Bear markets have three stages – sharp down, reflexive rebound and a drawn-out fundamental downtrend
Bear markets often START with a sharp and swift decline.
After this decline, there is an oversold bounce that retraces a portion of that decline.
The longer-term decline then continues, at a slower and more grinding pace, as the fundamentals deteriorate.
Dow Theory also suggests that bear markets consist of three down legs with reflexive rebounds in between.
However, the “bear market” is only one-half of a vastly more important concept – the “Full Market Cycle.”
The Full Market Cycle
Over the last decade, the media has focused on the bull market, making an assumption that the current trend would last indefinitely. However, throughout history, bull market cycles make up on one-half of the “full market” cycle. During every “bull market” cycle, the market and economy build up excesses, which must ultimately be reversed through a market reversion and economic recession. In the other words, as Sir Issac Newton discovered:
“What goes up, must come down.”
The chart below shows the full market cycles over time. Since the current “full market” cycle is yet to be completed, I have drawn a long-term trend line with the most logical completion point of the current cycle.
[Note:I am not stating the markets are about to crash to the 1600 level on the S&P 500. I am simply showing where the current uptrend line intersects with the price. The longer that it takes for the markets to mean revert, the higher the intersection point will be. Furthermore, the 1600 level is not out of the question either. Famed investor Jack Bogle stated that over the next decade we are likely to see two more 50% declines. A 50% decline from the all-time highs would put the market at 1600.]
As I have often stated, I am not bullish or bearish. My job as a portfolio manager is simple; invest money in a manner that creates returns on a short-term basis, but reduces the possibility of catastrophic losses, which wipe out years of growth.
Nobody tends to believe that philosophy until the markets wipe about 30% of portfolio values in a month.
The 4-Phases
AlphaTrends previously put together an excellent diagram laying out the 4-phases of the full-market cycle. To wit:
“Is it possible to time the market cycle to capture big gains? Like many controversial topics in investing, there is no real professional consensus on market timing. Academics claim that it’s not possible, while traders and chartists swear by the idea.
The following infographic explains the four important phases of market trends, based on the methodology of the famous stock market authority Richard Wyckoff. The theory is that the better an investor can identify these phases of the market cycle, the more profits can be made on the ride upwards of a buying opportunity.”
So, the question to answer, obviously, is:
“Where are we now?”
Let’s take a look at the past two full-market cycles, using Wyckoff’s methodology, as compared to the current post-financial-crisis half-cycle. While actual market cycles will not exactly replicate the chart above, you can clearly see Wyckoff’s theory in action.
1992-2003
The accumulation phase, following the 1991 recessionary environment, was evident as it preceded the “internet trading boom” and the rise of the “dot.com” bubble from 1995-1999. As I noted previously:
“Following the recession of 1991, the Federal Reserve drastically lowered interest rates to spur economic growth. However, the two events which laid the foundation for the ‘dot.com’ crisis was the rule-change which allowed the nation’s pension funds to own equities and the repeal of Glass-Steagall, which unleashed Wall Street upon a nation of unsuspecting investors.
The major banks could now use their massive balance sheet to engage in investment-banking, market-making, and proprietary trading. The markets exploded as money flooded the financial markets. Of course, since there were not enough ‘legitimate’ deals to fill demand and Wall Street bankers are paid to produce deals, Wall Street floated any offering it could despite the risk to investors.”
The distribution phase became evident in early-2000 as stocks began to struggle.
Names like Enron, WorldCom, Global Crossing, Lucent Technologies, Nortel, Sun Micro, and a host of others, are “ghosts of the past.” Importantly, they are the relics of an era the majority of investors in the market today are unaware of, but were the poster children for the “greed and excess” of the preceding bull market frenzy.
As the distribution phase gained traction, it is worth remembering the media and Wall Street were touting the continuation of the bull market indefinitely into the future.
Then, came the decline.
2003-2009
Following the “dot.com” crash, investors had all learned their lessons about the value of managing risk in portfolios, not chasing returns, and focusing on capital preservation as the core for long-term investing.
Okay. Not really.
It took about 27-minutes for investors to completely forget about the previous pain of the bear market and jump headlong back into the creation of the next bubble leading to the “financial crisis.”
During the mark-up phase, investors once again piled into leverage. This time not just into stocks, but real estate, as well as Wall Street, found a new way to extract capital from Main Street through the creation of exotic loan structures. Of course, everything was fine as long as interest rates remained low, but as with all things, the “party eventually ends.”
Once again, during the distribution phase of the market, the analysts, media, Wall Street, and rise of bloggers, all touted “this time was different.” There were “green shoots,” it was a “Goldilocks economy,” and there was “no recession in sight.”
They were disastrously wrong.
Sound familiar?
2009-Present
So, here we are, a decade into the current economic recovery and a market that has risen steadily on the back of excessively accommodative monetary policy and massive liquidity injections by Central Banks globally.
Once again, due to the length of the “mark up” phase, most investors today have once again forgotten the “ghosts of bear markets past.”
Despite a year-long distribution in the market, the same messages seen at previous market peaks were steadily hitting the headlines: “there is no recession in sight,” “the bull market is cheap” and “this time is different because of Central Banking.”
Well, as we warned more than once, all that was required was an “exogenous” event, which would spark a credit-event in an overly leveraged, overly extended, and overly bullish market. The “virus” was that exogenous event.
Lost And Found
There is a sizable contingent of investors, and advisors, today who have never been through a real bear market. After a decade long bull-market cycle, fueled by Central Bank liquidity, it is understandable why mainstream analysis believed the markets could only go higher. What was always a concern to us was the rather cavalier attitude they took about the risk.
“Sure, a correction will eventually come, but that is just part of the deal.”
As we repeatedly warned, what gets lost during bull cycles, and is always found in the most brutal of fashions, is the devastation caused to financial wealth during the inevitable decline. It isn’t just the loss of financial wealth, but also the loss of employment, defaults, and bankruptcies caused by the coincident recession.
This is the story told by the S&P 500 inflation-adjusted total return index. The chart shows all of the measurement lines for all the previous bull and bear markets, along with the number of years required to get back to even.
What you should notice is that in many cases bear markets wiped out essentially all or a very substantial portion of the previous bull market advance.
There are many signs suggesting the current Wyckoff cycle has entered into its fourth, and final stage. Whether, or not, the current decline phase is complete, is the question we are all working on answering now.
Bear market cycles are rarely ended in a month. While there is a lot of “hope” the Fed’s flood of liquidity can arrest the market decline, there is still a tremendous amount of economic damage to contend with over the months to come.
In the end, it does not matter IF you are “bullish” or “bearish.”What matters, in terms of achieving long-term investment success, is not necessarily being “right” during the first half of the cycle, but by not being “wrong” during the second half.
Previous Employment Concerns Becoming An Ugly Reality
Last week, we saw the first glimpse of the employment fallout caused by the shutdown of the economy due to the virus. To wit:
“On Thursday, initial jobless claims jumped by 3.3 million. This was the single largest jump in claims ever on record. The chart below shows the 4-week average to give a better scale.”
This number will be MUCH worse when claims are reported later this morning, as many individuals were slow to file claims, didn’t know how, and states were slow to report them.
The importance is that unemployment rates in the U.S. are about to spike to levels not seen since the “Great Depression.” Based on the number of claims being filed, we can estimate that unemployment will jump to 15-20% over the next quarter as economic growth slides 8%, or more. (I am probably overly optimistic.)
The erosion in employment will lead to a sharp deceleration in economic and consumer confidence, as was seen Tuesday in the release of the Conference Board’s consumer confidence index, which plunged from 132.6 to 120 in March.
This is a critical point. Consumer confidence is the primary factor of consumptive behaviors, which is why the Federal Reserve acted so quickly to inject liquidity into the financial markets. While the Fed’s actions may prop up financial markets in the short-term, it does little to affect the most significant factor weighing on consumers – their jobs.
The chart below is our “composite” confidence index, which combines several confidence surveys into one measure. Notice that during each of the previous two bear market cycles, confidence dropped by an average of 58 points.
With consumer confidence just starting its reversion from high levels, it suggests that as job losses rise, confidence will slide further, putting further pressure on asset prices. Another way to analyze confidence data is to look at the composite consumer expectations index minus the current situation index in the reports.
Similarly, given we have only started the reversion process, bear markets end when deviations reverse. The differential between expectations and the current situation, as you can see below, is worse than the last cycle, and only slightly higher than before the “dot.com” crash.
If you are betting on a fast economic recovery, I wouldn’t.
There is a fairly predictable cycle, starting with CEO’s moving to protect profitability, which gets worked through until exhaustion is reached.
As unemployment rises, we are going to begin to see the faults in the previous employment numbers that I have repeatedly warned about over the last 18-months. To wit:
“There is little argument the streak of employment growth is quite phenomenal and comes amid hopes the economy is beginning to shift into high gear. But while most economists focus at employment data from one month to the next for clues as to the strength of the economy, it is the ‘trend’ of the data, which is far more important to understand.”
That “trend” of employment data has been turning negative since President Trump was elected, which warned the economy was actually substantially weaker than headlines suggested. More than once, we warned that an “unexpected exogenous event” would exposure the soft-underbelly of the economy.
The virus was just such an event.
While many economists and media personalities are expecting a “V”-shaped recovery as soon as the virus passes, the employment data suggests an entirely different outcome.
The chart below shows the peak annual rate of change for employment prior to the onset of a recession. The current cycle peaked at 2.2% in 2015, and has been on a steady decline ever since. At 1.3%, which predated the virus, it was the lowest level ever preceding a recessionary event. All that was needed was an “event” to start the dominoes falling. When we see the first round of unemployment data, we are likely to test the lows seen during the financial crisis confirming a recession has started.
No Recession In 2020?
It is worth noting that NO mainstream economists, or mainstream media, were predicting a recession in 2020. However, as we noted in 2019, the inversion of the “yield curve,” predicted exactly that outcome.
“To CNBC’s point, based on this lagging, and currently unrevised, economic data, there is ‘NO recession in sight,’ so you should be long equities, right?
Which indicator should you follow? The yield curve is an easy answer.
While everybody is ‘freaking out’ over the ‘inversion,’it is when the yield-curve ‘un-inverts’ that is the most important.
The chart below shows that when the Fed is aggressively cutting rates, the yield curve un-inverts as the short-end of the curve falls faster than the long-end. (This is because money is leaving ‘risk’ to seek the absolute ‘safety’ of money markets, i.e. ‘market crash.’)”
I have dated a few of the key points of the “inversion of the curve.” As of today, the yield-curve is now fully un-inverted, denoting a recession has started.
While recent employment reports were slightly above expectations, the annual rate of growth has been slowing. The 3-month average of the seasonally-adjusted employment report, also confirms that employment was already in a precarious position and too weak to absorb a significant shock. (The 3-month average smooths out some of the volatility.)
What we will see in the next several employment reports are vastly negative numbers as the economy unwinds.
Lastly, while the BLS continually adjusts and fiddles with the data to mathematically adjust for seasonal variations,the purpose of the entire process is to smooth volatile monthly data into a more normalized trend. The problem, of course, with manipulating data through mathematical adjustments, revisions, and tweaks, is the risk of contamination of bias.
We previously proposed a much simpler method to use for smoothing volatile monthly data using a 12-month moving average of the raw data as shown below.
Notice that near peaks of employment cycles the BLS employment data deviates from the 12-month average, or rather “overstates” the reality. However, as we will now see to be the case, the BLS data will rapidly reconnect with 12-month average as reality emerges.
Sometimes, “simpler” gives us a better understanding of the data.
Importantly, there is one aspect to all the charts above which remains constant. No matter how you choose to look at the data, peaks in employment growth occur prior to economic contractions, rather than an acceleration of growth.
“Okay Boomer”
Just as “baby boomers” were finally getting back to the position of being able to retire following the 2008 crash, the “bear market” has once again put those dreams on hold. Of course, there were already more individuals over the age of 55, as a percentage of that age group, in the workforce than at anytime in the last 50-years. However, we are likely going to see a very sharp drop in those numbers as “forced retirement” will surge.
The group that will to be hit the hardest are those between 25-54 years of age. With more than 15-million restaurant workers being terminated, along with retail, clerical, leisure, and hospitality workers, the damage to this demographic will be the heaviest.
There is a decent correlation between surges in the unemployment rate and the decline in the labor-force participation rate of the 25-54 age group. Given the expectation of a 15%, or greater, unemployment rate, the damage to this particular age group is going to be significant.
Unfortunately, the prime working-age group of labor force participants had only just returned to pre-2008 levels, and the same levels seen previously in 1988. Unfortunately, it may be another decade before we see those employment levels again.
Why This Matters
The employment impact is going to felt for far longer, and will be far deeper, than the majority of the mainstream media and economists expect. This is because they are still viewing this as a “singular” problem of a transitory virus.
It isn’t.
The virus was simply the catalyst which started the unwind of a decade-long period of debt accumulation and speculative excesses. Businesses, both small and large, will now go through a period of “culling the herd,” to lower operating costs and maintain profitability.
There are many businesses that will close, and never reopen. Most others will cut employment down to the bone and will be very slow to rehire as the economy begins to recover. Most importantly, wage growth was already on the decline, and will be cut deeply in the months to come.
Lower wage growth, unemployment, and a collapse in consumer confidence is going to increase the depth and duration of the recession over the months to come. The contraction in consumption will further reduce revenues and earnings for businesses which will require a deeper revaluation of asset prices.
“Every financial crisis, market upheaval, major correction, recession, etc. all came from one thing – an exogenous event that was not forecast or expected.
This is why bear markets are always vicious, brutal, devastating, and fast. It is the exogenous event, usually credit-related, which sucks the liquidity out of the market, causing prices to plunge. As prices fall, investors begin to panic-sell driving prices lower which forces more selling in the market until, ultimately, sellers are exhausted.
It is the same every time.”
Over the last several years, investors have insisted the markets were NOT in a bubble. We reminded them that everyone thought the same in 1999 and 2007.
Throughout history, financial bubbles have only been recognized in hindsight when their existence becomes “apparently obvious” to everyone. Of course, by that point is was far too late to be of any use to investors and the subsequent destruction of invested capital.
It turned out, “this time indeed was not different.” Only the catalyst, magnitude, and duration was.
Pay attention to employment and wages. The data suggests the current “bear market” cycle has only just begun.
Technically Speaking: 5-Questions Bulls Need To Answer Now.
“From a purely technical basis, the extreme downside extension, and potential selling exhaustion, has set the markets up for a fairly strong reflexive bounce. This is where fun with math comes in.
As shown in the chart below, after a 35% decline in the markets from the previous highs, a rally to the 38.2% Fibonacci retracement would encompass a 20% advance.
Such an advance will ‘lure’ investors back into the market, thinking the ‘bear market’ is over.”
Honestly, no one knows for certain. However, there are 5-questions that “Market Bulls” need to answer if the current rally is to be sustained.
These questions are not entirely technical, but since “technical analysis” is simply the visualization of market psychology, how you answer the questions will ultimately be reflected by the price dynamics of the market.
Let’s get to work.
Employment
Employment is the lifeblood of the economy. Individuals cannot consume goods and services if they do not have a job from which they can derive income. From that consumption comes corporate profits and earnings.
Therefore, for individuals to consume at a rate to provide for sustainable, organic (non-Fed supported), economic growth they must work at a level that provides a sustainable living wage above the poverty level. This means full-time employment that provides benefits, and a livable wage. The chart below shows the number of full-time employees relative to the population. I have also overlaid jobless claims (inverted scale), which shows that when claims fall to current levels, it has generally marked the end of the employment cycle and preceded the onset of a recession.
This erosion in jobless claims has only just begun. As jobless claims and continuing claims rise, it will lead to a sharp deceleration in economic confidence. Confidence is the primary factor of consumptive behaviors, which is why the Federal Reserve acted so quickly to inject liquidity into the financial markets. While the Fed’s actions may prop up financial markets in the short-term, it does little to affect the most significant factor weighing on consumers – their job.
Question: Given that employment is just starting to decline, does such support the assumption of a continued bull market?
Personal Consumption Expenditures (PCE)
Following through from employment, once individuals receive their paycheck, they then consume goods and services in order to live.
This is a crucial economic concept to understand, which is the order in which the economy functions. Consumers must “produce” first, so they receive a paycheck, before they can “consume.” This is also the primary problem of Stephanie Kelton’s “Modern Monetary Theory,” which disincentivizes the productive capacity of the population.
Given that Personal Consumption Expenditures (PCE) is a measure of that consumption, and comprises roughly 70% of the GDP calculation, its relative strength has great bearing on the outcome of economic growth.
More importantly, PCE is the direct contributor to the sales of corporations, which generates their gross revenue. So goes personal consumption – so goes revenue. The lower the revenue that flows into company coffers, the more inclined businesses are to cut costs, including employment and stock buybacks, to maintain profit margins.
The chart below is a comparison of the annualized change in PCE to corporate fixed investment and employment. I have made some estimates for the first quarter based on recent data points.
Question:Does the current weakness in PCE and Fixed Investment support the expectations for a continued bull market from current price levels?
Junk Bonds & Margin Debt
While global Central Banks have lulled investors into an expanded sense of complacency through years of monetary support, it has led to willful blindness of underlying risk. As we discussed in “Investor’s Dilemma:”
“Classical conditioning (also known as Pavlovian or respondent conditioning) refers to a learning procedure in which a potent stimulus (e.g. food) is paired with a previously neutral stimulus (e.g. a bell). What Pavlov discovered is that when the neutral stimulus was introduced, the dogs would begin to salivate in anticipation of the potent stimulus, even though it was not currently present. This learning process results from the psychological “pairing” of the stimuli.”
That “stimuli” over the last decade has been Central Bank interventions. During that period, the complete lack of “fear” in markets, combined with a “chase for yield,” drove “risk” assets to record levels along with leverage. The chart below shows the relationship between margin debt (leverage), stocks, and junk bond yields (which have been inverted for better relevance.)
While asset prices declined sharply in March, it has done little to significantly revert either junk bond yields or margin debt to levels normally consistent with the beginning of a new “bull market.”
With oil prices falling below $20/bbl, a tremendous amount of debt tied to the energy space, and the impact the energy sector has on the broader economy, it is likely too soon to suggest the markets have fully “priced in” the damage being done.
Question:What happens to asset prices if more bankruptcies and forced deleveraging occurs?
Corporate Profits/Earnings
As noted above, if the “bull market” is back, then stocks should be pricing in stronger earnings going forward. However, given the potential shakeout in employment, which will lower consumption, stronger earnings, and corporate profits, are not likely in the near term.
The risk to earnings is even higher than many suspect, given that over the last several years, companies have manufactured profitability through a variety of accounting gimmicks, but primarily through share buybacks from increased leverage. That cycle has now come to an end, but before it did it created a massive deviation of the stock market from corporate profitability.
“If the economy is slowing down, revenue and corporate profit growth will decline also. However, it is this point which the ‘bulls’ should be paying attention to. Many are dismissing currently high valuations under the guise of ‘low interest rates,’ however, the one thing you should not dismiss, and cannot make an excuse for, is the massive deviation between the market and corporate profits after tax. The only other time in history the difference was this great was in 1999.”
It isn’t just the deviation of asset prices from corporate profitability, which is skewed, but also reported earnings per share.
The impending recession, and consumption freeze, is going to start the mean-reversion process in both corporate profits, and earnings. I have projected the potential reversion in the chart below. The reversion in GAAP earnings is pretty calculable as swings from peaks to troughs have run on a fairly consistent trend.
Using that historical context, we can project a recession will reduce earnings to roughly $100/share. (Goldman Sachs currently estimates $110.) The resulting decline asset prices to revert valuations to a level of 18x (still high) trailing earnings would suggest a level of 1800 for the S&P 500 index. (Yesterday’s close of 2626 is still way to elevated.)
The decline in economic growth epitomizes the problem that corporations face today in trying to maintain profitability. The chart below shows corporate profits as a percentage of GDP relative to the annual change in GDP. The last time that corporate profits diverged from GDP, it was unable to sustain that divergence for long. As the economy declines, so will corporate profits and earnings.
Question: How long can asset prices remain divorced from falling corporate profits and weaker economic growth?
Technical Pressure
Given all of the issues discussed above, which must ultimately be reflected in market prices, the technical picture of the market also suggests the recent “bear market” rally will likely fade sooner than later. As noted above”
“Such an advance will ‘lure’ investors back into the market, thinking the ‘bear market’ is over.”
Importantly, despite the sizable rally, participation has remained extraordinarily weak. If the market was seeing strong buying, as suggested by the media, then we should see sizable upticks in the percent measures of advancing issues, issues at new highs, and a rising number of stocks above their 200-dma.
However, on a longer-term basis, since this is the end of the month, and quarter, we can look at our quarterly buy/sell indication which has triggered a “sell” signal for the first time since 2015. While such a signal does not demand a major reversion, it does suggest there is likely more risk to the markets currently than many expect.
Question: Does the technical backdrop currently support the resumption of a bull market?
There are reasons to be optimistic on the markets in the very short-term. However, we are continuing to extend the amount of time the economy will be “shut down,” which will exacerbate the decline in the unemployment and personal consumption data. The feedback loop from that data into corporate profits and earnings is going to make valuations more problematic even with low interest rates currently.
While Central Banks have rushed into a “burning building with a fire hose” of liquidity, there is the risk that after a decade of excess debt, leverage, and misallocation of assets, the “fire” may be too hot for them to put out.
Assuming that the “bear market” is over already may be a bit premature, and chasing what seems like a “raging bull market” is likely going to disappoint you.
Bear markets have a way of “suckering” investors back into the market to inflict the most pain possible. This is why “bear markets” never end with optimism, but in despair.
Technically Speaking: Risk Limits Hit, When Too Little Is Too Much
For the last several months, we have been issuing repeated warnings about the market. While such comments are often mistaken for “being bearish,” we have often stated it is our process of managing “risk” which is most important.
Beginning in mid-January,we began taking profits out of our portfolios and reducing risk. To wit:
“On Friday, we began the orderly process of reducing exposure in our portfolios to take in profits, reduce portfolio risk, and raise cash levels.”
Importantly, we did not “sell everything” and go to cash.
Since then, we took profits and rebalanced risk again in late January and early February as well.
Our clients, their families, their financial and emotional “well being,” rest in our hands. We take that responsibility very seriously, and work closely with our clients to ensure that not only are they financially successful, but they are emotionally stable in the process.
This is, and has been, our biggest argument against “buy and hold,” and “passive investing.” While there are plenty of case studies showing why individuals will eventually get back to even, the vast majority of individuals have a “pain point,” where they will sell.
So, we approach portfolio management from a perspective of “risk management,” but not just in terms of “portfolio risk,” but “emotional risk” as well. By reducing our holdings to raise cash to protect capital, we can reduce the risk of our clients hitting that “threashold” where they potentially make very poor decisions.
In investing, the worst decisions are always made at the moment of the most pain. Either at the bottom of the market or near the peaks.
Investing is not always easy. Our portfolios are designed to have longer-term holding periods, but we also understand that things do not always go as planned.
This is why we have limits, and when things go wrong, we sell.
So, why do I tell you this?
On Friday/Monday, our “limits” were breached, which required us to sell more.
Two Things
Two things have now happened, which signaled us to reduce risk further in portfolios.
“After an emergency 50-basis-point rate cut on March 3, the Federal Reserve doubled down Sunday evening, lowering its benchmark rate by an additional 100 basis points to a range of 0%-0.25% following another emergency meeting.
After ramping up its $60 billion of monthly Treasury bill purchases to include Treasuries of all maturities and offering $1.5 trillion of liquidity to the market via repurchase agreements on March 3, the Fed doubled down Sunday evening with announced purchases of at least $500 billion of Treasuries and at least $200 billion of agency mortgage-backed securities.
