Value investing is an active management strategy that
considers company fundamentals and the valuation of securities to acquire that
which is undervalued. The time-proven investment style is most clearly defined
by Ben Graham and David Dodd in their book, Security
Analysis. In the book they state, “An
investment operation is one which, upon thorough analysis promises safety of
principal and an adequate return. Operations not meeting these requirements are
There are countless articles and textbooks written about, and
accolades showered upon, the Mount Rushmore of value investors (Graham, Dodd,
Berkowitz, Klarman, Buffett, et al.). Yet, present-day “investors” have shifted
away from the value proposition these greats profess as the time-tested secret to
successful investing and compounding wealth.
The graph below shows running ten year return differentials
between value and growth. Clearly, as shown, investors are chasing growth at
the expense of value in a manner that is quite frankly unprecedented over the
last 90 years.
Data Courtesy French, Fama, and
In the 83 ten year periods starting in 1936, growth outperformed value only eight times. Five of those ten year periods ended in each of the last five years.
Value stocks naturally trade at a discount to the market. Companies
with weaker than market fundamental growth leads to discounted valuations and a
perception among investors that is too pessimistic about their ability to
eventually achieve a stronger growth trajectory.
Growth stocks are those that pay little or no dividends but
promise exceptional revenue and earnings growth in the future.
The outperformance of growth over value stocks is natural in
times when investors become exuberant. Modern-day market participants claim
superior insight into this Fed-controlled, growth-friendly environment. Based
on the media, it appears as if the business cycle is dead, and recessions are
an archaic thing of the past. Growth stocks promising terrific streams of cash
flow at some point in the future rule the day. This naturally leads to
investors becoming too optimistic and extrapolate strong growth far into the
Meanwhile, value companies tend to retain an advantage by
offering higher market yields than growth stocks. That edge may only be 1 or 2%
but compounded over time, it is significant. The problem is that when
valuations on the broad market become elevated, as they are now, that premium
compresses and diminishes the income effect. The problem is temporary, however,
assuming valuations eventually mean-revert.
One other important distinction of value companies is that they, more commonly than growth companies, end up as takeover targets. Historically, this has served as another premium in favor of value investing. Over the course of the past 12 years, however, corporate capital has uncharacteristically been more focused on growth companies and the ability to tell their shareholder a tale of wild earnings growth that accompany their takeover targets. This is likely due to the environment of ultra-low interest rates, highly accommodative debt markets, and investors that are not focused on the inevitability of the current business cycle coming to an end.
Active versus Passive
Another related facet to the value versus growth discussion
is active versus passive investment management. Although active management may
be involved in either category, value investing, as mentioned above, must be an active strategy. Managers
involved in active management require higher fees for those efforts. Yet, as
value strategies have underperformed growth for the past 12 years, many
investors are questioning the active management logic.
Why pay the high fees of active managers when passive
management suffices at a cost of pennies on the dollar? But as Graham and Dodd
defined it, passive strategies are not investing, they are speculating. As the
graph below illustrates, the shift out of active management and into passive
funds is stark.
Overlooking the historical benefits and outperformance of
value managers, current investors seek to chase returns at the lowest cost. This
behavior is reflective of a troubling lack of discipline and suggests that investors
are complacent about the possibility of having their equity wealth cut in half
as it was in two episodes since 2000.
Pure passive investing, investing in a mutual fund or
exchange-traded fund (ETF) that mimics an index, represents a low-fee approach
to speculation. It does not involve “thorough analysis,” the promise of “safety
of principal,” or an “adequate return.” Capital received is immediately
deployed and invested dollars are weighted most heavily toward the most
expensive stocks. This approach represents the opposite of the “buy-low,
sell-high” golden rule of investing.
Active management, on the other hand, involves analytical rigor by usually seasoned managers and investors seeking out opportunities in good companies in which to invest at the best price.
Definition of Terms
To properly emphasize the worth of value investing, it is important
first to define a couple of key terms that many investors tend to take for
Risk – Contrary to Wall Street marketing
propaganda, risk is not a number calculated by a formula in a spreadsheet. Risk is simply the likelihood of a
substantial and permanent loss of capital with no ability to ever recover. Exposure
to risk cannot be mitigated by blind diversification. Real risk cannot be
quantified by processing the standard deviation of historical returns or the
sophisticated variations of Value-at-Risk. These calculations and the many assumptions
within them lead to misperceptions and misplaced confidence.
Wealth – Wealth is savings. It is that
which is left over after consumption and is the accumulation of savings over
time. Wealth results from the compounding of earnings. Wealth is not the net value of assets minus
liabilities. That is a balance sheet metric that can change dramatically and
suddenly depending on economic circumstances. An investor who seeks to sell
high and buy low, like a business owner who prudently waits for opportunities
to buy out competitors when they are distressed, uniquely illustrates proper wealth management and are but two forms
of value investors.
Understanding these terms is important because it affects one’s economic worldview and the ability to make prudent investment decisions consistently. As Dylan Grice of Edelweiss Holdings describes it:
“Language is the machinery with which we conceptualize the world around us. Devaluing language is tantamount to devaluing our ability to think and understand.” Grice continues, clarifying that point, “linguistic precision leads to cognitive precision.”
Value investors understand that compounding wealth depends on
avoiding large losses. These terms and their proper definitions serve as a
rock-solid foundation for sound reasoning and analytical rigor of market
forces, central bank policies, and geopolitical dynamics that influence global
liquidity, asset prices, and valuations. They enable critical foresight.
Proper definitional terms clarify the logical framework for
an investor to benchmark their wealth, net
of inflation, rather than obsessing with benchmarking returns to those of the
S&P 500 or other passive indexes. Redefining one’s benchmark to inflation
plus some excess return properly aligns target returns with life goals. Comparisons
to the returns of the stock market are irrelevant to your goals and induce one
to be dangerously urgent and speculative.
Value investing is having the courage to be opportunistic when others are
pessimistic, to buy what others are selling, and to embrace volatility because
it is in those times of upheaval that the greatest opportunities arise. That courage is derived from clarity
of goals and a sturdy premise of assessing value. This is not an easy task in a
world where the discounting mechanism itself has become so disfigured as to be
rendered little more than a reckless guess.
Properly executed, value investing seeks
to find opportunities to deploy capital in such a way that reduces risk by
acquiring assets at prices that are sufficiently below intrinsic value. This
approach also extends to potential gains and creates a desirable performance
In the words of famed investor and former George Soros colleague, Jim Rogers, “If you buy value, you won’t lose much even if you’re wrong.” And let’s face it, everybody in this business is wrong far more than they’re right.
Analytically, safety, and profits are rooted in buying assets
with abnormally large risk premiums and then having the patience to wait for
mean reversion. It often requires the rather unconventional approach of
identifying those areas where there is distress and misguided selling is
As briefly referenced above in the definition of wealth, a value investor manages money
as a capitalist business owner would manage his company. A value investor is
more interested in long-term survival. Their decisions are motivated by
investing in companies that are doing those things that will add to the
substance and durability of the enterprise. They are interested in companies
that aim to enhance the cash flow of the operation and, ideally, do so with a very
long time-preference and as a habitual pattern of behavior.
