September 2013 – Page 3 – The Aleph Blog

The Rules, Part LIII

Posted on 9 September 201320 June 2017 by David Merkel

The tech market washes out about every eight years or so.? The broad market, which is a more robust beast, washes out far less frequently.? My question: are these variants of the same phenomenon?

I wrote this back in early 2003.? I can now answer my own question: No.

I’ve looked at this question many times, and debated the answer, but there are a few things that have made me decide “No.”

Sectors often move independently of the market as a whole, particularly growthy sectors that lose their growth.
The big moves of the market as a whole have usually been correlated with credit crises, which are part of the financial sector, not the tech sector.
The tech sector grows more slowly as a whole now, and hasn’t washed out for a while.
The financial sector fails because of financial leverage, the firms are too levered, and take too much credit risk.? The tech sector fails because market players bid up the prices of stock assuming permanently high rates of growth.? These are fundamentally different reasons for over-valuation, because most tech stocks have little debt.

Credit crises lead to big overall declines in market values, particularly with financial stocks, but affecting all other stocks, because when credit conditions are tight, things slow for all firms.

When tech stocks are overbid, it is more of a local mania where market players overestimate the degree of growth the sector can achieve.? There is little collateral damage to the market.? A seeming exception to this is 2000-2002, where the market went down with tech, but financials were less affected. In that drawdown, tight Fed policy drew everything down, and tech more than everything else.? Remember the NASDAQ over 5000?? Still hasn’t returned there, while the Dow, S&P 500, and Russell 2000 have hit new highs.

Here’s the summary: financial stress tends to be pervasive, affecting everything.? Stress from growth expectations that disappoint tend to be sector-specific, and don’t drag down the market as a whole.

And so the answer to my question that I asked 10+ years ago is “no.”

The Rules, Part LII

Posted on 7 September 2013 by David Merkel

g_e + E/P > i_{longest bond}

Let me explain.? The first term is the growth rate of earnings for a company.? The second term is the earnings yield of a company.? The last term is the yield on the longest, most subordinated bond or preferred stock a company has issued.

The idea here, is that the more risk you take with a company, the more return you should invest for.? Bank debt should yield less than senior unsecured debt, which should yield less than preferred stock, which should yield less than the expected total return from the common stock.

This is a simple idea, but it can occasionally yield good buy or sell ideas when the equation seemingly does not work.? If it does not work, consider buying the bonds and/or selling the stock.? On the other hand, when the equation works, and the gap is wide, consider buying the stock and/or selling the bonds.

The idea is to look for the best risk-adjusted returns, and not be wedded to one particular type of asset.

Another way to think about it is when a company would buy back its shares.? Would it buy them back when it costs more to borrow on safe terms than the company is earning, including likely increases? in earnings?? No, that’s not likely, they might even issue more shares in such a situation.? Buying the shares back requires that the debt or excess cash is less valuable than the stock being bought.

The main point of this rule is to think through the capital structure of a corporation, and look at the relative valuations.? Deviations of expected returns from likely risk deserve attention.

Here’s an example: my boss called me one day and told me he sold short two stocks that afterward doubled on him.? What should he do?? I looked at the bonds of the stocks and saw that they were trading above par.? He thought they were going bankrupt, but the bond market did not agree.? I told him to cover.? He objected, but I said, do you want to cover at a higher level?? Eventually he covered.

Pay attention to all of the securities in the capital structure of companies that you own (or short).? They may give you valuable data that the stock market does not know.

Should You Buy Shares of Stock or Not?

Posted on 7 September 20137 September 2013 by David Merkel

Well, I was honored to be tweeted to by Mark Cuban.? Here it is:

@howardlindzon @AlephBlog the real question is why would an individual buy a share of stock? It no longer reps ownership in company

Now let me try to answer the question.? Yes, average people buying stocks with the small amount of money that they have, have no control over their investments.? What is worse is that those who invest through mutual funds have less control, because the mutual funds don’t care much about governance except when something critical comes to them: an acquisition, a spinoff, a merger, etc.

