Tag Archives: estimates

Charts Both Bulls & Bears Should Consider

There has been a litany of articles written recently discussing how the stock market is set for a continued bull rally and that last year’s 20% decline was just an anomaly. The are some primary points that are common threads among each of these articles which are:  1) interest rates are low, 2) corporate profitability is high, and; 3) the Fed continues to put a floor under stocks, and 4) there is no recession in sight. Each of these arguments, while currently accurate, are based primarily on artificial influences and conjecture.

  • Interest rates are low because real economic growth remains weak.
  • Profitability is high due to accounting gimmicks and share repurchases.
  • The Fed is verbally putting a floor under stocks but continues to extract liquidity from the market, and;
  • “There is no recession in sight” argument have been famous last words historically.

While the promise of a continued bull market is very enticing it is important to remember that all markets ultimately complete a “full cycle.” Therefore, if your portfolio, and ultimately your retirement, is dependent upon the thesis of an indefinite bull market, you should at least consider the following charts.

It is often stated that valuations are still cheap based on forward estimates. However, as I noted on Tuesday, forward estimates are always flawed, overly estimated, and repeatedly lead to poor outcomes over time (buy high/sell low) Therefore, trailing reported earnings is truly the only measure one should use.

The chart below shows Dr. Robert Shiller’s cyclically adjusted P/E ratio combined with Tobin’s Q-Ratio. Both measures of valuations simply show that markets are not cheap which historically lead to lower future returns.

  • Shiller’s PE Ratio – is calculated by taking the current price of the market and dividend it by the average of 10-years of reported earnings.
  • Tobin’s Q Ratio – is calculated as the market value of a company divided by the replacement value of the firm’s assets.) 

Most people dismiss valuations because of their inefficiency in dictating market turns. I understand.

However, valuations are NOT, and have never been, a market timing indicator. They are simply a “road map” to future returns.

On a much shorter time-frame, a look at the price of the market as compared to corporate profits give us a better clue. Currently, with the market is trading substantially above the level of corporate profits, any weakness in profit growth (which is heavily tied to economic growth) will foster a reversion in price.

Another way to look at the excess over time is by examining the inflation-adjusted S&P 500 index as compared to real profits. Note that previous extensions of price above profits have generally not ended well when profit growth reversed.

We recently proved this point by looking at the RIA Economic Composite Index as compared to the annual rate of change of the market. Not surprisingly, markets tend to perform poorly during weakening economic environments.

Another way to look at the issue of profits as it relates to the market is shown below. When we measure the cumulative change in the S&P 500 index as compared to the level of profits we find again that when investors pay more than $1 for a $1 worth of profits there is an eventual mean reversion.

The correlation is clearer when looking at the market versus the ratio of corporate profits to GDP. (Again, since corporate profits are ultimately a function of economic growth, the correlation is not unexpected.) With investors paying more today than at any point in history, the next mean reversion will be a humbling event.

Another argument made lately to support the bullish meme is that retail investors all jumped out of the market. The chart below shows the percentage of stocks, bonds and cash owned by individual investors according to the American Association of Individual Investor’s survey.  As you can see, equity ownership did indeed drop from the second highest level on record. However, while many are suggesting this is “bullish,” it is worth noting that historically sharp downturns have also denoted the start of bigger declines and bear markets.

As we have noted previously, investors have been leveraging up portfolios to chase the market. The issue with margin debt is NOT the increasing levels of it. Rising leverage provides buying power to continue to push stocks higher. The issue of margin debt is when it reverses. Just as margin debt increases the rise of stock prices, the reverse is also true.

The chart below shows the history of margin debt levels versus the 12-month moving average. Over the last decade, when the 12-month moving average was violated it has previously been met with Central Bank interventions. Currently, the Fed still remains on a path of reducing accommodative policy and liquidity is being slowly drained. The decline in margin debt is an additional removal of liquidity which has previously supported higher asset prices.

As a money manager, we are currently long the stock market albeit at reduced levels currently. The reality is that I must maintain exposure or potentially suffer career risk. However, my job is not only to make money for my clients, but also to preserve their gains, and investment capital, as much as possible.

The bullish case is based on expectations that current trends from the last decade will continue indefinitely, such as:

  1. Profit margins will only grow and never mean revert.
  2. Yields will remain stable at low levels.
  3. Fed rate hikes and yield curve inversions no longer matter
  4. Weakness in housing, autos, and other credit sensitive ares will not impact domestic growth.
  5. $1 Trillion+ deficits won’t slow the economy.
  6. Inflationary pressures will remain forever muted.
  7. Political turmoil will not roil markets or inhibit consumer confidence.
  8. U.S. dollar won’t appreciate to higher levels
  9. The U.S. economy can remain indefinitely decoupled from the rest of world.
  10. Trade wars and tariffs are a non-event.
  11. Corporations will continue to be the predominant purchasers of U.S. stocks.
  12. Liquidity will remain plentiful
  13. The Central Bank “put” will remain in place forever.
  14. This time is different.

Understanding these bullish arguments is important. But more importantly is the understanding that many of these beliefs have already begun to deteriorate and are substantially increasing the risk to investors and their capital. The markets will not rise indefinitely, and the eventual mean reversion will be more destructive than most realize.

Unfortunately, since most individuals only consider the “bull case,” as it creates confirmation bias for their “greed” emotion, they never see the “train coming.”

Hopefully, these charts will give you some food for thought. 

The Economy IS Slowing

In August of last year, I wrote an article entitled “As Good As It Gets which discussed the record levels being set by a broad swath of economic indicators. To wit:

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 data is hitting “record levels” it is when investors get “the most bullish.” Conversely, they are the most “bearish” at the lows.

But as investors, such is exactly the opposite of what we should do. It is just our 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

There currently seems to be a very high level of complacency that the economy will continue its current cycle indefinitely. Or should I say, there seems to be a very large consensus the economy has entered into a “permanently high plateau,” or an era in which economic recessions have been effectively eliminated through monetary and fiscal policy.

Interestingly, it is that very belief on which the Fed is dependent.  They have voiced some minor concerns over a slowing in some of the data, yet they remain committed to trailing economic data points which suggest the economy remains robust.

But herein lies “the trap” for investors.

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, “instability of stability” is now the biggest risk.

The “stability/instability paradox” assumes that all players are rational and such rationality implies avoidance of complete destruction. In other words, all players will act rationally and no one will push “the big red button.”

Again, the Fed is highly dependent on this assumption to provide the “room” needed, after a decade of the most unprecedented monetary policy program in U.S. history, to extricate themselves from it.

The Fed is dependent on “everyone acting rationally.” However, as was seen in the last two months of 2018, such may not actually be the case.

That market rout, and pressure from the White House, has caused the Fed to tilt a bit more “dovish” as of late. However, it should not be mistaken that their views have substantially changed or that they are no longer committed to the reduction of their balance sheet and hiking rates, albeit at a potentially slower pace.

There is good reason to expect that this strong [economic] performance will continue. I believe that this gradual process of normalization remains appropriate.

But that may be a mistake as I pointed out recently:

“But the cracks are already starting to appear as underlying economic data is beginning to show weakness. While the economy ground higher over the last few quarters, it was more of the residual effects from the series of natural disasters in 2017 than “Trumponomics” at work. The “pull forward” of demand is already beginning to fade as the frenzy of activity culminated in Q2 of 2018.

To see this more clearly we can look at our own RIA Economic Output Composite Index (EOCI) which is an extremely broad indicator of the U.S. economy. It is comprised of:

  • Chicago Fed National Activity Index (an index comprised of 85 subcomponents)
  • Chicago Purchasing Managers Index
  • ISM Composite Index (composite of the manufacturing and non-manufacturing surveys)
  • Richmond Fed Manufacturing Survey
  • New York (Empire) Manufacturing Survey
  • Philadelphia Fed Manufacturing Survey
  • Dallas Fed Manufacturing Survey
  • Markit Composite Manufacturing Survey
  • PMI Composite Survey
  • Economic Confidence Survey
  • NFIB Small Business Index 
  • Leading Economic Index (LEI)

All of these surveys (both soft and hard data) are blended into one composite index which, when compared to U.S. economic activity, has provided a good indication of turning points in economic activity.

As shown, the slowdown in economic activity has been broad enough to turn this very complex indicator lower.

One of the components of the EOCI is the Leading Economic Index (LEI) which is a strong leading indicator of the economy as shown below.

The recent downturn in the LEI suggests economic data will likely be weaker in the quarters ahead. However, this downturn wasn’t a surprise and was something I showed would be the case in July of 2018.

As shown, over the last six months, the decline in the LEI has actually been sharper than originally anticipated. Importantly, there is a strong historical correlation between the 6-month rate of change in the LEI and the EOCI index. As shown, the downturn in the LEI predicted the current economic weakness and suggests the data is likely to continue to weaken in the months ahead.

Another component of the EOCI is the National Federation of Small Business index. In 2018, that index peaked at a record of 108.8 and has since fallen more than 4-points in recent months. While it has been of little concern to the media, it should be noticed that at no point in history did the index peak at a record and not substantially decline over the coming months.

More importantly, notice that peaks in the optimism have previously always occurred shortly after a recession ended, not nearly a decade into an economic upturn. Such suggests the time between the current peak and the next recessionary spat could be closer than seen previously.

However, while small business owners are still “saying” they are optimistic, they are not necessarily acting that way. A look at their level of economic confidence versus their capital expenditures suggests a much more cautious stance relative to their level of “optimism.”

Currently, their level of capital expenditures has plunged back to levels more often seen during a recessionary period than a burgeoning economic upswing.

The same goes for the difference between the “expectation of sales” versus their “actual sales.”

Notice that actual sales are always less than expectations, but the current gap is one of the largest on record. More importantly, both actual and expected sales have turned lower in recent months which was during the seasonally strong Christmas shopping period.

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.” 

However, while the Fed is focused on what has happened in the past, the market is focused on what will happen in the future. What the current trend of economic data suggests is that the global economic weakness, which we have been discussing for the last few months, has now come home to roost. As shown below, the EOCI index has provided a leading indication historically to market weakness. The difference between small corrections and larger declines was determined by the secular period of the market.

What shouldn’t be overlooked, is that the risk to investors is a negative impact to corporate profitability in the quarters ahead. Valuations are still a major issue for investors as corporate profits have not grown over the last 8-years. (They have only set a record recently on an “after tax” basis due to recent legislative changes.)

Of course, changing profits on the bottom line of the corporate balance sheet is not what drives the economy. That comes from consumption, and if pretax corporate profits aren’t growing, neither is revenue which is consistent with the modest rates of economic growth seen over the last decade.

This is why both the Fed, and the markets, are very dependent on “stability.” As long as no one asks the “tough questions,” the bullish thesis can continue as momentum and psychology remain intact.

Unfortunately, as seen in the last quarter of 2018, “instability” can happen very quickly leaving investors with little time to react. The recent market rout was likely a warning sign that investors should not dismiss as a “one-off” event.

  • The Federal Reserve is still looking to increase rates.
  • They are also committed to continuing the reduction of their balance sheet which is extracting liquidity from the financial markets.
  • Even if the Fed doesn’t hike rates further, rates are still materially higher than they were two-years ago which is impinging consumers discretionary incomes.
  • Earnings estimates are still too high
  • China is becoming a bigger problem.
  • Debt remains a substantial problem as default risks increase
  • Domestic economic weakness, as shown, is gaining traction
  • The Global economy is weakening at a faster pace than the US economy, and;
  • Markets have begun to show their vulnerabilities.

What happens next is anyone’s guess, but erring to the side of caution currently will likely turn out to be a good decision.

What Will Cause The Next Recession?

J. Bradford Delong wrote a very interesting article discussing the trigger for the next recession. 

“Three of the last four US recessions stemmed from unforeseen shocks in financial markets. Most likely, the next downturn will be no different: the revelation of some underlying weakness will trigger a retrenchment of investment, and the government will fail to pursue counter-cyclical fiscal policy.

Over the past 40 years, the US economy has experienced four recessions. Among the four, only the extended downturn of 1979-1982 had a conventional cause. The US Federal Reserve thought that inflation was too high, so it hit the economy on the head with the brick of interest-rate hikes. As a result, workers moderated their demands for wage increases, and firms cut back on planned price increases.

The other three recessions were each caused by derangements in financial markets. After the savings-and-loan crisis of 1991-1992 came the bursting of the dot-com bubble in 2000-2002, followed by the collapse of the sub-prime mortgage market in 2007, which triggered the global financial crisis the following year.”

While I agree with Bradford’s point, I think there is a disconnect between the crises he points out and repeated behaviors which lead to those events.

Let’s review some basic realities about the economy that seems to be lost on the mainstream media. 

First, this is NOT an economic cycle:

This is:

Despite the hopes the economy will continue into an everlasting expansion, such has historically never been the case. The current economic expansion, which has been driven by massive infusions of liquidity, extremely accommodative interest rate policy, and a surge in debt accumulation, is just 4-months away from setting a new record. 

Secondly, while the recession prior to 1980 was driven by a super-aggressive Fed rate tightening policy, since 1950 we can find fingerprints of monetary policy in every event.

I am not saying that just because the Fed hikes rates, that a recession, or crisis, will be triggered.

What I am saying is that over the entire rate cycle, the Fed has fostered the credit driven expansion and laid the groundwork necessary for a crisis to be born.

Let’s revisit Bradford’s three specific crises.

The S&L Crisis

The savings and loan crisis of the 1980s and 1990s (commonly dubbed the S&L crisis) was the failure of 1,043 out of the 3,234 savings and loan associations in the United States from 1986 to 1995.

However, just looking at the event we miss the bigger picture.

If we go back in time before the crisis began, we find an environment where the Federal Reserve had drastically lowered the overnight lending rates in order to spur more borrowing and economic activity coming out of the back-to-back recessions of the late ’70s and early ’80s.

Of course, in a capitalist-driven economy, as demand for loans for cars, housing, businesses, etc. rose; bankers figured out ways to continue to extend credit in order to maximize their profitability. As is always the case, greed over took prudence and many bankers relaxed risk management protocols which would ultimately cost them their jobs and in many cases the bank.

Of course, in 1979, when the Federal Reserve hiked the discount rate from 9.5% to 12%, ostensibly to quell inflation pressures, it also slowed the economy. Since the S&L’s had issued long-term loans at fixed rates lower than the now higher rate at which they could borrow the rise in rates combined with rising default rates, led to insolvency.

Probably the most famous example from the S&L Crisis period was
that of financier Charles Keating, who paid $51 million financed through Michael Milken’s “junk bond” operation, for his Lincoln Savings and Loan Association which at the time had a negative net worth exceeding $100 million.

The Dot.Com Bubble

While the “dot.com” bubble is often thought of as a one-off event caused by speculative excess, there was actually much more going on at the time.

Many have forgotten the names of Enron, WorldCom, Global Crossing, and other booming tech companies which were riff with financial shenanigans at the time which ultimately led to the passage of the Sarbanes-Oxley Act.

However, again, we can’t look at just the event itself but need to go back prior to the event to understand the groundwork that was laid.

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.

Of course, it wasn’t long until the Federal Reserve, again concerned about the prospect of rising inflation and an overheating economy, started hiking rates. As monetary policy became more restrictive, the cost of capital rose, and the economy slowed.

It wasn’t long before the system came unglued.

The Great Financial Crisis

In response to the “Dot.com” crisis, the Federal Reserve once again drastically lowered interest rates to spur economic growth.

This was also the point where the Bush Administration, along with the Alan Greenspan headed Federal Reserve, decided that “everyone” should own a home. Lending standards were relaxed and a variety of new mortgage structures were introduced by Wall Street in the quest to make money.

Over the next several years, as lending rates declined, and everyone wanted to buy into the surging housing market, Wall Street packaged mortgages into exotic instruments allowing them to sell the mortgages to investors. The cycle continued with ever increasing demand from home buyers and demand from investors.

As the housing market boomed, the stock market fully recovered from the “dot.com” crash, and with the economy booming, the Federal Reserve, now under the leadership of Ben Bernanke, decided to start tightening monetary policy in the belief that inflation was an imminent threat from an overheating economy.

But there were no pressing concerns as it was believed that “subprime mortgage loans were contained” and the ongoing “Goldilocks economy” would continue uninterrupted.

They weren’t and it didn’t.

If you are interested in this crisis we urge you to read or watch The Big Short by Michael Lewis

The Common Threads

While each of these events were much more complex than what I have outlined here, there were many others along the way like the Russian Debt Default, The Asian Contagion, and Long-Term Capital Management, which all shared important commonalities between them.

In each case we find that prior to the event the Federal Reserve was loosening monetary policy to spur economic growth following a preceding economic downturn. They did this to halt the downturn but in doing so failed to allow the system to clear itself over time.

Looser monetary policy, and continuing relaxation of regulations led to excessive greed by the primary players in the market which was supported by a rising level of speculative frenzy and easy access to capital by investors.

In other words, instead allowing the system to clear the previous build up of excesses, the Federal Reserve intervened to keep that process from happening. As a result, each crisis has been worse than the one before it because the debt and leverage in the system continues to mount.

As shown in the chart below, whenever the Federal Reserve previously loosened monetary policy, debt as a percentage of the economy surged. Naturally, when monetary policy was reversed, things tended to go bad…and generally very quickly.

Since 1980, the eventual and inevitable unwind of an overly levered system was met by a drastic drop in the Fed Funds rate to stimulate debt induced consumption and spur economic activity. The problem, is that each effort by the Fed to limit the impact to the system has required a lower interest rate than the one that preceded.

With rates near the lowest level on record still, the next event will once again require dramatic measures to stem the unwinding of a decade long, debt supported, economic cycle.

But this is where Bradford gets it absolutely right about the cause of the next recession.

“Specifically, the culprit will probably be a sudden, sharp ‘flight to safety’ following the revelation of a fundamental weakness in financial markets. “

Of course, such has always been the case when it comes to the financial markets.

However, the risk of a recession has continue to rise in recent months with plenty of warnings already showing up from a near-inverted yield curve, declining economic momentum, low nominal and real bond yields, and struggling stock prices

The problem, as Bradford notes, is the next financial cataclysm may well fall outside of the capability of the Federal Reserve and Government to neutralize.

“If a recession comes anytime soon, the US government will not have the tools to fight it. The White House and Congress will once again prove inept at deploying fiscal policy as a counter-cyclical stabilizer; and the Fed will not have enough room to provide adequate stimulus through interest-rate cuts. As for more unconventional policies, the Fed most likely will not have the nerve, let alone the power, to pursue such measures.”

As a result, for the first time in a decade, Americans and investors cannot rule out a downturn. At a minimum, they must prepare for the possibility of a deep and prolonged recession, which could arrive whenever the next financial shock comes.”

He is absolutely correct in his assessment of the impact of the next fiscal problem. When it comes, it will be totally unexpected, unanticipated, and unprepared for by investors. Such has always been the case through out history.

But there is one thing that all these crises have in common.

A belief by the Federal Reserve that inflation is going to be problem and that they can control inflation through monetary policy.

This time will be no different.

The Problem With Wall Street’s Forecasts

Over the last few weeks, I have been asked repeatedly to publish my best guess as to where the market will wind up by the end of 2019.

Here it is:

“I don’t know.”

The reality is that we can not predict the future. If it was actually possible, fortune tellers would all win the lottery.  They don’t, we can’t, and we aren’t going to try.

However, this reality certainly does not stop the annual parade of Wall Street analysts from pegging 12-month price targets on the S&P 500 as if there was actual science behind what is nothing more than a “WAG.” (Wild Ass Guess).

The biggest 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 show that 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.

Most importantly, the reason 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 “analyst’s forecasts have been almost 100% too high” which leads investors into making much more aggressive bets in the financial markets which has a general tendency of not working as well as planned.

However, since “optimism” is what sells products, it is not surprising, as we head into 2019, to see Wall Street once again optimistic about higher markets even after massively missing 2018’s outcome.

But, that was so last year.

For 2019, analysts have outdone themselves on scrambling to post the most bullish of outcomes that I can remember. Analysts currently expect a median projected return of 23.66% from the 2018 close.

No…seriously. This is what Wall Street is currently expecting despite the fact that foreign and domestic economic data is weakening, corporate profit growth is likely peaking, trade wars are heating up and the Federal Reserve is tightening monetary policy. As Greg Jensen, co-chief investment officer of Bridgewater Associates, the biggest hedge fund in the world, recently stated: 

“The biggest theme developing is that you are going to have significantly weaker growth, near recession-level growth in 2019, based on our measures, and the markets are generally not pricing that in.

Although the movement has been in that direction, the degree of [ the market’s decline] is still small relative to what we are seeing in terms of the shifts in likely economic conditions.  2019 will be a year of weaker growth and central banks struggling to move from their current tightening stance to easing and finding it difficult to ease because they have very little ammunition to ease.”

All of this should sound very familiar if you have been reading our work over the past year.

The problem with the year-end “guesses” above is they are based on “forward operating earnings estimates” which is another set of severely flawed “WAG’s” on top of a “WAG.”

Let me explain.

First, operating earnings are at best a myth, and mostly a lie. As opposed to reported earnings, operating earnings are essentially “earnings if everything goes right with all the bad stuff excluded.”

Secondly, operating earnings are cooked, baked, and fudged in more ways than you can imagine to win the “beat the estimate gaime.” The Wall Street Journal confirmed as much in a 2012 article entitled “Earnings Wizardry” which stated:

“If you believe a recent academic study, one out of five [20%] U.S. finance chiefs have been scrambling to fiddle with their companies’ earnings. Not Enron-style, fraudulent fiddles, mind you. More like clever—and legal—exploitations of accounting standards that ‘manage earnings to misrepresent [the company’s] economic performance,’ according to the study’s authors, Ilia Dichev and Shiva Rajgopal of Emory University and John Graham of Duke University. Lightly searing the books rather than cooking them, if you like.”

This should not come as a major surprise as it is a rather “open secret.” Companies manipulate bottom line earnings by utilizing “cookie-jar” reserves, heavy use of accruals, and other accounting gimmicks to either increase or depress, earnings.


“The tricks are well-known: A difficult quarter can be made easier by releasing reserves set aside for a rainy day or recognizing revenues before sales are made, while a good quarter is often the time to hide a big ‘restructuring charge’ that would otherwise stand out like a sore thumb. What is more surprising though is CFOs’ belief that these practices leave a significant mark on companies’ reported profits and losses. When asked about the magnitude of the earnings misrepresentation, the study’s respondents said it was around 10% of earnings per share.”

Since company executives are highly compensated by rising stock prices, it should not be surprising to see 93% of the respondents pointing to “influence on stock price” and “outside pressure” as reasons for manipulating earnings.

Note: For fundamental investors, this manipulation of earnings skews valuation analysis particularly with respect to P/E’s, EV/EBITDA, PEG, etc.

This was brought to the fore in 2015 by the Associated Press in: “Experts Worry That Phony Numbers Are Misleading Investors:”

“Those record profits that companies are reporting may not be all they’re cracked up to be.

As the stock market climbs ever higher, professional investors are warning that companies are presenting misleading versions of their results that ignore a wide variety of normal costs of running a business to make it seem like they’re doing better than they really are.

What’s worse, the financial analysts who are supposed to fight corporate spin are often playing along. Instead of challenging the companies, they’re largely passing along the rosy numbers in reports recommending stocks to investors.

Here were the key findings of the report:

  • Seventy-two percent of the companies reviewed by AP had adjusted profits that were higher than net income in the first quarter of this year.
  • For a smaller group of the companies reviewed, 21 percent of the total, adjusted profits soared 50 percent or more over net income. This was true of just 13 percent of the group in the same period five years ago.
  • From 2010 through 2014, adjusted profits for the S&P 500 came in $583 billion higher than net income. It’s as if each company in the S&P 500 got a check in the mail for an extra eight months of earnings.
  • Fifteen companies with adjusted profits actually had bottom-line losses over the five years. Investors have poured money into their stocks just the same.
  • Stocks are getting more expensive. Three years ago, investors paid $13.50 for every dollar of adjusted profits for companies in the S&P 500 index, according to S&P Capital IQ. Now, they’re paying nearly $18.

These “gimmicks” to boost earnings, combined with artificially suppressed interest rates and massive rounds of monetary interventions, unsurprisingly pushed asset prices to historically high levels. However, as noted, the boost to “profitability” did not come from organic economic growth. As I showed previously:

“Since the recessionary lows, much of the rise in ‘profitability’ has come from a variety of cost-cutting measures and accounting gimmicks rather than actual increases in top-line revenue. While tax cuts certainly provided the capital for a surge in buybacks; revenue growth, which is directly connected to a consumption-based economy, has remained muted. 

