since 1913, the value of a dollar has been eroded by 96% due to inflation. This usually gets the perma-bears very angry, as if the only asset allocation is cash stuffed into a mattress.

Perma-bears have always hated the Fed, but they really hated Alan Greenspan. The perma-bear goldbug crowd saw Greenspan as a dangerous departure from the already maligned Federal Reserve of yore.

After the crash of 1987, they were incensed that Greenspan “bailed out” the stock market by cutting interest rates and intervening to ensure that liquidity was available. In this view, the Greenspan era was the beginning of the end, taking us down to a path of Fed manipulation leading the United States and the US dollar towards a great reckoning. In their view, Greenspan’s 1987 cutting of interest rates in response to the stock market crash was the original sin that started it all and led us down a path to ruin. They further believe that his softening of interest rates in the mid-90’s furthered the problem and contributed to the dot com bubble. Then, taking interest rates to 1% in the mid-2000s blew up the real estate bubble.

Some take it back further, and blame Nixon for ending the gold standard, creating fiat currency, which they believe will ruin the world economy. This is despite the fact that the world economy has thrived for the last 50 years since we ended price controls and dollar pegs to gold.

Then, along came Bernanke and Yellen, who really broke the brains of the perma-bears. Bernanke and Yellen, in their view, continued the insanity by pushing Washington to bail out the banks and then undergoing successive rounds of quantitative easing, creating the “everything bubble” that is sure to destroy the global economy.

The perma-bears really had their day in the sun in the wake of the GFC, when the world was ripe to their message. They thought that quantitative easing was going to cause hyperinflation. All of this money printing was sure to wreck the world.

The trouble is: the hyperinflation never came. In fact, the 2010s was a decade with some of the most mild inflation since World War II. Ironically, this was during the most aggressive expansion of monetary policy since World War II.

inflation

The perma-bears will say all of this is nonsense. They say that the inflation is here and that the CPI is a sham statistic. They point to healthcare prices and student tuition as evidence of Fed induced inflation. They also argue that the inflation may not be happening in consumer prices, but that it is being swept up into asset inflation. They believe that the housing bubble was a perfect example of this: the Fed pumped up a big bubble in real estate even though the CPI didn’t rise in a meaningful way.

My Disagreements with the Perma Bears

Listening to the perma-bears has been a recipe for investment disaster.

They have been calling for the end of our financial system since Richard Nixon ended the gold standard, and the world economy keeps chugging along. Occasionally, gold has its day in the sun (the 2000s, the 1970s), but typically financial assets like bonds and stocks that actually generate cash flows do better over time.

I also think that the CPI is legit and I think inflation remains depressed for another reason outside of shadow statistics and asset inflation: money velocity is at generational lows.

The best explanation of the relationship between monetary policy and inflation is the equation MV = PQ, and velocity is a critical component of that inflation. Velocity has remained depressed since the GFC, which is why inflation has remained subdued even while the money spigots have been open.

The segments of the economy that are undergoing inflation (healthcare & education) are being inflated for reasons that have nothing to do with the Fed. The Fed didn’t make the decision to back student loans with taxpayer & deficit financed money, flooding the sector with cheap debt. The Fed also didn’t create the perverse incentive system around medical pricing, in which no one directly pays for anything, the Federal government floods the sector with taxpayer & deficit financed money, and prices predictably rage out of control.

Neither healthcare or education inflation have anything to do with the Fed.

m2 velocity

I also disagree with the perma-bear Fed hatred.

Looking at the history of recessions in the United States, recessions were more frequent and more severe before the Federal Reserve was created than after. I think this is due to a simple factor: inflation. By creating a mostly constant rate of inflation, recessions did not coincide with deflation after the Fed’s creation.

Before the Fed, price levels would shrink during recessions and rise during booms. Deflation makes recessions particularly nasty. With falling prices, consumers and businesses hold off on purchases, hoping that prices will be lower in the future. This then extends and deepens the downturn. At no time was this more apparent during the Great Depression itself.

My views on the Great Depression are informed by the work of Milton Friedman. This is pretty good explanation of what happened during the Great Depression from Milton’s point of view:

If you want to learn more about Milton Friedman’s views, he wrote two excellent books for non-economists summarizing his views:

Free to Choose

Capitalism and Freedom

Both books had a big influence on my thinking. I read them at an impressionable age in high school. For years, I could never get a coherent explanation of what caused the Great Depression. I remember asking a teacher: “What caused the Great Depression?” She told me: “The crash of 1929.” I replied: “We had a crash in 1987, why didn’t that cause a Great Depression?” No one could give me a satisfactory explanation and I’m pretty sure that the teacher thought I was an a-hole.

It wasn’t until I read Milton Friedman that I found an explanation that made any sense.

In Milton’s view, the Fed caused the Great Depression. The Fed fueled a boom during the 1920’s, but then did very little to contain the bust. They were also handicapped by the gold standard itself. They let banks fail. Their decisions and failures led to a shrinking of the monetary supply. They turned what would have been a nasty recession into a decade long Depression.

Imagine that in 2008, instead of trying to contain the collapse, the Fed let all the banks fail and let the money supply contract. This nightmare scenario is exactly what happened during the early 1930’s, and turned what would have been a nasty recession into a decade long Great Depression.

In many ways, the Fed’s handling of the 2008 crisis is the opposite of the way that the Depression was handled. If it weren’t for Bernanke’s decisive action, we likely would have had a decade very similar to the 1930’s. A decade of stagnation, 25% unemployment, soup lines, etc.

We complain about the Great Recession, but it was truly a cake walk compared to the economic horrors of the Great Depression. Charlie Munger summarizes it pretty well here:

“And of course, most of my schooling was in the Great Depression, but that means I’m one of the very few people that’s still alive who deeply remembers the Great Depression. That’s been very helpful to me. It was so extreme that people like you have just no idea what the hell was like. 

It was really there was just nobody had any money the rich people didn’t have any money. People would come and beg for a meal at the door, and we had a hobo jungle not very far from my grandfather’s house. I was forbidden to walk through a good amount, so I walked through it all the time.  

And I was safer in that hobo jungle the depths of the 30s when people are starving, practically, than I am walking around my own neighborhood now in Los Angeles at night. The world has changed on that. You’d think the crime would be less [now], but the crime was pretty low in those days.”

My grandfather grew up during the Great Depression, and I would often listen to his stories about how bad things were. It left quite the impression and I never forgot it. It was a time that was so rough that I don’t think most people today can even imagine it.

I think that the Fed and Bernanke helped us avoid the 1930’s fate. We could have wound up with 1/4 of the population unemployed. I also think that 21st century hobo-jungles would be more crime ridden than the 1930’s alternatives. Imagine the 1930’s hobo jungles with meth addicts and tents. That’s what a 21st century Great Depression would be like.

The perma-bears seem to think that the Fed should have let this all happen. In their view, we deserved a Depression as some kind of Calvinist atonement for the booms of the 1990’s and 2000’s.

I think that’s crazy.

In fact, I’m not so sure that the Fed caused the real estate bubble, which has been accepted as a truth by most people. For instance, did the Fed pass the Community Reinvestment Act, which effectively created the subprime real estate market? Did the Fed repeal Glass Steagall? Did the Fed create CDO’s? Did the Fed create the immoral collusion between the banks and rating agencies? Did the Fed create the post-internet bubble narrative that real estate was safe and stocks were insane? Did the Fed take Wall Street’s investment banks public, removing the strong risk management controls that existed during the partnership era?

Sure, 1% interest rates might have sprinkled some lighter fluid on an already raging bonfire of greed and mismanagement, but I don’t think the Fed caused the problem. It was a bubble that was brewing for decades for a lot of reasons.

The Fed certainly has made a lot of mistakes throughout their existence. They let the 1920’s bubble rage out of control. They failed to contain the effects of the bust. They were too loose with monetary policy in the 1960’s and 1970’s and caused massive inflation. They also deserve credit: Volcker and Greenspan both created an idyllic period during the Great Moderation, an era of low inflation and infrequent recessions.

The Fed tends to be the cure to and the cause of most recessions. They tend to tighten too much at the end of an expansion, causing the recession. They tend to loosen too much, leading to inflation and imbalances in the economy. Despite this, I think on the whole they have been a positive influence, and I think the history of US recessions confirms this.

Nor do I think bubbles are caused by the Fed. Bubbles are caused by human nature. The Fed might push it along, but there isn’t any government policy that will stop bubbles. People will always get excited about new narratives and that will always cause bubbles. Bubbles are a feature of the human race. We had bubbles before the Fed was ever created and we’ll have bubbles until the end of civilization.

Gold’s Terrible Track Record

Not only do I have disagreements with the perma-bear messengers of doom, but the data agrees more with Warren Buffett’s assessment of the asset class than Ron Swanson’s: gold is an asset with no margin of safety and no cash flows. It’s simply a bunch of volatile price action.

Ron Swanson: my favorite gold bug

Since 1980, for instance, we can compare the performance of both financial assets in simple terms. Since 1980, stocks have delivered a 11.38% rate of return, turning $10,000 into $746,067. Meanwhile, $10,000 invested in gold delivered only a 2.59% return, turning $10,000 into $27,757.

This even obscures the story a bit. While gold delivered a positive return over this 40 year period, all of the return was captured in one time period: an epic move from the lows in 2000 to a high in 2012. Around the time that gold coins began to be sold on Fox News aggressively, the gold market peaked.

Meanwhile, shortly after Paul Volcker decimated inflation in the early 1980s, gold went through a 61% draw-down from 1980 through 1999 while stocks ripped into an extraordinary bull market.

The greatest period of time for the gold market was the 1970’s. During the 1970’s, when inflation ravaged every other financial asset, gold delivered a 28% CAGR and turned $10,000 into $163,717.

What caused gold’s ascent during the 1970’s? Inflation is one key cause. Another is Nixon’s end to the gold standard in the early 1970’s. Until the Nixon shock, gold could be converted to dollars at a pre-determined price. This effectively amounted to price controls imposed by the federal government. When the link was severed and gold was allowed to float freely, the price skyrocketed after being unnaturally suppressed for decades.

These events also finally made the dollar into a fiat currency, a concept which has melted the brains of so many interested in permanent bearishness. For Boomer perma-bears, many have embraced the goldbug mantra. Crypto-fanatics are the Millennial’s answer to the perma-bear, a group that is equally maddened by the concept of fiat currencies.

So, in additon to the solid arguments or Warren Buffett, the fact that I don’t believe gold has any margin of safety, and my dismissive attitude towards the arguments of perma-bears and anti-fiat cranks, I’ve dismissed gold.

Rethinking My Position

While I haven’t changed my fundamental point of view about gold and perma-bears, I have been re-thinking my aversion to owning gold in a portfolio.

While gold on its own may be a bad asset to hold, that doesn’t mean that it can’t work effectively in a portfolio with other assets as a risk management tool.

One of the really nice things about gold is that it tends to do well when stocks are doing poorly. In addition to the 1970’s and 2000’s, gold also did very well during the worst years of the Great Depression, rising from $20.78 to $35 from 1929 through 1934. When the world looked like it was ending during those dark times, people began to hoard onto physical gold as a way to deal with the calamity.

The effect that gold hoarding had on gold-backed USD led FDR to implement Executive Order 6102. The order effectively outlawed the “hoarding” of gold and forced people to exchange their gold for a low price of $20.67. This was later amended via the Gold Reserve Act of 1934, which changed the convertibility of the gold price to $35. This was effectively a devaluing of the US dollar and was used to alleviate the effects of the Great Depression.

This arrangement and system of price controls was further solidified by the Bretton Woods agreement, which pegged all currencies to the dollar and pegged the dollar to gold at a conversion rate of $35. This amounted to government controls on the price of gold. When Nixon finally lifted those price controls and eliminated the convertibility of dollars to gold, the gold price raged out of control.

Anyway, to make a long story short: gold does really well when stocks are doing poorly. This means it may deserve a place in a portfolio. Gold’s best decades were during the 1930’s, the 1970’s and the 2000’s, which were the worst decades to own stocks.

Much of the price action in gold has been driven by the legal maneuvering of the US government, but there seems to be an innate tendency of investors to flock to the safety of “hard assets” when the world looks like it is going to hell.

These characteristics makes gold an interesting component to a portfolio.

Gold In a Portfolio

Let’s say that the price action of gold in the 1930s was a fluke because the government used gold as a way to manage the value the dollar. The price action in the ’30s was a fluke caused by the Depression and Roosevelt’s efforts to contain it. The price action of the ’70s was due to the final lifting of decades of price controls on gold.

That’s why I think 1980 is a decent starting point to think about the price of the gold. Since 1980, gold has performed terribly, as discussed earlier in the blog.

However, in a portfolio, it adds some benefits, mainly due to the fact that it is so uncorrelated with US stocks and does well during bad periods for US stocks.

Let’s look at a really crazy portfolio: 50% US stocks, 50% gold. The two assets together interact with each other in a beautiful way, reducing volatility and drawdowns. Here is the result since 1980:

portfolios

On its own, gold is a terrible thing to own. It had a horrible 61% drawdown over a 20 year period. It delivered only a 2.59% CAGR over four decades.

However, if you add it into a 50/50 portfolio with stocks, and you get a pretty decent portfolio. Volatility is reduced. Max drawdowns are reduced. It then delivers a decent rate of return of 7.66%.

Looking at my own asset allocation, I’ve compared what would happened if I replaced my 20% allocation to TIPS with a 20% allocation to gold. It significantly improves the results.

vsggold

Not only does it improve the results of the portfolio, but I believe that it reduces the risks. Currently, 40% of my portfolio is tied up in treasuries. Treasuries, particularly long term treasuries, are the best asset to own in a portfolio when markets are in trouble.

But – does it make sense to have 40% of my money in one asset class?

What if the perma-bears are right, even temporarily? What if rounds of quantitative easing cause hyperinflation? For instance, what if all of this money creation over the last decade has created a forest of dried out wood? If money velocity picks up, that could cause a forest fire of hyperinflation.

What if US government bonds are not a truly safe haven asset? Looking at the balance sheet of the US federal government, I certainly think there is a danger. Does it make sense to have 40% of my money invested in something tied to the solvency of a spendthrift government that has no plans to implement any discipline?

