Category Archives: Macro

Are bonds for losers?

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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.

Confronting reality

I first confronted this reality when my parents needed investment advice. They asked me to look at statements provided by their financial advisor.

To be frank, the financial statements pissed me off.

The advisor had them in “safe” options appropriate for their age, but it was all stuffed into an incomprehensible soup of mutual funds. All of the funds had relatively high fees. Even worse, the advisor frequently moved in and out of funds even though they were essentially the same thing. I assume this was churning and it was merely to generate commissions.

The money was my parent’s life savings, and this guy was not treating it with the appropriate respect.

While I was growing up, I watched my parents struggle and work hard to earn this money. They would forego luxury. They always shopped with coupons; they bought store brand food, they never bought new cars, they always they worked hard at their jobs. My father is a construction worker, and my mother is a dental assistant.

They worked hard for their money and made the right decisions, and this guy was treating it like it was a game.

My first advice was simple: dump this financial advisor.

Back in college, I wanted to be a financial advisor. I changed my mind after an internship where I spent all of my time cold calling. I went through a list of phone numbers, read from a script, and asked rich and not-so-rich people to invest. After talking to the financial advisors at the firm, I realized they weren’t providing any value. When I asked them how they selected investments, they showed me software that popped out whatever fund mix the computer spit out after plugging in age and risk tolerance. The computer did the work. Their real role was sales, not guiding people or helping them.

(Yes, I *KNOW* there are good financial advisors out there. There are financial advisors that genuinely care about their clients and can provide a good service. They offer behavioral coaching when the market takes a fall, they offer tax and estate advice, and they can be a good judge of character when it comes to assessing someone’s tolerance for risk. Unfortunately, I don’t know any. I certainly don’t know any who would provide such a service for a small client like me or my family.)

Then I had to ask myself, “If I’m telling them to dump the financial advisor, what should I tell them to do instead?”

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

I knew that my personal attitude was inappropriate for my parent’s level of risk tolerance and age. They couldn’t afford a “lost decade” of stock returns. They couldn’t afford to lose half of their money tomorrow. They couldn’t double down and get a second job if their investments fell apart. This money needed to last. Mine had to be worth a lot in 40 years. These are completely different objectives.

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)

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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 portfolio 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.

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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.

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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.

A financial health check up for the S&P 500

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Debt: The Best Measure of Risk

One of my core beliefs as an investor is that debt is the best measure of risk.

Academic attempts to define risk as the volatility of a stock price are ridiculous. Risk is the possibility of a permanent loss of capital. The risk that a company will go out of business is heightened through the use of leverage.

There is no perfect measure of risk, but I think that debt levels give the clearest signals about the risk of an investment. A company without debt can withstand incredible business problems, while a company in deep debt won’t be able to survive the slightest shake-up.

Debt levels are one of my chief concerns when I purchase a stock.

As a deep value investor, I focus on firms that are going through a tough time in their business or sector. Because they are going through difficulty, it is paramount that balance sheet risk is low. If they have a healthy balance sheet, then they will be able to survive whatever trouble they are mired in.

I try to find the firms that are still profitable and are still in a strong financial position so they can survive the temporary business setback.

Corporate debt at all-time highs!

Due to my views on the subject, I was alarmed when I read several articles indicating that debt is rising to all-time highs within the S&P 500. High leverage levels were one of the driving forces behind the crisis of 2008.

The narrative of the corporate debt scare articles goes like this: (1) the Fed made debt too cheap after the crisis, (2) companies are taking advantage of it and spending it on frivolous activities like buying back shares, (3) corporate debt is now at all-time highs and will trigger a severe credit contraction in the future.

The headlines are usually along the lines of “corporate debt is at all-time highs!”

Well . . . based on inflation alone, corporate debt should regularly hit all-time highs in raw dollar terms. Looking at the total dollar volume of debt issuance doesn’t make a lot of sense.

The Real Story

What, then, is the best way to measure the debt risks to corporate America? Many like interest coverage ratios . . . but I don’t like this, as interest rates can change on a dime for the better or the worse. I look at total debt relative to earnings and assets.

When I assembled the data, I was pleasantly surprised to see that the situation is actually not that bad. Corporate America is financially healthy. Despite record low interest rates, corporate America hasn’t gone on a debt binge. Quite the opposite. They have been deleveraging since the crisis.

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debtequity

This suggests that if we do fall into a recession, it won’t be the painful credit crunch we endured in 2008. Even though interest rates are at historic lows, corporate America is not taking the bait.

This also explains why the Fed has been able to keep interest rates near all-time lows. Few companies are actually taking advantage of the low rates.