In addition, the Fed reduced reserve requirements to zero, encouraged banks to borrow from its discount window at a rate of 0.25%, and, in coordination with five other central banks, lowered the price of U.S. dollar swap arrangements to facilitate dollar liquidity abroad”
We had been anticipating the Federal Reserve to try and rescue the markets, which is why we didn’t sell even more aggressively previously. The lesson investors have been taught repeatedly over the last decade was “Don’t Fight The Fed.”
One of the reasons we reduced our exposure in the prior days was out of concern the Fed’s actions wouldn’t be successful.
On Monday, we found out the answer. The Fed may be fighting a battle it can’t win as markets not only failed to respond to the Fed’s monetary interventions but also broke the “bullish trend line” from the 2009 lows. (While the markets are oversold short-term, the long-term “sell signals” in the bottom panels are just being triggered from fairly high levels. This suggests more difficulty near-term for stocks.
“As you can see in the chart below, this is a massive surge of liquidity, hitting the market at a time the market is testing important long-term trend support.”
It is now, or never, for the markets.
With our portfolios already at very reduced equity levels, the break of this trendline will take our portfolios to our lowest levels of exposure.
What happened today was an event we have been worried about, but didn’t expect to see until after a break of the trendline – “margin calls.” This is why we saw outsized selling in “safe assets” such as REITs, utilities, bonds, and gold.
Cash was the only safe place to hide.
We aren’t anxious to “fight the Fed,” but the markets may have a different view this time.
Use rallies to raise cash, and rebalance portfolio risk accordingly.
We are looking to be heavy buyers of equities when the market forms a bottom, we just aren’t there as of yet.”
On Monday morning, with that important trendline broken, we took some action.
Did we sell everything? No. We still own 10% equity, bonds, and a short S&P 500 hedge.
Did we sell the bottom? Maybe.
We will only know in hindsight for certain, and we are not willing to risk more of our client’s capital currently.
There are too many non-quantifiable risks with a global recession looming, as noted by David Rosenberg:
“The pandemic is a clear ‘black swan’ event. There will be a whole range of knock-on effects. Fully 40 million American workers, or one-third of the private-sector labor force, are directly affected ─ retail, entertainment, events, sports, theme parks, conferences, travel, tourism, restaurants and, of course, energy.
This doesn’t include all the multiplier effects on other industries. It would not surprise me at all if real GDP in Q2 contracts at something close to an 8% annual rate (matching what happened in the fourth quarter of 2008, which was a financial event alone).
The hit to GDP can be expected to be anywhere from $400 billion to $600 billion for the year. But the market was in trouble even before COVID-19 began to spread, with valuations and complacency at cycle highs and equity portfolio managers sitting with record-low cash buffers. Hence the forced selling in other asset classes.
If you haven’t made recession a base-case scenario, you probably should. All four pandemics of the past century coincided with recession. This won’t be any different. It’s tough to generate growth when we’re busy “social distancing.” I am amazed that the latest WSJ poll of economists conducted between March 6-10th showed only 49% seeing a recession coming”.
The importance of his commentary is that from an “investment standpoint,” we can not quantify whether this “economic shock” has been priced into equities as of yet. However, we can do some math based on currently available data:
The chart below is the annual change in nominal GDP, and S&P 500 GAAP earnings.
I am sure you will not be shocked to learn that during “recessions,” corporate “earnings’ tend to fall. Historically, the average drawdown of earnings is about 20%; however, since the 1990’s, those drawdowns have risen to about 30%.
As of March 13th, Standard & Poors has earnings estimates for the first quarter of 2020 at $139.20 / share. This is down just $0.20 from the fourth quarter of 2019 estimates of $139.53.
In other words, Wall Street estimates are still in “fantasy land.”
If our, and Mr. Rosenberg’s, estimates are correct of a 5-8% recessionary drag in the second quarter of 2020, then an average reduction in earnings of 30% is most likely overly optimistic.
However, here is the math:
Current Earnings = 132.90
30% Reduction = $100 (rounding down for easier math)
At various P/E multiples, we can predict where “fair value” for the market is based on historical assumptions:
20x earnings: Historically high but markets have traded at high valuations for the last decade.
18x earnings: Still historically high.
15x earnings: Long-Term Average
13x earnings: Undervalued
10x earnings: Extremely undervalued but aligned with secular bear market bottoms.
You can pick your own level where you think P/E’s will account for the global recession but the chart below prices it into the market.
With the S&P 500 closing yesterday at 2386, this equates to downside risk of:
20x Earnings =-16% (Total decline from peak = – 40%)
NOTE: I am not suggesting the market is about to decline 60-70% from the recent peak. I am simply laying out various multiples based on assumed risk to earnings. However, 15-18x earnings is extremely reasonable and possible.
When Too Little Is Too Much
With our risk limits hit, and in order to protect our clients from both financial and emotional duress, we made the decision that even the reduced risk we were carrying was still too much.
One concern, which weighed heavily into our decision process, was the rising talk of the “closing the markets” entirely for a week or two to allow the panic to pass. We have clients that depend on liquidity from their accounts to sustain their retirement lifestyle. In our view, a closure of the markets would lead to two outcomes which pose a real risk to our clients:
They need access to liquidity, and with markets closed are unable to “sell” and raise cash; and,
When you trap investors in markets, when they do open again, there is a potential “rush” of sellers to get of the market to protect themselves.
That risk, combined with the issue that major moves in markets are happening outside of transaction hours, are outside of our ability to hedge, or control.
This is what we consider to be an unacceptable risk for the time being.
We will likely miss the ultimate “bottom” of the market.
Probably.
But that’s okay, we have done our job of protecting our client’s second most precious asset behind their family, the capital they have to support them.
The good news is that a great “buying” opportunity is coming. Just don’t be in a “rush” to try and buy the bottom.
I can assure you, when we see ultimately see a clear “risk/reward” set up to start taking on equity risk again, we will do so “with both hands.”
And we are sitting on a lot of cash just for that reason.Save
RIA PRO: Risk Limits Hit
For the last several months we have been issuing repeated warnings about the market. While such comments are often mistaken for “being bearish,” we have often stated it is our process of managing “risk” which is most important.
Beginning in mid-January,we began taking profits out of our portfolios and reducing risk. To wit:
“On Friday, we began the orderly process of reducing exposure in our portfolios to take in profits, reduce portfolio risk, and raise cash levels.”
Since then, as you know, we have taken profits, and rebalanced risk several times within the portfolios.
Importantly, we approach portfolio management from a perspective of “risk management,” but not just in terms of “portfolio risk,” but “emotional risk” as well. By reducing our holdings to raise cash to protect capital, we can reduce the risk of our clients hitting that “threshold” where they potentially make very poor decisions.
In investing, the worst decisions are always made at the moment of the most pain. Either at the bottom of the market or near the peaks.
Investing is not always easy. Our portfolios are designed to have longer-term holding periods, but we also understand that things do not always go as planned.
This is why we have limits, and when things go wrong, we sell.
So, why do I tell you this?
On Friday/Monday, our “limits” were breached, which required us to sell more.
Two Things
Two things have now happened which signaled us to reduce risk further in portfolios.
“After an emergency 50-basis-point rate cut on March 3, the Federal Reserve doubled down Sunday evening, lowering its benchmark rate by an additional 100 basis points to a range of 0%-0.25% following another emergency meeting.
After ramping up its $60 billion of monthly Treasury bill purchases to include Treasuries of all maturities and offering $1.5 trillion of liquidity to the market via repurchase agreements on March 3, the Fed doubled down Sunday evening with announced purchases of at least $500 billion of Treasuries and at least $200 billion of agency mortgage-backed securities.
In addition, the Fed reduced reserve requirements to zero, encouraged banks to borrow from its discount window at a rate of 0.25%, and, in coordination with five other central banks, lowered the price of U.S. dollar swap arrangements to facilitate dollar liquidity abroad”
We had been anticipating the Federal Reserve to try and rescue the markets, which is why we didn’t sell even more aggressively previously. The lesson investors have been taught repeatedly over the last decade was “Don’t Fight The Fed.”
One of the reasons we reduced our exposure in the prior days was out of concern we didn’t know if the Fed’s actions would be successful.
On Monday, we found out the answer. The Fed may be fighting a battle it can’t win as markets not only failed to respond to the Fed’s monetary interventions, but also broke the “bullish trend line” from the 2009 lows. (While the markets are oversold short-term, the long-term “sell signals” in the bottom panels are just being triggered from fairly high levels. This suggests more difficulty near-term for stocks.
“As you can see in the chart below, this is a massive surge of liquidity hitting the market at a time the market is hitting important long-term trend support.”
It is now, or never, for the markets.
With our portfolios already at very reduced equity levels, the break of this trendline will take our portfolios to our lowest levels of exposure. However, given the extreme oversold condition, noted above, it is likely we are going to see a bounce, which we will use to reduce risk into.
What happened today was an event we have been worried about, but didn’t expect to see until after a break of the trendline – “margin calls.”
This is why we saw outsized selling in “safe assets” such as REITs, utilities, bonds, and gold.
Cash was the only safe place to hide.
This also explains why the market “failed to rally” when the Fed announced $500 billion today. There is another $500 billion coming tomorrow. We will see what happens.
We aren’t anxious to “fight the Fed,” but the markets may have a different view this time.
Use rallies to raise cash, and rebalance portfolio risk accordingly.
We are looking to be heavy buyers of equities when the market forms a bottom, we just aren’t there as of yet.”
On Monday morning, we took some action.
Did we sell everything? No. We still own 10% equity, bonds, and a short S&P 500 hedge.
Did we sell the bottom? Maybe.
We will only know in hindsight for certain, and we are not willing to risk more of our client’s capital currently.
There are too many non-quantifiable risks with a global recession looming, as noted by David Rosenberg:
“The pandemic is a clear ‘black swan’ event. There will be a whole range of knock-on effects. Fully 40 million American workers, or one-third of the private sector labor force, are directly affected ─ retail, entertainment, events, sports, theme parks, conferences, travel, tourism, restaurants and, of course, energy.
This doesn’t include all the multiplier effects on other industries. It would not surprise me at all if real GDP in Q2 contracts at something close to an 8% annual rate (matching what happened in the fourth quarter of 2008 which was a financial event alone).
The hit to GDP can be expected to be anywhere from $400 billion to $600 billion for the year. But the market was in trouble even before COVID-19 began to spread, with valuations and complacency at cycle highs and equity portfolio managers sitting with record-low cash buffers. Hence the forced selling in other asset classes.
If you haven’t made recession a base-case scenario, you probably should. All four pandemics of the past century coincided with recession. This won’t be any different. It’s tough to generate growth when we’re busy “social distancing.” I am amazed that the latest WSJ poll of economists conducted between March 6-10th showed only 49% seeing a recession coming”.
The importance of his commentary is that from an “investment standpoint,” we can not quantify whether this “economic shock” has been priced into equities as of yet. However, we can do some math based on currently available data:
The chart below is annual nominal GDP, and S&P 500 GAAP earnings.
I am sure you will not be shocked to learn that during “recessions,” corporate “earnings’ tend to fall. Historically, the average drawdown of earnings is about 20%, however, since the 1990’s, those drawdowns have risen to about 30%.
As of March 13th, Standard & Poors has earnings estimates for the first quarter of 2020 at $139.20/share. This is down just $0.20 from the fourth quarter of 2019 estimates of $139.53.
If our, and Mr. Rosenberg’s, estimates are correct of a 5-8% recessionary drag in the second quarter of 2020, then an average reduction in earnings of 30% is most likely overly optimistic.
However, here is the math:
Current Earnings = 132.90
30% Reduction = $100 (rounding down for easier math)
At various P/E multiples we can predict where “fair value” for the market is based on historical assumptions:
20x earnings: Historically high but markets have traded at high valuations for the last decade.
18x earnings: Still historically high.
15x earnings: Long-Term Average
13x earnings: Undervalued
10x earnings: Extremely undervalued but aligned with secular bear market bottoms.
You can pick your own level where you think P/E’s will account for the global recession but the chart below prices it into the market.
With the S&P 500 closing yesterday at 2386, this equates to downside risk of:
20x Earnings =-16% (Total decline from peak = – 40%)
NOTE: I am not suggesting the market is about to decline 60-70% from the recent peak. I am simply laying out various multiples based on assumed risk to earnings. However, 15-18x earnings is extremely reasonable and possible.
When Too Little Is Too Much
With our risk limits hit, and in order to protect our clients from both financial and emotional duress, we made the decision that even the reduced risk we were carrying was still too much.
One concern, which weighed heavily into our decision process, was the rising talk of the “closing the markets” entirely for a week or two to allow the panic to pass. We have clients that depend on liquidity from their accounts to sustain their retirement lifestyle. In our view, a closure of the markets would lead to two outcomes which pose a real risk to our clients:
They need access to liquidity, and with markets closed are unable to “sell” and raise cash; and,
When you trap investors in markets, when they do open again there is a potential “rush” of sellers to get of the market to protect themselves.
That risk, combined with the issue that major moves in markets are happening outside of transaction hours, are outside of our ability to hedge, or control.
This is what we consider to be unacceptable risk for the time being.
We will likely miss the ultimate “bottom” of the market?
Probably.
But that’s okay, we have done our job of protecting our client’s second most precious asset behind their family, the capital they have to support them.
The good news is that a great “buying” opportunity is coming. Just don’t be in a “rush” to try and buy the bottom.
I can assure you that when we see ultimately see a clear “risk/reward” set up to start taking on equity risk again, we will do so “with both hands.”
And we are sitting on a lot of cash just for that reason.Save
Technically Speaking: On The Cusp Of A Bear Market
“Tops are a process, and bottoms are an event”
Over the last couple of years, we have discussed the ongoing litany of issues that plagued the underbelly of the financial markets.
The “corporate credit” markets are at risk of a wave of defaults.
Earnings estimates for 2019 fell sharply, and 2020 estimates are now on the decline.
Stock market targets for 2020 are still too high, along with 2021.
Rising geopolitical tensions between Russia, Saudi Arabia, China, Iran, etc.
The impact of the “coronavirus,” and the shutdown of the global supply chain, will impact exports (which make up 40-50% of corporate profits) and economic growth.
The collapse in oil prices is deflationary and can spark a wave of credit defaults in the energy complex.
European growth, already weak, continues to weaken, and most of the EU will likely be in recession in the next 2-quarters.
Valuations remain at expensive levels.
Long-term technical signals have become negative.
The collapse in equity prices, and coronavirus fears, will weigh on consumer confidence.
Rising loan delinquency rates.
Auto sales are signaling economic stress.
The yield curve is sending a clear message that something is wrong with the economy.
Rising stress on the consumption side of the equation from retail sales and personal consumption.
I could go on, but you get the idea.
In that time, these issues have gone unaddressed, and worse dismissed, because of the ongoing interventions of Central Banks.
However, as we have stated many times in the past, there would eventually be an unexpected, exogenous event, or rather a “Black Swan,” which would “light the fuse” of a bear market reversion.
Over the last few weeks, the market was hit with not one, but two, “black swans” as the “coronavirus” shutdown the global supply chain, and Saudi Arabia pulled the plug on oil price support. Amazingly, we went from “no recessionin sight”, to full-blown “recession fears,” in less than month.
“Given that U.S. exporters have already been under pressure from the impact of the “trade war,” the current outbreak could lead to further deterioration of exports to and from China, South Korea, and Japan. This is not inconsequential as exports make up about 40% of corporate profits in the U.S. With economic growth already struggling to maintain 2% growth currently, the virus could shave between 1-1.5% off that number.
With our Economic Output Composite Indicator (EOCI) already at levels which has previously denoted recessions, the “timing” of the virus could have more serious consequences than currently expected by overzealous market investors.”
On The Cusp Of A Bear Market
Let me start by making a point.
“Bull and bear markets are NOT defined by a 20% move. They are defined by a change of direction in the trend of prices.”
There was a point in history where a 20% move was significant enough to achieve that change in overall price trends. However, today that is no longer the case.
Bull and bear markets today are better defined as:
“During a bull market, prices trade above the long-term moving average. However, when the trend changes to a bear market prices trade below that moving average.”
This is shown in the chart below, which compares the market to the 75-week moving average. During “bullish trends,” the market tends to trade above the long-term moving average and below it during “bearish trends.”
In the last decade, there have been three previous occasions where the long-term moving average was violated but did not lead to a longer-term change in the trend.
The first was in 2011, as the U.S. was dealing with a potential debt-ceiling and threat of a downgrade of the U.S. debt rating. Then Fed Chairman Ben Bernanke came to the rescue with the second round of quantitative easing (QE), which flooded the financial markets with liquidity.
The second came in late-2015 and early-2016 as the market dealt with a Federal Reserve, which had started lifting interest rates combined with the threat of the economic fallout from Britain leaving the European Union (Brexit). Given the U.S. Federal Reserve had already committed to hiking interest rates, and a process to begin unwinding their $4-Trillion balance sheet, the ECB stepped in with their own version of QE to pick up the slack.
The latest event was in December 2018 as the markets fell due to the Fed’s hiking of interest rates and reduction of their balance sheet. Of course, the decline was cut short by the Fed reversal of policy and subsequently, a reduction in interest rates and a re-expansion of their balance sheet.
Had it not been for these artificial influences, it is highly likely the markets would have experienced deeper corrections than what occurred.
On Monday, we have once again violated that long-term moving average. However, Central Banks globally have been mostly quiet. Yes, there have been promises of support, but as of yet, there have not been any substantive actions.
However, the good news is that the bullish trend support of the 3-Year moving average (orange line) remains intact for now. That line is the “last line of defense” of the bull market. The only two periods where that moving average was breached was during the “Dot.com Crash” and the “Financial Crisis.”
(One important note is that the “monthly sell trigger,” (lower panel) was initiated at the end of February which suggested there was more downside risk at the time.)
None of this should have been surprising, as I have written previously, prices can only move so far in one direction before the laws of physics take over. To wit”
“Like a rubber band that has been stretched too far – it must be relaxed before it can be stretched again. This is exactly the same for stock prices that are anchored to their moving averages. Trends that get overextended in one direction, or another, always return to their long-term average. Even during a strong uptrend or strong downtrend, prices often move back (revert) to a long-term moving average.”
With the markets previously more than 20% of their long-term mean, the correction was inevitable, it just lacked the right catalyst.
The difference between a “bull market” and a “bear market” is when the deviations begin to occur BELOW the long-term moving average on a consistent basis. With the market already trading below the 75-week moving average, a failure to recover in a fairly short period, will most likely facilitate a break below the 3-year average.
If that occurs, the “bear market” will be official and will require substantially lower levels of equity risk exposure in portfolios until a reversal occurs.
Currently, it is still too early to know for sure whether this is just a “correction” or a “change in the trend” of the market. As I noted previously, there are substantial differences, which suggest a more cautious outlook. To wit:
Downside Risk Dwarfs Upside Reward.
Global Growth Is Less Synchronized
Market Structure Is One-Sided and Worrisome.
COVID-19 Impacts To The Global Supply Chain Are Intensifying
Any Semblance of Fiscal Responsibility Has Been Thrown Out the Window
Peak Buybacks
China, Europe, and the Emerging Market Economic Data All Signal a Slowdown
The Democrats Control The House Which Effectively Nullifies Fiscal Policy Agenda.
The Leadership Of The Market (FAANG) Has Faltered.
Most importantly, the collapse in interest rates, as well as the annual rate of change in rates, is screaming that something “has broken,” economically speaking.
Here is the important point.
Understanding that a change is occurring, and reacting to it, is what is important. The reason so many investors “get trapped” in bear markets is that by the time they realize what is happening, it has been far too late to do anything about it.
Let me leave you with some important points from the legendary Marty Zweig: (h/t Doug Kass.)
Patience is one of the most valuable attributes in investing.
Big money is made in the stock market by being on the right side of the major moves. The idea is to get in harmony with the market. It’s suicidal to fight trends. They have a higher probability of continuing than not.
Success means making profits and avoiding losses.
Monetary conditions exert an enormous influence on stock prices. Indeed, the monetary climate – primarily the trend in interest rates and Federal Reserve policy – is the dominant factor in determining the stock market’s major decision.
The trend is your friend.
The problem with most people who play the market is that they are not flexible.
Near the top of the market, investors are extraordinarily optimistic because they’ve seen mostly higher prices for a year or two. The sell-offs witnessed during that span were usually brief. Even when they were severe, the market bounced back quickly and always rose to loftier levels. At the top, optimism is king; speculation is running wild, stocks carry high price/earnings ratios, and liquidity has evaporated.
I measure what’s going on, and I adapt to it. I try to get my ego out of the way. The market is smarter than I am, so I bend.
To me, the “tape” is the final arbiter of any investment decision. I have a cardinal rule: Never fight the tape!
The idea is to buy when the probability is greatest that the market is going to advance.
Most importantly, and something that is most applicable to the current market:
“It’s okay to be wrong; it’s just unforgivable to stay wrong.” – Marty Zweig
There action this year is very reminiscent of previous market topping processes. Tops are hard to identify during the process as “change happens slowly.” The mainstream media, economists, and Wall Street will dismiss pickup in volatility as simply a corrective process. But when the topping process completes, it will seem as if the change occurred “all at once.”
The same media which told you “not to worry,” will now tell you, “no one could have seen it coming.”
The market may be telling you something important, if you will only listen.
Save
Technically Speaking: Sellable Rally, Or The Return Of The Bull?
Normally, “Technically Speaking,” is analysis based on Monday’s market action. However, this week, we are UPDATING the analysis posted in this past weekend’s newsletter, “Market Crash & Navigating What Happens Next.”
Specifically, we broke down the market into three specific time frames looking at the short, intermediate, and long-term technical backdrop of the markets. In that analysis, we laid out the premise for a “reflexive bounce” in the markets, and what to do during the process of that move. To wit:
“On a daily basis, the market is back to a level of oversold (top panel) rarely seen from a historical perspective. Furthermore, the rapid decline this week took the markets 5-standard deviations below the 50-dma.”
Chart updated through Monday
“To put this into some perspective, prices tend to exist within a 2-standard deviation range above and below the 50-dma. The top or bottom of that range constitutes 95.45% of ALL POSSIBLE price movements within a given period.
A 5-standard deviation event equates to 99.9999% of all potential price movement in a given direction.
This is the equivalent of taking a rubber band and stretching it to its absolute maximum.”
Importantly, like a rubber band, this suggests the market “snap back” could be fairly substantial, and should be used to reduce equity risk, raise cash, and add hedges.”
Importantly, read that last sentence again.
The current belief is that the “virus” is limited in scope and once the spread is contained, the markets will immediately bounce back in a “V-shaped” recovery. Much of this analysis is based on assumptions that “COVID-19” is like “SARS” in 2003 which had a very limited impact on the markets.
However, this is likely a mistake as there is one very important difference between COVID-19 and SARS, as I noted previously:
“Currently, the more prominent comparison is how the market performed following the ‘SARS’ outbreak in 2003, as it also was a member of the ‘corona virus’ family. Clearly, if you just remained invested, there was a quick recovery from the market impact, and the bull market resumed. At least it seems that way.”
“While the chart is not intentionally deceiving, it hides a very important fact about the market decline and the potential impact of the SARS virus. Let’s expand the time frame of the chart to get a better understanding.”
“Following a nearly 50% decline in asset prices, a mean-reversion in valuations, and an economic recession ending, the impact of the SARS virus was negligible given the bulk of the ‘risk’ was already removed from asset prices and economic growth. Today’s economic environment could not be more opposed.”
This was also a point noted by the WSJ on Monday:
“Unlike today, the S&P 500 ETF (SPY) spent about a year below its 200-day moving average (dot-com crash) prior to the SARS 2003 outbreak. Price action is much different now. SPY was well above its 200-day moving average before the coronavirus outbreak, leaving plenty of room for profit-taking.”
