Tag Archives: portfolio

2020 – INVESTMENT SUMMIT

RIA Advisors is proud to present the 2020 Investment Summit 

Hosted By: Lance Roberts, CIO RIA Advisors

Featuring:

  • Michael Lebowitz, CFA – RIA Portfolio Manager
  • Teddy Valle – Pervalle Global
  • Thomas Thornton – HedgeFund Telemetry
  • Jeffery Marcus – TP Analytics

Topics include:

  • Impact of Government bailouts
  • The Fed is fighting a losing battle
  • Market Outlook
  • ETF Liquidity issues
  • And more….

CLICK HERE TO START WATCHING NOW


A Black Swan In The Ointment

A good person is as rare as a black swan”- Decimus Juvenal

In 2007, Nassim Taleb wrote a bestselling and highly impactful book titled The Black Swan: The Impact of the Highly Improbable. The book uses the analogy of a black swan to describe negative events that appear to be very rare and occur without warning.  Since the book was published, the term black swan has been overused to describe all kinds of events that were predictable to some degree.

Last April, we wrote A Fly in the Ointment, which was one of a few articles that pointed out the risk of higher inflation to the markets and economy. Thinking about inflation in the context of the Corona Virus and the Fed’s aggressive monetary policy, might our fly be a black swan.

Corona Virus

The economic impact of the Corona Virus has been negligible thus far in the U.S., but in a growing list of other countries, the impact is high. In China, cities more populated than New York City are being quarantined. Citizens are being told to stay at home, and schools, factories, and shops are closed. Japan just closed all of its schools for at least a month. Airlines have reduced or suspended flights to these troubled regions.

From an inflation perspective, the impact of these actions will be two-fold.

Consumers and businesses will spend less, especially on elastic goods. Elastic goods are products that are easy to forego or replace with another good. Examples are things like movies, coffee at Starbucks, cruises, and other non-necessities. Inelastic goods are indispensable or those with no suitable replacement. Examples are essential medicines, water, and food. Many items fall somewhere between perfectly elastic and perfectly inelastic, and in many cases, the classification is dependent upon the consumer.

On the supply side of the inflation equation, production suspensions are leading to shortages of parts and final goods. Companies must either do without them and slow/suspend production or find new and more expensive sources.

We are purposely leaving out the role that the supply of money plays in inflation for now.

With that as a backdrop, we pose the following questions to help you assess how the virus may impact prices.

  • Will producers of elastic goods lower prices if demand falters?
  • If so, will lower prices induce more consumption?
  • Can producers lower the prices of goods if the cost to produce those goods rise?
  • How much margin compression can companies tolerate?
  • Will producers of inelastic goods try to pass on the higher costs of goods, due to supply chain problems, to consumers?
  • Inflationary or deflationary?

We do not have the answers to the questions but make no mistake; inflation related to hampered supply lines could more than offset weakened demand and pose a real inflation risk.

The Fed’s Conundrum

Monetary policy has a direct impact on prices. To quote from our recent article, Jerome Powell & The Fed’s Great Betrayal:

“One of the most pernicious of these issues in our “modern and sophisticated” intellectual age is that of inflation. Most people, when asked to define inflation, would say “rising prices” with no appreciation for the fact that price movements are an effect, not a cause. They are a symptom of monetary circumstances. Inflation defined is, in fact, a disequilibrium between the amount of currency entering an economic system relative to the productive output of that same system.”

For the past decade, the Fed has consistently sought to generate more inflation. They have kept interest rates lower than normal given the tepid economic growth trends. Further, they employed four rounds of QE. QE provides reserves to banks, which increases their ability to create money. Easy money policies, the type we have grown accustomed to, is designed to increase inflation.

On March 3, 2020, the Fed cut interest rates to try to offset the negative economic impact of the Corona Virus.  How lower interest rates will cure a disease is a question for another day. Today’s big question is the Fed fueling the embers of inflation with this sudden rate cut?

Enter the Black Swan

What would the Fed need to do if inflation were to rise due to compromised supply lines and overly aggressive Fed actions? If inflation becomes a problem, they would need to do the opposite of what they have been doing, raise interest rates and reduce the assets on their balance sheet (QT).

Such policy worked well in the 1970s when Fed Chairman Paul Volker increased Fed Funds to 20% and restricted money supply to bring down double-digit inflation. Today, however, such a prudent policy response would be incredibly problematic due to the massive amount of debt the U.S. and its citizens have accumulated. The graph below shows that there is about three and a half times more debt than annual economic activity currently in the U.S.

Unlike the 1970s, when household, corporate, and public debt levels were much lower, higher interest rates and less liquidity today would inevitably result in massive defaults by both consumers and corporations. Further, it would cause a surge in the Federal budget deficit as interest expense on U.S. Treasury debt would rise.

Over the last few decades, we have seen a steady decline in interest rates. At times in this cycle, rates have risen moderately. Each time this occurred, a crisis developed as funding problems arose. What would happen today if mortgage rates rose to 7% and auto loans to 5%? What would happen to corporate profits if borrowing rates doubled from current levels? How would corporations that depend on routine, cheap refinancing of their debt obtain it?

In such an environment, taking on new debt would be much less appealing and servicing existing debt would require a larger portion of the budget. Clearly, an inflationary outbreak accompanied by higher interest rates would result in a severe recession.

Summary

What is a black swan? A black swan is an unforeseen event like the rapid spreading of the Corona Virus that results in inflation. It is not the obvious outcome but rather an obscure second or third-order effect. Our modern economic policy framework is not designed for inflation, nor are many people even thinking about it as a possibility. That is a black swan.  