Financial journalism is in the business of creating sensational click-bait headlines. They aren’t particularly useful. This is why individual investors need to do their own homework and think independently.

I think low corporate debt is also is a major reason that the economy isn’t growing more than 2% even though interest rates are rock bottom.

While it means less growth for the economy, it also means less risk for corporate America. That’s a good thing.

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 is hard and probably a waste of time

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Macro is probably a waste of time, but I can’t help myself

Everywhere I turn in discussions of the stock market, everyone seems to have made a similar conclusion: (1) The stock market is in a bubble, (2) the Federal Reserve created the bubble, (3) When the bubble bursts, we will be faced with financial Armageddon.

The mood among value investors looking at a historically high CAPE ratio is something like this:

giphy - Copy

I love talking and thinking about Macro, but I suspect it is mostly a fun waste of time and not entirely useful. Peter Lynch offered the following advice about these matters:

Far more money has been lost by investors preparing for corrections or trying to anticipate corrections than has been lost in the corrections themselves.

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.

I think living through 2008 might have polluted everyone’s minds, the same way 1929 poisoned the minds of a generation of investors and made them stay out of the market for life to their own detriment.

Unlike the 2000-02 meltdown, in 2008 there was nowhere to hide. This is because the 2000 collapse was driven by an overvalued stock market falling apart. 2008 was different because it was an economy-wide credit contraction that caused everything to decline.

This left investors with a kind of financial PTSD. As for myself, I had hardly any money at the time, so I wasn’t concerned about my financial assets going down, but I was still consumed by fear.

By day I am an operations nerd for a bank, so I was acutely aware of what was going on. I had very little savings (I was in my mid-20’s and had just started making decent money), a pile of debt and I was mostly worried about basic survival if I lost my job and faced a Depression job market. My main personal lesson from the crisis was about the dangers of being in too much debt and not having sufficient savings. Today I have zero debt and an emergency fund if I lose my job. I sleep better at night.

If anything, this is why the simple low-PE low-debt Graham strategy intuitively appeals to me. Financial problems facing a company or a person are always manageable . . . Unless you’re in heavy debt.

Post-crisis, everyone is consumed with trying to predict the next meltdown after getting burned so badly.

We look at investors who made the right call — people like John Paulson — and are in awe that they made the right call. They knew what was going to happen. We want to be able to predict what is going to happen. We become obsessed with finding tools that will help us prevent losing money.

Post-crisis hindsight also puts the permanent bears in a positive light. They are lauded for getting it right in 2008, but how much money has been lost listening to them since then?

Prediction is Hard

As small investors, I think we may have to just accept the fact that if we want equity-sized returns, we need to take equity-sized risks. A 25% drawdown a couple times a decade is pretty standard. A 50%+ drawdown 3 or 4 times a century is also typical. The average person lives about 80 years, so when they see these events happen a couple of times it looks extraordinary in the context of our lives and permanently affects our thinking. In the grand scheme of things, these events are not uncommon and we should expect them.

Charlie Munger gave this great advice about the subject:

This is the third time Warren and I have seen our holdings in Berkshire Hathway go down, top tick to bottom tick, by 50%.  I think it’s in the nature of long-term shareholding of the normal vicissitudes, of worldly outcomes, of markets that the long-term holder has his quoted value of his stocks go down by say 50%.  In fact, you can argue that if you’re not willing to react with equanimity to a market price decline of 50% two or three times a century you’re not fit to be a common shareholder and you deserve the mediocre result you’re going to get compared to the people who do have the temperament, who can be more philosophical about these market fluctuations.

We can’t invest like 1929 or 2008 are going to occur tomorrow. It’s not a useful long-term strategy for building wealth. We need to accept the fact that we will face those kinds of drawdowns and face the fact that there will be more minor drawdowns frequently (or the 20-25% variety) and don’t give into our emotional need to panic. If we constantly live in fear that a big drawdown is imminent, then we should stay out of the market and won’t earn equity sized returns.

Using valuation tools to time to the market

There are tools to predict future market returns (like the CAPE ratio, the average equity allocation, market-cap-to-GDP, etc.) that give us clues as to where we stand in the cycle, but timing the market using those tools isn’t particularly effective either. I’ve talked about them on this blog.

You can use these tools to predict market returns 10 years out, but it doesn’t tell you if a correction is going to happen tomorrow and they are not particularly useful for timing the market.

The 10-year S&P returns predicted by valuation tools don’t happen in a straight line. My favorite indicator (the average equity allocation), suggests a 10-year rate of return for the S&P 500 of 3.34%. With the 10-year treasury yielding only 2.361%, that actually makes sense. We are likely in store for a decade of low returns across all asset classes. “Low returns over 10 years” does not mean “We are facing Old Testament biblical meltdown.”