Importantly, the concern we have in the intermediate-term is not “people getting sick.” We currently have the “flu” in the U.S. which, according to the CDC, has affected 32-45 MILLION people which has already resulted in 18-46,000 deaths.
Clearly, the “flu” is a much bigger problem than COVID-19 in terms of the number of people getting sick. The difference, however, is that during “flu season,” we don’t shut down airports, shipping, manufacturing, schools, etc. The negative impact to exports and imports, business investment, and potentially consumer spending, which are all direct inputs into the GDP calculation, is going to be reflected in corporate earnings and profits.
The recent slide, not withstanding the “reflexive bounce” on Monday, was beginning the process of pricing in negative earnings growth through the end of 2020.
More importantly, the earnings estimates have not be ratcheted down yet to account for the impact of the “shutdown” to the global supply chain. Once we adjust (dotted blue line) for the a negative earnings environment in 2020, with a recovery in 2021, you can see just how far estimates will slide over the coming months. This will put downward pressure on stocks over the course of this year.
Given this backdrop of weaker earnings, which will be derived from weaker economic growth, in the months to come is why we suspect we could well see this year play out much like 2015-2016. In 2015, the Fed was beginning to discuss tapering their balance sheet which initially led to a decline. Given there was still plenty of liquidity, the market rallied back before “Brexit” risk entered the picture. The market plunged on expectations for a negative economic impact, but sprung back after Janet Yellen coordinated with the BOE, and ECB, to launch QE in the Eurozone.
Using that model for a reflexive rally, we will likely see a failed rally, and a retest of last weeks lows, or potentially even set new lows, as economic and earnings risks are factored in.
Rally To Sell
As expected, the market rallied hard on Monday on hopes the Federal Reserve, and Central Banks globally, will intervene with a “shot of liquidity” to cure the market’s “COVID-19” infection.
The good news is the rally yesterday did clear initial resistance at the 200-dma which keeps that important break of support from being confirmed. This clears the way for the market to rally back into the initial “sell zone” we laid out this past weekend.
Importantly, while the volume of the rally on Monday was not as large as Friday’s sell-off, it was a very strong day nonetheless and confirmed the conviction of buyers. With the markets clearing the 200-dma, and still oversold on multiple levels, there is a high probability the market will rally into our “sell zone” before failing.
For now look for rallies to be “sold.”
The End Of The Bull
I want to reprint the last part of this weekend’s newsletter as the any rally that occurs over the next couple of weeks will NOT reverse the current market dynamics.
“The most important WARNING is the negative divergence in relative strength (top panel). This negative divergence was seen at every important market correction event over the last 25-years.”
“As shown in the bottom two panels, both of the monthly ‘buy’ signals are very close to reversing. It will take a breakout to ‘all-time highs’ at this point to keep those signals from triggering.
For longer-term investors, people close to, or in, retirement, or for individuals who don’t pay close attention to the markets or their investments, this is NOT a buying opportunity.
Let me be clear.
There is currently EVERY indication given the speed and magnitude of the decline, that any short-term reflexive bounce will likely fail. Such a failure will lead to a retest of the recent lows, or worse, the beginning of a bear market brought on by a recession.
Please read that last sentence again.
Bulls Still In Charge
The purpose of the analysis above is to provide you with the information to make educated guesses about the “probabilities” versus the “possibilities” of what could occur in the markets over the weeks, and months, ahead.
It is absolutely “possible” the markets could find a reason to rally back to all-time highs and continue the bullish trend. (For us, such would be the easiest and best outcome.) Currently, the good news for the bulls, is the bullish trend line from the 2015 lows held. However, weekly “sell signals” are close to triggering, which does increase short-term risks.
With the seasonally strong period of the market coming to its inevitable conclusion, economic and earnings data under pressure, and the virus yet to be contained, it is likely a good idea to use the current rally to rebalance portfolio risk and adjust allocations accordingly.
As I stated in mid-January, and again in early February, we reduced exposure in portfolios by raising cash and rebalancing portfolios back to target weightings. We had also added interest rate sensitive hedges to portfolios, and removed all of our international and emerging market exposures.
We will be using this rally to remove basic materials and industrials, which are susceptible to supply shocks, and financials which will be impacted by an economic slowdown/recession which will likely trigger rising defaults in the credit market.
Here are the guidelines we recommend for adjusting your portfolio risk:
Step 1) Clean Up Your Portfolio
Tighten up stop-loss levels to current support levels for each position.
Take profits in positions that have been big winners
Sell laggards and losers
Raise cash and rebalance portfolios to target weightings.
Step 2) Compare Your Portfolio Allocation To Your Model Allocation.
Determine areas requiring new or increased exposure.
Determine how many shares need to be purchased to fill allocation requirements.
Determine cash requirements to make purchases.
Re-examine portfolio to rebalance and raise sufficient cash for requirements.
Determine entry price levels for each new position.
Determine “stop loss” levels for each position.
Determine “sell/profit taking” levels for each position.
(Note: the primary rule of investing that should NEVER be broken is: “Never invest money without knowing where you are going to sell if you are wrong, and if you are right.”)
Step 3) Have positions ready to execute accordingly given the proper market set up. In this case, we are adjusting exposure to areas we like now, and using the rally to reduce/remove the sectors we do not want exposure too.
Stay alert, things are finally getting interesting.
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Retired Or Retiring Soon? Yes, Worry About A Correction
When I was growing up, my father used to tell me I should “never take advice from anyone who hasn’t succeeded at what they are advising.”
The most truth of that statement is found in the financial press, which consists mostly of people writing articles and giving advice on topics where they have little experience, and in general, have achieved no success.
The best example came last week in an email quoting:
“You recently suggested that you took profits from your portfolios; however, I read an article saying retirees shouldn’t change their strategies. ‘If you’ve got a thoughtful financial plan and a diversified investment portfolio, the general rule is to leave everything alone.'”
This seems to be an entirely different approach to what you are suggesting. Also, since corrections can’t be predicted, it seems to make sense.”
One of the biggest reasons why investors consistently underperform over the long-term is due to flawed investment advice.
Let me explain.
Corrections & Bear Markets Matter
It certainly seems logical, by looking the 120-year chart of the market, that one should just stay invested regardless of what happens. Eventually, as the financial media often suggests, the markets always get back to even. One such chart is the percentage gain/loss chart over the long-term, as shown below.
This is one of the most deceptive charts an advisor can show a client, particularly one that is close to, or worse in, retirement.
The reality is that you DIED long before ever achieving that 8% annualized long-term return you were promised. Secondly, math is a cruel teacher.
Visually, percentage drawdowns seem to be inconsequential relative to the massive percentage gains that preceded them. That is, until you convert percentages into points and reveal an uglier truth.
It is important to remember that a 100% gain on a $1000 investment, followed by a 50% loss, does not leave you with $1500. A 50% loss wipes out the previous 100% gain, leaving you with a 0% net return.
For retirees, this is a critically important point.
In 2000, the average “baby boomer” was around 45-years of age. The “dot.com” crash was painful, but with 20-years to go before retirement, there was time to recover. In 2010, following the financial crisis, the time to retirement for the oldest boomers was depleted, and the average boomer only had 10-years to recover. During both of these previous periods, portfolios were still in accumulation mode. However, today, only the youngest tranche of “boomers,” have the luxury of “time” to work through the next major market reversion. (This also explains why the share of workers over the age of 65 is at historical highs.)
With the majority of “boomers” now faced with the implications of a transition into the distribution phase of the investment cycle, such has important ramifications during market declines. The following example shows a $1 million portfolio with, and without, an annualized 4% withdrawal rate. (We are going into much deeper analysis on this in a moment.)
While a 10% decline in the market will reduce a portfolio from $1 million to $900,000, when combined with an assumed monthly withdrawal rate, the portfolio value is reduced by almost 14%. This is the result of taking distributions during a period of declining market values. Importantly, while it ONLY requires a non-withdrawal portfolio an 11.1% return to break even, it requires nearly a 20% return for a portfolio in the distribution phase to attain the same level.
Impairments to capital are the biggest challenges facing pre- and post-retirees currently.
This is an important distinction. Most articles written about retirees, or those ready to retire, is an unrealized assumption of an indefinite timeline.
While the market may not be different than it has been in the past. YOU ARE!
Starting Valuations Matter
As I have discussed previously, without understanding the importance of starting valuations on your investment returns, you can’t understand the impact the market will have on psychology, and investor behavior.
Over any 30-year period, beginning valuation levels have a tremendous impact on future returns.
As valuations rise, future rates of annualized returns fall. This should not be a surprise as simple logic states that if you overpay for an asset today, the future returns must, and will, be lower.
This is far less than the 8-10% rates of return currently promised by the Wall Street community. It is also why starting valuations are critical for individuals to understand when planning for both the accumulation and distribution, phases of the investment life-cycle.
Let’s elaborate on our example above.
We know that markets go up and down over time, therefore when advisors use “average” or “annualized” rates of return, results often deviate far from reality. However, we do know from historical analysis that valuations drive forward returns, so using historical data, we calculated the 4-periods where starting valuations were either above 20x earnings, or below 10x earnings. We then ran a $1000 investment going forward for 30-years on a total-return, inflation-adjusted, basis.
The results were not surprising.
At 10x earnings, the worst performing period started in 1918 and only saw $1000 grow to a bit more than $6000. The best performing period was actually not the screaming bull market that started in 1980 because the last 10-years of that particular cycle caught the “dot.com” crash. It was the post-WWII bull market that ran from 1942 through 1972 that was the winner. Of course, the crash of 1974, just two years later, extracted a good bit of those returns.
Conversely, at 20x earnings, the best performing period started in 1900, which caught the rise of the market to its peak in 1929. Unfortunately, the next 4-years wiped out roughly 85% of those gains. However, outside of that one period, all of the other periods fared worse than investing at lower valuations. (Note: 1993 is still currently running as its 30-year period will end in 2023.)
The point to be made here is simple and was precisely summed up by Warren Buffett:
“Price is what you pay. Value is what you get.”
To create our variable return assumption model, we averaged each of the 4-periods above into a single total return, inflation-adjusted, index. We could then see the impact of $1000 invested in the markets at both valuations BELOW 10x trailing earnings, and ABOVE 20x. Investing at 10x earnings yields substantially better results.
Starting Valuations Are Critical To Withdrawal Rates
With a more realistic return model, the impact of investing during periods of high valuations becomes more evident, particularly during the withdrawal phase of retirement.
Let’s start with our $1 million retirement portfolio. The chart below shows various “spend down” assumptions of a $1 million retirement portfolio adjusted for an 8% annualized return, the impact of inflation at 3%, and the effect of taxation on withdrawals.
By adjusting the annualized rate of return for the impact of inflation and taxes, the life expectancy of a portfolio grows considerably shorter. Unfortunately, this is what “really happens” to investors over time, but is never discussed in mainstream analysis.
To understand “real outcomes,” we must adjust for variable rates of returns. There is a significant difference between 8% annualized rates of return and 8% real rates of return.
When we adjust the spend down structure for elevated starting valuation levels, and include inflation and taxes, a far different, and less favorable, outcome emerges. Retirees will run out of money not in year 30, but in year 18.
With this understanding, let’s revisit what happens to “buy and hold” investors over time. The chart below shows $3000 invested annually into the S&P 500 inflation-adjusted, total return index at 10% compounded annually, and both 10x and 20x valuation starting levels. I have also shown $3000 saved annually and “stuffed in a mattress.”
The red line is 10% compounded annually. While you don’t get compounded returns, it is there for comparative purposes to the real returns received over the 30-year investment horizon starting at 10x and 20x valuation levels. The shortfall between the promised 10% annual rates of return and actual returns are shown in the two shaded areas. In other words, if you are banking on some advisor’s promise of 10% annual returns for retirement, you aren’t going to make it.
Questions Retirees Need To Ask About Plans
What this analysis reveals is that “retirees” SHOULDbe worried about bear markets.
Taking the correct view of your portfolio, and the risks being undertaken is critical when entering the retirement and distribution phase of the portfolio life cycle.
Most importantly, when building and/or reviewing your financial plan, these are the questions you must ask and have concrete answers for:
What are the expectations for future returns going forward given current valuation levels?
Should the withdrawal rates be downwardly adjusted to account for potentially lower future returns?
Given a decade long bull market, have adjustments been made for potentially front-loaded negative returns?
Has the impact of taxation been carefully considered in the planned withdrawal rate?
Have future inflation expectations been carefully considered?
Have drawdowns from portfolios during declining market environments, which accelerates principal bleed, been considered?
Have plans been made to harbor capital during up years to allow for reduced portfolio withdrawals during adverse market conditions?
Has the yield chase over the last decade, and low interest rate environment, which has created an extremely risky environment for retirement income planning, been carefully considered?
What steps should be considered to reduce potential credit and duration risk in bond portfolios?
Have expectations for compounded annual rates of returns been dismissed in lieu of a plan for variable rates of future returns?
If the answer is “no” to the majority of these questions. then feel free to contact one of the CFP’s in our office who take all of these issues into account.
With debt levels rising globally, economic growth on the long-end of the cycle, earnings growth weak, valuations high, and potential risk of a recession, the uncertainty of retirement plans has risen markedly. This lends itself to the problem of individuals having to spend a bulk of their “retirement” continuing to work.
Yes, not only should you worry about bear markets, you should worry about them a lot.
The Fed & The Stability/Instability Paradox
“Only those that risk going too far can possibly find out how far one can go.”– T.S. Eliot
Well, this certainly seems to be the path that the Federal Reserve, and global Central Banks, have decided take.
Yesterday, the Fed lowered interest rates by a quarter-point and maintained their “dovish” stance but suggested they are open to “allowing the balance sheet to grow.” While this isn’t anything more than just stopping Q.T. entirely, the markets took this as a sign that Q.E. is just around the corner.
That expectation is likely misguided as the Fed seems completely unconcerned of any recessionary impact in the near-term. However, such has always been the case, historically speaking, just before the onset of a recession. This is because the Fed, and economists in general, make predictions based on lagging data which is subject to large future revisions. Regardless, the outcome of the Fed’s monetary policies has always been, without exception, either poor, or disastrous.
“In the U.S., the Federal Reserve has been the catalyst behind every preceding financial event since they became ‘active,’ monetarily policy-wise, in the late 70’s. As shown in the chart below, when the Fed has lifted the short-term lending rates to a level higher than the 2-year rate, bad ‘stuff’ has historically followed.”
The idea of pushing limits to extremes also applies to stock market investors. As we pointed out on Tuesday, the risks of a liquidity-driven event have increased markedly in recent months. Yet, despite the apparent risk, investors have virtually “no fear.”(Bullish advances are supported by extremely low levels of volatility below the long-term average of 19.)
“First, “record levels” of anything are records for a reason. It is where the point where previous limits were reached. Therefore, when a ‘record level’ is reached, it is NOT THE BEGINNING, but rather an indication of the MATURITY of a cycle. While the media has focused on employment, record stock market levels, etc. as a sign of an ongoing economic recovery, history suggests caution.”
In the “rush to be bullish” this a point often missed. When markets are hitting “record levels,” it is when investors get “the most bullish.” That is the case currently with retail investors “all in.”
Conversely, they are the most “bearish” at the lows.
It is just human nature.
“What we call the beginning is often the end. And to make an end is to make a beginning. The end is where we start from.” – T.S. Eliot
The point here is that “all things do come to an end.” The further from the “mean” something has gotten, the greater the reversion is going to be. The two charts below illustrate this point clearly.
Bull markets, with regularity, are almost entirely wiped out by the subsequent bear market.
Despite the best of intentions, market participants never act rationally.
Neither do consumers.
The Instability Of Stability
This is the problem facing the Fed.
Currently, investors have been led to believe that no matter what happens, the Fed can bail out the markets and keep the bull market going for a while longer. Or rather, as Dr. Irving Fisher once uttered:
“Stocks have reached a permanently high plateau.”
Interestingly, the Fed is dependent on both market participants, and consumers, believing in this idea. As we have noted previously, with the entirety of the financial ecosystem now more heavily levered than ever, due to the Fed’s profligate measures of suppressing interest rates and flooding the system with excessive levels of liquidity, the “instability of stability” is now the most significant risk.
The “stability/instability paradox” assumes that all players are rational and such rationality implies an avoidance of complete destruction. In other words, all players will act rationally, and no one will push “the big red button.”
The Fed is highly dependent on this assumption as it provides the “room” needed, after more than 10-years of the most unprecedented monetary policy program in U.S. history, to try and navigate the risks that have built up in the system.
Simply, the Fed is dependent on “everyone acting rationally.”
Unfortunately, that has never been the case.
The behavioral biases of individuals is one of the most serious risks facing the Fed. Throughout history, as noted above, the Fed’s actions have repeatedly led to negative outcomes despite the best of intentions.
In the early 70’s it was the “Nifty Fifty” stocks,
Then Mexican and Argentine bonds a few years after that
“Portfolio Insurance” was the “thing” in the mid -80’s
Dot.com anything was a great investment in 1999
Real estate has been a boom/bust cycle roughly every other decade, but 2006 was a doozy
Today, it’s ETF’s and “Passive Investing,” and levered credit.
As noted Tuesday, the risk to this entire house of cards is a credit-related event.
“Anyone wonder what might happen should passive funds become large net sellers of credit risk? In that event, these indiscriminate sellers will have to find highly discriminating buyers who–you guessed it–will be asking lots of questions. Liquidity for the passive universe–and thus the credit markets generally–may become very problematic indeed.
The recent actions by Central Banks certainly suggest risk has risen. Whether this was just an anomalous event, or an early warning, it is too soon to know for sure. However, if there is a liquidity issue, the risk to ‘uniformed investors’ is substantially higher than most realize.
Risk concentration always seems rational at the beginning, and the initial successes of the trends it creates can be self-reinforcing. That is, until suddenly, and often without warning, it all goes “pear\-shaped.”
In November and December of last year, it was the uniformity of the price moves which revealed the fallacy “passive investing” as investors headed for the door all at the same time. While, that rout was quickly forgotten as markets stormed back to all-time highs, on “hopes” of Central Bank liquidity and “trade deals.”
The difference today, versus then, are the warning signs of deterioration in areas which pose a direct threat to everyone “acting rationally.”
“While yields going to zero] certainly sounds implausible at the moment, just remember that all yields globally are relative. If global sovereign rates are zero or less, it is only a function of time until the U.S. follows suit. This is particularly the case if there is a liquidity crisis at some point.
It is worth noting that whenever Eurodollar positioning has become this extended previously, the equity markets have declined along with yields. Given the exceedingly rapid rise in the Eurodollar positioning, it certainly suggests that ‘something has broken in the system.’”
Risk is clearly elevated as the Fed is cutting rates despite the “economic data” not supporting it. This is clearly meant to keep everyone acting rationally for now.
The problem comes when they don’t.
The Single Biggest Risk To Your Money
All of this underscores the single biggest risk to your investment portfolio.
In extremely long bull market cycles, investors become “willfully blind,” to the underlying inherent risks. Or rather, it is the “hubris” of investors they are now “smarter than the market.”
Yet, the list of concerns remains despite being completely ignored by investors and the mainstream media.
Growing economic ambiguities in the U.S. and abroad: peak autos, peak housing, peak GDP.
Political instability and a crucial election.
The failure of fiscal policy to ‘trickle down.’
An important pivot towards easing in global monetary policy.
Geopolitical risks from Trade Wars to Iran
Inversions of yield curves
Deteriorating earnings and corporate profit margins.
Record levels of private and public debt.
More than $3 trillion of covenant light and/or sub-prime corporate debt. (now larger and more pervasive than the size of the subprime mortgages outstanding in 2007)
For now, none of that matters as the Fed seems to have everything under control.
The more the market rises, the more reinforced the belief “this time is different” becomes.
Yes, our investment portfolios remain invested on the long-side for now. (Although we continue to carry slightly higher levels of cash and hedges.)
However, that will change, and rapidly so, at the first sign of the “instability of stability.”
Unfortunately, by the time the Fed realizes what they have done, it has always been too late.
The 5-Mental Traps Investors Are Falling Into Right Now
I recently wrote about the “F.I.R.E.” movement and how it is a byproduct of late-stage bull market cycle. It isn’t just the “can’t lose” ideas which are symptomatic of bullish cycles, but also the actual activities of investors as well. Not surprisingly, the deviation of growth over value has become one of the largest in history.
This divergence of the “performance chase” should be a reminder of Benjamin Graham’s immortal warning:
“The investor’s chief problem, and even his worst enemy, is likely to be himself.”
With valuations elevated, prices at record highs, and the current bull market the longest in U.S. history, it seems like a good time to review the 5-most dangerous psychological biases of investing.
The 5-Most Dangerous Biases
Every year Dalbar releases their annual “Quantitative Analysis of Investor Behavior” study which continues to show just how poorly investors perform relative to market benchmarks over time. More importantly, they discuss many of the reasons for that underperformance which are all directly attributable to your brain.
From Dalbar’s 2018 study:
“In 2018 the average investor underperformed the S&P 500 in both good times and bad, lagging behind the S&P by more than 100 basis points in two different months.”
Cognitive biases are a curse to portfolio management as they impair our ability to remain emotionally disconnected from our money. As history all too clearly shows, investors always do the “opposite” of what they should when it comes to investing their own money.
Here are the top-5 of the most insidious biases investors are falling into RIGHT NOW!
1) Confirmation Bias
As individuals, we tend to seek out information that conforms to our current beliefs. If one believes that the stock market is going to rise, they tend only to seek out news and information that supports that position. This confirmation bias is a primary driver of the psychological investing cycle of individuals as shown below. I discussed this just recently in why “Media Headlines Will Lead You To Ruin.”
As individuals, we want “affirmation” our current thought processes are correct. As human beings, we hate to be told we are wrong, so we tend to seek out sources which tell us we are “right.”
Currently, individual investors are “fully” back in the market despite a fairly decent bruising in 2018. Historically, this has not turned out well for individuals, but given that “optimism sells,” it is not surprising to see the majority of the mainstream meeting touting a continuation of the bull market.
This is why it is always important to consider both sides of every debate equally and analyze the data accordingly. Being right and making money are not mutually exclusive.
2) Gambler’s Fallacy
The “Gambler’s Fallacy” is one of the bigger issues faced by individuals when investing. As emotionally driven human beings, we tend to put a tremendous amount of weight on previous events believing that future outcomes will somehow be the same.
The bias is clearly addressed at the bottom of every piece of financial literature.
“Past performance is no guarantee of future results.”
However, despite that statement being plastered everywhere in the financial universe, individuals consistently dismiss the warning and focus on past returns expecting similar results in the future.
This is one of the key issues that affect an investor’s long-term returns. Performance chasing has a high propensity to fail, continually causing investors to jump from one late cycle strategy to the next. This is shown in the periodic table of returns below. “Hot hands” only tend to last on average 2-3 years before going “cold.”
I traced out the returns of large capitalization stocks (S&P 500) and U.S. Fixed Income (Barclay’s Aggregate Bond Index) for illustrative purposes. Importantly, you should notice that whatever is at the top of the list in some years tends to fall to the bottom in subsequent years.“Performance chasing” is a major detraction from investor’s long-term investment returns.
Currently, money is chasing Technology, Discretionary, and Communications, with Energy, Healthcare, and Bonds lagging. From a contrarian viewpoint, with “Value” dramatically underperforming “Growth” at this juncture of the investment cycle, there may be a generational opportunity soon approaching.
3) Probability Neglect
When it comes to “risk-taking” there are two ways to assess the potential outcome. There are “possibilities” and “probabilities.”As individuals, we tend to lean toward what is possible such as playing the “lottery.”
