Before I start this evening, I have a request for readers, and a comment for new readers.  (Note: if you are reading this anywhere but directly at my blog, please realize that you have to come to my blog for me to hear what you are saying.  I do not read comments anywhere else but at Aleph Blog.)  First the request: I would like to test the robustness of the Impossible Dream TAA model on another country.  If any of you have data on any non-US market, which would require the following:

  • Index price series
  • Earnings series
  • Dividends series
  • And a fixed income return or yield series

Contact me, and we can discuss whether you should send me the data or not.  Monthly data would probably work best, but I am open to other periodicities.

Second, for new readers, welcome to my blog.  Why do I write this after 4 1/4 years of blogging?  May 2011 is my biggest month ever, largely because of the “Impossible Dream” pieces.

For new readers, here is what you have to understand about me: I write about a lot of different things.  I have lots of interests.  I almost named this blog “The Investment Omnivore” but didn’t, because I planned on creating a firm called Aleph Investments back in 1996.  It eventually happened — 14 years later.

So, if I don’t always write about investment strategy, or any other single topic (all crisis, all the time) please don’t get disappointed.  I write in proportion to what is of current interest, and what discoveries I have been making.

So, travel with me on this trail where I cover everything from the global macroeconomy to personal finance issues.  My goal is to help you learn to think about economic/finance/investment issues, and help you see the interconnections between markets, so that you can develop your own perspective on the markets, and not just parrot me.  (Not that many do… 😉 )


All assets represent future goods.  The prices of assets represent the trade-off between present goods and assets.

I wrote a piece recently called Inflation Speculation.  The idea was to explain how it is difficult to save for the future in a way that will transfer today’s purchasing power to the future without diminution, particularly when you have a central bank trying to stimulate the economy through the creation of credit, and the nation as a whole is overindebted.

So, if the Fed is patting itself on the back for:

  • lowering corporate yield spreads
  • rising stock market prices

I would tell them: it is easy to change the discount rate, but hard to change the cash flows.  Yes, as you flooded the market with credit, the values of risky assets rose.  Big deal.  Most executives are smart — they still see that demand is punk, and won’t do any real creation of plant and equipment that they weren’t already planning to do.  Little new investment took place, the value of existing assets got revalued up.

When asset prices are high, it means that money today will not buy a lot of future goods.  High P/Es, low interest rates tell us that new investments will have low yields, absent some amazing transforming technology that improves productivity dramatically.

Some people will say to me, “I need more yield today.  Yields are so low.”  I say, “When yields are so low, it is time  to avoid yield and preserve capital.  The time to seek yield is when yields are high, and no one wants to part with money to lend to them.

In March of 2009, I helped to rescue the firm of a friend.  He needed cash in the midst of the crisis, and a few of us lent to him at rates exceeding 10%, with warrants, realizing that he might be bankrupt in short order.  But things turned, and not only did he survive but he thrived.  I am still receiving interest, but will likely be redeemed soon.

Maybe that’s not such a good example.  I put 40% of my congregation’s building fund into high yield and low investment grade debt in late 2008 — made up for a lot of 2008 losses.


Think of it a different way: shares in corporations are a proxy for the future well being of the country.  When P/Es are low, the potential for capital gains is large, as is the ability to keep up with inflation.  When P/Es are high, the potential for capital gains is small, as is the ability to keep up with inflation.  Same for bond yields — better to be aggressive when rates and spreads are high, and defensive when they are low.

Thus I would tell Ben Bernanke to lay off the quantitative easing.  It has not helped.  Yes, you have pushed asset prices up, and interest rates down, but has not created any significant new economic activity.  And why should it?  Consumers are still overindebted, and 30% of those with mortgages will lose money on a sale.  The real problem was the debt overhang, and you did nothing to to address that, not that you could, or should.

Buffett once said that most people should not be glad when they see asset prices rising, because they will need to invest more in the future, and will now have to pay higher prices.  Thus times like September 2008 offer the future at a discount to those who have ready liquidity, whereas 2007 offers the future at a premium price.

To the extent that you can, commit capital when it is most needed, and avoid chasing markets up.

It seems that I can’t escape AIG anymore.  I asked my kids (who are still at home) today, “Of all the jobs I had, where did I get treated the worst?”  The oldest answered “AIG.”  He was born shortly after I left AIG in 1992.

I guess I made some of the wounds obvious enough.  I don’t believe in “payback,” I believe in “Love your enemies,” and “Be honest.”  Thus I find it odd that I am being ever more sought out by reporters on any AIG news.

Granted, I’ve written on underreserving by AIG, the problems they had at their operating insurance subsidiaries during the financial crisis, which got picked up by SIGTARP.

What has prompted recent inquiries, is the sale of stock at $29/share,  at only a 1.6% discount to the prior closing price.  That price was a hodgepodge between what the market would bear, and what would give the government a “profit.”  Bad idea in my opinion; it would have been better to price the deal lower, say $28.50, where the government took a loss, but where the market might have driven the price up.  A 1.6% gap is marginal and would invite sellers. $28.50 would be over 3% and would invite buyers.

Now, some sympathy for Bruce Berkowitz — He saw book value decline by almost $1 today, from $47.32 to $46.35.  I don’t know if he was buying as the largest private shareholder of AIG, but he was certainly disappointed by the company offering shares.  Why offer shares at less than 2/3rds of book?

Easy, because AIG can’t borrow or issue any other security.  But that is a signal to what the company is worth.  I mean at worst, AIG could have procured a secured loan to  provide $3 billion, offering a valuable subsidiary as collateral.  They chose to dilute, which tells you what the stock is likely worth.

Also, with such a large fall in price after the offering the next offering should come at a larger discount to the recent market price.  Those that were burned in this offering will be less willing to step up and take immediate losses.

Now, AIG has two other ways to improve their stock price.  Improve transparency, and improve Return on Equity.  The first of those means eliminate the sense that there could be negative surprises in the future.  That means that reserves have to be modestly conservative, unlike they have been in the past.  That means taking one last reserve strengthening to do so, if needed, even if it temporarily hurts the stock price because of the loss.