(Hell, if we were facing an Old Testament Mad Max kind of situation, what good is your 401(k) going to do you anyway?)

You can use market valuation tools to get a fair understanding of what returns will look like, but it is not a crystal ball. It doesn’t predict if a crash will happen tomorrow or what the road to those returns will look like.

Current valuations are basically where we were around 1973 and 1998. The 10 years after ’73 and ’98 were not particularly good for the indexes . . .  but they were great for value investors, the indexes still delivered a small return, and the world didn’t end. Value stocks had an excellent bull market from 2000-2003 and 1975-1978.

The difference between the two eras is that in 1973-74, value stocks went down with everything else before their bull market in 1975 and in 2000-03 value experienced a bull market during the decline of everything else.

This happened because the 1973-74 event was caused by a real economic shock, while the 2000-03 meltdown was the stock market coming back down from crazy valuations. The 2000-03 collapse was unique in that the market caused the economy to contract, while most meltdowns (like ’73-’74 and ’07-’09) are the economy causing the market to contract. The stock market wasn’t overvalued in 2008, the real estate market was. The decline in real estate caused the economic contraction, which ultimately impacted stocks.

Whether the current situation is like the ’70s or the early 2000s is tough to predict. I suspect that it will be more like the ’70s (value will go down in the bear market with everything else, but then perform nicely). Hopefully I’m wrong and it pans out more like the 2000-03 event. This is discussed in depth in this blog post.

It’s also tempting to short stocks in this environment, but that’s not something I do. You shouldn’t do it, either (unless your name is David Einhorn). Shorting is a dangerous game. For instance, tech shorts in 1999 were correct in their analysis. Even though they were right, most were completely wiped out when tech stocks doubled in 1999. They were ultimately vindicated but, as Keynes warned us, markets can stay irrational longer than you can remain solvent.

It’s tempting to try to time the market with macro valuation tools. I found a great post at Tobias Carlisle’s blog exploring this issue of timing the market using CAPE ratios. You can read the post here and here.  The conclusion is simple: timing the market using valuation tools is a waste of time. He makes the following point:

The Shiller PE is not a particularly useful timing mechanism. This is because valuation is not good at timing the market (really, nothing works–timing the market is a fool’s or genius’s game). Carrying cash does serve to reduce drawdowns.

Japan

Japan in the 1980s is the common comparison among bears to today’s market. There was a similar sentiment among bears in the late ’90s.

In the 1980s, the success of Japanese firms combined with an easy monetary policy caused a massive asset bubble. There was a widespread perception that Japan was going to take over the world.

Easy monetary policy and rising asset prices are where the comparison ends, however. Valuations in late 1980s Japan were genuinely insane. In 1989, the real estate around Japan’s imperial palace was worth more than all the real estate in the entire state of California.

During the 1980s, the Nikkei rose from around 6,600 in 1980 to 38,000 by 1989. Everyone thought that Japan had figured it out: their management was superior, their workers were better, their processes were more efficient. The zeitgeist was captured in the Ron Howard movie “Gung Ho.”

Like all bubbles, the Japanese bubble collapsed. The Nikkei fell from its high of 38,000 in 1989 to 9,000 in 2003. This is the nightmare scenario that the bears fear will happen to the United States stock market.

Valuation puts this in context. Today’s investors fret of a Shiller PE around 30. In Japan circa 1989, the Shiller PE was three times that at 90. Indeed, there is no comparison between US stocks today and Japanese stocks in the 1980s. Valuations today suggest bad returns in the future for US stocks. Valuations in Japan indicated that a complete collapse was inevitable.

Lost from the typical talk of Japan’s lost decade is a discussion of its actual economy. The focus is solely on the markets. Japan’s economy continued to chug along despite the complete meltdown in markets. Its central bank scrambled to contain the collapse, but likely merely prolonged the pain as the market was destined to return to a normal CAPE. Their unemployment rate has never even gone above 6% during the meltdown!

It took nearly 20 years for Japan to go from a Shiller PE of 90 to a more normal Shiller PE of 15. Markets are worth what they’re worth and they will eventually fall to normal levels of valuation. That’s what happened in Japan. Very little changed in their real economy, it just took a long time to work off their crazy 1989 valuations.

Value in Japan

Even if the US is in a Japanese style asset bubble (even though it is nowhere near those levels), I was curious how a value strategy performed in Japan during their asset meltdown if this were the future for the United States.