I think gold can be an effective way to hedge against these risks. If these risks turn out to be nothing, then 80% of my portfolio is geared towards a “normal” view of the world and I’ll do okay. Gold has historically kept up with inflation and risen during periods of strife, so they will work effectively in a portfolio. If we do have an economic disaster – gold should do extraordinarily well and 20% of my portfolio will further help me sleep at night.

It seems logical that people will continue to flock to gold as a safe haven when the global economy is in turmoil. If the perma-bears are right and the Fed unleashes hyperinflation, it’s difficult to imagine how gold wouldn’t do well in that environment. If the perma-bears are right and the US government deficit finally blows up, then it’s difficult to imagine how gold wouldn’t do well. It’s also hard to imagine why gold wouldn’t be a stabilizing force in the event of a sharp reduction in stock prices.

Conclusion

I think I have been wrong about my aversion to gold. I think I confused my disagreement with the messengers to an aversion to the entire asset class, which is effective at reducing risk and volatility within a portfolio.

I think gold can function well in a portfolio. It can also help an investor sleep at night, knowing that they will hold something that will retain value even in nightmare scenarios like hyperinflation, a Communist take over, or the global economy going to hell. It can provide piece of mind and it can help diversify a portfolio, reduce volatility, and reduce risk.

Random

This is a fun song.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

2019: A Year In Review

returns

Performance

After miserably under-performing in 2017 and 2018, I had a somewhat decent year and slightly exceeded the performance of the S&P 500. For an outline of my complete strategy, you can click here.

I launched this blog and set aside this chunk of my IRA in late 2016. It has been a fun ride.

I wanted to use this account to systemically follow my own version of Ben Graham’s “Simple Way” strategy and keep a live trading journal.

I also figured I’d buy net-net’s when they were available. There haven’t been many that I could find in the last few years, with the exception of Amtech (which I took one free 50% puff from), and Pendrell (which I roughly broke even on). I’m anxiously awaiting a time in which I can buy a lot of cigar butts. For now, I’m buying Simple Way stocks: low debt/equity, low P/E’s, low enterprise multiples.

Every trade has been recorded when it happens on this blog and I’ve also posted my rationales for when I buy a new position.

I thought this blog would be something different. Most of the investing blogs I found included a lot of talk about discipline, about how to find the companies, and even had write ups for new positions.

Few of the investing blogs out there showed a real person’s portfolio. Few showed when they buy,  when they sell, and show the outcome. I wanted this to be a live trading journal with all the failures and all of the successes, for all to see. I wanted to show the real, long, lonely, grind of active value investing for a normal person. I wanted this to be something different.

When I set out to do this, I wrote: “A key thing to keep in mind is that while these methods succeed over the long haul, there are periods of time when they do not work. I hope this blog will help me remain disciplined and focused on my own value investment journey.”

The last three years have certainly been a test of my discipline and that of most deep value investors. For deep value investors, this has been a particularly grueling slog.

For many, it has been tempting to stray. There are plenty of “value” investors who went out and bought a bunch of compounders with 200 P/E’s and cited See’s Candy and some Munger mental models as the reason for the style drift.

“Hey, even Buffett paid up for a good business! That’s why I’m buying Amazon and Facebook!”

“Yea dude, you’re just like Buffett in the ’70s. He really threw caution to the wind when he bought See’s at a P/E of 5 and less than sales . . . but hey, it wasn’t a net-net.”

They have been rewarded for their style drift. Over the long haul, I think they’re going to suffer the same fate as those who bought the Nifty 50 in the early ’70s and tech stocks in the late ’90s, but we shall see.

I digress. This year’s performance is an outcome that pleases me. It wasn’t much out-performance, but hey, a win is a win.

Value’s Underperformance Continues

pain

Clubber Lang explains deep value investing

My performance this year has been especially pleasing because 2019 was another year when value under-performed the broader market.

My style is closely aligned with small cap value, and here is how this year’s small cap ETF’s performed:

VBR (Vanguard Small-Cap Value) – Up 22.77%

SLYV (SPDR S&P 600 Small-Cap ETF) – Up 24.26%

They didn’t do badly. Over 20% returns are excellent. Unfortunately, in relative terms, they didn’t do as well as the S&P.

Looking at the universe of stocks with an EV/EBIT multiple under 5 in the Russell 3,000, they are currently up a measly 12.7%.

The total return of the EV/EBIT<5 universe doesn’t even tell the whole story. In early March, this group was up over 20% after a massive rally. The rally then fell apart completely, and the group suffered a face-ripping 24% drawdown. The market gods made us feel hope, and then punched us in the gut.

Earlier this year, the under-performance was even worse than 1999. It rebounded a bit at the end of the year, but it’s still a staggering level of under-performance. Deep value is suffering its worst slog since the late ’90s, and 2019 year was quite similar to 1999.

cheapobucket

So, while I matched the performance of the S&P 500, I outperformed most value strategies. Why was this the case?

The reason, I think, is that I had a high turnover at the right time. We’re all taught by Buffett that high turnover is wrong, but it helped me this year. When positions reached a decent value, I sold them. With the massive rally this year, that happened a lot sooner than I originally anticipated. I was usually right (Gap) but I got out of some stocks way too early (I’m looking at you, UFPI).

I also finally exited my long suffering Gamestop position once their private equity dreams were dashed. I got out at $11.45, which looks like it was a good move, as the stock is now down to $6.08.

I’m also the guy who bought Gamestop (twice!) at an average price of $24, but I take consolation that it could have been worse.

Here are all of the positions I sold this year:

closedyearend

Yes, that’s a lot of turnover. It’s very un-Berkshire.

I’ve long wondered if I’m adding anything to a value strategy with my stock picking and trading. This year, at least, it looks like it paid off. I avoided a significant drawdown for value and still enjoyed the Q1 and Q4 rallies.

I’ve held a significant amount of cash this year, after being all-in and 100% invested when the opportunity was rich a year ago.

I sold positions when they moved to my estimate of their intrinsic value, or when my thesis fell apart (Gamestop), or when the companies started to undergo significant operational slip-ups. My selling intensified after the yield curve inversion, as I thought the likelihood of a recession was higher. Market sell off’s then occured over developments in the trade war (not recession concerns), but I avoided some big drawdowns even though my rationale was wrong.

After being nearly 50% cash earlier this year, I gradually bought and scaled into positions that I thought were cheap.

This quarter, I purchased five new positions. The positions and corresponding write-ups are below:

  1. Movado
  2. National General Holdings
  3. Prudential
  4. Principal Financial Group
  5. RMR Group

A Tale of Two Decembers (Macro Stuff)

If you don’t care about my Macro views, you can skip this section

This December and last December are opposite images of each other.

The best way to represent this is CNN’s Fear and Greed index.

feargreed

Right now, the index is at 93, indicating “extreme greed.” A year ago, we were a level of 12, or “extreme fear.”

Mr. Market is one crazy lunatic.

bigtrouble

What changed fundamentally to cause this emotional swing? Nothing. The only difference is the price action and how everyone feels after a great year for stocks.

Last year, I was bullish. Cheap stocks were plentiful. On Christmas Eve 2018, I felt like Santa gave me an early Christmas present, as there were nearly 100 stocks in the Russell 3k with an EV/EBIT multiple under 5. It was the best opportunity set we’ve had in 5 years. Meanwhile, the yield curve was not inverted (it had only flattened, and only longer-dated maturities were inverted), so I knew that the odds of a recession in the next year were minimal. It seemed to me to be a great time to go long, and that’s what I did. At the end of last year, I was 100% invested and quite excited.

Right now, I’m quite bearish. The 3-month and 10-year yield curve have inverted this year. Meanwhile, bargains are less plentiful.

I believe that the yield curve is a proxy for how tight or loose monetary policy is, which is why the yield curve is a forward-looking indicator for the economy. The eggheads say that the yield curve doesn’t matter, and this time is different – but those are the same lines we heard after the last two inversions. I’ll take the easy rule that works every time over the expert opinions of the eggheads.

The yield curve inverted after four years of the Fed tightening monetary policy.

yieldcurve

The eggheads assure us that this is nothing to worry about.

The Fed was raising rates for four years and finally reversed course this summer. They then started cutting the balance sheet in early 2018.

My view that the Fed was too restrictive is perplexing for many involved, especially the Fed haters who believe that the Fed was too loose with policy. After all, how can the Fed be too restrictive when interest rates are so historically low?

The yield curve tells a different story. The yield curve indicates that monetary policy was too restrictive. It seems insane, but one also needs to look at the velocity of money, an important and often ignored component of the overall monetary picture, best expressed by the classical equation, MV=PQ.

When velocity is low – as it has been since the GFC – seemingly low interest rates can still be restrictive.

velocity

Money velocity plummeted after the GFC and never recovered. This is why I think an ultra-accommodating monetary policy didn’t cause hyperinflation as everyone feared (myself included) and the fears were best expressed by this 2010 viral cartoon.

I think that four years of monetary tightening were restrictive and baked a recession into the cake.

Shortly after the Fed inverted the yield curve, the Fed started cutting rates over the summer. In September, they began to increase the size of the balance sheet again. The Fed is now in a loosening mode, which markets have interpreted as a bullish signal.

The discussion around the yield curve is quite funny. Historically, a yield curve inversion predicts a recession roughly a year or two ahead of time. The attitude of most market participants is ridiculously short term and seems to be “the yield curve inverted, and the market went up for a few months. Therefore, it’s nothing to worry about.”

I think this year’s Fed easing is too little, too late. The markets are rallying just because the Fed is loosening policy, and investors believe we will avoid a recession. The yield curve has un-inverted and is steepening, implying that monetary policy is now accommodative. Unfortunately, I think that the Fed shifted to accommodation too late in the game.

This is what usually happens. The Fed always begins loosening policy before the recession arrives, and it is always too little, too late.

In the last cycle, the Fed began cutting rates in the summer of 2007. By the end of 2007, after multiple rate cuts, the yield curve steepened. Markets hit their peak in the fall of 2007. As we now know, we were not out of the woods in late 2007. We were only at the beginning of the pain.

During the tech boom, the same thing happened. The Fed started to cut rates at the end of 2000 and un-inverted the yield curve. We still had a recession in 2001, with the stagnation that lingered into 2003.

There is always a lag between a shift in monetary policy and the impact on the real economy. The Fed began loosening policy in mid-2007. The economy didn’t start to rebound until mid-2009. The Fed started tightening its policy back in 2004, and the recession didn’t start until the end of 2007.

There is always a lag between monetary policy and its impact on the real economy.

I think the same outcome is likely this time. We haven’t seen the full impact of the tightening that occurred from 2015 through 2019. Similarly, we probably won’t know the effect of the recent loosening of policy for a couple of years.

The length of a yield curve inversion also correlates to the length of a recession. The last yield curve inversion lasted from mid-2006 to late-2007. The recession lasted from December 2007 to the summer of 2009.

This inversion lasted for five months, from May through October this year. The length of the inversion implies we’re in store for a roughly 6-month recession. I think this means we’ll have a relatively mild recession. It will be a recession that is more like the early ’90s and early 2000s recession than it is going to be like the last, big, bad, 2008 debacle.

To summarize: I think we’re going to have a recession. I also don’t think it’s going to be as bad as 2008.

The Bigger They Are, The Harder They Fall (More Macro)

Again, skip if you don’t care about my opinion on Macro stuff.

Unfortunately, a “mild recession” doesn’t necessarily mean we’re going to have a mild bear market. The early 2000s recession (in which unemployment only peaked at 6.2%) led to a 44% drawdown in the market.

The extent of a big drawdown tends to be a combination of the severity of the recession and the extent of the overvaluation. That’s why a frothy market can drawdown severely when faced with minor economic turbulence.

In other words, the bigger they are, the harder they fall.

Before the 2000 drawdown, the market represented 146% of GDP. The massive overvaluation at the time is why such a minor recession was able to cause such a significant stock drawdown. It’s sort of like how a bubblicious stock can completely disintegrate when reality is only slightly off from the market’s lofty expectations.

Compare this to the early ’90s recession. The early ’90s recession was relatively minor, similar to the early 2000s. The increases in unemployment during the early ’90s recession were nearly identical to the early 2000s event. However, unlike the 44% drawdown in the early 2000s, in the early 1990s, the market only suffered a 16% drawdown. Why was the drawdown so minimal? Simple: valuations weren’t as high in the early ’90s. The market cap to GDP was only about 59%.

In contrast to the minor events of the early ’90s and early 2000s, the 2008 recession was the most severe recession since World War II. The market was frothy, but it wasn’t quite at 2000 bubble levels. We suffered a 50% drawdown. The 2008 drawdown happened because of the severity of what was happening in the real economy. It was not entirely a response to overvaluation in the stock market, which is what happened in the early 2000s.

I think that if we had the 2008 recession at 2000 valuations, then the early 2000s meltdown would have been much more severe. We likely would have gone into a 60% or 80% drawdown, rivaling the Great Depression. We lucked out in the early 2000s by having a relatively minor recession.

This year we crossed an important milestone. The market cap to GDP exceeded the previous bubble in 2000. In 2000, we peaked at 146% of GDP. The market currently trades at 153% of GDP.

The same is true on a price/sales basis. The market is the most expensive it has been in history. The S&P 500 currently trades at 235% of sales. At the peak of the 2000 bubble, we were at 180%.

Another great metric is the average investor allocation to equities. Currently, that’s not quite at 2000 levels, but it’s still pretty high. Keep in mind that this chart ends in Q3. It’s probably higher now, probably around 44%.

Using the equation I described in an earlier blog post, the current investor allocation to equities suggests a 2.3% real return for US Stocks over the next decade. If history is any guide, that’s a 2.3% real return that will probably have a 50% drawdown somewhere in there.

For US stocks, the 2020s is not going be anything like the 2010s.

average

Earnings-based metrics look a little better. The TTM P/E is about 24. The CAPE ratio is 31.

Of course, the problem with earnings-based metrics for macro valuations is that they are based on a cycle where profit margins have been exceptionally high. Margins are likely to mean revert. Margins have also been boosted by leverage. Forward P/E’s don’t look insane, but forward P/E’s are a notoriously unreliable indicator.

margins

Profit margins have remained high over the last decade. Bulls will say that this is a new era. I think that this is likely to return to historical norms.