The statistical probabilities of winning the lottery are astronomical. In fact, you are more likely to die on the way to purchase the ticket than actually winning the lottery. However, it is the “possibility” of instant wealth that makes the lottery such a successful “tax on poor people.”
As humans, we tend to neglect the “probabilities,” or rather the statistical measures of “risk,” undertaken with any given investment, in exchange for the “possibility” of gaining wealth. Our bias is to “chase” stocks, or markets, which already have large gains as it is “possible” they could move higher. However, the “probability” is that a corrective action will likely occur first.
With markets currently well deviated above long-term historical means, and valuations elevated, the possibility is greatly outweighed by the probability of a mean-reverting event first. The following chart is derived from Dr. Robert Shiller’s inflation-adjusted price data and is plotted on a QUARTERLY basis. From that quarterly data is calculated:
The 12-period (3-year) Relative Strength Index (RSI),
Bollinger Bands (2 and 3 standard deviations of the 3-year average),
CAPE Ratio, and;
The percentage deviation above and below the 3-year moving average.
The vertical RED lines denote points where all measures have aligned
Over the next several weeks, or even months, the markets could certainly extend the current deviations from long-term mean even further drive by the psychology of the “herd.”But such is the nature of every bull market peak, and bubble, throughout history as the seeming impervious advance lures the last of the stock market “holdouts” back into the markets.
Probability neglect is another major component to why investors consistently “buy high and sell low.”
4) Herd Bias
Though we are often unconscious of the action, humans tend to “go with the crowd.” Much of this behavior relates back to “confirmation” of our decisions, but also the need for acceptance. The thought process is rooted in the belief that if “everyone else” is doing something, then if I want to be accepted, I need to do it too.
“If all your friends jump off a cliff, are you going to do it too?” – said by every Mother in history.
In life, “conforming” to the norm is socially accepted and in many ways expected. However, in the financial markets the “herding” behavior is what drives market excesses during advances and declines.
As noted above, the “momentum chase” currently is good example of “herding” behavior. As Michael Lebowitz noted recently:
“The graph below charts ten year annualized total returns (dividends included) for value stocks versus growth stocks. The most recent data indicates value stocks have underperformed growth stocks by 2.86% on average in each of the last ten years.”
“There have only been eight ten-year periods over the last 90 years (total of 90 ten-year periods) when value stocks underperformed growth stocks. Two of these occurred during the Great Depression and one spanned the 1990s leading into the Tech bust of 2001. The other five are recent, representing the years 2014 through 2018.
When the cycle turns, we have little doubt the value-growth relationship will revert. In such a case value would outperform growth by nearly 30% in just two years. Anything beyond the average would increase the outperformance even more.”
Moving against the “herd” is where investors have generated the most profits over the long term. The difficulty for most individuals, unfortunately, is knowing when to “bet” against the stampede.
5) Recency Bias
Recency bias occurs when people more prominently recall, and extrapolate, recent events and believe that the same will continue indefinitely into the future. This phenomenon frequently occurs in with investing. Humans have short memories in general, but memories are especially short when it comes to investing cycles.
As Morningstar once penned:
“During a bull market, people tend to forget about bear markets. As far as human recent memory is concerned, the market should keep going up since it has been going up recently. Investors therefore keep buying stocks, feeling good about their prospects. Investors thereby increase risk taking and may not think about diversification or portfolio management prudence. Then a bear market hits, and rather than be prepared for it with shock absorbers in their portfolios, investors instead suffer a massive drop in their net worths and may sell out of stocks when the market is low. Selling low is, of course, not a good long-term investing strategy.”
This bias in action looks a lot like the chart below.
During bull markets, investors believe that markets can only go up – so “buy the dip” becomes a “can’t lose” investment strategy. This bias also works in reverse during bear markets. Investors become convinced the market will only go lower which eventually leads them to “panic selling” the lows.
Recency bias is the primary driver behind the “Buy High/Sell Low” syndrome.
Everyone’s A Genius
The last point brings me to something Michael Sincere once penned:
“At market tops, it is common to see what I call the ‘high-five effect’ — that is, investors giving high-fives to each other because they are making so much paper money. It is happening now. I am also suspicious when amateurs come out of the woodwork to insult other investors.”
Michael’s point is very apropos, particularly today, it’s currently “high-fives and pats on the back.”
The market’s ability to seemingly recover from every setback, and to ignore fundamental issues, has led investors to feel “bulletproof” as investment success breeds overconfidence.
The reality is that strongly rising asset prices, particularly when driven by emotional exuberance, “hides” investment mistakes in the short term. Poor, or deteriorating, fundamentals, excessive valuations, and/or rising credit risk is often ignored as prices increase. Unfortunately, it is only after the damage is done the realization of those “risks” occurs.
For investors, it is crucially important to understand that markets run in full cycles (up and down). While the bullish “up” cycle lasts twice as long as the bearish “down” cycle, the majority of the previous gains are repeatedly destroyed.
The damage to investors is not a result of lagging markets as they rise, but in capturing the inevitable reversion. This is something I discussed in “Bulls And Bears Are Both Broken Clocks:”
“In the end, it does not matter IF you are ‘bullish’ or ‘bearish.’ The reality is that both ‘bulls’ and ‘bears’ are owned by the ‘broken clock’ syndrome during the full-market cycle. However, what is grossly important in achieving long-term investment success is not necessarily being ‘right’ during the first half of the cycle, but by not being ‘wrong’ during the second half.”
We are only human, and despite the best of our intentions, it is nearly impossible for an individual to be devoid of the emotional biases which inevitably leads to poor decision making over time. This is why all great investors have strict investment disciplines they follow to reduce the impact of their emotions.
At market peaks – everyone’s a “Genius.”Save
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Understanding Market Cycles
I was digging through some old charts over the weekend and stumbled across this gem from AlphaTrends which explains the “best time to buy stocks.”
“Is it possible to time the market cycle to capture big gains?
Like many controversial topics in investing, there is no real professional consensus on market timing. Academics claim that it’s not possible, while traders and chartists swear by the idea.
The following infographic explains the four important phases of market trends, based on the methodology of the famous stock market authority Richard Wyckoff.
The theory is that the better an investor can identify these phases of the market cycle, the more profits can be made on the ride upwards of a buying opportunity.”
So, the question to answer, obviously, is:
“Where are we now?”
I’m glad you asked.
Let’s take a look at the past two full-market cycles, using Wyckoff’s methodology, as compared to the current post-financial-crisis half-cycle. While actual market cycles will not exactly replicate the chart above, you can clearly see Wyckoff’s theory in action.
1992-2003
The accumulation phase, following the 1991 recessionary environment was evident as it preceded the “internet trading boom” and the rise of the “dot.com” bubble from 1995-1999.
As I noted last week:
“Following the recession of 1991, the Federal Reserve drastically lowered interest rates to spur economic growth. However, the two events which laid the foundation for the ‘dot.com’ crisis was the rule-change which allowed the nations pension funds to own equities and the repeal of Glass-Steagall which unleashed Wall Street upon a nation of unsuspecting investors.
The major banks could now use their massive balance sheet to engage in investment-banking, market-making, and proprietary trading. The markets exploded as money flooded the financial markets. Of course, since there were not enough “legitimate” deals to fill demand and Wall Street bankers are paid to produce deals, Wall Street floated any offering it could despite the risk to investors.”
The distribution phase became evident in early-2000 as stocks began to struggle.
While the names of Enron, WorldCom, Global Crossing, Lucent Technologies, Nortel, Sun Micro, and a host of others are “ghosts of the past,” relics of an era the majority of investors in the market today are unaware of, they were the poster children for the “greed and excess” of the preceding bull market frenzy.
As the distribution phase gained traction, it is worth remembering the media and Wall Street were touting the continuation of the bull market indefinitely into the future.
Then, came the decline.
2003-2009
Following the “dot.com” crash investors had all learned their lessons about the value of managing risk in portfolios, not chasing returns and focusing on capital preservation as the core for long-term investing.
Okay. Not really.
It took about 27 minutes for investors to completely forget about the previous pain of the bear market and jump headlong back into the creation of the next bubble leading to the “financial crisis.”
During the mark-up phase investors once again piled into leverage. This time not just into stocks, but real estate, as well as Wall Street, found a new way to extract capital from Main Street through the creation of exotic loan structures. Of course, everything was fine as long as interest rates remained low, but as with all things, the “party eventually ends.”
Once again, during the distribution phase of the market, the analysts, media, Wall Street, and a rise of bloggers, all touted “this time was different.” There were “green shoots,” it was a “Goldilocks economy,” and there was “no recession in sight.”
They were disastrously wrong.
Sound familiar?
2009-Present
So, here we are, a decade into the current economic recovery and a market that has risen steadily on the back of excessively accommodative monetary policy and massive liquidity injections by Central Banks globally.
Once again, due to the length of the “mark up” phase, most investors today have once again forgotten the “ghosts of bear markets past.” Despite a year-long distribution in the market, the same messages seen at previous market peaks have been steadily hitting headlines: “there is no recession in sight,” “the bull market is cheap” and “this time is different because of Central Banking.”
Lost And Found
There is a sizable contingent of investors, and advisors, today who have never been through a real bear market. After a decade long bull-market cycle, which only seems to go up, you can certainly understand why mainstream analysis continues to believe the markets can only go higher.
What is concerning is the rather cavalier attitude the mainstream media takes about bear markets.
“Sure, a correction will eventually come, but that is just part of the deal.”
What gets lost during these bullish cycles, and is found in the most brutal of fashions, is the devastation caused to financial wealth during the inevitable decline.
Let’s look at the S&P 500 inflation-adjusted total return index in a different manner. The first chart shows all of the measurement lines for all the previous bull and bear markets with the number of years required to get back to even.
What you should notice is that in many cases bear markets wiped out essentially a substantial portion, if not all, of the previous bull market advance. This is shown more clearly when we look at a chart of bull and bear markets in terms of points.
Whether or not the current distribution phase is complete, there are many signs suggesting the current Wyckoff cycle may be entering its final stage of completion.
Let me remind you of something Ben Graham said back in 1959:
“‘The more it changes, the more it’s the same thing.’ I have always thought this motto applied to the stock market better than anywhere else. Now the really important part of the proverb is the phrase, ‘the more it changes.’
The economic world has changed radically and will change even more. Most people think now that the essential nature of the stock market has been undergoing a corresponding change. But if my cliché is sound, then the stock market will continue to be essentially what it always was in the past, a place where a big bull market is inevitably followed by a big bear market.
In other words, a place where today’s free lunches are paid for doubly tomorrow. In the light of recent experience, I think the present level of the stock market is an extremely dangerous one.”
He is right, of course, things are little different now than they were then.
For every “bull market” there MUST be a “bear market.”
While “passive indexing” sounds like a winning approach to “pace” the markets during an advance, it is worth remembering that approach will also “pace” the decline.
The recent sell-off should have been a wake-up call to just how quickly things can change and how damaging they can be.
There is no difference between a 100% gain and a 50% loss.
(For the mathematically challenged: If the market rises from 1000 to 2000 it is a 100% gain. A fall from 2000 to 1000 is a 50% loss. Net return is 0%)
Understanding that investment returns are driven by actual dollar losses, and not percentages, is important in the comprehension of how devastating corrections can be on your financial outcome. So, before sticking your head in the sand and ignoring market risk based on an article touting “long-terminvesting always wins,” there is a huge difference between just making money and actually reaching your financial goals.
U.S. Household Wealth Is In A Bubble – Part 1
This article is Part I of a series that explains why U.S. household wealth is experiencing a dangerous bubble, why this bubble is heading for a powerful bust, and how to preserve and grow your wealth when this bubble inevitably bursts.
This series of articles will cover the following key points:
How inflated household wealth currently is compared to historic levels
What forces are driving household wealth to such extreme levels
A look at the underlying components of household wealth and why they are inflated
A look at the growing bubbles in equities, housing, and bonds
How the household wealth bubble is driving consumer spending
How the wealth bubble contributes to our artificial economic recovery
How the wealth bubble is creating a temporary surge of inequality
How the wealth bubble will burst
How to preserve your wealth when the wealth bubble bursts
Part I: U.S. Household Wealth Is In A Bubble
In most people’s minds, any increase in wealth is a good thing. Surely, only a misanthrope would argue otherwise, right? Well, in this article series, I’m going to make the unpopular argument that America’s post-Great Recession household wealth boom is actually a very dangerous phenomenon.
Since the financial crisis in early-2009, household wealth has surged by nearly $46 trillion or 83 percent to a record $100.8 trillion. As the chart below shows, the powerful increase in household wealth (blue line) has far exceeded the growth of the underlying economy, as measured by the GDP (orange line). Household wealth should closely track the economy, as it did during the 20th century until the extreme boom-bust era that started in the mid-to-late 1990s.
When household wealth tracks the growth of the economy, it’s a sign that the wealth increase is likely organic, healthy, and sustainable. When household wealth far outpaces the growth of the underlying economy, however, that is a tell-tale sign that the boom is artificial and unsustainable. The last two times household wealth growth exceeded GDP growth by a large degree was during the late-1990s dot-com bubble and the mid-2000s housing bubble, both of which ended in tears. The gap between household wealth and the economy is far larger today than it was in the last two bubbles, which means that the coming reversion or crash is going to be even more painful, unfortunately.
Another way of visualizing the household wealth bubble is to plot it as a percent of GDP, which paints the same picture as the chart above. U.S. household wealth is currently 505 percent of the GDP, which is even more extreme than the housing bubble’s peak at 473 percent, and the dot-com bubble’s peak at 429 percent. Household wealth has averaged 379 percent of the GDP since 1951, so the current 505 percent figure is completely out of line, which means that a violent reversion to the mean (aka, another crash) is inevitable. To make matters even worse, the 379 percent average figure is skewed upward by the anomalous boom-bust period that began in the mid-to-late 1990s. When U.S. household wealth comes crashing down again, there is a very good chance that it will overshoot below its historic average due to how stretched it has become during the current bubble.
What is driving the current U.S. household wealth bubble and why is it happening? The answer lies squarely with the U.S. Federal Reserve and its actions during and after the Global Financial Crisis. During the Crisis, household wealth plunged as stocks, housing prices, and bonds (aside from Treasuries) cratered. These aforementioned assets make up the bulk of household wealth, so bull markets in stocks, housing, and bonds lead to bull markets in household wealth and vice versa. When household wealth plunges as it did in 2008 and 2009, consumers pare back their spending dramatically, which leads to even more economic pain.
In an attempt to pull the economy and financial markets out of their deep-freeze, the Federal Reserve cut interest rates to record low levels and launched emergency monetary stimulus policies known as quantitative easing or QE. QE basically entails creating new money out of thin air (this is done digitally) and using the proceeds to buy mortgage-backed securities and Treasury bonds with the idea that the massive influx of liquidity into the financial system would indirectly find its way into riskier assets such as stocks. Even though the Fed only has two official mandates (maximizing employment and maintaining price stability), boosting asset prices essentially became their unspoken third mandate after the 2008 financial crisis.
As former Fed chairman Ben Bernanke wrote in a 2010 op-ed in which he explained (what he claimed to be) the virtues of the Fed’s new, unconventional monetary policies:
And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.
While the idea of having a central bank like the Federal Reserve boost asset prices to create an economic recovery may seem clever and admirable, it is terribly misguided because asset booms driven by central bank intervention are overwhelmingly likely to be unsustainable bubbles rather than genuine booms. Central bank-driven booms are very similar to sugar highs or highs from hard drugs – a crash is inevitable once the substance wears off. When central banks interfere in markets, they create mass distortions and false signals that trick investors into believing that the boom is legitimate, even though it’s not.
The chart below shows the Fed Funds Rate, which is the interest rate that the Fed raises and lowers in order to steer the economy. When the Fed holds rates at very low levels (which keeps borrowing costs in the economy low), dangerous bubbles form in asset prices and the overall economy. When the Fed ultimately raises rates, the bubble pops, which results in stock bear markets and recessions. The dot-com and housing bubbles formed during periods of low interest rates and popped when interest rates were raised.
What is terrifying is the fact that interest rates have remained at record low levels for a record length of time since the financial crisis, which means that the current market distortion and coming crisis will be even more extreme than the last two. Remember how extreme the current household wealth bubble looked in the two charts shown earlier in this piece? Well, that is certainly no coincidence: it is a direct result of the extremely loose monetary conditions over the last decade.
This next chart shows the Federal Reserve’s balance sheet, which shows the assets purchased by the central bank during its QE programs. Each QE program led to an increase in the Fed’s balance sheet and corresponding surge in asset prices. The three QE programs caused the Fed’s balance sheet to expand by over $3.5 trillion to a peak of approximately $4.5 trillion. Since late-2017, the Fed has been attempting to shrink its balance sheet (this is known as quantitative tightening or QT), which has roiled the financial markets.
Summary – Part I
To summarize, we are currently experiencing an explosion of wealth on a scale that has never been seen before. Unfortunately, it’s not the good kind of wealth explosion, but the bad kind – the kind that precedes wealth implosions that lead to deep economic recessions and depressions. While most people are cheering this boom on and are delighted by the return to prosperous times, they have absolutely no clue what is driving it or the fact that it will prove to be fleeting and ephemeral.
Please stay tuned for Part II, where I will discuss the underlying components of U.S. household wealth (stocks, bonds, etc.) and provide even more evidence that they are experiencing speculative bubbles in their own right.
If you are like most investors, the U.S. household wealth bubble means that your own investments, wealth, and retirement fund are extremely inflated and exposed to grave risk of another crash. Most investment firms have absolutely no clue that another storm is coming, let alone how to navigate it. Clarity Financial LLC, my employer, is a registered investment advisor firm that specializes in preserving and growing investor wealth in precarious times like these.
Please click here to contact us so that we can help protect your hard-earned wealth.
Technically Speaking: The Formula Behind “Buy High/Sell Low”
“Technically Speaking” is a regular Tuesday commentary updating current market trends and highlighting shorter-term investment strategies, risks, and potential opportunities. Please send any comments or questions directly to me via Email, Facebook or Twitter.
With the markets closed on Monday, there really isn’t much to update you on “technically” from this past weekend’s missive. The important point, if you haven’t read it, was:
“The failure of the market to rotate to the “risk on” trade should not be lightly dismissed. A healthy breakout of the market should have been accompanied by both an increase in trading volume and leadership from the “smaller and riskier” stocks in the market. The chart below is the Russell 2000 Index as compared to the S&P 500 Index.”
You can see this exuberance in the deviation of the S&P 500 from its long-term moving averages as compared to the collapse in the volatility index. There is simply “NO FEAR” of a correction in the markets currently which has always been a precedent for a correction in the past.
The chart below is a MONTHLY chart of the S&P 500 which removes the daily price volatility to reveal some longer-term market dynamics. With the markets currently trading 3-standard deviations above their intermediate-term moving average, and with longer-term sell signals still weighing on the market, some caution is advisable.
While this analysis does NOT suggest an imminent “crash,”it DOES SUGGEST a corrective action is more likely than not. The only question, as always, is timing.
However, this brings me to something I have addressed in the past but thought would be a good reminder as we head into the summer months:
“The most dangerous element to our success as investors…is ourselves.”
The Formula To Buy High / Sell Low
This past week, Mark Yusko and I had the following exchange on Twitter.
Great point…A formula for why individuals always lose: Speculation + Psychology + Media Hype – Lack Of Discipline = Buy High/Sell Lowhttps://t.co/MoU2aFddQM
The point here is quite simple. Individuals, especially in very late-stage cyclical bull markets, tend to get “sucked” into the markets primarily due to the Wall Street and media driven hype which feeds the “fear of missing out (FOMO).” As I noted previously:
“The longer a bull market exists, the more it is believed that it will last indefinitely.”
The chart below shows the long-term view of the market with its inherent full-market (combined secular bull and bear) cycles exposed.
The idea of full market cycles is important to understand as this is precisely how the formula functions. In the latter stages of the bull market cycle, as “exuberance” eventually sucks the last of the holdouts back in, the “buy high” side of the equation is fulfilled. The second half of the full-market cycle will complete the process.
Every year Dalbar releases their annual “Quantitative Analysis of Investor Behavior” study which continues to show just how poorly investors perform relative to market benchmarks over time. More importantly, they discuss many of the reasons for that underperformance which are all directly attributable to your brain.
George Dvorsky once wrote that:
“The human brain is capable of 1016 processes per second, which makes it far more powerful than any computer currently in existence. But that doesn’t mean our brains don’t have major limitations. The lowly calculator can do math thousands of times better than we can, and our memories are often less than useless — plus, we’re subject to cognitive biases, those annoying glitches in our thinking that cause us to make questionable decisions and reach erroneous conclusions.“
Cognitive biases are an anathema to portfolio management as it impairs our ability to remain emotionally disconnected from our money. As history all too clearly shows, investors always do the “opposite” of what they should when it comes to investing their own money. They “buy high” as the emotion of “greed” overtakes logic and “sell low” as “fear” impairs the decision-making process.
Here are the top-5 of the most insidious biases which keep you from achieving your long-term investment goals.
1) Confirmation Bias
As individuals, we tend to seek out information that conforms to our current beliefs. If one believes that the stock market is going to rise, they tend to only seek out news and information that supports that position. This confirmation bias is a primary driver of the psychological investing cycle of individuals as shown below. I discussed this just recently in why “5-Laws Of Human Stupidity” and in “Media Headlines Will Lead You To Ruin.”
As individuals, we want “affirmation” our current thought processes are correct. As human beings, we hate being told we are wrong, so we tend to seek out sources that tell us we are “right.”
This is why it is always important to consider both sides of every debate equally and analyze the data accordingly. Being right and making money are not mutually exclusive.
The issue of “confirmation bias” also creates a problem for the media. Since the media requires “paid advertisers” to create revenue, viewer or readership is paramount to obtaining those clients. As financial markets are rising, presenting non-confirming views of the financial markets lowers views and reads as investors seek sources to “confirm” their current beliefs.
As individuals, we want “affirmation” our current thought processes are correct. As human beings, we hate being told we are wrong, so we tend to seek out sources that tell us we are “right.”
This is why it is always important to consider both sides of every debate equally and analyze the data accordingly. Being right and making money are not mutually exclusive.
2) Gambler’s Fallacy
The “Gambler’s Fallacy” is one of the biggest issues faced by individuals when investing. As emotionally driven human beings, we tend to put a tremendous amount of weight on previous events believing that future outcomes will somehow be the same.
The bias is clearly addressed at the bottom of every piece of financial literature.
“Past performance is no guarantee of future results.”
However, despite that statement being plastered everywhere in the financial universe, individuals consistently dismiss the warning and focus on past returns expecting similar results in the future.
This is one of the key issues that affect investor’s long-term returns. Performance chasing has a high propensity to fail continually causing investors to jump from one late cycle strategy to the next. This is shown in the periodic table of returns below. “Hot hands” only tend to last on average 2-3 years before going “cold.”
I traced out the returns of the S&P 500 and the Barclay’s Aggregate Bond Index for illustrative purposes. Importantly, you should notice that whatever is at the top of the list in some years tends to fall to the bottom of the list in subsequent years.“Performance chasing” is a major detraction from investor’s long-term investment returns.
Of course, it also suggests that analyzing last year’s losers, which would make you a contrarian, has often yielded higher returns in the near future. Just something to think about with “bonds” as one of the most hated asset classes currently.
3) Probability Neglect
When it comes to “risk taking” there are two ways to assess the potential outcome. There are “possibilities” and “probabilities.”As individuals, we tend to lean toward what is possible such as playing the “lottery.” The statistical probabilities of winning the lottery are astronomical, in fact, you are more likely to die on the way to purchase the ticket than actually winning the lottery. It is the “possibility” of being fabulously wealthy that makes the lottery so successful as a “tax on poor people.”