Here is the real kicker. Since 2009, the reported earnings per share of corporations has increased by a total of 391%. This is the sharpest post-recession rise in reported EPS in history. However, the increase in earnings did not come from a commensurate increase in revenue which has only grown by a marginal 44% during the same period. This is an important point when you realize only 11% of total reported EPS growth actually came from increased revenues.”

“While stock buybacks, corporate tax cuts, and debt-issuance can create an illusion of profitability in the short-term, the lack of revenue growth the top line of the income statement suggests a much weaker economic environment over the long-term.”

Way Too Optimistic

With share buyback activity already beginning to slow, the Federal Reserve extracting liquidity from the financial markets, and the Administration continuing their “trade war,” the risks to extremely elevated forward earnings estimates remain high. We are already seeing the early stages of these actions through falling home prices, automobile sales, and increased negative guidance for corporations.

If history, and logic, is any guide, we will likely see the U.S. economy pushing into a recession in 2019 particularly as the global economy continues to weaken. This is something both domestic and global yield curves are already screaming is an issue, but to which few are listening.

Currently, analysts’ forward earnings estimates are still way too lofty going into 2019. As I noted in the recent missive on rising headwinds to the market, earnings expectations have already started to get markedly ratcheted down for the end of 2019. In just the last 45-days the estimates for the end of 2019 have fallen by more than $14/share. The downside risk remains roughly $10/share lower than that and possibly much more if a recession hits.

As stated, beginning in 2019, the estimated quarterly rate of change in earnings will drop markedly and head back towards the expected rate of real economic growth. (Note: these estimates are as of 12/31/18 from S&P and are still too high relative to expected future growth. Expect estimates to continue to decline which allow for continued high levels of estimate “beat” rates.)

The end of the boost from tax cuts has arrived.

Since the tax cut plan was poorly designed, to begin with, it did not flow into productive investments to boost economic growth. As we now know, it flowed almost entirely into share buybacks to boost executive compensation. This has had very little impact on domestic growth.

The “sugar high” of economic growth seen in the first two quarters of 2018 has been from a massive surge in deficit spending and the rush by companies to stockpile goods ahead of tariffs. These activities simply pull forward “future” consumption and have a very limited impact but leave a void which must be filled in the future.

Nearly a full year after the passage of tax cuts, we face a nearly $1 Trillion deficit, a near-record trade deficit, and, as expected, economic and earnings reports are now showing markedly weaker projections. Apple (AAPL) is just the first of many companies that will confirm this in the coming weeks.

It is all just as we predicted.

The problem when it comes to blindly invest in markets without a thorough understanding of underlying dynamics is much the same as playing “leapfrog with a unicorn,” eventually, there is a very negative outcome.

As we head into 2019, all of the anecdotal evidence continues to suggest weaker markets rather than a surging recovery.

But, that is just a guess.

As I said, I honestly “don’t know.”

What I do know is that I will continue to manage our portfolios for the inherent risks to capital, take advantage of opportunities when I see them, and will allow the market to “tell me” what it wants to do rather than “guessing” at it.

While I read most of the mainstream analyst’s predictions to get a gauge on the “consensus.”  This year, more so than most, the outlook for 2019 is universally, and to many degrees, exuberantly bullish.

What comes to mind is Bob Farrell’s Rule #9 which states:

“When everyone agrees…something else is bound to happen.”

The Money Game & The Human Brain

Jason Zweig, a neuroscience and Benjamin Graham expert, re-published an article last year entitled: “Ben Graham, The Human Brain, And The Bubble.” The entire article is a worthy read but there were a few points in particular he made that are just as relevant today as they were when he wrote the original essay in 2003.

“At the peak of every boom and in the trough of every bust, Benjamin Graham‘s immortal warning is validated yet again: ‘The investor’s chief problem — and even his worst enemy — is likely to be himself.'” 

I have written about the psychological issues which impede investors returns over longer-term time frames in the past. They aren’t just psychological, but also financial. To wit:

“Another common misconception is that everyone MUST be saving in their 401k plans through automated contributions. According to Vanguard’s recent survey, not so much.

  • The average account balance is $103,866 which is skewed by a small number of large accounts.
  • The median account balance is $26,331
  • From 2008 through 2017 the average inflation-adjusted gain was just 28%. 

So, what happened?

  • Why aren’t those 401k balances brimming over with wealth?
  • Why aren’t those personal E*Trade and Schwab accounts bursting at the seams?
  • Why are so many people over the age of 60 still working?

While we previously covered the impact of market cycles, the importance of limiting losses, the role of starting valuations, and the proper way to think about benchmarking your portfolio, the two biggest factors which lead to chronic investor underperformance over time are:

  • Lack of capital to invest, and;
  • Psychological behaviors

Psychological factors account for fully 50% of investor shortfalls in the investing process. It is also difficult to ‘invest’ when the majority of Americans have an inability to ‘save.'”

“These factors, as shown by data from Dalbar, lead to the lag in performance between investors and the markets over all time periods.”

While “buy and hold” and “dollar cost averaging” sound great in theory, the actual application is an entirely different matter. Ultimately, as individuals, we do everything backwards. We “buy” when market exuberance is at its peak and asset prices are overvalued, and we “sell” when valuations are cheap and there is a “rush for the exits.” 

Behavioral biases are an issue which remains little understood and accounted for when individuals begin their investing journey. Dalbar defined (9) nine of these behavioral biases specifically:

  • Loss Aversion – The fear of loss leads to a withdrawal of capital at the worst possible time.  Also known as “panic selling.”
  • Narrow Framing – Making decisions about on part of the portfolio without considering the effects on the total.
  • Anchoring – The process of remaining focused on what happened previously and not adapting to a changing market.
  • Mental Accounting – Separating performance of investments mentally to justify success and failure.
  • Lack of Diversification – Believing a portfolio is diversified when in fact it is a highly correlated pool of assets.
  • Herding– Following what everyone else is doing. Leads to “buy high/sell low.”
  • Regret – Not performing a necessary action due to the regret of a previous failure.
  • Media Response – The media has a bias to optimism to sell products from advertisers and attract view/readership.
  • Optimism – Overly optimistic assumptions tend to lead to rather dramatic reversions when met with reality.

Cognitive biases impairs our ability to remain emotionally disconnected from our money.

But it isn’t entirely your fault. The Wall Street marketing machine, through effective use of media, have changed our view of investing from a “process to grow savings over time” to a “get rich quick scheme” to offset the shortfall in savings. Why “save” money when the market will “make you rich?”

As I addressed in “Retirees Face A Pension Crisis Of Their Own:”

Using faulty assumptions is the linchpin to the inability to meet future obligations. By over-estimating future returns, future retirement values are artificially inflated which reduces the required saving amounts need by individuals today. Such also explains why 8-out-of-10 American’s are woefully underfunded for retirement currently.”

The Illusion Of Control

Jason discussed another important psychological barrier to our success.

Online trading firms went further, blowing the traditional brokerage model to bits. With no physical branch offices, no in-house research, no investment banking, and no brokers, they had only one thing to offer their customers: the ability to trade at will, without the counterweight of any second opinion or expert advice. Once, that degree of freedom might have frightened investors. But the new Internet brokerages cleverly fostered what psychologists call ‘the illusion of control’ — the belief that you are at your safest in an automobile when you are the driver. Investors were encouraged to believe that the magnitude of their portfolio’s return would be directly proportional to the amount of attention they paid to it — and that professional advice would reduce their return.”

The “illusion of control,” is another behavioral bias that individuals regularly face. When stock prices are rising, especially in a momentum-driven market, individuals believe that have it “all figured out.” The inherent problems which arise from this “over-confidence” are the layering of “risks” in portfolios which are misunderstood until a correction process begins. As I wrote previously:

“Bull markets hide investing mistakes, bear markets reveal them.” 

The reality is that as individuals we are NOT investors, but rather just speculators hoping the share of stock we purchased today, will be able to be sold at a higher price later. Unfortunately, since individuals are told to “buy,” but never “sell,” only one-half of the investment process is completed.

In other words, the illusion we are in “control” is simply that. Logically, we know we should “buy low” and “sell high.” Yet it is the entirety of our other behavioral biases that keep us from doing so. But most importantly, it is the consistent message from the mainstream media which “feeds our greed” that asset prices will only move higher…and you surely don’t want to miss out on that.

(Read: Experience Is The Only Cure)

The Video Game 

Another risk Jason points out is our “addiction.”

“Psychologist Marvin Zuckerman at the University of Delaware has written about a form of risk called ‘sensation-seeking’ behavior. This kind of risk — people daring each other to push past the boundaries of normally acceptable behavior — is largely a group phenomenon (as anyone who has ever been a teenager knows perfectly well). People will do things in a social group that they would never dream of doing in isolation.”

As individuals, we are “addicted” to the “dopamine effect.” It is why social media has become so ingrained in society today as individuals constantly look to see how many likes, shares, retweets, or comments they have received. That instant gratification and acknowledgment keep us glued to our screens and less involved in the world around us.

We are addicted.

As Jason notes, a team of researchers have proved this point:

“Wolfram Schultz at Cambridge and Read Montague at Baylor in Houston, Texas, have shown that the release of dopamine, the brain chemical that gives you a ‘natural high,’ is triggered by financial gains. The less likely or predictable the gain is, the more dopamine is released and the longer it lasts within the brain. Why do investors and gamblers love taking low-probability bets with high potential payoffs? Because, if those bets do pay off, they produce an actual physiological change — a massive release of dopamine that floods the brain with a soft euphoria.

After a few successful predictions of financial gain, speculators literally become addicted to the release of dopamine within their own brains. Once a few trades pay off, they cannot stop the craving for another ‘fix’ of profits — any more than an alcoholic or a drug abuser can stop craving the bottle or the needle.”

Fortunately, we have support groups to help with most of our addictions from alcohol to gambling. While these groups are there to help us curb our addictive and destructive behaviors for some things, the investing world is full of groups which exist to “feed” our investing addiction.

“Until the advent of the Internet, there was simply no such thing as a network or support group for risk-crazed retail traders. Now, quite suddenly, there was — and with every gain each of them scored, they goaded the other members of the group on to take even more risk. Comments like ‘PRICE IS NO OBJECT’ and ‘BUY THE NEXT MICROSOFT BEFORE IT’S TOO LATE’ and ‘I’LL BE ABLE TO RETIRE NEXT WEEK’ became commonplace.

And the public was urged to hurry. ‘EVERY SECOND COUNTS,’ went the slogan of Fidelity’s discount brokerage — implying that investors could somehow achieve their long-term goals by engaging in short-term behavior.”

By using technology to turn investing into a video game — lines snaking up and down a glowing screen, arrows pulsating in garish hues of red and green — the online brokerages were tapping into fundamental forces at work in the human brain.”

What are the most popular apps on our “smartphones?” 

Video games and social media.

Why, because of the “dopamine” our brain releases.

This is why apps like “Robinhood” and “Stash” that allow for online trading straight from our phones have gained in such popularity. The “immediacy effect” of instant feedback on success or failure keeps us clicking for next winner. Wall Street has become a full-blown casino with individuals lining up to pull the lever to see if they are the next big winner. But, just as it is in Las Vegas, the “house usually wins.” 

The Prediction Addiction

Adding to our list of behavioral flaws and biases when it comes to investing, Jason points out another:

“In 1972, Benjamin Graham wrote: ‘The speculative public is incorrigible. In financial terms it cannot count beyond 3.  It will buy anything, at any price, if there seems to be some ‘action’ in progress.’ – Graham, The Intelligent Investor, pp. 436-437.

In a stunning confirmation of his argument, the latest neuroscientific research has shown that Graham was not just metaphorically but literally correct that speculators ‘cannot count beyond 3.’ The human brain is, in fact, hard-wired to work in just this way: pattern recognition and prediction are a biological imperative.

Scott Huettel, a neuropsychologist at Duke University, recently demonstrated that the anterior cingulate, a region in the central frontal area of the brain, automatically anticipates another repetition after a stimulus occurs only twice in a row. In other words, when a stock price rises on two consecutive ticks, an investor’s brain will intuitively expect the next trade to be an uptick as well.

This process — which I have christened ‘the prediction addiction’ — is one of the most basic characteristics of the human condition. Automatic, involuntary, and virtually uncontrollable, it is the underlying neural basis of the old expression, ‘Three’s a trend.’ Years ago, when most individual investors could obtain stock prices only once daily, it took a minimum of three days for the ‘I get it’ effect to kick in. But now, with most websites updating stock prices every 20 seconds, investors readily believed that they had spotted sustainable trends as often as once a minute.”

While individuals regularly proclaim to be “long-term investors,” the average holding period for stocks has shrunk from more than 6-years in the 1970’s to less than 6-months currently.

The Advisor’s Role

These psychological and behavioral issues are exceedingly difficult to control and lead us regularly to making poor investment decisions over time. But this is where the role of an “advisor” should be truly defined and valued.

While the performance chase, a by-product of the very behavioral issues we wish to control, leads everyone to seek out last years “hottest” performing manager or advisor, this is not really the advisor’s main role. The role of an Advisor is NOT beating some random benchmark index or to promote a “buy and hold” strategy. (There is no sense in paying for a model you can do yourself.)

Jason summed it well:

“The only legitimate response of the investment advisory firm, in the face of these facts, is to ensure that it gets no blood on its hands. Asset managers must take a public stand when market valuations go to extremes — warning their clients against excessive enthusiasm at the top and patiently encouraging clients at the bottom.”

Given that individuals are emotional and subject to emotional swings caused by market volatility, the Advisors role is not only to be a portfolio manager, but also a psychologist. Dalbar suggested four successful practices to reduce harmful behaviors:

  1. Set Expectations below Market Indices: Change the threshold at which the fear of failure causes investors to abandon an investment strategy. Set reasonable expectations and do not permit expectations to be inferred from historical records, market indexes, personal experiences or media coverage. The average investor cannot be above average. Investors should understand this fact and not judge the performance of their portfolio based on broad market indices.
  2. Control Exposure to Risk: Include some form of portfolio protection that limits losses during market stresses.
    Explicit, reasonable expectations are best set by agreeing on a goal that consists of a predetermined level of risk and expected return. Keeping the focus on the goal and the probability of its success will divert attention away from frequent fluctuations that lead to imprudent actions
  3. Monitor Risk Tolerance: Periodically reevaluate investor’s tolerance for risk, recognizing that the tolerance depends on the prevailing circumstances and that these circumstances are subject to change.
    Even when presented as alternatives, investors intuitively seek both capital preservation and capital appreciation. Risk tolerance is the proper alignment of an investor’s need for preservation and desire for capital appreciation. Determination of risk tolerance is highly complex and is not rational, homogenous nor stable.
  4. Present forecasts in terms of probabilities: Simply stating that past performance is not predictive creates a reluctance to embark on an investment program.
    Provide credible information by specifying probabilities or ranges that create the necessary sense of caution without negative effects. Measuring progress based on a statistical probability enables the investor to make a rational choice among investments based on the probability of reward.

The challenge, of course, it understanding that the next major impact event, market reversion, will NOT HAVE the identical characteristics of the previous events. This is why comparing today’s market to that of 2000 or 2007 is pointless. Only the outcome will be the same.

One thing that all the negative behaviors have in common is that they can lead investors to deviate from a sound investment strategy that was narrowly tailored towards their goals, risk tolerance, and time horizon.

The best way to ward off the aforementioned negative behaviors is to employ a strategy that focuses on one’s goals and is not reactive to short-term market conditions. The data shows that the average mutual fund investor has not stayed invested for a long enough period of time to reap the rewards that the market can offer more disciplined investors. The data also shows that when investors react, they generally make the wrong decision.

The reality is that the majority of advisors are ill-prepared for an impact event to occur. This is particularly the case in late-stage bull market cycles where complacency runs high.

When the impact event occurs, advisors who are prepared to handle responses, provide clear messaging, and an action plan for both conserving investment capital and eventual recovery will find success in obtaining new clients.

The discussion of why “this time is not like the last time” is largely irrelevant. Whatever gains that investors garner in the between now and the next impact event by chasing the “bullish thesis” will be largely wiped away in a swift and brutal downdraft. Of course, this is the sad history of individual investors in the financial markets as they are always “told to buy” but never “when to sell.”

You can do better.

Experience Is The Only Cure

I recently penned an article which discussed the Fed and the risk of a monetary policy error in the future. This isn’t a possibility, it is a probability given that every Fed rate-hiking campaign in the past has led to a financial market-related event, recession, or worse.

Of course, when you publish views on a regular basis it always attracts those“individuals” who want to consistently deride and distract an otherwise informed debate. Normally, I don’t respond to comments because there is nothing to be gained in trying to persuade someone who is already convicted of their beliefs.

As my dad use to tell me growing up: “The only permanent cure of ignorance, is experience.”

I am going to make an exception this week as a recent comment brought to light many of the common media-driven narratives about investing. The comment was long, so I have broken it down to highlight the important points which need addressing.

The Lie Of Percentages

“The average bear market lasts 1.4 years on average and falls 41% on average.-The average bull market (when the market is rising) lasts 9.1 years on average and rises 476% on average. This fact confirms that Bull Markets do rise 10 TIMES LONGER than bear markets. And they last SIX LONGER. Those are facts.”

While the statement is not false, it is a false narrative. (It is important to remember the “buy and hold” revolution was developed by Wall Street firms beginning in the late 1980’s to shift the industry from a “transactional basis” to an “annuitized” income stream. It is great for them, not necessarily for you.)

Using “percentage changes” distorts to the true impact to what happens to investors over time. The chart below shows the PERCENTAGE return of each bull and bear market going back to 1900. (The chart is the S&P 500 Total Return Inflation-Adjusted index.)

Clearly, the point made is valid that bull markets rise 10x, more and last 6x as long, as bear markets.

“Lies, Damned Lies, and Statistics.” – Mark Twain

Here are the basics of math.

  • If the index goes from 100 to 200 it is indeed a 100% gain.
  • If the index goes from 200 back to 100, it is only a 50% loss.
  • Mathematically it would seem as if an investor is still 50% ahead, the net return is actually ZERO.

This is the error of measuring returns in terms of percentages. To understand the real impact of bull and bear markets on a portfolio it must be measured in POINTS rather than percentages.

When measured in points, the damage becomes more apparent as bull markets have been almost entirely wiped out by subsequent bear markets.

The other problem, as shown in the chart below, is the lost time required to get back to even following a bear market. During these periods, wealth is not compounded and time required to achieve financial goals is lost.

(It is worth noting the entirety of the markets return over the last 118-years occurred in only 4-periods: 1925-1929, 1959-1968, 1990-2000, and 2016-present)

Since most investors only have 20 to 30-years to reach their goals, if that period begins when valuations are elevated, the odds of success falls dramatically.

Time Is An Unkind Companion

The point of “time” is critical.

While it is nostalgic to use 100+ years of market data to try and prove a point about the benefits of “buy and hold” investing, the reality is that we “mere mortals” do not have the life-span required to achieve those returns.

As I stated in my last missive:

“Despite the best of intentions, a vast majority of the ‘bullish’ crowd today have never lived through a real bear market.”

I have been managing money for people for a very long time. The one simple truth is that once an individual has lost a large chunk of their savings, they are very reluctant to go through such an experience a second time. This is particularly the case as individuals get ever closer to their retirement age.

The reader’s next comment clearly showed a lack experience in how a true bear market destroys someone’s financial, and family, life.

“Since 1950, there have 36 stock market corrections (or once every 2 years). All 36 of these stock market corrections have been completely erased within a matter of weeks and months. 36 out of 36 is a 100% success rate. Buying any major dip in the S&P 500 has been a virtual guarantee of higher returns.”

The statement is true. It just proves two points.

  1. If an investor had bought the lows they would have indeed garnered higher returns. However, such means the “highs were sold” and not “bought and held.” (You can’t “buy low” if you don’t “sell high”)
  2. A lack of understanding of the impact of getting back to even.

The purpose of investing is to:

 “Grow savings at a rate which maintains the same purchasing power parity in the future and provides a stream of living income.” 

Nowhere in that statement is a requirement to “beat a benchmark index.” 

For most people, a $1 million account sounds like a lot of money. It’s a big, fat round number. The problem is that the end number is much less important than what it can generate. The table below shows $1,000,000 and what it can generate at varying interest rate levels.

30-years ago, when prevailing rates were substantially higher, and living standards were considerably cheaper, a $1,000,000 nest egg was substantial enough to support retirement when combined with social security, pensions, etc.

Today, that story is substantially different. Again, the REASON we invest is not to “beat the market,” but rather to “grow” our hard-earned “savings” at a rate to offset inflation over time. 

Let’s use an example. An individual who earns $75,000 a year in 1988 starts with a $100,000 investment. The purple line shows the portfolio value required, on an inflation adjusted basis, to replace a $75,000/per year income stream at a 3% withdrawal rate 30-years into the future. The gold line is our reader’s “buy and hold” approach. The blue line uses a simple 12-month moving average to switch from stocks to cash, and vice versa, whenever the S&P 500 breaches the average. Both charts are inflation-adjusted total return indices with $625 monthly contributions (a 10% annual savings rate). 

While “buying and holding” the S&P 500 index did indeed achieve a respectable outcome, spending numerous years getting “back to even” devastated the compounding effect of the portfolio. Even with “dollar cost averaging,” the benefit of three major bull market advances, and falling rates of inflation, investors were still left extremely short of their investment goals. Only by avoiding the two major drawdowns would investors accumulate enough money to fund their retirement needs.

But that statement almost always elicits two more comments: 1) You can’t time the market, and 2) active managers always underperform their benchmark.

  • First, I am not a “market timer,” which is being “all in” or “all out” of the market at any given time. However, I do believe there are times I want less capital exposed to equity risk than others. Using breaches of long-term averages are just one method to determine when to have more, or less, exposure to equity-related risk.
  • Secondly, active managers do indeed underperform their benchmark indices from one year to the next quite often. But it is the long-term performance that is the most important. (Also, benchmark indices do not pay taxes, have expenses, operations, transaction costs, distributions, etc. which impact short-term performance.)

I quickly grabbed 5-major mutual funds and compared them to the Vanguard S&P 500 Index. Each fund manager indeed underperformed their benchmark at one time or another. They also all vastly outperformed over time.

(Note: Looking at 1, 3, 5, and 10-year records are misleading as it assumes you invested, and held, from the start of each period. If you invested at any other point, your outcome is very different.)

Let’s take the same 12-month average switching strategy mentioned above but reduce performance by 2% annually on the upside. In other words, in every up year for the S&P 500, the strategy made 2% less than the index.

Clearly, under-performing a random benchmark index is not what investors should be concerned with.

The message is clear: “getting back to even” is not the same as “growing savings.” 

Oh, yes, about those losses.

“According to a study by J.P. Morgan Asset Management, buying and holding the S&P 500 between Jan. 1, 1995, and Dec. 31, 2014, would have netted an investor a 555% return, which works out to almost 10% per year. But missing just the 10 best days out of this more than 5,000-day trading period would have returned only 191%, less than half. If you missed a little more than 30 of the best trading days, your gains would have completely disappeared.”

While that statistic is often bantered about, it is “missing the losses” that are far more important to returns.

Where You Start Determines Where You End

As we have discussed previously, it is the starting level of valuations which are most important. Today, those valuations are the second highest level on record.

“What is clear, and unarguable, is that when valuations are elevated, future returns on investments decline. There are two ways in which the ratio can revert back to levels where future returns on investments rise. 1) Prices can rapidly decline, or 2) Earnings can rise significantly while prices remain flat. Historically, and as shown above, option 2) has never been a previous outcome.

While such isn’t a hard concept to understand, in the rush to make a point about “buy and hold” investing, statements like the following are made:

“Timing is irrelevant, it’s all about TIME IN the market. But WAIT. it gets even Better.-The 500 Index has had ZERO negative 20-year periods, while averaging 10%;-Out of all Rolling 5-Year periods since 1954, only 7 of them have been negative, the worst one was -2.4% (1974).”

That point is only true if you don’t adjust for the impact of inflation over time. However, once you add inflation into the calculation, a far different picture emerges.

But, we also need to include dividends to be factually correct. Even on a 20-year real total return basis, there was a negative return period. But while the three other periods were not negative after including dividends, when it comes to saving for retirement, a 20-year period of 1% returns isn’t much different from zero.

Unfortunately, we are just mere mortals, and using 100+ years of market data misses the real point.

As stated above, the single most important ingredient to investing success is the level of valuations at the start of your journey.

There are many investors today who started investing after the “financial crisis.” Also, there are over 13-million newly minted financial advisors who have never seen a “bear market.”