There are plenty of people who say, “this is a bubble, but it’s not as bad as the late ’90s.” They usually cite the fact that this bubble hasn’t included a bunch of money-losing dot com IPO’s. To which I say: so what? We’ve had similar insanity in initial coin offerings and money-losing venture capital moonshots. Last time we had Pets.com. This time, we have WeWork, Theranos, and fake electronic currency. No bubble is exactly the same, but they’re all bubbles and they all end in tears.

What Does This Mean for Value?

In the early 2000s, value stocks did well, while the broader market went down. If we’re lucky, the same will happen again.

Unfortunately, we probably are not that lucky. Once the broader market goes down, value stocks usually go down with it. The outperformance often happens in the early stages of an economic recovery. It’s also possible that value stocks will decline by less than the broader market.

I think value investors are in store for a significant drawdown, just like index investors likely are. We’ll just have to wait and see.

I’m preparing for this situation by holding onto cash when I can’t find bargains, rather than making an outright bet that we’re going to have a recession by going short or buying a massive amount of long-term treasury bond ETF’s.

Earlier this year, I purchased CDs that matured in December and yielded 2% on average. When they all matured this month, the market was even pricier than it was before that, which was disappointing.

Cash is King

Fortunately, a positive development occurred before my bank CD’s matured in December. My broker eliminated commissions.

The elimination of commissions made cash equivalent short term bond ETF’s more appealing to me. Before commissions were eliminated, it seemed foolish to buy a cash ETF for a commission, and then gradually exit the position and pay a new commission each time. That was almost certain to eat into even the paltry interest that I was receiving.

The commissions would eat into any interest I earned on the cash. With the elimination of these commissions, cash ETF’s are now a viable option for me. The removal of commissions is why I purchased NEAR, a cash ETF from iShares, with a TTM yield of 2.6%.

Currently, I am 20% cash. My approach to this environment is simple: I’ll buy cheap stocks when I find them and I’ll hold cash when I can’t. Hopefully, I’ll still get solid exposure to the value factor and limit my drawdown in the next recession.

Random

In 2019, I wrote some blog posts that I am pleased with, including:

Here is some random ’80s:

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

Q3 2019 Update

Performance

q3

My performance has essentially matched that of the S&P 500 year to date.

In Q2, I moved to nearly 50% cash after many of my stocks hit my estimate of their intrinsic value and a few of them exhibited some operational declines (bottom line earnings losses, major declines at the top of the income statement).

I was also spooked by the yield curve inversion. I’m still spooked by the yield curve inversion. I believe a recession is coming and I suspect a lot of my highly cyclical stocks will suffer in this event, hence the fact that I’m trigger happy to sell.

At the same time, I feel compelled to go where the bargains are, so I continue to own these cyclical names. I realize that P/E can be misleading at the peak of an economic cycle, as the E reflects peak earnings. With that said, even when I look at some of these stocks on a price-to-book or price-to-sales basis, some of them trade at levels they last experienced in 2009. It’s like the recession is already priced into them. The prices don’t make sense, therefore, I feel the need to own them.

Here is a breakdown of the current valuation metrics on some of my cyclical names. They seem absurdly cheap to me, which is why I own them even though I have a fairly grim assessment of the macro picture right now.

psales

The compromise I’ve settled on in this environment is to sell aggressively when the companies reach my conservative estimate of their value or when they experience an operational decline, all while holding cash instead of remaining fully invested.

Be Fearful When Others are Greedy

Warren Buffett likes to say “be greedy when others are fearful, and fearful when others are greedy.” That’s a great saying, but it’s one that is hard to implement in practice. Buffett also advises against timing the market, but this quote is implicitly a market timing suggestion. To be greedy when others are fearful, you need to actually have cash on hand to buy from the fearful. To be fearful when others are greedy, you actually need to sell to the greedy people. If your investment philosophy is buy-and-hold no matter what, then I don’t see how you could implement Buffett’s advice.

Buffett’s advice to not time the market also flies in the face of his own actions. Berkshire currently has $122 billion in cash. This is market timing. Buffett will say that it’s not timing and there aren’t any large deals or bargains that he can buy. The truth is that there aren’t any large deals or bargains because we’re at the peak of an economic cycle and people are overpaying for good businesses.

Buffett knows this. A good example of his knowledge on this subject is his speech at Sun Valley in 1999, which you can read here. He gave this speech during a time of buoyant optimism about the stock market. I was only in high school, but I remember clearly that every restaurant always had a TV tuned to CNBC, as a parade of “analysts” hyped up their latest bubble pick of the day. It’s the reason I became interested in the market in the first place at an early age. Buffett challenged the euphoria and boiled down his analysis to cold, hard facts: the direction of the stock market depended on how much corporate America could scoop up in profits from the US economy, how the market valued these companies relative to the size of the economy, and the direction of interest rates.

As a valuation metric, Buffett discussed US stock market capitalization to GDP, which was at all time highs back then. Right now, we’ve exceeded the previous late 1990s high. It certainly seems to me to be a good time to be fearful when others are greedy and keep some cash on hand to take advantage of a downturn.

I think Buffett is reluctant to directly criticize present valuations because of his stature in the markets. His words could cause a stock market crash. He’s a lot more famous now than he was in 1999, after all.

market cap to gdp

Value’s Wild Ride

The move to cash turned out to be an opportune one. Shortly after this occured, value was crushed in Q2. Vanguard’s small cap value ETF (VBR) suffered a 8.13% drawdown. SPDR’s S&P 600 small cap value ETF (SLYV) suffered a 9.92% drawdown. Finally, QVAL, one of the most concentrated value ETF’s suffered a 13.99% drawdown.

I avoided much of this drawdown, which is why I’m doing better than the value ETF’s year to date. This is why matching the performance of the S&P is a decent outcome this year.

With that said, I probably got lucky. The market sold off over worries of the trade war, not an imminent recession. Whatever the reason, I’ll take the outperformance over other value strategies.

Year to date, VBR is up 14.55%, SLYV is up 15.23%, and QVAL is up 12.70%.

Of course, this year to date performance obscures some of the tremendous volatility that occurred this year.

Below is the performance of these three value ETF’s for the past year:

value

As you can see on the chart, in early September there was a major move that benefited cheap investors.

I am currently 80% invested, but I also took part in this swing. My portfolio had a 9.5% swing in value from the August lows to the September peak.

I have no idea what caused the move. This could be turn out to be a head fake. A similar move occurred in late 2016 after Trump won the election, as investors anticipated a big infrastructure bill and tax cuts (Oh, we were so young), which was supposed to benefit more cyclical cheap stocks.

Trading

I sold two positions this quarter.

  • Twin Disc (TWIN) – I exited this position with a 34.29% loss after they reported a loss and it looked to me like the business was deteriorating. I exited the stock at a price of $10.0608.
  • Winnebago (WGO) – I am trigger happy to sell cyclicals once they hit a reasonable price. I sold Winnebago at a price of $39.8777 for a gain of 21.31%. This was around the price that Winnebago traded at last summer before the declines in Q4 2018. Once the market began worrying about a recession in Q4 2018, the stock dropped down to $24. Now that the stock is back to where it was when there was a “healthy” economic outlook, I got out of it.

I bought a few positions this quarter. Below are the companies and links to my reasoning for why I bought them.

  • Bank OZK. A regional bank trading below book value.
  • Insight Enterprises. A fast growing tech company at a cheap valuation.
  • Domtar. A stable, boring, mature, company with a single digit P/E and a 5.2% dividend yield.

Macro

I still have nearly 20% of my portfolio in cash and CDs that mature in December, when I conduct my annual re-balancing of the portfolio.

Despite the recent stock rally, the yield curve remains inverted. This is a signal that predicts every single recession. Each time, we’re told it doesn’t matter. All of the talk about why the yield curve doesn’t matter strikes me as wishful thinking. I’m guessing that the rule works better than the analysis of the talking heads who tell us it doesn’t.

My thinking about the yield curve is quite simple: it’s a measure of how accommodative or loose monetary policy is. Monetary policy is the key determinant of the direction of the economy.

A steep yield curve tells you that the Fed is pouring stimulus into the economy and the markets. It is a poor idea to fight this and take a short position in the markets when that is going on. Meanwhile, an inverted yield curve tells you that the Fed is too tight with monetary policy and the economy is likely to contract.

What complicates the yield curve as a forecasting tool is that there is a significant lag between the direction of monetary policy and the direction of the economy. After a yield curve inversion, it can take 2 years before the recession begins. The same is true for expansions and a very steep yield curve. The Fed begins accommodating at the first signs of a slowdown. Usually, by the time that they begin loosening, it is already too late. It takes a year or two for their stimulus to begin affecting the actual economy. The Fed was already ultra accomodative in 2008, for instance, but it was too late and the recovery didn’t begin until the second half of 2009, about a year and a half after they started cutting interest rates.

Adding further confusion to this is the fact that the market anticipates moves in the economy before they actually occur. This is why the market began rallying in March of 2009 while the economy was still mired in a recession. It’s also why the market began declining in late 2007 when most observers thought the economy was strong.

3month.PNG

The Fed recently cut by another quarter of a point. Some criticize this move as the Fed trying to prop up the markets. Well, of course they are. There isn’t anything wrong with the Fed trying to use market signals to get ahead of a recession. I think that the Fed is also responding to very real data and economic weakness.

I also think that the Fed is likely not cutting enough, which is why the yield curve is screaming at them to be more aggressive.

In fact, while the Fed was talking about loosening policy since December, they were in fact still cutting the size of the balance sheet. They only recently began increasing the size of the balance sheet in September of this year.

fed balance sheet

I listened to a great podcast recently with Cam Harvey and Meb Faber, which you can listen to here. Cam discovered the yield curve tool as a recession forecasting mechanism in the 1980s and discusses why it is a robust indicator.

The market remains fixated on Trump tweets and the trade war, but I think the real story is an emerging US recession. A US recession seems perplexing to everyone involved in the US economy because the US economy looks so strong. Well, it always looks strong at the top.

Meanwhile, declines in the unemployment have flattened. Once the unemployment rate shifts and begins increasing, a recession is imminent. That hasn’t happened yet, but it appears to be flattening. This is typically not a good sign.

unemployment

This might sound crazy when interest rates are this low, but my belief is that the Fed is currently too tight. A nice, simple, way to look at monetary policy is the equation of exchange, MV=PQ. Everyone has scratched their head for the last decade as quantitative easing and ultra low interest rates haven’t fueled a rise in consumer inflation. The explanation is revealed in the equation of exchange. For money creation to result in high inflation, the velocity of money needs to be in a healthy condition. The fact is that money velocity has plummeted since the Great Recession and has not picked up. Low velocity means that monetary policy can be very accomodative without creating inflation.

velocity

It’s really hard for money creation to stoke inflation when people aren’t actively spending the cash at the same levels that they have in the past. This is why I think that even though interest rates look like they are absurdly low, the Fed is actually too tight and they are going to push the economy into a recession.

The Great Question

The great question for value investors is whether this will shake out like the early 2000s or every other recession.

The fact of the matter is that value stocks have under-performed the market throughout this expansion, just as it did in the 1990s. In the 1990s, money poured into hotter, more promising areas of the market and these boring stocks were left for dead.

Eventually, everyone collectively realized that the tech bubble was insane and capital shifted into cheap value stocks. This created a unique moment where cyclically sensitive value stocks increased while the broader market declined, because the broader market was dominated by large cap tech names that were deflating to more normal valuations.

declines.jpg

Value’s wonderful early 2000s run was aided by the fact that the early 2000s recession was so mild. The actual businesses of value stocks continued to generate earnings and profits, so it was easy for these stocks to mean revert. In more serious recessions, like 2008 or the 1973-74, many of these cyclical businesses were undergoing serious problems, which is why the stocks were crushed during those recessions.

A good way to measure the severity of a recession is to look at the maximum unemployment rate. Unemployment peaked at only 6.3% in 2003. In contrast, during the expansion of 2010s, unemployment reached 6.3% in 2014, when we were far along into an expansion.

Right now, we have one ingredient for a value resurgence: value is ridiculously cheap relative to growth. Growth proponents will argue that this is nothing like the ’90s expansion. They cite trashy firms like Pets.com and the money that poured into money losing IPOs. Surely, you can’t say that Netflix is anything like those trashy dot com stocks.

I disagree. I think this moment is a lot like the 1990s. First of all, the 1990s bubble wasn’t restricted to trashy IPOs. It affected large cap names of all stripes, including quality companies like Coca Cola and Microsoft. Earlier, this quarter, I tweeted this out to demonstrate:

spy

It wasn’t all trash. There were bubbles in industrial conglomerates, quality big box retailers, computer hardware manufacturers. The bubble was in large cap quality stocks. Coca Cola even reached bubbly levels back in 1998, around 40x earnings.

You couldn’t get higher quality than General Electric back in 2000, and yet it was ridiculously overvalued and this fueled its decline. It fell from a peak of $50 a share down to $25. In the current era, there isn’t any disagreement that companies like Amazon and Facebook are incredible. That doesn’t mean that they’re not overvalued.

In the 1990s and the 2010s, investors who ignored valuation and simply bought up the best companies have been rewarded. Compounder bro’s are the darlings of the moment. They paid a price in the early 2000s bear market and I don’t see why history won’t repeat itself.

Meanwhile, just because there aren’t a lot of insane IPO’s flooding the market, it doesn’t mean that this market is without insanity. I think the crypto craze is a good example of a classical bubble invaded by charlatans of many different stripes. The venture capital world also appears to be in an insane state. After some early successes in this cycle, they have been gambling on anything that promises to “disrupt” something. At this point, you could probably score capital if you promised to disrupt the soap market. Ali G could probably secure financing for his ice cream glove. It appears that the glow around angels and venture capital is starting to fade, as demonstrated by the recent difficulty with the WeWork IPO. On Twitter, VC’s are fuming that public markets actually care about things like earnings and cash flow. It’s funny to watch. I also can’t roll my eyes any further into my head.

Bears are treated like they are absolute morons, which is how they were treated during the 1990s bubble. Back in 1999, bears all universally looked stupid after being wrong for a such a long and fruitful economic expansion. When the bear market was actually imminent, they were the boy who cried wolf and everyone ignored them.

I think the mistake that bears made is that they thought this market would pop on its own from the weight of valuation. The fact is that a bubble needs a needle to pop, a catalyst. There hasn’t been a catalyst to end the insanity for a long time. I think one is coming, and it’s in the form of a recession.