Unlike a business owner and an “investor,” most people who buy stocks think in terms of acquiring financial securities in hopes of selling them at a higher price. As a result, they make decisions primarily with a concern about what other investors’ expectations may be since that will determine tomorrow’s price. This is otherwise known as speculation, not investing, as properly defined by Graham and Dodd.
Although value investing strategies have underperformed relative to growth strategies for the past decade, the extent to which value has become cheap is reaching its limit.
We leave you with a question to ponder; why do you think Warren Buffet’s Berkshire Hathaway is sitting on $128 billion in cash?
Value Your Wealth – Part Six: Fundamental Factors
final article of our Value Your Wealth
Series we explore four more fundamental factors. The first four articles in the
Series researched what are deemed to be the two most important fundamental
factors governing relative stock performance – the trade-off between growth and
value. In Part Five, we explored how returns fared over time based on companies
market cap. Thus far, we have learned that leaning towards value over growth
and smaller market caps is historically an investment style that generates
positive alpha. However, there are periods such as now, when these trends fail
The last ten
years has generally bucked long-standing trends in many factor/return
relationships. This doesn’t mean these factors will not provide an edge in the
future, but it does mean we need to adapt to what the market is telling us
today and prepare for the day when the historical trend reverts to normal. When they do, there will likely be abundant
opportunities for investors to capture significant alpha.
The five prior articles in the Value Your Wealth series are linked below:
In this section, we explore four well-followed factors to understand how they performed in the past and how we might want to use them within our investment decision-making process.
in this article are based on data from Kenneth French and can be found HERE. The data encompasses a wide universe of
domestic stocks that trade on the NYSE, Amex, and NASDAQ exchanges.
Earnings to Price
betting on companies with a higher ratio of Earnings to Price (E/P), also known
as the earnings yield, have historically outperformed investors betting on companies
with lower E/P ratios. Such outperformance of companies priced at relatively
cheap valuations should be expected over time.
chart compares monthly, ten year annually compounded returns for the highest
and lowest E/P deciles.
The graph of
E/P is very similar to what we showed for growth versus value. Other than a
period in the 1990s and the current period value outperformed growth and the
top E/P companies outperformed the bottom ones. This correlation is not
surprising as E/P is a key component that help define value and growth.
buying the top ten percent of the cheapest companies, using E/P, have been
docked almost 5% annually or about 50% since the recovery following the
financial crisis versus those buying the lowest ten percent of companies using
fundamental faith in mean reversion, we have no doubt this trend will begin to
normalize in due time. To help us gauge the potential return differential of an
E/P reversion, we calculate future returns based on what would happen if the
ten-year return went back to its average in three years. This is what occurred after
the tech bust in 2000. In other words, if the ten year annualized compounded
return in late 2022 is average (4.81%) what must the relative outperformance of
high E/P to low E/P companies be over the next three years? If this occurs by
2022, investors will earn an annual outperformance premium of 28.1% for each
of the next three years. The returns increase if the time to reversion is
shorter and declines if longer. If normalization occurs in five years the annual
returns drop to (only) 14.75%.
Needless to say, picking out fundamentally solid stocks seems like a no-brainer at this point but there is no saying how much longer speculation will rule over value.
Cash Flow to Price
below charts the top ten percent of companies with the largest ratio of cash
flow to price and compares it to the lowest ones. Like E/P, cash flow to price
is also a component in value and growth analysis.
surprisingly, this graph looks a lot like the E/P and value vs. growth graphs.
Again, investors have shunned value stocks in favor of speculative entities
meaning they are neglecting high quality companies that pay a healthy dividend
and instead chasing the high-flying, over-priced “Hollywood” stocks. Also
similar to our potential return analysis with E/P, those electing to receive
the most cash flows per dollar of share price will be paid handsomely when this
factor reverts to normal.
last 100 years, using dividend yields to help gain alpha has not been as
helpful as value versus growth, market cap, earnings, and cash flows as the
chart below shows.
On average, higher dividend stocks have paid a slight premium versus the lowest dividend stocks.While dividend yields are considered a fundamental factor it is also subject to the level of interest rates and competing yields on corporate bonds.If we expect Treasury yield levels to be low in the future then the case for high dividend stocks may be good as investors look for alternative yield as income. The caveat is that if rates decline or even go negative, the dividend yield may be too low to meet investors’ bogeys and they may chase lower dividend stocks that have offered higher price returns.
this analysis, is calculated by ranking total returns from the prior ten months
for each company and then sorting them. Before we created the graph below, we assumed
that favoring momentum stocks would be a dependable investment strategy. Our
assumption was correct as judged by the average 10.89% annual outperformance.
However, we also would have guessed that the last few years would have been good
for such a momentum strategy.
Quite to the
contrary, momentum has underperformed since 2009. The last time momentum
underperformed, albeit to a much a larger degree, was the Great Depression.
Our initial expectation
was based on the significant rise of passive investing which favors those
companies exhibiting strong momentum. As share prices rise relative to the
average share price, the market cap also rises versus the average share and
becomes a bigger part of indexes. If we
took the top 1 or 2% of companies using momentum we think the strategy would
have greatly outperformed the lower momentum companies, but when the top and
bottom ten percent are included momentum has not recently been a good strategy.
investors an informational edge. However, despite long term trends that offer
favorable guidance, there are no sure things in investing. The most durable
factors that have supplied decades of cycle guidance go through extended
periods of unreliability. The reasons for this vary but certainly a speculative
environment encouraged by ultra-low and negative interest rates has influence. Investors
must recognize when they are in such periods and account for it. More importantly, though, they must also
understand that when the trends are inclined to reverse back to normal. The
potential for outsized relative gains at such times are large.
Advisors, Factor analysis is just one of many tools we use to help us manage
our portfolios and select investments. We are currently leaning towards value
over growth with the belief that the next market correction will see a revival
of the value growth trends of the past. That said, we are not jumping into the
trade as we also understand that growth may continue to beat value for months
or even years to come.
discipline, and awareness are essential to good investing.
Value Your Wealth – Part Five: Market Cap
The first four
articles in this series focused on what might be the most important pair of fundamental
factors – growth and value. Those factors have provided investors long-standing,
dependable above-market returns. Now, we
take the series in a different direction and focus on other factors that may
also give us a leg up on the market.
The term “a
leg up” is important to clarify. In general, factor-based investing is used to
gain positive alpha or performance that is relatively
better than the market. While “better” than market returns are nice, investing
based on factor analysis should not be the only protection you have when you
fear that markets may decline sharply. The combination of factor investing and adjustments
to your total equity exposure is a time-trusted recipe to avoid large drawdowns
that impair your ability to compound wealth.
this series with a discussion of market capitalization.
prior articles in the Value Your Wealth
series are linked below:
Market capitalization, commonly known as market cap, is a simple calculation that returns the current value or size of publicly traded companies. The formula is the number of shares outstanding times the price per share. For example as we wrote this article, Apple has 4.601 billion shares outstanding and Apple’s stock trades at roughly $210 per share. Apple’s market cap is $966.21 billion.
investors, along with those in the financial media, tend to distinguish
companies market caps/size by grouping them into three broad tiers – small-cap,
mid-cap, and large-cap. Over most periods, stocks in the three categories are
well correlated. However, there are periods when they diverge, and we are
currently amidst such a deviation. Since September 1, 2018, the price of the Large
Cap S&P 500 Index has risen by 4.1%, while the price of the Small Cap
S&P 600 Index is down 12.9%. Deviations in historical relationships,
whether short or long-term in nature, can provide investors an opportunity to
capitalize on the normalization of the relationship, but timing is everything.