I have lived through several bear markets in my career and have learned to have great respect for what markets can do to portfolios, retirement plans, and families lives.

You can’t time the market? I agree.

However, you can manage the risk.

Every great portfolio manager over time from Warren Buffett to Ben Graham had one simple concept in managing money – “buy low, sell high.” 

Not one of them ever practiced “buy and hold” as an investment strategy.

If they didn’t. Why should you?

Currently, with the bull market now the longest on record, monetary policy becoming more restrictive, and valuation levels at the second highest level in history – starting your investment process today is likely going to have similar results over the next 20-year period as we have seen throughout similar periods in history.

Such is how all cycles end, and at the extremes, opposing views are always disregarded.

“People don’t want to hear the truth because they don’t want their illusions destroyed” – Fredrich Nietzsche

Should You Ignore John C. Bogle?

Listen, I get it.

When markets are rising everyone wants to be bullish.

Why not? As Bob Farrell’s Rule #10 states:

“Bull markets are more fun than bear markets.” 

It is also safer to be “always bullish.” No one remembers the guy that called the previous bull market peak as human psychology is designed to “mask pain.” If it wasn’t, women would never have children after their first one.

Despite the fact that many media commentators and pundits yelled “buy” all the way down in 2008, people only remember when the call to “buy” was eventually right. We like to “feel good,” and bull markets “feel good.”

Yes, 80% of the time the markets rise. It’s just the other 20% that’s a real bitch.

But “bear markets” are like “Fight Club” and the first rule of “Fight Club” is:

“Never Talk About Fight Club”

Last week, Eric Nelson, CFA, published an interesting article discussing predicted returns by Vanguard Founder, John Bogle. He starts by quoting Bogle from 2009:

“1) Beware of market forecasts, even by experts. As 2008 began, strategists from Wall Street’s 12 major firms forecast the end-of-the-year closing level and earnings of the Standard and Poor’s 500 Stock Index. On average, the forecast was for a year-end price of 1,640 and earnings of $97. There was remarkably little disparity of opinion among these sages.

Reality: the S&P closed the year at 903, with reported earnings estimated at $50.”

This is a fantastic point and a clear lesson that should be learned by all investors.

It is also Bob Farrell’s Rule #9:

When all the experts and forecasts agree – something else is going to happen.”

Eric goes on.

“The irony of this advice, however, is that Bogle regularly makes forecasts about what stock returns will be going forward and how those will compare to historical returns.  Now, you might find that peculiar, but not particularly upsetting.  Except, what would you do if you learned that Bogle was predicting significantly lower-than-average future returns?  Would you stick with your stocks or would you be tempted to consider safer bonds instead or even time the market?”

He is right. Given that Bogle is the veritable “Godfather” of “buy and hold” investing, it is a bit ironic he would discuss future rates of return.

But this is where Eric and I disagree a bit.

How have Bogle’s forecasts held up?  About what you’d expect based on Bogle’s prediction about the futility of forecasting!  Through August 22nd, the DFA US Large Cap Equity Fund (DUSQX) returned +13.3% a year over the last five years and +15.2% in the previous three years.

Now, we don’t know what the next five to seven years will look like, but unless stocks have zero returns over this timeframe, Bogle’s forecasts will prove to be way off.  His actual prediction over the decade beginning in late 2013 was for stocks to earn +97%.  In the first five years, they’re already up +86%.  His latest forecast, in 2015, was for stocks to make +48% over the coming decade.  In the first three years, they’ve already eclipsed his forecast, up +53%!”

Hold on just a minute. Read that bolded part again.

In order to make a bullish case for owning equities, Eric assumes NO bear markets over the next 5-7 years (a year of 0% returns is not a bear market.)

If this happens, Eric will indeed be right.

However, historically speaking “bear markets” do tend to be a problem.

The chart below uses the S&P 500 Total Return Index (not adjusted for inflation.)

The average and CAGR (compound annual growth rates) for 3,5, 10, and 17 years are below. You will note that while post-recession performance has exceeded the 10% annualized growth rate target, once you start capturing “bear market” periods, longer-term returns fall quickly.

But let’s do a little math to see if Bogle himself might actually be proved correct.

According to Eric the next 5-7 years will likely still provide elevated returns even if the market returns zero. The table and chart below show three different scenarios.

  1. Zero Returns Ahead: Follows Eric’s example of zero returns ahead.
  2. One Big Drop: Allows for 10% returns every year going forward with the exception of one 40% decline.
  3. The Double Dip: Looks at variable rates of return with a 10% and a 20% drawdown along the way. 

As you can see, even if Eric is correct and returns are zero over the next 7-years, 3.52% returns are not anything to really write home about. Secondly, once you factor in the very high probability of a negative return year, or two, returns fall far short of the 10% annualized growth rate.

But here is the real kicker.

Once you trim off 2%, or so, for inflation forward returns range between 0% and 3% for the decade following 2015.

Which is just about where Jack Bogle suggested they would be.

This isn’t stock market forecasting.

This is just math.

As Michael Lebowitz noted:

“I struggle to grasp the point of using prior returns and expected future returns to arrive at an investment conclusion. Yes, I agree that if the market average return is 7% and I return 20% in years one through ten but 0% in years ten through twenty, the approximate 10% return was above average. The problem is the 20% returns in my example are in the rearview mirror. All that matters is what are the returns going forward and more importantly, how can I make them as favorable as possible. Relying on gains of years past all but assures that my outperformance of the past ten years will be erased.  

Let’s put this into a sports metaphor.

The Washington Redskins coach feels assured he is going to receive a big fat bonus because so far his team is 8-0 and they are halfway through the season. However, over the next 8 games, they lose by 50 points each. Is his bonus intact?  He had a commendable 8-8 season, but it won’t feel average when he’s looking for a new job.”

The takeaway?

Eric is correct when he concluded:

“We don’t know what stock returns will be in the near future, you should expect significant uncertainty, and results may not match historical averages.” 

I also agree that you should not go making wholesale portfolio changes either.

However, expecting a decade-long bull market to continue uninterrupted for another decade is a dangerous proposition. This is especially the case given current valuations, extreme long-term technical deviations, tightening monetary policy and economic maturity.

As Bob Farrell’s Rule #2 states:

“Excesses in one direction will lead to an opposite excess in the other direction.”

That isn’t a market forecast either.

It is just historical fact.

Interview Chart Book: The Markets Are Waiving A Huge Red Flag

Last week, I spent some time with Chris Martenson of Peak Prosperity discussing a variety of issues ranging from the stock market to the economy to the debt. As you listen to the embedded interview, I have included the relevant charts to support the points I was making.

I have edited down the full transcript to hit the important points, but the full interview is posted at the bottom for your listening pleasure.

Chris: Lance, equities in the S&P 500 and NASDAQ within whispers of all time new highs. What are your thoughts here?

Lance Roberts: Well, I’ve been writing about this now for the last couple of months that there’s enough momentum in the markets currently that there was a real possibility that we would get back towards from these highs, back from January. Now, mind you, while we’re talking about all-time highs, sounds great. We were here just back in January, so in the last six months, technically, the markets haven’t gone anywhere which is a little bit discouraging simply from the fact that we’re had these blowout earnings over the last two quarters with this caveat: the majority of these earnings, which have been exceptional, no doubt about that, has primarily been due to the substantially low tax rate.

Amazon had a blowout quarter as an example. That was due to a 3 percent tax rate. Now, that’s going to start going away beginning next quarter because now the quarter over quarter comparisons become much more challenging. In other words, Amazon’s quarter, next quarter, is going to be based on this quarter, so that growth rate is not going to nearly as large around the corner. So my concern is that while markets have been rallying nicely over the last few months, we’ve set aside trade wars, we’ve priced that in, we’ve set aside Russia, we’ve set aside all these issues on the back of earnings. But that issue of earnings becomes much more challenging in the future.

Chris: Well, the earnings are indeed strong. The Wall Street Journal recently had a front page above the fold article that read: Profits Soar as the Economy Accelerates, and then, did note that profits jumped an estimated 23.5 percent in the three months through June. Astonishing. But what was also astonishing, maybe, was that they didn’t mention anything about corporate buybacks in there. They did mention that the effect of the tax cuts and all of that. But let’s talk about the real momentum behind those earnings. They also noted that while the profits were up 23.5 percent revenues weren’t up anywhere close to that. Is that a red flag or not?

Lance Roberts: Oh, it’s a huge red flag. Look, at the end of the day, we can manipulate the bottom line of earnings statements all we want. But if I’m a business, look, I run three businesses, and if I don’t have revenue coming in at the top line, I can manipulate my bottom line through accounting gimmicks. I can do some wage suppression. I can layoff all of my employees. I can maintain an illusion of profitability for some period of time, but at some point, I’ve got to have the revenue, which is what happens at the top line of the income statement.

And, just to put this into some context, since 2009, now the number I’m about to give you is not annualized, this is total. total growth of revenues for the S&P 500 since 2009 is running about 30 percent in total, right. So total growth 30 percent. Bottom line profitability has grown by almost 300 percent during that same time frame. So earnings per share have grown tenfold over revenue growth because of things like corporate stocks buybacks, because of weight suppression, because of employment suppression, because of accounting gimmicks and the things that we have done.

Note: I updated the chart below for Q1 and Q2 (so far) which accounts for a large drop in shares outstanding due to buybacks. As shown, bottom line EPS has exploded by 329% as compared to just a 49% total increase in top line revenue.  More importantly, revenue actually declined between Q4 and Q1 despite a surge in bottom-line earnings.

Chris: Now, that’s an astonishing statistic of 30 percent growth in top line and 300 percent growth in bottom line. I want to turn now to this idea of corporate buybacks which have been not just a little bit of rocket fuel but breaking all records if 2018 continues as it has for the first six months, just an absolute flood of money coming back in. And the tax cuts were allegedly supposed to be used – the idea was, just the like the one that happened before under Bush – that this money would be repatriated and companies would hire people, pay them more and invest in property, plant, and equipment. Do we have any sign of that, or is this mostly – has that money come home and been used to boost CEO pay packages?

Lance Roberts: Well, it depends of what you look at. You know, if you take a look at the mainstream media headlines, mainstream economic data, economic growth 4.1 percent in the last quarter. Great number. Then take a look at wages. We’ve seen a tick up in actual wages. Finally seeing some growth in wages. But the problem is when you look at those numbers at the top line you have to break out what’s happening within the real economy.

So, for instance, you take a look at real disposable incomes. Now, what is disposable income? Disposable income is simply, and the way the government measures it, income after taxes. But disposable income for the average American family is what did I have come in the door after taxed versus the bills I have to pay, and what’s actually left over that “disposable” for me to go buy a new Apple iPhone with, as an example.

Well, the problem is when you look at the bottom 80 percent of the population versus the top 20 percent, there is no wage perk, and disposable income is absolutely nonexistent. In fact, the average household, to maintain their current standard of living, is running at almost $8,000 deficit every single year which explains why credit card growth is running at rampant paces. And just an article out just yesterday talking about the number of baby boomers now moving into retirement over the age of 65 filing bankruptcy is spiking at very fast levels.

Not surprising based upon the fact that this is what’s happening in the underlying situation in America. And any of these economic measures that measure income or net worth, etcetera, it is heavily skewed by the top 10 to 15 percent of the economy which owns almost entirely all the wealth.

Chris: Lance, that’s an excellent point. I just got in a little Twitter battle with a Bloomberg journalist who put out an interesting chart that said hey, look, the amount of mortgage service cost for Americans, based on their disposable income, is really at a very low level. And I said, well, hold on, you’re trying to express an average when there’s no average implied here. That’s total disposable income and to total mortgage payments. So if there is any skewing in this data, if all the disposable income growth has gone to the top five percent, that has no bearing on what the average mortgage service cost is going to be.

I couldn’t believe that the plummeting and the statistic was huge. It didn’t make sense by anything you could possibly read about actual wage growth. So it’s just those sorts of disconnects are really important to understand. And to me, as I look at this, it’s pretty clear that disposable income, that revision that they just did under that last GDP revision, just really, I thought was one of the most inappropriate revisions I’ve ever seen. Really muddied the waters, I think, for the average reader.

Lance Roberts: Two things there, and if anybody actually looked at the data, there were two things that actually occurred there. There was the big – we revised GDP up by a trillion dollars. Well, that was all an inflation adjustment. All we did was change from 2009 dollars to 2012 dollars. What happened to inflation between 2009 and 2012? It went down. So the drop in inflation rate basically revised upward the real inflation-adjusted value of the economy by almost a trillion dollars.

Same thing for savings. So when we take a look at the savings rate, savings rate had a big upper revision, and a lot of mainstream media has been coming out and going oh, this is great, look, Americans are just saving more. No, they’re not. The top ten percent is saving more because you’ve had a booming stock market and they’re the ones that own the majority of all the wealth in the country in terms of stocks and investable assists.

One of the biggest misconceptions is that everybody contributes to a 401K plan. No, they don’t. Statistic after statistic after statistics shows – even Banger [PH] just came out, and Fidelity both – just came out with recent studies looking at their 401K plans – because they are the two major providers of 401K plans in this country – about 30 percent of the people actually contribute to the plan in terms of the employees, and most of them contribute very little at all to those plans.

So the majority of the wealth is held in the top 10 or 15 percent like we just said a second ago. And so the revision to the savings rate was simply just adjusting up to the realization that that’s where the bulk of the wealth is. And that’s due to the booming stock market; that’s due to the Federal Reserve interventions that have been liquefying the markets, global Central Bank interventions, a suppression of interest rates that is inured to the wealth of those at the top 10 or 20 percent.

That also goes to wages and executive compensation. When we talked about tax reform a second ago, I wrote article after article, before they even passed tax reform, and said when they pass tax reform the only people that are going to benefit are going to be corporations and executive employees of those companies because of the fact all this money will go to stock buybacks and go to executive compensation through option issuances as well as stock-based compensation increases, as well as salary increase. And that’s exactly where it’s all gone ever since then.

So, not surprising. You saw an uptick in the savings rate, but it’s all skewed to the top end. The bottom 80 percent of America, they’re not saving anymore. In fact, statistic after statistic after statistic shows they can’t come up with $500 in an emergency.

Chris: No. Exactly. And that’s, of course, where the strength of the economy is supposed to rest if you can wake the slumbering masses up and get them to buy more, that’s where the strength really comes from. CEOs taking home and an extra $10 million doesn’t really move the needle in terms of overall consumption.

But let’s talk about this corporate buyback. We never really completed that. I’m looking at a chart right here, right now, of corporate debt. It looks a little exponential to me. You mentioned that growth in top-line revenue of 30 percent over the past decade, I’m seeing a near doubling of corporate debt over the same period of time. They’ve been piling on the debt, and all I ever read about in the media is about their cash hordes. For example, Apple. Hey, they’ve got $240 billion in cash. Yeah, they also have $220 billion in short and long-term debt. Where do you look at the corporate debt cycle as far as where we are in this cycle?

Lance Roberts: It doesn’t really matter how you break it down. Corporate debt is an important point, but if you look at margin debt in terms of investors and how much leverage they’re carrying within the market – take a look at household debt; take a look a government debt. We’re at record levels on debt across the board. In fact, I run a chart every now and then that shows what I call total system leverage. And what total system leverage looks at is all the debt; government, marching [PH], corporate, personal debt, all put into one indicator. And we’re talking in excess of $120, $130 trillion of total debt outstanding right now relative to an economy that’s growing at $20 trillion.

Note: The chart below is total system leverage excluding the $40-50 Trillion of unfunded liabilities of social security and Medicare.

So this is, of course, the highest level ever on record, and the impacts of this have been a function – and back to your corporate debt question – corporations have, of course, they’ve used ultra-low interest rates to lever up balance sheets to pay out dividends, to do stock buybacks, etcetera, and a lot of these stock buybacks that have been done have been done through corporate leverage because it was a better use of capital; I get to write off the interest on my balance sheet in terms of what I’m borrowing on the debt plus the buyback shares and improve my bottom line earnings. That’s been a win-win for corporations.

The problem, though, eventually is that a lot of this debt that’s been issued is sub quality credit in terms of investment. When you talk about investment grade investment, BBB or better, a lot of this debt that’s outstanding is BB or less. And that’s going to be an issue when two things occur: one, when interest rates rise enough that the cost of borrowing is no longer acceptable and two, when you have the next major market crash that causes a massive deleveraging cycle in the markets, and that will be triggered by an increase in interest rates from the Federal Reserve.

Lance Roberts: And not only that, and I don’t want to get off into a big pollical bend here, but if you take a look at how the government has kind of been staked with players, really since the current administration has come in, these are a lot of the old guard guys: Wilber Ross, Navarro, Kudlow, etcetera, these are all Reaganites. And they have this strong belief that they can reignite the Reagan years by doing trickledown economics.

The one thing that all of them have missed, along with the mainstream media and the majority of the mainstream analysis is this ain’t Reagan. We’re not in an economy of the Reagan years. Remember, Reagan started, when Reagan went into office he was coming out of a double back to back recession, just coming off the back of a major 1974 bear market crash where valuations were down to six and seven times earnings. Dividend yields were at 6 percent, interest rates were 14 percent, inflation was 14 percent. That was falling. Valuations were low and beginning to rise. Dividend yields were high and, of course, economic growth was already running at 6 percent.

You don’t have that environment today. So there was no way that “trickle-down Reaganomics” is, or will, work in the current environment. So you can slash taxes; you can do the things you want to do; you can do trade wars and tariffs, but all you’re going to do is negatively impact the economy because of the fact we’re running $21 trillion in debt, we’re going to run a trillion-dollar deficit by the end of this year, that’s going to become two trillion over the next five years. And the growth trajectory of debt and, of course, where we are in terms of economic growth, that will only substantially go lower by next decade.

Chris: Let’s talk about bonds now. What sort of signals are bonds sending? I note that you’re looking at some technical signals that might say lower bond yields on the say?

Lance Roberts: A couple things. Let’s remember that interest rates are a function of the economy. So Jamie Diamond out yesterday saying that interest rates should be 4.0 percent, and they’re going to 5.0 percent, so get ready for higher yields. That sounds great. Sounds fantastic. The problem is that if you go back through history there’s a very high correlation between interest rates and economic growth. Surprise. If interest rates are rising that means the cost of borrowing is going up, and that means that as a consumer I have to make a decision. So I want to buy a house or I want to buy a car or I want to finance some type of product that I want to buy, I look at the payment, and if they payment fits within my budget then I’ll buy it, I’ll finance it. I’ll buy a car, I’ll buy a house or finance a new iPhone at $1,000; that’s about the only way people can afford it these days. So I’ll finance it.

But if the interest rate goes up on that to a point to where I can’t afford it within my budget, well, I either have to buy something else at a much lower price or I postpone the payment. And, of course, as interest rates go up, this specifically works to slow economic activity. That’s why the Federal Reserves lifts interest rates. Why do they lift interest rates? They’re not lifting interest rates because they expect the economy to boom from this, they’re actually trying to slow economic growth to quail inflationary pressures. That’s why we lift interest rates; it increases the cost of borrowing.

The problem is that we’re not in an environment currently, economically speaking, to support higher interest rates. See, back in the 40’s, 50’s, 60’s, and 70’s, you can look at that period of time and look at economic growth. Economic growth was rising during that period. So quarter over quarter, year over year, economic growth was increasing because, remember we were coming back from World War II, we have bombed out the entirety of the rest of the known world and Europe and everywhere else, and we were helping them rebuild manufacturing. We were industrial power housed in America. We were manufacturing and rebuilding the rest of the world.

As a function of that activity, that increase in productivity, that increase in output, we were growing our economy. So, as a function of that, as the economy was growing, interest rates were also rising because individuals were making more money, they were saving more, productivity was going up, economic growth up which means that we could sustain higher levels of interest rates. There’s a relationship there.

Beginning in 1980, we reversed our economy and moved from a manufacturing base to a servicing base which has a much lower output. Inflation and interest rates were under attack by the Federal Reserve, and they had begun this long trend lower. And, as a consequence, interest rates have followed the rate of economic growth which has been lower.

The annual rate of economic growth back in the late 70s, early 80s, was between 6 and 8 percent. We’re at 2 percent today. And that’s been declining substantially every single decade over the last forty years. And here were are today at roughly running 2.0. 2.5 percent, which means that interest rates on the ten-year treasury should run 2.0, 2.5 percent. Not 4.0, not 5.0 because you don’t have economic growth on sustainable basis running at 4.0 or 5.0 percent. Inflation, interest rates, wages and economic growth are all pretty much tied to it because they are all part and parcel built on one thing, the consumer, which is 70 percent of the economy.

Chris: Wouldn’t that make sense? And I’ve often been critical of the Fed by saying that they are not this magical, wealth-creating body. That’s not what they do. They’re a wealth redistribution body. They take from the bottom to the top, but they did something else too. Let me get your thought on this. They steal from the future and bring it to the present.

Lance Roberts: Yes. And that’s exactly what quantitative easing does. When you do anything, suppress interest rates, when you do anything like adding more liquidity to the market – so, in other words, for the average American, we don’t save any money. We know that. So if I give you – this is the whole myth behind giving people a payout or doing some type of government bonus to Americans. It would be great. We could give every American in this country $5,000 today and they would all go out and spend it today, and then the benefit is over, and you’re right back to where you were before because you’ll create these little short terms pops in economic activity by doing things.

But unless you create a sustainable rate of wealth growth, in other words, helping people grow their wealth by giving them jobs and higher wages and these types of things – I’m talking about real employment. I’m not talking about employment at the rate of population growth which is all we’ve had since 2009. Since 2009, we’ve created roughly about 20 million jobs, the economy has grown by 23 million working age Americans, so there’s still about a six to eight-million-person gap between just the people entering the workforce and that people who are getting hired.

And this is when we take a look at all the employment statistics; employment to population ratios at the lowest levels since 1965, and they go well, that’s the baby boomers. Okay, fine. Let’s strip out everybody over the age of 55, let’s assume we went “Logan’s Run” way and they were just all eliminated – if you don’t know what that reference is, look it up on the internet – it’s from the 1970s – it for old people who remember.

Chris: I remember it.

Lance Roberts: I know you do. And if we take out all the people under the age of 24. So let’s just – they’re all in school. Okay, so fine. We’ll take out everybody in the workforce under the age of 24. Why is it that 24 to 55-year-old, that population, only 50-percent of them have full-time jobs? I mean, that’s what’s happening in the economy. And you can’t create economic prosperity when you have real unemployment still at much higher rates then what the government statistics would suggest.

But, again, doing any type of activity where I give you a benefit, I give you ultra-low interest rates, zero percent financing, if you’ll come buy a car today. Hey, I’m there. Right? But ultimately, I have got to make the payments. And while I can create short term incentives to pull forward future purchases, in order to create sustainable economic growth, I need to focus on creating the ability to consume more in the future because I have more money with which to consume.

Chris: Indeed, the statistics show that we’ve had what we would call sub-par growth for well over a decade now. And from my standpoint this all makes a lot of sense because you have to understand the role of debt in that story and you have to understand the role of energy in that story. So I have a story that says yeah, sub-par is the new normal, and that’s just something that we have to get used to.

But the Fed is trying to recreate conditions as is sub-par wasn’t the new normal. They want the 50’s and 60’s to reemerge. Not going to happen. So you’re saying – the summary of that, one summary, is that interest rates could fall from here, and they should fall if they’re going to match the level of economic activity. But let me take a devil’s advocate on that. You said the magic thing before which was a one trillion-dollar Federal deficit going to two, isn’t that an upward pressure on bond yields potentially?

Lance Roberts: Look, there’s the fundamental backdrop and then there’s the technical backdrop. Okay. So the fundamental backdrop, and this is the belief right now, and we’re about to do this, right – we haven’t had a budget in ten years with our federal government. The end of September is the end of the 2018 fiscal year, and we’ve passed two continuing resolutions last year of roughly about two trillion dollars all together to fund last year’s spending. We’re going to have to pass another continuing resolution by October the 1st to fund the 2019 fiscal year. That’s already estimated in the first round, which will not make it the entire fiscal year, mind you – it’ll make it about six months – is $1.3 trillion.

Well, that means this is new debt to be issued by the government. That means that people are going to have to buy them, and the concern is right now there’s simply not enough people to buy that debt. China is not buying as much debt as they were, and of course, the Federal Reserve is not buying bonds at this moment. In fact, they’re trying to reduce their balance sheet – they’re selling $50 billion a month. But yet the ten-year treasure rate remains below 3.0 percent, now, along with other factors that suggested that’s going to be the case.