But if it can be shown that the loss is likely the last of such losses, and that AIG isn’t going to use its reserves to manipulate earnings any more, the loss in the stock price should be minimal.  After all, a lot of that is buried in the discount to book anyway.

Then comes improving ROE. The CFO Peter Hancock has said, ‘“We are moving away from any kind of top-line targeting,” Hancock said in a call with analysts. “We think that leads you to do business at the margin, which is unattractive.”’

That’s some of the best news I have heard on AIG in some time.  If AIG limits its underwriting, and focuses on profitability, it has a lot of potential for upside, but that would mean:

  • Reducing overhead expenses
  • Compensating line managers on underwriting profitability, conservatively estimated.  Tie their long-term bonuses to aggregate underwriting profits.
  • Eliminating marginal lines of business, including selling off lines where AIG has no sustainable competitive advantage, like investment management, consumer finance, aircraft leasing, and domestic life insurance.  The last of those is the most controversial — I would sell off the domestic life insurers to the highest bidder.  I suspect there would be willing buyers among the big players of the life insurance industry.  Use the proceeds to buy back stock from the government, or to reduce debt.

AIG would do best if it were a pure play P&C insurer.  As I have argued since long before the crisis, the size and complexity of AIG make it unmanageable.  Better management will come through creating a more focused company that does not require having a “superman” like Maurice Greenberg to manage it.

Disclosure: I don’t own any AIG, nor am I short.  The same for my clients.

Every 100 posts, I take a step back and try to think about where we have been over the last five months.  The investment world has been bullish, favoring stocks and commodities, and not bonds.  Money market rates have been driven to zero or so. (Have they tried to bill you yet for holding your money? 😉 )

I have a wide array of interests, which is what makes my blog a little different.  I’ve been doing more with stock and bond investing, which reflects the work that I do, but I still have time for commentary on Macroeconomics, banking regulation, and monetary policy.  I know that there are few who want to read everything I write, but there are many who want to read a few things I write.

The biggest things I have written recently have been:

That doesn’t count RSS and the many places where my blog is syndicated. I’m relatively free with my content.  But if you are reading me elsewhere, if you want to make a comment, please come to my site.  I do not interact with readers outside of my own site, and that includes Seeking Alpha.  I don’t have time for it, so if you want my attention, come to my site.

Away from blogging, my asset management business has launched.  let me quote from an e-mail to a more successful friend of mine:

I have had a lot of lessons over the past four months, and I don’t think they are over.

1) Unrealistic expectations: partly because there was quite a lag between my announcement and my start up, a lot of people that I think lost interest because of the lag.  But when I talked with other investment advisors later, they told me I had:

  • More prospects than I should reasonably expect for a new advisor, and
  • A better conversion percentage of prospects to clients than most, and
  • Chosen an underserved section of the market ($100-500K).

So, after four months, I am managing a little more money than my own assets at the firm, with about 12 clients, and 5 more on the way.

2) I did not realize that I would need to create fixed income management so early.  But for those that can’t hedge, I had to have another way of reducing equity market risk.  No track record there, but a lot of experience doing it, both with bonds and ETFs.

3) The most common objection of potential customers is that the market is too high, and so they don’t want to invest.  Still more asked for a Tactical Asset Allocation strategy, which I eventually created.  No telling whether it will work well, or build assets.

4) Custodial issues have not been absent.  Getting set up with Interactive Brokers is more difficult than with most because everything is automated; if one thing is wrong, it rejects and you have to try again.  Once Interactive Brokers is set up though, things work easily, the trading tools are great, and they are cheap, especially for clients in $100-500K range.  So I try to help clients as much as I can going in; so far, so good, with a little annoyance to me and clients.

Aside from that, I have been underperforming of late.  Not by much, but it feels bad to be missing the benchmark with the money of others.  I did not enter this business to lose.  After beating for so many years, it is a test to be missing now, largely because my posture is the most conservative it has been for the last eleven years.Anyway, that’s how I am doing.  I think I will reach viability by the end of 2012, but who can tell?

Indeed who can tell, but I got another new client today, equal to my largest external client, and there may be more if I do well.  I am grateful for their confidence.  Hey, perhaps one day I might get investors larger than me.  I hope so.  If I get to double my current size, I will try to hit up the emerging manager funds — there aren’t many emerging managers with 11 year track records.  And from there, who can tell?

I have an intern (child #7) and she is a very bright young woman who wants to learn investing.  She may have the “gene” that I got from my mom, but she sees this as the best way to be economically productive as a future wife and mother.  My Mom and Dad were equals economically, though Dad’s work made more difference early with his work — Mom earned more in the later years from the investing.  Give Mom credit for wisdom, and Dad credit for setting her free to do it (more or less).

I am enjoying this a lot, and am not worried about recent underperformance.  It has always corrected in the past, and then some.  If nothing else, it makes me work harder.  I like working hard.



Ken Fisher and Lara Hoffmans write well.  This book is accurate (with a few quibbles), and succinct.  I know these topics well; it took me less than three hours to read it.

There are many half-truths that travel around Wall Street.  There are still more that come from salesmen.  There are those that your investing friends will teach you.

Some come from the idea that the economy affects the markets in the short-run, or that good or bad policy will drive the market higher or lower.

Markets are far less predictable than we imagine.  They abhor simple rules.  Indeed the “rules” created in one cycle may be pure poison in the next one.

Also, absent war on your home soil, pestilence, plague and rampant socialism on a greater level than what Western Europe has seen, equity markets are pretty resilient.  Fisher’s native optimism has served him well in his lifetime.  There are few pessimistic millionaires.

That leads his asset allocation advice to be more geared to stocks, and more than the norm to foreign stocks.  (Which is good so long as the rule of law is maintained.)

In general, Fisher has written a very good book here.  The points are made briefly in an average of four pages each.  For those that want a quick introduction to the many fallacies on Wall Street, this book will do an excellent job.  After that, you can look to other books to fill in the details.