Inflation is the one thing that prevents the Fed and other central banks from supporting the economy and markets in the way they have become accustomed.

As discussed in prior articles, we believe there is ample evidence of problematic inflation data for those who choose to look. At the same time, global central bankers continue to engage in imprudent policies that are inflationary in nature. Lastly, the Corona Virus threatens to hamper supply lines and change consumer spending habits.

Whether or not those factors result in inflation is unknown. Although one cannot predict the future, one can prepare for it. Inflation is not dead, but it has been hibernating for decades. Even if the odds of inflation are relatively low, that does not mean we should ignore them. As the sub-title to Taleb’s book says, “The Impact of the Highly Improbable” can be important. An event that has a 1% chance of occurring but would cause a massive loss of wealth should not be ignored.

7-Difficult Trading Rules To Follow In Bull Markets

As we wrap up the last two-trading days of the decade, I am wrapping up the recent series on “investing rules” (see here and here). The purpose of this series is to remind investors of the importance of having an investment discipline to protect investment capital when market volatility eventually comes.

I know…I know…volatility seems to be a thing of the past, particularly given the amount of exuberance currently embedded in the markets. This was a point I made in the most recent newsletter:

I have written many articles previously on investing, portfolio and risk management, and the fallacy of long-term “average” rates of returns. Unfortunately, few heed these warnings until it is generally far too late.

The biggest problems facing investors over the long-term are falling prey to the various psychological behaviors which impede our investing success. From herding to recency bias, to the “gambler’s fallacy,” these behaviors create critical errors in our portfolio management process, which ultimately leads to the destruction of our investment capital.

As I have addressed many times previously, the major problem is the loss of “time” to achieve your investment goals. When a major correction occurs in the financial markets, which occur quite frequently, getting back to even is NOT the real problem. While capital can be recovered following a destructive event, the time to reach your investment goals is permanently lost. 

The problem is that most mainstream commentators continue to suggest that “you can not manage” your money. If you sell, then you are going to “miss out” on some level of the bull market advance. The problem is they fail to tell you what happens when you lose a large chunk of your capital by chasing the bull market to its inevitable conclusion. (See “Math Of Loss”)

While investing money is easy, it is the management of the inherent “risks” that are critical to your long-term success. This is why every great investor in history is defined by the methods which dictate both the “buy”, but most importantly, “the sell” process.

The difference between a successful long term investor, and an unsuccessful one, comes down to following very simple rules. Yes, I said simple rules, and they are; but they are incredibly difficult to follow in the midst of a bull market. Why? Because of the simple fact that they require you to do the exact OPPOSITE of what your basic human emotions tell you to do:

  • Buy stuff when it is being liquidated by everyone else, and;
  • Sell stuff when it is going to the moon.


The 7 Impossible Trading Rules To Follow:

Here are the rules – they are not unique or new. They are time tested, and successful investor, approved. If you follow them you succeed – if you don’t, you won’t.

1) Sell Losers Short: Let Winners Run:

It seems like a simple thing to do, but when it comes down to it the average investor sells their winners and keeps their losers hoping they will come back to even.

2) Buy Cheap And Sell Expensive: 

You haggle, negotiate, and shop extensively for the best deals on cars and flat-screen televisions. However, you will pay any price for a stock because someone on TV told you too. Insist on making investments when you are getting a “good deal” on it. If it isn’t – it isn’t, don’t try and come up with an excuse to justify overpaying for an investment. In the long run, overpaying will end in misery.

3) This Time Is Never Different:

As much as our emotions, and psychological makeup, want to always hope for the best; this time is never different than the past. History may not repeat exactly, but it often rhymes extremely well.

4) Be Patient:

As with item number 2; there is never a rush to make an investment, and there is NOTHING WRONG with sitting on cash until a good deal, a real bargain, comes along. Being patient is not only a virtue, it is a good way to keep yourself out of trouble.

5) Turn Off The Television: 

Any good investment is NEVER dictated by day to day movements of the market, which are nothing more than noise. If you have done your homework, made a good investment at a good price, and have confirmed your analysis to be correct; then the day to day market actions will have little, if any, bearing on the longer-term success of your investment. The only thing you achieve by watching the television is increasing your blood pressure.

6) Risk Is Not Equal To Your Return: 

Taking RISK in an investment, or strategy, is not equivalent to how much money you will make. It only equates to the permanent loss of capital which will be incurred when you are wrong. Invest conservatively, and grow your money over time with the LEAST amount of risk possible.

7) Go Against The Herd: 

The populous is generally “right” in the middle of a move up in the markets, but they are seldom correct at major turning points. When everyone agrees on the direction of the market due to any given set of reasons, generally something else happens. However, this also cedes to points 2) and 4); in order to buy something cheap or sell something at the best price, you are generally buying when everyone is selling, and selling when everyone else is buying.

These are the rules. They are simple and impossible to follow for most. However, if you can incorporate them you will succeed in your investment goals over the long run. You most likely WILL NOT outperform the markets on the way up, but you will not lose as much on the way down. This is important because it is much easier to replace a lost opportunity in investing. It is impossible to replace lost “time.”

As an investor, it is simply your job to step away from your “emotions” for a moment, and look objectively at the market around you. Is it currently dominated by “greed” or “fear?” Your long-term returns will depend greatly not only on how you answer that question, but how you manage the inherent risk.