But, technically, interest rates are at a level that have historically, whether you look at it on a weekly basis, a daily basis, a monthly basis, a quarterly basis or an annual basis, interest rates now, and this goes back into going back the 1940’s and 1950’s, when rates were rising and economic growth was rising. So it doesn’t matter whether economic growth and rates are rising or falling, but it does show that every time that interest rates technically – now look, this is just technical – this is just the function of rate movement – technically, every time rates have been this over bought historically on any measure of time-frame, it has denoted a peak within the economic cycle and has also denoted a peak within the financial markets. And it doesn’t mean that the markets always crash, although they did something, but it also meant that we had periods where they stuck exceptionally low. And, more importantly, rates fell.

So how do those two marry up? How does this fundamental backdrop marry up to the fact that technicals are suggesting an entirely different outcome which would suggest that yields are going to fall? Let me tell you how I think it plays out and why I think that the technical may be right over the fundamental view for now. The first reason is that interest rates are rising in an environment where we have slower economic growth and we are ten years into a stellar stock market run that has been fueled by a lot of artificial stimulus. I don’t know what will be the cause or the catalyst, but as you mentioned before and we talked about, we have debt leverage and speculation at the highest levels on record.

I’m doing a chart right now for an article I’m writing for Thursday showing household equity ownership is a percentage of total net worth. Any time that number is above 40, which right now we’re at 42.3, it has equated to a very not good outcome for investors in the financial markets. So what would cause rates to fall despite the fact we’re having record treasury issuances? That would be a major event within the financial and/or credit markets. Now, I don’t know what it’ll be. I can’t tell you whether it’s going to be an Italian blow-up or something in America or mortgage crisis. You won’t know until it happens. Just like we didn’t know about the financial crisis until Lehman popped up.

We don’t know what the trigger will be. We know we have all the ingredients. You and I talked about this previously. We have all the ingredients from leverage and speculation in place, but all we’re missing is the match to light the fuse. And whatever that catalyst is will create an environment where QE4 will come from the Federal Reserve, the bond buying will come back in as a flight to safety.

Now, let me be really clear – when I’m talking about interest rates we are only talking about U.S. government treasuries because the place you do not want to be is in corporate bonds, high yield debt or any other type of state and local government issued debt, municipalities, etcetera because one of the big factors coming up in the next crisis, no matter what it is and what causes it, will be a devastation of U.S. pension funds which have a $5 trillion hole sitting there, and they will not be recoverable this time around, even with a bailout. The pension system will come crashing down if that even is severe enough to trigger that because they are so underfunded now and are so dependent upon 7.0 annualized rates of return that another big drawdown at this point, after two previous ones, will provide a scenario where they cannot get catch up. Period.

Chris: Excellent. Talk to you next time.

Lance Roberts: Thank you.

The Myths Of Stocks For The Long Run – Part XI

Written by Lance Roberts and Michael Lebowitz, CFA of Real Investment Advice

CHAPTER 11 – Portfolio Strategies For The Long-Run

Over the previous 10-chapters of this series, we have discussed many of the fallacies of investing for the long-term. The two biggest of these issues, which impacts performance over time, is the lack of capital to invest and human psychology. As Howard Marks once said:

“I’ve been in this business for over forty-five years now, so I’ve had a lot of experience.  In addition, I am not a very emotional person. In fact, almost all the great investors I know are unemotional. If you’re emotional then you’ll buy at the top when everybody is euphoric and prices are high. Also, you’ll sell at the bottom when everybody is depressed and prices are low. You’ll be like everybody else and you will always do the wrong thing at the extremes.”

While the idea of “buy and hold” investing is proselytized by the mainstream media, the reality is that ultimately all investors wind up “buying tops” and “selling bottoms.”  

There are numerous “investing legends” who are revered for their investment knowledge and success. While we idolize these individuals for their respective “genius,” we can also save ourselves time and money by learning from their wisdom and their experiences. Their wisdom was NOT inherited, but was birthed out of years of mistakes, miscalculations, and trial-and-error. Most importantly, what separates these individuals from all others is their ability to learn from those mistakes, adapt, and capitalize on that knowledge in the future.

Experience is an expensive commodity to acquire, which is why it is always cheaper to learn from the mistakes of others.

Most importantly, not one of these legendary investors has “buy and hold” as a rule. Yes, they believe in long holding periods, but they also have a healthy respect for valuation, risk and capital preservation. They sell when value is no longer present and/or the risk of capital loss outweighs the potential reward.

There are only a few basic “truths” of investing, and protecting the value of your investment capital is the most important.

In 2010, Brett Arends wrote “The Market Timing Myth” which sets up our discussion for today.

For years, the investment industry has tried to scare clients into staying fully invested in the stock market at all times, no matter how high stocks go or what’s going on in the economy. ‘You can’t time the market,’ they warn. ‘Studies show that market timing doesn’t work.’

They’ll cite studies showing that over the long-term investors made most of their money from just a handful of big one-day gains. In other words, if you miss those days, you’ll earn bupkis. And as no one can predict when those few, big jumps are going to occur, it’s best to stay fully invested at all times. So just give them your money… lie back, and think of the efficient market hypothesis. You’ll hear this in broker’s offices everywhere. And it sounds very compelling.

There’s just one problem. It’s hooey.

They’re leaving out more than half the story.

And what they’re not telling you makes a real difference to whether you should invest, when and how.”

In this chapter, we will explore three broad and basic strategies for managing a portfolio. These are just examples to explain the concept of managing risk, and we hope it encourages you to explore, learn, and expand your investing knowledge and expertise.

1. Technical – Stock/Bond Swap Using 12-Month Moving Avg.

It is true that you “can’t time the market.”

Importantly, we are not endorsing “market timing” which is specifically being “all in” or “all out” of the market at any given time.

However, having a methodology to “buy” and “sell” investments is the core of investing, hence the very basic rule of investing which is to “buy low and sell high.”

While there are many sophisticated methods of handling risk within a portfolio, even using a basic method of price analysis, such as a moving average, can be a valuable tool over the long-term holding periods. Will such a method ALWAYS be right? Absolutely not. However, will such a method keep you from losing large amounts of capital? Absolutely.

For example, the chart below shows a simple 12-month moving average study. What becomes clear is that using a basic form of price analysis can provide useful identification of periods when portfolio risk should be REDUCED. 

Importantly, I did not say risk should be eliminated; just reduced.

Again, no one is suggesting, or stating, that such signals mean going 100% to cash. The overarching premise is that when “sell signals” are given, it is often time where some action should be taken to manage portfolio risk.

Let’s review an example of this strategy at work.

In 1988, Bob was 35 years old, had saved up a $100,000 nest egg and decided to invest it in the S&P 500 index. He added $625/month to the index every month and never touched it. When Bob retires at 65, he wants to maintain his current $75,000 lifestyle. We will assume he can generate 3% a year in retirement on his nest egg.

The chart below shows the difference between two identical accounts. Each started at $100,000, each had $625/month in additions, and both were adjusted for inflation and total returns. The purple line shows the amount of money required, inflation-adjusted, to provide a $75,000 per year retirement income to Bob at a 3% yield. The only difference between the two accounts (blue and gold) is that one went to “cash” when the S&P 500 broke the 12-month moving average and avoided major losses of capital multiple times.

Yes, “buy and holding” an index, or a basket of stocks, will certainly make you money given enough time but will leave you far short of your investment goals.

There is a clear advantage of adhering to a risk management protocol for portfolios over time. The problem, as we discussed previously, is that most individuals, even if they have a strategy, fail to follow it because of “short-termism.”

This type of risk management strategy doesn’t just apply to investing in an index but also to individual stocks.

Whenever we discuss “risk management” in the context of long-term investing there is almost always a comment made that:

“If someone had just bought Apple when they first went public, they would have made lots of money.” 

First of all, this is an extremely poor argument. While Apple (AAPL) is a great company today, it struggled for nearly two decades before their rebirth as a “consumer product” company with the advent of the iPhone. Few individuals remained loyal to Apple during the “go-go” 1990’s when other tech companies far outpaced its return.

Secondly, while it is nostalgic to talk about buying Apple, or Amazon (AMZN), when they first went public, the reality is that for every big winner today, there are many that went bankrupt like Enron, Netscape, Global Crossing, etc. For every big winner, there is a trail of bodies along the way. As any skilled investor will tell you, “skill” is only part of the equation, “luck” and “timing” are the others. 

But let’s assume we did buy Apple and applied a 3-month/9-month moving average crossover buy/sell strategy to determine when to buy, sell or hold Apple.  (This is for example purposes only and focuses solely on capital appreciation.)

While it is true that a $1000 investment in 1984 on a “buy and hold” basis would have grown impressively to more than $500,000 currently, the buy/sell strategy would have grown that same portfolio to more than $4 million. The point here is simple, much more wealth is created by avoiding periods of capital destruction.

It’s just math.

2. Fundamental and Technicals

“But I am a fundamental investor and not a trader. “

So are we.

Just to reiterate – so are we.

We believe that “fundamental value” is what drives long-term returns in portfolios over time. However, what does an investor do when markets are excessively overvalued and “fundamental value” becomes a rare commodity?

This is where technical analysis can enhance a fundamental strategy.

To explain this with an example, we are going to use Shiller’s CAPE ratio. This ratio, which is the price of the market divided by the 10-year average of trailing earnings, has been widely discussed in the media, and often dismissed during bull market advances, because of it does not timely signal turning points in the market.

The chart below tells a simple story. When valuations are elevated (red), forward returns have been low and market corrections have been exceptionally deep. When valuations are cheap (green), investors have been handsomely rewarded for taking on investment risk.

With valuations currently on par with those on the eve of the Great Depression and only bettered by the late 1990’s tech boom, it should not be surprising that many are ringing alarm bells about potentially low rates of return in the future. It is not just CAPE, but a host of other measures including price/sales, Tobin’s Q, and Equity-Q are sending the same message.

The problem with fundamental measures, as shown with CAPE, is that they can remain elevated for years before a correction, or a “mean reverting” event, occurs. It is because of these long periods where valuation indicators “appear” to be wrong where investors dismiss them and chase market returns instead.

Such has always had an unhappy ending.

The chart below marries a technical “buy/sell” rule to provide “timeliness” to the slow-moving CAPE fundamental indicator shown above.

  • Blue LineReal S&P 500 index with a 24-month (2-year) moving average.
  • Lower Chart – Shiller’s CAPE ratio:  Red = CAPE > 20,  Grey = CAPE > 10 & < 20, Green = CAPE < 10
  • Blue Shaded Bars “Sell Signal” when CAPE > 20 AND market closes below 24-month MA
  • Purple Shaded Bars “Sell Signal” when S&P 500 closes below the 24-month MA

What jumps out immediately is that the combination of both the fundamental and technical signal certainly kept investors from getting trapped in the most severe historical market corrections. But by establishing some “rules” around the signal, we can vastly improve potential returns. The chart below shows $1000 invested in four different strategies.

  1. $1000 into a “buy and hold” investment strategy.
  2. $1000 into a valuation ONLY strategy that is long the S&P 500 until CAPE exceeds 20x earnings and then goes to cash until CAPE is below 10x earnings.
  3. $1000 into a technical switching strategy that switches from the S&P 500 to cash based solely on the break of the 24-month moving average. (Buy S&P 500 when price moves above the 24-month moving average, Sell when below. Based on the close of the last day of the trading month.)
  4. $1000 into a fundamental/technical strategy.
    • Buy and hold the S&P 500 when valuations are less than 10x earnings.
    • Sell when CAPE is above 20x earnings AND the S&P 500 breaks below the 24-month moving average.
    • During the mean reversion process (20x to 10x CAPE) the portfolio utilizes the technical strategy only.
    • When valuations are below 10x earnings, buy and hold the S&P 500 index.

While it is true that a “buy and hold” investment strategy will work over a long enough time frame, every other strategy outperformed it. As we have explained previously, avoiding losses and spending less time “getting back to even” leads to greater investment returns over time.

The problem with CAPE as a portfolio management tool is exposed as well. While an investor using CAPE only would have outperformed the “buy and hold” strategy, they would have been out of the market since the 1990’s.

Clearly, the two best methods for managing portfolio risk, avoiding major drawdowns, and creating wealth over time are the technically driven methods.

Did these models avoid every correction, drawdown, or stumble? Of course, not. Did they underperform the benchmark index in some years because they were “out” of the market? Absolutely.

But over time, the avoidance of the major destruction of capital leads to greater appreciation and attainment of financial goals which is the sole goal and reason why we invest.

3. Options Strategy

There are an infinite number of options strategies that one can deploy to serve all kinds of purposes.  We discuss three strategies that involve hedging exposure to the S&P 500. The purpose is to give you a sense of the financial cost, opportunity cost, and loss mitigation benefits that can be attained via options.

Option details in the examples below are not based on current pricing. If you are interested in exploring any or all of these strategies please use current index and options prices.

Elementary Put Hedge

A Put Hedge option strategy is the simplest option hedge one can employ. A put provides its holder a right to sell a security at a given price. For instance, if you own the S&P 500 ETF (SPY) at a price of 100 and want to limit your downside to -10%, you can buy a put with a strike price of 90. If SPY drops below 90, the value of the put will rise dollar-for-dollar with the loss on SPY, thus nullifying any SPY losses beyond 10%.

To help visualize what a return spectrum might look like on a portfolio hedged in this manner consider a simple scenario in which one owns the S&P 500 (SPY) and hedges with SPY options.  The following assumptions are used:

  • Own 400 shares of SPY at a price of $246.80 per share at the cost of $98,720.
  • The holding period is 1 year.

The graph below provides the return profile of the long SPY position (black) and three hedged portfolios for a given range of SPY prices. The example provides three different hedging options to show what under-hedged (2 options), perfectly-hedged (4 options) and over-hedged (8 options) outcomes might look like.

Note the breakeven point (yellow circle) on the hedged portfolios occurs if SPY were to decline 10% to $221 per share. The cost of the options in percentage terms shown on the right side of the breakeven point is the difference in returns between the black line and the dotted lines.

Conversely, the benefit of the options strategies appears in the percentage return differentials to the left of the breakeven point. In this example, we assume the options are held to the expiration date. Changes in other factors such as time to expiration, rising or falling volatility, and intrinsic value will produce results that do not correspond perfectly with the results above at any point in time other than at the expiration date.


The simple Put Hedge strategy was straightforward as it only involved buying a one-year put option. Like the first strategy, a collar entails holding a security and buying a put to limit the downside risk. However, to reduce the cost of the put option a collar trade requires one also to sell (write) a call option. A call option entitles the buyer/owner to purchase the security at the agreed upon strike price and the seller/writer of the option to sell it to them at the agreed-upon strike price. Because the investor is selling/writing an option, he is receiving payment for selling the option. Incorporating the call option sale in a collar strategy reduces the net cost of the hedge but at the expense of upside returns.

To help visualize what the return spectrum might look like with a collared portfolio that owns the S&P 500 (SPY) and hedges with SPY options, consider the following assumptions:

  • Own 400 shares of SPY at a price of $246.80 per share at the cost of $98,720.
  • The holding period is 1 year
  • Purchase SPY put options with a strike price of $230.
  • Sell/write SPY call options with a strike price of $270.

As diagrammed below, a collar strategy puts a collar or limit around gains and losses.

Writing the call option reduces the net hedging cost by $1,550, limits losses to 9% but caps the ability to profit if the market increases by at least 7.21%.

Sptiznagel’s Tail Strategy

Mark Spitznagel is a highly successful hedge fund manager and the author of a book we highly recommend called “The Dao of Capital.”  Spitznagel uses Austrian school economic principles and extensive historical data to describe his unique perspectives on investing. In pages 244-248 of the book, he presents an options strategy that served him well in periods like today when valuations foreshadowed significant changes in market risk. The goal of the strategy is not to hedge against small or even moderate losses, as in the first two examples, but to protect and profit from severe tail risks which can destroy wealth like the recent experiences of 2000 and 2008.

Sptiznagel’s strategy hedges a market position with put options expiring in two months. On a monthly basis, he sells the put options and buys new options expiring in two months. The strike price on his options are 30% below current prices. To replicate his strategy and compare it to the ones above we assume the following:

  • Own 400 shares of SPY at a price of $246.80 per share at the cost of $98,720.
  • The holding period is 1 year.
  • Purchase 82 SPY put options (equivalent to .50% of the portfolio value) with a strike price of $175 (30% out of the money). Because the options are 30% out of the money the price of the options are relatively cheap.
  • For purposes of this example, new options are purchased when the current options mature every two months (Spitznagel sells and buys new options on a monthly basis).
  • We also assume this hedge was already in place for a year resulting in an accrued trade cost of $2,952 (6 *$492) to date.

The graph below highlights the cost-benefit analysis.

The strategy graphed above looks appealing given the dazzling reward potential, but we stress that the breakeven point on the trade is approximately 30% lower than current prices. While the cost difference to the right of the breakeven point looks relatively small, the axis’s on the graph has a wide range of prices and returns which visually minimizes the approximate 6% annual cost. Similar strategies can be developed whereby one gives up some gains in a severe drawdown in exchange for a lower cost profile.

Cost/Benefit Table

The table below compares the strategies detailed above to give a sense of returns across a wide range of SPY returns.

The option strategies in this article are designed for the initial stages of a decline. Pricing of options can rise rapidly as volatility, a key component of options prices, increases. The data shown above could be vastly different in a distressed market environment. These options strategies are just examples. We recommend an investment professional be used to customize options strategies to meet investor’s needs.

15-Rules To Follow

The examples shown above are just a small sampling of the many different portfolio management strategies, techniques, and processes that could be employed. No one strategy is right for everyone, but some strategy is better than no strategy at all.

However, behind every investment strategy, portfolio management discipline and portfolio process should be a guiding set of principals.

It is from Howard Marks’ view on risk management that our own portfolio management rules are derived which drive our investment discipline at Real Investment Advice. While we are currently tagged as “bearish,” due to our views and analysis of economic and fundamental data, we are actually neither bullish or bearish. We follow a very simple set of rules which are the core of our portfolio management philosophy with a focus on capital preservation and long-term “risk-adjusted” returns.

  1. Cut losers short and let winner’s run(Be a scale-up buyer into strength.)
  2. Set goals and be actionable. (Without specific goals, trades become arbitrary and increase overall portfolio risk.)
  3. Emotionally driven decisions void the investment process.  (Buy high/sell low)
  4. Follow the trend. (80% of portfolio performance is determined by the long-term, monthly, trend. While a “rising tide lifts all boats,” the opposite is also true.)
  5. Never let a “trading opportunity” turn into a long-term investment. (Refer to rule #1. All initial purchases are “trades,” until your investment thesis is proved correct.)
  6. An investment discipline does not work if it is not followed.
  7. “Losing money” is part of the investment process. (If you are not prepared to take losses when they occur, you should not be investing.)
  8. The odds of success improve greatly when the fundamental analysis is confirmed by the technical price action. (This applies to both bull and bear markets)
  9. Never, under any circumstances, add to a losing position. (As Paul Tudor Jones once quipped: “Only losers add to losers.”)
  10. Markets are either “bullish” or “bearish.” During a “bull market” be only long or neutral. During a “bear market”be only neutral or short. (Bull and Bear markets are determined by their long-term trend.)
  11. When markets are trading at, or near, extremes do the opposite of the “herd.”
  12. Do more of what works and less of what doesn’t. (Traditional rebalancing takes money from winners and adds it to losers. Rebalance by reducing losers and adding to winners.)
  13. “Buy” and “Sell” signals are only useful if they are implemented. (Managing a portfolio without a “buy/sell” discipline is designed to fail.)
  14. Strive to be a .700 “at bat” player. (No strategy works 100% of the time. However, being consistent, controlling errors, and capitalizing on opportunity is what wins games.)
  15. Manage risk and volatility. (Controlling the variables that lead to investment mistakes is what generates returns as a byproduct.)

How you choose to manage your portfolio is entirely up to you. This is just how we approach managing money for our clients who are approaching retirement and can ill-afford a major loss of investment capital.

Every investment strategy has a consequence and will lose money from time to time. The only difference is the amount of the loss, what causes it, and the amount of time lost in reaching your investing goals.

With that in mind, we leave you with the prescient words of Brett Arends:

“Can’t time the market? It was clear as a bell that investors should have gotten out of stocks in 1929, in the mid-1960s, and 10 years ago. Anyone who followed the numbers would have avoided the disaster of the 1929 crash, the 1970s or the past lost decade on Wall Street. Why didn’t more people do so? Doubtless, they all had their reasons. But I wonder how many stayed fully invested because their brokers told them ‘You can’t time the market.’”

The Myths Of Stocks For The Long Run – Part X

Written by Lance Roberts and Michael Lebowitz, CFA of Real Investment Advice

CHAPTER 10 – Risk Knows No Age

“If you are a young investor, you need to take on as much risk as possible. The more risk you take, the greater the reward.”

This is actually a false statement.

Let’s start with the definition of “risk” according to Merriam-Webster:

1: possibility of loss or injury peril
2someone or something that creates or suggests a hazard
3a the chance of loss or the perils to the subject matter of an insurance contract; also the degree of probability of such loss
3b a person or thing that is a specified hazard to an insurer
3c an insurance hazard from a specified cause or source 
4the chance that an investment (such as a stock or commodity) will lose value

Nowhere in that definition does it suggest a positive outcome for taking on “risk.”

In fact, the more “risk” assumed by an individual the greater the probability of a negative outcome. We can use a mathematical example of “Russian Roulette” to prove the point.

The number of bullets, the prize for “surviving,” and the odds of “survival” are shown:

While there are certainly those that would “eat a bullet” for their family, the point is simply while “more risk” equates to more reward, the consequences of a negative result increases markedly.

The same is true in investing.

At the peak of bull market cycles, there is a pervasive, cancerous dogma communicated by Wall Street and the media which suggests that in the long run, stocks are a “safe bet,” and risk is somehow mitigated over time.

This is simply not true.

Blaise Pascal, a brilliant 17th-century mathematician, famously argued that if God exists, belief would lead to infinite joy in heaven, while disbelief would lead to infinite damnation in hell. But, if God doesn’t exist, belief would have a finite cost, and disbelief would only have at best a finite benefit.

Pascal concluded, given that we can never prove whether or not God exists, it’s probably wiser to assume he exists because infinite damnation is much worse than a finite cost.

A recent comment from a reader further confirms what many investors to believe about risk and time.

“The risk of buying and holding an index is only in the short-term. The longer you hold an index the less risky it becomes.”

So according to our reader, the “risk” of losing capital diminishes as time progresses.

First, risk does not equal reward. “Risk” is a function of how much money you will lose when things don’t go as planned. The problem with being wrong, and facing the wrath of risk, is the loss of capital creates a negative effect to compounding that can never be recovered.

As we showed previously, let’s assume an investor wants to compound investments by 10% a year over a 5-year period. The table below shows what happens to the “average annualized rate of return” when a loss is experienced.

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. 

The problem with following Wall Street’s advice to be “all in – all the time” is that eventually you are going to be dealt a losing hand such as in our example above. During bull market advances, prices rise in part due to earnings growth but also because investors are willing to pay more for a dollar of earnings than they were in the past. This is called multiple expansion and it is the hallmark of almost every bull market. Periods where price gains were largely the result of excessive multiple expansion, such as the 1920’s and 1990’s, were met with devastating losses when valuations normalized. The losses simply brought prices back to, or even below, levels which were commensurate with earnings.

The longer we chase a market where multiples are expanding well past norms, the greater the deviation from earnings and the greater the risk. As multiples expand, investors unwittingly escalate the inherent risk more than they realize which exposes them to greater damage when markets go through an eventual reversion process.

Even in healthy markets with fair valuations, risks exist. But in markets with high valuations the risk of a reversion increases as time marches on.

Here is another way to view how “risk” increases over time. Currently, valuations stand at levels similar to those of 1929 and not far behind those of 2000. Lets examine the current cost of “buying insurance” (put options) on the S&P 500 exchange-traded fund ($SPY). If the “risk” of ownership actually declines over time, then the cost of “insuring” the portfolio should decline as well. Why then, as shown below, does the cost of insurance rise over time?

As you can see, the longer the period our “insurance” covers, the more “costly” it becomes. This is because the risk of an unexpected event which creates a loss in value rises the longer an event doesn’t occur.

Furthermore, history shows that large drawdowns occur with regularity over time.

In early 2017, Byron Wien was asked the question of where we are in terms of the economy and the market to a group of high-end investors. To wit:

“The one issue that dominated the discussion at all four of the lunches was whether or not we were in the late stages of the business cycle as well as the bull market. This recovery began in June 2009 and the bull market began in March of that year. So we are more than 100 months into the period of equity appreciation and close to that in terms of economic expansion.