Historical Relative Performance
following graphs are based on data from Kenneth French and can be found HERE.
The data encompasses a wide universe of
domestic stocks that trade on the NYSE, Amex, and NASDAQ exchanges.
The data set
provides returns based on market cap groupings based on deciles. The
first graph compares annualized total return and annualized volatility since 1926
of the top three (High) and bottom three (Low) market cap deciles as well as
the average of those six deciles. To be clear, a decile is a discrete range of
market caps reflecting the stocks in that group. For example, in a portfolio of
100 stocks, decile 1 is the bottom ten stocks, or the smallest ten market cap
stocks, decile two is the next ten
smallest cap stocks, etc.
graph below uses monthly ten year rolling returns to compare total returns of
the highest and lowest deciles. This graph is a barometer of the premium that
small-cap investing typically delivers to long term investors.
from both graphs is that small-cap stocks tend to outperform large-cap stocks
more often than not. However, the historical premium does not come without a
price. As shown in the first graph, volatility for the lowest size stocks is
almost twice that of the largest. If you have a long time horizon and are able
and willing to stay invested through volatile periods, small caps should fare
better than large caps.
stocks, in general, have high expected growth rates because they are not
limited by the constraints that hamper growth at larger companies. Unfortunately,
small-cap earnings are more vulnerable to changes in industry trends, consumer
preferences, economic conditions, market conditions, and other factors that
larger companies are better equipped and diversified to manage.
Periods of Divergence
graph above shows there are only three periods where large caps outperformed
small caps stocks since 1926. Those three exceptions, the 1950’s, 1990’s and,
the post-financial crisis-era are worth considering in depth.
The 1950s The Nifty Fifty- The end of World War II coupled with a decade of historically low interest rates disproportionately helped larger companies. These firms, many global, benefited most from the efforts to rebuild Europe and partake in the mass suburbanization of America.
Tech Boom- With double-digit inflation a distant memory and the swelling technology
boom, larger companies that typically benefited most from lower rates, less
inflation, and new technologies prospered. While this new technology benefited
all companies in one form or another, larger ones had the investment budgets and
borrowing capacity to leverage the movement and profit most.
Post Financial Crisis Era –The current period of large-cap outperformance is
unique as economic growth has been prolonged but below average and productivity
growth has been negligible. Despite relatively weak economic factors, massive
amounts of monetary stimulus has fueled record low corporate borrowing rates,
which in turn have fueled stock buybacks. Further, the mass adaptation of
passive cap-weighted investment strategies naturally favors companies with
large market caps. Circularly, passive investing feeds on itself as indexed ETFs
and mutual funds must increasingly allocate more to large caps which grow in
size relative to the other holdings.
To reiterate an important point: the
current period of outperformance is not based on solid economic fundamentals
and resulting corporate earnings growth as in the two prior periods described. This episode is a byproduct of
below highlights the distinction between the current period and the two prior
periods where large caps outperformed.
small-cap stocks tend to provide a return premium over large-cap stocks. However,
as we pointed out, there are periods where that is not the case. Currently, large-cap
stocks are the beneficiaries of overly generous monetary and fiscal policy. We
do believe the relationship will return to normal, but that will likely not
occur until a bear market begins.
As we wait
for a normalization of valuations and traditional relationships that have
become so disfigured in this cycle, we consider the current relative valuations
on small-cap stocks similar to those we described in value stocks earlier in
this series. The time to weight your stock portfolio allocation more heavily toward
small-cap opportunities is coming, but every investor must decide on their own
or with good counsel from an advisor when to make that adjustment. When appropriate, a gradual shift to small-cap
stocks from large caps depends on an investor’s risk appetite and defensive
have a plan in place because when the market does meaningfully correct, the
premium small-cap stocks provide will likely help cushion against a stock
Value Your Wealth – Part Four: Mutual Fund & ETF Analysis
Parts One through Three of the series are linked below.
One, the introduction to our Value Your Wealth series, we documented
how recent returns for investors focused on growth companies have defied the
history books and dwarfed returns of investors focused on value stocks. In
particular: “There have only been eight
ten-year periods over the last 90 years (total of 90 ten-year periods) when
value stocks underperformed growth stocks. Two of these occurred during the
Great Depression and one spanned the 1990s leading into the Tech bust of 2001.
The other five are recent, representing the years 2014 through 2018.”
In this, the
fourth part of the Value Your Wealth series,
we focus on growth and value mutual funds and ETFs. Our purpose is to help determine
which professional value and growth fund managers are staying true to their stated
A large part
of most investor’s investment process starts with the determination of an
investment objective. From this starting point, investors can appropriately determine
the asset classes and investment strategies that will help them achieve or even
exceed their objectives.
Once an investor
decides upon an objective, strategy, and asset class, they must select
individual securities or funds. This article focuses singularly on assessing
growth and value mutual funds and ETFs. In particular it shows how an investor
focused on growth or value can choose funds that are managed properly to meet
usually key on the following factors when selecting a mutual fund or ETF:
fund strategy (Growth or Value in this case)
and expense structure
of the fund family and possibly the manager
factors provide valuable information but can be misleading.
instance, prior returns provide a nice scorecard for the past but can be deceptive.
As an example, if we are currently scanning for value funds based on
performance, the highest ranking funds will more than likely be those that have
leaned most aggressively toward growth stocks. While these funds may seem
better, what we believe is more important the fund managers adherence to their
objectives. Given we are looking forward
and believe value will outperform growth, we want fund managers that we can
trust will stick with value stocks.
It is also
important not to shun funds with the highest expenses and/or gravitate towards those
with the lowest. We must be willing to pay up, if necessary, to achieve our
objectives. For instance, if a fund offers more exposure to value stocks than
other comparable value funds, it may be worth the higher fee for said exposure.
Conversely, there are many examples where one can gain more exposure to their
preferred strategy with cheaper funds.
investors check the fund strategy, but they fail to determine that a fund is
being effectively and cost efficiently managed towards their stated
compare the largest growth and value mutual funds and ETFs to assess which
funds offer the most value, so to speak.
Mutual Fund/ETF Analysis
In order to limit
the population of value and growth mutual funds and ETFs to a manageable number,
we limited our search to the largest funds within each strategy that had at
least 85% exposure to U.S. based companies. We further restricted the
population to those funds with a stated strategy of growth or value per
articles of this series, we have used Bloomberg growth and value factor scores
and our own growth and value composite scores. While we would prefer to use our
own computations, the large and diverse holdings of the mutual funds and ETFs
make it nearly impossible for this exercise. Accordingly, Bloomberg growth and
value factor scores provide us the most accurate description of where the
respective funds lie on the growth/value spectrum. It is important to note that
Bloomberg assigns every fund both a growth and a value score. We consider both
scores and not just the score pertinent to growth or value.
understand most of our readers do not have access to Bloomberg data. As such,
we provide a DIY approach for investors to track growth and value exposure
amongst mutual funds and ETFs.