I think it’s inevitable that this bubble will pop, and value will likely outperform growth over the next decade and valuations mean revert to more normal levels. While growth stocks will return to a normal valuation, multiples will continue changing in the value universe, which is what fuels the idiosyncratic return of value strategies. My thinking for a long time is that this will be more like the 1970s than the 2000s. Value will get crushed, but not as badly as the bubble names, and will then do nicely once the economy begins expanding again.

In the 1973-74 debacle, value was crushed because the economy was crushed. Meanwhile, the Nifty Fifty (the bubble names of that era) were crushed even more because the were so ridiculously overvalued. I think this is likely to happen again.

If the next recession is mild, like the early 2000s, then value will likely have a similar experience. If this recession is severe, like 1973-74 or 2008, then value is going to suffer a decline with everything else. I don’t know which outcome is going to happen, but I think that the 1970s experience is more likely.

We’ll see.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

Q1 2019 Update

return

I had a good quarter. I gained 15.74%, which compares to the S&P 500’s total return of 13.5%.

For the last few years, I’ve done a major rebalance in December and then usually did absolutely nothing in the first quarter. This year, the market move and company specific events compelled me to sell some positions, and with the cash I established some new ones.

Sales

Gamestop – After two years of waiting in Gamestop for the company to be bought out,  Gamestop announced they were going to stop trying to sell to a private equity firm, dashing all of my hopes. The major source of Gamestop’s cash flow is the re-selling of old video games and system platforms. This is a dying business as more video game consumers will download games directly and purchase platforms online. With that said, I think the business will be around longer than the market thinks. This is why about 4 years of Gamestop’s business could pay for the entire company. While the business is  in decline, this cashflow has value if Gamestop plays it correctly. My hope was that an acquirer would see this value, because Gamestop itself seems to be blowing the dwindling cash on dividends.

Looking back at this debacle, I likely should have sold this after the first accounting loss a year ago and admitted defeat. I also foolishly doubled down on the position in 2017. This is usually a bad idea. I lost 52% on the stock.

Sanderson Farms – I sold Sanderson Farms after an operating loss. At the moment, this looks like a mistake. The stock is now up to $130/share from my sale price of $115/share. Sanderson is a great company, but I try to sell when my positions approach a rich valuation, even if I like the business. A higher valuation plus a top line loss compelled me to sell. I made 16.6% on the position. I will likely return if the stock becomes cheap again.

ProPetro – I made 45.33% on this position in a very short time. I purchased this in December, and I thought the uptick was absurd, so I sold. Since then, it has gone higher.

Gap – Gap announced on March 1st that they were going to split the company up into a “good company” (Old Navy) and a “bad company” (all of the mall retailers). The stock soared on the news very quickly in one day. This made no sense to me, as current shareholders still own the same thing. I thought the increase didn’t make any sense, so I sold for a 19.76% gain. This looks like it was a good trade, as I sold at the top after the surge and the stock has steadily declined since then.

Thor – Thor reported terrible results and I sold the stock because of the deteriorating fundamentals. I sold the stock for a loss of 38.27%.

Aaron’s – Aaron’s reached a 52-week high in March, and the valuation increased significantly, so I sold the stock for a 29% gain.

Buys

With all of the unexpected cash from my sells, I purchased some brand new positions. The new positions are listed below with links to my rationales.

  1. Louisana Pacific
  2. Hollyfrontier
  3. Winnebago
  4. Urban Outfitters
  5. Express

I also expanded my position in Nucor.

The Value Opportunity

In the fall of last year, Mr. Market’s temper tantrum created a high number of bargain stocks, which is historically an excellent sign for value stocks. More bargains typically result in higher returns.

In December, the number of cheap stocks in the Russell 3,000 peaked at 108 stocks. My definition of cheap is an EV/EBIT multiple under 5.

The below chart, which I put together back in 2017, breaks down the number of cheap stocks in the market and the subsequent return they delivered over the next calendar year.

Generally speaking, a higher quantity of cheap stocks tends to result in higher returns for this group. It means that the “cheap” stocks are unusually cheap, giving them a long runway to expand their multiples and substantially increase in price.

cheap

2000 and 2001 stand out as years of substantial outperformance for value. The indexes suffered declines as the tech bubble deflated, but value performed exceptionally well. This is because the cheapest stocks were cheap on an absolute basis after being overlooked during the mania of the late ’90s and their multiples expanded despite the carnage in the broader market.

I noticed that the situation at the end of 2018 was similar to 2000, a year which delivered epic outperformance for value investors. There were over 100 cheap stocks in the US market and, as the yield curve had not yet inverted, it didn’t seem likely that we were going to have a recession.

The market delivered on this faster than I imagined. December was a time when investors needed to strike while the iron was hot, as the opportunity came and quickly dissipated. As a group, the number of cheap stocks went from 108 on Christmas Eve to 67 today.

The record for this cohort has been mixed. In February, the group was up nearly 20% for the year. That gain has since dissipated to a 10% year to date return, now underperforming the index.  We’ll see how this shakes out as the year continues.

Macro

I think that the yield curve is the best indicator of the likelihood of a recession. I covered the use of the yield curve as a recession predictor in this post: the Dark Art of recession prediction.

Why does the yield curve “work” as a recession indicator? Simply put, the Federal Reserve is the dominant factor in the business cycle. The Federal Reserve is the cause of and cure to nearly every recession. Expansions in the US end when the Fed is too tight. A yield curve inversion is a sign that the fed is too tight.

The 3-month and 10-year treasury yield inverted a few weeks ago. The 2 year and 10 year haven’t inverted yet, but have flattened. The 10 and the 30 is another good indicator, as pointed out in this post by Scott Grannis.

There is typically a lag between a yield curve inversion and the onset of a recession of a year or two. There is a similar lag between Fed cuts and the beginning of a new economic expansion. The yield curve inverted in 2005-06 and the impact of that relatively tight monetary policy wasn’t felt until 2008-09. The Fed began aggressively cutting rates in 2007, but this didn’t start to have a positive effect on the economy until late 2009.

Ray Dalio famously says an economy is a machine. I think it’s more likely an organism, responding slowly and organically to policy changes.

The slow way that the economy responds to these changes is difficult to navigate for investors. We are like blindfolded people trying to navigate our way through a funhouse. It’s particularly confusing because the year or two after a yield curve inversion is often one of the best parts of the business cycle. The economy is red hot, and everything seems wonderful. Think about the mood in 1989, 1999, or 2006. The party was about to end, but it was also at its most roaring. All of these years were after a yield curve inversion, and it was difficult for investors to look at the robust economy and imagine how it could fall apart.

Ensemble Capital had a great tweet summarizing how strong the environment is at the end of the cycle.

ensemble

It’s almost as if the market tries to lure investors in before it slaughters them.

Another great indicator of where we are in the cycle is trending in the unemployment rate, as pointed out in this post. Right now, the unemployment rate hasn’t yet changed its trend, but it looks like it is flattening. It is already below the lows experienced in 2000. How much lower can it go?

uetrendA yield curve inversion is like a yellow light. A shift in the unemployment rate is a big red light telling you that a recession is imminent and we might already be in one.

I still think the yield curve is a valuable tool for forecasting recessions. One of the reasons it is such a useful tool is because so many people doubt it every time it happens. I remember being a teenager watching CNBC in the late ’90s and listening to pundits say that the yield curve didn’t matter. A popular narrative at the time was that the US budget surplus was distorting rates. There was similar talk in 2006. A popular narrative at that time was that the “global savings glut” (emerging markets had high savings rates and they were pouring money into treasuries) was distorting the bond market, and the yield curve didn’t mean anything.

No one wants a recession except for maybe the perma-bear crowd. Listening to a recession prediction is like telling someone that they’re going to get into a car accident tomorrow or that their significant other is going to cheat on them. It’s a horrible prediction, and our minds will try very hard to find reasons not to believe it.

The narrative this time is that rates are too low for the yield curve to matter. The Fed can’t trigger a recession when the Fed funds rate is only 2.5%. I don’t accept this explanation, either. I think rates are only “low” in the context of our experiences in the ’80s and ’90s, when rates were abnormally high.

I like to boil things down to their essential components, and I don’t think anything explains the relationship between the quantity of money and inflation better than the classical equation, MV = PQ, the equation of exchange that Milton Friedman had on his license plate. The equation simply states that the quantity of money and the velocity of money are the key determinants of inflation.

The instinct of most people was that the Fed’s dramatic expansion of the money supply would result in a massive inflation problem. This never happened. Inflation hasn’t even gone above 3% throughout this entire expansion.

It seemed logical that an explosion of the Fed’s balance sheet and the quantity of money would result in massive inflation. The reason this didn’t happen is that the velocity of money remained stuck at an absurdly low level after the carnage of the financial crisis.

This decline in the velocity of money could have happened for a few reasons. It could be demographic reasons, such as declining birth rates and an expanding elderly population. This is a popular explanation for what happened in Japan, who didn’t experience inflation after an explosion in their own monetary base and ultra-low interest rates. The US has more favorable demographics than Japan, so I’m not sure if this holds up. Another possibility is that the crisis was so severe that it psychologically scarred households and firms and depressed the overall velocity of money.

Whatever the explanation, it looks like monetary velocity is stuck at a low level, meaning that rates can stay “low” with little impact on inflation.

m2

Money velocity: extraordinarily low

inflation

Inflation: can barely crack 3% even with unemployment near all-time lows

Rates look low when we compare them to recent experiences in the ’80s and ’90s, when we were working off the Great Inflation of the 1970s and when money velocity was high. I believe that with an inflation rate below 3% and money velocity stuck at a low level, a 2.5% fed funds rate can be high enough to push the economy into a recession even though it appears to be absurdly low based on our experiences in recent decades.

What do I do about it?

The phrase “late cycle” has become a punchline. People have been saying “late cycle” for the last 7 years. With that said, the yield curve seems to indicate that at this point we really are in the late cycle. This is 1998, 1989, 2005. Trouble is probably on the horizon.

In my little world, I am merely trying to determine what I should do about it.

Option #1 – Do nothing and stay fully invested. This is what Peter Lynch and Warren Buffett would recommend. They ignore the macro environment and focus on the businesses in the portfolio. This would also be the advice of many quants, who all advise that timing the market is nearly impossible. I’m sympathetic to this point of view, but I find it hard to accept. I analyze individual businesses, but none of them exist in a vacuum. Their fates are wholly determined by the macro environment, so I find it hard to accept the idea that I should just ignore it completely. It also doesn’t jive with what Munger and Buffett actually do. Berkshire carries massive cash balances. Munger kept Daily Journal mostly out of the market in the mid-2000s, moving aggressively once the global financial crisis dished out a tremendous opportunity set.

Option #2 – Get out of stocks completely. Should I get out of stocks completely? It is extremely difficult to time an economic cycle correctly and it is even harder to time a factor like value. There are unusual moments such as the early 2000s when value investing performed well even though the economy was in a recession. Missing a time like that would be terrible for my returns.

Much of the evidence indicates that the cycles are so difficult to time and the performances are so lumpy that it’s best to just stay fully invested.

My sense is that this cycle is more like the late ’60s and early ’70s than it is like anything like the ’90s or 2000s. The ’70s was a period of time where value was crushed with the overall market in the ’73-’74 drawdown. The darlings of that era, the Nifty Fifty, weren’t anything like the late ’90s absurdity. They were quality companies at crazy valuations.

How did value hold up during this period? Below is a comparison of S&P 500 returns to those of Walter Schloss along with the low P/E low debt/equity strategy that Ben Graham pursued and was backtested by Wes Gray’s Alpha Architect team.

70s1

Schloss was known for holding a lot of cash when he couldn’t find bargains, which is likely why he avoided a lot of the horror in the ’73-’74 drawdown. The fully invested Ben Graham quant strategy fared worse.

I would like to avoid the next drawdown and have a lot of cash to take advantage of the opportunities that will emerge in the aftermath of the decline.

The classical value investing approach is to not time the market but only invest in the bargains, like Schloss did. At the end of the expansion, there will be fewer bargains, and you’ll end up accurately timing the market without really trying.

This approach is easier said than done. If you took a classical asset value approach, Schloss would have had to wind up the partnership in the late ’60s when the net-net’s disappeared in the United States. Instead, he shifted his focus to stocks selling below book value. If he waited for the net-net’s to return, he would have missed out on some of his best years for returns. Not only could you wait for a few years, but you could also end up waiting for an investing lifetime.  For this reason, I think it would be foolish to “get out” of the market entirely.

At the same time, I don’t want to suffer horrific drawdowns and have no cash to take advantage of the opportunities that will inevitably result from a significant drawdown.

Option #3 – Short the market. I don’t short anything. I am proud to say that I have never shorted a stock in my life. After following markets for the last twenty years, I have developed a deep appreciation for how insane markets can be. Tech stocks were overvalued in 1998. They still doubled in 1999. Enron was engaged in fraudulent behavior going all the way back to the 1980s. It didn’t melt down until 2001.

Shorting is speculation and can result in a permanent loss of capital. I don’t do it. Shorting is for masochists.

This isn’t to knock the shorts. They’re the smartest people in the market and often do the most in-depth diligence. This doesn’t make it a wise investing strategy. I feel the same way about marathon runners. They are hard working, dedicated, impressive people. They’re also masochists who pursue pain for the sake of pain. Just because they are awesome individuals doesn’t mean that it’s a good idea to go out and run a bunch of marathons.

I’m also not interested in hedging. The best hedge is to merely own less of whatever it is that you’re hedging.

I’m also averse to complicated investing strategies. Perhaps I read “When Genius Failed” too many times. Whenever I hear a complex investing approach touted by an investing egghead, it’s hard for me not to roll my eyes. My instincts scream at me to steer clear.

Option #4 – Gradually adjust my positioning.

This is what I will probably do.

Right now, the cheapest stocks in the market are cyclicals. I own a lot of them. These stocks will likely be annihilated in a drawdown. Winnebago is a glaring one. There aren’t a lot of people with enough confidence and disposable income to go out and buy a big, expensive, RV during a recession. Winnebago suffered an 80% drawdown during the financial crisis.