In Chapter 15, he mistakes immediate annuities for fixed annuities.  Immediate annuities are annuities that are paying out now.  Fixed annuities are those that pay interest, whether they are immediate or deferred (not paying out now).

In Chapter 16, he talks about Equity Indexed Annuities.  He misses several things:

1) Growth is more typically guaranteed at 2-3%, not 6%.

2) He misses Asian design contracts, which offer higher participation in exchange for having the option pay out on average returns over a year.  People don’t get what they are giving up there, but it looks better to them.

3) The surrender charges are higher and longer than they are for other deferred annuity designs.

There are other details that I think he mangles, but in his main thrust he is correct in both chapters to steer people away from any annuity aside from immediate annuities for those who need income.  Anything the insurance company can do with annuities, you can do, and cheaper.

But if Mr. Fisher wants to write about life insurance products more, maybe he would like to get a life actuary on staff, or at least someone with the LOMA credential.

Aside from that, Mr. Fisher should read “This Time is Different” by Reinhart and Rogoff.  Government deficit levels are not a thing of indifference, though they will affect stocks less than long bonds.

My penultimate quibble is that many common sayings are true within limits.  The limits imply broader models that might be discovered by multivariate regression.  There is little of that in the book.

Finally, the rule should be sell in April, buy in October.  More at my blog, I have an article to write.

Who would benefit from this book:

Ordinary people who don’t have a lot of time to consider each issue would benefit from this book.  They get a broad amount of protection from a single book.  The lessons come quickly, and immunize investors against a lot of investing mistakes.

If you want to, you can buy it here: Debunkery: Learn It, Do It, and Profit from It-Seeing Through Wall Street’s Money-Killing Myths.

Full disclosure: I asked the publisher for this book, and they sent it to me.  I read and review ~80% of the books sent to me, but I never promise a review, or a  favorable review.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

When I start a hard project, I take out a blank piece of paper, and I write out the question, or desired goal, and start writing down what I know about the question.  The question that has been posed to me by many investors (in many different ways) boils down to: how can I be out of the markets when markets offer less potential return, and in when they offer more potential return?  Other names for this: Tactical Asset Allocation, or Market Timing.

This question comes while the markets are regarded by many but not all to be high.  Since I am trying to manage as business that had as its initial concept managing long-only stock portfolios, this perception creates a headwind.

So what did I think of as factors as I approached this?  The first thing that came to mind was the credit cycle.  Recall my stylized version of the credit/equity cycle from last time:

  1. After a washout, valuations are low and momentum is lousy.  People/Institutions are scared to death of equities and any instruments with credit exposure.  Only rebalancers and deep value players are buying here.  There might even be some sales from leveraged players forced by regulators, margin desks, or “Risk control” desks.  Liquidity is at a premium.
  2. But eventually momentum flattens, and yield spreads for the survivors begin to tighten.  Equities may have rallied some, but the move is widely disbelieved.  This is usually a good time to buy; even if you do get faked out, and momentum takes another leg down, valuation levels are pretty good, so the net isn’t far below you.
  3. Slowly, but persistently the equity market rallies.  Momentum is strong.  The credit markets are quicker, with spreads tightening to normal-ish levels.  Bit-by-bit valuations rise until the markets are fairly valued.
  4. Momentum remains strong.  Credit spreads are tight. Valuations are high, and most value-type players have reduced their exposures.  Liquidity is cheap, and only rebalancers are selling.  (This is where we are now.)
  5. The market continues to rise, but before the peak, momentum flattens, and the market meanders.  Credit spreads remain tight, but are edgy, and maybe a little volatile.  This is usually a good time to sell.  Remember, tops are often a process.
  6. Cash flow proves insufficient to cover the debt at some institution or set of institutions, and defaults ensue.  Some think that the problem is an isolated one, but search begins for where there is additional weakness.  Credit spreads widen, momentum is lousy, and valuations fall to normal-ish levels.
  7. The true size of the crisis is revealed, defaults mount, valuations are low, credit spreads are high.  A few institutions and investors fail who you wouldn’t have expected.  Momentum is lousy.  We are back to part 1 of the cycle.  Remember, bottoms are often an event.

The transition from phase 5 to phase 6 is the key, as is recognizing when we are in phase 1/7.  What metrics could be useful?

  • Credit spreads, implied volatility, actual volatility
  • Direction of credit spreads
  • Earnings yields or P/E, and variations thereon.
  • Earnings yields less yields on Baa bonds
  • Momentum of prices, and variations thereon.
  • Momentum of earnings, and variations thereon.

I did a variety of experiments using the same data set as before, melding the Moody’s Bond yields with Robert Shiller’s S&P 500 data.  Before the experiments started, my expectation was that the final result would be a combination of a valuation factor and a momentum factor, with other factors playing lesser roles.  I wasn’t disappointed.



Since 1871, the price of the S&P 500 has risen at a rate of 5.17% annualized.  This doesn’t include dividends, which would add another 3.61%, which sums to an 8.78% annualized total return.  Yes, dividends have added that much in the past.  Now consider how earnings have done over the same period:

Earnings grow at a 4.87% annualized rate, very similar to the rate of price increase, but over 130 years, it results in a rise in the P/E of 45% in terms of the trend.  Interest rates are lower now, so that may explain it.

The logarithmic graphs accentuate the panic and euphoria as it was felt at the time.  Distances up and down measure percentage changes.  Doing the graphs in multiples of two makes it easy to see each series as it doubles.

The two graphs look very similar – makes one remember Peter Lynch’s comment “Earnings drive the market.”  It would be tempting to create an indicator out of the amount above or below the trend line, but no one could see the trend line in the past, and a series of shorter trendlines would likely prove deceptive.  Mean reversion tends to play at longer periods.

Regarding Double Factor Quintile Analysis (as I do it)

Doing an analysis of quintiles using two factors creates a five-by-five grid.  More often than not, the two factors are somewhat correlated.  The easy way is see is which diagonal is more populated:


  • Northwest to Southeast (negative)
  • Southwest to Northeast (positive)


Because individual cells are statistically insignificant, creating larger groups can help solidify the aggregate effects.  Adding more cells to off-diagonal groups can lead to statistically significant groups that help tell a story of what is going on.