“The investor’s chief problem – and even his worst enemy – is likely to be himself.” – Benjamin Graham

The Market Doesn’t Care How “Fantastic” Your Stocks Are

The Roman philosopher Seneca wasn’t talking about the stock market when he wrote that “Time discovers truth,” but he could have been. In the long run a stock price will reflect a company’s (true) intrinsic value. In the short run the pricing is basically random. Here are two real-life examples.

Let’s say you had the smarts to buy Microsoft in November 1992. It would have been a brilliant decision in the long run — the software giant’s stock has gone up many-fold since. But nine months later, in August 1993, that call did not look so brilliant: Microsoft shares had declined 25% in less than a year. In fact, it would have taken you 18 months, until May 1994, for this purchase to break even. Eighteen months of dumbness?

In the early 1990s, the PC industry was still in its infancy. Microsoft’s DOS and Windows operating systems were de facto standards. Outside of Apple Macs and a tiny fraction of computers, every computer came preinstalled with DOS and Windows. Microsoft had a pristine balance sheet and a brilliant co-founder and CEO in Bill Gates who would turn mountains upside-down to make sure the company succeeded. The above sentence is infested with hindsight — after all, that was almost 30 years ago. But Microsoft clearly had an incredible moat, which became wider with every new PC sold and every new software program written to run on Windows.

Here is another example: GoPro is a maker of video cameras used by surfers, skiers, and other extreme sports enthusiasts. If you had bought the stock soon after it went public, in 2014, you would have paid $40 a share for a $5.5 billion–market-cap company earning about $100 million a year — a price-earnings ratio of about 55. Your impatience would, however, have been rewarded: The stock more than doubled in just a few short months, hitting $90.

Would it have been a good decision to buy GoPro? The company makes a great product — I own one. But GoPro has no protective “moat” around its business. None. Most components that go into its cameras are commodities. There are no barriers to entry into the specialized video camera segment. Most important, there are no switching costs for consumers. Investors who bought GoPro after its IPO paid a huge premium for the promise of much higher earnings from a company that might or might not be around five years later.

What is even more interesting is that some of those buyers were then selling to even bigger fools who bought at double the price a few months later. GoPro was a momentum stock that was riding a wave about to break. Fast-forward a few years and GoPro sales have been on decline; nowadays its stock trades below $6.

These two examples bring us to the nontrivial topics of complex systems and nonlinearity. My favorite thinker, Nassim Taleb, wrote the following in his book “Antifragile: Things That Gain from Disorder”:

“Complex systems are full of interdependencies — hard to detect — and nonlinear responses. Nonlinear means that when you double the dose of, say, a medication, or when you double the number of employees in a factory, you don’t get twice the initial effect, but rather a lot more or a lot less.”

The stock market is a complex system where in the short term there are few if any interdependencies between decisions and outcomes. In the short run, stock prices are driven by thousands of random variables. Stock market participants have different risk tolerances and emotional aptitudes, and diverse time horizons ranging from milliseconds (for high-speed traders) to years (for long-term investors).

In other words, predicting where a stock price will be in a day, a month or even a year is not much different from prognosticating whether the ball on a roulette wheel will land on red or black. In the longer run, good decisions should pay off because fundamentals will shine through — as was the case with buying Microsoft in 1992 and not buying GoPro in 2014. But in the short run there is no correlation between good decisions and results.

Whenever you look at your portfolio, think of Microsoft and GoPro. The performance of your stocks in the short run tells you absolutely nothing about what you own or about the quality of your decisions. You may own a portfolio of Microsofts, and its value is going down because at this juncture the market doesn’t care about Microsofts. Or maybe you stuffed your retirement fund with overpriced fads that may not be around a year from now. But in the longer run, remember what Seneca knew:

“Time discovers truth.”

Why We Sold Apple Stock

Our firm bought Apple shares for clients’ portfolios in 2013, and we are used to being a contrarian voice when it comes to the stock (read here and here) — we loved it when it was hated. Now we are contrarian again — this time going against the company’s faithful.

Here are key reasons why we sold our entire Apple stake just last week:

The iPhone, though indispensable, is a mature product. Since introduction of the iPhone X, as been raising prices on iPhones. For instance, last quarter iPhone sales jumped 24% despite the number of iPhones sold not changing — all growth came from higher iPhone prices. Smartphone penetration is high globally, and thus most of the growth currently comes from replacement phones. Higher prices and lack of significant incremental improvements will likely lead to elongation of the replacement cycle from two years to three (or possibly four).

Recently Apple announced that it will stop disclosing iPhone and iPad shipments. There is only one way to read this news: The iPhone is a mature, middle-aged product with a wife and two kids. Apple’s management is desperately trying to create the narrative that it is becoming a service company. The second line of Apple’s quarterly press release says, “Services Revenue of $10 Billion Reaches New All-Time High.” Apple is trying to monetize its enormous installed base of iPhones, iPads, and Macs by selling digital goods and services to their owners.

This is where we lost optimism further. Apple has done a good job of selling digital goods (apps, movies, music, space) in its digital store, but so far it has proved to be a lousy services company. Its iCloud (email, calendar, data storage) and Apple Maps have been either outright failures or much-inferior products. Apple’s email (originally known as MobileMe) and iCloud data-storage service were basically rendered irrelevant by Google’s Gmail and Google Drive (and Dropbox). Apple Maps is only in business because it is the default map software in the iPhone. Google is light years ahead in accuracy when it comes to maps — just ask anyone who ever tried using Apple Maps.

In addition to Google, Apple competes in services with another giant, Amazon.com, which is spending hundreds of millions of dollars on movies and music. Apple’s streaming music service was initially a disaster. In all fairness, it has improved, but today it is fighting an uphill battle because Apple’s walled-garden approach doesn’t allow Apple Music to work on Amazon’s and Google’s speakers. This gave plenty of breathing room for competitors, who otherwise would not have had a chance.