Growth and Value Scores
plot below shows the 54 funds analyzed. Each dot represents a fund and the intersection
of its respective growth (x-axis) and value scores (y-axis). The funds most
heavily skewed towards value (high value scores and low growth scores) are in
the upper left, while heavily growth oriented funds are in the bottom right
(high growth score and low value scores).
Information about the funds used in this report and their scores can be
found in the tables below the graph. Certain funds are labeled for further discussion.
(Growth -.60, Value +.37): While this value fund is farthest to the left, there
are other funds that offer more value exposure. However, this fund has the
lowest growth score among value funds.
(Growth -.43, Value +.68): This value fund offers an interesting trade off to
VIVAX sporting a higher value score but a less negative growth score.
(Growth +.10, Value -.05): Despite its classification as a value fund, AIVSX
has a slight bias towards growth. Not surprisingly, this fund has recently outperformed
other value funds but would likely underperform in the event value takes the
(Growth +.88, Value -.64): This growth fund offers both the highest growth
score and lowest value score. For investors looking for an aggressive profile
with strong growth exposure and little value exposure, this fund is worth
(Growth -.04, Value +.16): Despite its classification as a growth fund, VPMCX
has a slight bias towards value.
our opinion, the six funds with growth and value scores near zero (+/-.20) in
the red box do not currently have a significant growth or strategy orientation,
and as such, they are similar to a broad market index like the S&P 500.
important to stress that the data represents a snapshot of the fund portfolios
for one day. The portfolio managers are always shifting portfolios toward a value
or growth bias based on their market views.
(CLICK on the tables to enlarge)
Data Courtesy Bloomberg
The data above
gives us potential funds to meet our strategic needs. However, we also need to
plots below isolate growth and value funds based on their respective growth or
value score and fees charged.
three groupings of the growth funds to help point out the interaction of fees
and growth scores. The four funds in the blue circle have average or above average
fees versus other growth funds yet provide a minimal bias towards growth. The
yellow circle represents a sweet spot between low fees and a good exposure to
growth stocks. Lastly, the red circle shows funds where heavy exposure to growth comes with above
circles three groupings of value funds to help point out the interaction of
fees and growth scores. The blue circle contains funds with little to no bias
towards value. The yellow circle represents a good mix of value and cheap fees.
The red circle, our sweet spot in this graph, shows that heavy exposure to value
can be had with fees near the group average.
Alpha and Bad Incentives
Alpha is a
measure that calculates how much a portfolio manager, trader, or strategy over
or underperforms an index or benchmark. From a career perspective, alpha is
what separates good fund managers from average or bad ones.
alpha as we believe the current prolonged outperformance of growth over value
is pushing professional fund managers to stray from their stated objectives. As
an example, a value based fund manager can add exposure to growth stocks to
help beat the value index he or she is measured against.
Adding growth to a value fund may have proven to be alpha positive in the past, but we must concern ourselves with how well the fund manager is adhering to the fund’s objective Simply put, we are trying to find managers that are staying true to their objectives not those who have benefited from a deviation from stated strategy in the past.
important to note that positive alpha can be attained by sticking to the stated
objective and finding stocks that outperform the index. This is the type of
alpha that we seek.
growth and value factors can change for funds based on the whims of the portfolio
manager. Therefore, the data provided in this article will not age well. If you
do not have access to Bloomberg to track value and growth scores we offer
provides a blunt but effective style analysis tool. To access it, go to www.morningstar.com and select
your favorite fund. Then click on the tab labeled Portfolio and scroll down to
The following screen print shows Morningstar’s style analysis for value fund DFLVX.
The box in
the top right separates the fund’s holdings by market capitalization and value growth
classifications. We can use this data to come up with our own scores. For
instance, 59% (46+13) of DFLVX is biased toward value (red circle) while only
6% (5+1) is in growth companies (blue circle). To further demonstrate how a
fund compares to its peers, the Value & Growth Measures table on the bottom
left, compares key fundamental statistics. As shown by three of the first four
valuation ratios, DFLVX has more value stocks than the average for funds with
The word “Value”
in a fund name does not mean the fund takes on a value bias at all times. As
investors, we must not rely on naming conventions. This means investors must do
some extra homework and seek the funds that are truly investing in a manner
consistent with the funds, and ultimately the investor’s, objective.
As we have
mentioned, we are at a point in the economic and market cycles where investors
should consider slowly rotating towards value stocks. Not only is the style
historically out of favor, many of the names within that style are
unjustifiably beaten down and due for mean reversion to more favorable levels. We
hope this article provides some guidance to ensure that those who heed our
advice are actually adding value exposure and not value in name only.
Value Your Wealth – Part Three: Sector Analysis
embarked on our Value Your Wealth series, we decided to present it using a top-down
approach. In Parts One and Two, we started with basic definitions and broad
analysis to help readers better define growth and value investment styles from
a fundamental and performance perspective. With this basic but essential
knowledge, we now drill down and present investment opportunities based on the
two styles of investing.
focuses on where the eleven S&P sectors sit on the growth-value spectrum.
For those that invest at a sector level, this article provides insight that
allows you to gauge your exposure to growth and value better. For those that
look at more specialized funds or individual stocks, this research provides a
foundation to take that analysis to the next level.
The 505 companies
in the S&P 500 are classified into eleven sectors or industry types. While
very broad, they help categorize the S&P companies by their main source of
revenue. Because there are only eleven sectors used to define thousands of business
lines, we must be acutely aware that many S&P 500 companies can easily be
classified into several different sectors.
(COST), for instance, is defined by S&P as a consumer staple. While they
sell necessities like typical consumer staples companies, they also sell pharmaceuticals
(health care), clothes, TVs and cars (discretionary), gasoline (energy),
computers (information technology), and they own much of the property (real-estate)
upon which their stores sit.
there is no such thing as a pure growth or value sector. The sectors are
comprised of many individual companies, some of which tend to be more
representative of value and others growth.
discussed in Part Two, we created a composite growth/value score for each S&P
500 company based on their respective z-scores for six fundamental factors
(Price to Sales, Price to Book, Price to Cash Flow, Price to Earnings, Dividend
Yield, and Earnings Per Share). We then ranked the composite scores to allow
for comparison among companies and to identify each company’s position on the S&P
500 growth-value spectrum. The higher the
composite score, the more a company is growth oriented and the more negative
the score, the more value-oriented they are.
below summarizes the composite z-scores by sector. To calculate this, we grouped each company
based on its sector classification and weighted each company’s z-score by its
market cap. Given that most indexes and ETFs/Mutual funds are market cap
weighted, we believe this is the best way to arrange the sector index scores on
the growth-value spectrum.