Additionally, the fact that a yield curve inversion usually takes a year or two to impact the “real” economy gives me time to adjust my positioning. As I sell positions (as they age, run up in price, or the fundamentals change), I will likely reduce my positioning in cyclicals.

I will probably hold onto my cheap insurance and more defensive picks. Oshkosh is a good example. With a significant chunk of their business originating from the federal government, it should hold up well in a large equity drawdown.

Fortunately, I own zero leveraged companies. I specifically stick to stocks with low debt/equity ratios at all times because I know they will hold up well in a drawdown and I have a healthy enough respect for the market to know that a bloodbath can happen at any time, regardless of what the yield curve and unemployment are doing. It’s also what Ben Graham recommended. I covered my logic for this approach in this post about the debt/equity ratio and how a lack of leverage provides protection during drawdowns. To summarize, sticking to companies with healthy balance sheets enhances long-term returns by reducing the extent of a drawdown during a market meltdown.

debtequity

As I reduce my exposure to cyclicals, I will need to find a home for the cash. I don’t want this money sitting around earning nothing. I am considering buying more defensive stock picks and accumulating a position in long-term government bonds. As the Fed reduces interest rates to combat a recession, long-term bonds should perform well. Long-term bonds increased by over 20% in 2008, for instance. I will likely do this through an ETF vehicle like TLT.

At the same time, if I’m wrong, long-term bonds will go down but will still pay interest and won’t suffer huge drawdowns. I think this is a much safer choice than outright shorting the market.

Conclusions

I’m curious about your thoughts and input into how you are navigating the rapidly changing environment. What do you think the best approach is?

Random

I love the latest season of Documentary Now. The below is an excellent parody of “Wild, Wild, Country.”

 

 

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

 

2018: A Year In Review

myperformance

My Portfolio

This has not been a good year for my portfolio. I am below where I started, and I am down 16.4% for the year.

This is the second year in a row in which I have underperformed the S&P 500. This is certainly disheartening. The last two years for me have made a strong case for shutting up and putting money in an index fund, but I’m not ready to give up just yet. More on this later.

Buys

This quarter, I purchased a number of new positions. You can read the write-ups below.

Most of these companies are statistically cheap on the basis of earnings, cash flows, enterprise multiples, and sales. All have a strong financial position with low debt/equity ratios, good Z-scores, good Piotroski F-Scores. From a quantitative perspective, they’re all in the right neighborhood.

One position, Amtech, was purchased for the asset value. Amtech is selling below net current asset value and near cash. This is high quality for a net-net, considering that the company actually has earnings and positive cash flow. Most net-net’s tend to be terrifying perpetual money losers.

For the stocks I purchased for earnings, a common concern for them is that their underlying businesses are at a “cyclical peak”. I don’t believe we are going to have a recession in the next year, which is why I am comfortable purchasing them. I’ll explain more on my views of the macro landscape later in this post.

Sells

Below is a list of all of my sells this year:

2018sells

Previously, I tried to hold stocks for at least a year before selling them unless the stock was up significantly.

I loosened that rule up this year to give myself an escape hatch if the fundamentals deteriorate. For me, the biggest red flag is an actual loss at the top of the income statement. This helped me get out of two value traps early: Big Five Sporting Goods and Francesca’s Holding. I managed to exit Big Five with an 8.27% gain, which is incredible considering that the stock is down 62% for the year. Getting out of Francesca’s early was another great move, as it is down 87% for the year.

I try not to get married to positions. I think it’s important to keep an eye on the fundamentals of the companies I own. If the fundamental change, I should revisit my opinion.

International Indexing

This year, I also abandoned my “international indexing” strategy, which I pursued because of the poor opportunity set in the US combined with my poor skills in researching individual foreign companies.

The debacle in Turkey exposed this as a bad idea for me.

In order to stick with a position, I need to understand it. I don’t know anything about the situation in Turkey other than the market was cheap. That’s not a good thesis that will give me enough confidence to hold through a horrific drawdown.

I decided in the fall that this account should focus on my original mission when I set aside this money and started this blog. I set out originally when I launched this blog to hold individual positions in companies that I’ve researched. That’s what I am sticking with.

Misery Loves Company

This has been a difficult year for systematic value investing. As they say, misery loves company. Value investing has had a terrible year and my portfolio is not an outlier. Here are some examples:

  • The Russell 2000 value index is down 15.3%.
  • The Vanguard small-cap value ETF (VBR) is down 14.8%.
  • QVAL, the quantitative value ETF from Alpha Architect, is down 19.69%.
  • Validea’s 20-stock Ben Graham screen is down 15%. The 10-stock various is down 23%.
  • AAII hasn’t updated it yet, but as of November 30th the value screens did not have a good year. I suspect that when they update for December, the results will be a lot worse. As of 11/30, the Ben Graham “enterprising investor” screen (probably the closest proxy to what I’m doing) was down 15.5%. Their low price-to-free cash flow screen was down 12.5%. The high F-score screen was down 17%. Notably, the magic formula held up nicely this year. They show that screen with a gain of 7%.

The current situation could go many different ways, as is always the case in markets.

Traditionally, value stocks sell off before the rest of the market before a major calamity. They tend to be canaries in the coal mine. This was certainly the case in 2007. This is because value stocks are cyclically sensitive and, at the end of the expansion, they are the most vulnerable to a decline. This is also why they tend to rip in the early years of expansion, like 2003 and 2009. Everyone thought they were utterly doomed, but the world doesn’t end the way everyone was expecting. Stocks that had the biggest clouds hanging over them tend to perform exceptionally well once the weather improves.

The critical question, then, is: are we at the end of the economic expansion? Are we at the end of this cycle of economic development, or is the recent market sell-off one of Mr. Market’s typical bouts of insanity?

For possible answers, I turn to history.

Mr. Market’s meaningless temper tantrums

The market is replete with the corrections of the 10-30% magnitude that don’t reflect any reality in the real economy.

The most famous example of this is the crash of 1987, which had hardly any impact on the real economy. Mr. Market went into euphoric overdrive in the first half of 1987 (probably cocaine-fueled), with the market rising 22% from January 1st through the August peak. It then suffered a 33.7% peak to trough decline from August 1987 through December.

People are obsessed with another 1987 style crash happening again. Whenever the market has a nice run, Twitter is replete with comparisons of the chart to a stock chart of 1987.

I find this amusing. We should be so lucky. The 1987 crash had zero impact on the real economy and turned out to be an incredible buying opportunity. During the crash, Buffett’s friends (people like Bill Ruane and Walter Schloss) were at their annual conclave in Williamsburg, Virginia. They saw the panic for what it was and went to the phones to buy stocks.

Buffett used the crash to buy one of his most famous investments: his large allocation to Coca-Cola, which would set Berkshire’s returns into overdrive in the 1990s.

The people who are trying to predict the next crash of 1987 are missing the point. You can’t predict things like the crash of 1987. The trick is to identify the opportunities created by these events by buying new opportunities with a prudently calculated margin of safety.

Even indexers were fine in the crash of 1987 as long as they didn’t succumb to panic selling. Amid all of the “carnage” of 1987, the S&P 500 returned 5.25% that year. In 1988, the index returned 16.61%. In 1989, it returned 31.69%. It was a non-event, but market commentators are still obsessed with it.

Who suffered from the 1987 decline? Speculators. People who were leveraged. People who bought financial derivatives and exotic financial products. People who bought concentrated positions in speculative names. People who bought concentrated positions on margin. In other words: they’re the same people that always lose money over the long run and people who deserve to lose money over the long run.

Investors, in contrast to speculators, made out just fine in 1987. In modern parlance, these are the kind of people who thought they could predict volatility and went long in XIV. Alternatively, these are the kind of people who thought they could predict the price movement of cryptocurrency – i.e., a financial product best suited for anonymously buying heroin. Because blockchain is going to alter Western Civilization or something. Speculators always lose, and they’re always surprised when they lose. It’s so strange to me how people keep flocking to speculation like blood-sucking mosquitoes to a bug zapper.

What are some other instances of market downturns that didn’t reflect or predict anything in the real economy? In 1961-62 the market suffered a 28% drawdown. In the summer of 1998, the S&P suffered a 19% drawdown. ’83-’84 – 14% drawdown. 2011 – 19.4%. 1967 – 22%. 1975 – 14%. You get the idea. These things happen all the time.

Here is a young Warren Buffett talking about the 1962 hiccup. It sounds pretty familiar.

 

 

 

What particularly amuses me is how people are always trying to develop explanations for why these things happened. The 1987 crash is the most studied crash of all time with extensive media coverage. There still isn’t any consensus on what caused it. Some blame “portfolio insurance”. Others blame the Plaza Accords. Others still contend that the 1980s stock boom was a speculative bubble and the bubble never ended. They think the Fed has just been bailing out markets for 30 years and all of the gains since 1987 have been illusory.

Trying to predict and explain these things is a fool’s errand, unless you think you’re the next Taleb or Paul Tudor Jones (you’re not). I usually laugh at the commentators with impressive credentials and expensive suits who go on cable and explain why this stuff happened. Well, sir, if you look at the 200-day moving average, put this over the 50 day moving average, and if you look at the uptick in volume, and compare this to steel prices, and then take a look at these Bollinger Bands, and then look at the M2 supply’s impact on bond outflows, and compare this to the put/call ratio . . . blah, blah, blah

They might as well be astrologers. They might as well be ripping apart chicken guts and trying to predict tomorrow’s lottery numbers. Of course, this really shouldn’t be a surprise coming from the Wall Street elite. This stuff isn’t above them. They’re not all rational. These are people who buy healing crystals, after all.

The people who try to predict Mr. Market’s moods are like dutiful scientists following around someone at a bar after 15 tequila shots and trying to explain all of their behavior, trying to develop some rhyme or reason to it. “Hmmmm, very interesting, she is projectile vomiting after singing Sweet Caroline. Perhaps there is a correlation between vomit and Neil Diamond.”

I suppose much of it has to do with the rise of the efficient markets theory. If markets are efficient and they reflect all available information, then Mr. Market’s temper tantrums must actually mean something.

From their perspective, it can’t be my simple explanation: people are crazy and stuff happens. It can’t be that Ben Graham got it right in the 1930s and that much of financial theory since then has been a big waste of time.

Mr. Market gets it right (sort of)

Occasionally, Mr. Market gets it right and the carnage is tied to real turmoil in the real economy that will cause a real impact on the fundamentals.

Sort of, anyway. Even when Mr. Market gets it right, he overreacts. Mr. Market usually believes every bad recession is the end of Western civilization and the market suffers a 50% drawdown that would not be justified if markets were truly efficient. This is evidenced by the fact that the market normally snaps back by 50-100% in a year or two after the bloodbath.

The ’73-’74 drawdown is one example of an authentic event. The S&P 500 suffered a peak-to-trough decline of 48%. Oil drove the economic funk. With US oil production peaking in the 1970s, the US economy became more reliant on oil imported from OPEC nations. When OPEC colluded to restrict supply in response to US support for Israel, oil skyrocketed. This caused a severe and brutal recession in the United States.

The 2008 event was tied to real economic activity, as we’re all aware of and I don’t need to repeat. Banks were failing and it felt like the system was falling apart.

How about 2000? Many cite the 2000-02 market as one long bear market. I divide it up into stages. The initial fall in 2000 was simply Mr. Market throwing a temper tantrum. There was no catalyst. In 2000, people suddenly realized that it was crazy to pay 100x earnings for Cisco, even though it was a great company. They realized it was insane to pay 10x sales for IPOs of dot com companies that didn’t make any money. It was simply a mood wearing off.

Side note: Cisco was the first stock I ever bought. I sold it after I read “The Intelligent Investor” and realized it was crazy to own it.

In 2001, however, the deflation in the stock market along with 9/11 began to have a real impact on the economy, which triggered the more serious sell off of 2002 and early 2003.

What is this thing – a meaningless temper tantrum or something real?

The key question is whether or not the recent decline is merely Mr. Market panicking or if he is predicting real damage in the US economy.

To answer that, we should ask what distinguishes speculative panics from real events.

The most significant difference between a real event and speculative BS is that there is no consensus explanation for speculative panics. There are plenty of scapegoats for the crash of 1987, the “flash crash” of 2011, but no consistent broadly accepted explanation. In contrast, there is no doubt what caused the market declines of 1981-82, 1973-74, 1990, 2008.

Is there any consensus on what caused the recent collapse? Not really. Speculation abounds: the market is concerned about trade wars, the Fed hiking interest rates, hedge funds are “de-risking.” There isn’t any consensus. There isn’t a clear bogeyman. That leads me to believe that the market is not accurately predicting any carnage in the real economy within the upcoming year.

I also doubt we’re entering a recession for the following reasons:

1) The yield curve hasn’t inverted. While some rates briefly inverted this year, there is a lot of noise in the shorter end of the curve (under 5 years). The inversion that accurately predicts recessions, the 2 year versus 10 year, has not inverted. It’s also worth noting that the inversion usually happens a year or two before the recession begins in earnest. The fact that it hasn’t happened at all leads me to believe that rates are not yet high enough to push the economy into a recession.

yieldcurve

2) There has been no discernible change in the unemployment trend. October 2018 marked an all-time low in the unemployment rate. The unemployment rate usually begins to tick upward before the onset of a recession. The unemployment rate started to rise in the first half of 2007, months before the beginning of a bear market or the start of the recession in December 2007. The unemployment rate also began to rise in the fall of 2000, the summer of 1990, and the fall of 1981. I would expect the unemployment rate to begin tipping upward if a recession was imminent.

unemployment

broader unemployment

3) Household leverage is healthy. Think about what causes a recession. Typically, it is driven by monetary policy. In a boom, interest rates are cut and households accumulate debt, which drives the expansion. In the later stages of a boom, the Fed increases interest rates. The higher debt burden plus the higher interest rates restrict the cash flow of households. As they cut back to deal with the stress on cash flows, this pushes the economy into a recession. Currently, household debt payments as a percentage of disposable income are near all-time lows, despite the recent increases in interest rates.

leverage

4) There isn’t any sign of a slip in broad economic indicators. In fact, most of them are at all-time highs. Here are a couple: truck tonnage and industrial production.

trucktonnage

industrialproduction

The Opportunity For Value Investors

In the last couple of years, I have been concerned about rich equity valuations. I invested anyway in the best bargains I could find. I invest for the market that exists, not the one that I wish for. I wish every year could offer up 2009-style bargains. I also wish pizza, cookies, and ice cream didn’t cause me to gain weight. Unfortunately, my wishes are not reality.