Then there is Siri. In the beginning it was the smartest digital voice assistant, but not anymore. Not to be disrespectful to Siri, but its IQ has been dropping rapidly in comparison to Amazon’s and Google’s assistants. Google and Amazon opened the APIs (application programming interfaces) of their digital voice assistants to other developers, and soon every appliance in your house will be responding to “Hey Google” and “Alexa.”

There are several reasons why Apple has done so poorly in services. First, it’s a product company. Macs, iPhones, and iPads are incredibly complex devices that, though they are packed with software, are released every year or every few years. Services are software — they almost require gradual, even daily improvement. You release an imperfect product and then keep improving it with continual releases. This approach seems to go against Apple’s DNA.

The second and even more important point is that Apple is facing innovator’s dilemma: Today two-thirds of Apple revenues come from the iPhone, and for that beast to survive it requires a walled garden. This is why Apple’s music doesn’t work on Amazon’s or Google’s speakers. Oh, and what about Apple’s speakers? Apple predictably took a “premium” strategy with its speakers, a strategy that worked great with Macs, iPhones, and iPads. However, the strategy has failed in the case of speakers because Apple’s product is several times more expensive than the “good enough” offerings from Google and Amazon. Moreover, the walled-garden strategy has backfired here. For instance, Apple speakers will not play Spotify, an incredibly popular music service with 75 million paying users and 150 million active users that competes with Apple’s Music. Thus, to protect its iPhone cash cow, Apple services is fighting with one arm tied behind its back.

As shareholders, we became concerned about future sales of the iPhone and not highly confident that Apple’s service strategy will bear fruit, and herein lies the biggest problem for Apple: It needs a new huge product category. (The Apple Watch was a mildly successful product, but in the context of $265 billion of sales, it was a rounding error.) A car was supposed to be that category — it’s the largest product category globally — but, according to the New York Times, Apple has changed its car strategy several times and has basically given up on that category.

When Apple stock was lower, we did not have to worry as much about slower growth, but now we do — so we got out.

Average Stock Is Overvalued: Between Tremendously & Enormously

My business is to constantly look for new stocks by running stock screens, endlessly reading (blogs, research, magazines, newspapers), looking at the holdings of respected investors, talking to a large network of investment professionals, attending conferences, scouring through ideas published on value investor networks, and finally, scouring a large (and growing) watch list of companies to buy at a significant margin of safety.

With all of that, my firm is having little success finding solid companies at attractive valuations.

Don’t just take my word for it. Take a look at several charts, below, that show the magnitude of the stock market’s overvaluation and, more importantly, put it into historical context.

Each chart examines stock market valuation from a slightly differently perspective, but each arrives at the same conclusion: the average stock is overvalued — somewhere between tremendously and enormously. If you don’t know whether “enormously” is greater than “tremendously” or vice versa, don’t worry, I don’t know either. But this is my point exactly: When an asset class is significantly overvalued and continues to get overvalued, quantifying its overvaluation brings little value.

Let’s go to the charts. The first chart shows price-to-earnings of the S&P 500  in relation to its historical average. The average stock today is trading at 73% above its historical average valuation. There are only two other times in history that stocks were more expensive than they are today: just before the Great Depression hit and in the 1999 run-up to the dotcom bubble burst.

We know how the history played in both cases — consequently stocks declined, a lot. Based on over a century of history, we are fairly sure that, this time too, stock valuations will at some point mean-revert and stock markets will decline. After all, price-to-earnings behaves like a pendulum that swings around the mean, and today that pendulum has swung far above the mean.

What we don’t know is how investors will fare in the interim. Before the inevitable decline, will price-to-earnings revisit the pre-Great Depression level of 95% above average, or will it say hello to the pre-dotcom crash level of 164% above average? Nobody knows.

One chart is not enough. Here’s another, called the “Buffett Indicator.”Apparently, Warren Buffett likes to use it to take the temperature of market valuations. Think of this chart as a price-to-sales ratio for the entire U.S. economy, that is, the market value of all equities divided by GDP. The higher the price-to-sales ratio, the more expensive stocks are.

This chart tells a similar story to the first one. Though I was not around in 1929, we can imagine there were a lot of bulls celebrating and cheerleading every day as the market marched higher in 1927, 1928, and the first 10 months of 1929. The cheerleaders probably made a lot of intelligent, well-reasoned arguments, which could be put into two buckets: First: “This time is different” (it never is). Second: “Yes, stocks are overvalued, but we are still in the bull market.” (They were right about this until they lost their shirts.)

I was investing during the 1999 bubble. I vividly remember the “This time is different” argument of 1999. It was the New Economy vs. the old, and the New was supposed to change or at least modify the rules of economic gravity. The economy was now supposed to grow at a much faster rate. But economic growth over the past 20 years has not been any different than in the previous 20. Actually, I take that back — it’s been lower. From 1980 to 2000 the U.S. economy’s real growth was about 3% a year, while from 2000 to now it has been about 2% a year.

Finally, let’s look at a Tobin’s Q Ratio chart. This chart simply shows the market value of equities in relation to their replacement cost. If you are a dentist, and dental practices are sold for a million dollars while the cost of opening a new practice (phone system, chairs, drills, x-ray equipment, etc.) is $500,000, then Tobin’s Q Ratio is 2.0. The higher the ratio the more expensive stocks are. Again, this one tells the same story as the other two charts: U.S. stocks are extremely expensive — and were more expensive only twice in the past hundred-plus years.