It’s encouraging that value-oriented strategies actually performed very well during the Japanese market collapse. In James Montier’s epic The Little Note That Beats the Markethe observed that Joel Greenblatt’s magic formula returned 18.1% from 1993 to 2005 in Japan. EBIT/EV alone returned an excellent 14.5%.

This suggests that as long as you stick to a value framework, even in a market that is in long-term decline, a value strategy should hold up over a long stretch of time.

Conclusions

My apologies if this post is a bit of a mess, but it summarizes many of the things that have been on my mind lately.  To summarize my conclusions:

  • It is probably best for most investors to not obsess over macroeconomics. The smartest people in the world are playing that game . . . and they’re bad at it. We cannot do any better.
  • Market valuation tools are useful for predicting returns over the next decade but aren’t particularly helpful in predicting short-term market moves.
  • The United States is not in a Fed-induced, Japanese-style asset bubble. Our market is high, but a definite return is still likely over the next 10 years.
  • Even if we were in a Japanese style asset bubble (which we’re not), a disciplined value-oriented strategy should still perform very well in the United States.
  • 50% drawdowns 3-4 times a century and 25% corrections are standard. They’re the cost of earning equity returns. If equities went up by their historical 8% average every year in a straight line, they would eventually stop delivering those returns. If you can’t handle corrections of that magnitude, you shouldn’t invest in stocks.

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.

 

 

Going Global with Value Investing

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Holding Cash in a Euphoric Market

I have a problem. 26% of my portfolio is in cash. I hate cash. It earns nothing. My preference is to be fully invested at all times. I prefer not to try to time the market.

But . . . I am frightened by the valuations present in the U.S. market right now. I don’t believe in market timing, but with a Shiller CAPE around 30, average equity allocation at 42% (probably higher now), and market cap to GDP at 132% . . . it definitely feels like the market is primed for a fall. Usually, value stocks tumble with everything else (except for the early 2000s).

This conflicts with my belief that investors shouldn’t time the market. If you own cheap stocks, it shouldn’t matter what the general market is doing, they will eventually realize their intrinsic value. The CAPE ratio or any valuation metric for that matter isn’t entirely predictive. Just because stocks are expensive now doesn’t mean that the market is necessarily going to crash. Valuations may even be justified if interest rates stay low. That seems like wishful thinking, but we’ve gone through long stretches before where interest rates stay very low (as they did in the 1930s and 1940s). You just don’t know. No one has a crystal ball.

Whether it is stocks or companies, all that you can do is put the probabilities in your favor.  Expensive stocks and markets can get more expensive. Cheap stocks and markets can go down. As a group, though, this is unlikely. Buying cheap stacks the odds in your favor.

International Net-Net Investing

The prudent course seems to me to expand outside of the United States for diversification. It is also a way to make sure I am not overly correlated with the US market. The most tempting way to do this is to buy net-nets in foreign countries.

Net-net investing involves buying companies at sub-liquidation values. In the most basic form, you take all current assets and subtract all liabilities to arrive at the net current asset value (NCAV). No value is given to long term assets like plant, property, and equipment which might be more difficult to sell. Graham advocated buying a net-net at 2/3 of the NCAV value and then selling when it reaches full value (thus securing a 50% gain). Graham remarked about net-nets: “I consider it a foolproof method of systematic investment . . . not on the basis of individual results but in terms of the expectable group outcome.”

Studies show that net-net investing is the best way to earn the highest returns. Buffett’s best returns were when he was investing in net-nets in the 1950s and 1960s. Joel Greenblatt created his original “magic formula” with a net-net strategy in 1981. He devised a strategy of buying net-nets with low P/E’s and demonstrated that you could earn 40% returns.  The period he studied was after the market crash of 1973-74.

Those net-net opportunities were eliminated during the bull market of the 1980s and 1990s, which is why he didn’t stick to that strategy. Net-net investing is also hard for professionals investing a lot of money (i.e., over $10 million or so), as the stocks usually have extremely low market caps. It’s only something that individuals like me can pursue who are dealing with relatively small sums of money.

The strategy I pursue during frothy bull markets is Graham’s low P/E strategy that he devised in the 1970s. Graham demonstrated that this strategy delivers 15% rates of return over the long run. 15% returns are incredible but not nearly as exciting as what you can make investing in net-nets which amp up returns to the 20% level. I look at other value factors (price to sales, EBIT-Enterprise Value, relative valuation), but I try to stick to Graham’s rules (low debt to equity ratio and an earnings yield that doubles corporate bond yields).

While Graham’s P/E strategy is my base during bull markets, I look at other value factors (price to sales, EBIT-Enterprise Value, relative valuation). I like to see multiple signals that a stock is cheap but I try to stick to Graham’s rules (low debt to equity ratio and an earnings yield that doubles corporate bond yields).