As investors, we tend to neglect the “probabilities” of any given action which is specifically the statistical measure of “risk” undertaken with any given investment. As individuals, our bias is to “chase” stocks that have already shown the biggest increase in price as it is “possible” they could move even higher. However, the “probability” is that most of the gains are likely already built into the current move and that a corrective action will occur first.
Robert Rubin, former Secretary of the Treasury, once stated;
“As I think back over the years, I have been guided by four principles for decision making. First, the only certainty is that there is no certainty. Second, every decision, as a consequence, is a matter of weighing probabilities. Third, despite uncertainty we must decide and we must act. And lastly, we need to judge decisions not only on the results, but on how they were made.
Most people are in denial about uncertainty. They assume they’re lucky, and that the unpredictable can be reliably forecast. This keeps business brisk for palm readers, psychics, and stockbrokers, but it’s a terrible way to deal with uncertainty. If there are no absolutes, then all decisions become matters of judging the probability of different outcomes, and the costs and benefits of each. Then, on that basis, you can make a good decision.”
Probability neglect is another major component to why investors consistently “buy high and sell low.”
4) Herd Bias
Though we are often unconscious of the action, humans tend to “go with the crowd.” Much of this behavior relates back to “confirmation” of our decisions but also the need for acceptance. The thought process is rooted in the belief that if “everyone else” is doing something, they if I want to be accepted I need to do it too.
In life, “conforming” to the norm is socially accepted and in many ways expected. However, in the financial markets, the “herding” behavior is what drives market excesses during advances and declines.
As Howard Marks once stated:
“Resisting – and thereby achieving success as a contrarian – isn’t easy. Things combine to make it difficult; including natural herd tendencies and the pain imposed by being out of step, since momentum invariably makes pro-cyclical actions look correct for a while. (That’s why it’s essential to remember that ‘being too far ahead of your time is indistinguishable from being wrong.’
Given the uncertain nature of the future, and thus the difficulty of being confident your position is the right one – especially as price moves against you – it’s challenging to be a lonely contrarian.”
Moving against the “herd” is where the most profits are generated by investors in the long term. The difficulty for most individuals, unfortunately, is knowing when to “bet” against the stampede.
5) Anchoring Effect
This is also known as a “relativity trap” which is the tendency for us to compare our current situation within the scope of our own limited experiences. For example, I would be willing to bet that you could tell me exactly what you paid for your first home and what you eventually sold it for. However, can you tell me what exactly what you paid for your first bar of soap, your first hamburger or your first pair of shoes? Probably not.
The reason is that the purchase of the home was a major “life” event. Therefore, we attach particular significance to that event and remember it vividly. If there was a gain between the purchase and sale price of the home, it was a positive event and, therefore, we assume that the next home purchase will have a similar result. We are mentally “anchored” to that event and base our future decisions around a very limited data.
When it comes to investing we do very much the same thing. If we buy a stock and it goes up, we remember that event. Therefore, we become anchored to that stock as opposed to one that lost value. Individuals tend to “shun” stocks that lost value even if they were simply bought and sold at the wrong times due to investor error. After all, it is not “our” fault that the investment lost money; it was just a bad stock. Right?
This “anchoring” effect also contributes to performance chasing over time. If you made money with ABC stock but lost money on DEF, then you “anchor” on ABC and keep buying it as it rises. When the stock begins its inevitable “reversion,” investors remain “anchored” on past performance until the “pain of ownership” exceeds their emotional threshold. It is then that they panic “sell” and are now “anchored” to a negative experience and never buy shares of ABC again.
This is ultimately the “end-game” of the current rise of the “passive indexing” mantra. When the selling begins, there will be a point where the pain of “holding” becomes to great as losses mount. It is at that point where “passive indexing” becomes “active selling” as our inherent emotional biases overtake the seemingly simplistic logic of “buy and hold.”
Conclusion
In the end, we are just human. Despite the best of our intentions, it is nearly impossible for an individual to be devoid of the emotional biases that inevitably lead to poor investment decision making over time. This is why all great investors have strict investment disciplines that they follow to reduce the impact of human emotions.
Take a step back from the media, and Wall Street commentary, for a moment and make an honest assessment of the financial markets today. Does the current extension of the financial markets appear to be rational? Are individuals current assessing the “possibilities” or the “probabilities” in the markets?
As individuals, we are investing our hard earned “savings” into the Wall Street casino. Our job is to “bet” when the “odds” of winning are in our favor. Secondly, and arguably the most important, is to know when to “push away” from the table to keep our “winnings.”
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Shiller’s CAPE – Is It Really Just B.S. – Part I
Shiller’s Cape – Part 2
“Price Is What You Pay. Value Is What You Get.” – Warren Buffett
One of the hallmarks of very late stage bull market cycles is the inevitable bashing of long-term valuation metrics. In the late 90’s if you were buying shares of Berkshire Hathaway stock it was mocked as “driving Dad’s old Pontiac.” In 2007, valuation metrics were being dismissed because the markets were flush with liquidity, interest rates were low and “Subprime was contained.”
Today, we once again see repeated arguments as to why “this time is different” because of the “Central Bank put.”
First, let me just say that I have tremendous respect for the guys at HedgEye. They are insightful and thoughtful in their analysis and well worth your time to read. However, a recent article by HedgEye made a very interesting point that bears discussion.
“Meanwhile, a number of stubborn bears out there continue to make the specious argument that the U.S. stock market is expensive. ‘At 22 times trailing twelve-month earnings,’ they ask, ‘how on earth could an investor possibly buy the S&P 500?’
The answer is simple, really. Valuation is not a catalyst.”
They are absolutely right.
Valuations are not a catalyst.
They are the fuel.
But the debate over the value, and current validity, of the Shiller’s CAPE ratio, is not new. Critics argue that the earnings component of CAPE is just too low, changes to accounting rules have suppressed earnings, and the financial crisis changed everything. This was a point made by Wade Slome previously:
“If something sounds like BS, looks like BS, and smells like BS, there’s a good chance you’re probably eyeball-deep in BS. In the investment world, I encounter a lot of very intelligent analysis, but at the same time I also continually step into piles of investment BS. One of those piles of BS I repeatedly step into is the CAPE ratio (Cyclically Adjusted Price-to-Earnings) created by Robert Shiller.”
Let’s break down Wade’s arguments against Dr. Shiller’s CAPE P/E individually.
Shiller’s Ratio Is Useless?
Wade states:
“The short answer…not very. For example, if investors followed the implicit recommendation of the CAPE for the periods when Shiller’s model showed stocks as expensive they would have missed a more than quintupling (+469% ex-dividends) in the S&P 500 index. Over a shorter timeframe (2009 – 2014) the S&P 500 is up +114% ex-dividends (+190% since March 2009).”
Wade’s analysis is correct. However, the problem is that valuation models are not, and were never meant to be, “market timing indicators.”The vast majority of analysts assume that if a measure of valuation (P/E, P/S, P/B, etc.) reaches some specific level it means that:
The market is about to crash, and;
Investors should be in 100% cash.
This is incorrect.
Valuation measures are simply just that – a measure of current valuation. More, importantly, it is a much better measure of “investor psychology” and a manifestation of the “greater fool theory.”
If you “overpay” for something today, the future net return will be lower than if you had paid a discount for it.
Think about housing prices for a moment as shown in the chart below.
There are two things to take away from the chart above in relation to valuation models. The first is that if a home was purchased at any time (and not sold) when the average 12-month price was above the long-term linear trend, the forward annualized returns were significantly worse than if the home was purchased below that trend. Secondly, if a home was purchased near the peak in valuations, forward returns are likely to be extremely low, if not negative, for a very long time.
This is the same with the financial markets. When investors “pay” too much for an investment, future returns will suffer. “Buy cheap and sell dear” is not just some Wall Street slogan printed on a coffee mug, but a reality of virtually all of the great investors of our time in some form or another.
Cliff Asness discussed this issue in particular stating:
“Ten-year forward average returns fall nearly monotonically as starting Shiller P/E’s increase. Also, as starting Shiller P/E’s go up, worst cases get worse and best cases get weaker.
If today’s Shiller P/E is 22.2, and your long-term plan calls for a 10% nominal (or with today’s inflation about 7-8% real) return on the stock market, you are basically rooting for the absolute best case in history to play out again, and rooting for something drastically above the average case from these valuations.”
We can prove that by looking at forward 10-year total returns versus various levels of PE ratios historically.
Asness continues:
“It [Shiller’s CAPE] has very limited use for market timing (certainly on its own) and there is still great variability around its predictions over even decades. But, if you don’t lower your expectations when Shiller P/E’s are high without a good reason — and in my view, the critics have not provided a good reason this time around — I think you are making a mistake.”
While, Wade is correct that investors who got out of the market using Shiller’s P/E ratio would have missed the run in the markets from 2009 to present, those same individuals most likely sold at the bottom of the market in 2008 and only recently began to return as shown by net equity inflows below.
In other words, they missed the “run up” anyway. Investor psychology has more to do with long-term investment outcomes than just about anything else.
What valuations tell us, is that at current levels investors are strictly betting on there always being someone to pay more in the future for an asset than they paid today.
Huckster Alert…
It is not surprising that due to the elevated level of P/E ratios since the turn of the century, which have been fostered by one financial bubble after the next due to Federal Reserve interventions, there has been a growing chorus of views suggesting that valuations are no longer as relevant. There is also the issue of the expanded use of forward operating earnings.
First, it is true that P/E’s have been higher over the last decade due to the aberration in prices versus earnings leading up to the 2000 peak. However, as shown in the chart below, the “reversion” process of that excessive overvaluation is still underway. It is likely the next mean reverting event will complete this process.
Cliff directly addressed the issue of the abuse of forward operating earnings.
“Some outright hucksters still use the trick of comparing current P/E’s based on ‘forecast’ ‘operating’ earnings with historical average P/E’s based on total trailing earnings. In addition, some critics say you can’t compare today to the past because accounting standards have changed, and the long-term past contains things like World Wars and Depressions. While I don’t buy it, this argument applies equally to the one-year P/E which many are still somehow willing to use. Also, it’s ironic that the chief argument of the critics, their big gun that I address exhaustively above [from the earlier post], is that the last 10 years are just too disastrous to be meaningful (recall they are actually mildly above average).”
Cliff is correct, of course, as it is important to remember that when discussing valuations, particularly regarding historic over/undervaluation, it is ALWAYS based on trailing REPORTED earnings. This is what is actually sitting on the bottom line of corporate income statements versus operating earnings, which is “what I would have earned if XYZ hadn’t happened.”
Beginning in the late 90’s, as the Wall Street casino opened its doors to the mass retail public, use of forward operating earning estimates to justify extremely overvalued markets came into vogue. However, the problem with forward operating earning estimates is they are historically wrong by an average of 33%. To wit:
“The biggest single problem with Wall Street, both today and in the past, is the consistent disregard of the possibilities for unexpected, random events. In a 2010 study, by the McKinsey Group, they found that analysts have been persistently overly optimistic for 25 years. During the 25-year time frame, Wall Street analysts pegged earnings growth at 10-12% a year when in reality earnings grew at 6% which, as we have discussed in the past, is the growth rate of the economy.”
Ed Yardeni published the two following charts which shows analysts are always overly optimistic in their estimates.
“This is why using forward earnings estimates as a valuation metric is so incredibly flawed – as the estimates are always overly optimistic roughly 33% on average. Furthermore, the reason that earnings only grew at 6% over the last 25 years is because the companies that make up the stock market are a reflection of real economic growth. Stocks cannot outgrow the economy in the long term…remember that.
The McKenzie study noted that on average ‘analysts’ forecasts have been almost 100% too high’ and this leads investors into making much more aggressive bets in the financial markets.”
The consistent error rate in forward earnings projections makes using such data dangerous when making long-term investments. This is why trailing reported earnings is the only “honest” way to approach valuing financial markets. Importantly, long-term investors should be abundantly aware of what the future expected returns will be when buying into overvalued markets. Bill Hester recently wrote a very good note in this regard in response to critics of Shiller’s CAPE ratio and future annualized returns:
“We feel no particular obligation defend the CAPE ratio. It has a strong long-term relationship to subsequent 10-year market returns. And it’s only one of numerous valuation indicators that we use in our work – many which are considerably more reliable. All of these valuation indicators – particularly when record-high profit margins are accounted for – are sending the same message: The market is steeply overvalued, leaving investors with the prospect of low, single-digit long-term expected returns.“
As clearly stated throughout this missive, fundamental valuation metrics are not, and were never meant to be, market timing indicators. This was a point made by Dr. Robert Shiller himself in an interview with Henry Blodgett:
“John Campbell, who’s now a professor at Harvard, and I presented our findings first to the Federal Reserve Board in 1996, and we had a regression, showing how the P/E ratio predicts returns. And we had scatter diagrams, showing 10-year subsequent returns against the CAPE, what we call the cyclically adjusted price-earnings ratio. And that had a pretty good fit. So I think the bottom line that we were giving – and maybe we didn’t stress or emphasize it enough – was that it’s continual. It’s not a timing mechanism, it doesn’t tell you – and I had the same mistake in my mind, to some extent — wait until it goes all the way down to a P/E of 7, or something.”
Currently, there is clear evidence that future expectations should be significantly lower than the long-term historical averages.
Do current valuation levels suggest you should be all in cash? No.
However, it does suggest that a more cautious stance to equity allocations and increased risk management will likely offset much of the next “reversion” when it occurs.
My job is to protect investment capital from major market reversions and meet investment returns anchored to retirement planning projections. Not paying attention to rising investment risks, or adjusting for lower expected future returns, are detrimental to both of those objectives.
Next week, I will introduce a modified version of the Shiller CAPE ratio which is more constructive for shorter-term outlooks.
Last week, I discussed the “World’s Most Deceptive Chart” which explored the deception of “percentage” versus actual “point” losses which has a much greater effect on both the real, and psychological, damage which occurs during a bear market. To wit:
“The problem is you DIEDlong before ever achieving that 5% annualized long-term return.
Outside of your personal longevity issue, it’s the ‘math’ that is the primary problem.
The chart uses percentage returns which is extremely deceptive if you don’t examine the issue beyond a cursory glance. However, when reconstructed on a point gain/loss basis, the ugly truth is revealed.”
Of course, there are those that still don’t get the basic realities of math, loss and time and resort to other flawed theses to support an errant view. As shown by a comment received by a reader:
“This is true only for price return, not for total return (dividends included). Since 1926, there has never been a negative 20-year period or 15-year period. There have been only four negative 10-year periods, 1928-1938, 1929-1939, 1998-2008, and 1999-2009.
The same fatal flaw afflicts that last graph. It shows inflation-adjusted price return (dividends not included). Including dividends increases that Mar 2009-Feb 2017 gain from 167% to 218%. Does Mr. Roberts throw away all his dividend cheques? Does anybody?” – Sam Baird
Sorry, Sam, the data WAS total, real returns, but the larger point you missed was the importance of understanding the devastating difference between POINT gain or loss, versus a PERCENTAGE gain or loss.
However, the point Sam made was nonetheless important as it showed another commonly held belief that is a fallacy.
Which bring us to….
The World’s Second Most Deceptive Chart
The following chart is the same real, inflation-adjusted, total return of the S&P 500 index from last week but converted to the compounded growth of a $1000 investment.
Note: The red lines denote the number of years required to get back to even following a bear market.
“See, other than those couple of periods, just buying, holding and collecting dividends is the way to go. Right?”
Again, not so fast.
First, as shown in the chart below, There have currently been four, going on five, periods of low returns over a 20-year period. Importantly, there also HAS been a NEGATIVE 20-year real, total return, holding period average of -0.22%.
(Again, sorry Sam.)
I have added the P/E ratio which exposes the issue, once again, of the importance of valuation on future returns. In other words, your investment success depends more on WHEN you start, than IF you start investing.
“But Lance, yes, while there are some low periods, you made money provided you stayed invested. So what’s the issue?”
That brings me to my second point of that nagging problem of “time.”
Until Death Do Us Part
In all of the analysis that is done by Wall Street, “life expectancy” is never factored into the equations used when presenting the bullish case for investing.
Therefore, in order to REALLY calculate REAL, TOTAL RETURN, we have to adjust the total return formula by adding in “life expectancy.”
RTR =((1+(Ca + D)/ 1+I)-1)^(Si-Lfe)
Where:
Ca = Capital Appreciation
D = Dividends
I = Inflation
Si = Starting Investment Age
Lfe = Life Expectancy
For consistency from last week’s article, we will assume the average starting investment age is 35. We will also assume the holding period for stocks is equal to the life expectancy less the starting age. The chart below shows the calculation of total life expectancy (based on the average of males and females) from 1900-present, the average starting age of 35, and the resulting years until death. I have also overlaid the rolling average of the 20-year total, real returns and valuations.
If we use the stat and end dates, as shown in the first chart and table above, and calculate real total return based on the life expectancy for each period we find the following.
The horizontal red line is critically important.
One to the most egregious investing “myths” is when investors are told:
“The power of compounding is the most powerful force in investing.”
What the red line shows you is when, ON AVERAGE, you failed to achieve 6%-annualized average total returns(much less 10%.) from the starting age of 35 until DEATH.
Importantly, notice the level of VALUATIONS when you start investing has everything to do with the achievement of higher rates of return over the investable life expectancy of an individual.
“Yes, but there are periods where my average return was higher than either 6% or 10%. So it’s not actually a fallacy. What am I missing?”
Simple.
The stock market does not COMPOUND returns.
There is a massive difference between AVERAGE and ACTUAL returns on invested capital. The impact of losses, in any given year, destroys the annualized “compounding” effect of money.
As shown in the chart box below, I have taken a $1000 investment for each period and assumed a real, total return holding period until death. No withdrawals were ever made. (Note: the periods from 1983 forward are still running as the investable life expectancy span is 40-plus years.)
The gold sloping line is the “promise” of 6% annualized compound returns. The blue line is what actually happened with invested capital from 35 years of age until death, with the bar chart at the bottom of each period showing the surplus or shortfall of the goal of 6% annualized returns.
In every single case, at the point of death, the invested capital is short of the promised goal.
The difference between “close” to goal, and not,was the starting valuation level when investments were made.
This is why, as I discussed in “The Fatal Flaws In Your Retirement Plan,” that you must compensate for both starting period valuations and variability in returns when making future return assumptions. If you calculate your retirement plan using a 6% compounded growth rates (much less 8% or 10%) you WILL fall short of your goals.
But wait….
It’s Actually Even Worse
The analysis above does NOT INCLUDE the effect of taxes, fees, expenses or a withdrawal rate once individuals hit retirement age.
This was the point I discussed in “Retirees May Have A Spend Down Problem.”
“The chart below takes the average return of all periods where the starting P/E was above 20x earnings (black line) and uses those returns to calculate the spend down of retiree’s in retirement assuming similar outcomes for the markets over the next 30-years. As opposed to the analysis above, I have added a 4% annual withdrawal rate at retirement and included the impact of inflation and taxation.”
“On the surface, it would appear a retiree would not have run out of money over the subsequent 30-year period. However, once the impact of inflation and taxes are included, the outcome becomes substantially worse.”
Time To Get Real
The analysis above reveals the important points that individuals should OF ANY AGE should consider:
Expectations for future returns and withdrawal rates should be downwardly adjusted due to current valuation levels.
The potential for front-loaded returns going forward is unlikely.
Your personal life expectancy plays a huge role in future outcomes.
The impact of taxation must be considered.
Future inflation expectations must be carefully considered.
Drawdowns from portfolios during declining market environments accelerates the principal bleed. Plans should be made during up years to harbor capital for reduced portfolio withdrawals during adverse market conditions.
The yield chase over the last 8-years, and low interest rate environment, has created an extremely risky environment for investors. Caution is advised.
Expectations for compounded annual rates of returns should be dismissed in lieu of variable rates of return based on current valuation levels.
You cannot INVEST your way to your retirement goal. As the last decade should have taught you by now, the stock market is not a “get wealthy for retirement” scheme. You cannot continue under-saving for your retirement hoping the stock market will make up the difference. This is the same trap that pension funds all across this country have fallen into and are now paying the price for.
Importantly, chasing an arbitrary index that is 100% invested in the equity market requires you to take on far more risk that you most likely realize. Two massive bear markets over the last decade have left many individuals further away from retirement than they ever imagined.
As shown above, our life expectancy rates are finite and the later we get started saving for goals, the less time we have to waste trying to “get back to even” following a “mean reverting event.”
Investing for retirement, should be done conservatively, and cautiously, with the goal of outpacing inflation over time. Trying to beat some random, arbitrary index that has nothing in common with your financial goals, objectives, and most importantly, your life span, has tended to end badly for individuals.
You can do better.
The Fatal Flaws In Your Financial Plan
Congratulations! If you are reading this article it is probably because you have money invested somewhere in the financial markets.
That’s the good news.
The bad news is the majority of you reading this article have probably NOT saved enough for retirement. Such isn’t my assumption, it is what survey after survey tells us. To wit:
“While the ongoing interventions by the Federal Reserve have certainly boosted asset prices higher, the only real accomplishment has been a widening of the wealth gap between the top 10% of individuals that have dollars invested in the financial markets and everyone else. This was shown by the Fed’s most recent consumer survey.“
“With the average American still living well beyond their means, the reality is economic growth will remain mired at lower levels as savings continue to be diverted from productive investment into debt service. This skew in wealth, between the top 10% and bottom 90%, has distorted much of the economic data which suggests savings rates and incomes are rising across the broad spectrum of the economy.The reality, as shown by repeated studies and surveys, is an inability for many individuals to meet even small emergencies, must less being anywhere close to having sufficient assets to support a healthy retirement. To wit:“
“Take a look at that graphic carefully.
33% of Americans have $0 saved for retirement.
56% only have $0-$10,000
66% have less than one-year of median income saved.
74% have less than $100,000 saved for retirement.
With 3/4th’s of America dependent upon an already overburdened social security system in retirement, the “consumption function,” on which roughly 70% of the economy is dependent, is being grossly overestimated. “
In other words, 74% of American’s are “hoping” the financial markets will bail them out of their “under-saving.”
This is the same problem that faces every pension in America right now…and the pensioners depending on them.
As I discussed last week in the “Myth Of Passive Investing:”
“The idea of “passive” investing is ‘romantic’ in nature. It’s a world where everyone just invests some money, the markets rise 7% annually and everyone one’s a winner.
Unfortunately, the markets simply don’t function that way.”
During strongly trending bull markets, investors tend to forget that devastating events happen. Major events such as the “Crash of 1929,”“The Great Depression,” the “1974 Bear Market,” the “Crash of ’87”, Long-Term Capital Managment, the “Dot.com” bust, the “Financial Crisis,” etc. These events are often written off as “once in a generation” or “1-in-100-year events,” however, it is worth noting these financial shocks have come along much more often than suggested. Importantly, all of these events had a significant negative impact on individual’s “plan for retirement.”
I bring this up because I received several emails as of late questioning me about current levels of savings and investments and whether there would be enough to make it through retirement. In almost every situation, there are significant flaws in the analysis due primarily to the use of “online financial planning” tools which are fraught with wrong assumptions.
Your Personal Returns Will Be Less Than An “Index”
One of the biggest mistakes that people make is assuming markets will grow at a consistent rate over the given time frame to retirement. There is a massive difference between compounded returns and real returns as shown above. Furthermore, the shortfall is compounded further when you begin to add in the impact of fees, taxes, and inflation over the given time frame.
The chart below shows what happens to a $1000 investment from 1871 to present including the effects of inflation, taxes, and fees.(Assumptions: I have used a 15% tax rate on years the portfolio advanced in value, CPI as the benchmark for inflation and a 1% annual expense ratio. In reality, all of these assumptions are quite likely on the low side.)
As you can see, there is a dramatic difference in outcomes over the long-term.
An index has no life expectancy requirements – but you do.