With that said, the recent sell-off has helped the situation. It’s not 2009 cheap, but it’s a much better situation than it has been in a long time. The Shiller P/E is down to 27.69, which is hardly cheap but is better than it has been in a few years. The latest data isn’t available, but I’m sure that the average investor allocation to equities has also declined, which is also good news for future returns.

The drawdown has produced an ample number of cheap stocks, which is great news for value investors. The high number of cheap stocks is unprecedented for a healthy economy.

In December of 2016, there were only 47 stocks in the Russell 3,000 with an EV/EBIT multiple under 5. In December 2017, the count was down to 40. There are now 90 of these stocks, which is historically very high. Such a high number of cheap stocks bodes well for value. In past years when there have been more than 80 of these, as a group, these cheap stocks have delivered an average annual return of 32%.

The year 2000, in particular, was an incredible year for the relative performance of this group. This group of stocks with an EV/EBIT multiple below 5 delivered a 28.35% return compared to a loss of 9.1% in the S&P 500. This was extraordinary out-performance. The good times made the careers of a number of value investors who were new to the game and weren’t already tarnished by the under-performance of value in the ’90s, like David Einhorn.

Everyone knows that value has under-performed for a decade and this is similar to the late 1990s. The thinking goes that this under-performance will lead to another period like the 2000s when value stocks crushed expensive stocks. For the last few years, I wanted to believe that this situation was bound to mean revert soon. The main factor that made me doubt this reversion to the mean was the low number of cheap stocks that were available.

What made value roar in the early 2000s? The ’90s bubble led to a plethora of bargains in the small-cap value universe. The depth of these bargains led to an incredible performance in the early 2000s. Looking at the dearth of cheap names in 2016-2018, my concern was that even though value had under-performed recently, I didn’t see the quantity of bargains that I knew existed circa 2000.

The recent sell-off has changed that dynamic. There were 101 stocks with an EV/EBIT multiple under 5 back in 2000. Now, there are 90. A week ago, there were 108.

This leads me to believe that we are entering a situation very similar to 2000. Just like 2000, the economy is fundamentally healthy and not in a recession. A recession would negatively impact all stocks, not merely the pricey growth-oriented names. Meanwhile, there are a massive number of bargains to choose from.

Despite my under-performance in the last two years, I am now more optimistic than ever.

I think we will see substantial out-performance for value and I think my portfolio of diversified value names should perform well. Value stocks are no longer merely cheap on a relative basis; they are cheap on an absolute basis as well.

Moreover, the sentiment that the value factor is played out and over-farmed is more widely accepted than ever before. You even see this in the behavior of so-called “value” investors. Value investors in recent years have thrown away the old metrics and adopted a “can’t beat ’em, join ’em” philosophy. “Value” guys are out there pitching Facebook, Amazon, and the like. Usually, the pitch involves wildly overoptimistic metrics plugged into a DCF model along with talk of “moats”. Excellent value investors like David Einhorn are treated like out of touch dinosaurs.

Everything feels right to me. The time for value is now, and I am wildly excited for the upcoming year in a way that I wasn’t previously.

Random

  • I read a number of good books this year. Chief among these is Margin of Safety by Seth Klarman. I wrote a blog post about it here. Saudi America was another great read, which I wrote about here. Here are a few other standouts I read this year:
    • Seinfeldia. If you are a Seinfeld and Curb Your Enthusiasm fan like myself, this book is a must read. It’s all about the birth of Seinfeld and the history of the show, with an inside scoop on all of the details of production.
    • Keeping at It. This was Paul Volcker’s autobiography. It was an amazing read about my favorite Fed chairman. You’ll come away with a sense of how hard economic policy is. Everything Paul Volcker did now seems so clear, but at the time it was extraordinarily hard and uncertain.
    • Brat Pack America: A Love Letter to ’80s Teen Movies. I grew up on a steady diet of movies from my favorite decade, the 1980s. This was an in depth homage to all of them. The author clearly has a deep love of the decade and the movies and music it produced. It shines through in this book. He ties each movie into larger cultural trends which were happening at the moment. He also interviews many of the creators of these movies and visits the real life locations in which they happened. Highly recommended.
  • I found myself watching Star Trek III a lot this year. It is such an underrated movie in the wake of Star Trek II. This is the ending and it should be heart warming to every nerd out there.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

Macro Environment & Upcoming December Rebalance

Jitters

October’s price action seems to have given many investors the jitters. Mr. Market doesn’t quite need a defibrilator or even Pepto Bismol, but he is at least popping a Tums. This expansion and bull market have been long. They are going on 10 years now, which is relatively unprecedented. Unemployment is at historic lows. Meanwhile, the Fed is raising rates, which is usually the beginning of the end.

Valuations don’t help with the anxiety. Everyone knows that valuations are stretched. The CAPE ratio currently stands at 30.94, giving the market an earnings yield of 3.23%. The average investor allocation to equities is presently 44%, giving us an expected 10-year return of 2.3%. In other words, the realistic return that investors can expect over the next 10 years is probably somewhere in the vicinity of 2-4%. This does not provide much of a premium to the 10-year treasury yield, which is currently 2.993%. The AAA corporate bond yield is now 4.14%, a significant premium to what we can expect from equities.

yields

A 2-4% return for US stocks isn’t going to happen in a straight line and it isn’t going to be evenly disbursed across all stocks. Stock market return averages are an average of abnormal returns. There are going to be years when stocks will advance by 30%, and there will be years when they decline by 50%. The decline will likely coincide with a recession.

Recession Watch

At the same time, while it’s evident to me that valuations are stretched, I do not believe we are going to have a recession in the upcoming year. This is the main reason I am comfortable remaining 100% invested in stocks that I feel are at attractive valuations, including cyclical stocks.

I believe that the Federal Reserve is the cause and cure of every recession. Right now, the yield curve is flattening but has still not inverted. The Fed typically chokes off an economic expansion by tightening too much. They then usually save the day by aggressively responding to the downturn by cutting rates, often overshooting and causing other problems. This seems to have been the case in the mid-2000s.

Despite the tightening of the last year and the flattening of the yield curve, the curve is still not flat and it is still not inverted. Scott Grannis recently had a great post about this here.

curve

Typically, once the yield curve inverts, we get a recession within a year or two. Right now, the 10 year is at a .22% premium to the 2 years. This implies that the Fed hasn’t yet taken things too far with rate increases. A recession, therefore, does not appear to an imminent danger. To put this in historical perspective, this is where the yield curve was in 2005, 1997, and 1988.

Another thing that tends to happen before a recession is that the unemployment rate shifts its trend. The unemployment rate began to change direction back in 2000, long before the beginning of the recession in 2001. It also did this in 2007 before the Great Recession went underway. There is no sign that the unemployment has shifted course.

unemployment rate

This is further evidence that a recession is not imminent.

Another indicator that I look at is household debt payments as a percentage of disposable income. This shows you the sensitivity of households to rising interest rates. This is not worrisome at all.

households

December Rebalance

Hopefully, this gives context to decisions I am going to make in my portfolio in the upcoming month.

I am currently gearing up to rebalance my portfolio in December. I will sell many positions that are on their 1-2 year birthday and replace these positions. I have my eye on many stocks, which are listed below. If anyone has done any work on these securities, I would love to hear from you.

I’ve spent the last few weeks researching the below positions. They meet my quantitative criteria, and I am attempting to determine whether or not I feel they are likely to recover from the problems that the market perceives.

candidates

My opinion on the likelihood of a recession impacts what kind of stocks I own. In particular, it will determine whether or not I will buy stocks that are cyclical and closely tied to the performance of the macroeconomy. An example of this would be a company like Micron (MU), a cheap position that bears suspect is cheap because it is at a cyclical peak. Another example would be Thor (THO). These would be positions I wouldn’t own if I thought a recession was going to occur in the upcoming year. Some examples of cyclical positions on the above list that I am looking at include Manpower Group (MAN) and Hollyfrontier (HFC).

I’m also looking at cheap retail positions like GAP (GPS) and Chico’s (CHS), even though they have been historically graveyards for my portfolio.

It also determines whether I am comfortable holding cash. When a recession is imminent, I will likely move more of my portfolio to short-term treasuries while I wait for compelling bargains to appear. A 1-year treasury is expected to yield 2.69% right now, which compares favorably to what I expect from US markets over the next decade.

Of course, I fully acknowledge that my predict the future is as good as anyone else’s. This is the reason that I always attempt to purchase undervalued securities with a margin of safety. A margin of safety is very much a margin for error.

I’m also eagerly anticipating the next recession. While I would like to avoid some of its damage, I suspect this is the moment when I am going to find truly compelling bargains, which are now in short supply in the US. It will be an opportunity to buy sub-liquidation net-net’s extraordinarily cheap security on an earnings basis, as well. It will be an opportunity to do very well, and I’m looking forward to it.

Hopefully, this sheds some light on my thought process as I select new stocks to fill my portfolio in the upcoming month as we look to 2019 and my portfolio (and this blog) turn 2 years old. Let’s hope the “terrible twos” doesn’t affect my money.

Random

  • I have been reading Paul Volcker’s book, Keeping at It. It’s a great book from a man that I believe is the greatest Fed chair of all time. I wrote about it here.
  • I gave up sugar back in October. So far I’ve lost 10 pounds since making that choice. I fell a bit off the rails on Thanksgiving when I ate a significant amount of pie, but what the hell? That’s what Thanksgiving is for. I haven’t eaten any sugar since.
  • I started watching “The Man in High Castle” and have really been enjoying it. It makes me really appreciate the sacrifices made by the Greatest Generation. If it weren’t for their efforts, the horrific world featured in that series would be a reality.
  • I was saddened to hear about the loss of George H.W. Bush. Looking back on him, whether you disagreed with him or not, he was an exceptional human being who treated the opposition with respect. He was the last President of the World War II generation, and that’s why I think his Presidency feels like a distant, bygone era. That generation had a better perspective on life. That’s why their passing brings a real sense of loss. I think their perspective comes from seeing a World War and living through a Depression. These were experiences so intense, so palpable that Boomers, Gen Xers, and Millennials can’t relate to these experiences on any level. Our worries are trivial compared to worrying about the Nazis winning World War II, or starving to death in the Depression. After going through times like a Depression and World War, they didn’t sweat the small stuff the way that we do. They realized that the stakes weren’t so high and you didn’t need to vilify people because you disagree with them about minor things like taxes, budgets, whatever. I really believe that things were better with that generation in power. People who vehemently disagreed with each other, like Tip O’Neal and Ronald Reagan, could hang out after work and still get along. I wish things were like that now. We weren’t entrenched into competing camps convinced that the other side was evil or bent out to destroy the country because they happen to disagree. I wish that’s a perspective that we could bring back. I wish I could have that kind of perspective. I worry that’s not possible, because it’s a perspective you can only earn from going through the sort of horrible times that they went through in their youth.
  • I’ve been listening to a lot of a synth band called Electric Youth. They sound straight out of 1984, and I love it.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

Are bonds for losers?

stocksbonds

Returns for US Stocks and US Bonds since 1900 in real and nominal terms

No Pain, No Gain. Deal With It.

My attitude about bonds has evolved over the years.

Years ago, I had a pretty simple attitude about them: paraphrasing our President, bonds are for losers. The returns tell the story. Stocks massively outperform bonds over the long run (and cheap stocks outperform everything).

(They’re for losers unless they are bearer bonds. As I learned from Die Hard, Heat, and Beverly Hills Cop, bearer bonds are insanely cool. It’s too bad that the government discontinued these relics of a more heist-friendly time.)

Bonds historically have poor returns and sometimes struggle to keep up with inflation. Stocks traditionally have fantastic performances but have horrific drawdowns. Stocks were cut in half in 2008. They fell by 80% during the Depression. My attitude has always been that if you can’t handle the volatility, then you just need a stronger stomach. No pain, no gain. Toughen up.

With that said, a gung-ho attitude about stocks is easy when you are in your 20’s or 30’s. It was a natural thing for me to get bullish in 2009 after the market crashed. I went “all in” that year in my 401(k) into stocks with the tiny $4,000 I had saved up at the time. Being reckless at the beginning of your working career with a small amount of savings is easy. Try it when you are 65 and have your entire life savings to deal with.

My callous attitude towards “pain” was ignorant. “No pain, no gain” is an attitude you can’t afford to have if you are older and are dealing with a lifetime of savings. You don’t have a lot of high earning years ahead of you, and you might need this money to survive.

Age

My instinct with my own money is to swing for the fences and go for the high returns. No pain, no gain.

Older people can’t have this attitude. They can’t afford a “lost decade” of stock returns. They couldn’t afford to lose half of their money tomorrow. They can’t double down and get a second job if their investments fell apart. For retired people, money needs to last. Mine has to be worth a lot in 40 years. These are completely different objectives.

My parents asked me to recommend as good retirement fund. After thinking about it, I decided that the best option was the “Vanguard Target Retirement Income Fund” (VTINX). It is a fund which Vanguard designed for people in my parent’s situation, who are already retired. It is 70% bonds, 30% stocks and mixed geographically. Fees are only .14%.

The fund isn’t going to provide a high rate of return, but it ought to preserve their capital if they have an emergency and need it. It’s automatically rebalanced so they don’t have to think about it.

In terms of the worst case scenario, I looked at the 2008 drawdown, and it was only 10.93%. That’s tough, but not fatal.

What about interest rates? What about the bond bubble?

Everyone you talk to in the financial world “knows” that interest rates are going up. “They’re as low as they’re ever going to be” is the popular refrain. It certainly makes sense to me. I was born in 1982, and interest rates have declined for my entire lifetime. Eventually, it has to turn around and go back to “normal”, right?

It makes sense that the final straw would be successive rounds of quantitative easing, which will cause inflation, which will ultimately spur higher interest rates.

The more I thought about it, the more it worried me when I thought about my parent’s high allocation to bonds. When interest rates rise, bond prices decline. That’s Finance 101. Did I steer them in the wrong direction? What if interest rates spike and their savings are in jeopardy?