I would much rather invest in net-nets than the low P/E strategy, as the returns are better, it is easier to calculate intrinsic value, and it is easier to determine the appropriate selling point (you sell when the stock hits the net current asset value). Unfortunately, in the United States, there aren’t enough net-nets available to make it viable. Net-net returns are higher than any other strategy, but a net-net is also more likely to go bankrupt than a normal company, so diversification is paramount. When Graham bought net-nets for his partnership, he would buy them in bulk. I read once that he would own nearly 100 net-nets at any given time.

We live in a different world. To put it in perspective, there are about 9 net-nets in the United States right now. Of these 9 choices, they aren’t of the best quality and most of them can only be bought on OTC exchanges.

Net-nets become available in bulk in the United States during market meltdowns like 2008 and 2009. There were also a lot of them in the early 2000s during the tech crash. During both periods, net-nets performed exceptionally well.

There are quality net-nets available internationally, but the problem I have with buying them is that I don’t trust my ability to read foreign financial statements or research companies. I can’t go into Edgar and read an annual report for a Korean net-net, for instance.

I don’t even know where I can run reliable screens to hone in on the right opportunities. Unforeseen tax consequences would also plague me by investing in individual foreign stocks. While I wouldn’t owe US taxes because this is an IRA account, I would still owe taxes in the foreign countries on any gains. For those reasons, I am not keen on buying individual stocks outside of the United States.

Another reason I prefer buying individual companies in the United States is the SEC. I’m happy that the SEC is active in the US market. The SEC misses quite a bit, but it’s still better than what exists internationally.

For all of these reasons, I don’t want to buy international net-nets even though I think the returns are probably substantial and it would allow me to diversify outside of the frothy United States market.

I will shift to net-nets when they are available in bulk quantities (as they were in 2008 and 2009) during the next market meltdown and I can buy at least 10 quality choices. Unfortunately, that’s not an option in the current market.

A Possible International Solution

Thinking about the issue, I thought of something I once heard of listening to a Meb Faber speech from 2014 at Google. He discussed a really interesting idea: applying Robert Shiller’s CAPE ratio internationally.

Meb Faber has done a great research (available on his website) about this topic. He has empirically demonstrated that countries with a low CAPE tend to deliver higher returns (as a group) compared to those markets with higher valuations. Just like individual companies with low valuation metrics, this occurs as a group and it’s not an iron clad rule of prediction.

The CAPE ratio isn’t the best valuation metric for a market, but it’s good enough and it’s readily available for most markets.

This brings me to a possible solution: buying international indexes via ETFs for countries posting low CAPE ratios. This would allow me to avoid the tax consequences of international investing in individual stocks, remain consistent with a value approach, and provide adequate diversification. I will also be able to lower my correlation with the US market in a manner consistent with a value template.

I found a decent list of countries by CAPE ratio. The cheapest market in the world right now is Russia. The reasons for Russia’s low valuation is obvious. Oil has been crushed in recent years and Russia’s economy is very oil dependent. They are also under international heat and sanctions. For these reasons, Russia has a CAPE ratio of 4.93. Russia is hated by international investors. Of course, that is music to my ears: the best investments are the ones that everyone hates.

If it’s not behaviorally difficult to buy, it’s not really a bargain.

To give some perspective on how low Russia’s CAPE ratio is — there were only a handful of times that the US has a CAPE ratio that low — the early 1920s, the early 1930s, World War II, the early 1950s, the early 1980s. All of these were exceptional times to buy stocks. Even in March of 2009, the CAPE ratio for the US market only went down to 15.

In the early 1920s, early 1930s and the early 1980s – people hated stocks, which made them the best times to buy them.

Business Week ran a cover in 1979 called “the death of equities”. This was right before the greatest bull market in history from 1982-2000, which took the Dow from below 1,000 to over 10,000. The reason people hated stocks in the early 1930s is obvious. In the early 1920s, people in the United States hated stocks because the country suffered a severe but short Depression, which everyone forgets about because it is overshadowed by the Great one in the 1930s.

It’s true for individual companies and it’s true for entire markets: buy them when everyone hates them, sell them when everyone loves them.

Possible Investments

I haven’t decided if I’m willing to pull the trigger on this idea just yet, but I am curious to hear anyone’s thoughts.

I was considering putting 10% of my portfolio into two of the below ETFs:

iShares MSCI Brazil Index (Ticker: EWZ).  Brazil currently has a CAPE ratio of 10.4.

iShares MSCI Russia Capped ETF (Ticker: ERUS).  Russia currently has a CAPE ratio of 4.9.

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.

Is the Bubble About to Burst?