Did the stock market decline cause the recession, or did the recession cause the stock market decline? The answer is not that important, because no one can predict a recession or a stock market decline.

In December 2007 I was one of the speakers at the Colorado CFA Society Forecast Dinner. A large event, with a few hundred attendees. One of the questions posed was “When are we going into a recession?” I gave my usual, unimpressive “I don’t know” answer. The rest of the panel, who were well-respected, seasoned investment professionals with impressive pedigrees, offered their well-reasoned views that foresaw a recession in anywhere from six months to 18 months. Ironically, as we discovered a year later through revised economic data, at the time of our discussion the U.S. economy was already in a recession.

My firm spends little time trying to predict the next recession, and we don’t try to figure out what will cause this market to roll over. Our ability to forecast is poor and is thus not worth the effort.

An argument can be made that stocks, even at high valuations, are not expensive in context of the current incredibly low interest rates. This argument sounds so true and logical, but there is a crucial embedded assumption that interest rates will stay at these levels for the next decade or two. In truth, no one knows when interest rates will go up or by how much. But as that happens, stocks’ appearance of cheapness will dissipate.

Here’s another twist: If interest rates remain where they are today, or even decline, this will be a sign that the economy has big, deflationary (Japan-like) problems. A zero-percent interest rate did not protect the valuations of Japanese stocks from the horrors of deflation — Japanese P/Es contracted despite the decline in rates. The U.S. is maybe an exceptional nation, but the laws of economic gravity work here as they do elsewhere.

Finally, buying overvalued stocks because bonds are even more overvalued has the feel of choosing a less painful poison. How about being patient and not taking the poison at all?

You may ask, how do we invest in an environment when the stock market is extremely expensive? The key word is invest. Buying expensive stocks hoping that they’ll go even higher is not investing, it’s gambling. We don’t do that and won’t.

Our goal is to win a war, and to do that we may lose a few battles. It’s great to make money, but it is even more important not to lose it. If the market continues to climb higher, my firm’s portfolio will likely lag behind. The stocks we own will become fully valued, and we’ll sell them and hold cash.

One thing is certain: We are not going to sacrifice our standards and let our portfolio be a byproduct of forced or irrational decisions. Timing the market is impossible. I don’t know anyone who has done it successfully on a consistent and repeated basis. In the short run, stock market movements are completely random — as random as you guessing the next card on the blackjack table.

In contrast, valuing companies is not random. In the long run stocks revert to their fair value. If we assemble a portfolio of high-quality companies that are significantly undervalued, then we should do well in the long run. Yet in the short run we have little control over how the market will price our stocks.

The market doesn’t need to collapse for us to be buyers. The market falls in love and out of love with specific sectors and stocks all the time. We also spend a lot of time looking for stocks outside the U.S., in countries that have a free market system and the rule of law.

We don’t own the market. Though the market may be overvalued, our portfolio is not.

A Few Simple Rules For Money Managers

I simply don’t trust the fundamentals of the global economy right now. The system is built on quicksand.

Debt is growing globally and governments are running huge deficits while interest rates are still incredibly low. Looking at almost any metric, stock markets have been more expensive once in the last 100 years — just before the dot-com bubble burst. There is also another risk in a category of its own: China.

A recent Bloomberg report on Chinese real estate noted that from June 2015 through the end of last year, the 100 City Price Index, published by SouFun Holdings Ltd., rose 31% to almost $202 per square foot. That’s 38% higher than the median price per square foot in the U.S., where per-capita income is more than 700% greater than in China.

This China story gets more interesting. Most of these apartments are sitting empty because they are purchased as investments. Rental yields in China are 1.5%, while the cost of borrowing (mortgage cost) is around 5%-6%. Chinese consumer debt-to-GDP is much greater than it was in the U.S. during the 2008-09 financial crisis.

Since household real estate lending is 22% of Chinese banks’ assets, if you are the almighty Chinese government, you have a decision to make: Do you let real estate prices normalize (decline) and then suddenly discover that your financial institutions are bankrupt, or do you allow (and actually support) the inflation of housing prices?

Predictably, as the Bloomberg report relates: China is ramping up development, and rather than curtail leverage, banks are jumping into the speculative real-estate bubble: mortgage growth is now at 20%.[signinlocker]

Which brings me to one of my all-time favorite books, “Margin of Safety,” by investing legend Seth Klarman, who writes:

“There is the old story about the market craze in sardine trading when the sardines disappeared from their traditional waters in Monterey, California. The commodity traders bid them up and the price of a can of sardines soared. One day a buyer decided to treat himself to an expensive meal and actually opened a can and started eating. He immediately became ill and told the seller the sardines were no good. The seller said, “You don’t understand. These are not eating sardines, they are trading sardines.”

Applying this to China, when an apartment becomes an unoccupied asset whose sole purpose to be used as a investment or speculation, it turns into a trading sardine. Its price will rise until — nobody knows; but at some point someone will metaphorically open that trading can and Chinese real estate prices will collapse, bringing the banking system and the nation’s economy down with them. Simply put, things that cannot go on forever don’t — it just feels like they’ll go on forever while you’re waiting for them to stop.

Today’s global investment environment is a game of musical chairs. Investors are up and marching along because the music is playing, hoping they’ll be able to grab a chair when the music stops (few will do so). Accordingly, I am investing as if the music might stop any second.

Over the past 10 years it has not paid to be cautious. Low interest rates drove prices of almost all assets higher. Pricier assets made people feel wealthier and thus magically created economic growth. Low interest rates also pushed people into riskier assets, thus creating a mismatch between the assets people hold and their true risk affordability and appetite.