Data courtesy Bloomberg
the Financial, Energy, and Utility sectors are the three most heavily weighted
towards value. Real-estate, Information Technology,
and Consumer Discretionary represent the highest weighted growth sectors.
might be tempting to select sectors based on your growth-value preferences
solely using the data in the table, there lies a risk. Some sectors have a
large cross-section of both growth and value companies. Therefore they may not provide you the growth
or value that you think you are buying. As an example, we explore the
communications sector (represented by the ETF XLC) is a stark combination of
old and new economy stocks. The old economy stocks are traditional media
companies such as Verizon, Fox, CBS and News Corp. New economy stocks that depend
on newer, cutting edge technologies include companies like Google, Facebook,
Twitter, and Trip Advisor.
As one might
expect, the older media companies with more reliable earnings and cash flows
are priced at lower valuations and tend to be defined as value stocks by our
analysis. Conversely, the new economy companies have much higher valuations,
are short on earnings, but come with the prospect of much higher growth
plot below offers an illustration of the differences between growth, value and
market capitalization within the communications sector. Each dot represents the
intersection of market capitalization and the composite z-score for each
company. The table below the scatter plot provides fundamental and performance
data on the top three value and growth companies.
Data courtesy Bloomberg
As shown in the graph, the weighted average z-score (the orange circle) for the communications sector leans towards growth at +0.19. Despite the growth orientation, we deem 58% of the companies in the communications sector as value companies.
following table compares the weighted average z-score for each S&P sector along
with the variance of the underlying companies within the sector and the
percentage of companies that are considered value and growth. We use standard
deviation on the associated composite z-scores to determine whether companies
are close together or far apart on the growth/value spectrum. The lower the standard deviation, the more
similar the companies are in terms of growth or value
Data courtesy Bloomberg
weightings, market capitalization, and the influence of individual stocks
within a sector are important to understand The industrial sector, as shown
above, has a score of +0.232, which puts it firmly in growth territory. However,
Boeing (BA), due to its large market cap and significant individual growth
score skews this sector immensely. Excluding BA, the weighted average composite
score of the industrial sector registers as a value sector at -0.07. Again this
highlights the importance of understanding where the growth and or value in any
particular sector comes from.
The graph below
shows the clear outperformance of the three most heavily growth-oriented sectors
versus the three most heavily value-oriented. Since the beginning of the post-financial
crisis, the three growth companies grew by an average of 480%, almost three
times the 166% average of the three value companies.
analysis provides you a basis to consider your portfolio in a new light. If you
think the market has a few more innings left in the current expansion cycle,
odds continue to favor a growth-oriented strategy. If you think the economy is
late-cycle and the market is topping, shifting towards value may provide much-needed
believe the economic and market cycles are late stage, they have not ended. We
have yet to receive a clear signal that value will outperform growth going
forward. At RIA Advisors, growth versus value is a daily conversation, whether applied
to sector ETF’s, mutual funds or individual stocks. While we know it’s early, we also know that
history has been generous to holders of value, especially after the rare
instances when growth outperformed it over a ten-year period as it has recently.
Value Your Wealth – Part Two: Quantifying the Value Proposition
This article is the second in a series focused on growth versus value investment styles and its significance to managing your wealth in the current environment. If you have not read Part One, we urge you to read it first as it provides a foundation upon which this article builds. If you already read Part One, it may be helpful to go back and review the fundamental definitions of growth and value.
behavior has demonstrated the willingness of investors to get caught up in the
euphoria of financial bubbles. The history books are chock full of tales about
investors chasing the prices of tulips, technology stocks, and real estate to
stratospheric levels. The collective enthusiasm of such periods has a hypnotic
way of lulling even the most astute investors into the belief that stocks have
reached “a permanently high plateau”
(prominent economist Irving Fisher, 1929).
and tides, however, markets and human behavioral patterns are cyclical. Mean
reversion, like change, is one thing we can all count on. As the analysis below
will illustrate, we appear to be in another one of those euphoric periods.
euphoria will turn to despair. It is with this knowledge that we continue to
expose the current paradigm between growth and value stocks so that you can
prepare for this inevitability. Those who seek to compound wealth are
well-served to understand the current circumstances and the nature of the
contrast between the two investment approaches.
differences in their valuations and performance are extreme in both magnitude
and duration. If we are to believe that the realities of the world in which we
live have been permanently suspended and there will be no mean reversion, then
we should proceed to do what we did yesterday. If we believe that this cycle
too will end, then we need to understand what is at risk and strategize on how
to protect ourselves.
which follows puts a much finer point on the extremes we are currently
observing and therefore the risks we assume by failing to acknowledge them.
What Constitutes Growth and Value
across compelling work articulated on Bloomberg by Nir
Kaisser, we decided to look deeper into the contrast between growth
and value stocks. In taking on this project, we had two problems. The first
problem was deciding how to quantitatively define growth and value. The second
problem was retrieving and processing the data required to fairly analyze these
two broad categories.
To keep this
analysis both simple and applicable, we chose to limit our analysis to the
constituents of the S&P 500. We also decided to use the six fundamentals listed
below to quantitatively define and screen between value and growth.
Price-to-Cash Flow (P/CF)
Dividend Yield (DY)
Earnings per Share (Trailing 12-Months) (EPS)
companies tend to have higher price-to-sales, price-to-book, price-to-cash flow
and earnings per share and lower (often zero) dividend yield. Value companies
are the opposite.
mind, the S&P 500 accounts for roughly 80% of U.S. stock market
capitalization and within that index, 100 of the largest companies in the
United States reside firmly in either the growth or value category. They are
the top 50 in growth and the top 50 in value (by our definition) selected based
on the fundamentals as described above.
Growth vs. Value Analysis
companies within the S&P 500 that properly fit into either the growth or
value category was done by evaluating the valuation metrics referenced above,
ranking companies based on a standard deviation (z-score) for each metric, and
then aggregating data to compute a composite z-score.
which tells us how many standard deviations from the mean a specific number is,
can be calculated by taking the company-specific reading in one category,
subtracting it from the average for the S&P 500, and then dividing that
number by the standard deviation for the total S&P 500. One standard
deviation includes approximately 68% of the data. To clarify, we provide the example below.
The price-to-sales (P/S) for Boston
Scientific (BSX) is 4.94
The average P/S for the S&P 500
The standard deviation for P/S for
the S&P 500 is 3.25 (~68% of the data has a P/S of 3.60 +/-3.25)
Therefore, BSX has a P/S z-score of
0.413 calculated as (4.94-3.60)/3.25
This tells us that BSX’s P/S is 0.413
standard deviations above the average (conversely, if the z-score had been
-0.413 then BSX P/S would have been 0.413 below the average)
Based solely on its positive P/S
z-score and above average P/S ratio, BSX can be defined as a growth company.
the same analysis for each S&P 500 company and each of the six fundamental
metrics listed above. We then created a
composite based on the six z-scores for each company and ranked them.
Of the 500
companies in the S&P 500, we selected the 50 companies with the highest
z-score composite, those clearly demonstrating the characteristics of a growth
company, and the 50 lowest z-score composites, which are companies that fit the
characteristics of a value company.
results of the z-score analysis, we also looked at the total rate of return
over various time frames for those stocks in our growth and value identified
sectors. Return figures are inclusive of dividends.