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Q4 2016 Data

In an earlier post I referenced an excellent market valuation model that I found at the Philosophical Economics blog. To sum it up: the model projects the next 10 years of market returns by using the average investor allocation to equities. The theory is that most bull markets are fueled by rising valuations as investors move money from other asset classes into stocks. The model tells you how much “fuel” is out there to push equities higher.

The Q4 2016 number recently became available over at Fred. The current average equity allocation at the end of the year was 41.279%. Let’s plug this into the equation I referenced in my earlier blog post on this topic:

Expected 10 year rate of return = (-.8 * Average Equity Allocation)+37.5

(-.8 * 41.279) + 37.5 = 4.48%

We can therefore expect the market to deliver a 4.48% rate of return over the next ten years. Not particularly exciting, but not the end of the world either.

Market Timing

Most hedge fund letters this year emphasized how market valuations are at historic highs and take a cautionary approach to stocks. I agree with their spirit because I think everyone should always approach the market with caution. If someone cannot handle losing half of their money, then they have no business in the stock market. A drop of that magnitude can happen at any time no matter where valuations stand. That short-term risk is the very reason that stocks outperform other asset classes over the long-term.

If I were an alarmist, I would agree with some of the hedge fund letters and say: “The market hasn’t traded at these valuations since 2007! Get to the chopper!” This implies that we are on the brink of another historic meltdown in stocks. This is the prognostication that is often heard about stocks today. I think it is misleading.

Valuation simply predicts the magnitude of future returns over the long run. Higher valuations mean lower returns and lower valuations mean higher returns. That’s it. It does not predict what the market will do over the next 12 months. It does not mean that if you wait long enough, you’ll have an opportunity to buy when valuations are at more attractive levels. Anything can happen in the next year. There could be an oil embargo. A war could break out. Terrorists could strike. Our politicians could cause another crazy showdown that imperils the economy. Trump-o-nomics might actually work. Maybe it won’t. No one really knows and anyone who proclaims otherwise is lying.

It is tempting to look at market valuations as a tool to time the market. Wouldn’t it be great to sell in 2007 and buy in 2009? Get in when the market is depressed and get out when valuations rise and the market looks like it is due for a correction? My view is that market valuations should not be used as a market timing tool. When it comes to timing the market, I think Peter Lynch put it best when he said:

“Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.” – Peter Lynch

This is great advice. Today’s market valuations may be at 2007 levels — but they were also around these levels in 2004 (S&P 500 up 8.99%), 1968 (up 7.32%), 1997 (up 25.72%) or 1963 (up 17.51%). It makes little sense to try to time the market based on valuation or refuse to participate simply because the market isn’t offering the kind of compelling bargains that it presented in 2009. The question is: is this 2007 or 1997?

Stopped clocks are always right twice a day. This is how I feel about the permanent bears. They certainly called it in 2008, but did they call the turnaround? How many of them have been predicting disaster for the last decade and have been proven wrong year after year? There is bound to be another meltdown at some point in the future, but there is no way to predict when that will happen. The wait can be long. While you wait, more money can be lost through unrealized gains than is lost in the actual correction. 2017 may be the year for a major market meltdown of and the end of the bull market. Perhaps. Taking the advice of the permanent bears will help you avoid it, but how much more money was lost listening to their advice since 2009? It doesn’t make sense to refuse to participate in the market simply because the market isn’t offering compelling valuations.

Valuation in a Vacuum

Stock market valuation doesn’t occur in a vacuum. One should always compare the expected returns in stocks against the expected returns in other asset classes. My view is that the best asset to compare stocks to is AAA corporate bonds. The way to think about stocks is as corporate bonds with variable yields. The question isn’t “is the market overvalued?” The question is “Do current earnings yields justify the risk of owning stocks when compared to the returns on safer asset classes?”

This is why interest rates drive the stock market.

“Interest rates act on asset values like gravity acts on physical matter.” – Warren Buffett

Below is a historical perspective of market valuation compared to the interest rates on corporate bonds. The expected 10 year S&P 500 return is derived from the equation described earlier in this post.

Year Expected 10 Year S&P 500 Return AAA Corporate Bond Yield Equity Risk Premium
2017 4.48% 3.05% 1.43%
2012 9.38% 3.85% 5.53%
2007 5.06% 5.33% -0.27%
2002 4.33% 6.55% -2.22%
1997 7.86% 7.42% 0.44%
1992 14.43% 8.20% 6.23%
1987 14.37% 8.36% 6.01%
1982 19.24% 14.23% 5.01%
1977 15.03% 7.96% 7.07%
1972 5.22% 7.19% -1.97%
1967 4.41% 5.20% -0.79%
1962 5.66% 4.42% 1.24%
1957 9.81% 3.77% 6.04%
AVERAGE 2.60%

Historical

As you can see, there are times when the market adequately compensates investors for the risk of owning stocks and there are times when it does not. It is also evident that there is a strong correlation between interest rates and future market returns. Higher interest rates mean that stocks need to deliver higher earnings yields, something that is usually achieved by a market correction that depresses P/E ratios and boosts earnings yields.