Small investors need to realize that they are riding on the bus of the company (ies) that they own.? They have little ability to affect the board of the company, much less management.

So why buy, if you don’t get control?

Well, let’s talk about institutional investing in alternatives.? Many institutions ride on the buses of general partners with expertise, while they are limited partners.? They have little to no control, and they invest because they think their LP interests will be worth more by the time the partnership matures.? The partnership must raise liquidity by the end of the term, and players get paid, even if they are rolling into the next deal.

The key here is a liquidity event, or the threat of one.? Something that forces the investment to interact with the cash world.? It can be a spinoff, selling a subsidiary, an outright sale of the company, etc.

But liquidity events are rare with publicly traded equities.?? Maybe not *so* rare, when you consider dividends and buybacks.? But full acquisitions happen rarely, and individuals play a small role in M&A.

So here is the answer, which only makes sense if you are a value investor: we buy stocks that we think will compound value.? We may not have control, but we look for situations where management honors the investments of outside passive minority shareholders.

We may be aided by larger investors that seek control, or not.? When you own an undervalued company, catalysts appear. It may take time, but the effort to make value emerge will work more than half of the time.

My view is to focus on companies that are growing value and own them.? That will result in increases in the underlying value of the companies held, which will result in high market values.

Yes, we may not have control.? But if we focus on undervalued equities, we may own companies that those large enough to buy whole companies will buy out, rewarding our patience in holding neglected companies.

And so, Mr. Cuban, though I am nowhere as successful as you, I regularly do better than the S&P 500 by picking stocks with my value discipline, buying stuff that few want to own, and profiting when the stocks exceed expectations.

That is why I own individual stocks, for myself and my clients.? I note that you on rare occasion buy common stocks, including this purchase of Apollo Group.? Guess what?? I own that as well.

I buy the stocks of companies that are out of favor, but have a margin of safety — if I am wrong, I won’t get killed.

That’s why I buy shares of common stock even though I know my ability to control is limited.? (That said, at least in the insurance industry, if I call they will listen to me, at least among the midcap and smallcap firms.)

But I agree with you.? Small investors ride on the backs of larger control investors.? Thus small investors should ask, “What will the large control investors like?? And that is why clever small investors should buy shares of stock, despite the lack of control.

Full Disclosure: Long APOL

Sorted Weekly Tweets

Posted on 6 September 2013 by David Merkel

Rest of the World

Risks of Capital Account Liberalization in China http://t.co/WkuOTqJsid Need stable macro policy, sound banking, & developed finl mkts $$ Sep 07, 2013
Putin Overwhelms Obama at the Sulky Summit http://t.co/5Hh3ShOjkp Putin is in a stronger position, b/c blocking is easier than attacking $$ Sep 07, 2013
China Beats US for Korean Students Seeing Career Ticket http://t.co/k2OK4qbWW3 English is common; learning Mandarin adds 2 skills $$ Sep 07, 2013
China and its Financial System: What Could Go Wrong? http://t.co/FBWAcwC792 Carl Walter explains it all in this well-written article $$ Sep 07, 2013
No Swift China Breakthrough Seen by Mao-to-Xi Scholar of Economy http://t.co/nwrmjWwpnF “You sow dragons? teeth, but you harvest fleas.” $$ Sep 06, 2013
Rich Norwegians Turn Down Labor Party as Welfare Loses Its Allure http://t.co/mpdTvgL3mu Fiscal policy about 2 get aggressive in Norway $$ Sep 06, 2013
Pension Stealth Rule Clears Path to Buy 60 Stocks: Korea http://t.co/ok3yTplmzy Natl Pension Svc receives approval to hold >10% of 60 cos $$ Sep 06, 2013
Banks Employing ‘Princelings’ Played Roles in Big Hong Kong IPOs http://t.co/jLPUCmKy7M Difficult to stop cos from hiring connected ppl $$ Sep 06, 2013
Europe?s Workers Flock to Norway for Better-Paying Jobs http://t.co/FsrMAaVHYJ Migration of under- & un-employed 2 stronger economies $$ Sep 06, 2013
The economics of China’s one-child policy http://t.co/tsSiRgnUdH Number of workers in China is already shrinking, aged are growing fast $$ Sep 06, 2013
The EU budget is a disaster that cannot save Greece http://t.co/6u6n2HArPB You can get money 4 capital projects, but not relief $$ Sep 05, 2013
Rajan Brings Stature to RBI Hamstrung by India?s Deficits http://t.co/dotiRrfaS4 Monetary policy forced to undertake impossible goals $$ Sep 05, 2013
The one map that shows why Syria is so complicated http://t.co/ElpNdB54pM Nations r hard 2 govern when they r collections of diff tribes $$ Sep 05, 2013
Fire and Water: China’s Looming Coal Problem http://t.co/LisCi2ocIJ China is short on water & long on coal. But u need water 2 get coal $$ Sep 02, 2013
Norway Oil Riches Up for Grabs as Anti-Tax Group Set to Win http://t.co/TlvF1ZcQ5K Politicians discover Sovereign Wealth Fund Cookie Jar $$ Sep 02, 2013
Plunging Currencies Plague Asian Companies http://t.co/qLhM89yUtZ Decoupling? The volatility machine of Fed policy smashes decoupling! $$ Sep 02, 2013
Today’s Alarming Japan-China Charts – James Fallows http://t.co/k8pLOfMZVd This should not be a surprise, they irritate each other often $$ Aug 31, 2013 *