Results – Fundamentals
below shows the sharp contrast between the average metrics for the 50 growth
stocks and the 50 value stocks.
Data courtesy Bloomberg
table contrasts this data in a z-score format for each metric. The z-score
analysis provides the ability to compare the two styles and understand how the
growth and value companies compare to the entire S&P 500. As a reminder,
the higher or lower the z-score, the more it varies from the average.
Data courtesy Bloomberg
Results – Total Returns
returns for the top and bottom 50 stocks, we stretch a bit and assume that the
50 growth and value stocks identified today have been in that realm for the
past ten years. While we know that is not entirely the case; it is not
unreasonable to think both groups have been in the ballpark. The table below
highlights the total returns of each group across various timeframes.
Data courtesy Bloomberg
in metrics between growth stocks and value stocks could not be starker. The
differentials are incredibly large, which indicates one is either paying
eye-watering prices for growth, or they are truly finding value in the value category.
The total return performance over each time frame highlights the chasm between
investor preferences for growth over value since the financial crisis.
stocks have rewarded investors for taking risk and punished those with a tried
and true value approach. While memories are nice, we remind you that as
investors we must look forward. Value stocks provide a large cushion for error,
whereas growth stocks are priced for a level of perfection not since the
technology bubble. As long as the market remains euphoric, growth will likely
continue to outperform value. However, when rationality strikes the market over
the head, the ridiculous prices the market assigns to growth stocks will
normalize. At the same time, investors will seek out boring companies with
steady earnings and relatively cheap valuations that constitute the value
Value Your Wealth – Part One Introduction
In this article
and a series of others to follow, we explore the distinction between growth and
value investment styles. Those looking in their rearview mirror will likely laugh
at our analysis and focus on what worked yesterday. Those aware of the inevitable
turns in the road ahead will understand the unique worth that a value-focused
investment style offers.
the market is on the precipice of a monumental shift, and one that will
blindside most investors. Through this series of articles, we aim to provide
research and investment ideas that will allow you to protect your wealth when
the investment cycles shift and thrive when most investors suffer.
Discipline, Process, and an Appreciation for Cycles
sprung, flowers are blooming, and pollen is swirling through the air. It’s time
to put away our winter boots, scarves, and bulky jackets and replace them with
swimming trunks, baseballs gloves and the promise of afternoon naps on the
also has its seasons. Economic and investment cycles alternate between periods
where risk-taking and speculating is preferred and periods where conservatism
and discrimination are essential. Unlike the seasons, there is no calendar that
tells us when these investing cycles begin and end. Nevertheless, an
appreciation for history along with an understanding of economic trends, valuations,
demographics, and monetary and fiscal policy provides helpful clues.
potential changes in economic and market cycles, however vague the timing is,
allow us to strategize on how to reposition our portfolios when the change in
season appears imminent. Because of vastly different investing environments and
associated outcomes, success in building wealth over long time frames requires discipline
and a durable investment process. It is important to ride the market higher in
the good times, but we can’t stress enough the value of avoiding the inevitable
large market drawdowns that erase wealth and the precious time you have to
Value vs. Growth
surge higher since the financial crisis and the governmental and corporate
policies used to sustain economic and market growth have been nothing short of
extraordinary. In many articles, we discussed topics such as the unparalleled
use of monetary policy to prop markets higher, massive fiscal spending designed
to keep economic growth positive, how corporations have shunned future growth
to buy-back stock, and the substantial shift towards passive investment styles.
As a result
of these behaviors and actions, we have witnessed an anomaly in what has historically
spelled success for investors. Stronger companies with predictable income generation
and solid balance sheets have grossly underperformed companies with unreliable
earnings and over-burdened balance sheets. The
prospect of majestic future growth has trumped dependable growth. Companies
with little to no income and massive debts have been the winners.
Over the past
decade, investors have favored passive instruments that track a market or a large
swath of the market. By doing so, they have easily outperformed active
investors that are doing their homework and applying time-tested fundamental
analysis to their investment selection process. This passive behavior is
circular in nature and has magnified the growth/value imbalance. The investment
world has been turned on its head.
underperformance of value stocks relative to growth stocks is not unique, but the
current duration and magnitude of underperformance are unprecedented. Before
embarking on a more detailed discussion, a clear definition of what is meant by
growth and value is important.
Growth- Growth stocks represent companies that have demonstrated
better-than-average gains in sales and/or earnings in recent years and are
expected to continue delivering high levels of profit growth. They are
generally higher priced than the broad market in terms of their
price-to-earnings and price-to-sales, and their stock prices tend to be more
volatile. To help fuel earnings, growth stocks often do not pay out a dividend.
generally perform better when interest rates are falling and corporate earnings
are robust. On the other hand, they are also most at risk of losses when the
economy is cooling.
A value stock tends to include companies that have fallen out of favor but
still have good fundamentals such as dividends, earnings, and sales. Value
stocks are lower priced than the broader market, are often priced below similar
companies in their industry, and are perceived to carry less risk than the market.
Value stocks generally hold their
value better in an economic slowdown, tend to do well early in an economic
recovery, and frequently lag in a prolonged bull market. In general they pay
above market dividends.
Historical Context – Growth vs. Value
It is important
to understand which investment styles have been successful during the
post-financial crisis era. Given that we are statistically and logically very
likely nearing the end of the cycle, it is even more crucial to grasp what
decades of investment experience through all sorts of economic and market
climates, not just the last ten years, tells us should be successful in the future.
below charts ten year annualized total returns (dividends included) for value
stocks versus growth stocks. The most recent data point representing 2018,
covering the years 2009 through 2018, stands at negative 2.86%. This indicates
value stocks have underperformed growth stocks by 2.86% on average in
each of the last ten years.
The data for
this analysis comes from Kenneth French and Dartmouth University.
There are two
important takeaways from the graph above:
the last 90 years, value stocks have outperformed growth stocks by an
average of 4.44% per year (orange dotted line).
have only been eight ten-year periods over the last 90 years (total of 90 ten-year
periods) when value stocks underperformed growth stocks. Two of these occurred
during the Great Depression and one spanned the 1990s leading into the Tech
bust of 2001. The other five are recent, representing the years 2014 through
To say the post-financial crisis era has
been an anomaly is an understatement. The current five-year string of a
negative trailing 10-year annualized return differential is the longest on
record, and the most recent ten-year return ending last year is the lowest on
record at NEGATIVE 2.86%.
cycle turns, we have little doubt the value-growth relationship will revert. As
the graph above shows, seldom does such reversion stop at the average. To
better understand why this is so important, consider what happens if the
investment cycle turns and the relationship of value versus growth returns to
the average over the next two years. In
such a case value would outperform growth by nearly 30% in just two years.
Anything beyond the average would increase the outperformance even more.
and the others to follow are not intended to implore you to immediately buy
value and sell growth. They will, however, provide you with a road map that
allows you to plan, strategize and use discipline in moving to a more
conservative, value-based strategy if you so choose.
mentioned, we will explore this topic in much more depth in coming articles.