It doesn’t have to compensate for distributions to meet living requirements – but you do.
It requires you to take on excess risk (potential for loss) in order to obtain equivalent performance – this is fine on the way up, but not on the way down.
It has no taxes, costs or other expenses associated with it – but you do.
It has the ability to substitute at no penalty – but you don’t.
It benefits from share buybacks – but you don’t.
The reality is that you have nothing in common with a “benchmark index.”
Investing is not a “competition” and treating it as such has disastrous consequences over time.
When You Start Makes All The Difference
Importantly, the return that investors receive from the financial markets is more dependent on “WHEN” you begin investing with respect to “valuations” and your personal “life-span”.
The single biggest mistake made in financial planning is NOT to include variable rates of return in your planning process.
Furthermore, choosing rates of return for planning purposes that are outside historical norms is a critical mistake. Stocks tend to grow roughly at the rate of GDP plus dividends. Into today’s world GDP is expected to grow at roughly 2% in the future with dividends around 2% currently. The difference between 8% returns and 4% is quite substantial.
Also, to achieve 8% in a 4% return environment, you must increase your return over the market by 100%. The level of “risk” that must be taken on to outperform the markets by such a degree is enormous. While markets can have years of significant outperformance, it only takes one devastating year of losses to wipe out years of accumulation.
Currently, the S&P 500 (as of 1/27/17) is trading at 2,294 with Q4 trailing reported earnings of $97.98. (S&P Data) This puts the current trailing P/E ratio of the S&P at a rather lofty 23.41x.
We also know that forward 30-Year returns from current valuation levels have been much closer to 2-5% than 8%. In fact, there has never been a 30-year return of 8% from current valuation levels – ever.
The level of valuations also has a massive impact on your survivability of your financial plan when you include the impact of withdrawals.
Consider The Impacts
There are generally three major flaws with financial planning assumptions that I consistently see and have to correct for.
Return rates are nominal and compounded,
The impact of fees and taxes during the investment time span are not included, and;
The level of valuations are ignored in future return assumptions.
Let’s take a look at the impact of these issues.
For this exercise, using Robert Shiller’s data, I have located points in history when valuations exceeded 20x earnings and calculated real forward 30-year total returns from those points as compared to an 8% compounded rate.
As you can see, with the exceptions of 1922 (front-end loaded returns) and 1934 (as the markets left the Great Depression and entered into a post-WWII secular bull market), returns fared worse than the expected 8% rate.
The chart below takes the average of all periods above (black line) and uses those returns to calculate the spend down of retiree’s in retirement assuming similar outcomes for the markets over the next 30-years. As above, I have calculated 4% annual withdrawal rate include the impact of inflation and taxation.
On the surface, it would appear the retiree would not have run out of money over the subsequent 30-year period. However, once the impact of inflation and taxes are included, the outcome becomes substantially worse.
What Your Financial Planning Should Consider
The analysis above reveals the important points individuals should consider in their financial planning process:
Expectations for future returns and withdrawal rates should be downwardly adjusted.
The potential for front-loaded returns going forward is unlikely.
The impact of taxation must be considered in the planned withdrawal rate.
Future inflation expectations must be carefully considered.
Drawdowns from portfolios during declining market environments accelerates the principal bleed. Plans should be made during up years to harbor capital for reduced portfolio withdrawals during adverse market conditions.
The yield chase over the last 8-years, and low interest rate environment, has created an extremely risky environment for retirement income planning. Caution is advised.
Expectations for compounded annual rates of returns should be dismissed in lieu of plans for variable rates of future returns.
Time To Get Real
You cannot INVEST your way to your retirement goal. As the last decade should have taught you by now, the stock market is not a “get wealthy for retirement” scheme. You cannot continue under-saveing for your retirement hoping the stock market will make up the difference. This is the same trap that pension funds all across this country have fallen into and are now paying the price for.
Chasing an arbitrary index that is 100% invested in the equity market requires you to take on far more risk that you most likely want. Two massive bear markets over the last decade have left many individuals further away from retirement than they ever imagined. Furthermore, all investors lost something far more valuable than money – the TIME that was needed to prepare properly for retirement.
Investing for retirement, no matter what age you are, should be done conservatively and cautiously with the goal of outpacing inflation over time. This doesn’t mean that you should never invest in the stock market, it just means that your portfolio should be constructed to deliver a rate of return sufficient to meet your long-term goals with as little risk as possible.
Save More And Spend Less: This is the only way to ensure you will be adequately prepared for retirement. It ain’t sexy, or fun, but it will absolutely work.
You Will Be WRONG. The markets go through cycles, just like the economy. Despite hopes for a never-ending bull market, the reality is “what goes up will eventually come down.”
RISK does NOT equal return. The further the markets rise, the bigger the correction will be. RISK = How much you will lose when you are wrong, and you will be wrong more often than you think.
Don’t Be House Rich. A paid off house is great, but if you are going into retirement house rich and cash poor you will be in trouble. You don’t pay off your house UNTIL your retirement savings are fully in place and secure.
Have A Huge Wad. Going into retirement have a large cash cushion. You do not want to be forced to draw OUT of a pool of investments during years where the market is declining. This compounds the losses in the portfolio and destroys principal which cannot be replaced.
Plan for the worst. You should want a happy and secure retirement – so plan for the worst. If you are banking solely on Social Security and a pension plans, what would happen if the pension was cut? Corporate bankruptcies happen all the time and to companies that most never expected. By planning for the worst, anything other outcome means you are in great shape.
Most likely what ever retirement planning you have done, is wrong. Change your assumptions, ask questions and plan for the worst. There is no one more concerned about YOUR money than you and if you don’t take an active interest in your money – why should anyone else?
The Real Value Of Cash
It’s the Fed’s fault.
Over the past several years, the Federal Reserve has forced interest rates lower in an all-out assault on “cash.”
The theory was simple. Make returns on “cash” so low it is forced out of savings account and into risk assets.
It worked.
But here is the problem.
While the ongoing interventions by the Federal Reserve have certainly boosted asset prices higher, the only real accomplishment has been a widening of the wealth gap between the top 10% of individuals that have dollars invested in the financial markets and everyone else. This was shown by the Fed’s most recent consumer survey.
With the average American still living well beyond their means, the reality is that economic growth will remain mired at lower levels as savings continue to be diverted from productive investment into debt service. This skew in wealth, between the top 10% and bottom 90%, has distorted much of the economic data which suggests savings rates and incomes are rising across the broad spectrum of the economy.The reality, as shown by repeated studies and surveys, is an inability for many individuals to meet even small emergencies, must less being anywhere close to having sufficient assets to support a healthy retirement. To wit:
Take a look at that graphic carefully.
33% of Americans have $0 saved for retirement.
56% only have $0-$10,000
66% have less than one-year of median income saved.
74% have less than $100,000 saved for retirement.
With 3/4th’s of America dependent upon an already overburdened social security system in retirement, the “consumption function,” on which roughly 70% of the economy is dependent, is being grossly overestimated.
The Risk Of Holding Cash
As I noted in this past weekend’s missive, the level of cash being held by individual investors currently is near record lows.
Of course, Wall Street, analysts and the media have been all complicit in the “war on cash.”
The argument against holding cash is simply this:
“Since there is “no yield on cash,” you MUST invest in the stock market otherwise you are losing money due to inflation and opportunity costs.”
This is a true statement ONLY IF you hold cash for an EXTREMELY long period. However, holding cash as a “hedge” against market volatility during periods of elevated uncertainty is a different matter entirely.
It is relatively unimportant the markets are making new highs. The reality is that new highs only represent about 5% of the market’s action while the other 95% of the advance was making up previous losses.“Getting back to even” is not a long-term investing strategy.
In a market environment that is extremely overvalued, the projection of long-term forward returns is exceedingly low. I have discussed this previously, but this cannot be overstated enough. This, of course, does not mean that markets just trade sideways, but in rather large swings between exhilarating rises and spirit-crushing declines. This is an extremely important concept in understanding the “real value of cash.”
The chart below shows the inflation-adjusted return of $100 invested in the S&P 500 (capital appreciation only using data provided by Dr. Robert Shiller). The chart also shows Dr. Shiller’s CAPE ratio. However, I have capped the CAPE ratio at 23x earnings which has historically been the peak of secular bull markets in the past. Lastly, I calculated a simple cash/stock switching model which buys stocks at a CAPE ratio of 6x or less and moves back to cash at a ratio of 23x.
I have adjusted the value of holding cash for the annual inflation rate which is why during the sharp rise in inflation in the 1970’s there is a downward slope in the value of cash. However, while the value of cash is adjusted for purchasing power in terms of acquiring goods or services in the future, the impact of inflation on cash as an asset with respect to reinvestment may be different since asset prices are negatively impacted by spiking inflation. In such an event, cash gains purchasing power parity in the future if assets prices fall more than inflation rises.
While no individual could effectively manage money this way, the importance of “cash” as an asset class is revealed. While cash did lose relative purchasing power, due to inflation, the benefits of having capital to invest at lower valuations produced substantial outperformance over waiting for previously destroyed investment capital to recover.
While we can debate over methodologies, allocations, etc., the point here is that “time frames” are crucial in the discussion of cash as an asset class. If an individual is “literally” burying cash in their backyard, then the discussion of the loss of purchasing power is appropriate.
However, if cash is a “tactical” holding to avoid short-term destruction of capital, then the protection afforded outweighs the loss of purchasing power in the distant future.
Much of the mainstream media will quickly disagree with the concept of holding cash and tout long-term returns as the reason to just remain invested in both good times and bad. The problem is it is YOUR money at risk. Furthermore, most individuals lack the “time” necessary to truly capture 30 to 60-year return averages.
8-Reasons To Hold Cash
I’ve been managing money in some form coming up on 30-years. I learned a long time ago that while a “rising tide lifts all boats,” eventually the “tide recedes.” I made one simple adjustment to my portfolio management over the years which has served me well. When risks begin to outweigh the potential for reward, I raise cash.
The great thing about holding extra cash is that if I’m wrong, simply make the proper adjustments to increase the risk in my portfolios. However, if I am right, I protect investment capital from destruction and spend far less time “getting back to even” and spend more time working towards my long-term investment goals.
Here are my reasons having cash is important.
1) We are not investors, we are speculators. We are buying pieces of paper at one price with an endeavor to eventually sell them at a higher price. This is speculation at its purest form. Therefore, when probabilities outweigh the possibilities, I raise cash.
2)80% of stocks move in the direction of the market. In other words, if the market is moving in a downtrend, it doesn’t matter how good the company is as most likely it will decline with the overall market.
3)The best traders understand the value of cash. From Jesse Livermore to Gerald Loeb they all believed one thing – “Buy low and Sell High.” If you “Sell High” then you have raised cash. According to Harvard Business Review, since 1886, the US economy has been in a recession or depression 61% of the time. I realize that the stock market does not equal the economy, but they are somewhat related.
4)Roughly 90% of what we’re taught about the stock market is flat out wrong: dollar-cost averaging, buy and hold, buy cheap stocks, always be in the market. The last point has certainly been proven wrong because we have seen two declines of over -50%…just in the past two decades! Keep in mind, it takes a +100% gain to recover a -50% decline.
5)80% of individual traders lose money over ANY 10-year period. Why? Investor psychology, emotional biases, lack of capital, etc. Repeated studies by Dalbar prove this over and over again.
6) Raising cash is often a better hedge than shorting. While shorting the market, or a position, to hedge risk in a portfolio is reasonable, it also simply transfers the “risk of being wrong” from one side of the ledge to the other. Cash protects capital. Period. When a new trend, either bullish or bearish, is evident then appropriate investments can be made. In a “bull trend” you should only be neutral or long and in a “bear trend” only neutral or short. When the trend is not evident – cash is the best solution.
7) You can’t “buy low” if you don’t have anything to “buy with.” While the media chastises individuals for holding cash, it should be somewhat evident that by not “selling rich” you do not have the capital with which to “buy cheap.”
8) Cash protects against forced liquidations. One of the biggest problems for Americans currently, according to repeated surveys, is a lack of cash to meet emergencies. Having a cash cushion allows for working with life’s nasty little curves it throws at us from time to time without being forced to liquidate investments at the most inopportune times. Layoffs, employment changes, etc. which are economically driven tend to occur with downturns which coincide with market losses. Having cash allows you to weather the storms.
Importantly, I am not talking about being 100% in cash. I am suggesting that holding higher levels of cash during periods of uncertainty provides both stability and opportunity.
With the fundamental and economic backdrop becoming much more hostile toward investors in the intermediate term, understanding the value of cash as a “hedge” against loss becomes much more important.
“The overall economic and financial landscape, then, is one where obscene valuations imply zero or negative S&P 500 total returns for more than a decade — an outcome that is largely baked-in-the-cake regardless of shorter term economic or speculative factors. Presently, market internals remain unfavorable as well. Coming off of recent overvalued, overbought, overbullish extremes, this has historically opened a clear vulnerability of the market to air-pockets, free-falls and crashes.”
As stated above, near zero returns do not imply that each year will have a zero rate of return. However, as a quick review of the past 15 years shows, markets can trade in very wide ranges leaving those who “rode it out” little to show for their emotional wear.
Given the length of the current market advance, deteriorating internals, high valuations, and weak economic backdrop; reviewing cash as an asset class in your allocation may make some sense. Chasing yield at any cost has typically not ended well for most.
Of course, since Wall Street does not make fees on investors holding cash, maybe there is another reason they are so adamant that you remain invested all the time.
Technically Speaking: Common Trading Mistakes
As we enter into the first full week of trading since Christmas, the Dow Jones has been unable to attain the magical 20,000 level. While I still suspect this will eventually occur, the challenge has been more difficult that I expected.
I noted in last weekend’s newsletter, “The Problem With Forecasts,” the Dow is currently working on completing an advance of 5000 points over a 24-month span. The last time such a compressed advance occurred was during the 1998-1999 period.
But what about the S&P 500?
Following the 1994 market lull, the S&P 500 began its first serious bull market advance as a wave of investors flooded into the market due to the introduction of online trading and the official opening of the “Wall Street Casino.”From 1995 to its peak in March of 2000 the market advance (whole number basis only) by 1000 points over that 60-month period.
Of course, the subsequent correction of the “dot.com” mania reset the market by roughly 50% of that previous advance.
Following the crash, investors reluctantly began to return to the markets in mid-2003. As the Federal Reserve, and deregulation of Wall Street advanced, so did investors speculation in the markets as a real estate sub-prime lending took hold. Beginning in 2003, the market began a 60-month trek higher of 700-points before once again finding the limits of “fantasy and reality.”
So, here we are once again. Over the last 60-months the markets have advanced by 1100-points, and 1400-points over the last 84 months, as Fed-induced monetary stimulus and suppression of interest rates have once again led investors to believe “this time is different.”
Throughout history, as shown in the chart below, prices have ALWAYS, and I repeat ALWAYS, eventually found their limits. There has never been a “permanently high plateau” that inoculated investors from devastating consequences of misconceived and poorly managed investments.
Importantly, as you will note above, whenever prices have had extreme deviations from the underlying long-term growth trend, as we have currently, the resolution of those excesses were never accomplished by just a “reversion TO the mean.”
With the markets, and the economy, currently pushing the historical limits of time and distance, the reality of an unexpected mean-reverting event has risen in recent months. While such a statement does not imply that a correction will occur immediately, or even within the next few months,
Since I covered “Curing The Trading Addiction” yesterday, which were more general concepts of money management, I wanted to follow up with the specific actions we take which lead us to poor outcomes over time.
Common Trading Mistakes
Many of these are related and are part and parcel of the same refusal to pay proper attention to risk management. If you recognize your own actions in some of these, join the club. Over the years, I’ve committed every sin on the list at least once. Still do on occasion.
1) Refusing To Take A Loss – Until The Loss Takes You.
When you buy a stock it should be with the expectation that it will go up – otherwise, why would you buy it?. If it goes down instead, you’ve made a mistake in your analysis. Either you’re early, or just plain wrong. It amounts to the same thing.
“There is no shame in being wrong, only in STAYING wrong.”
This goes to the heart of the familiar adage: “let winners run, cut losers short.”Nothing will eat into your performance more than carrying a bunch of dogs and their attendant fleas, both in terms of actual losses and in terms of dead, or underperforming, money.
2) The Unrealized Loss
From whence came the idiotic notion that a loss “on paper” isn’t a “real” loss until you actually sell the stock? Or that a profit isn’t a profit until the stock is sold and the money is in the bank? Nonsense!
“Your portfolio is worth whatever you can sell it for, at the market, right at this moment. No more. No less.”
People are reluctant to sell a loser for a variety of reasons. For some it’s an ego/pride thing, an inability to admit they’ve made a mistake. That is false pride, and it’s faulty thinking. Your refusal to acknowledge a loss doesn’t make it any less real. Hoping, and waiting, for a loser to come back and save your fragile pride is just plain stupid.
Losses are a cost of doing business, a part of the game. If you never have losses, then you are not trading properly. Most pros have three losers for every winner. They make money by keeping the losses small and letting the profits build. You should be almost happy to take a loss. It means that you have jettisoned an underachiever stock and have freed up that dead money to put to better use elsewhere. Take your losses ruthlessly, put them out of mind and don’t look back, and turn your attention to your next trade.
3) If I Bet Big – I Win Big
You also lose big.
Preservation Of Capital Is Paramount. If you run out of chips, the game is over. Most professionals will allocate no more than 2-5% of their total investment capital to any one position.
Even when your analysis is overwhelmingly bullish, it never hurts to have some cashon hand, even if it earns ZERO in money markets. This gives you liquid cash to buy opportunities, but also keeps you from having to liquidate a position at an inopportune time to raise cash for the “Murphy Emergency”(the emergency that always occurs when you have the least amount of cash available – Murphy’s Law #73)
As the market becomes more overbought, overextended, and overvalued, your cash level should rise accordingly. Then as the market gets more oversold and undervalued, you have cash to raise your market exposure. Or rather, “sell high so you can buy low.”
4) Bottom Feeding Knife Catchers
Don’t ANTICIPATE bottoms. It’s almost always better to let the stock find its bottom on its own, and then start to nibble. Just because a stock is down, doesn’t mean it can’t go down even more. Let stocks and markets bottom and top on their own and limit your efforts to recognizing the fact “soon enough.”
“Nobody, and I mean nobody, can consistently nail the bottom tick or top tick. Anyone who says they do, is probably lying.”
5) Dollar Cost Averaging
Don’t do it. For one thing, you shouldn’t even have the opportunity, because you should have sold that dog before it got to the level where averaging down is tempting. The pros average UP, not down. They got to be pros because they added to winners, not losers.
Only advisors without a real investment discipline or strategy, or those just collecting fees for assets under management, promote dollar cost averaging.
6) You Can’t Fight City Hall OR The Trend
The vast majority of stocks, roughly 80%, will go with the market flow. And so should you.
It doesn’t make sense to counter trade the prevailing market trend. Don’t short stocks in strong uptrends and don’t buy stocks in strong downtrends. Remember, real investors don’t speculate – “The Trend Is Your Friend”
If you’re worried about a short-term pullback, simply cut back on your trading, take a few profits, and build up your stash of cash until the squall has passed. There is “NO RULE” that says you have to be invested “all the time.”
7) A Good Company Is Not Necessarily A Good Stock
This is, at heart, a problem with fundamental analysis which will identify great companies but doesn’t take into account market, and investor, sentiment. Combining fundamental analysis, which tells you “what” to buy, with technical analysis, to determine “when” to buy, will help you own a great company which is also a great stock.
8) Chasing Performance
Yes, you can make a quick buck chasing momentum, but you can lose it even quicker. You can never be sure there’s a greater fool coming in after you, and that could make you the “greatest fool” of all.
9) Technically Trapped
Amateur technicians regularly fall into periods where they tend to favor one or two indicators over all others. No harm in that, so long as the favored indicators keep on working.
However, market conditions change which also means the efficacy of your indicators will change. Indicators which work in one type of market, may lead you badly astray in another. You have to be aware of what’s working now and what’s not, and be ready to shift when conditions shift.
There is no Holy Grail indicator that works all the time and in all markets. If you think you’ve found it, get ready to lose money. Instead, take your trading signals from the “accumulation of evidence” among ALL of your indicators, not just one.
10) The Tale Of The Tape
I get a kick out of people who insist that they’re intermediate or long-term investors, buy a stock, then anxiously ask whether they should bail the first time the stocks drops a point or two. More likely than not, the panic was induced by watching the tape, or hearing some talking head on CNBC.
Watching the ticker can be dangerous. It leads to emotional and often hasty decisions. Try not to make trading decisions when the market is in session. Do your analysis and make your plan when the market is closed, then calmly execute your plan the following day.
11 ) Worried About Taxes
Don’t let tax considerations dictate your decision on whether to sell a stock. Pay capital gains tax willingly, even joyfully. The only way to avoid paying taxes on a stock trade is to not make any money on the trade.
“If you are paying taxes – you are making money…it’s better than the alternative”
12) Leave The Guru’s In India
They are everywhere – television, print, radio (including me) and everyone has an opinion. You should not be letting some self-appointed market expert dictate or dominate your trading decisions.
“The media is there to sell advertising not make you money – it is for entertainment.”
The most you should expect, or accept, from folks like me, are market analysis, some tidbits of trading strategies, and a bit of guidance in maintaining a solid trading discipline.
13) Everybody’s A Genius
Don’t confuse genius with a bull market. It’s not that hard to make money in a roaring bull market. Keeping your gains when the bear comes prowling is the hard part.
“The market whips all of our butts now and then, and that whipping usually comes just when we think we’ve got it all figured out.”
Managing risk is the key to survival in the market and ultimately in making money. Leave the pontificating to CNBC. Focus on managing risk, market cycles and exposure.
In the long-run, you will likely be better off.
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10-Steps To Curing The “Trading Addiction”
THE ADDICTION
Those who’ve had any brush with addiction know an addict will go to any length to support the habit, including stealing, lies and deception. The addict is aided and abetted by co-dependent friends and family members who cover up for the addict’s bizarre behavior and pretend nothing’s wrong. Breaking the addiction starts with the co-dependents recognizing their role and refusing to provide support to the addict.
Investors have been turned into stock market addicts with their addiction aided and abetted by the media, the financial community, analysts, neighbors, friends and the local checkout clerk. Since 1990, when the Internet began to mainstream investing to the average investor, millions have been lured by the promise of the lifestyles of the rich and famous by simply playing “the game.”
Now, after eight years of a bull market, investors are piling into the market for their next fix, living from one headline to the next looking for reassurance “this time is different.”
But why wouldn’t they considering they have been repeatedly told the stock market is a “sure thing”, a near guaranteed way to make money. It’s so easy, after all. You just “buy and hold” stocks and the market will return 10% a year just as it has over the last 100 years.
This fallacy has been repeatedly espoused by pundits, brokers, financial advisors, and the media. Even Dave Ramsey, the famous debt counselor, espouses buying and holding four mutual funds (25% in each of growth, growth & income, aggressive growth and international) and then bingo – you will make 12% per year.
If it were true, then explain why roughly 80% of Americans, according to numerous surveys, have less than one years salary saved up on average? Furthermore, no one who simply bought and held the S&P 500 has ever lost money over a 20-year time span. Right?
Not exactly.
Here is the problem.
No matter how resolute people think they are about buying and holding, they usually fall into the same old emotional pattern of buying high and selling low.
Investors are human beings. As such we gravitate towards what feels good and we seek to avoid pain. When things are euphoric in the market, typically at the top of a long bull market, we buy when we should be selling. When things are painful, at the end of bear market, we sell when we should be buying.
In fact, it’s usually the final capitulation of the last remaining “holders” that sets up the end of the bear market and the start of a new bull market. As Sy Harding says in his excellent book “Riding The Bear,” while people may promise themselves at the top of bull markets they’ll behave differently:
“No such creature as a ‘buy and hold’ investor ever emerged from the other side of the subsequent bear market.”