His point is that markets rotate between bullish and bearish phases. When he made that statement he was simply saying the current economic recovery and the bull market are very long in the tooth. As shown below why shouldn’t we expect a market decline to follow, it has every other time?

The “full market cycle” will complete itself in due time to the detriment of those who fail to heed history, valuations, and psychology.

“There are two halves of every market cycle. 

“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.”

But as Mr. Pascal suggests, even if the odds that something will happen are small, we should still pay attention to that slim possibility if the potential consequences are dire. Rolling the investment dice while saving money by skimping on insurance may give us a shot at amassing more wealth, but the RISK of failure, and possibly a devastating failure, increase substantially.

Duration Matching

In the bond market the concept of “duration matching” is commonplace. If I have a specific target date, say 10-years in the future, I don’t want a portfolio of bonds maturing in 20-years. By matching the duration of the bond portfolio to my target date, I can immunize the portfolio against increases in interest rates which would negatively affect the principal value in the future.

Unfortunately, in the equity markets, and particularly given the advice of the vast majority of mainstream analysis suggesting that all individuals should “buy and hold” indexed based investments over the long-term, the concept of duration matching is disregarded.

Stocks are considered to be going concerns and therefore have no maturity, therefore the question of “duration matching” a stock portfolio becomes problematic. However, the problem can be somewhat solved through a combination of both allocation and risk management.

Over the years, I have done hundreds of seminars discussing how economic, fundamental and market dynamics drive future outcomes. At each one of these events, I always take a poll asking participants how long they have from today until retirement. Not surprisingly, the average is about 15 years.

The reason is obvious. For most in their 20’s and 30’s, they are simply not making enough money yet to save aggressively nor or is that a focus. During the 30’s and early 40’s, they are buying a house, raising kids, and paying for college – again, not a lot of money left over to save. For most, it is the mid-40’s and early 50’s where the realization to save and invest for retirement becomes a priority. Not surprisingly, this is the dynamic that we see across most of the country today in survey’s showing the majority of individuals VASTLY under-saved for retirement. 

Chart Courtesy Of Motley Fool


As you can see, the median American household will struggle to fund retirement..

There are two problems facing investor outcomes.

First, you don’t have 100+ years to invest in the market to get the “average” long-term returns.

Second, your “long-term” investment horizon is simply the time you have between today and when you retire. As I stated above, for most people that is about 15 years.

So, for argument sake, let’s be generous and assume you have 20-years from today until retirement. As we discussed previously, we know that based on current valuations in the market, forward real total returns in the market will likely be, on average, fairly low to negative. 

What this chart clearly shows is the “WHEN” you invest is crucially more important than “IF” you invest in the financial markets. In regards to the current market environment consider this chart from Brett Freeze.

Based on 70 years of history, there has never been a period in which the ratio of market cap to GDP (red vertical dotted line) has been this high and returns over the next ten years were positive.

This is where the concept of “Duration Matching” in equity portfolios becomes important.

Given a 15 to 20-year time horizon for most individuals, investing when market valuations were elevated resulted in a loss of principal value during the time frame heading into retirement. In other words, most individuals simply “ran out of time” to reach their retirement goals. This has been the case currently for those 15-20 years ago that were planning to retire currently. Those plans have now been greatly postponed.

This is also the case for those with a 10-20 year horizon who put their trust into a “buy and hold” portfolio and disregard both valuations and risk.

When building a portfolio model, an investor must take into consideration the actual “time-frame” to retirement and the relative valuation level of the market at the beginning of the investing time frame.

For example, for an individual with a 15-year time frame to retirement and elevated market valuations, a portfolio model might resemble the following:


Note: The equity portion is “managed for downside risk protection” which we will explain in an upcoming chapter, which means that during certain periods the exposure to equities is reduced substantially.

The portfolio is designed to deliver a “total return” including capital appreciation to adjust the value of the individual’s “savings” for inflation, interest income and dividend yield. Each of these components is critical to achieving long-term investing success. While we can build a portfolio of bonds with a specific maturity, we have no such option in equities. This is where “risk management” must be used as a substitute. 

Let’s compare the portfolio above with an all-equity portfolio in a market environment that is either +/- 10% in a given year.

Assume: Equity delivers a 2% dividend yield and taxable bonds deliver 3% in interest income.


The 50% recapture on the balanced portfolio means that we assume risk mitigation techniques will reduce losses by 50% relative to the decline of the S&P 500 index.

As you can see, managing a portfolio against downside can greatly increase future outcomes of the time frame an individual has until retirement. We regularly post a real-time model in the weekly newsletter since 2007 which adjusts a 60/40 allocation model for risk.  By reducing the amount of time required to “get back to even” long-term returns can be improved to reach projected retirement goals.

Disclaimer: All information contained in this article is for informational and educational purposes only. Past performance is not indicative of future results. This is not a solicitation to buy or sell any securities. Use at your own risk and peril. No recommendations are being made or suggested.

Should you invest in the markets? Yes.

However, the allocation model used must adjust for both the time horizon to your financial goals and corresponding valuation levels.

If you are 20-years old and buy into the top of a market cycle, you could likely find yourself 20-years toward your retirement goal without much progress. Conversely, if you are 45-years, or older with valuations elevated, fundamental and economic prospects weak, and the majority of the previous bull-market behind you; managing your portfolio as if you were a 20-year old will have significantly negative outcomes. 

As I stated above, the problem with equities is that they never mature. Unlike bonds where a specific rate of return can be calculated at the time of purchase, we can only guess at the future outcome of an equity-related investment. This is why some form of a “risk management” process must be adopted particularly in the latter years of the savings and accumulation time frame. 

While it is always exhilarating to chase markets when they are rising, cheered on by the repetitious droning of the “buy and hold” crowd, when markets reverse those cheers turn to excuses. You are likely familiar with “no one could have seen the crash coming” and “you’re a long-term investor, right?” 

The problem is that the “long-term” of the market and the “long-term” of your retirement goals are always two VERY different things.

There is only one true fact to remember:

“All bull markets last until they are over.” – Jim Dines

You see, risk has no age.

Risk is risk.

The Myths Of Stocks For The Long Run – Part IX

Written by Lance Roberts and Michael Lebowitz, CFA of Real Investment Advice

The Problem With Passive

Passive strategies, which are widely popular with individual investors, are often based on Nobel Prize winning portfolio theories about efficient markets and embraced by the banks and brokers that profit from selling the strategies. They are often marketed as “all-weather” strategies to help you meet your financial goals.

To be blunt – there is no such thing as an all-weather passive strategy, no matter the IQ of the person who created it. As we have repeated throughout this series, buy and hold/passive strategies are only as good as your luck. If valuations are cheap when you start passively investing, then you have a decent shot at meeting your financial goals. If, on the other hand, valuations are extreme and rich, you are likely to endure a multi-year period of low to even negative returns which would leave you halfway to retirement without much progress towards that goal.

That is not a hypothetical statement. It is simply a function of math.

Howard Marks, via Oaktree Capital Management, and arguably one of the most insightful thinkers on Wall Street penned a piece discussing the risk to investors.

Today’s financial market conditions are easily summed up:  There’s a global glut of liquidity, minimal interest in traditional investments, little apparent concern about risk, and skimpy prospective returns everywhere. Thus, as the price for accessing returns that are potentially adequate (but lower than those promised in the past), investors are readily accepting significant risk in the form of heightened leverage, untested derivatives and weak deal structures.  The current cycle isn’t unusual in its form, only its extent. There’s little mystery about the ultimate outcome, in my opinion, but at this point in the cycle it’s the optimists who look best.”

Unfortunately, that was also a repeat of a passage he wrote in February 2007. In other words, while things may seemingly be different this time around, they are most assuredly the same.

This brings us to the “Rule of 20.” The rule is simply inflation plus valuation should be “no more than 20.” Interestingly, while the rule is pushing the 3rd highest level in history, only behind 1929 and 2000, such levels suggest the market is more than “fully priced.” Regardless of what definition you choose to use, the math suggests forward 10-year returns will be substantially lower than the last.

In a market where momentum is driving an ever smaller group of participants, fundamentals become displaced by emotional biases. As David Einhorn once stated:

The bulls explain that traditional valuation metrics no longer apply to certain stocks. The longs are confident that everyone else who holds these stocks understands the dynamic and won’t sell either. With holders reluctant to sell, the stocks can only go up – seemingly to infinity and beyond. We have seen this before.

There was no catalyst that we know of that burst the dot-com bubble in March 2000, and we don’t have a particular catalyst in mind here. That said, the top will be the top, and it’s hard to predict when it will happen.”

Such is the nature of market cycles.

Missing The Target

The trouble with passive investing is best exemplified by the greatly flawed concept of Target Date Funds (TDF). TDF’s are mutual funds that determine asset allocation and particular investments based solely on a target date. These funds are very popular offerings in 401k and other retirement plans as well as in 529 College Savings Plans.

When TDFs are newly formed with plenty of time until the target date, they allocate assets heavily towards the equity markets. As time progresses they gradually reallocate towards government bonds and other highly-rated fixed income products.

The following pie charts below show how Vanguard’s TDF allocations shift based on the amount of time remaining until the target date.

The logic backing these funds and others like it are based on two assumptions:

  1. You can afford to take more risk when your investment horizon is long and you should reduce risk when it is short.
  2. Stocks always provide a higher expected return and more potential risk than bonds.

Let’s address each assumption.

With regard to the premise of #1 about age and the propensity to take risks, we agree that an investor looking to withdraw money from their portfolio in the next year or two should be more conservative than one with a longer time horizon. The problem with that statement resides in our thoughts for #2 – there is no such thing as a steady state of expected risk and returns. The truth of the matter is that expected returns for stocks and bonds vary widely over time.

When an asset’s valuation is low, ergo asset prices are cheap, the potential downside is cushioned while the upside is greater than average. Conversely, high valuations leave one with limited upside and more risk. This concept is akin to the popular real-estate advice about buying the cheapest house on the block and avoiding the most expensive. Investment risk is not a sophisticated calculation, it is simply the probability of losing money.

To demonstrate, the chart below plots average annualized five-year returns (expected returns), annualized maximum drawdowns (risk potential) and the odds of witnessing a 20% or greater drawdown for various intervals of valuations.

The graph shows, in no uncertain terms, that risks are lower and the potential returns are higher when CAPE is low and vice versa when valuations are high. Based on this historical evidence, we question how an investor can determine asset allocation based on a target date and the assumption that the expected risk and return do not fluctuate.

Currently, CAPE is at 32 which, based on historical data, implies flat to negative expected returns and almost guarantees there will be at least a 20% drawdown over the next five years. Granted, there is not a robust sample size because valuations have rarely been this high. However, given this poor risk/return tradeoff, why should a 2040 TDF invest heavily in stocks? Might bonds, commodities, other assets or even cash, have a higher expected return with less risk? Alternatively, during periods when stock valuations are well below normal and the risks are less onerous, why shouldn’t even the most conservative of investors have an increased allocation to stocks?

To point out the flaws of TDF’s the article is largely based on stock valuations and their expected risk and return. We do not want to convey the thought that investing is binary (i.e. one can only own stocks or bonds) as there are many ways to gains exposure to a variety of asset classes. Active management takes this into consideration before allocating assets. Active managers may largely avoid stocks and bonds at times, for the comfort of cash or another asset that offers rewarding returns with limited risk.

Simply, the goal of an active portfolio manager is to invest based on probabilities.

Math always wins.

You Aren’t Passive

At some point, a reversion process will take hold. It is then investor “psychology will collide with “leverage” and the problems associated with market liquidity. It will be the equivalent of striking a match, lighting a stick of dynamite and throwing it into a tanker full of gasoline.

When the “herding” into “passive indexing strategies” begins to reverse, it will not be a slow and methodical process but rather a stampede with little regard to price, valuation or fundamental measures.

Importantly, as prices decline it will trigger margin calls which will induce more indiscriminate selling. The forced redemption cycle will cause large spreads between the current bid and ask pricing for passive funds. As investors are forced to dump positions to meet margin calls, the lack of buyers will form a vacuum causing rapid price declines which leave investors helpless on the sidelines watching years of capital appreciation vanish in moments.

Don’t believe me? It happened in 2008 as the “Lehman Moment” left investors helpless watching the crash.

Over a 3-week span, investors lost 29% of their capital and 44% over the entire 3-month period. This is what happens during a margin liquidation event. It is fast, furious, and without remorse.

Currently, with investor complacency and equity allocations near record levels, no one sees a severe market retracement as a possibility. But maybe that should be warning enough.

If you are paying an investment advisor to index your portfolio with a “buy and hold” strategy, then “yes” you should absolutely opt for buying a portfolio of low-cost ETF’s and improve your performance by the delta of the fees. But you are paying for what you will get, both now, and in the future.

However, the real goal of investing is not to “beat an index” on the way up, but rather to protect capital on the “way down.” Regardless of “hope” otherwise, every market has two cycles. It is during the second half of the cycle that capital destruction leads to poor investment decision making, emotionally based financial mistakes, and the destruction of financial goals.

No matter how committed you believe you are to a “buy and hold” investment strategy – there is a point during every decline where “passive indexers” become “panicked sellers.”

The only question is how big of a loss will you take before you get there?

The Myths Of Stocks For The Long Run Series – RIA Pro

We started writing a series titled The Myths of Stocks for the Long Run two months ago.  Quite frankly we got fed up with common investing misconceptions that are constantly being bandied about by professionals in the financial press and on social media. These “false-isms” and others tend to grow in popularity as markets peak.  Ultimately they cause individual investors significant financial harm.

Each article in the series is linked below. When put together they provide a comprehensive roadmap for successful investing. Please note there are a few more chapters on the way.

While we highly encourage you to read these articles if you haven’t already, we share with you the simple but important recurring theme throughout this series – Buy and Hold Won’t Get You There.

The Myths Of Stocks For The Long Run – Part VIII

Written by Lance Roberts and Michael Lebowitz, CFA of Real Investment Advice

The Only Benchmark That Really Matters

In Part V of this series, Choosing the Right Portfolio Benchmark, we detailed the difficulties that investors face when trying to track a particular index. In particular we closed with the following thoughts:

“Stock indexes have little to do with your goals. However, just because your portfolio beat the S&P 500, it does not mean your wealth is actually growing.”

While Part V focused on the trouble of trying to match the returns on the popular equity indexes, we must shift our focus to the only benchmark, or index, that if matched or outperformed will guarantee you have met your retirement goals.

In a recent interview, New England Patriots quarterback Tom Brady stated that they start each year with one goal; “win the Super Bowl“. Unlike many other NFL teams, the Patriots do not settle for a better record than last year or improved statistics. Their single-minded goal is absolute and crystal clear to everyone on the team. It provides a framework and benchmark to help them coach, manage and play for success. Anything short of winning the Lombardi Trophy is a failure.

When most individuals think about their investment goals, they have hopes of achieving Super Bowl like returns that guarantee a comfortable retirement. Interestingly, however, tracking an all equity benchmark like the S&P 500 index does not necessarily provide individuals with the road map to meet their goals. It is akin to the Patriot’s aiming to have a playoff worthy record.

To explain this clearly, we need to have a better understanding of what we are talking about. Despite much of the mainstream commentary that if you simply “buy and hold” an index over a 118-year period you will be fabulously wealth, for the rest of us mere mortals, we only have the time from the start our saving and investing journey to where it ends. This is typically 25-35 years.

The S&P 500

Almost all investors benchmark their returns, manage their assets and ultimately measure their success based on the value of a stock, bond or a blended index(s). The most common investor benchmark is the S&P 500, a measure of the return of 500 large-cap domestic stocks.

The performance of the S&P 500 and your retirement goals are unrelated. The typical counter-argument claims that the S&P 500 tends to be well correlated with economic growth and is therefore a valid benchmark for individual portfolio performance and wealth. While that theory can be easily challenged, especially over the past decade, the following question remains:

“Is economic growth a more valid benchmark than achieving a desired retirement goal?”

Additionally, there are long periods like we are currently witnessing where returns can be very flat, or negative, from the previous starting point as shown in the chart below.

The table below is the most critical. The table shows the actual point gain and point loss for each period. As you will note, there are periods when the entire previous point gains have been either entirely, or almost entirely, destroyed. 

What About Inflation & Purchasing Power

Even if we have a very long investment time horizon and are willing to ignore the high frequency of large variances between price and valuation, there is a much bigger problem to examine.

Consider the following question:

“If you are promised a consistent annualized return of 10% until your retirement, will that allow you to meet your retirement goals?”

Regardless of your answer, we bet that most people perform a similar analysis to answer it. Compound your current wealth by 10% annually to arrive at a future portfolio value and then determine if that is enough for the retirement need in mind.

Simple enough, but this calculus fails to consider an issue of vital importance. What if inflation were to run at an 11% annual rate from today until your retirement date?  Your portfolio value will have increased nicely by retirement, but your wealth in real terms, measured by your purchasing power, will be less than it is today. Now, suppose that instead of a constant 10% return, you were offered annual returns equal to the annual rate of inflation (the consumer price index or CPI) plus 3%.

This past year, based on 2017 CPI of approximately 2%, the CPI plus 3% would provide a total return of approximately 5% (2% + 3%). That compares poorly to greater than 20% total return for the S&P 500. We venture to say that many readers would be reluctant to accept such an “unsexy” proposition. Whether a premium of 3% is the right number for you is up for debate, but what is not debatable is that a return based on inflation, regardless of the performance of popular indexes, is a much more effective determinant of future wealth and purchasing power.

A quick side note– “Gambler’s Fallacy” as discussed in Part VII is a big physiological barrier facing most investors.

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.”

As a “saver,” trying to reach our financial objectives, we have three primary responsibilities:

  1. Have an appropriate savings rate for our goals,
  2. Ensure those savings adjust for inflation over time, and;
  3. Don’t lose it. 

There have been plenty of times in history where you literally could stick your money in a “savings” account and earn enough, “risk-free,” to “save” your way to retirement. The chart below shows the savings rate on short-term deposits adjusted for inflation.

However, in recent decades, “savers’ have not been so fortunate. Furthermore, as noted above, most investors do NOT have 90, 100, or more years to invest. Given that most investors do not start seriously saving for retirement until the age of 35, or older, that leaves 25-35 years for them to reach their goals. If that stretch of time happens to include a 12-15 year period in which returns are flat, as history tells us is probable, then the odds of achieving their goals are massively diminished.

Let’s set up an example to explain the impact of inflation more clearly.

In 1988, Bob is 35-years old, earns $75,000 a year, saves 10% of his gross salary each year and wants to have the same income in retirement that he currently has today. In our forecast, we will assume the market returns 7% each year (same as promised by many financial advisors) and we will assume a 2.1% inflation rate (long-term median) to help determine his desired retirement income.

Looking 30 years forward, as shown below, when Bob will be 65, his equivalent annual income requirement will increase to approximately $137,000 as shown below.

Understanding the relevance of this simple graph is typically problem number one for investors. Many savers fail to realize that their income needs will rise significantly due to inflation. In Bob’s case, $137,000 is the future equivalent to his current $75,000 salary assuming a modest 2.1% rate of inflation. If the double-digit inflation rate of the 1970’s were to reappear, Bob’s income needs would be significantly higher, and a larger lump sum of savings would be required to generate that higher level of income. Even if inflation remains moderate slight increases in inflation will have a big effect on Bob’s equivalent income. A 3.0% rate of inflation, for instance, increases his annual need by $39,000.

In this case, to meet his $137,000 retirement income goal and keep his wealth intact, Bob will need to amass a portfolio over $4.5 million. The figure is based on a 3% withdrawal rate matching the long-term Treasury yield.

(The graph excludes social security, pensions, etc. – this is for illustrative purposes only.)

In this analysis, we give Bob a big advantage and assume that he has been a diligent saver and has accumulated a nest egg of $100,000 to jump-start his savings adventure. Furthermore, we start his investment period in 1988 following the 1987 crash. Bob’s first 12 years of investing was one of the greatest periods to be in U.S. equities.

But did Bob reach his investment goals after doing EVERYTHING right according to the current mainstream investing commentary? Did just “buying, holding and dollar cost averaging” into the S&P 500 give Bob more than enough capital to meet his goals?

Let’s take a look at 3-different investment portfolios.

  • Portfolio 1 – “Buy & Hold:” – the “real” total return, dividend reinvested, S&P 500 index.
  • Portfolio 2 – “Buy Gold” – the gold index price (since gold is supposed to adjust for inflation)
  • Portfolio 3, – “Risk Managed” – the “real” total return S&P 500 index, but will switch to cash when the S&P 500 violates its 12-month moving average.
  • Each portfolio will be “dollar cost averaged” at a rate of $650/month or $7500/annually.

(I have not included fees, taxes, and expenses, which also reduces long-term returns, which I have covered previously here.)

The reality of saving for your retirement should be clear as 2 of the 3 methods discussed above would have left Bob well short of his financial goals.

  • “Buy & Hold” leaves you nearly $3 million short
  • “Gold” leaves you more than $3.6 million behind; but
  • “Risk Managed” has the best chance at succeeding.

There is an important point to be made here. The old axioms of “time in the market” and the “power of compounding” are true, but they are only true as long as principal value is not destroyed along the way. The destruction of the principal destroys both “time” and “the magic of compounding.”

Or more simply put – “getting back to even” is not the same as “growing.”

Inflation based indexing

Unlike benchmarking to a popularly traded equity or bond index using ETFs and mutual funds, managing to an inflation-linked benchmark is more difficult. It requires an outcome-oriented approach that considers fundamental and technical analysis across a wide range of asset classes. At times, alternative strategies might be necessary or prudent. Further, and maybe most importantly, one must check one’s ego at the door, as returns can vary widely from those of one’s neighbors.

The challenge of this approach explains why most individuals and investment professionals do not subscribe to it. It is far easier to succeed or fail with the crowd than to take an unconventional path that demands rigor. As we just discussed in part VII, herd bias, is a common psychological reason why most investors do not meet their financial goals.

Most simply put and the recurring theme throughout this series – Buy and Hold Won’t Get You There.

The Myths Of Stocks For The Long Run – Part VII

Written by Lance Roberts and Michael Lebowitz, CFA of Real Investment Advice

The Problem Of Psychology

During this series so far we have primarily discussed the more mechanical issues surrounding “investing myths” over the duration of an individuals investing “life-span.” 

Individuals are often told:

“There has never been a 10 or 20-year period in the market with negative returns.”

As we showed previously, such is not exactly correct once you account for inflation.

While “buying and holding” an index will indeed create a positive return over a long enough holding period, such does not equate to achieving financial success. But even if “investing your way to wealth” worked as advertised, then why are the vast majority of Americans so poorly equipped for retirement?

Every three years, the Federal Reserve conducts a study of American finances which exposes the lack of financial wealth for the bottom 90% of households. (Read: The Bottom 90% & The Failure Of Prosperity)

Other survey’s also confirm much of the same. Via Motley Fool:

“Imagine how the 50th percentile of those ages 35 – 44 has a household net worth of just $35,000 – and that figure includes everything they own, any equity in their homes, and their retirement savings to boot.

That’s sad considering those ages 35 and older have had probably been out in the workforce for at least ten years at this point.

And even the 50th percentile of those ages 65+ aren’t doing much better; they’ve got a median net worth of around $171,135, and quite possibly decades of retirement ahead of them.

How do you think that is going to work out?”

Another common misconception is that everyone MUST be saving in their 401k plans through automated contributions. According to Vanguard’s recent survey, not so much.

  • The average account balance is $103,866 which is skewed by a small number of large accounts.
  • The median account balance is $26,331
  • From 2008 through 2017 the average inflation-adjusted gain was just 28%. 

So, what happened?

  • Why aren’t those 401k balances brimming over with wealth?
  • Why aren’t those personal E*Trade and Schwab accounts bursting at the seams?
  • Why are so many people over the age of 60 still working?

While we previously covered the impact of market cycles, the importance of limiting losses, the role of starting valuations, and the proper way to think about benchmarking your portfolio, the two biggest factors which lead to chronic investor underperformance over time are:

  • Lack of capital to invest, and;
  • Psychological behaviors

Psychological factors account for fully 50% of investor shortfalls in the investing process. It is also difficult to “invest” when the majority of Americans have an inability to “save.”

These factors, as shown by data from Dalbar, lead to the lag in performance between investors and the markets over all time periods.

While “buy and hold” and “dollar cost averaging” sound great in theory, the actual application is an entirely different matter. The lack of capital is an issue which can only be resolved through financial planning and budgeting, however, the simple answer is:

Live on less than you make and invest the rest.