From this perspective, the market isn’t wildly overvalued. The current market valuation is largely in line with historical norms based on where interest rates are today.

That is the right way to think about stocks. It is folly to think “valuations are too high, therefore I will not participate because a correction is imminent.” That is short-term prognostication and it is typically wrong. No one knows what will happen over the next year and market valuations won’t provide the answer.

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.

Your Politics and Your Portfolio Do Not Mix

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Your Political Opinions are Emotional

Political opinions are powerful forces. Usually, they are more influenced by emotions and passion than they are by facts. The enemy of good investing is human emotion. Human emotion fueled the internet bubble. Human emotion drove people to buy homes they couldn’t afford (it’s the American dream!). Human emotion took the Nasdaq to 5,000 in 2000 and took the stock market to a 15 year low in the spring on 2009. Most investors underperform because of their emotions.  They pile into stocks when they are overvalued and exit when they are at their most appealing level. Winning at investing isn’t about smarts, it’s about mastery of your emotions. If the market were made up of people like Spock, then Mr. Market wouldn’t be able to act so crazy. Fortunately the market is made up of people who are the opposite.

Making the Wrong Call

The emotional impact of politics is one of the key reasons it should be excluded from investment decisions. Case in point: I am sympathetic to a small government perspective. After the election of Barack Obama and a completely Democratic congress in 2008 during a financial crisis while the Federal Reserve was increasing the money supply like Weimar Germany, it was tempting for people of my orientation to think that the country was about to turn into a hyperinflationary socialist state. At this time it was more tempting than ever to shout “sell” from the rooftops.

Selling in late 2008 would have been a terrible mistake. It is a mistake made by many right wingers who loaded up on gold as they prepared for financial Armageddon. Since 2009, the S&P 500 is up 155%.  Gold is only up about 15%.  In 2009, the immediate year after the collapse, the S&P rose 28%.

Let’s examine another scenario. Let’s say you were someone of a more liberal orientation when Ronald Reagan was elected is in 1980. Many of the leading (liberal) economists of the time predicted that Reagan’s policies would be a complete failure.  They predicted that his fiscal policies would stoke instead of quell inflation. The Reagan years saw a 144% increase in the S&P 500.

The bottom line is that while you may try to convince yourself that your politics are hard grounded in facts and are as immutable as the laws of nature, you simply can’t use your political beliefs as a useful metric to predict future market returns. Your politics are grounded in emotion and for that reason they shouldn’t guide your investment thinking.

Does it Even Matter Who the President Is?

Nor do I think politics even matter that much to the economy. The popular news creates the impression that politics is the only thing that influences the economy, but the truth is that it doesn’t really matter all that much. American businesses are going to try to sell more products and be more productive no matter who is President.

My guess is that if Al Gore won the 2000 election, Alan Greenspan would have still cut interest rates in the wake of the internet bubble, homeowners would have still levered up, and the housing collapse was inevitable. Similarly, was Bill Clinton responsible for the surpluses and prosperity of the late 1990s, or was it simply a surge of computer-driven productivity gains that would have happened anyway?  The President and their party receive the credit for booms and the punishment for busts in the public’s mind, but their actual real world influence is limited.

Also, the United States political system is set up to resist radical change.  That may be frustrating when the President can’t implement their desired mix of policies, but it is a good thing for the health of the economy.  The Constitution is designed to derail radical change and it works most of the time.

Productivity

The Federal Reserve plays a more important role than the President in the direction of the economy. The Fed’s influence is still limited, though.  The Fed can only influence the short-term gyrations of the economy and the inflation rate. They can’t impact the long-run trend of the economy because the long-run trend is driven by productivity. Despite the attempts of policy makers to influence productivity, I doubt that public policy can have any impact at all on productivity rates.

Productivity seems to be driven more by the forces of capitalism and the abilities of managers than it is by policy.  I doubt that laws can make a country more productive any more than a law can change the weight on my bathroom scale.  Productivity is the true driver of economic performance and it appears to be out of the hands of policy makers.  That’s probably a good thing.

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Source: United States Department of Labor.  Productivity does not seem to care who the President is.