Already in the works are the following analyses:
stock screen that discerns between value and growth stocks.
tool to help find funds and ETF’s that provide value versus those that use
Value in their name but provide little value.
analysis to steer you toward specific industries that tend to have more value stocks
than growth stocks.
growth are just two of the many factors to explore. In the future, we will also
introduce and discuss others such as momentum and size.
We want to be
astute stewards of wealth and safeguard our portfolios so that when the
investing cycle comes to an end, we are prepared to take advantage of what the
next season has in store. This will help ensure those naps on the beach are not
dreams but reality.
Exclusive Interview: Peter Boockvar
Last week, I visited with Peter Boockvar, Chief Investment Officer at Bleakley Advisory Group and Editor of The Boock Report. He previously was the Chief Market Analyst for The Lindsey Group, a macro economic and market research firm started by Larry Lindsey. Prior to this, Peter spent a brief time at Omega Advisors, a New York-based hedge fund, as a macro analyst and portfolio manager. Before this, he was an employee and partner at Miller Tabak + Co for 18 years where he was recently the equity strategist and a portfolio manager with Miller Tabak Advisors.
Peter and I cover a wide range of topics from the market, the coming recession, the impact and risks of higher rates, and the Federal Reserve.
If you like the content – please share with your friends.
Why QE Is Like Wearing Bear Goggles For Wall Street
What Happens When QE Ends
The Three Most Important Things Following The Election
I recently spent some time with Chris Martenson from Peak Prosperity about the market, the economy, and the “Great Reset” which is approaching.
Chris Martenson, PhD (Duke), MBA (Cornell) is an economic researcher and futurist specializing in energy and resource depletion, and co-founder of PeakProsperity.com (along with Adam Taggart). As one of the early econobloggers who forecasted the housing market collapse and stock market correction years in advance, Chris rose to prominence with the launch of his seminal video seminar: The Crash Course which has also been published in book form (Wiley, March 2011). It’s a popular and extremely well-regarded distillation of the interconnected forces in the Economy, Energy and the Environment (the “Three Es” as Chris calls them) that are shaping the future, one that will be defined by increasing challenges to growth as we have known it. In addition to the analysis and commentary he writes for his site PeakProsperity.com, Chris’ insights are in high demand by the media as well as academic, civic and private organizations around the world, including institutions such as the UN, the UK House of Commons and US State Legislatures.
The interview has been broken down into 3-chapters for your viewing consumption.
If you like the content – please share with your friends.
Why I Am A Perma-Bear
Who Is Swimming Naked Now?
How Long Can The US Remain An Island Of Economic Growth?
My interview with the brilliant Doug Kass on the recent market rout, his views on the world, economic growth, and earnings outlook going into next year. We also talk bonds, market cycles, and why the bull market remains at risk.
Doug cut his teeth as an investigator and truth-teller as a member of “Nader’s Raiders,” Ralph Nader’s crusaders for consumer protection and safety. In fact, he co-authored Citibank: The Ralph Nader Report with Ralph Nader and the Center for the Study of Responsive Law.
Kass started his investment career as a housing analyst at Kidder, Peabody in 1972 after receiving his bachelor’s from Alfred University and his MBA in Finance from the University of Pennsylvania’s Wharton School.
After holding a number of senior positions at brokerages, hedge funds and other institutions for the next three decades, he launched his own hedge fund, Seabreeze Partners Management, where he is President.
At Seabreeze, and as the top investor at Real Money Pro, Doug Kass identifies big winners again and avoids nasty losses by challenging Wall Street’s conventional wisdom.
He’s appeared in the New York Times, Wall Street Journal, Bloomberg, Barron’s, The Washington Post, The New York Post, CNBC and most major financial media.
Why The Dominant Investor Is The Most Dangerous
Three Ways To Most Gainfully Spend Time As An Investor
VLOG: Rising Rates Send A Warning & Why It Matters
While it has been stated that rising interest rates don’t matter, the reality is that they do. I take a deeper look at the impact of higher rates across the financial and economic spectrum and the warning that rates are currently sending to investors.
VLOG – Why Smart Investors Should Fear An Inversion
Clarity Financial Chief Investment Strategist Lance Roberts shows why the danger of asset bubbles in every investment class is part of a recipe for reversal as the bond yield curves begin to invert…and what that means for your money.
Fox Business recently discussed a new study showing that more Americans doubted they would be able to save enough for retirement than those confident of reaching their goals. There were some interesting stats from the study:
37% are NOT confident they can save enough to retire
32% ARE confident they can save enough.
48%, however, don’t think their retirement savings will reach $1 million.
“Americans feel under-prepared for the financial realities of retirement, according to new data from Northwestern Mutual. Nearly eight in 10 (78%) Americans are “extremely” or “somewhat” concerned about affording a comfortable retirement while two-thirds believe there is some likelihood of outliving retirement savings.”
Those fears are substantiated even further by a new report from the non-profit National Institute on Retirement Security which found that nearly 60% of all working-age Americans do not own assets in a retirement account.
Here are some additional findings from the report:
Account ownership rates are closely correlated with income and wealth. More than 100 million working-age individuals (57 percent) do not own any retirement account assets, whether in an employer-sponsored 401(k)-type plan or an IRA nor are they covered by defined benefit (DB) pensions.
The typical working-age American has no retirement savings. When all working individuals are included—not just individuals with retirement accounts—the median retirement account balance is $0 among all working individuals. Even among workers who have accumulated savings in retirement accounts, the typical worker had a modest account balance of $40,000.
Three-fourths (77 percent) of Americans fall short of conservative retirement savings targets for their age and income based on working until age 67 even after counting an individual’s entire net worth—a generous measure of retirement savings.
So, what’s the problem?
Why do so many Americans face a retirement crisis today after a decade of surging stock market returns?
“13 percent of Americans are saving less for retirement than they were last year and offers insight into why much of the population is lagging behind. The most popular response survey participants gave for why they didn’t put more away in the past year was a drop, or no change, in income.”
“For the third consecutive year, households in the United States experienced an increase in real annual median income. Median household income was $61,372 in 2017, a 1.8 percent increase from the 2016 median of $60,309 in real terms. Since 2014, median household income has increased 10.4 percent in real terms.”
So, if median incomes just hit an all-time high, then why are Americans having such a problem saving for retirement?
The cost of living has risen much more dramatically than incomes. According to Pew Research:
“In fact, despite some ups and downs over the past several decades, today’s real average wage (that is, the wage after accounting for inflation) has about the same purchasing power it did 40 years ago. And what wage gains there have been have mostly flowed to the highest-paid tier of workers.”
But the problem isn’t just the cost of living due to inflation, but the “real” cost of raising a family in the U.S. has grown incredibly more expensive with surging food, energy, health, and housing costs.
Researchers at Purdue University recently studied data culled from across the globe and found that in the U.S., $65,000 was found to be the optimal income for “feeling” happy. In other words, this was a level where bills were met and there was enough “excess” income to enjoy life. (However, that $65,000 was based on a single individual. For a “family of four” in the U.S., that number was $132,000 annually.)