Behavioral biases, however, are an issue which is little understood and accounted for when managing money. Dalbar defined (9) nine of the irrational investment behavioral biases specifically:

  • Loss Aversion – The fear of loss leads to a withdrawal of capital at the worst possible time.  Also known as “panic selling.”
  • Narrow Framing – Making decisions about on part of the portfolio without considering the effects on the total.
  • Anchoring – The process of remaining focused on what happened previously and not adapting to a changing market.
  • Mental Accounting – Separating performance of investments mentally to justify success and failure.
  • Lack of Diversification – Believing a portfolio is diversified when in fact it is a highly correlated pool of assets.
  • Herding– Following what everyone else is doing. Leads to “buy high/sell low.”
  • Regret – Not performing a necessary action due to the regret of a previous failure.
  • Media Response – The media has a bias to optimism to sell products from advertisers and attract view/readership.
  • Optimism – Overly optimistic assumptions tend to lead to rather dramatic reversions when met with reality.

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.

Let’s dig into the top-5 of the most insidious biases which keep us from achieving our long-term investment goals.

1) Confirmation Bias

As individuals, we tend to seek out information that conforms to our current beliefs. For instance if one believes that the stock market is going to rise, they tend to heavily rely on news and information from sources that support that position. Confirmation bias is a primary driver of the psychological investing cycle.

To confront this bias, investors must seek data and research that they may not agree with. Confirming your bias may be comforting, but challenging your bias with different points of view will potentially have two valuable outcomes.

First, it may get you to rethink some key aspects of your bias, which in turn may result in modification, or even a complete change, of your view. Or, it may actually increase the confidence level in your view.

The issue of “confirmation bias” is well known by the media. Since the media profits from “paid advertisers,” viewer or readership is paramount to obtaining those clients. The largest advertisers on many financial sites are primarily Wall Street related firms promoting products or services. These entities profit from selling product they create to individuals, therefore it should be no surprise they advertise on websites that tend to reflect supportive opinions. Given the massive advertising dollars that firms such as Fidelity, J.P. Morgan (JPM), and Goldman Sachs (GS) spend, it leaves little doubt why the more successful websites refrain from presenting views which deter investors from buying related products or services. 

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, analyze the data accordingly, and form a balanced conclusion. 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.

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.”

We 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 an 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.

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 it. However, it is this infinitesimal “possibility” of being fabulously wealthy that makes the lottery so successful. Las Vegas exists for one reason; amateur gamblers favor possibility over probability.

As investors, we tend to neglect the “probabilities,” or specifically the statistical measure of “risk” undertaken, with any given investment. 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 by the time the masses have come to discover the opportunity, most of the gains have likely already been garnered.

“Probability Neglect” is the very essence of the “buy high, sell low” syndrome.

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 forecasted. 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.”

4) Herd Bias

Maybe the best way to show how susceptible we are to follow the crowd is by watching this video from Candid Camera.

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, and if I want to be accepted, then I need to do it also.

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 markets to extremes.

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 not necessarily knowing when to “bet” against the stampede but the psychologically debilitating action of being different. As they say, “it is lonely at the top.”

5) Anchoring Effect

This is also known as a “relativity trap” which is the tendency 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 are likely to assume that the next home purchase will have a similar result. When we become mentally “anchored” to an event we tend to base our future decisions around it.

When it comes to investing we do very much the same thing. If we buy a stock and it goes up, we remember that stock and that outcome. Therefore, we become anchored to that stock. Individuals tend to “shun” stocks which lost value even though the individual simply bought and sold at the wrong times. After all, it is not “our” fault an investment lost money; it was just a bad company. 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 they tend to panic “sell” and now become “anchored” to a negative experience and never buy shares of ABC again. Worse, DEF, despite your past experience owning it, may present great value at reduced prices, but your previous negative experience reduces your inclination to purchase it.


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. Are valuations at levels that have previously lead to higher rates of future returns? Are interest rates rising or falling? Are individuals currently assessing the “possibilities” or the “probabilities” in the markets?

As individuals, we invest our hard earned “savings” into a “speculative” environment where we are “betting” on a future outcome. The reality is the majority of individuals are ill-prepared for an impact event to occur. This is particularly the case in late-stage bull market cycles where complacency runs high.

The discussion of why “this time is not like the last time” is largely irrelevant. Whatever gains investors garner in the first-half of an investment cycle by chasing the “bullish thesis” will be almost entirely wiped out during the second-half. Of course, this is the sad history of individual investors in the financial markets as they are always “told to buy,” but never “when to sell.”

The Myths Of Stocks For The Long Run – Part VI

Written by Lance Roberts and Michael Lebowitz, CFA of Real Investment Advice

Should You Invest Like Warren Buffett?

Whenever we discuss this issue of the fallacies to “buy and hold” investing, invariably there is the comment:

“Then why does Warren Buffett say that the ideal holding period is forever?”

First of all, we have the utmost respect for Warren Buffett. If investing had a “hall of fame,” Warren’s bust would be displayed in the front row along with Benjamin Graham. Through hard work, a grounded set of value principles, and great timing, he has been able to amass a great amount of wealth for himself and his shareholders.

Buffett’s specialty is value investing. That means buying stocks with long-term prospects that are believed (by a value investor) to be undervalued. The unloved underdog, for instance, which has been unfairly cast aside by Wall Street and whose value will be rediscovered in the future.

He articulated this approach succinctly in his 2008 letter to Berkshire Hathaway (BRK/A) shareholders:

“Long ago, Ben Graham taught me that ‘Price is what you pay; value is what you get.’ Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”

While there is often a rush in trying to justify “buy and hold” investing by selectively choosing quotes from Warren Buffett as noted above, Mr. Buffett’s most basic premise is that of active asset management:

“Be fearful when others are greedy and greedy when others are fearful.”

Or, as Baron Rothschild once quipped:

“Buy cheap, Sell dear.”

Not only is the most basic tenant of value investing, but it is the most basic premise of investing…period.

Like Buffett, as value-based portfolio managers ourselves, we also prefer extremely long holding periods. However, just because we “prefer” extremely long holding periods, things can and do change which can shorten that holding period immensely.

We also realize there are tremendous differences which we, and other “Buffett” disciples, cannot replicate. Yes, you can buy the same stocks as Buffett, but your outcome is going to be dramatically different from Berkshire Hathaway for several reasons.

There is an old joke that goes:

“The first step in investing like Warren Buffett: start with $1 billion…”

The joke, however, only begins to highlight the incredibly unique position Buffett enjoys in the investing world. Buffett is an anomaly; he is part private-equity deal broker, part investment bank, part Wall Street insider and part activist investor. He is also an investing icon, and as such, many investors copy his actions which lend price support to his investments.

Investors flock to Omaha for his annual shareholder meetings in hopes of glimmering information on how he is able to produce such great returns. Yet, no one has been able to come close to matching his track record. While many think Mr. Buffett has found the secret formula to investing – it is actually a combination of several “special” circumstances which have afforded Mr. Buffett his edge over the years.

Timing Is Everything – we have discussed through this entire series the importance of valuation analysis at the “beginning” of the investing journey. When you start your investing journey is one of the most important facets of long-term investing returns. While Buffett clearly bested the S&P 500 index over the years, he benefited greatly from the luck of catching the greatest bull market run in history in the 80’s and 90’s.

“Timing” and “good luck” are two of the most critical aspects of successful long-term investing. For Buffett, his timing could not have been better as a bulk of his outperformance in the early years came from his nimbleness to capture opportunities as the U.S. emerged from back-to-back recessions, low-valuations, high dividends and falling rates of inflation and interest rates.

As of this writing, those factors no longer exist for investors wishing to replicate his performance going forward. Valuations are elevated, interest rates and inflation are low, and economic growth remains weak. As for Berkshire, the fund has grown to nearly $500 billion and accordingly the opportunities for outsized performance are rarely available in a size which moves the “performance alpha” needle much.  As noted by Michelle Perry Higgins

Buy what I’ve found most insightful is to chart the trend in Berkshire’s annual stock performance compared to the S&P 500. As an example, this is Berkshire’s alpha, for its excess return over the broader market through 2016:”

(Note: Berkshire’s first 5-years were problematic as market valuations were still falling through the 1974 market crash. However, that crash set Buffett up for a spectacular run over the next two decades.)

“This shows that Berkshire’s best days were in the late 1970s, a tumultuous decade thanks to wildly fluctuating energy prices and rapidly accelerating inflation. Since then, Berkshire’s performance relative to the S&P 500 has steadily narrowed. The rolling five-year average of Berkshire’s alpha dipped into negative territory in three out of the past five years.

Working against Berkshire is its growing size, a point Buffett has pointed out in the past. It has the fifth largest market capitalization on the S&P 500, behind only AppleAlphabetMicrosoft, and Facebook. It also owns a vast assortment of subsidiaries, from home builders to car insurers to restaurants.

The net result is that Berkshire’s annual returns theoretically should, and increasingly are, mirroring that of the economy and thus the broader market. Buffett has said this would happen. He’s obviously right.”

Management Control – As individuals, we can buy shares in a company and hope the company makes good decisions which leads to future rates of increased profitability. Buffett, on the other hand, often takes significant positions in companies which allow him direct input into the decisions the company makes.

“Warren Buffett walks into a board meeting, looks at the guy at the head of the table and says ‘excuse me, you’re sitting in my chair.’” – Wall Street humor.

While humorous, it is also true. We make speculative bets in companies by buying ethereal pieces of paper at one price and hoping to sell them at a higher price later to someone else. In every sense of the word, while we wish to fancy ourselves as investors, we are “speculating” on a future outcome.

Buffett, on the other hand, actually “invests” in companies not only through his influx of capital but also through his ability to provide insight, opportunity, and connections. The seat in the boardroom that Buffett is able to acquire helps pick executives, set the future course for the company, and create opportunities that might not have otherwise existed through synergies with other Buffett related holdings. Their direct hand in management also provides them information not available to most shareholders.

Private investments/Special Opportunities – Unlike the vast majority of portfolio managers and individuals, Mr. Buffett is not limited to just publicly traded stocks and other securities available to the public. Their size and clout gives them access to invest in private situations that many investors have no access to.

A good example was in September 2008. Goldman Sachs (GS) offered Buffett a deal which was too good to be true. With GS trading at $123/share and having capital issues due to market illiquidity, they offered Buffett the right to buy $5 billion of preferred stock yielding 10% and an attached warrant allowing Buffett a five-year option to buy the common stock at $115/share. Five years later, GS was trading at $185/share resulting in a 60% return on the warrants. As if 60% was not enough, it was on top of the 10% dividend they received annually. Needless to say, the average investor was never offered such a deal.

Time horizon – Buffett has no time horizon. In other words, while individuals have a set time frame based on retirement goals and life expectancy, which factor heavily into both the accumulation and distribution phases of the wealth building process, Buffett does not. As discussed previously, capital destruction can wreak havoc on financial goals.

Buffett buys companies. As such, he is focused on the long-term growth potential acquisition. Berkshire Hathaway is also a company, with a board of directors, officers, etc., which also provides the portfolio an “eternal” lifespan. As such, Berkshire can truly act as a long-term investor without concern for market volatility, living requirements, or death. As we have continually mentioned throughout this series, you and I will likely fail to meet our retirement goals if we have to endure a 10-20 year period of no gains. For Berkshire, it will simply be a function of economic growth and the resultant net profitability to investors and shareholders.

Leverage – One of the most interesting aspects, and one of Berkshire’s biggest advantages, is unique in they own an insurance company. The insurance float represents the available reserve, or the amount of funds available for investment once the insurer has collected premiums, but is not yet obligated to pay out in claims. The money is invested for future claims by the insurer.

Here is where Buffett has a huge advantage over every else as explained by Vintage Value:

“During that time, the insurer invests the money. Insurance float is so valuable that insurance companies often operate at an underwriting loss – that is, the premiums received are not enough to cover the eventual losses (hurricanes, car accidents, etc.) that must be paid and the expenses required to resolve those claims, operate the business, etc.

Why would an insurer operate at a loss? Again, because the insurer can invest the insurance float and make even more money. In this sense, insurance float is like a loan and the underwriting loss is like the interest rate on that loan (i.e. cost of capital).

Now, for most insurers the cost of float is usually a few percentage points. Berkshire Hathaway’s insurance operations, however, are so well run that the company’s historical cost of float has actually been positive… meaning Berkshire Hathaway is actually being paid to take other people’s money!”

The ability to leverage portfolios over time provides a huge amount of potential alpha generation to returns. However, for the average investor, leverage can also be extremely destructive when used improperly.

Don’t Get Swept Up By The Crowd

While we are avid Buffett admirers, with a deep respect for value investing and long-term returns, which is why we model our equity portfolios on value and fundamental factors, we also are well aware of the limitations of our client’s portfolio duration, capital needs and risk tolerance.

As we addressed in Part 2 of this series, simply buying and holding a basket of stocks over long periods will likely map you fairly closely to the S&P 500 index. (Repeated studies show that more than 30-stocks in a portfolio will essentially replicate the return of the S&P 500 index.) However, historically speaking, while over a given 20 to 30-year investing period an investor will make money, there can be huge shortfalls in meeting investment goals.

As Tom Brakke once stated in an interview:

“No name gets dropped quite as much as Warren Buffett’s by those writing about investments, including me.

The infatuation with Mr. Buffett is understandable given his success and his folksy manner. But investors should be aware that he plays a different game than the rest of us. He gets the first call on deals and he gets attractive terms on his investments. We can’t replicate those advantages.

Another thing to keep in mind is how much Mr. Buffett’s strategy has changed over time. Whereas most investors are urged to adopt a plan and stick to it, Mr. Buffett showed that different times and different circumstances mean that core principles should be examined and adapted as necessary.”

Yes, it is true that Buffett prefers long-holding periods, however, it is a mistake to suggest that he is not an “active” portfolio manager. Buffett has regularly sold parts, or all, of the companies he owns when “value” is no longer present. Furthermore, you should not make the mistake of thinking that anything that Mr. Buffett holds is worth owning currently. As Tom concludes:

“Many investors did that in the ’90s, buying Coca-Cola and other stocks because Buffett owned them, even though they were trading at historic levels of overvaluation. The results weren’t good. So, don’t cherry-pick Mr. Buffett’s ideas and expect to do well. That’s not a great way to emulate him.”

The theme of this series is to avoid these pitfalls as much as possible. Given current valuations the risk/return framework of the market and BRK/A are poor. The graph below highlights this concern. It shows that 90-day rolling correlation of price changes in BRK/A and the S&P 500 are statistically similar. In the market crash of 2008/09 BRK/A’s price was cut in half, similar to the S&P 500. Based on correlations we suspect a similar relationship will hold true for the next big market drawdown.

Be Like Warren

The hardest thing for investors to do is to turn off the media, discount the “buy and hold” mantra, and focus on what matters for long-term investing – valuation. As Tom Brakke concluded:

The most important lesson that Mr. Buffett can offer anyone: Don’t get swept up by the crowd.

For example, he has been willing to sit on a mountain of cash, even though interest rates are extremely low. Most financial advisers would scoff at that, but Mr. Buffett will wait in cash if there aren’t compelling values available elsewhere.

And he is willing to be out of step for long periods in order to do well in the end. Most of us have a very hard time doing that.”

The patience required to withstand a low return on the cash while the market moves higher is high. To put this concept in a different light, we potentially give up short-term gains in exchange for the opportunity to “buy” when market prices are “cheap” and potential returns are high.

Want to invest like Warren? Then follow his rules:

  1. “Don’t lose money.”
  2. Refer to Rule #1
  3. Buy that which is “cheap”
  4. Sell that which is “dear”
  5. Hold excessive levels of cash if necessary
  6. Do not follow the herd
  7. Have patience, patience and even more patience
  8. If you want to beat the market, you cannot look like the market

There is nothing “passive” about Warren Buffett or his investment strategy. But there is one lesson in particular that every long-term investor should remember which is the core staple of our investment philosophy and discipline.

“A patient, long-term value investor is the one that sees the big picture and understands stock-market cycles. He or she will likely not fall into the greed or fear trap. Warren Buffett is a brilliant man and has many lessons that investors should emulate. One of his most valued quotes for me is, ‘We (must) simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.’ That is the epitome of breaking away from the herd.”Michelle Perry Higgins

The Myths Of Stocks For The Long Run – Part V

Written by Lance Roberts and Michael Lebowitz, CFA of Real Investment Advice

Choosing The Right Portfolio Benchmark

“Investing isn’t about beating others at their game. It’s about controlling yourself at your own game.” –Ben Graham

Benchmarks serve an important role in growing one’s wealth. Most importantly they provide a yard-stick to see how we are doing in meeting our future retirement goals. For those that rely on professionals to manage their money, a benchmark allows the client to gauge how the manager is performing versus what the market is providing.

We do not disparage the use of benchmarks. However, the purpose of this article is to help you understand the differences between an equity index and your portfolio. As we discussed in Part 2 of this series, the proper benchmark for any portfolio is the rate of inflation plus a rate of growth that achieves the specific level of inflation-adjusted dollars required at retirement. Meeting such a benchmark guarantees you meet your goal. No other index can claim that. Benchmarking to the S&P 500, or any other equity index, requires investors to take on excess investment risk which is not correlated to the financial goals or duration of the portfolio.

This article specifically addresses the difficulty of trying to track an equity benchmark index (i.e. the S&P 500.)

The continual efforts 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 has been drilled into 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, most individuals have done far worse. 

The annual studies from Dalbar show the dismal truth, individuals consistently underperform the benchmark index over EVERY time frame.

The reason this underperformance consistently occurs is due to emotional and behavioral tendencies and the many differences between a “market capitalization weighted index” versus a “dollar invested portfolio.” 

Let’s set aside the emotional and behavioral mistakes for today, and focus on the differences between a benchmark index and your portfolio which make beating an index difficult.

Building The Sample Index

To best understand why tracking the S&P 500 index is hard we must first understand how the S&P 500 index is constructed. The following explanation is from Investopedia:

“The S&P 500 is a U.S. market index that is computed by a weighted average market capitalization.  The first step in this methodology is to compute the market capitalization of each component in the index.

This is done by taking the number of outstanding shares of each company and multiplying that number by the company’s current share price, or market value. For example, if Apple Computer has roughly 830 million shares outstanding and its current market price is $53.55, the market capitalization for the company is $44.45 billion (830 million x $53.55).

Next, the market capitalizations for all 500 component stocks are summed to obtain the total market capitalization of the S&P 500, as illustrated in the table below. This market capitalization number will fluctuate as the underlying share prices and outstanding share numbers change.


In order to understand how the underlying stocks affect the index, the market weight (index weight) needs to be calculated. This is done by dividing the market capitalization of a company on the index by the total market capitalization of the index.

For example, if Exxon Mobil’s market cap is $367.05 billion and the S&P 500 market cap is $10.64 trillion, this gives Exxon a market weight of roughly 3.45% ($367.05 billion / $10.64 trillion). The larger the market weight of a company, the more impact each 1% change will have on the index.

For example, if Exxon Mobil were to rise by 20% while all other companies remained unchanged, the S&P 500 would increase in value by 0.6899% (3.45% x 20%). If a similar situation were to happen to The New York Times, it would cause a much smaller, 0.0076% change to the index because of the company’s smaller market weight.”

Okay, with that baseline understanding of the construction of the S&P 500, let’s create a most basic index called the Sample Index which is comprised of 5 fictional companies. For simplicity purposes, each company has 1000 shares of stock outstanding and all trade at $10 per share. The table shows the index versus “Your Portfolio” which is a $50,000 investment weighted identically.

We will take both the Sample Index and Your Portfolio through various events and price changes that cause differences to occur between the two. The events, and passage of time, are labeled at the top of each table. At the end of the exercise, we provide you a performance chart covering the entire period.

In Year 1, our starting point, we divide “your portfolio’s” $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 amplified versus that of the must broader indexes. 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 that we will cover today, that have major impacts on performance. Corporate events such as mergers, buyouts, and acquisitions affect the index. Your portfolio is also impacted by withdrawals, contributions, and  your dividend reinvestment policy.

Lastly, and most importantlynone 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 typically 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 year two, we assume that nothing exceptional, other than typical price appreciation or depreciation occurred. The table below shows the impact of price changes on both the Sample Index and Your Portfolio.

As you can see the Sample Index and Your Portfolio had the same price return and remain exactly the same.

Share Buybacks & Bankruptcy

Over the last ten years, 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 buybacks are often a tool used to artificially inflate bottom line earnings per share which, temporarily, drives share prices higher. The biggest beneficiary of buybacks are the executives whose compensation is heavily tied to stock options. The losers are the long terms shareholders. Not only must the debt and interest expense, frequently incurred to conduct buybacks, be paid for with future earnings, but the buyback, in many cases, took precedence over investment in the company’s future. The long-term implications for the company and the economy are troubling.

The importance of buybacks cannot be overlooked. The dollar amount of sales, or top-line 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 “per share” results in order to boost share prices and meet “Wall Street Expectations.”

Stock buybacks DO NOT show faith in the company by the executives but rather a LACK of better ideas for which to use the capital for.

Importantly, for our overall example, the reduction in outstanding shares reduces market capitalization.

Let’s go back to our original index and portfolio example.

In year 3, Company DEF buys back 100 shares and each company experiences a change in its share price.

The table below shows the impact of these three events on the index and the portfolio.

Notice that the DEF share buyback caused the market capitalization of the index to fall and the weighting of DEF to decline versus the other stocks. Your Portfolio was unchanged and accordingly, the weightings of the index and your portfolio are different. As we will see the returns will begin to diverge at this point because of the slight change in weighting.

Substitution Effect

In year four we introduce the “substitution effect.”

When company’s such as GM, AIG, Enron, Worldcom, and a host of others in history, goes bankrupt or have shrunken considerably, they are swapped out of the index for another company. The index is naturally reweighted for the “substitution.” The table below shows the impact of the substitution on the index and your portfolio.

The substitution not only adds a new stock to the index, but a stock with a much higher weighting than the one removed. Not only does Your Portfolio not hold the new stock but whatever value is left on the removed stock is still affecting your portfolio. Additionally, the change in weightings cause further misalignment between the index and your 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 replaced with PQR. The problems with doing this are shown in the next table.

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 we 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.

Comparison Is The Problem

The point of this exercise is to show how different types of index and corporate events change the composition of the Index. Unless one is consistently rebalancing their portfolio they will not be able to match the index. Even if one is constantly trading to mimic the index, the commissions, taxes, and fees will weigh heavily on results over time and will lead to underperformance of the benchmark index. 

The chart below once again returns us to our $100,000 invested into the nominal index versus a $100,000 portfolio adjusted for “reality.” A $100,000 investment in 1998 has had a compounded annual growth rate of 6.72% on a nominal basis as compared to just a 4.39% rate when adjusted for reality. The numbers are far worse if you started in 2000 or 2008.

Furthermore, both numbers also fall far short of the promised 8% annualized rates of return often promised by the mainstream analysts promising riches if you just buy their investment product, or service, and hang on long enough.

The reality, as shown previously, is that such an outcome will likely prove to be extremely disappointing. However, the financial media continually pushes the idea that we must “beat the index.”

However, comparison is the cause of more unhappiness than anything else. Perhaps it is inevitable that human beings as social animals have an urge to compare themselves with one another. Maybe it is just because we are all terminally insecure in some cosmic sense. Social comparison comes in many different guises. “Keeping up with the Joneses,” is one well-known way.

Comparison is why individuals 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 an individual makes 12% on their investments, they are very pleased. That is, until they learn “everyone else” made 14%. Now they are 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 benchmarks, indices and style boxes is nothing more than the creation of more things to COMPARE to which keeps individuals in a perpetual state of outrage creating more revenue for Wall Street.

Comparison of your performance to an index is potentially dangerous to your investing objectives. 

The major learning points regarding benchmarking 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 cannot be regained.

 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 additional risk) the results will likely be disastrous.

We want to reiterate an important thought from the start of this article. Stock indexes have little to do with your goals. Later in this series, we will discuss a benchmark that is extremely relevant to every investor but used by a precious few – inflation. Simply, if your portfolio is growing faster than inflation your wealth is growing. However, just because your portfolio beat the S&P 500, it does not mean your wealth is actually growing.

As Ben Graham suggests, investing is not a competition and there are horrid consequences for treating it as such.

The Myths Of Stocks For The Long Run – Part IV

Written by Lance Roberts, Michael Lebowitz, CFA and John Coumarianos, M.S. of Real Investment Advice

The Math Of Loss

The “mantra” of “this time is different” is always uttered during ebullient periods in the stock market when “investment risk” is ignored and the pursuit of gains is all that seems to matter. It is during these times where markets “only seem to go up” when statements such as “investing is about ‘time-in’ the market rather than ‘timing’ the market” are made. Such statements are generally regretted in the not-so-distant future.