US Politics & Policy

Push Intensifies for House Backing on Strikes http://t.co/bxnmgS9kRj House Emerges as Formidable Barrier for Attacks on Syria $$ Sep 07, 2013
Summers Faces Key ‘No’ Votes if Picked for Fed http://t.co/TGmWutqb8C Will be an interesting vote; how many Reps would support Summers? $$ Sep 07, 2013
Noonan: Why America Is Saying ‘No’ http://t.co/6esab4sOt4 We get that prior interventions haven’t helped, & we don’t have interests there $$ Sep 07, 2013
NSA Code Cracking Puts Google, Yahoo Security Under Fire http://t.co/2XNaPYKSi6 Foreign govts will cease to trust US internet companies $$ Sep 06, 2013
Congressional Vote Count on Syria http://t.co/y8DrdvFEjc Congress may not vote for military action. Graphic: http://t.co/czjHlMzT4Z $$ Sep 06, 2013
Edward Snowden and Chelsea Manning, the New Dissidents? http://t.co/pvy4J0lM4X US govt has too many secrets, collects data it should not $$ Sep 06, 2013
Abortion Clinics Close at Record Pace After States Tighten Rules http://t.co/Xw7rlQyyQu Many would like 2 adopt babies that r not wanted $$ Sep 06, 2013
Health Savings Accounts as Antidote to Obamacare http://t.co/BfoHItREQi HSAs r closer to a first party payer model & reduces costs $$ Sep 06, 2013
Why Wall Street Wants Larry Summers (and Why the Rest of Us Should Not) http://t.co/fgkERCxJHV We lose either way; Yellen is no prize $$ Sep 05, 2013
Budget cuts laying off scientists http://t.co/OLSk4V7t7J Scientist shouldn’t b given special status, their labor doesn’t always work out $$ Sep 05, 2013
Across U.S., bridges crumble as repair funds fall short http://t.co/iEZdmTdLAE Deferred Maintenance takes its toll on bridges $$ #sadbuttrue Sep 05, 2013
Bloomberg United States Financial Conditions Index Chart – BFCIUS http://t.co/bf6Df4mCNA Lending markets r calm, even complacent $$ #uhoh Sep 05, 2013
The White House walk-and-talk that changed Obama’s mind on Syria http://t.co/q47QbKgLe3 Syria is not our responsibility; let others fight $$ Sep 03, 2013
Wall Street Knows a Bad Trade When it Sees One http://t.co/WrqYD97yrV Cold. Calculated. Politically savvy. @reformedbroker nails it $$ Sep 03, 2013
Judge Rules in Case of Fortune Tied to Buffett http://t.co/Vzfu6CUaRr Fascinating, tangled tale of the invasion of endowment funds $$ $BRK.B Sep 02, 2013
Have to give Obama some praise. War is such a serious thing that it should run through Congress, to get the wide assent of the people. $$ Sep 01, 2013