Averages along the horizontal and vertical are useful for telling how an individual factor performs, but what is more valuable is when we see performance improve diagonally, because it shows how the two factors interact.


On to the Factors – Bonds

Horizontal factor: Yield on Baa bonds – Hypothesis: When yields are high, stock valuations tend to be low.


Vertical factor: spread of Baa bond yields over Aaa bond yields – Hypothesis: When spreads are high, stock valuations tend to be low.


The variable being analyzed is the return of the S&P 500 over the next month, including dividends.  This is the same for all the analyses that follow.


Analysis: This was surprising.  Neither seemed to have a significant impact.  Spread had no discernible impact on returns, and the Baa yield effect was nonlinear, almost like a smile – highest and lowest do best , with the middle doing less well.


The diagonal effects are weird, the market does the best when yields and spreads are high or when yields and spreads are low.  When there are high spreads and low yields (like now), or low spreads and high yields, the market doesn’t do so well.  That may be the market’s way of saying that we like normal-ish bond markets, and that we don’t like times when Treasury yields are too low or too high.


I take that conclusion with a grain of salt, but it seems more reasonable than my initial hypotheses.  I don’t think I would manage money off that conclusion.


Earnings Momentum

Horizontal factor: Percentage that earnings are over/under their 10-month moving average – Hypothesis: The faster earnings rise, the faster the market rises.


Vertical factor: Percentage that earnings have risen over the last 10 months – Hypothesis: The faster earnings rise, the faster the market rises.


Analysis: These variables are highly correlated, so the NW-SE diagonal is packed.  But leaving aside that the market doesn’t do too well in the first quintile of either, these variables don’t discriminate too well.  Being in the fifth quintile for both measures may be a good sign for performance, but I would not put too much confidence in that.  Of my five “groups” the difference from best to worst is small.


Price Momentum

Horizontal factor: Percentage that stock prices are over/under their 10-month moving average – Hypothesis: The faster prices rise, the faster the market will rise.


Vertical factor: Percentage that stock prices have risen over the last 10 months – Hypothesis: The faster prices rise, the faster the market will rise.


Analysis: These variables are highly correlated, so the NW-SE diagonal is packed.  But that leaving aside, both of these variables discriminate well, and they seem to work well together.  Strong price momentum tends to produce strong markets in the short run.


CAPE10 and CAPE Tri-5


Horizontal factor: Dr. Shiller’s Cyclically Adjusted P/E (Ten year average earnings divided by price) Hypothesis: The higher the CAPE10 earnings yield, the faster the market will rise.


Vertical factor: My Cyclically Adjusted P/E (Five year trailing triangular average earnings divided by price) Hypothesis: The higher the CAPE Tri-5 earnings yield, the faster the market will rise.


Analysis: These variables are highly correlated, so the NW-SE diagonal is packed.  But that leaving aside, both of these variables discriminate well, but the CAPE10 is better.  CAPE Tri-5 was an effort to put more weight on present earnings, with progressively less weight until we are five years in the past, as a kind of compromise between CAPE10 and current P/E.  Current P/E should work well, but doesn’t.  CAPE10 gives a lot more weight to the past, implicitly assuming mean-reversion.  Much as I was not crazy about CAPE10 in the past, I think it is a keeper.  But what it implies is that average people who look at the current P/E for guidance on the market are looking at a measure that is influenced too heavily by near-term expectations for a long term asset.

CAPE10 and CAPE10 Risk Premium

Horizontal factor: Dr. Shiller’s Cyclically Adjusted P/E (Ten year average earnings divided by price) less the Baa bond yield.  Hypothesis: The higher the CAPE10 risk premium over bonds, the faster the market will rise.


Vertical factor: Dr. Shiller’s Cyclically Adjusted P/E (Ten year average earnings divided by price) Hypothesis: The higher the CAPE10 earnings yield, the faster the market will rise.


Analysis: These variables are highly correlated, so the NW-SE diagonal is packed.  But that leaving aside, CAPE10 discriminates well, while the risk premium variable displays a smile as it did in the bond test.  The market has done best when Baa yields have been high or low.


That said, the risk premium factor shows that the largest gains tend to come in the southwest quadrant: low equity valuations and high Baa bond yields, which is a perfect set-up for mean reversion.  It’s a pity that we are in the opposite quadrant now.


Valuation Plus Momentum – The Impossible Dream?

Horizontal factor: Percentage that stock prices are over/under their 10-month moving average – Hypothesis: The faster prices rise, the faster the market will rise.


Vertical factor: Dr. Shiller’s Cyclically Adjusted P/E (Ten year average earnings divided by price) Hypothesis: The higher the CAPE10 earnings yield, the faster the market will rise.


Analysis: These two factors are slightly negatively correlated.  Thus, NW-SE are triangles, while SW-NE are squares, unlike the other analyses.  But for practical purposes, they are uncorrelated, which is shown by the relatively even count of cells in the five-by-five grid.


In general, returns get better heading Southeast.  The best expected market returns come from cheap valuations and strong momentum.  Second best is high valuations and strong momentum.


Now, I didn’t do this for the others, but how volatile are the returns by quintile?  The standard deviation of returns is highest for cheap valuations and negative momentum.  For the most part, volatility drops as the market heads northeast, though once you are out of the “L” that makes up the bottom and left of the grid, it doesn’t improve much.  Credit market volatility is highest in the “L.”  It also highlights the uncertainty that happens when valuations are low, regardless of momentum.

Transition Probabilities

Down 40.03%
Down 30.07%
Down 21.87%
Down 117.59%5.93%
Up 116.71%5.99%
Up 22.02%
Up 30.07%
Up 40.05%

But one might ask, when in a given cell, how likely is it to shift to another cell the next month?  Valuation moves a lot less than Momentum – Valuation never moves by more than one quintile in a month, and the odds of moving up or down one quintile are around 6%.  96% of the time Momentum moves one quintile or stays the same.  It only moves three or four quintiles 0.22% of the time.  That’s about once every 37 years or so.