So far, none of this has mattered — the more risk you took, the more money you made. It will matter when risk gets ugly, because investor reaction to it will be more irrational than usual. This is why my firm hedges our portfolios through put options.

The problem with an economy being propped up by artificially appreciated assets is that this pendulum swings both ways. At some point, prices will decline. No one knows what will cause the decline — maybe higher interest rates, maybe a presidential tweet, maybe the implosion of the Chinese economy, or maybe just because stock markets and real estate prices don’t grow to the sky. Or it could be triggered by something completely unseen today.

What is clear is that since interest rates are low and global economies are highly leveraged, central banks and governments will not have as much power to help.

This is one reason why my firm’s portfolio holds a lot of healthcare stocks, including Walgreens Boots Alliance. Healthcare companies have great balance sheets; their business is not cyclical (the demand for its products doesn’t fluctuate with the whims of the global economy); and there is a huge tailwind behind their backs in the form of the aging global population. Moreover, many of these stocks trade at highly attractive valuations.

How To Invest In A Market Due For A Hard Landing

I simply don’t trust the fundamentals of the global economy right now. The system is built on quicksand.

Debt is growing globally and governments are running huge deficits while interest rates are still incredibly low. Looking at almost any metric, stock markets have been more expensive once in the last 100 years — just before the dot-com bubble burst. There is also another risk in a category of its own: China.

A recent Bloomberg report on Chinese real estate noted that from June 2015 through the end of last year, the 100 City Price Index, published by SouFun Holdings Ltd., rose 31% to almost $202 per square foot. That’s 38% higher than the median price per square foot in the U.S., where per-capita income is more than 700% greater than in China.

This China story gets more interesting. Most of these apartments are sitting empty because they are purchased as investments. Rental yields in China are 1.5%, while the cost of borrowing (mortgage cost) is around 5%-6%. Chinese consumer debt-to-GDP is much greater than it was in the U.S. during the 2008-09 financial crisis.

Since household real estate lending is 22% of Chinese banks’ assets, if you are the almighty Chinese government, you have a decision to make: Do you let real estate prices normalize (decline) and then suddenly discover that your financial institutions are bankrupt, or do you allow (and actually support) the inflation of housing prices?

Predictably, as the Bloomberg report relates: China is ramping up development, and rather than curtail leverage, banks are jumping into the speculative real-estate bubble: mortgage growth is now at 20%.

Which brings me to one of my all-time favorite books, “Margin of Safety,” by investing legend Seth Klarman, who writes:

“There is the old story about the market craze in sardine trading when the sardines disappeared from their traditional waters in Monterey, California. The commodity traders bid them up and the price of a can of sardines soared. One day a buyer decided to treat himself to an expensive meal and actually opened a can and started eating. He immediately became ill and told the seller the sardines were no good. The seller said, “You don’t understand. These are not eating sardines, they are trading sardines.”

Applying this to China, when an apartment becomes an unoccupied asset whose sole purpose to be used as a investment or speculation, it turns into a trading sardine. Its price will rise until — nobody knows; but at some point someone will metaphorically open that trading can and Chinese real estate prices will collapse, bringing the banking system and the nation’s economy down with them. Simply put, things that cannot go on forever don’t — it just feels like they’ll go on forever while you’re waiting for them to stop.

Today’s global investment environment is a game of musical chairs. Investors are up and marching along because the music is playing, hoping they’ll be able to grab a chair when the music stops (few will do so). Accordingly, I am investing as if the music might stop any second.

Over the past 10 years it has not paid to be cautious. Low interest rates drove prices of almost all assets higher. Pricier assets made people feel wealthier and thus magically created economic growth. Low interest rates also pushed people into riskier assets, thus creating a mismatch between the assets people hold and their true risk affordability and appetite.

So far, none of this has mattered — the more risk you took, the more money you made. It will matter when risk gets ugly, because investor reaction to it will be more irrational than usual. This is why my firm hedges our portfolios through put options.

The problem with an economy being propped up by artificially appreciated assets is that this pendulum swings both ways. At some point, prices will decline. No one knows what will cause the decline — maybe higher interest rates, maybe a presidential tweet, maybe the implosion of the Chinese economy, or maybe just because stock markets and real estate prices don’t grow to the sky. Or it could be triggered by something completely unseen today.

What is clear is that since interest rates are low and global economies are highly leveraged, central banks and governments will not have as much power to help.

This is one reason why my firm’s portfolio holds a lot of healthcare stocks, including Walgreens Boots Alliance. Healthcare companies have great balance sheets; their business is not cyclical (the demand for its products doesn’t fluctuate with the whims of the global economy); and there is a huge tailwind behind their backs in the form of the aging global population. Moreover, many of these stocks trade at highly attractive valuations.

Funds For The Brave – RIA Pro

The ongoing currency crisis in Turkey means emerging markets stocks and bonds have suddenly become dangerous. Addressing EM bonds, Nomi Prins thinks EM countries have benefited from an avalanche of borrowed dollars that will soon become difficult to pay back as the dollar appreciates from higher interest rates. And one missed payment, Prins argues, “could set off a chain reaction of defaults.”

Speaking of emerging markets stocks, Ben Inker of Boston-based Grantham, Mayo, van Otterloo (GMO) argues in the firm’s most recent quarterly letter that, despite their currency problems, they continue to offer the best 10-year return prospects compared to other stock markets in the world “by a large margin..” Their recent volatility owes more to their correlation to movements in their currencies. (U.S. investors also take on foreign currency exposure unless they invest through a fund that uses currency hedges.) Momentum is not on their side now, but over the long term, “valuation is much more predictive of returns for emerging (markets stocks) than momentum is,” says Inker.