Statistics compiled by Ned Davis Research back up Harding’s assertion. Every time the market declines more than 10% (and “real” bear markets don’t even officially begin until the decline is 20%), mutual funds experience net outflows of investor money.
Fear is a stronger emotion than greed.
Most bear markets last for months (the norm), or even years (both the 1929 and 1966 bear markets), and one can see how the torture of losing money week after week, month after month, would wear down even the most determined “buy and hold” investor. This is also why the next true “bear market” will demolish the “RoboAdvisor” industry as “buy and hold” once again reverts to “get me the #&%@ out!”
But the average investor’s pain threshold is a lot lower than that. The research shows that it doesn’t matter if the bear market lasts less than 3 months (like the 1990 bear) or less than 3 days (like the 1987 bear).People will still sell out, usually at the very bottom, and almost always at a loss.
So THAT is how it happens.
And the only way to avoid it – is to avoid owning stocks during bear markets. If you try to ride them out, odds are you’ll fail. And if you believe that we are in a “New Era,” and that bear markets are a thing of the past, your next of kin will have my sympathies.
10-Step Process To Curing The Addiction
STEP 1: Admitting there is a problem
The first step in solving any problem is to realize that you have a “trading” problem. Be willing to take the steps necessary to remedy the situation
STEP 2: You are where you are
It doesn’t matter what your portfolio was in March of 2000, March of 2009 or last Friday. Your portfolio value is exactly what it is, rather it is realized or unrealized. The loss is already lost, and understanding that will help you come to grips with needing to make a change. Open those statements and look at them – shock therapy is usually effective in bringing about awareness.
STEP 3: You are not a loser
Most people have a tendency to believe that if they “sell a loser,” then they are a “loser” by extension. They try to ignore the situation, or hide the fact they lost money, which in turn causes more mistakes. This only exacerbates the entire problem until they then try to assign blame to anyone and anything else.
You are not a loser. You made an investment mistake. You lost money.
It has happened to every person that has ever invested in the stock market, and there are many others who lost more than you. Anyone, and I do mean anyone, who tells you that they have never lost money in the markets, is a liar!
STEP 4: Accept responsibility
In order to begin the repair process, you must accept responsibility for your situation. It is not the market’s, current advisor’s or money manager’s fault. It is not the fault of Wall Street, nor is it the fault of the demon breed of corporate executives.
It is your fault.
Once you accept that it is your fault and begin fixing the problem, rather than postponing the inevitable and suffering further consequences of inaction, only then can you begin to move forward.
STEP 5: Understand that markets change
Markets change due to a huge variety of factors from interest rates to currency risks, political events to Geo-economic challenges. Does it really make sense to buy and hold?
If the markets are in a constant state of flux and your portfolio remains in a constant state then the law of change must apply:
The law of change: Change will occur and the elements in the environment will adapt or become extinct and that extinction in and of itself is a consequence of change.
Therefore, if you are a buy and hold investor then you have to modify and adapt to an ever-changing environment or you will become extinct.
STEP 6: Ask for help
This market has baffled, and confused, even the best of investors and will likely continue to do so for a while. So, what chance do you have doing it on your own?
Don’t be afraid to ask, or get help, if you need it. This is no longer a market which will forgive mistakes easily and while you may pay a little for getting help, a helping hand may keep you from making more costly investment mistakes in the future.
STEP 7: Make change gradually
No one said that change was going to easy or painless. Going against every age old philosophy and piece of advice you have ever been given about investing is tough, confusing and froth with doubt.
However, make changes gradually at first – test the waters and measure the results. For example, sell the positions that are smallest in size with the greatest loss. You will make no noticeable change in the portfolio right away, but it will make you realize that you can actually execute a sell order without suffering a negative consequence.
Gradually work your way through the portfolio on rallies and cleanse the portfolio of the evil seeds of greed that now populate it, and replace them with a garden of investments that will flourish over time.
STEP 8: Develop a strategy
Now that you have cleaned everything up you should be feeling a lot more in control of your portfolio and your investments. Now you are ready to start moving forward in the development of a goal-based investment strategy.
If your portfolio is a hodge-podge of investments, then how do you know whether or not your portfolio will generate the return you need to meet your goals. A goal-based investment strategy builds the portfolio to match investments, and investment vehicles, in an orderly structure to deliver the returns necessary with the least amount of risk possible. Ditch the benchmark index and measure your progress against your investment destination instead.
STEP 9: Learn it. Live it. Love it.
Once you have designed the strategy, including monthly contributions to the plan, it is time implement it. This is where the work truly begins.
You must learn the plan inside and out so every move you make has a reason and a purpose.
You must live the plan so that adjustments are made to the plan, and the investments, to match performance, time and value horizons.
Finally, you must love the plan so that you believe in it and will not deviate from it.
It must become a part of your daily life, otherwise, it will be sacrificed for whims and moments of weakness.
STEP 10: Live your life
That’s it.
You are in control of your situation rather than the situation controlling you.
The markets will be continue to remain volatile, a major “bear market” is coming at some point, and there will be lot’s of opportunities to make money along the way.
But that is just how it works. As long as you work your plan, the plan will work for you and you will reach your goals…eventually. There is no “get rich quick” plan.
So, live your life, enjoy your family and do whatever it is that you do best. Most importantly, make your portfolio work as hard for you as you did for the money you put into it.
The Long-Term Investing Myth
During my morning routine of caffeine supported information injections, I ran across several articles that just contained generally bad investment advice and poorly formed analysis. Each argument was hinged on the belief that bull markets last indefinitely, bear markets are simply an opportunity to “buy” more, and investing for the long term always works. One such article, in particular, was this gem published at MarketWatch:
“But it’s important to remember that in the grand scheme of things, this sell off is a mere blip.
Kieron Nutbrown, former head of global macro fixed income at First State Investments in London, has just the reminder to help investors take a step back and look at things from a long-term perspective.
The chart, which first appeared on his blog, follows the path of global stocks over the past 500 years and demonstrates how prices have fared through wars, revolutions, and depressions.”
See, it is really quite simplistic, just buy the dips.
the 500-year chart of share prices clearly shows that every dip is a buying opportunity pic.twitter.com/1t6oTyHsam
Unfortunately, investing doesn’t work that way because this chart ignores both the value and quantity of the one commodity that we can not acquire or create more of – “time.”
While the markets may have recently hit “all-time” highs, for the majority of investors this is not the case. This is because, as I addressed last week, investors tend to do exactly the “opposite” of what they should do when investing. To wit:
“Unfortunately, investors rarely do what is ‘logical,’ but react ’emotionally’ to market swings. When stock prices are rising, instead of questioning when to ‘sell,’ they are instead lured into market peaks. The reverse happens as prices fall. First, comes ‘paralysis,’ then ‘hope’ that losses may be recovered, but eventually ‘capitulation’ sets in as the emotional strain becomes too great and investors ‘dump’ shares at any price to preserve what capital they have left. They then remain out of the market as prices rise only to ‘jump back in’ about mid-way to the next market peak. Wash. Rinse. Repeat.”
This is shown in the flows of money into bonds/equities by investors according to the research from ICI. (Note: Beginning in 2014, ICI began reporting on ETF fund flows which have been included into the cumulative.)
Despite the rally to all-time highs, flows into equities continue to remain negative. While November’s data has not been fully released yet, it will be interesting to see if the spike in interest rates has done much to change the net cumulative flows into bonds vs. equities.
However, the problem for far too many Americans today is that time will run out for them as they are faced with tough retirement choices and being forced to work far longer than any of them ever planned.
Amazingly, after two major bear market reversions, individuals still place too much faith on predictions of future outcomes when it comes to their savings, and more importantly, their retirement.
While looking at a 500-year history of the markets is certainly interesting, it is the reality that most investors have far less life-span than that.
In order to be truly successful over the long term, and this is especially important if you are close to your retirement date, a focus on 1) capital preservation and 2) returns at a rate to offset inflationary pressures are the most critical.
The second part of that statement is the most important. Just as the problem with pension funds continues to prove, trying to use financial markets to offset a lack of savings has consistently turned out badly. People that try to build wealth by investing, rather than saving, tend to lose more often than not as they inherently take on excessive risk trying to “beat the market.”
What has been lost in recent years is the financial markets are a tool to make sure that your “savings” maintain their future purchasing power parity. In other words, your savings are adjusted for inflation over time.
If you truly have 30 years to be invested before you retire, then you can ignore this article, buy a stock market index fund, stick money in it every month and most likely you will be fine.
However, if you are like me, and the millions of other Americans who are within 10-15 years to retirement, we don’t have the luxury of time on our side. Therefore, sudden market losses can be devastating to long term financial sustainability in retirement.
Hopes Vs Reality
While we all “hope” that markets will provide a positive net impact on our long-term goals, there are several issues that individuals must understand. The first, is while markets have risen over time, the markets spend roughly 95% of their time making up for previous losses. The chart below shows this fairly clearly.
Secondly, exactly how much time do individuals really have? While it certainly sounds charming that “youngsters” are throwing their money into the Wall Street casino, the reality is this is hardly the case. Youngsters rarely have sufficient levels of investible savings to actually invest. Between starting a career, raising a family and maintaining their specific standard of living there is rarely little remaining to be “saved.”(Read this)
For most, it is not until the late 30’s or early 40’s that individuals are earning enough money to begin to save aggressively for retirement. More importantly, it takes even longer before they “save” enough investible capital to actually make investing work for them after fees, expenses and taxes.
Therefore, by the time most achieve a level of income and stability to begin actually saving and investing for retirement – they have, on average, about 40 years of investable time horizon before they expire. Unfortunately, that is only about 460 years short of the first chart in achieving those rates of return.
I have prepared two different charts to show you the impact of investing over a 40-year time span. I used an initial investment of $1000 at the beginning of each decade and analyzed the capital appreciation for the ensuing 40 year period. In this regard, we can garner a clearer picture about the impact of both secular bull and bear market cycles on the total investment returns.[Note: The data below uses Shiller’s price data on a nominal basis and is based on monthly capital appreciation only.]
The first chart shows the average annual return for each starting decade.
The next chart shows the capital appreciation of a $1000 initial investment.
Importantly, the major difference on the ending result depends greatly on “WHEN” you start investing. If you started investing during the 50’s and 60’s then you were lucky enough to capture the raging “bull market” of the 80’s and 90’s which offset the secular bear market of the 70’s. However, if it started in 1990, so far, results haven’t been all that great as the secular bear market of the 21st century has slowly chipped away at the gains of the 90’s.
One very important thing to be noted here, which I discussed in “Yes, You Should Worry About Corrections,” is valuations have been a key driver of these 40-year cycles. The best 40-year returns came from when the starting point in valuations was below 10x trailing reported earnings. Today, at over 20x trailing reported earnings (the only valuation measure that is historically consistent),it suggests that returns in the years ahead will likely be substandard.
So, what if we “invest backward?”
What would portfolio returns look like if stocks were bought when trailing valuations were at 7x earnings, or less, and then the portfolio was fully rotated into bonds whenever trailing valuations exceed 25x or more. While this is what we should do as investors, it is completely backward to what is espoused in the mainstream media.
The chart below is a $10,000 investment invested into a switching strategy versus the total return S&P 500 index.
As you can see, the returns over the VERY long term investment horizon closely correlate with the total return of the S&P 500 without the downside volatility risk during major market reversions. (Again, however, you likely died at least twice along the way)
While this is an extreme example, and not something I would recommend, the point to be made is the incessantly bullish commentary is not necessarily in your best interest due to the following:
1) You don’t have 86 years to invest
2) The accumulation phase of portfolios is generally much shorter than the distribution phase, particularly now as average life expectancy creeps ever closer to 100.
3) The returns actually received by investors are far lower due to inflation, taxes, and expenses.
4) Returns are diminished further due to investor behaviors such as “chasing returns” and “panic selling.”
With forward returns likely to be lower and more volatile than what was witnessed in the 80-90’s, the need for a more conservative allocation model is rising. Controlling risk, reducing emotional investment mistakes and limiting the destruction of investment capital will likely be the real formula for investment success in the decade ahead.
This brings up some very important investment guidelines that I have learned over the last 30 years.
Investing is not a competition. There are no prizes for winning but there are severe penalties for losing.
Emotions have no place in investing.You are generally better off doing the opposite of what you “feel” you should be doing.
The ONLY investments that you can “buy and hold”are those that provide an income stream with a return of principal function.
Market valuations (except at extremes) are very poor market timing devices.
Fundamentals and Economics drive long-term investment decisions – “Greed and Fear” drive short term trading. Knowing what type of investor you are determines the basis of your strategy.
“Market timing” is impossible– managing exposure to risk is both logical and possible.
Investment is about discipline and patience. Lacking either one can be destructive to your investment goals.
There is no value in daily media commentary– turn off the television and save yourself the mental capital.
Investing is no different than gambling– both are “guesses” about future outcomes based on probabilities. The winner is the one who knows when to “fold” and when to go “all in”.
No investment strategy works all the time. The trick is knowing the difference between a bad investment strategy and one that is temporarily out of favor.
As an investment manager, I am neither bullish or bearish. I simply view the world through the lens of statistics and probabilities. My job is to manage the inherent risk to investment capital. If I protect the investment capital in the short term – the long term capital appreciation will take of itself.
But one thing I absolutely know for sure – you aren’t going to live for 500-years.
Bob Farrell’s Illustrated 10-Investment Rules
Over the weekend, it was interesting to see the number of advisors/analysts rushing to defend their “buy and hold” investing philosophies following the sharp decline on Friday. As I wrote this past weekend:
“The downfall of all investors is ultimately ‘greed’ and ‘fear.’
They don’t sell when markets are near peaks, nor do they buy market bottoms. However, this does not just apply to individuals but many advisors as well.
When I read articles from advisors/managers promoting ‘buy and forget’ strategies it is for one of three reasons. They either can’t, don’t want to, or don’t know how to manage portfolio risk. Therefore, the easy message is simply:
‘You just have to ride the market out. Long-term it will go up. But hey, let me charge you a fee for holding your stuff in an account.’
The reality is that markets do not return 6%, 8% or 10% annually, and spending years making up previous losses is not a way to successfully obtain retirement goals. (Read this)
It is also worth pointing out that those promoting these ‘couch potato’ methodologies are generally out in full force near peaks of bull market cycles, and are rarely heard of near bear market bottoms. This is why, as I discussed in ‘Why You Still Suck At Investing,’ investors consistently underperform over long periods of time.”
When markets are at, or near, “record levels,” those levels are records for a reason. Throughout history, awe-inspiring bull markets are followed by devastating bear markets. Like “yen and yang,” a bull cannot exist without its forever intertwined counterpart.
Despite the media, advisors, and analysts’ rhetoric to the contrary, investors DO have the ability to manage the inherent risk in their portfolios.
Investors can capture returns and grow their “savings” instead of blindly hoping that history will not repeat itself. While I can’t tell you exactly when the second half of the full-market cycle will manifest itself, I can assure you it will, and the negative impact on retirement goals, and the time lost, will be just as damaging.
One other question to ponder. While Wall Street tells you to “just hold on and ride the market out,” why are they managing risk, spending billions on trading platforms and algorithms, and in many instances betting against you?
With this in mind, I present Bob Farrell’s 10-Investment Rules. These rules should be a staple for any investor who has put their hard-earned “savings” at risk in the market. However, they are rarely heeded in the heat of the bull market, just as they are being ignored now.
Who is Bob Farrell?
Bob is a Wall Street veteran with over 50 years of experience crafting his investing rules. Farrell obtained his master’s degree from Columbia Business School and started as a technical analyst at Merrill Lynch in 1957. Even though Farrell studied fundamental analysis under Gramm and Dodd, he turned to technical analysis after realizing there was more to stock prices than balance sheets and income statements. Farrell became a pioneer in sentiment studies and market psychology. His 10 rules on investing stem from personal experience with dull markets, bull markets, bear markets, crashes, and bubbles. In short, Farrell has seen it all and lived to tell about it.
The Illustrated 10-Rules Of Investing
1) Markets tend to return to the mean (average price) over time.
Like a rubber band stretched too far – it must be relaxed to be stretched again. Such is the same for stock prices which are anchored to their moving averages. Trends that get overextended in one direction, or another, always return to their long-term average. Even during a strong uptrend or downtrend, prices often return (revert) to a long-term moving average. The chart below shows the S&P 500 with a 52-week simple moving average.
The bottom chart shows the percentage deviation of the market’s current price from the 52-week moving average. During bullish trending markets, there are regular reversions to the mean, which create buying opportunities. However, what is often not stated is that investors should have taken profits from portfolios as deviations from the mean reached historic extremes. Conversely, in bearish trending markets, such reversions from extreme deviations should be used to sell stocks, raise cash and reduce portfolio risk rather than “panic sell” at market bottoms.
The dashed RED lines denote when the markets changed trends from positive to negative. Such is the very essence of portfolio “risk” management.
2) Excesses in one direction will lead to an opposite excess in the other direction.
Markets that overshoot on the upside will also overshoot on the downside, like a pendulum. The further it swings to one side, the further it rebounds to the other side. Such is the extension of Rule #1 as it applies to longer-term market cycles (cyclical markets).
While the chart above shows prices behave on a short-term basis – on a longer-term basis markets also respond to Newton’s 3rd law of motion: “For every action, there is an equal and opposite reaction.”The first chart shows that cyclical markets reach extremes when they are more than 2 standard deviations above or below the 50-week moving average. Notice that these excesses ARE NEVER worked off by just going sideways.
The second chart shows the price reversions of the S&P 500 on a long-term basis and adjusted for inflation. Notice that when prices have historically reached extremes – the reversion in price is just as extreme. It is clear that the current reversion in the stock market is still underway from the 2000 peak.
3) There are no new eras – excesses are never permanent.
There will always be some “new thing” that elicits speculative interest. These “new things” throughout history, like the “Siren’s Song,” has led many investors to their demise. In fact, over the last 500 years, we have seen speculative bubbles involving everything from Tulip Bulbs to Railways, Real Estate to Technology, Emerging Markets (5 times) to Automobiles and Commodities. It always starts the same and ends with the utterings of “This time it is different.”
[The chart below is from my March 2008 seminar discussing that the next recessionary bear market was about to occur.]
As legendary investor Jesse Livermore once stated:
“A lesson I learned early is that there is nothing new on Wall Street. There can’t be because speculation is as old as the hills. Whatever happens in the stock market today has happened before and will happen again.”
4) Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways
The reality is that excesses, such as what we are seeing in the market now, can go much further than logic dictates. However, as stated above, these excesses are never worked off simply by trading sideways. Corrections are always just as brutal as the advances were exhilarating. The chart below shows when the markets broke out of their directional trends – the corrections came soon after that.
5) The public buys the most at the top and the least at the bottom.
The average individual investor is bullish at market tops and bearish at market bottoms. Such is due to investors’ emotional biases of “greed” when markets are rising and “fear” when markets fall. Logic would dictate that the best time to invest is after a massive sell-off; unfortunately, this is the opposite of what investors do.
6) Fear and greed are stronger than long-term resolve.
As stated in Rule #5, emotions cloud your decisions and affect your long-term plan.
“Gains make us exuberant; they enhance well-being and promote optimism,” says Santa Clara University finance professor Meir Statman. His studies of investor behavior show that “Losses bring sadness, disgust, fear, regret. Fear increases the sense of risk and some react by shunning stocks.”
The bullish sentiment index shows that “greed” is again beginning to reach levels where markets have generally reached intermediate-term peaks.
In the words of Warren Buffett:
“Buy when people are fearful and sell when they are greedy.”
Currently, those “people” are getting extremely greedy.
7) Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names.
Breadth is important. A rally on narrow breadth indicates limited participation and the chances of failure are above average. The market cannot continue to rally with just a few large-caps (generals) leading the way. Small and mid-caps (troops) must also be on board to give the rally credibility. A rally that “lifts all boats” indicates far-reaching strength and increases the chances of further gains.
The chart above shows the ARMS Index, which is a volume-based indicator that determines market strength and breadth by analyzing the relationship between advancing and declining issues and their respective volume. It is usually used as a short-term trading measure of market strength. However, the chart shows a weekly index smoothed with a 34-week average for extended periods. Spikes in the index have generally coincided with near-term market peaks.
8) Bear markets have three stages – sharp down, reflexive rebound, and a drawn-out fundamental downtrend
Bear markets often start with a sharp and swift decline. After this decline, an oversold bounce retraces a portion of that decline. The longer-term decline then continues, at a slower and more grinding pace, as the fundamentals deteriorate. Dow Theory suggests that bear markets consist of three down legs with reflexive rebounds.
The chart above shows the stages of the last two primary cyclical bear markets. The point to be made is there were plenty of opportunities to sell into counter-trend rallies during the decline and reduce risk exposure. Unfortunately, the media/Wall Street told investors to “hold on” until they finally sold out at the bottom.
9) When all the experts and forecasts agree, something else will happen.
This rule fits within Bob Farrell’s contrarian nature. As Sam Stovall, the investment strategist for Standard & Poor’s, once stated:
“If everybody’s optimistic, who is left to buy? If everybody’s pessimistic, who’s left to sell?”
As a contrarian investor, along with several of the points already made within Farrell’s rule set, excesses are built by everyone on the same side of the trade. Ultimately, when the shift in sentiment occurs – the reversion is exacerbated by the stampede going in the opposite direction.
Being a contrarian can be quite difficult at times as bullishness abounds. However, it is also the secret to limiting losses and achieving long-term investment success. As Howard Marks once stated:
“Resisting – and thereby achieving success as a contrarian – isn’t easy. Things combine to make it difficult; including natural herd tendencies and the pain imposed by being out of step, since momentum invariably makes pro-cyclical actions look correct for a while. (That’s why it’s essential to remember that ‘being too far ahead of your time is indistinguishable from being wrong.’)
Given the uncertain nature of the future, and thus the difficulty of being confident your position is the right one – especially as price moves against you – it’s challenging to be a lonely contrarian.”
10) Bull markets are more fun than bear markets
As stated above in Rule #5 – investors are primarily driven by emotions. As the overall markets rise, up to 90% of any individual stock’s price movement is dictated by the market’s general direction. Such is the derivation of the saying, “a rising tide lifts all boats.”
Psychologically, as the markets rise, investors begin to believe they are “smart” because their portfolio is going up. In reality, it is primarily a function of “luck” rather than “intelligence” driving their portfolio.
Investors behave much the same way as individuals who are addicted to gambling. When they are winning, they believe their success is based on their skill. However, when they begin to lose, they keep gambling, thinking the next “hand” will be the one that gets them back on track. Eventually – they leave the table broke.
Bull markets are indeed more fun than bear markets. They elicit euphoria and feelings of psychological superiority. However, bear markets bring fear, panic, and depression.
What is interesting is that no matter how many times we continually repeat these “cycles” – as emotional human beings, we constantly “hope” that somehow this “time will be different.”Unfortunately, it never is, and this time won’t be either. The only questions are: when will the next bear market begin, and will you be prepared for it?
Conclusions
Like all rules on Wall Street, Bob Farrell’s rules are not meant to have hard and fast rules. There are always exceptions to every rule, and while history never repeats precisely, it often “rhymes” very closely.
Nevertheless, these rules will benefit investors by helping them to look beyond the emotions and the headlines. Awareness of sentiment can prevent selling near the bottom and buying near the top, which often goes against our instincts.
Regardless of how often I discuss these issues, quote successful investors, or warn of the dangers – the response from both individuals and investment professionals is always the same.
“I am a long term, fundamental value, investor. So these rules don’t really apply to me.”
No, you’re not. Yes, they do.