Statistically, there is a slight correlation in the movements of valuation and momentum.  When momentum is positive for a while, valuations get higher, and when momentum is negative for a while, valuations get lower.  But this effect is so small that it is not statistically significant, as seen in the table below.

This portrays graphically how jumps between cells happen.  Pity I could not create thicker lines for higher occurrences.  Note how the big momentum jumps happen in the cheap valuation quintile.

So What’s It All Worth?

It’s potentially worth a lot.  Look at this return graph:


The logarithmic scale makes it look small, but the strategy trounces the stock market over the last 130 years.  Wait, strategy, what strategy?


First and second quartiles for stock momentum: own bonds.

Fourth and fifth quartiles for stock momentum: own stocks.

Third quartile for stock momentum: own stocks, unless in the first quartile for valuation (expensive) own bonds.


Here are the stats:


Std. Dev.4.30%14.50%9.39%


That is two percent over stocks with more than five percent less volatility.  Quite a performance.  Now ask me, what are the limitations?




1)  Some of these strategies were known already, and may indicate data-mining.  Yes, CAPE10 came from Shiller, and the ten month moving average of prices came from Mebane Faber.   But no one put them together before, at least, no one that I know of.

2) This is just a backtest; you wedged this result. I used the ideas of two bright guys, Faber, and Shiller – I did not use any sort of advanced technique – quintiles are ancient.  My ability to finagle matters was constrained.   All that said, all illustrated returns deserve distrust – there are too many ways to make the results come out in a way favorable for the investment advisor.


I made two passes on the data.  One to find the momentum indicator, and one for valuation.  Aside from that, I did little to “optimize” the strategy.


3) Transaction costs would eat up some of the returns.  So would taxes.


Final notes

1) Though I think it could be applied more broadly than to just the S&P 500, valuation-based investors can do better by:


  • buying once momentum flattens after a bust
  • waiting for momentum to flatten after a rally
  • being willing to exit the market even when valuations look good if momentum heads south
  • enter if momentum is strong, even if valuation doesn’t seem compelling.


2) If this is such a great strategy, why would I reveal it?  One thing I learned as a professional bond and equity investor is that few people and firms are willing to change their ways.  Value investors will not do this.  Trend-followers will not pay attention to valuation.  Tactical asset allocators will find it thin gruel.  So, I’m not concerned about a large amount of money in the market doing this.

3) For clients that want a tactical approach that enters and exits the stock market, this is how I will do it.  But will I use it for my account?  Maybe a little.  But I’ve been good industry and stock picker over time, and I don’t care about volatility so much.  Buffett said something to the effect of “I’d rather have a bumpy 15% than a smooth 12%.”  I agree, so, though I might hedge my taxable account on occasion, I will likely remain long only, trying to scoop up bargains when momentum is negative; it has worked in the past for me.  That’s where I have gotten some of my biggest winners.  And if I won’t likely use it, that may be the greatest reason for not worrying about publishing this.

4) If I were to augment this, I would add in something on bond yields; there is something significant going on there, but I’m not sure how I would use it.

This post was stimulated by this academic research piece: When Smaller Menus Are Better: Variability in Menu-Setting Ability.  The truth is, we do best in choosing between a limited menu of options.  Let me give you an example.

For a while, my wife asked me if we could replace our living room furniture.  Trying to be frugal while starting up my business, I showed her some items from Ikea, and she said yes, but I could not replace the recliner at Ikea.

So, after a month, she asked about the recliner.  I did a little searching and went to La-Z-Boy.  (Note: she uses the recliner most.)  I looked around the place and had three thoughts:

  • Low price
  • Reclines the way she likes.
  • Fabrics/colors that I know she likes.

Those criteria enabled me to narrow down the field to two recliners, and a field of six or so “maybes.”  I know my wife pretty well; she trusts me in purchases that many wives would not let their husbands touch.  But for something she uses so much, I took her to the store, along with our youngest (who got a kick out of playing with the electronic recliners).  I took her to the two recliners.  She oohed over them and sat in both.  She liked the fabric better in one, and the comfort of the other.  She tentatively chose the latter, and went on to look at other recliners. As she went on, she said that she wasn’t finding anything that she really liked.  We ended up buying the second chair.  It’s at home now, and she likes it.  Score one more for the husband.

The key to my success was winnowing down the choices.  There were over 100 recliners at the store. But by eliminating options that I knew would not work, I came to solutions that would save my wife time, while making the decision truly hers.


Now let’s talk about 401(k) and mutual fund investing, and asset allocation more generally.  There are more investments out there than there are recliners.  How to wade through the mess?

The first thing is to set the asset allocation.  How much stocks, bonds, commodities, and cash?  Look at your age and future needs, but look at the markets as well.  If the market is dirt cheap and you are 70, it may be time to move to 80% equities.  If the market is rich, and you are 30, it may be time to move to 20% equities.  Those are extreme moves, but I am trying to point out that when risk assets are rich or cheap, it is time to adjust holdings.

After that comes questions of:

  1. how much foreign/emerging exposure you want in stocks and bonds
  2. active vs passive — look at any active manager and try to ask whether he isn’t a closet indexer, or worse.
  3. large vs mid vs small capitalization
  4. value vs growth

That list is roughly in order of importance.  Now, for 401(k) plans, or working through a single mutual fund company, going through it this way will enable you to narrow down the field so that you are able to make comparisons against similar funds, making the comparisons relatively simple.

That’s the outline — implementing this takes some work, but the process is more orderly, and likely to yield better results.

Longtime readers know that I am an Evangelical Christian, and worse yet, a Calvinist (or, Reformed).  I am even one of the leaders in my congregation, and I serve my denomination.  But if religion turns you off, or you hate Christianity for some reason, stop reading now, because this is an abnormal post at this blog — I try to limit posts like this to once or twice a year, so if you don’t like this sort of thing, hit the backspace key.  That said, you might learn a little about how some Christians think.