I decided to look at the historical data concerning bond returns, particularly in rising interest rate environments. The period I chose to focus in on was the Great Inflation of the 1960s and 1970s.

The Great Inflation (1960 – 1982)

prime rate

The prime rate from 1950 to today

There was no period for rising interest rates like the Great Inflation of the 1960s and 1970s. Having learned their lessons from the deflationary 1930s a little too well (the Fed didn’t act enough in the 1930s, which turned a panic into a prolonged hellish period of declining prices and high unemployment), the Fed played it fast and loose with monetary policy in the ’60s and ’70s.

The US government also began to play it fast and loose with fiscal policy, which was difficult to manage with the dollar tied to gold.

 

 

The “Nixon Shock”: The end of the gold standard

Paying for the Vietnam War and the Great Society was an expensive endeavor with the dollar tied to gold. Nixon’s solution was to abandon the Bretton Woods gold standard and end the dollar’s link to gold so we would have full autonomy to spend what we wanted.

The “Nixon Shock” kicked an escalating inflation situation into overdrive, with inflation reaching the double digits by the end of the 1970s. The OPEC embargo didn’t help. Economic stagnation combined with high inflation was “stagflation,” and it contributed to widespread fears that the United States had lost its mojo.

By 1979, 84% of the American people polled said they were “very dissatisfied” with the direction of the country. The malaise, as they called it, ran deep.

Paul Volcker, the Fed chairman at the time, knew that this had to stop. He took extraordinary measures to stop inflation, pushing interest rates to historic highs. By 1981, he had driven the prime rate to 20%. The high-interest rates caused a genuinely horrific recession. The recession of the early 1980s was slightly worse than the Great Recession of recent memory. Unemployment peaked at 10.8% in 1982. In comparison, it peaked at 10% in 2009.

Ronald Reagan, to his credit, stuck by Volcker’s tough medicine even though it was not in his political interest. Reagan’s poll numbers dropped into the 30s. A lesser President would have fired Volcker or publicly criticized his actions. Reagan did no such thing. He knew that inflation had to be contained and knew it was in the long-term interests of the country to beat it.

The tough medicine worked. Inflation was defeated. As inflation eased, we were able to reduce interest rates for nearly 40 years. The bond bull market has benefitted almost every U.S. asset class for the last few decades. We have been reaping the benefits of Paul Volcker and Ronald Reagan’s tough medicine for decades.

So how did bonds do during the Great Inflation?

I digress. The question I wanted to answer was how bonds held up during the Great Inflation of the 1960s and 1970s, which is the worst case scenario for interest rates rising. From 1960 to 1981, the prime rate rose from 4.5% to 20%. My instincts told me that bonds must have been completely crushed during this time period.

They weren’t crushed. However, in inflation-adjusted returns, they barely kept up. In nominal terms, they performed surprisingly well. There was only one down year (1969) in which the bond market experienced a 1.35% decline.

bond returns

While the real returns were terrible, they certainly fared better than cash or a savings account during the highest period of inflation in US history (inflation was advancing at a 10% pace, if you can imagine that).

With all of that said, in a diversified portfolio for a risk-averse investor like my parents, they served their purpose. They provided nominal returns and controlled for the drawdowns of the stock market.

Taking it back a little further, I looked at the returns of my parent’s 70/30 Vanguard fund and broke it out by decade. This asset allocation provided a suitable buffer for the volatility in the stock market. The decades where it performed poorly were solely due to inflation. Even though they struggled to keep up with inflation, the portfolio still held up better in those decades (the 1910s, 1940s, and 1970s) than cash in a savings account would have. The next decades (the 1920s, 1950s, and 1980s), as interest rates eased, the portfolio performed extraordinarily well.

conservative portfolio

Additionally, the portfolio also protected investors during extreme market events, which is the key purpose of a bond allocation. During the Depression and the drawdown of 1929-33 (when the market declined by nearly 80%), this allocation held up well, losing only 15.88%. During the crash of 2008, the drawdown was only 7.57%. It’s also worth noting that the portfolio delivered positive returns in the 2000s, which was a “lost decade” for American stocks.

That’s what bonds are all about: in a balanced portfolio, they are for an investor who can’t take a lot of pain. They are a pain buffer. They limit the drawdowns when stocks periodically fall apart and they deliver a low return that exceeds cash in a mattress or the bank.

Bonds aren’t for losers. Bonds are for people who can’t afford short-term massive, painful, losses. They can’t look at a stock market crash and just take a philosophical approach and say “well, 10 years from now I’ll be okay.”

Yes, bonds aren’t nearly as good as stocks over the long run. Yes, they won’t do well during an inflationary period when interest rates are rising.

They’re not supposed to do those things. Bonds help risk-averse people stay the course with the equity piece of their portfolio, which will provide the real capital appreciation and long-term returns. I was wrong for scoffing at bonds as a piece of a balanced portfolio and delving into the issue made me more confident with the advice I gave my parents.

Interest rates & inflation: no one knows

Looking at the history of inflation & interest rates and taking a historical perspective towards it also gave me the sense that no one really knows where either is headed.

The confident predictions that interest rates will rise are based on the perception that interest rates aren’t “normal”, simply because they look low in the context of the last 30 years.

From a broader perspective, the last 30 years have been an unwinding of the historically unprecedented interest rates of the 1970s. Interest rates might just be around normal levels now.

You constantly hear confident forecasts from “experts”. None of them really know any more about the future than we do. They are making educated guesses, just like you and me. Just because they have an impressive title and credentials doesn’t mean they know the future.

No one really knows what the future will bring and it is wrong to steer investors away from bonds simply because we “know” interest rates are going up. At the end of the day, no one really knows anything when it comes to predicting the future.

I don’t know if the next decades will be anything like the 1960s or 1970s, but even if that’s the case, the money that my parents invested in VTINX ought to hold up, which is what I and they care about. The bond allocation ought to perform better than cash and it ought to protect them if the stock market crashes.

Again, no one knows what the future will bring. You just have to make decisions that are appropriate for your risk tolerance, not anyone else’s.

Random

  • I’ve been reading “Brat Pack America: A Love Letter to ’80s Teen Movies“. It’s a fun book delving into the history of 1980’s teen movies, which are some of my favorite guilty pleasures. It’s making me appreciate them on an even deeper level. John Hughes was the first director to make movies in which teenagers were treated like actual human beings instead of a vehicle for the nostalgia of older people. When you see them through this context, they’re pretty amazing. I don’t think modern movies treat teenagers with the same level of respect that John Hughes did. They’re unique in this sense, which is probably why they have stood the test of time and are still popular.
  • Speaking of John Hughes . . . “Oh, you know him?”

 

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

The Dark Art of Recession Prediction

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The Masters: this is a bad idea

I refer to recession prediction as a “dark art” because all of the respected sages of investing say you shouldn’t do it. It’s a taboo subject in finance and economics. I imagine it’s akin to walking into a vegan’s house and eating a rack of ribs.

The Peter Lynch/Warren Buffett/Jack Bogle school of macroeconomic sends off a pretty basic message: don’t bother.

“The only value of stock forecasters is to make fortune-tellers look good.” – Warren Buffett

“After nearly 50 years in this business, I do not know of anybody who has done market timing successfully and consistently. I don’t even know anybody who knows anybody who has done it successfully and consistently.” – Jack Bogle

Nobody can predict interest rates, the future direction of the economy or the stock market. Dismiss all such forecasts and concentrate on what’s actually happening to the companies in which you’ve invested.” – Peter Lynch

Meanwhile, since 2010, we have listened to most macro forecasters provide year after year of gloomy apocalyptic forecasts that never happen. After 2008, people confidently predicted bubble after bubble and thought every year would bring a new recession. The Federal Reserve’s recklessness would trigger hyperinflation, they told us. We were supposed to have a commercial real estate crash. There was supposed to be a crisis in municipal bonds.

Eventually, of course, they will be right. Since World War II, the average expansion has been 57 months, and the ordinary recession has been 18 months. Since 1980, the average expansion has been long and the typical recession has been short. Are we becoming better at managing the economy? Are we lucky? Probably some combination of both.

You’re not supposed to pay attention to macro. I can’t help myself.

The Yield Curve predicts recessions . . . 20 months ahead of time

Lately, there has been a lot of lamenting on FinTwit and in the financial media about the “flattening” of the yield curve. It’s well documented that inversions of the yield curve predict recessions. An inversion in the yield curve is when long duration bonds yield less than short duration bonds. Essentially, it shows you that monetary policy is too tight. The bond market is indicating that short-term rates are too high and the Fed will have to ease in the near future.

As you can see by the below chart comparing the 10-year bond to the 2-year bond, recessions tend to occur shortly after the inversion.

10 vs 2

This is why everyone is freaking out that the yield curve is “flattening”. As you can see, a flattening of the curve isn’t something to worry about. You should worry when the curve inverts.

Once the yield curve inverts, there is a lag of 20 months on average before the recession begins:

inversions

20 months is a long time. This suggests to me that we shouldn’t worry about the yield curve “flattening.”  We should worry when it inverts and, even then, we have some time.

Why the yield curve works

While it is commonly known that inversions in the yield curve occur before recessions, there is little thought that goes into why the yield curve predicts recessions.

The reason that the yield curve predicts recessions is because the Federal Reserve is the most critical factor in the American economy. The Fed can’t control how productive our economy is, but they can control the timing of recessions and recoveries. The Fed is both the cure and cause of every recession.

As Ray Dalio told us, economic cycles occur because of debt. Ray calls this the “short-term debt cycle.”

The short-term (5-10 year) debt cycle behaves like the below. The Fed is at the center of it all, and the yield curve gives a good indication of where they are in the cycle.

Recession (year 0): Incomes and asset values decline. People are losing a lot of money, and the attitude is grim. Unemployment is high, and fear is high. The Federal Reserve responds by increasing the supply of money: they cut interest rates and engage in quantitative easing.

Early recovery (year 1-3): As the Fed cuts rates, the yield curve steepens, and the economy begins to turn around. Asset prices start going up. The unemployment rate starts going down. Fresh from the wounds of a recession, people and institutions take on loans but do so reluctantly and with caution.

Middle Recovery (year 2-6): Interest rates are low, and lending picks up. The economy recovery gathers steam. People and institutions are cautiously optimistic. As a result, they are more likely to take on debt.

Late Recovery (year 3-9): The economy has been doing well, and debts have accrued. Worried about inflation and an overheating economy, the Fed begins to raise interest rates. The yield curve inverts.  The debts accumulated during the rest of the recovery start to rise in costs. People and institutions start to suffer “sticker shock” when looking at their bills. They begin to scale back their borrowing and spending to deal with the rise in debt payments.

Recession: The scaling back of borrowing and spending is what causes the slowdown. The Fed created the recession by raising interest rates too much. At this point, the only cure for the recession is to cut rates.

And on and on the cycle goes . . .

Can you time the market?

We understand that yield curve inversions occur before recessions and we know why the yield curve works (it shows how tight monetary policy is and where we are in the cycle).

With that knowledge, could you use the yield curve to time the market?  In other words, stay out during the years of inversion and get back in when the curve turns positive. Below is a rough test of this idea and the ending result:

rough

As you can see, merely staying invested all of the time yields better results than trying to time the market with the yield curve. The yield curve accurately predicts recessions, but even armed with that knowledge, attempting to bob in and out of the market winds up costing investors over the long run.

Remaining fully invested from 1978-2017 turned $10,000 into $873,590.25. Timing the market using the yield curve turned $10,000 into $510,034.21. You avoided the bear markets, but you also missed out on some of the best years in the bull markets. Additionally, you would have bought back in prematurely in 2002. The yield curve was positive, but the bear market raged on.

While the information is useful to determine where we are in the cycle, the yield curve is unfortunately not an effective way to time the market.

Peter Lynch, Warren Buffett, and Jack Bogle are right. You shouldn’t try to time the market.

The dark arts in fiction are usually something seductive that comes at a terrible price. Like eternal life . . . by splitting your soul up into horcruxes. Timing the market isn’t quite as dramatic. The seduction of avoiding bear markets simply leads to poor returns over the long run.

As I’ve said before . . . Macro is fun, but it’s probably a waste of time.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

2017: A Year In Review

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My Performance

My performance was, in the words of Benjamin Graham, unsatisfactory. I lagged the S&P 500 substantially.

breakdown

The S&P 500 was a mighty opponent this year. It was like the Kurgan in Highlander, or perhaps the T-1000 in Terminator 2. It kicked my butt. The market steadily increased with minimum volatility and drawdowns. It was quite possibly the most perfect stock market rally in history.

The road to my return was also far rockier than the S&P’s. As recently as August, I was down 4.8%. My portfolio recovered 12.5% from those levels in the last few months. The S&P, in contrast, increased every month this year in a smooth and unstoppable fashion.

The S&P 500 was not to be trifled with this year.

Much of my underperformance is attributable to the underperformance of value investing as a strategy. This is to be expected. We’re in the late stage of a bull market. Value underperforms in the late stages of bull markets. In the late stages of a bull market, the stocks that shined the most during that bull market are going to be propelled forward by momentum while the laggards (i.e., beaten down value stocks) are going to be ignored or pushed down further.

Every AAII value stock screen underperformed the market this year. The lowest decile of EBIT/EV returned 8% this year, lagging the S&P 500 by 10%. The last time that EBIT/EV exhibited this level of underperformance was in 1999 when it lagged the index by 12%.

The parallel with 1999 could be an excellent thing. After 1999, from 2000-2003, value stocks went on to experience a substantial bull market while the indexes declined. The outperformance of value was significant during that time period:

cheap

Will value investors be as lucky as they were during the 2000-2003 period? I hope so. A more likely scenario would be that value will go down in the next bear market with everything else, then recover nicely. There is no way to know for sure, which is why I will simply stick to the discipline at all times.

While there are psychological underpinnings to the current environment, it is also driven by the perverse nature of indexing. Index funds pile more money into the best-performing stocks of the index. As a stock goes up, the index fund buys more of it. As a stock goes down, the index fund sells it.

When investors look at the recent returns for index funds, they pour money into them. The index funds then go out and buy based on market cap, giving momentum to the companies with the highest recent market cap gains. When money is pouring into index funds, it fuels momentum in the top performing large-cap stocks. This happened in the late ‘90s, and it is happening again.