Individuals are long-term investors only as long as the markets are rising. Despite endless warnings, repeated suggestions, and outright recommendations, getting investors to sell, take profits, and manage your portfolio risks is nearly a lost cause as long as the markets are rising. Unfortunately, when the fear, desperation, or panic stages are reached, it is far too late to act, and I will only be able to say I warned you.
Bulls, Bears & The Broken Clock Syndrome
“Bears are like broken clocks, they are only right twice a day.”
This is a statement that is often thrown out during rising bull markets by the inherently optimistic crowd. However, such a statement really points to the ignorance of those that make such a claim. Why? Because if the “bears” are right twice a day, then the “bulls,” logically speaking, are wrong twice a day as well. In the game of investing, it is the timing of being “wrong” that is the most critical.
The chart below shows the bullish and bearish cycles, in terms of “real,” inflation-adjusted price, for the S&P 500 from 1871-present.
Throughout history, bull market cycles are only one-half of the “full market” cycle. This is because during every “bull market” cycle the markets and economy build up excesses that are then “reverted” during the following “bear market.” In the other words, as Sir Issac Newton once stated:
“What goes up, must come down.”
The next chart shows the full market cycles over time. Since the current “full market” cycle is yet to be completed I have drawn a long-term trend line with the most logical completion point of the current cycle.
[Note:I am not stating that I “believe” the markets are about to crash to the 700 level on the S&P 500. I am simply showing where the current uptrend line intersects with the price. The longer that it takes for the markets to mean revert the higher the intersection point will be. Furthermore, the 700 level is not out of the question either. Famed investor Jack Bogle stated that over the next decade we are likely to see two more 50% declines. A 50% decline from current levels would put the market below 1000 which would likely be in the “ballpark” of completing the current full market cycle.)
The Problem Of Time
The biggest fallacy perpetrated on investors today is how long-term investing is promoted. A quick glimpse at the chart above tells you that if you had just invested in stocks in 1871, and held them, that you would be wealthy beyond imagination today. Unfortunately, you died long before you ever realized such wealth.
During my morning routine of caffeine supported information injections, I ran across several articles that just contained generally bad investment advice and poorly formed analysis. Each argument was hinged on the belief that bull markets last indefinitely, bear markets are simply an opportunity to “buy” more, and investing for the long term always works.
This got me to thinking about the how we are told to invest in the markets. When markets are rising, and valuations are increasing, individuals are berated by financial media and Wall Street into shoving their hard earned “savings” into a rising risk environment. They are always told to “buy” but never to “sell.” When markets invariably revert, they are told to “hold on,”“average down,” or “buy more.” After all, you are investing for the long term, right?
There are several problems which need to be addressed. First, while markets have indeed risen over long-term time frames, the markets have spent roughly 95% of their time making up for previous losses. The chart below shows this fairly clearly.
Secondly, exactly how much time do individuals really have? While it certainly sounds charming “youngsters” should throw their money into the Wall Street casino, the reality is this is hardly the case. Youngsters rarely have sufficient levels of investible savings to actually invest. Between starting a career, raising a family and maintaining their specific standard of living there is rarely little remaining to be “saved.”For most, it is not until the late 30’s or early 40’s that individuals are earning enough money to begin to save aggressively for retirement and have enough investable capital to actually make investing work for them after fees, expenses and taxes. Therefore, by the time most achieve a level of income and stability to begin actually saving and investing for retirement – they have, on average, about 40 years of investable time horizon before they expire.
I have prepared two different charts to show you the impact of investing over 40-year time spans. I used an initial investment of $1000 at the beginning of each decade and analyzed the capital appreciation for the ensuing 40-year period. In this regard, we can garner a clearer picture about the impact of both secular bull and bear market cycles on the total investment returns.[Note: The data below uses Shiller’s price data on a nominal basis and is based on monthly capital appreciation only.]
The first chart shows the average annual return for each starting decade.
The next chart shows the capital appreciation of a $1000 initial investment.
“Importantly, the major difference on the ending result depends greatly on ‘WHEN’ you start investing. If you started investing during the 50’s and 60’s, then you were lucky enough to capture the raging ‘bull market’ of the 80’s and 90’s which offset the secular bear market of the 70’s. However, if you started in 1990, so far, results haven’t been all that great as the secular bear market of the 21st century has slowly chipped away at the gains of the 90’s.”
The problem for most is time. While we can manufacture more “money,” we can not create more “time.”
The reality is that no one has 100 years to invest to achieve the long-term investment returns often touted on Wall Street. What all investors do face is the reality of the incredible time crunch between the beginning and end of the “accumulation phase.” The problem is that the “accumulation phase” is generally much shorter than the “distribution” phase particularly as life expectancy creeps ever closer to 100 years of age. Therefore, investing mistakes made early on have a tremendous impact on the end result due to the lack of “time.”
Psychological Failure
In reality, the problem is far worse than what is shown. Dalbar Research produces an annual report on investor behavior that clearly shows investors compound their investment problems by “buying high and selling low.”The growth of the markets, as shown in the charts above, has NEVER been achieved by investors when including the impact of fees, expenses, taxes and emotional mistakes.
Despite the media’s commentary that ‘if an investor had ‘bought’ the bottom of the market…’ the reality is that few, if any, actually did. The biggest drag on investor performance over time is allowing ‘emotions’ to dictate investment decisions. Investor studies show “psychological factors” account for between 45-55% of underperformance. From Dalbar:
“Analysis of investor fund flows compared to market performance further supports the argument that investors are unsuccessful at timing the market. Market upswings rarely coincide with mutual fund inflows while market downturns do not coincide with mutual fund outflows.”
In other words, investors consistently bought the ‘tops’ and sold the ‘bottoms.’ The other two primary reasons of underperformance from the study related to a lack of capital to invest. This is also not surprising given the current economic environment where roughly 80% of Americans lack sufficient savings to meet a $500 emergency.
These psychological investment mistakes are never discussed by the mainstream media, but they are real and extremely destructive to long-term returns. What is interesting is that these investment mistakes are generally made during the first half of the full-market cycle as “greed” overtakes a logical and disciplined investment process. Those mistakes, however, are only recognized during the second half of the cycle as the “panicto sell” overwhelms individuals.
The Fallacy Of The “Broken Clock”
In this past weekend’s newsletter, I quoted John Hussman who put a very fine point on the importance of understanding the “full market cycle:”
“Put simply, most apparent “opportunities” to obtain investment returns above zero in conventional assets over the coming decade are based on a misunderstanding of valuations, total returns, and historical yield relationships. At current valuations, virtually everything is priced for a decade of zero. The unwinding of these speculative extremes is likely to be chaotic, and will likely occur over a shorter horizon than investors imagine. That chaos, driven not by central bank tightening but by an emerging default cycle, will usher in fresh investment opportunities in conventional assets, where presently there are none.
Looking beyond the near-term, my view is that a ‘permanently high plateau’ is unlikely, and we will instead see a violent unwinding of recent speculative extremes over the completion of the current market cycle, even if central banks ease aggressively, as they did throughout the 2000-2002 and 2007-2009 collapses. Corporate income growth and profit margins have already begun to narrow from their extremes, and the default cycle has already turned higher. The completion of this cycle won’t arrive because central banks suddenly become enlightened enough to abandon their recklessness. It will arrive precisely because they have sustained yield-seeking speculation for too long already; because they have amplified the vulnerability of the debt and equity markets to normal economic fluctuations; and because the consequences of this fragility are now fully baked in the cake.”
While John is absolutely correct, he is often dismissed because of his bearish overtone. In my opinion, this is a mistake. However, it is exactly that dismissal which is indicative of the willful blindness to the underlying problems and the inherent disaster to long-term goals that awaits many unwary individuals in the markets currently.
As I have often stated, I am not bullish or bearish. My job as a portfolio manager is simple; invest money in a manner that creates returns on a short-term basis but reduces the possibility of catastrophic losses which wipe out years of growth.
In the end, it does not matter IF you are “bullish” or “bearish.”The reality is that both “bulls” and “bears” are owned by the “broken clock” syndrome during the full-market cycle.However, what is grossly important in achieving long-term investment success is not necessarily being “right” during the first half of the cycle, but by not being “wrong” during the second half.
Here Is Why You Shouldn’t Benchmark Your Portfolio
When markets begin to decline, particularly after extremely long periods of advances, there is a rush by the media and financial bloggers to proclaim “patience.” These claims are generally accompanied by advice to just “hold on” to investments and ride out the volatility over the long-term. After all, the index always rises, right?
The problem, is that market indices and investor portfolios are two very different things and there are a few very important things to consider before “jumping off this particular cliff.”
One of the most important fallacies of benchmarking portfolios, as I addressed recently, is the disparity between compound and variable rates of return. To wit:
“The ‘power of compounding’ ONLY WORKS when you do not lose money. As shown, after three straight years of 10% returns, a drawdown of just 10% cuts the average annual compound growth rate by 50%. Furthermore, it then requires a 30% return to regain the average rate of return required. In reality, chasing returns is much less important to your long-term investment success than most believe.
Here is another way to view the difference between what was “promised,” versus what “actually” happened. The chart below takes the average rate of return, and price volatility, of the markets from the 1960’s to present and extrapolates those returns into the future.”
“When imputing volatility into returns, the differential between what investors were promised (and this is a huge flaw in financial planning) and what actually happened to their money is substantial over the long-term.
The second point, and probably most important, is that YOU DIED long before you realized the long-term average rate of return.”
Most importantly, as noted above, the of “TIME” is critical to the investing equation. While 10% annualized returns sound fantastic, those returns were over the course of more than 100 years and included an average dividend yield of almost 4%. Unfortunately, you will not live long enough to realize those “average rates of return.”
I want to specifically address the fallacy of chasing a benchmark index (i.e. the S&P 500.)The continual chase to “beat the benchmark” leads individuals to make emotional decisions to buy and sell at the wrong times; jump from one investment strategy to another, or from one advisor to the next. But why wouldn’t they? This mantra that has been drilled into all of us by Wall Street over the last 30 years. While the chase to “beat the index” is great for Wall Street, as money in motion creates fees and commissions, most individuals have done far worse.
The annual studies from Dalbar show the dismal truth, individuals consistently under perform the benchmark index over EVERY time frame.
The reason this underperformance consistently occurs is due to emotional mistakes and the many factors that affect a “market capitalization weighted index” far differently than a “dollar invested portfolio.”
Let’s set aside the emotional mistakes for today and focus on the differences between a benchmark index and your portfolio.
Building The Sample Index
For example purposes, let’s create a very simplistic index called the Sample Index which is comprised of 5 fictional companies. For this purpose, each company has 1000 shares of stock outstanding and all trade at $10 per share. The table below shows the index versus “Your Portfolio” which is a $50,000 investment weighted equally.
I have also labeled each of the six following examples as year 1, 2, etc. so that I can give you a performance chart at the end of this missive.
In Year 1, our starting point, we divide a $50,000 investment into exactly the same weights and stocks as the Sample Index as follows:
There are a couple of caveats here. The first is that by using so few stocks the percentage changes to the index, and subsequently the portfolio, are going to be amplified. However, this only for informational and learning purposes – it is the concept we are after.
Secondly, there are many other factors, outside of the examples covered here, which have major impacts on performance. Events such as mergers, buyouts, and acquisitions affect the index. Your portfolio is impacted by withdrawals and contributions. Also, the example assumes no dividends which would change portfolio performance.
Lastly, and most importantly, none of the examples today include the significant impacts to portfolio performance over time which comes from taxes, fees, commissions and other expenses. These factors alone can account for a bulk of the underperformance over the long term but are often ignored by investors trying to chase some random benchmark index.
The Status Quo
In the second year of our example – we assume that nothing exceptional, other than just normal price appreciation or depreciation. The table below shows the impact of price changes on both the Sample Index and Your Portfolio.
Not surprisingly, since both the index and the portfolio are directly affected by price changes – the performance between the two is identical. However, in the real world such a “stagnant” situation rarely exists over a twelve month period.
Share Buybacks & Bankruptcy
Since the end of the last recession, corporations have become major buyers of their own stock pushing such actions to record levels. Stock buybacks are typically viewed as a good thing by Wall Street analysts supposedly because it is a sign that the “company believes” in itself, however, nothing could be further from the truth.
The reality is that stock buy backs are a tool used to artificially inflate bottom line earnings per share which, ultimately, drives share prices higher.
The importance of buybacks cannot be overlooked. The dollar amount of sales, or topline revenue, is extremely difficult to fudge or manipulate. However, bottom line earnings are regularly manipulated by accounting gimmickry, cost cutting, and share buybacks to enhance results in order to boost share prices and meet “Wall Street Expectations.”
Let me show you a simple mathematical example.
The first table and chart below show sales for a hypothetical company over a 5 year period. The sales are stagnant at $10,000 a year.
Look at what happens to Sales/Share and Earnings/Share as the amount of outstanding stock is reduced.
If you were only looking at the two charts, you would assume that this stock was growing strongly. In reality, it did not grow AT ALL over a 5-year period.
Let’s look at the same example but this time let’s reduce sales and earnings for the company at the same time we are buying back stock.
As you can see – once again if you only looked at the charts of Sales/Share and Earnings/Share, the latter being the main focus of Wall Street, you would have been lured into thinking this was a strongly growing company. However, in reality, sales and earnings were deteriorating but masked by the reduction in outstanding shares. Stock buybacks DO NOT show faith in the company by the executives but rather a LACK of better ideas for which to use capital for.
Importantly, for our overall example, the reduction in outstanding shares ALSO reduces market capitalization.
Let’s go back to our original index and portfolio example.
In year 3, there are THREE events that occur which impact both the index and our portfolio.
Company DEF buys back 50% of their outstanding shares
Company MNO files for bankruptcy.
Each company experiences a change in share price.
The table below shows the impact of these three events on the index and the portfolio.
Notice that the share buyback and the bankruptcy combined cause market capitalization of the index to collapse by almost 18%. However, the dollar loss to your portfolio is roughly only 9%.
This reduction in market capitalization of Company DEF did nothing to change the price or number of shares owned on a dollar basis in your portfolio. However, the collapse in the stock of Company MNO as it filed for bankruptcy resulted in a significant loss of investor principal.
Substitution Effect
This brings us to the “substitution effect.” This is something that is rarely talked about to investors who are chided to chase the financial markets at their own peril.
When a company such as GM, AIG, Enron, Worldcom, and a host of others in history, goes bankrupt they are swapped out of the index for another company. The index is then reweighted for the “substitution.” The table below shows the impact of the substitution on the index and your portfolio.
The substitution immediately provides a positive push to the index due to the boost in market capitalization. However, your personal investment portfolio does not see such a positive effect. On a dollar-weighted basis, the bankrupt company still weighs on the value of the total portfolio.
In order for you to get your portfolio back into alignment with the Sample Index, the stock of MNO Company must be sold and then replaced with PQR.
The Replacement Effect
The replacement of a stock in your actual portfolio is confronted by a problem. Since there is no cash in the portfolio, other than what was raised by the sell of MNO – only 100 shares of PQR can be purchased as shown in the table below.
As with each year previously I have also included changes in price for each individual company other than PQR so that the substitution and replacement were done at the same price for example purposes.
Note: Yes, I could have rebalanced the portfolio to raise cash to purchase more shares of PQR, however, we have NOT rebalanced the index. Therefore, using just available cash is the appropriate measure.
If you take a look at the Year 4 table above you will see that both the index and your portfolio declined by $1000 in total between year 4 and 5. However, the decline of the index was -2.7% versus only -1.96% for your portfolio. This is specifically due to the fact that your portfolio is $4000 less than the index at this point.
What About Performance?
Comparison in the financial arena is the main reason clients have trouble patiently sitting on their hands, letting whatever process they are comfortable with work for them. They get waylaid by some comparison along the way and lose their focus. If you tell a client that they made 12% on their account, they are very pleased. If you subsequently inform them that ‘everyone else’ made 14%, you have made them upset. The whole financial services industry, as it is constructed now, is predicated on making people upset so they will move their money around in a frenzy. Money in motion creates fees and commissions. The creation of more and more benchmarks and style boxes is nothing more than the creation of more things to COMPARE to, allowing clients to stay in a perpetual state of outrage.”
This could not be more to the point than anything that we have discussed today. Comparison of your performance to an index is the most useless, and potentially dangerous, thing that you can do as an investor.
The issues of stock buybacks, the “substitution effect”, taxes, expenses and fees all lead to underperformance of the index. Repeated studies have shown that roughly only 1 in 4 mutual fund managers outperform the market index over long periods of time. Of those that outperformed, the average outperformance was just .12% before fees and expenses. However, the fees and expenses were larger than the level of outperformance. This, of course, does not also include the tax impact on gains and income.
The problem with chasing performance, of course, is that once you fall behind you take on MORE risk to try and make up the difference. This leads, ultimately, to bigger mistakes that cost investors dearly.
The major learning points regarding the fallacy of chasing a “benchmark index” are:
1) The index contains no cash
2) It has no life expectancy requirements – but you do.
3) It does not have to compensate for distributions to meet living requirements – but you do.
4) It requires you to take on excess risk (potential for loss) in order to obtain equivalent performance – this is fine on the way up, but not on the way down.
5) It has no taxes, costs or other expenses associated with it – but you do.
6) It has the ability to substitute at no penalty – but you don’t.
7) It benefits from share buybacks – but you don’t.
In order to win the long-term investing game, your portfolio should be built around the things that matter most to you.
– Capital preservation
– A rate of return sufficient to keep pace with the rate of inflation.
– Expectations based on realistic objectives. (The market does not compound at 8%, 6% or 4%)
– Higher rates of return require an exponential increase in the underlying risk profile. This tends to not work out well.
– You can replace lost capital – but you can’t replace lost time. Time is a precious commodity that you cannot afford to waste.
– Portfolios are time-frame specific. If you have a 5-years to retirement but build a portfolio with a 20-year time horizon (taking on more risk) the results will likely be disastrous.
The index is a mythical creature, like the Unicorn, and chasing it takes your focus off of what is most important – your money and your specific goals. Investing is not a competition and there are horrid consequences for treating it as such.
Of the last few weeks, I have touched on the impact of valuations and forward returns. However, it is not just valuations that are an issue, but also the surge in corporate debt, balance sheet leverage combined with declining profitability which is a result of weak economic growth. All in all, such a combination of factors have historically been associated with “bear markets” in equities.
However, none of these fundamental concerns seem to be a problem currently. Despite one selloff after another leading to increased volatility, the markets are currently hovering near all-time highs as the “chase for yield” continues. Just recently David Rosenberg made an interesting observation in this regard:
“All this reminds me of what Alan Greenspan said about this type of behavior more than a decade ago:
Thus, this vast increase in the market value of asset claims is in part the indirect result of investors accepting lower compensation for risk. Such an increase in market value is too often viewed by market participants as structural and permanent. To some extent, those higher values may be reflecting the increased flexibility and resilience of our economy. But what they perceive as newly abundant liquidity can readily disappear. Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher asset prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk premiums.
Alan Greenspan, August 25th, 2005.
A decline in perceived risk is often self-reinforcing in that it encourages presumptions of prolonged stability and thus a willingness to reach over an ever-more extended time period. But, because people are inherently risk averse, risk premiums cannot decline indefinitely. Whatever the reason for narrowing credit spreads, and they differ from episode to episode, history caution’s that extended periods of low concern about credit risk have invariably been followed by reversal, with an attendant fall in the prices of risky assets. Such developments apparently reflect not only market dynamics but also the all-too-evident alternating and infectious bouts of human euphoria and distress and the instability they engender.
Alan Greenspan, September 27th, 2005.
Well, remember what happened next! The ensuing two years caught up to investors pretty quickly.
It goes without saying that we should all heed the message from a zero percent interest rates. We are seeing in some cases negative interest rates right out to the 10-year part of the yield curve or even sub-zero as is the case in Japan and Germany, something we only really saw to this scale in the 1930s.“
David’s comments reminded me of George Soros’ take on bubbles.
“First, financial markets, far from accurately reflecting all the available knowledge, always provide a distorted view of reality. The degree of distortion may vary from time to time. Sometimes it’s quite insignificant, at other times, it is quite pronounced. When there is a significant divergence between market prices and the underlying reality, there is a lack of equilibrium conditions.
I have developed a rudimentary theory of bubbles along these lines. Every bubble has two components: an underlying trend that prevails in reality and a misconception relating to that trend. When a positive feedback develops between the trend and the misconception, a boom-bust process is set in motion. The process is liable to be tested by negative feedback along the way, and if it is strong enough to survive these tests, both the trend and the misconception will be reinforced. Eventually, market expectations become so far removed from reality that people are forced to recognize that a misconception is involved. A twilight period ensues during which doubts grow and more and more people lose faith, but the prevailing trend is sustained by inertia. As Chuck Prince, former head of Citigroup, said, ‘As long as the music is playing, you’ve got to get up and dance. We are still dancing.’ Eventually, a tipping point is reached when the trend is reversed; it then becomes self-reinforcing in the opposite direction.
Typically bubbles have an asymmetric shape. The boom is long and slow to start. It accelerates gradually until it flattens out again during the twilight period. The bust is short and steep because it involves the forced liquidation of unsound positions.”
The chart below is an example of asymmetric bubbles.
Soros’ view on the pattern of bubbles is interesting because it changes the argument from a fundamental view to a technical view. Prices reflect the psychology of the market which can create a feedback loop between the markets and fundamentals. As Soros stated:
“Financial markets do not play a purely passive role; they can also affect the so-called fundamentals they are supposed to reflect. These two functions, that financial markets perform, work in opposite directions. In the passive or cognitive function, the fundamentals are supposed to determine market prices. In the active or manipulative function market, prices find ways of influencing the fundamentals. When both functions operate at the same time, they interfere with each other. The supposedly independent variable of one function is the dependent variable of the other, so that neither function has a truly independent variable. As a result, neither market prices nor the underlying reality is fully determined. Both suffer from an element of uncertainty that cannot be quantified.”
The chart below utilizes Dr. Robert Shiller’s stock market data going back to 1900 on an inflation-adjusted basis. I then took a look at the markets prior to each major market correction and overlaid the asymmetrical bubble shape as discussed by George Soros.
There is currently much debate about the health of financial markets. Have we indeed found the “Goldilocks economy?” Can prices can remain detached from the fundamental underpinnings long enough for an economy/earnings slowdown to catch back up with investor expectations?
The speculative appetite for “yield,” which has been fostered by the Fed’s ongoing interventions and suppressed interest rates, remains a powerful force in the short term. Furthermore, investors have now been successfully “trained” by the markets to “stay invested” for “fear of missing out.”
The increase in speculative risks, combined with excess leverage, leave the markets vulnerable to a sizable correction at some point in the future. The only missing ingredient for such a correction currently is simply a catalyst to put “fear” into an overly complacent marketplace.
In the long term, it will ultimately be the fundamentals that drive the markets. Currently, the deterioration in the growth rate of earnings, and economic strength, are not supportive of the current levels of asset prices or leverage. The idea of whether, or not, the Federal Reserve, along with virtually every other central bank in the world, are inflating the next asset bubble is of significant importance to investors who can ill afford to, once again, lose a large chunk of their net worth.
It is all reminiscent of the market peak of 1929 when Dr. Irving Fisher uttered his now famous words: “Stocks have now reached a permanently high plateau.” The clamoring of voices proclaiming the bull market still has plenty of room to run is telling much the same story. History is replete with market crashes that occurred just as the mainstream belief made heretics out of anyone who dared to contradict the bullish bias.
It is critically important to remain as theoretically sound as possible. The problem for most investors is their portfolios are based on a foundation of false ideologies. The problem is when reality collides with widespread fantasy.
Does an asset bubble currently exist? Ask anyone and they will tell you “NO.” However, maybe it is exactly that tacit denial which might just be an indication of its existence.
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