My goal here is to explain Harold Camping as I see him.  I probably would not write this, except that I have two bits of secondhand personal data about him, and there is little intelligent commentary in the general news media about him.

In 1988 I was a member of Covenant Reformed Church of Sacramento.  Excellent church, I recommend it to all near Sacramento.  Now, Calvinism is sparse across the US, but it is even more sparse in the West of the US.  Calvinism does not appeal to individualists.  So, if there is some sort of fracas in the Reformed churches in central California, well, word tends to get around.

I met a person who was in the last church that Harold Camping belonged to, which was in the Christian Reformed Church at that time, and he told me that Camping had been a Sunday School teacher for the adults at the church, and that the pastor eventually cut him off because what he was teaching was not Biblical.  And after that, Camping left, never to darken the doorsteps of the established church again, though for quite some time, he encouraged his hearers to go to Reformed churches.

After that, a minister from Georgia came to our congregation.  He had come to Sacramento in 1988, to minister to a group of followers of Camping in Sacramento (Camping had not at that time told his followers to leave the churches).  He told them during his candidating that he was not a follower of Camping, and he would not follow Camping’s interpretations of Scripture.  They called him anyway, and he came, with a wife and three children.  After he arrived, after a few months, they fired him.  What gored him was how the members would dismember his sermons saying, “What would Camping say about XYZ?”  Camping was their gold standard.

He went to visit Camping at a conference, and tried to ask him questions during a time of free questions, and Camping just ignored him.  No matter what he tried, Camping ignored him, so he told me.  To the degree that Camping gave answers, it was akin to a politician who does not answer a question, but answers a related question that he would like to answer.


Harold Camping is a Evangelical Christian, in some sense of the term.  But he has a bevy of personal doctrines that differ widely from Evangelical Christian doctrines.  Most notable is that figurative and numerological interpretations of Scripture are valid.  Most Evangelicals believe that the Bible should be interpreted like any other document.

  • Understand the literary genre being used.
  • Interpret books, then chapters, then paragraphs, then phrases.  Don’t ask, “What does this phrase mean?” until you understand the book, chapter and paragraph, in that order.
  • Look for the plain meaning of the text, unless there are reasons from the genre to do otherwise.

Those who look for figurative and numerological meanings everywhere, like Camping, are trying to escape the plain meaning.  The plain meaning is powerful enough, so why would Camping build up a following telling nonsense stories?

Evangelicals who are not Calvinists have a hard time understanding the Old Testament, and Camping makes their life easy by flattening it into “easy-to-understand” narrative that resembles salvation in a simple sense.  For many, a simple interpretation is better than a correct one.

But beyond that his idea that the Church age has been over since over since 1994 is just sour grapes over his prior prediction of 1994 failing.  Like Ellen White in 1844, he makes something up to say he was really right, but you just didn’t see it.

But his his idea that the Church age is finished stems from his past rejection by pastors of the church.  His teachings are aberrant in many ways, not the least of which is that one can name the date of the return of Christ.  All those who have tried to suggest a date for Christ’s return in their lifetime have erred.  Many have had sins they were trying to hide.


Camping has a big media platform.  I don’t.  If I could have drowned him out, I would have done it.  He disgraces Christianity by his commentary, and by encourages those who dislike Christianity to jeer when May 22nd arrives.

But when there is no Rapture on May 21st, will Camping repent?  In 1996, two fellows who upset South Korea on similar terms repented on national television.  If Camping does not repent, it will do great harm to the cause of his Savior that he claims to represent.

Luther was once asked if he were planning to plant  a tree the next day, and he then learned that Jesus was returning tomorrow, what would he do?  He said that he would plant that tree to the glory of God.

And so it goes… Luther is very common-sense, as is Calvin.  Harold Camping is not common-sense — you must rely on his unique interpretations of the Scriptures, which he uniquely developed.

God does not work through “lone wolves.”  In the Bible, he revealed through 44+ men, over 2000 years, who agreed. Any religion that relies on one writer is false.  I leave it to you to fill in the blanks there.


But after all of the media furor, I have to say there are few among Evangelical Christians who believe what Camping says.  That group is very small; the only reason it gets the press that it does is that Camping has his fleet of radio stations.

Thus, aside from damage to the church and individual believers who have believed Camping (a small number), I see little effect from all the furor.  In June,  few will remember this.

I am a firm believer in “you can’t get something for nothing.”  So it is when a new derivative is proposed.  Either there are natural counterparties to take up the exposure (reducing their risk), or speculators must be encouraged to take the risk (more likely).

So, with longevity derivatives, the risk is people living too long leading to more pension payments in future years.  The proposition is: find a party that is willing to make more payments if mortality is better than expected, and offer him a payment, or series of payments, as an inducement to enter the transaction.

Let’s think for a moment, what entities benefit from a rise in longevity?  I can think of one: life insurers.  But there is a problem: anti-selection.  People who buy life insurance tend to be sicker than those of the general population, who tend to be sicker than annuitants.  Annuitants live the longest, and their lifespans improve the most on average.  Life insurers would find taking on longevity risk to be a dirty hedge at best for their life insurance books.  In general there have been few reinsurance agreements for longevity risk for immediate annuity portfolios, but then, that would be a really small component of the life insurance industry at present.

Even when terminal funding was permitted (back in the 1980s to early 90s) — where plan sponsors could buy annuities from insurers to free themselves from their pension obligations, it typically wasn’t a big business, and what did get done transferred credit risk from the plan sponsor to the participant.  Life insurer insolvency means the pension is at risk, subject to the limits of the state guaranty funds.  An acquaintance of mine, who was an actuary, who partially lost a pension on such an insolvency, said the solution wasn’t that hard — allow a lump sum as an option to those for whom the obligation was being transferred from plan sponsor to insurer.

The terminal funding business ceased because of changes in IRS regulations because a few companies realized gains out of terminating their plans.  That sat ill with Congress, especially past the era of corporate raiders, so an excise tax dramatically reduced the business.