The best performers of a bull market are rewarded even more because of the money being pumped into index funds. Companies like Amazon, Apple, Google, Netflix, and Tesla expand their market caps. In the ‘90s bull market, it was Microsoft, Oracle, Intel, Cisco and General Electric. They did well throughout the bull market and then experienced a manic frenzy at the very end.

The critical thing to realize about these moments is that they’re not caused by any change in the fundamentals. They are caused solely by money pouring into index funds, which rewards large market capitalization stocks with price momentum and punishes underperforming stocks further.

I have no idea when the current environment will end. I just know that it will end eventually. This might be 1999. It might also be 1996, and this thing might just be getting started.

What I try to do is take a long-term perspective: I am invested in stocks purchased at attractive valuations with safe balance sheets. It is unpredictable what years will deliver the returns, but I am confident that over the long run I should be able to beat the market if I stick to this approach.

Value investing is pain. Value investors don’t earn their return when the strategy is working. They earn the return by enduring the pain when it isn’t working. The pain is how we make our return. If this were easy, everyone would do it, and these bargains would disappear. There isn’t a way to time it. We have to consistently maintain our discipline and buy with a margin of safety. We have to avoid fads. We have to stay away from what’s cool. We have to maintain the discipline. The concepts of value investing are simple. Sticking to those concepts through thick and thin is not. It’s simple, but it’s certainly not easy.

Mistakes & Goofs

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All of my underperformance isn’t attributable to the underperformance of value investing, though. I made specific mistakes and blunders this year which caused a good portion of my underperformance.

I made many mistakes in the last year. I think errors are fine, as long as you learn from them. Below are my biggest mistakes of the year. I learned the following lessons from all of them: (1) Do more homework, (2) Revisit the thesis when the company posts an operating loss, (3) Stay away from asset managers, (4) Don’t panic. Let Mr. Market do that.

Cato Corp (CATO)

CATO was a retail stock I purchased for an attractive valuation and dividend yield. I bought it for the same reason I bought my other retail stocks: I think sentiment against the industry is too negative. However, CATO was in a state of fundamental deterioration when I purchased it. The first time that the company posted an operating loss in January, I should have exited the position.

Lesson learned: when a company you own posts a loss in operating income, revisit the thesis. Going forward, if a company shows such apparent signs of a deterioration in the fundamentals, I think I should admit that I was wrong in my analysis and get out.

I lost 51% on my position in CATO.

Manning & Napier (MN)

Manning & Napier is a small asset manager. I bought it because the valuation was low and I thought that sentiment against asset managers was too negative.

I learned two lessons from this stock: (1) I should do more homework and (2) I shouldn’t mess around with asset managers because they are difficult to value.

If I did more homework, I would have seen that their assets under management were in a state of decline even when things were rosy for other asset managers and that their strategies underperformed all of their respective benchmarks.

I lost 51.56% on Manning & Napier.

United Insurance Holdings (UIHC) & Federated National Holdings (FNHC)

These weren’t mistakes because I bought them, they were mistakes because of the circumstances that I sold them. I purchased both Florida-based insurance companies because they were cheap in the wake of Hurricane Matthew and were well run.

I reacted emotionally when Hurricane Irma was barrelling towards Florida and sold both in a panic. If I just stayed put, it would have worked out fine. While they plunged substantially more after I sold them, they later recovered quickly from the depths of the decline and are now higher than when I sold them.

Lesson learned: don’t panic. Also, don’t buy more than 1 insurance company in Florida!

I lost 3.8% on UIHC and 23.36% on FNHC.

IDT Corp (IDT)

IDT was purchased because of the low P/E and low financial debt. Like CATO, IDT gave me an obvious warning sign that I was about to lose money: it posted an operating loss in the spring. I should have paid closer attention to the deterioration in fundamentals and exited the position.

My sale of IDT was pure luck. I exited on December 1st to begin my rebalance and was lucky enough to get out at one of the more attractive prices this year after the spring meltdown. I managed to exit losing 21.44%. A few days later, the stock plunged another 32%.

Lesson learned (same as CATO): when a company that you own posts an operating loss then it’s time to revisit the thesis.

US Market Valuations

We’re currently at a CAPE ratio of 32.56. Japan was around a similar valuation in 1985 when the Plaza accords were signed. Returns a decade out were predictably low, but that didn’t stop the Japanese market from stampeding to a CAPE of 100 by the end of the ‘80s. The same thing could happen to the US market. There is no way of knowing.

I don’t pretend to know what will happen in the upcoming year, but I do look at macro indicators to identify what we can expect over the long term (10 years from now) in the United States. I hope to earn a premium over the market return, but the market return will act as the force of gravity on my own gains. For that reason, I pay close attention to it.

My favorite metric of market valuation is the average investor allocation to equities. With the most recent data, that figure currently stands at 42.82%. Plugging this into my formula (Expected 10-year rate of return = (-.8 * Average Equity Allocation)+37.5), I get an expected 10-year return of 3.24%.

investorallocation

3.24% isn’t particularly exciting, but it’s not the end of the world either. It is a premium to the current 10-year yield, which is currently at 2.41%. The road to those returns is unknowable, but if history is any guide, it will not be 3.24% in a straight and orderly line. Within the next 10 years, there are going to be both screaming bull markets and savage bear markets. Through it all, a 3-4% return is the likely outcome.

Market returns are going to be low over the next decade, but not negative. Investors are likely to be disappointed in their future profits. With that said, it’s also not a Mad Max end of Western civilization scenario.

Recession Risk

As for the US economy, the current risk of a recession is low. If the market turns in 2018, I don’t think it will be driven by a recession or a problem brewing from within the economy. It may be caused by valuations just coming back to normal. In 2000, high flying stocks didn’t come back down to Earth because of a recession. People just realized that the prices were nuts. It just happened. Oddly, the decline in stocks likely caused the recession of 2001. Most of the time, this happens the other way around. Macro trouble brings stocks back down to Earth.

I think recession risk is low because the Federal Reserve is still accommodative and the balance sheets of households and businesses are still in good shape. Of course, wild things could happen like a war against North Korea or oil spiking to an insane level due to a revolution in Saudi Arabia. With that said, a recession is unlikely to occur naturally.

The Federal Reserve is both the cause and cure of nearly every U.S. recession, whether we like it or not. As they tighten monetary policy, they restrict cash flows for households and businesses. Ultimately, this causes households and businesses to limit spending, causing a recession. The Fed then loosens monetary policy until businesses and households begin borrowing and spending again. Cycle repeats.

A useful metric of the current household cash flow situation is household debt service payments as a percentage of disposable income.  Currently, this remains at a very low level of 9.91%. This implies that households are not going to restrict cash flows as a result of Fed tightening. Fed tightening isn’t having much of an impact (yet) because rates are low and most households cleaned up their balance sheets after the financial crisis. The same is true of the debt/equity ratio for the S&P 500. Firms haven’t gotten crazy with leverage in the current cycle after getting burned so badly last time.

households

Households aren’t stretched

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Corporate leverage also looks healthy

The yield curve is another excellent indicator of the current state of monetary policy. The best metric to measure this is the difference between the 10 and 2-year treasury yield. It’s still positive, implying that the Fed still has more room to tighten rates without triggering a recession. In other words, monetary policy is still accommodative.

yieldcurve

The yield curve has not yet inverted. Monetary policy is still accommodative.

With households and company cash flows in good shape (because of low leverage) and an accommodative monetary policy, the risk of a recession is very low.

My US macro view: (1) Returns are going to be low over the next 10 years because stocks are expensive, but equities will still return a premium over bonds. However, a 3.24% rate of return is significantly below the expectations of most investors.  (2) The risk of a recession is low because the current round of Fed tightening isn’t restrictive enough to cause businesses and firms to restrict their spending.

The 2018 Portfolio

For analysis of each company stock that I own, you can read my analysis here. A breakdown of my portfolio is below.

portfoliocomp

I currently own (1) a small piece of a net-net (Pendrell), (2) a spin-off at an attractive enterprise multiple (MSGN), (3) multiple companies in assorted industries with low valuations and safe balance sheets, (4) multiple retail stocks with low P/E’s and debt/equity ratios and (5) two very cheap airlines (Alaska & Hawaiian Air).

I also set aside 20% of my portfolio to put into country indexes with low Shiller P/E’s. I did this because it allowed for some international diversification in a manner consistent with a value framework and it reduces my exposure to retail. If I were to fill my portfolio with all the cheap stocks in the United States right now, my portfolio would be 60-80% in retail stocks. I decided to cap this at 30%. Currently, 28% of my portfolio is invested in the retail sector.

If these retail stocks are cut in half, I will lose 14% of my portfolio. That is a loss that I can deal with. If I were 60-80% in the retail sector, then a 50% drawdown in retail would take my portfolio down by 30-40%. That is a more difficult event to recover from.

In a value-oriented portfolio, you have to go where the bargains are. For the last couple of years that has been the retail sector and everyone knows why: Amazon. I think the retail sector is undervalued and that the current narrative is overblown. In 2018, we’ll see how that works out.

My concentration in the retail sector is not merely for the bargains, but also my belief that a recession is unlikely in the upcoming year. The economy is strong even though our markets are expensive and poised for disappointing gains in the future. If the yield curve were inverted and consumers looked stretched, I would have a different outlook.

My outlook for the US economy is also why I am comfortable investing in Kelly Services, a staffing company with low valuation metrics that will benefit from the tight labor market.

The full portfolio breakdown is below:

portfolio

Of course, all of this is speculation. That is why the margin of safety is the paramount concern when I make a purchase. Even if I’m wrong, I at least purchased at an attractive valuation. I buy stocks that post multiple low valuation metrics: low P/E’s, low enterprise multiples, low price/sales. I also like stocks with little debt as measured by debt/equity and debt/EBITDA. This is very similar to the strategy outlined by Benjamin Graham in the 1970s. Even if I’m wrong about the US economy, I am systematically buying cheap stocks with clean balance sheets, which should perform well over the long run.

Investing vs. Speculation

Bull markets dull the senses. Years of high returns with few drawdowns make people forget what the pain of losing money is like. They become more confident. They become more greedy.

As value investors, one of our key responsibilities is to not get swept up in the mania. We have to keep our wits about us. One of the key things to keep in mind is the difference between investing and speculation.

Graham defined the difference as follows: “An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”

In other words, an investment is something for which you can calculate a margin of safety. Your margin of safety might be wrong. There are undoubtedly many ways to determine if you have a margin of safety. There are value investors who focus on assets. There are some who look at earnings based ratios. There are others who perform discounted cash flow analysis. Some take a relative valuation standpoint. Others try to purchase growth at a reasonable price.

“Value investing” is a big tent and there isn’t one right approach or one true faith, but the important concept is: value investors are trying to figure out what something is worth and they are trying to pay less for it. They might be wrong in their analysis, but at least there is logic to it.

Speculation, in contrast, is when you can’t calculate a margin of safety and buy it anyway. Speculation is looking at a chart. Speculation is looking at recent price action and getting excited about it. Speculation is listening to a hot stock tip and buying it without doing any homework on your own. Speculation is buying something for which you can’t calculate a margin of safety and don’t understand.

With that said, you can’t be a speculator and a value investor at the same time. A value investor is a person for whom the margin of safety is the paramount concern in investing. Value investing isn’t a series of techniques and statistical abstractions: it is a way of thinking about the world.

The 21st-century term for speculation is FOMO. Fear of missing out. For a value investor, that’s the emotion that we need to continually keep in check and resist. Resisting FOMO may keep us out of “multi-baggers,” “compounders.” Investing is methodical and boring. Speculation is exciting. It may make us describe our returns in percentages and not “x.” It will also keep us from suffering permanent losses of capital. You can’t compound from zero.

 

One of the peculiar things about value investing is that the secret has been out since Benjamin Graham wrote “Security Analysis” in 1934. You would think that value investing would have been arbitraged away by now. You would think that it would be in the dustbin of history. The reason that hasn’t happened is because value investing goes against human nature. Most people are speculators. They are enticed by price action, they feel FOMO. People are never going to change, and that’s why Benjamin Graham’s lessons are timeless.

Only a select few are immune to this impulse. They’re the kind of people who look at a mania and think “this is BS.” They’re the kind of people who get excited when they buy a $50 pair of shoes for $25. They’re people who don’t look at value investing as some kind of statistical trick or academic exercise: it’s in their blood. It’s a way of thinking about the world. It’s a way of thinking that runs contrary to much of human nature. That’s why it continues to endure.

Before you make a purchase, think about it through this lens. Am I buying something for which I can calculate a margin of safety? Do I have a margin of safety? If the answer to both questions is “no” then you’re speculating, not investing.

There are certainly wealthy speculators, but they’re the exception. Speculation doesn’t work out too well for most of us. Speculation is buying something based on a chart, based on hype, based on a story. Success in investing requires us to avoid these impulses entirely.

Value investing isn’t low P/E, low price/sales, the magic formula, net current asset value, or low EV/EBIT. Value investing is a way of looking at the world rationally and not allowing ourselves to be swept up in the emotional impulse to speculate. This is an important thing to keep in mind in these frothy, speculative times.

The Blog

The year wasn’t entirely filled with folly. Concerning achievements, I’m most proud that I finally took the plunge and started this blog.

I’ve struggled with the itch to pursue active value investing for most of my adult life and lacked either the money or the courage to do so. The blog has been a real-time chronicle of my journey as a value investor. It also helps me stay accountable.

This year, I think my biggest achievement was finally pulling the trigger and doing this after thinking about it for so long.

Looking back at my posts, I am happy I did this. It is nice to look back and see my views in real time. It’s fun to share what I’m reading and thinking with others.

The blog is useful. It’s comfortable with the benefit of hindsight to look back and try to frame what I thought in the past. Putting down my thoughts on a blog makes it impossible to do that. It makes me more accountable for my decisions. I can look back and see why I did something and what my thought process was at the time. Hopefully, I can stick to it. I think it will help me become a better investor. I encourage others to do the same thing. Even if you don’t do it publicly, keep a journal and keep track of your decisions. Revisiting those decisions and your process will help improve your skills as an investor in the future.

I appreciate all of the feedback and am somewhat surprised that I actually have readers! Hopefully, you can all learn from my mistakes and goofs. Keep reading: you can learn about the markets on my dime!

To all of you, have a very happy, healthy and prosperous New Year!

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.