There is a major point of clarification that needs to be made here. I completely agree that investors cannot be “all in” or “all out” of the market on a consistently correct basis. However, it is at this point in the discussion that some analyst pulls out a chart showing how poor your investment returns would have been if you had missed the “10-best days in the market.”

While that bit of information is true, what is never discussed is what happens to investor returns when they capture market losses. The table below shows the damage done to an investor’s portfolio during a market drawdown and the subsequent return required to get “back to even.”

Even a modest 10% correction requires an 11.11% gain just to get back to even. This is why a strategy of “getting back to even” has never been a worthwhile investment discipline

But it is actually much worse than that when looking at a 10% loss over a longer-term investment time frame.

Let’s assume an investor wants to compound their investments by 10% a year over a 5-year period.

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 long-term time frames.

Not surprisingly, the idea of being “all in the market all the time” turns out to be a poor strategy when viewed in this manner. What bullish prognosticators forget is the importance of capital destruction as it relates to portfolio returns over time. It is also why you should question statements as:

“Losses are just part of investing in the stock market. If you aren’t prepared to lose tremendous amounts of value, you shouldn’t be in stocks.”

Wait a second.

Why should I need to be prepared to lose a tremendous amount of value in my portfolio?

Why can’t I apply some rather simplistic risk management tools, combined with a lower volatility portfolio allocation model, to create returns over time with a lower risk of major drawdowns? After all, is this not one of the most basic tenants of investing: “buy low/sell high?”

Or as Warren Buffett stated:

  • Rule #1: Don’t Lose Money
  • Rule #2: Refer To Rule #1

Managing The Risk

There are no great investors of our time that “buy and hold” investments. Even the great Warren Buffett sells investments. True investors buy when they see value and sell when value no longer exists.

While there are many sophisticated methods of handling risk within a portfolio, even using a basic method of price analysis, such as a moving average crossover, can be a valuable tool over the long-term holding periods.

Will such a method ALWAYS be right? Absolutely not. However, will such a method keep you from losing large amounts of capital? Absolutely.

The chart below shows a simple moving average crossover study. The actual moving averages used are not important, but what is clear is that using a basic form of price movement analysis can provide useful identification of periods when portfolio risk should be REDUCED. Importantly, I did not say risk should be eliminated; just reduced.

Again, we are not implying, suggesting or stating that such signals mean going 100% to cash. We are suggesting that when “sell signals” are given that is the time when individuals should perform some basic portfolio risk management such as:

  • Trim back winning positions to original portfolio weights: Investment Rule: Let Winners Run
  • Sell positions that simply are not working (if the position was not working in a rising market, it likely won’t in a declining market.) Investment Rule: Cut Losers Short
  • Hold the cash raised from these activities until the next buying opportunity occurs. Investment Rule: Buy Low

Missing The 10 Worst Days

With this understanding, let’s revisit the myth of “missing the 10-best days in the market.” The reason that portfolio risk management is so crucial is that it is not “missing the 10-best days” that is important, it is “missing the 10-worst days.” The chart below shows the comparison of $100,000 invested in the S&P 500 Index (log scale base 2) and the return when adjusted for missing the 10 best and worst days.

Clearly, avoiding major drawdowns in the market is key to long-term investment success. If I am not spending the bulk of my time making up previous losses in my portfolio, I spend more time compounding my invested dollars towards my long-term goals.

You Can’t Handle The Volatility

Despite the mainstream attempt at convincing you that it is “time in the market” that matters, the reality is that there have been many periods in history where you simply “ran out of time.”

Here’s another huge myth:

“There has never been a 10- or 20-year period that had negative returns.” 

Even on a total return (dividends included) basis, there have been four previous periods, working on the 5th, where a “near zero” 20-year return is not the outcome investors were hoping for. It also left many investors far short of their financial goals.

Of course, such dismal forward returns have only occurred when the starting 10-year cyclically adjusted P/E ratio was above 23x earnings. At over 30x earnings, this would suggest that “time in the market” may not be as beneficial over the next 20-years.

More importantly, it is the “human factor,” a subject we will explore thoroughly in another chapter, which leads to the poorest of outcomes over time. When markets are strongly trending positively, the emotion of “greed” leads to a diminishment as to the appreciation of risk contained within portfolios. Even the worst possible investment mistakes are masked by strongly rising prices. (It is near the peak of these periods when articles espousing “this time is different” and chastising those that “missed the rally…”)

However, it is only after a significant decline in prices, and a large amount of capital destruction, that individuals “panic sell” to stop the “pain of loss” and the risk in portfolios is realized. This is where investors do the most damage to their long-term portfolio goals. I have published the following “investor psychology” chart many times in the past – the message is all too clear.

Let me reiterate this point. A strict discipline of portfolio risk management will NOT eliminate all losses in portfolios. However, it will minimize the capital destruction to a level that can be dealt with logically rather than emotionally.

There is no reason to “benchmark” your portfolio to some random index. 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, as history shows, there are horrid consequences for treating it as such. This is why incorporating some method of managing the inherent risk of investing over the full-market cycle. I would question those who tell you not to do so as they are likely acting from a position of incompetence or self-interest. In the long run, you probably will not beat the index, but you are likely to achieve your financial goals which is why you invested to start with.

The Myths Of Stocks For The Long Run – Part III

Written by Lance Roberts, Michael Lebowitz, CFA and John Coumarianos, M.S. of Real Investment Advice

Part I – “Buy & Hold” Can Be Hazardous To Your Wealth

Part II – Why Crashes Matter & The Saving Problem

Valuations & Forward Returns

“Part III” of this series will discuss the issue of valuations, the impact on forward returns as it relates to investment outcomes, and withdrawal rates in retirement.

As discussed previously:

“Investors do NOT have 90, 100, or more years to invest. Given that most investors do not start seriously saving for retirement until the age of 35, or older, they have 30-35 years to reach their goals. If that stretch of time happens to include a 12-15 year period in which returns are flat, as history tells us is probable, then the odds of achieving their goals are massively diminished.”

But what drives those12-15 year periods of flat to little return? Valuations.

In this article, we focus on the Shiller Cyclically Adjusted Price to Earnings Ratio or CAPE. This technique differs from most other price-to-earnings ratios as it takes a longer term view by using ten-year average of earnings. The graph below shows how this compares over time.

What is clear, and unarguable, is that when valuations are elevated, future returns on investments decline. There are two ways in which the ratio can revert back to levels where future returns on investments rise. 1) Prices can rapidly decline, or 2) Earnings can rise significantly while prices remain flat. Historically, and as shown above, option 2) has never been a previous outcome.

One great thing about valuations, such as CAPE, is that we can use them to help us form expectations around risk and return. The graph below shows the actual 30-year annualized returns that accompanied given levels of CAPE.

While it is crystal clear, as evidenced by the graph, as valuations rise future rates of annualized returns fall. This should not be a surprise as simple logic states that if you overpay today for an asset, future returns must, and will, be lower.

Math also proves the same. Capital gains from markets are primarily a function of market capitalization, nominal economic growth plus the dividend yield. Using the Dr. John Hussman’s formula we can mathematically calculate returns over the next 10-year period as follows:

(1+nominal GDP growth)*(normal market cap to GDP ratio / actual market cap to GDP ratio)^(1/10)-1

Therefore, IF we assume that

  • GDP attains, and maintains, 4% annualized growth starting immediately, AND
  • There are NO recessions, AND
  • Current market cap/GDP stays flat at 1.25, AND
  • The current dividend yield of roughly 2% remains,

We would get forward returns of:

(1.04)*(.8/1.25)^(1/30)-1+.02 = 4.5%

But there’s a “whole lotta ifs” in that assumption.

More importantly, if we assume that inflation remains stagnant at 2%, as the Fed hopes, this would mean a real rate of return of just 2.5%.

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 the accumulation phase of the investment life-cycle.

Let’s take this a step further. For the purpose of this article, we went back through history and pulled the 4-periods where 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.

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.” 

This idea becomes much clearer by showing the value of $1000 invested in the markets at both valuations BELOW 10x trailing earnings and ABOVE 20x. I have averaged each of the 4-periods above into a single total return, inflation-adjusted, index, Clearly, investing at 10x earnings yields substantially better results.

Not surprisingly, the starting level of valuations has the greatest impact on your future results.

But, in investing, getting to your destination is only half of the journey.

Starting Valuations Are Critical To Withdrawal Rates

Valuations have even a bigger, and vastly more critical, impact on the outcomes of withdrawal rates during retirement. Michael Kitces wrote an article discussing the withdrawal rate in retirement (Why Most Retirees Will Never Draw Down Their Retirement Portfolio) where he laid out a typical example of a retirement portfolio during the distribution phase of retirement.

“Given the impact of inflation, it’s problematic to start digging into retirement principal immediately at the start of retirement, given that inflation-adjusted spending needs could quadruple by the end of retirement (at a 5% inflation rate). Accordingly, the reality is that to sustain a multi-decade retirement with rising spending needs due to inflation, it’s necessary to spend less than the growth/income in the early years, just to build enough of a cushion to handle the necessary higher withdrawals later!

For instance, imagine a retiree who has a $1,000,000 balanced portfolio, and wants to plan for a 30-year retirement, where inflation averages 3% and the balanced portfolio averages 8% in the long run. To make the money last for the entire time horizon, the retiree would start out by spending $61,000 initially, and then adjust each subsequent year for inflation, spending down the retirement account balance by the end of the 30th year.”

Before we get into the variability of returns and starting market valuations, I want to dig deeper into Kitces’ premise above by looking at the impact of inflation-adjusted returns and taxation.

The first chart below expands on Kitces’ chart above by adjusted the 8% return structure for inflation at 3% and also adjusting the withdrawal rate up for taxation at 25%.

By adjusting the annualized rate of return for the impact of inflation and taxes the life expectancy of a portfolio grows considerably shorter. However, the other problem, as first stated above, is 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 taxation, a much different, and far less favorable, financial outcome emerges – the retiree is out of money not in year 30, but in year 18.

So, with this understanding let me return once again to those that continue to insist the “buy and hold” is the only way to invest. 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 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.

I want you to take note of the following.

When investing your money at valuations above 20x earnings, it takes 22-years before it has grown more than money stuffed in a mattress. 

Why 22 years? 

Take a look at the chart below.

Historically, it has taken roughly 22-years to resolve a period of over-valuation. Given the last major over-valuation period started in 1999, history suggests another major market downturn will “mean revert” valuations by 2021.

The point here is obvious. Valuations are the ultimate arbiter of future returns. Whether you are in the first half of the investment cycle, or the last, the single most important factor to your long-term success is at “what valuation level” did you start your journey?

The Myths Of Stocks For The Long Run – Part II

Written by Lance Roberts, Michael Lebowitz, CFA and John Coumarianos, M.S. of Real Investment Advice

Crashes Matter A Lot

In Part I – Buy and Hold can be Hazardous to your Wealth, we showed how the stock markets tend to cycle between growth and decline. Passive, “buy and hold” investors who hold their investments through the cycles are likely to endure long periods of time in which they are recovering losses and not compounding their wealth. As discussed, falling into this age-old trap for a decade or longer violates Warren Buffett’s two golden rules of investing:

  1. Don’t Lose Money
  2. Refer To Rule #1

In “Part II” of this series, we will discuss why avoiding major market corrections is so important. We also dive into a related topic, the “savings problem.”

As noted previously, many of those who promote “buy and hold’ type philosophies often claim that those who dollar cost average (DCA) on a regular basis endure much shorter periods recovering previous losses. While they are partially correct, as recovery periods from losses are shorter, evidence clearly shows few individuals actually invest that way.

As discussed previously, investors do NOT have 90, 100, or more years to invest. Given that most investors do not start seriously saving for retirement until the age of 35, or older, that leaves 30-35 years for them to reach their goals. If that stretch of time happens to include a 12-15 year period in which returns are flat, as history tells us is probable, then the odds of achieving their goals are massively diminished.

Let’s walk through an example showing why avoiding “mean reverting events” matters.

Bob is 35-years old, earns $75,000 a year, saves 10% of his gross salary each year and wants to have the same income in retirement that he currently has today. In our forecast, we will assume the market returns 7% each year (same as promised by many financial advisors) and we will assume a 2.1% inflation rate (long-term median) to help determine his desired retirement income.

Looking 30 years forward, as shown below, when Bob will be 65, his equivalent annual income requirement will be approximately $137,000 as shown below.

Understanding the relevance of this simple graph is typically problem number one for investors. Many savers fail to realize that their income needs will rise significantly due to inflation. In Bob’s case, $137,000 is the future equivalent to his current $75,000 salary assuming a modest 2.1% rate of inflation. If the double-digit inflation rate of the 1970’s were to reappear, Bob’s income needs would be significantly higher, and a larger lump sum of savings would be required to generate that higher level of income.

In this case, to meet his $137,000 retirement income goal and keep his wealth intact, Bob will need to amass a portfolio over $4.5 million. The figure is based on a 3% withdrawal rate matching the long-term Treasury yield.

(The graph excludes social security, pensions, etc. – this is for illustrative purposes only.)

In this analysis, we give Bob a big advantage and assume that he has been a diligent saver and has accumulated a nest egg of $100,000 to jump-start his savings adventure. Furthermore, we start his investment period in 1988 following the 1987 crash. Bob’s first 12 years of investing was one of the greatest periods to be in U.S. equities.

As stated, we are giving Bob every benefit we can.

With the example set, let’s run an analysis to determine if “buying, holding and dollar cost averaging” into the S%P 500 will get Bob to his retirement goal.

To answer this question, the chart below shows the difference between two identical accounts.

  • Each started at $100,000, each reflects $625/month contributions (DCA)
  • Both were adjusted for inflation and include dividends. (Total Return)
  • The blue dotted line shows the amount of money Bob requires to meet his retirement goal in 30-years.
  • The gold line is the “buy and hold” strategy using the S&P 500 index.(Passive)
  • The blue line utilizes a simple switching strategy that goes to “cashwhenever the S&P 500 declines below the 12-month moving average. (Active)
  • The blue and red shaded areas show the deviation of the S&P 500 above and below the 12-month moving average.

Had Bob followed a buy and hold strategy he would have turned his $100,000 investment into a respectable $1.7 million nest egg.

While such a sum is certainly nothing to scoff at, when Bob applies his 3% withdrawal rate, his annual income will fall to just $51,000 per year. Not only is this less than he was making 30-years ago, it is far short of the $137,000 income needed.

What clearly impacted his progress was the recovery periods following the crashes of 2000 and 2008.

The obvious advantage of the actively managed portfolio is the avoidance of the major drawdowns which allowed it to effectively compound over the expected time frame. Not only did his initial $100,000 investment grow to $5.75 million, which exceeded his required retirement objective, at 3% interest it generated more than enough to meet his $137,000 income goal.

There is an important point to be made here. The old axioms of “time in the market” and the “power of compounding” are true, but they are only true as long as principal value is not destroyed along the way. The destruction of the principal destroys both “time” and “the magic of compounding.”

Or more simply put – “getting back to even” is not the same as “growing.”

While those selling passive strategies throw out the “you can’t time the market” argument, the simple truth is you can. Even the simple rule, as we applied, can be followed with little effort. The problem, however, isn’t the strategy, it is the investor. The biggest detraction from successful investing over the long-term is ourselves. Our emotional and behavioral biases consistently plague our investment decision making from the “fear of missing out,” to “herding,” “recency bias,” and many others are all inherent traits that we will discuss in an upcoming chapter. However, managing risk, and avoiding major mean reverting events, is quite achievable with a good bit of discipline and patience.

Crashes matter, and the time spent recouping those losses is likely to stop you from meeting your goals.

The Other Big Problem For Dollar Cost Averaging

In Bob’s example, we assumed dollar cost averaging. Today, there is little evidence individuals are actively saving adequately for their retirement.

We could fill pages with study after study, but you get the idea. The reality is that about 80% of Americans currently CANNOT save adequately for retirement because of the tremendous costs associated with raising children, mortgages, debt payments, food, energy costs and health insurance. For many, these costs exceed their disposable income. As shown below, even with a sharp ramp-up in consumer credit, there is still a nearly $7000 deficit between the required standard of living and what incomes and debt combined can fill.

This goes a long way in explaining why the majority of Americans are NOT saving for their retirement. While Josh Brown was correct that individuals add to their company plans on a regular basis, the reality is that most “Americans” do not invest at all.

“Americans do most of their saving for retirement at their jobs, though many private sector workers lack access to a workplace plan. In addition, many workers whose employers do offer these plans face obstacles to participation, such as more immediate financial needs, other savings priorities such as children’s education or a down payment for a house, or ineligibility. Thus, less than half of non-government workers in the United States participated in an employer-sponsored retirement plan in 2012, the most recent year for which detailed data were available.

But even if they don’t have access to a plan, they are surely investing in the stock market on their own, right? Not really.

“Among filers who make less than $25,000 a year, only about 8% own stocks. Meanwhile, 88% of those making more than $1 million are in the market, which explains why the rising stock market tracks with increasing levels of inequality. On average across the United States, only 18.7% of taxpayers directly own stocks.”

With the vast amount of individuals already vastly under-saved, the next major correction will reveal the full extent of the “retirement crisis” silently lurking in the shadows of this bull market cycle.


Markets stand at valuations that offer very little return yet historically large risks. In the past, every market environment like the current one was met with a major correction that took years for investors to recover from. While we do not know when such a move lower will start, make no mistake markets have not suddenly become immune from “mean reversion.”

We do not advocate you sell all of your stocks. We just hope you consider the risk/return proposition and invest with a strategy which aims to avoid major losses.

We end with a paragraph from Andrew W. Lo from his book Adaptive Markets: Financial Evolution at the Speed of Thought

“In this respect, we can think of markets as being bipolar- they can seem ordinary on most days, but once in a while, a dark mood settles over the market, and prices drop precipitously in response to the most innocuous news. When we compute an eighty-eight year average, the impact of these periodic slumps may not be very great, but the problem for investors is they do not get to earn the eighty-eight year average. Long-term averages can hide many important features of the financial landscape, especially when the long-term average is so long that it includes radically different financial institutions, regulations, political and cultural mores and investor populations. A river may have an average depth of only five feet, but that doesn’t mean it can be crossed safely by a six-foot hiker who can’t swim.

The Myths Of Stocks For The Long Run – Part I

Written by Lance Roberts, Michael Lebowitz, CFA and John Coumarianos, M.S. of Real Investment Advice

This article is Part I of a series discussing the fallacies of always owning stocks for the long run (aka “buy and hold” and passive strategies). Given the current bull market is not only long in the tooth compared to prior bull markets, but sitting at valuations that have always been met with more severe declines, we believe the points made in this series of articles are important for investors to understand.

This series of articles will cover the following key points:

  • “Buy and Hold,” and other passive strategies are fine, just not all of the time
  • Markets go through long periods where investors are losing money or simply getting back to even
  • The sequence of returns is far more important than the average of returns
  • “Time horizons” are vastly under-appreciated.
  • Portfolio duration, investor duration, and risk tolerance should be aligned.
  • The “value of compounding” only works when large losses are not incurred.
  • There are periods when risk-free Treasury bonds offer expected returns on par, or better than equities with significantly less risk.
  • Investor psychology plays an enormous role in investors’ returns
  • Solving the puzzle: Solutions to achieving long-term returns and the achievement of financial goals.

Part I: Buy and Hold Can Be Hazardous To Your Wealth

One would think that following two major market corrections of over 50% within the last two decades, investors would have a better appreciation for how much time it takes to compound your way out of losses. While buy-and-hold investors who stayed true to their strategy over the last two decades are indeed ahead, they lost many years of valuable compounding time in a quest to “get back to even.

Just recently, Michael Lebowitz tweeted a chart that highlighted the issue of the time required to “get back to even.”

The tweet, and graph, was a simple reminder that markets spend a good deal of time declining and retracing those declines. These are long periods when investors are not compounding their wealth. As he noted:

“This fact should be top of mind given ‘history, risk levels, and valuations.'”

Not surprisingly, his tweet quickly sparked rebuttal from some promoters of “buy and hold” investment strategies. Of note was a Tweet from Dan Egan.

Dan thinks that Michael’s message is “Fear Mongering.” If presenting factual data, and highlighting the certainty of market cycles, is fear mongering then maybe he is right. If so, he might also want to consider that investors should be fearful given current valuations and the economic underpinnings of corporate earnings. If fear is what it takes to help investors understand the next five years will likely not be similar to the last five, then it will have served a valuable purpose.

The reason, however, this message seems lost on many investment professionals and individuals is because:

  • They have never been through a major market reversion
  • They have only lived through one (2008) and assume another “financial crisis” cannot happen in our lifetimes.
  • They find it easier to passively manage money and blame major drawdowns on the markets rather than commit to the efforts, rigorous analysis, and mental fortitude to go against the crowd. These are all important traits needed to manage an active investment strategy.

As David Rosenberg recently noted, since 2009 nearly 13.4 million individuals have taken on roles in the financial industry. What this suggests, is there are many professionals currently promoting a “buy-and-hold” strategy who have never actually been through a “bear market” cycle. Even Dan Egan who quickly dismissed the analysis did not start his career with Betterment until after the financial crisis.

“Experience” is the most valuable teacher of investing over time. Severe market draw downs have permanent negative effects on an individual’s financial goals, their lives, and their families. Dan would likely have a much different opinion if he had to sit across the table from someone who had just lost 50% of their retirement savings pleading with him about how they are ever going to get it back.

This is why all great money managers throughout history have all operated under one simple investment philosophy – “buy low, sell high.”

Even the great Warren Buffett once noted the two most important rules of investing.

  1. Don’t Lose Money
  2. Refer To Rule #1

Josh Brown also commented on Michael’s tweet and made a good suggestion. (We are going to cover the concept of dollar cost averaging later in this series.)

Per Josh’s request, the chart below shows the total real return (dividends included) of $1,000 invested in the S&P 500 with dollar cost averaging (DCA). While the periods of losing and recovering are shorter than the original graph, the point remains the same and vitally crucial to comprehend: there are long periods of time investors spend getting back to even, making it significantly harder to fully achieve their financial goals. (Note the graph is in log format and uses Dr. Robert Shiller’s data)

The feedback from Josh, Dan and others expose several very important fallacies about the way many professional money managers view investing.

The most obvious is that investors do NOT have 118 years to invest. Given that most investors do not start seriously saving for retirement until the age of 35, or older, most investors have just one market cycle to reach their goals. If that cycle happens to include a 10-15 year period in which total returns are flat, the odds of achieving their savings goals are massively diminished. If an investor’s 30-year investment cycle happens to end with a major market crash, the result was devastating. Time, duration and ending dates are crucially important to expected investor outcomes.

Second and more importantly, “buy and hold” investors fail to consider risks, expected returns and alternative strategies. Consider that from 2000 through 2013, the S&P 500 Index, including dividends and inflation, delivered a zero rate of return. And from 2000 through 2017, it returned a scant 0.30% more than risk-free Treasury bonds (5.4% annualized for stocks versus 5.1% annualized for bonds). Further, to reach that return it required the expansion of valuation multiples to extreme and risky levels. Equity investors have endured two 50% draw downs, and over a decade of no returns, to achieve an 18-year, 30 basis point annualized pickup over bonds. In recent years that entailed holding equities that were well above long-term averages and presented a poor risk/return framework.

Given current valuations, it is possible, perhaps even likely, that we will wake up on New Year’s Day 2025 to a stock market that has lagged or only barely matched the return of bonds for a full quarter century. The chart below shows the annualized performance of 10-year equity returns versus 10-year U.S. Treasury notes based on over 100 years of history. Clearly equity investors will need to defy history to outperform risk-free bonds. Stocks vs. Bonds: What to own over the next decade.

Summary – Part I

As shown and described, markets go through cycles. During these cycles, there are often incredible opportunities to own stocks. However, these cycles also include periods when risk should be minimized and greed should be constrained. Active management, unlike the static, one-size-fits-all mindset of the popular “buy and hold” strategy, seeks to measure risk and expected returns and invest in a manner in which one is aggressive when valuations are cheap, and defensive when they are rich. The philosophy of this approach seeks first to avoid large losses which are the key to compounding wealth.

The bottom line, and the topic for Part II, is that corrections and crashes matter a lot. Avoiding losses weighs far more heavily in compounding wealth than does chasing returns. In the next article we will walk through the math of compounding and explain why investing in markets that are expensive may provide short-term satisfaction but more than likely will severely harm your ability to meet your retirement goals.