So, even when pension plans were able to use insurers to reduce/eliminate their liabilities, there were issues.  There will be issues for longevity derivatives as well.

A swap agreement could point to a “reference portfolio of lives” chosen from some neutral database, or could point to the actual lives that the plan sponsor is trying to hedge.  The first requires less underwriting, and can be more generic, the second has less basis risk, and solves the actual problem, but requires messy underwriting.

Swap agreements could be long or short, but if I were a plan sponsor, I would have a hard time deciding whether to do a long or short swap.  Long swap: counterparty risk.  Short swap: little risk relief.  And to me, long would be 30 years or more and short would be ten years or less.  On short swaps if I ended up on the winning side of the trade, I would probably find few new takers for swaps when the time period was up.

That leaves me with one idea that might work: use a long (~30 years) cat-bond-type structure, where the principal adjusts down as deaths occur.  But we still have the counterparty issue.  If it is the obligation of a operating corporation, there is credit risk.  If it is its own bankruptcy remote Special Purpose Vehicle (SPV – no recourse to a parent company), then there is the risk that the assets in the SPV might not earn the returns necessary over the long haul to pay the interest and redeem the principal.

Calling Ajit Jain.  This is one of those contingencies that yearns for a Buffett-like investor who has a strong balance sheet and can invest for the long haul with above average returns, and thus absorb the volatility of aging annuitants.

But such balance sheets and investors are few.  So I would submit the idea that if you could not get Berkshire Hathaway to issue longevity bonds through such a structure as I have described, you’ll have a hard time issuing long dated longevity bonds anywhere.

Short-dated structures are cute, but don’t offer the relief that pension plans need.  So, I look at this market and do not expect much from it.  Credit risk and longevity risk are at odds with one another, and can be solved by the “magic man” who can earn returns superior to any excess longevity, or unsolved, leaving a larger problem in his wake, by the charlatan that delivers subpar returns.

That said, if you know the “magic man,” the pension fund should disintermediate and hire him.  Problem solved.  Now, where is this genius?

It was 1992, and I had just been hired by a mutual life insurer, allowing me to escape the clutches of AIG.  I settled into my new work and felt a lot more healthy and grateful.  Within the first month, the best boss I ever had wandered into my office and said, “Sorry that I didn’t tell you before now, but we divided the entire division up into four cross-functional teams to analyze the problems of our division. Senior executives are excluded.  You, a junior executive are included, but we ask that you don’t enforce your authority on your group.”

The division had 3 senior executives, 4 junior executives (1 inactive due to a sickness of which he eventually died), and 30 rank-and-file.  That were four task forces, and so my group had 8 members, including my friend Roy, who was invaluable to the division — a kind of “Radar O’Reilly.”  Medium rank, but a lot of implied authority.  He had received a similar charge from the boss not to impose his authority.

Our team gathered together, and we learned that we were to analyze and improve the marketing of our division, which was a big task.  I had my ideas, and Roy had his experience, but we had been told to be quiet.  Let the rank and file show their competence.

We held the meeting and the group shared their ideas, summarized them, and then asked who would present them to the division next week.  One guy who was young and inexperienced raised his hand.  No one else did.  He was chosen.  The next week, he gave our presentation, and it was an embarrassment.  We came in last of the four groups. (One year later, the guy was collecting tolls on the Pennsylvania Turnpike.)

I hate losing.  I particularly hate losing when it was avoidable.  So while the other three cross-functional teams went into hibernation, I got to work.  (My boss said, “See, we knew the cross-functional teams wouldn’t amount to anything, we just wanted to prove it.”)  Shrewd judge of human nature, bad judge of me this time.

When the group got together, I said, “What does the field think about our products and services?”  I got the intelligent equivalent of a mumble.  I suggested, “Let’s survey the field and tell them what we think are issues, and ask them what they think are issues.”  Agreement, nods, and we are on our way after a short meeting.  (Free-form surveys are a great way to start.)

Two weeks later, we met again — the field has responded, and more than we expected.  They are frustrated.  They want new funds and help in selling those funds to pension clients.  By the time we are done with the meeting, we have 24 possible action items — too many to act on.  I suggest, “Let’s do survey #2, asking them how important each of these ideas are, and how urgently they are needed.” (Structured surveys are a great way to ferret out deeper thoughts of players.)

Two weeks later, we meet again — we have a pretty good idea of the needs of the field, but we are not perfectly sure.  What is most important, and what are representatives really asking for?  So I said, “Let’s do survey #3, which is deceptively simple but deeply informative.”  The survey would take the list of priorities, and say, “Pretend that we have made you the director of marketing.  You have a $100,000 budget.  In units of $1,000, allocate your marketing budget to the various priorities.”  One member of the team said, “But should we give the same weight to the opinion of little producers versus big producers?  If not, how do we track that?”  The room was in favor of tracking, so I said, “Random typos on the surveys we hand out.  We keep the list of random typos, and so we know who is who — worked on catching cheaters back when I was a TA.”  The collective reaction of the room was “Cool, let’s do it,” and so we did. (Note: good surveys force respondents to prioritize within a constraint, but few do such rigorous surveys.)

There were representatives that chose one option, those that chose a few, and those that allocated something to every remotely deserving idea on the sheet, but when we were done, and weighted the ideas by representative, it was clear — there was one main need, four smaller needs, and everything else was negligible.  So I asked the room, “Okay, by now you know the other three cross-functional teams are dead, but we got to the end of the process.  Who should present this to the marketing department?”  They pointed at me and Roy.  Great.  Actuaries telling marketers what to do.  It should always be so sweet.

One week later, after Roy and I turned it into a presentation, we arranged to show it to the senior executives.  At the end of the presentation, the Chief Marketing Officer said, “That makes so much sense, that’s how we should go.”  My boss, and his boss (who was the boss of the CMO) agreed.  Woo-hoo!

We went back to the team, and told them that we had won.  A job well-done.  We congratulated each other.

But what was the result?