Gallup also surveyed to find out what the “average” family required to support a family of four in the U.S. (Forget about being happy, we are talking about “just getting by.”) That number turned out to be $58.000.
Skewed By The 1%
The issue with the Census Bureau’s analysis is that the income numbers are heavily skewed by those in the top 20% of income earners. For the bottom 80%, they are well short of the incomes needed to obtain “happiness.”
The chart below shows the “disposable income” of Americans from the Census Bureau data. (Disposable income is income after taxes.)
So, while the “median” income has broken out to all-time highs, the reality is that for the vast majority of Americans there has been little improvement. Here are some stats from the survey data which was NOT reported:
$306,139 – the difference between the annual income for the Top 5% versus the Bottom 80%.
$148,504 – the difference between the annual income for the Top 5% and the Top 20%.
$157,635 – the difference between the annual income for the Top 20% and the Bottom 80%.
So, if you are in the Top 20% of income earners, congratulations. If not, it is a bit of a different story.
No Money, But I Got Credit
As noted above, sluggish wage growth has failed to keep up with the cost of living which has forced an entire generation into debt just to make ends meet.
While savings spiked during the financial crisis, the rising cost of living for the bottom 80% has outpaced the median level of “disposable income” for that same group. As a consequence, the inability to “save” has continued.
So, if we assume a “family of four” needs an income of $58,000 a year to be “make it,”such becomes problematic for the bottom 80% of the population whose wage growth falls far short of what is required to support the standard of living, much less to obtain “happiness.”
The “gap” between the “standard of living” and real disposable incomes is more clearly shown below. Beginning in 1990, incomes alone were no longer able to meet the standard of living so consumers turned to debt to fill the “gap.” However, following the “financial crisis,” even the combined levels of income and debt no longer fill the gap. Currently, there is almost a $3300 annual deficit that cannot be filled.
This is why we continue to see consumer credit hitting all-time records despite an economic boom, rising wage growth, historically low unemployment rates.
The mirage of consumer wealth has not been a function of a broad increase in the net worth of Americans, but rather a division in the country between the Top 20% who have the wealth and the Bottom 80% dependent on increasing debt levels to sustain their current standard of living.
Of course, by just looking at household net worth, once again you would not really suspect a problem existed. Currently, U.S. households are the richest ever on record. The majority of the increase over the last several years has come from increasing real estate values and the rise in various stock-market linked financial assets like corporate equities, mutual and pension funds.
However, once again, the headlines are deceiving even if we just slightly scratch the surface. Given the breakdown of wealth across America we once again find that virtually all of the net worth, and the associated increase thereof, has only benefited a handful of the wealthiest Americans.
Despite the mainstream media’s belief that surging asset prices, driven by the Federal Reserve’s monetary interventions, has provided a boost to the overall economy, it has really been anything but. Given the bulk of the population either does not, or only marginally, participates in the financial markets, the “boost” has remained concentrated in the upper 10%. The Federal Reserve study breaks the data down in several ways, but the story remains the same – “if you are wealthy – life is good.”
The illusion by many of ratios of “economic prosperity,” such as debt-to-income ratios, wages, assets, etc., is they are heavily skewed to the upside by the top 20%. Such masks the majority of Americans who have an inability to increase their standard of living.The chart below is the debt-to-disposable income ratios of the Bottom 80% versus the Top 20%. The solvency of the vast majority of Americans is highly questionable and only missing a paycheck, or two, can be disastrous.
While the ongoing interventions by the Federal Reserve have certainly boosted asset prices higher, the only real accomplishment has been a widening of the wealth gap between the top 10% of individuals that have dollars invested in the financial markets and everyone else. What monetary interventions have failed to accomplish is an increase in production to foster higher levels of economic activity.
It is hard to make the claim the economy is on the verge of acceleration with the underlying dynamics of savings and debt suggesting a more dire backdrop. It also goes a long way in explaining why, as stated above, the majority of Americans are NOT saving for their retirement.
“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 more importantly, they are not saving on their own either for the same reasons.
“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.
This isn’t just about the “baby boomers,” either.
Millennials are haunted by the same problems, with 40%-ish unemployed, or underemployed, and living back home with parents.
In turn, parents are now part of the “sandwich generation” who are caught between taking care of kids and elderly parents.
But the real crisis will come when the next downturn rips a hole in the already massively underfunded pension funds on which many American’s are now solely dependent.
For the 75.4 million “boomers,” about 26% of the population, heading into retirement by 2030, the reality is that only about 20% will be able to actually retire.
The rest will be faced with tough decisions in the years ahead.
VLOG – Markets Diverge From The U.S.
Clarity Financial Chief Investment Strategist Lance Roberts examines the divergence of world markets to the U.S. and discusses the message they may be sending to investors.
VLOG – A Shift In Valuations & Investor Perspectives
Clarity Financial Chief Investment Strategist Lance Roberts examines stock valuations vs investor sentiment, and agrees with Prof. Robert Shiller’s assessment that investors have become complacent to the risk of higher valuations.
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 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?”
“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:
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.
“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:
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.
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
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.
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.
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”)
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.
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.
Zero Returns Ahead: Follows Eric’s example of zero returns ahead.
One Big Drop: Allows for 10% returns every year going forward with the exception of one 40% decline.
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.”
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.
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.
“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 Line – Real S&P 500 index with a 24-month (2-year) moving average.
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.
$1000 into a “buy and hold” investment strategy.
$1000 into a valuation ONLY strategythat is long the S&P 500 until CAPE exceeds 20x earnings and then goes to cash until CAPE is below 10x earnings.
$1000 into a technical switching strategythat 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.)
$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.
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.
Cut losers short and let winner’s run. (Be a scale-up buyer into strength.)
Set goals and be actionable.(Without specific goals, trades become arbitrary and increase overall portfolio risk.)
Emotionally driven decisions void the investment process.(Buy high/sell low)
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.)
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.)
An investment discipline does not work if it is not followed.
“Losing money” is part of the investment process.(If you are not prepared to take losses when they occur, you should not be investing.)
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)
Never, under any circumstances, add to a losing position.(As Paul Tudor Jones once quipped: “Only losers add to losers.”)
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.)
When markets are trading at, or near, extremes do the opposite of the “herd.”
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.)
“Buy” and “Sell” signals are only useful if they are implemented.(Managing a portfolio without a “buy/sell” discipline is designed to fail.)
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.)
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.’”
“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
2: someone 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
4: the 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.
“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.
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.
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
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:
You can afford to take more risk when your investment horizon is long and you should reduce risk when it is short.
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.
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:
Have an appropriate savings rate for our goals,
Ensure those savings adjust for inflation over time, and;
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.
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?
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 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 becomementally “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.”
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 Apple, Alphabet, Microsoft, 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:
“Don’t lose money.”
Refer to Rule #1
Buy that which is “cheap”
Sell that which is “dear”
Hold excessive levels of cash if necessary
Do not follow the herd
Have patience, patience and even more patience
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
We respect your privacy and will only send you email that is
related to what you subscribed to and why you subscribed.
You can unsubscribe whenever you want with just a click
of your mouse. For more information please