Right now we’re in a productivity slump and everyone is losing their minds over it. I think this productivity slump is much like the slump that occurred in the 1970s: it’s temporary. Much like the boom in productivity from 1995 to 2005 was also temporary. Productivity appears to be stubbornly mean reverting. It has a tendency to revert to its 2% long term trend and there is little we can do to change it.

There was a belief in the late 1990s that information technology had permanently increased the productivity rate.  That’s what the “New Economy” talk and hyper optimistic federal government budget projections were driven by.  It wasn’t permanent and productivity is reverting to the mean.  Similarly, the worry now is that the productivity slump is a sign of permanent stagnation in the US economy.  That’s probably just as wrong as the 1990s optimism was.  At some point in the next 10 years when productivity starts surging due to mean reversion, we’ll hear that we are in a new economic era of higher productivity driven by artificial intelligence, social media, cloud computing, 3-D printers, etc.  Then it will revert to the mean and everyone will start wondering if we are in a permanent slump again.

There is very little that politicians do to change desire of individuals and businesses to earn more money, which is really the driving force behind productivity.

Ignore It

The lesson of history seems to be that the safest long term bet is to leave your politics at home when making investment decisions.  There is a human tendency to believe that if there are people you disagree with in power, then the world must be headed to hell in a handbasket.  If there are people that you agree with in power, then there is a tendency to believe that manna will begin to come down from the heavens.  It’s your emotions talking and emotions are the enemy of capital gains.

Besides, your political beliefs should be deeply held as a result of moral conviction.  They shouldn’t be formulated based on the impact that a policy will have on the S&P 500.  They’re for the voting booth, not your portfolio.

PLEASE NOTE: The information provided on this site is not financial advice and I am not a financial professional. I am an amateur and the purpose of this site is to simply monitor my successes and failures.  Full disclosure: my current holdings.

Bruce Greenwald on Globalization

This is a fascinating and thought provoking video with Bruce Greenwald on globalization and the future of the economy.

PLEASE NOTE: The information provided on this site is not financial advice and I am not a financial professional. I am an amateur and the purpose of this site is to simply monitor my successes and failures.

 

Are Markets Efficient?

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My high school interest in the stock market led me to major in Finance in college.  Hoping to learn juicy insights into beating the stock market, I was instead taught the efficient market hypothesis, or EMH.  The efficient market hypothesis states that markets are largely efficient at assessing risk and dishing out returns.  Over time, equities perform better than other asset classes because equities are riskier than other asset classes.  Returns are a compensation for risk.  Basically, business students pay a lot of money to learn that they don’t have a chance against an index fund.  Fortunately, I went to a state college for this advice.

Eugene Fama and Kenneth French, the architects of EMH, performed research which showed that value investing delivers higher rates of return but attributed this to the increased riskiness of value investing.  Value investors disagree and contend that their approach actually reduces risk because they demand a margin of safety from their investments.

I don’t have  PhD.  I don’t have a Nobel Prize. I’m just a working stiff with a blog and a brokerage account.  My analysis is lacking in sophisticated mathematical modeling, but I agree with the value crowd based on common sense.  Just look at the price ranges from the last year of a few large and stable American companies:

Apple: $118.69 to $89.47 – 24.62% difference

American Express: $75.74 to $50.27 – 33.63% difference

Caterpillar Inc: $56.36 to $97.40 – 43.47% difference

I find it difficult to believe that the underlying value of these business experienced such a wild fluctuation in the last calendar year.

One could also look to the entire market as a whole.  Look at the performance of the S&P 500 over the last 26 years:

1990 – 2000: Up 318.42%

2000-2003: Down 27.66%

2003-2007: Up 47.26%

2008-2010: Down 19.88%

2010-2016: Up 90.43%

Did the actual underlying economic output of the United States experience such wild swings over that time period, as the markets seemed to believe?

Here is the total economic output of the United States since 1990:

U.S. Bureau of Economic Analysis, Gross Domestic Product [GDP], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/GDP, December 31, 2016.

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It certainly doesn’t look like the actual economy of the United States experienced anywhere near the wild volatility that the United States markets experienced from 1990 to 2016.

I don’t believe that the markets are efficient.  It seems to me that Ben Graham’s characterization of Mr. Market, the crazy manic depressive shouting prices for businesses based on his mood, is closer to reality than the efficient market popularized by EMH.

I believe that astute investors can find mispriced stocks.  Fortunately, most of the investing community believes in EMH because this is what is written in Finance textbooks.  This a good thing.  The more people that believe that markets are efficient, the less competition there will be for value investors.

PLEASE NOTE: The information provided on this site is not financial advice and I am not a financial professional. I am an amateur and the purpose of this site is to simply monitor my successes and failures.