The marketing department followed our advice, and sales improved dramatically, profits improved more dramatically — the division as a whole did well and became the star of the company.  Low required investment, high returns, and high growth.

What did the cross-functional team get?  The satisfaction of a job well done.

What did my boss get?  He left for a much better job elsewhere, after he got his CFA Charter.

What did the boss’s boss get?  A comfortable retirement.

What did I get?  After my boss left, I was assigned to clean up another division, which I did in 18 months, before I left to join the investment department of another insurer.

What did the rank-and-file get?  The company was merged into another mutual insurer, and most kept their jobs, but the work we did was made obsolete by the merger.

The merger might not have happened without our unrewarded efforts, because it increased profits so much.  Yes, there may have been some small bonuses.  As my boss said to me, “Your team surprised us.  You were the least promising, but the most determined to succeed.  How did you do it?”  Roy and I were determined not to tip our hands, so we just said that it was dogged persistence, which was the truth, but not the whole truth.

But what I learned from the experience was different.  I am not a natural leader, and neither was Roy.  I learned that someone had to direct and encourage the observations of others, and get real data, in order to make effective changes.  Leadership is not always delegation, but co-ordination with foresight.  I did not impose my rank in the division to make it all work, but enabled their insights through structure that they themselves could not impose.

So did I disobey my boss’s charge to not lead the group?  Formally, no.  Practically yes, with Roy grinning, and with the gratitude of the senior management team at the end.

My firm view is that middle management is the most critical aspect of how a company works.  Motivate them well, and you have a good company.  So it was in our division, aside from the experiment.  But that experiment accidentally propelled the division to great success, not that it will ever be remembered.

I was an amateur investor before I was a professional investor, and so long ago I joined AAII.  My mom was a member, and eventually I bought a life membership.  I still send them money once a year to keep my stock screener fresh.

The last time that I attended an AAII local function was in Philadelphia 15 years ago when John Neff came to speak, and there were 1000+ people there.  Well, today there were 32 people to listen to the Chief Economist of a major asset manager in Baltimore.  Of the listeners, I think I was the second youngest in the room.  I estimated the average age of the listeners to be in the high 60s.  Very few women.

I found myself disagreeing more than agreeing with the economist.  It was a very “Wall Street” “Consensus” view.   Things are getting better, ignore the negative data. Equity valuations are reasonable.  So long as real GDP has positive momentum, everything will be okay.

But what really gored the listeners was the idea that inflation was under control.  These people might be well-off, but they said food and energy prices have risen distinctly, and “core” inflation does not reflect their situation.  The speaker repeatedly made excuses for why inflation was temporarily high in both areas.  “Bad harvests,” “Speculation on energy through ETFs,”  etc.

He placed a lot of stock in the idea that reducing position limits for ETFs at the futures exchanges would bring down energy prices (a result of Dodd-Frank).  I’m still thinking about that one — if it happens, the large ETFs would have to replace front month positions with later positions, and maybe with swaps, where counterparties would hedge with futures.  On net, it might lessen backwardation, and lead to better management of the ETFs because they don’t ride the front month, but forcing the ETFs off the exchange seems dumb — it will just lead to another level of intermediation and expense.

The speaker did not get the idea that the replacement cost for a barrel of oil has risen significantly (also true for ounces of gold and other commodities).  He also felt a few simple “actuarial tweaks” would get Medicare on track.  Those “tweaks” are benefit decreases by another name, and if you listen to the loony left on the topic, they howl at every one — raising ages, means-testing, limiting benefits, etc.  Reasonable ideas all, but they will be roundly opposed.

Another concern of the listeners was the lack of safe opportunities to earn income.  As an economist, he was able to beg off, saying that he wasn’t a bond expert, but that he personally liked dividend-paying common stocks.  Again, a consensus opinion, and one that I have some sympathy for now, but dividend paying common stocks are a lot more risky in the short run than the long run.  If you went back five years ago, banks would made up a decent chunk of such a portfolio — guess what happened?  There might be another sector in the future that runs into dividend stress as a result of economic change.

He added that holding bonds to maturity would be an important strategy in the future as interest rates rise.  I found this to be ridiculous.  If rates rise, and your bonds are under par, it can be advantageous to sell bonds at a loss and reinvest in more promising bonds at higher yields, or even move to money markets, should monetary policy ever normalize.

Another concern of the listeners was the sustainability of government policy, and the speaker agreed in principle, but showed a dated graph from the CBO that showed that the problem was tractable.  He felt that deficits needed to be dealt with soon, but that loose monetary policy should continue.  Reduce the borrowing from the future fiscally, but continue it monetarily.

I found the talk unsatisfying, and afterward, I ended up having a dispute with him over mark-to-market accounting — shallow people think that it was a significant cause of the crisis, rather than MTM accounting revealing liquidity and cashflow mismatches.  Those with (expensive) long-dated, noncallable funding did not suffer during the crisis.  Only speculators with short-dated funding holding illiquid assets suffered, and they should suffer, because they relied on the idea that financing will always be available on favorable terms, and that is a profitable idea in the short-run, but deadly in the long-run.  My own ideas for bank reform would cause banks investing in assets that they can’t value to fund them with equity, or debt that lasts past the maturity of the asset.  No borrowing short and lending long — that is what leads to liquidity crises.

Quality of Investor Education

I haven’t gone to AAII local meetings for the most part because of speaker quality.  I am reconsidering that idea because I had a good talk with the vice-chair after the meeting.  He said it would be valuable to perhaps have meetings where the group could share ideas, because often speakers don’t leave any practical ideas behind.  I’m wondering what good I could do for local investors. (The same way I try to do so here — this is pro bono, even if I earn a little off of ads and book reviews.)

I am also wondering if it would be smart to have a joint Baltimore CFA Society- Baltimore AAII meeting where we could have panels attempting to understand and develop financial solutions for those frustrated by the current market environment.  My heart goes out to the average investor.  That’s a main reason I write this blog — to give something back.  The solutions aren’t easy, but unless you try, you’ll miss 100% of the shots you don’t take, as Gretzky would say.