Things could get worse before they get better for emerging markets securities. And if the typical emerging markets bear market is an indication, things could get much worse. But for those who want to start wading in or who just want to be ready when they think the time is right, we’ll lay out some EM stock ETFs to consider:

In the stock category the iShares MSCI Emerging Markets ETF (EEM) is a way to capture the emerging markets index. Its expense ratio is 0.69% or $69 for every $10,000 invested per year. Chinese stocks soak up a full 30% of the fund’s assets. South Korea, Taiwan, and India together absorb another 35% of the fund’s assets. South Africa and Brazil come in at 6% each. The fund isn’t currency-hedged, and it is down more than 9% for the year through August 20th.

iShares offers a slew of country-specific and currency-hedged options too. But most investors should be wary of getting country-specific exposure in emerging markets. As for currency hedged funds, the dollar could appreciate more, but it’s already had quite a run.

Another interesting option is the iShares Emerging Markets Dividend ETF (DVYE). The fund’s emphasis on dividends gives it a 5.33% yield currently, but it also causes some deviations from the plain capitalization-weighted emerging markets index. Taiwan occupies 30% of this fund’s assets instead of China, which comes in at around 9%. Russia and Thailand also have elevated exposure compared to the plain capitalization weighted index at 15% and 9%, respectively. Both GMO and Newport Beach, Calif.-based Research Affiliates have argued that not only are emerging markets stocks cheap, but the value part of emerging markets is exceptionally cheap. A dividend fund often captures more of the value (low price/earnings and price/book value) stocks. The fund is down more than 4% for the year through August 20th.

Similarly, the Invesco FTSE RAFI Emerging Markets ETF (PXH) can help an investor capture some of those cheaper stocks. This fund gains exposure to 90% of the holdings of an index comprised of companies ranked on book value, cash flow, sales, and dividends. This “fundamental” methodology was devised by Rob Arnott of Research Affiliates. The methodology isn’t a pure value strategy the way simply buying the lowest price/book value or price/earnings stocks might be, but it can capture some of the value factor. The fund is down around 6% for the year through August 20th.

A third ETF to consider is the WisdomTree Emerging Markets SmallCap Dividend Fund (DGS). This fund captures the return of small cap emerging markets stocks that pay dividends, as its name suggests. It currently yields over 3%. Its biggest country weightings are Taiwan at 27%, China at 16%, South Africa at 10%, South Korea at 8%, and Thailand at 7%. The fund is down 10% for the year through August 20th so it has exhibited more volatility as one might expect from a small cap fund.

Even if you don’t have the courage to take the plunge now, or think Inker’s analysis isn’t cogent, at some point you might decide it’s time to get exposure to the developing part of the world. When that time comes, you’ll have a group of funds from which to choose.

Technically Speaking: 7-Deadly Investing Sins

Seven-deadly-sins

As I noted in this past weekend’s newsletter, I am on a much-needed family vacation this week. However, I would be remiss if I did not relay some of my thoughts in reference to the Monday’s market action as it relates to our current portfolio positioning.

As I stated on Saturday:

“As we discussed previously, what happens in the middle of the week is of little consequence to us. We are only truly interested in where the week ends. In that regard, the bulls remained stuck at the ‘Maginot Line’ which continues to keep the majority of our models on hold for now.”

The one thing that keeps us a bit more bullishly biased at the moment is the flood of earnings coming in as we progress into the Q2 reporting season. Google reported better than expected numbers (of course, that’s not saying much since estimates are always lowered so companies can beat them) which will give a lift to market today at least at the outset of the session.

However, as shown below, the bulls have cleared resistance momentarily. It is important the bulls are able to maintain control above 2800 through the end of the week. A failure of that level will likely result in a correction back to 2700.

If these current levels hold through the end of the week, the intermediate-term “buy signal” will also be triggered. (While it may seem to already have been triggered, this is a weekly signal so it requires a full week’s of data to confirm.) This signal will be supportive of current equity allocation levels and will suggest that a move higher in the short-term is likely.

The risk, in the short-term, remains the White House and geopolitical policy which could disrupt the markets. Longer-term it remains a story about valuations, economic cycles, and interest rates.

This is why I noted this past weekend that “with our portfolios are already mostly exposed to equity risk, there isn’t much for us to do currently. Our main job now is to focus on the risk of what could wrong and negatively impact portfolio capital.”


This morning I was sitting on the beach with my lovely wife having a cup of coffee when a prayer group formed on the beach. They sat in a circle as the sun crested the horizon. As streams of sunlight glinted off of the crystal blue waters, they read scripture and prayed. As my wife and I watched, and listened, a very peaceful feeling fell across us both.

As they finished, I looked down at my laptop with a blank page staring back at me. At that moment, I begin thinking about the risks which currently face us as investors and the sins we repeatedly commit as individuals which keep us from being successful over time.

If you were raised in a religious household, or were sent to a Catholic school, you have heard of the seven deadly sins. These transgressions — wrath, greed, sloth, pride, lust, envy, and gluttony — are human tendencies that, if not overcome, can lead to other sins and a path straight to the netherworld.

In the investing world, these same seven deadly sins apply. These “behaviors,” just like in life, lead to poor investing outcomes. Therefore, to be a better investor, we must recognize these “moral transgressions” and learn how to overcome them.

The 7-Deadly Investing Sins


Wrath – never get angry; just fix the problem and move on.