Quick Take: Bulls Attempt A “Jailbreak”

Yesterday, I discussed the “compression” of the market being akin to a “coiled spring” that when released could lead to a fairly decent move in one direction or another. To wit:

“As you can see in the ‘reddish triangle,’ prices have been continually compressed into an ever smaller trading range. This ‘compression’ is akin to coiling a spring. The more tightly the spring is wound, the more energy it has when it is released.”

As shown, the bulls are “attempting a jailbreak” of the “compression” that has pressured markets over the last two months. While the breakout is certainly encouraging, there isn’t much room before it runs into a more formidable resistance of the 100-day moving average. Furthermore, with interest rates closing in on 3% again, which has previously been a stumbling point for stock prices, it is too soon to significantly increase equity risk in portfolios.

This is just one day.

As I stated previously, as a portfolio manager I am not too concerned with what happens during the middle of the trading week, but rather where the market closes on Friday. This reduces the potential for “head fakes” as we saw last week with the break of the of the 200-dma on Thursday which was quickly reversed on Friday. The weekly close was one of the two outcomes as noted in our previous Quick-Take:

“If the market closes ABOVE the 200-dma by the close of the market on Friday, we will simply be retesting support at the 200-dma for the fourth time. This will continue to keep the market trend intact and is bullish for stocks.”

This breakout will provide a reasonable short-term trading opportunity for portfolios as I still think the most probable paths for the market currently are the #3a or #3b pathways shown above.

If we get a confirmed break out of this “compression range” we have been in, we will likely add some equity risk exposure to portfolios from a “trading” perspective. That means each position will carry both a very tight “stop price” where it will be sold if we are wrong as well as a “profit taking” objective if we are right.

Longer-term investments are made when there is more clarity about future returns. Currently, clarity is lacking as there are numerous “taxes” currently weighing on the markets which will eventually have to be paid.

  • Rising oil and gasoline prices (Tax on consumers)
  • Fed bent on hiking rates and reducing their balance sheet. (Tax on the markets)
  • Potential trade wars (Tax on manufacturers)
  • Geopolitical tensions with North Korea, Russia, China and Iran (Tax on sentiment)
  • Traders all stacked up on the “same side of the boat.” (Tax on positioning)

We continue to hold higher levels of cash, but have closed out most of our market hedges for now as we giving the markets a bit more room to operate.

With longer-term indicators at very high levels and turning lower, we remain cautious longer-term. However, in the short-term markets can “defy rationality” longer than anyone can imagine. But it is in that defiance that investors consistently make the mistake of thinking “this time is different.”

It’s not. Valuations matter and they matter a lot in the long-term. Valuations coupled with rising interest rates, inflationary pressures, and weak economic growth are a toxic brew to long-term returns. It is also why it is quite possible we have seen the peak of the market for this year.

I will update this “Quick Take” for the end of the week data in this coming weekend’s newsletter. (Subscribe at the website for email delivery on Saturday)

The Myth Of “Buy & Hold” – Why Starting Valuations Matter

If you repeat a myth often enough, it will eventually be believed to be the truth.

“Stop worrying about the market and just buy and hold stocks.”

Think about this for a moment. If it were true, then:

  • Why do major Wall Street firms have proprietary trading desks? (They aren’t buying and holding.)
  • Why are there professional hedge fund managers? (They aren’t buying and holding either)
  • Why is there volatility in the market? (If everyone just bought and held, prices would be stable.)
  • Why does Warren Buffett say “buy fear and sell greed?” (And why is he holding $115 billion in cash?)
  • Why are there financial channels like CNBC? (If everyone bought and held, there would be no viewers.)
  • Most importantly, why isn’t everyone wealthy from investing?

Because “buying and holding” stocks is a “myth.”

Wall Street is a business. A very big business which generates huge profits by creating products and selling it to their consumers – you. Just how big? Here are the sales and net income for some of the largest purveyors of investment products:

  • Goldman Sachs – Sales: $45 Billion / Income: $8.66 Billion
  • JP Morgan – Sales: $67 Billion / Income: $26.73 Billion
  • Bank Of America/Merrill Lynch – Sales: $59.47 Billion / Income: $20.71 Billion 
  • Schwab – Sales: $9.38 Billion / Income: $2.45 Billion
  • Blackrock – Sales: $13.25 Billion / Income: $4.02 Billion

There is nothing wrong with this, of course. It is simply “the business.”

It is just important to understand exactly which side of the transaction everyone is on. When you sell your home, there is you, the buyer and Realtor. It is clearly understood that when the transaction is completed the Realtor is going to be paid a commission for their services.

In the financial world the relationship isn’t quite as clear. Wall Street needs its customers to “sell” product to, which makes it less profitable to tell “you” to “sell” when they need you to “buy the shares they are selling for the institutional clients.”

Don’t believe me?  Here is a survey that was conducted on Wall Street firms previously.

“You” ranked “dead last” in importance.

Most importantly, as discussed previously, the math of “buy and hold” won’t get you to your financial goals either. (Yes, you will make money given a long enough time horizon, but you won’t reach your inflation-adjusted retirement goals.)

“But Lance, the market has historically returned 10% annually. Right?”

Correct. But again, it’s the math which is the problem.

  1. Historically, going back to 1900, using Robert Shiller’s historical data, the market has averaged, more or less, 10% annually on a total return basis. Of that 10%, roughly 6% came from capital appreciation and 4% from dividends.
  2. Average and Annual or two very different things. Investors may have AVERAGE 10% annually over the last 118 years, but there were many periods of low and negative returns along the way. 
  3. You won’t live 118 years unless you are a vampire.

The Entire Premise Is Flawed

If you really want to save and invest for retirement you need to understand how markets really work.

Markets are highly volatile over the long-term investment period. During any time horizon the biggest detractors from the achievement of financial goals come from five factors:

  • Lack of capital to invest.
  • Psychological and behavioral factors. (i.e. buy high/sell low)
  • Variable rates of return.
  • Time horizons, and;
  • Beginning valuation levels 

I have addressed the first two at length in “Dalbar 2017 Investors Suck At Investing” but the important points are these:

Despite your best intentions to “buy and hold” over the long-term, the reality is that you will unlikely achieve those promised returns.

While the inability to participate in the financial markets is certainly a major issue, the biggest reason for underperformance by investors who do participate in the financial markets over time is psychology.

Behavioral biases that lead to poor investment decision-making is the single largest contributor to underperformance over time. Dalbar defined nine of the irrational investment behavior biases specifically:

  • Loss Aversion – The fear of loss leads to a withdrawal of capital at the worst possible time.  Also known as “panic selling.”
  • Narrow Framing – Making decisions about on part of the portfolio without considering the effects on the total.
  • Anchoring – The process of remaining focused on what happened previously and not adapting to a changing market.
  • Mental Accounting – Separating performance of investments mentally to justify success and failure.
  • Lack of Diversification – Believing a portfolio is diversified when in fact it is a highly correlated pool of assets.
  • Herding– Following what everyone else is doing. Leads to “buy high/sell low.”
  • Regret – Not performing a necessary action due to the regret of a previous failure.
  • Media Response – The media has a bias to optimism to sell products from advertisers and attract view/readership.
  • Optimism – Overly optimistic assumptions tend to lead to rather dramatic reversions when met with reality.

The biggest of these problems for individuals is the “herding effect” and “loss aversion.”

These two behaviors tend to function together compounding the issues of investor mistakes over time. As markets are rising, individuals are lead to believe that the current price trend will continue to last for an indefinite period. The longer the rising trend last, the more ingrained the belief becomes until the last of “holdouts” finally “buys in” as the financial markets evolve into a “euphoric state.”

As the markets decline, there is a slow realization that “this decline” is something more than a “buy the dip” opportunity. As losses mount, anxiety increases until individuals seek to “avert further loss” by selling.

This is the basis of the “Buy High / Sell Low” syndrome that plagues investors over the long-term.

However, without understanding what drives market returns over the long term, you can’t understand the impact the market has on psychology and investor behavior.

Over any 30-year period the beginning valuation levels, the price you pay for your investments has a spectacular impact on future returns. I have highlighted return levels at 7-12x earnings and 18-22x earnings. We will use the average of 10x and 20x earnings for our savings analysis.

As you will notice, 30-year forward returns are significantly higher on average when investing at 10x earnings as opposed to 20x earnings or where we are currently near 25x.

For the purpose of this exercise, I went back through history and pulled the 4-periods where valuations were either above 20x earnings or below 10x earnings. I then ran a $1000 investment going forward for 30-years on a total-return, inflation-adjusted, basis.

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 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 than 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.” 

This is shown in the chart below. I have averaged each of the 4-periods above into a single total return, inflation-adjusted, index, Clearly, investing at 10x earnings yields substantially better results.

So, with this understanding let me return once again to those that continue to insist the “buy and hold” is the only way to invest. 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 in a mattress.

The red line is 10% compounded annually. You won’t get that, but it is there so you can compare it 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 advisors promise of 10% annual returns for retirement, you aren’t going to make it.

I want you to take note of the following.

When investing your money at valuations above 20x earnings, it takes 22-years before it has grown more than money stuffed in a mattress. 

Why 22 years? 

Take a look at the chart below.

Historically, it has taken roughly 22-years to resolve a period of over-valuation. Given the last major over-valuation period started in 1999, history suggests another major market downturn will mean revert valuations by 2021.

The point here is obvious, but difficult to grasp from a mainstream media that is continually enticing young Millennial investors to mistakenly invest their savings into an overvalued market. Saving your money, and waiting for a valuation based opportunity to invest those savings in the market, is the best, safest way, to invest for your financial future. 

Of course, Wall Street won’t like this much because they can’t charge you a fee if you are sitting on a mountain of cash awaiting the opportunity to “buy” their next misfortune.

But isn’t that what Baron Rothschild meant when quipped:

“The time to buy is when there’s blood in the streets.”

Quick Take: Market Breaks Important Support

I have often discussed that as a portfolio manager I am not too concerned with what happens during the middle of the trading week. The reason is daily price volatility can lead to many false indications about the direction of the market. These false indications are why so many investors suggest that technical analysis is nothing more than “voo doo.”

For me, price analysis is more about understanding the “trend” of the market and the path of least resistance for prices in the short and intermediate-term. This analysis allows for portfolio positioning to manage risk.

Over the last several weeks, I have been mapping out the ongoing correction in the market and have noted the important support that has been provided by the running 200-day moving average. The chart below is updated through this morning.

The break of the 200-dma today is not a good sign. Consolidation processes are much akin to the “coiling of a spring.”  As prices become compressed, when those prices break out there is a “release of energy” from that compression which tends to lead to rather sharp moves in the direction of the breakout.

Importantly, the break of support today is NOT a signal to run out and sell everything.  It is, however, a worrisome warning that should not be entirely dismissed.

As stated, nothing matters for me until we see where the market closes on Friday.

Here is what we are wanting to see:

  • If the market closes ABOVE the 200-dma by the close of the market on Friday, we will simply be retesting support at the 200-dma for the fourth time. This will continue to keep the market trend intact and is bullish for stocks. 
  • If the market closes BELOW the 200-dma on Friday, the break of support will be confirmed, suggesting a downside failure of the consolidation pattern over the last couple of months. This break is bearish for the market and suggests higher levels of caution. Such will lead to two other options:
    • With the market oversold on a short-term basis, any rally that fails at the 200-dma will further confirm the downside break of the consolidation. This would suggest lower prices over the next month or so.
    • If the market recovers by early next week, above the 200-dma, positioning will remain on hold.

I am often asked why I don’t just take ONE position and make a call.

Because we can not predict the future. We can only react to it.

After having raised cash over the last couple of months on rallies, there isn’t much we need to do at the moment.

However, the weakness in the market, combined with longer-term sell signals as discussed on Tuesday, is suggesting the market has likely put in its top for the year.

We remain cautious and suggest the time to “buy” has not arrived yet.

Bull Markets Actually Do Die Of “Old Age”

David Ranson recently endeavored in a long research report to simply declare that “bull markets do not die of old age.”

“The life expectancy of bull markets can be inferred from history. Fourteen bull markets in U.S. stocks have come and gone since 1927, and their mean lifetime is 55 months. But this calculation can be taken further. From the age of one year to the age of eight years, there’s no overall tendency for life expectancy to decline as a market advance gets older. The present stock market advance, which began 105 months ago, is no more likely to end within the next twelve months than it was when it was only twelve months old. Bull markets do not die of old age.”

Think about this for a moment.

This is the equivalent of suggesting that since the average male dies at 88-years of age if he lives to be 100, he has no more chance of dying in the next 12-months than he did when he was 40-years old. 

While a 100-year old male will likely expire within a relatively short time frame, it will not just “being old” that leads to death. It is the onset of some outside influence such as pneumonia, infection, organ failure, etc. that leads to the eventual death as the body is simply to weak to defend itself. While we attribute the death to “old age,” it was not just “old age” that killed the host.

This was a point that my friend David Rosenberg made in 2015 before the first rate hike:

“Equity bull markets never die simply of old age. They die of excessive Fed monetary restraint.

First, averages and medians are great for general analysis but obfuscate the variables of individual cycles. To be sure the last three business cycles (80’s, 90’s and 2000) were extremely long and supported by a massive shift in a financial engineering and credit leveraging cycle. The post-Depression recovery and WWII drove the long economic expansion in the 40’s, and the “space race” supported the 60’s.

But each of those economic expansions did indeed come to an end. The table below shows each expansion with the subsequent decline in markets.

Think about it this way.

  • At 104 months of economic expansion in 1960, no one assumed the expansion would end at 105 months.
  • At 118 months no one assumed the end of the “dot.com mania” was coming in the next month. 
  • In December of 2007, no one believed the worst recession since the “Great Depression” had already begun. 

The problem for investors, and the suggestion that “bull markets don’t die of old-age,” is that economic data is always negatively revised in arrears. The chart below shows the recession pronouncements by the National Bureau Of Economic Research (NBER) and when they actually began.

The point here is simple, by the time the economic data is revised to reveal a recession, it will be far too late to do anything about it from an investment perspective. However, the financial market has tended to “sniff” out trouble

The Infections That Kill Old Bull Markets

Infection #1: Interest Rates

As noted by David Rosenberg, with the Fed continuing to hike rates in the U.S., tightening monetary conditions, the previous 3-year time horizon is now substantially shorter. More importantly, the “average” time frame between an initial rate hike and recession was based on economic growth rates which were substantially higher than they are currently.

Furthermore, as interest rates rise, so does the cost of capital. In a heavily leveraged economy, the change in interest expense has been a good predictor of economic weakness. As recently noted by Donald Swain, CFA:

“What if marginal interest expense pressures are the true recession signal (cause of economic weakness) and the yield curve is just a correlated input to that process? If so, for the first time, the Fed is hiking into what is already the most hostile refit period in 35-years.”

The point is that in the short-term the economy and the markets (due to momentum) can SEEM TO DEFY the laws of gravity as interest rates begin to rise. However, as rates continue to rise they ultimately act as a “brake” on economic activity. Think about the all of the areas that are NEGATIVELY impacted by rising interest rates:

  1. Debt servicing requirements reduce future productive investment.
  2. The housing market. People buy payments, not houses, and rising rates mean higher payments. 
  3. Higher borrowing costs which lead to lower profit margins for corporations.
  4. Stocks are cheap based on low-interest rates. When rates rise, markets become overvalued very quickly.
  5. The economic recovery to date has been based on suppressing interest rates to spur growth.
  6. Variable rate interest payments for consumers
  7. Corporate share buyback plans, a major driver of asset prices, and dividend issuances have been done through the use of cheap debt.
  8. Corporate capital expenditures are dependent on borrowing costs.

Infection #2: Spiking Input Costs

When rate hikes are combined with a surge in oil prices, which is a double whammy to consumers, there has been a negative outcome as noted by Peter Cook, CFA last week.

“A better record of predicting recessions is achieved when Fed has hiked rates by 2.00%-2.50%, AND oil prices have at least doubled. The price of money and energy are major financial inputs to financial planning, so when they simultaneously rise sharply, consumers and businesses are forced to retrench. Based on the Fed’s well-communicated strategy, it plans to raise rates another 0.75% during 2018 on top of the previous 1.50% over the past few years. If crude oil stays above $50-60, both conditions for a recession would be met in the second half of 2018.

Yet neither the Fed, or any high-profile economist, is predicting the beginning of a recession during 2019, let alone 2018. Answering the inflation/deflation question correctly is the most important issue of the day for investment portfolios. If recession/deflation arrives before growth/inflation, a major adjustment in expectations, and capital market prices, is coming within the next year.” 

This shouldn’t be surprising.

In the past, when Americans wanted to expand their consumption beyond the constraint of incomes they turned to credit in order to leverage their consumptive purchasing power. Steadily declining interest rates, and lax lending standards, put excess credit in the hands of every American. Such is why, during the 80’s and 90’s, as the ease of credit permeated its way through the system, the standard of living seemingly rose in America even while economic growth slowed along with incomes.

As I recently discussed with Shawn Langlois at MarketWatch:

“With a deficit between the current standard of living and what incomes, savings and debt increases can support, expectations of sustained rates of stronger economic growth, beyond population growth, becomes problematic.

For investors, that poses huge risks in the market.

While accounting gimmicks, wage suppression, tax cuts and stock buybacks may support prices in the short-term, in the long-term the market is a reflection of the strength of the economy. Since the economy is 70% driven by consumption, consumer indebtedness could become problematic.”

Infection #3 – Valuations

Lastly, it isn’t an economic recession that is truly problematic for investors.

If asset prices rose equally with increases in earnings, in other words the price-to-earnings ratio remained flat, then theoretically “bull markets” would last forever.

Unfortunately, since asset prices are a reflection of investor psychology, or “greed,” it is not surprising that economic recessions reveal the mispricing between the premium investors pay for a stream of earnings versus what they are really worth.  As I noted just recently:

“Bull markets are born on pessimism, grow on skepticism, and die on euphoria.” -Sir John Templeton

Take a look at the chart below which is Robert Shiller’s monthly data back to 1871. The “yellow” triangles show periods of extreme undervaluation while the “red” triangles denote periods of excess valuation.

Not surprisingly, 1901, 1929, 1965, 1999, and 2007 were periods of extreme “euphoria” where “this time is different” was a commonly uttered phrase.


What the majority of mainstream analysis fails to address is the “full-cycle” of markets. While it may appear that “bull markets do not die of old age,” in reality, it is “old age that leaves the bull defenseless against infections.”

It is the impact of an exogenous event on an over-leveraged, extended and over-valued market that eventually leads to its death. Ignoring the “infections,” and opting for “hope,” has always led to emotionally driven mistakes which account for 50% of investor’s under-performance over a 20-year cycle.

With expectations rising the Fed will further tighten monetary policy, the vulnerabilities of an “aged bull market” will be an issue for investors in the future.

“In investing, the man who wins is the man who loses the least.” – Dick Russell

Analysts’ Estimates Go Parabolic – Is The Market Next?

At the end of February, I discussed the impact of the tax cut and reform legislation as it related to corporate profits.

“In October of 2017, the estimates for REPORTED earnings for Q4, 2017 and Q1, 2018 were $116.50 and $119.76. As of February 15th, the numbers are $106.84 and $112.61 or a difference of -$9.66 and -7.15 respectively. 

First, while asset prices have surged to record highs, reported earnings estimates through Q3-2018 have already been ratcheted back to a level only slightly above where 2017 was expected to end in 2016. As shown by the red horizontal bars – estimates through Q3 are at the same level they were in January 2017.  (Of course, “hope springs eternal that Q4 of this year will see one of the sharpest ramps in earnings in S&P history.)”

That was so yesterday.

Despite a recent surge in market volatility, combined with the drop in equity prices, analysts have “sharpened their pencils” and ratcheted UP their estimates for the end of 2018 and 2019. Earnings are NOW expected to grow at 26.7% annually over the next two years.

The chart below shows the changes a bit more clearly. It compares where estimates were on January 1st versus March and April. “Optimism” is, well, “exceedingly optimistic” for the end of 2019.

The surge in earnings estimates gives cover for Wall Street analysts to predict surging asset prices. Buy now before you miss out!

“While earnings season has only just gotten started (only 10% of the S&P 500 companies have reported so far), a whopping 84.6% have beaten their earnings estimates, and 78.8% have beaten their revenue estimates. Those are impressive stats. And this earnings season looks like it could be even better than the lofty expectations going into it. This sets the market up for all-time highs just ahead.” 

Sure, that could well be the case as a momentum-driven market is a very tough thing to kill. Despite the recent “hiccup” over the last month or so, the market remains above it’s 200-day moving average and there are few signs of investor panic currently.

However, there are two major concerns with the current trajectory of earnings estimates.

The first is that Wall Street has historically over-estimated earnings by about 33% on average.

Yes, 84% of companies have beaten estimates so far, which is literally ALWAYS the case, because analysts are never held to their original estimates. If they were, 100% of companies would be missing estimates currently. 

At the beginning of January, analysts overestimated earnings by more than $6/share, reported, versus where they are currently. It’s not surprising volatility has picked up as markets try to reconcile valuations to actual earnings.

Furthermore, the overestimation provides a significant amount of headroom for Wall Street to be disappointed in future, particularly once you factor in the impacts of higher interest rates and slower economic growth. 

But economic growth is set to explode. Right?

Most likely not.

As I discussed last week, the short-term boost to economic growth in the U.S., driven by a wave of natural disasters, is now beginning to fade. However, the same is seen on a global scale as well. To wit:

“The international slowdown is becoming increasingly obvious from the widely followed economic indicators. The most popular U.S. measures seem to present more of a mixed bag. Yet, as we pointed out late last year, the bond market, following the U.S. Short Leading Index, started sniffing out the U.S. slowdown months ago.”

Furthermore, the economy is sensitive to changes in interest rates. This is particularly the case when the consumer, which comprises about 70% of the GDP calculation, is already heavily leveraged. Furthermore, with corporations more highly levered than at any other point n history, and dependent on bond issuance for dividend payments and share buybacks, higher interest rates will quickly stem that source of liquidity. Notice that each previous peak was lower.

With economic growth running at lower levels of annualized growth rates, the “bang point” for the Fed’s rate hiking campaign is likely substantially lower as well. History suggests this will likely be the case. At every point in history where the Fed has embarked upon a rate hiking campaign since 1980, the “crisis point” has come at steadily lower levels.

But even if we give Wall Street the benefit of the doubt, and assume their predictions will be correct for the first time in human history, stock prices have already priced in twice the rate of EPS growth.

There are few, if any, Wall Street analysts expecting a recession at any point in the future. Unfortunately, it is just a function of time until a recession occurs and earnings fall in tandem.

More importantly, the expectation for a profits-driven surge in asset prices fails to conflate with the reality that valuations have been the most important driver of higher stock prices throughout history. Currently, despite surging earnings expectations, market participants are already revaluing equity and high-yield investments.

In our opinion, the biggest mistake that Wall Street is potentially making in their estimates is the differential between “statutory” and “effective” rates. As we addressed previously:

From 1947 to 1986 the statutory corporate tax rate was 49% and the effective tax rate averaged 36.4% for a difference of 12.6%. From 1987 to present, after the statutory tax rate was reduced to 39%, the effective rate has averaged 28.1%, 10.9% lower than the statutory rate.

In reality, a company that earned $5.00 pretax only paid $1.41 in taxes in 2017 on average, leaving an after-tax profit of $3.59, and not $3.25. Under the new tax law that after-tax profit would come in at the $3.95 as stated in the article and the gain would be 10%, or half, of the gain Wall Street expects.”

There is virtually no “bullish” argument that will currently withstand real scrutiny.

  • Yields are rising which deflates equity risk premium analysis,
  • Valuations are not cheap,
  • The Fed is extracting liquidity, along with other Central Banks slowing bond purchases, and;
  • Further increases in interest rates will only act as a further brake on economic growth.

However, because optimistic analysis supports our underlying psychological “greed”, all real scrutiny to the contrary tends to be dismissed. Unfortunately, it is this “willful blindness” that eventually leads to a dislocation in the markets.

Wall Street is notorious for missing the major turning of the markets and leaving investors scrambling for the exits.

This time will likely be no different.

Will tax reform accrue to the bottom lines of corporations? Most assuredly.

However, the bump in earnings growth will only last for one year. Then corporations will be back to year-over-year comparisons and will once again rely on cost-cutting, wage suppression, and stock buybacks to boost earnings to meet Wall Street’s expectations.

Are stocks ready to go parabolic?

Anything is possible, but the risk of disappointment is extremely high.