Individuals tend to believe that investments they make, or their advisor, should “always” work out. They don’t. And they won’t. Getting angry about a losing “bet” only delays taking the appropriate actions to correct it.

“Loss aversion” is the type of thinking that can be very dangerous for investors. The best course of action is to quickly identify problems, accept that investing contains a “risk of loss,” correct the issue and move on. As the age-old axiom goes: “Cut losers short and let winners run.”


Greed – greed causes investors to lose more money investing than at the point of a gun. 

The human emotion of “greed” leads to “confirmation bias” where individuals become blinded to contrary evidence leading them to “overstay their welcome.”

Individuals regularly fall prey to the notion that if they “sell” a position to realize a “profit” that they may be “missing out” on further gains. This mentality has a long and depressing history of turning unrealized gains into realized losses as the investment eventually plummets back to earth.

It is important to remember that the primary tenant of investing is to “buy low” and “sell high.” While this seems completely logical, it is emotionally impossible to achieve. It is “greed” that keeps us from selling high, and “fear” that keeps us from buying low. In the end, we are only left with poor results.


Sloth – don’t be lazy; if you don’t pay attention to your money – why should anyone else?

It is quite amazing that for something that is as important to our lives as our “money” is, how little attention we actually pay to it. Not paying attention to your investments, even if you have an advisor, will lead to poor long-term results.

Portfolios, like a garden, must be tended to on a regular basis, “prune” by rebalancing the allocation, “weed” by selling losing positions, and “harvest” by taking profits from winners.

If you do not regularly tend to a portfolio, the bounty produced will “rot on the vine” and eventually the weeds will eventually reclaim the garden as if it never existed.


Pride – when things are going good don’t be prideful – pride leads to the fall. You are NOT smarter than the market, and it will “eat you alive” as soon as you think you are.

When it comes to investing, it is important to remember that a “rising tide lifts all boats.” The other half of that story is that the opposite in also true.

When markets are rising, it seems as if any investment we make works; therefore, we start to think that we are “smart investors.” However, there is a huge difference between being “smart” and just being “along for the ride.” 

Ray Dalio, head of Bridgewater which manages more than $140 billion, summed it up best:

“Betting on any market is like poker, it’s a zero-sum game and the deck is stacked against the individual investor in favor of big players like Bridgewater, which has about 1,500 employees. We spend hundreds of millions of dollars on research each year and even then we don’t know that we’re going to win. However, it’s very important for most people to know when not to make a bet because if you’re going to come to the poker table you are going to have to beat me.”


Lust – lusting after some investment will lead you to overpay for it.  

“Chasing performance” is a guaranteed recipe for disaster as an investor. For most, by the time that “performance” is highly visible the bulk of that particular investments cyclical gains are already likely achieved.  This can been seen in the periodic table of returns below from Callan:

I have highlighted both the S&P 500 and U.S. Bond Market indexes as an example. Importantly, you can see that investment returns can vary widely from one year to the next. “Lusting” after last year’s performance leads to “buying high” which ultimately leads to the second half of the cycle of “selling low.”

It is very hard to “buy stuff when no one else wants it” but that is how investing is supposed to work. Importantly, if you are going to “lust,” lust after your spouse – it is guaranteed to pay much bigger dividends.


Envy – this goes along with Lust and Greed

Being envious of someone else’s investment portfolio, or their returns, will only lead to poor decision-making over time. It is also important to remember that when individuals talk about their investments, they rarely tell you about their losers. “I made a killing with XYZ. You should have bought some” is how the line goes. However, what is often left out is that they lost more than what they gained elsewhere.

Advice is often worth exactly what you pay for it, and sometimes not even that. Do what works for you and be happy with where you are. Everything else is secondary and only leads to making emotional decisions built around greed and lust which have disastrous long-term implications. 


Gluttony – never, ever over-indulge. Putting too much into one investment is a recipe for disaster.  

There are a few great investors in this world who can make large concentrated bets and live to tell about it. It is also important to know that they can “afford” to be wrong – you can’t. 

Just like the glutton gorging on a delicious meal – it feels good until it doesn’t, and the damage is often irreversible. History is replete with tales of individuals who had all their money invested in company stock, companies like Enron, Worldcom, Global Crossing; etc. all had huge, fabulous runs and disastrous endings.

Concentrated bets are a great way to make a lot of money in the markets as long as you are “right.” The problem with making concentrated bets is the ability to repeat success. More often than not individuals who try simply wind up broke.


Heed Thy Warnings – the path to redemption is rife with temptation

Regardless of how many times I discuss these issues, quote successful investors, or warn of the dangers – the response from both individuals and investment professionals is always the same.

“I am a long-term, fundamental value, investor.  So these rules don’t apply to me.”

No, you’re not. Yes, they do.

Individuals are long-term investors only as long as the markets are rising. Despite endless warnings, repeated suggestions, and outright recommendations – getting investors to sell, take profits and manage portfolio risks go unheeded.

With the markets currently rising, it is easy to ignore the warning signs. The “devil on your shoulder” is very convincing and keeps whispering in your ear to take on more risk with comments like: “This market has nowhere to go but up,” “the yield curve doesn’t matter this time,” “Fed rate hikes don’t cause recessions,” and “it’s still not to late to jump on this bull train.”

The hardest thing for individuals to overcome in investing is their own emotional biases. This is why laying out a strict written discipline, having a sound investment strategy and keeping a journal of your trading are key elements in winning the long-game. Investing, like religion, requires a belief system that you follow even when it doesn’t seem to work.

But that is incredibly difficult to do.