Market Impact

In a cold market, typically some of the best IPOs get done. They have economic purpose when capital is skittish. $$ http://t.co/vUZYJ6PifB Sep 06, 2013
Don?t cry for ?the little guy on Wall Street? http://t.co/yxshyVk1ZI @felixsalmon argues that added liquidity benefits small investors $$ Sep 06, 2013
Dealers in Debt Pare Commitments Raising Risk as Rules Bite http://t.co/rDNO5bjGb9 Given new regulations, using capital 2hold bonds loses $$ Sep 06, 2013
Buybacks to Dividends at Risk With Record-Low Yields Ending http://t.co/FmgW7Enddq If due to rises in real rates, yes. Inflation, no $$ Sep 06, 2013
Have ‘Alternative’ Investments Lost Their Diversification Value? http://t.co/bqviG1zz6o When buyer base gets broad, correlations increase $$ Sep 05, 2013
Money Fund Lehman Moment Lurks as New Protections Stall http://t.co/nYWXGT237C Better to eliminate units upon defaults & keep stable NAV $$ Sep 05, 2013
Mortgage Rate Flip-Flop: Jumbo Loans Now Cheaper http://t.co/X5lsOnm1eU Low mtge loan demand & fedfunds may allow this 2 persist 4 awhile $$ Sep 05, 2013
Mad Men or Wise Men? Investors Today vs the 1960s http://t.co/t4mgitnOTZ We turn over portfolios 10x faster, but business is not faster $$ Sep 03, 2013
The Number One Threat to the Market http://t.co/sIlbEa3T1s @reformedbroker argues that a quick bond market meltdown is the worst scenario $$ Sep 03, 2013

US Economics & Monetary Policy

Economy recovers, income doesn’t http://t.co/TdJovea4GZ More of the total earnings stream flows through profits, median doesn’t have that $$ Sep 05, 2013
QE3 is ineffective in growing credit in the US http://t.co/EfbCDHpEdW Banks r content to not take much risk 4 now $$ Sep 05, 2013
America’s ‘Baby Bust’ Starts to Ease http://t.co/s2NNshIR6t When total fertility rates decline, it is almost impossible 2 get them 2 rise $$ Sep 05, 2013
Money For Nothing:Inside the Federal Reserve- Coming to a theater near you! Check out the trailer: http://t.co/Mi1umflvO6 @FedDocumentary $$ Sep 04, 2013
Starbucks Pastor-to-Be Shows Shift in US Part-Time Job Market http://t.co/RSAVmIYcM3 Part-time work fits the lives of childless students $$ Sep 02, 2013
Investors Are Doing Better Than Workers http://t.co/48jh3R8nxl Wages stagnant, stocks rising from buybacks, dividends, little new capex $$ Aug 31, 2013

Companies & Industries

Gorman Says Chance of Another Financial Crisis ?Close to Zero? http://t.co/BZlTXxjfQX Revisit when the Fed starts tightening; 2 early now $$ Sep 07, 2013
Batista?s $1B Put Propels OGX to Record Gain http://t.co/iEYE6XOAqf Avoid: novel financing, currency mismatches, forced recapitalizations $$ Sep 06, 2013
Tankers Worst Since 1997 on Africa Oil Slowdown to China http://t.co/z0t63Q5CWl Chinese economy slowing down, reveals tanker glut $$ Sep 05, 2013

Other

NASA Set to Launch Moon Probe http://t.co/BPAF7X5OlU I have neighbors going to the local high spot 2c if they can see the rocket ascend $$ Sep 07, 2013
The rocket blasts off from NASA Wallops Flight Facility on the Eastern Shore of Virginia near Chincoteague National Wildlife Refuge Sep 07, 2013
Your Phone Is Deadlier Than Pacific Sushi http://t.co/sqNFG9r55d Interesting argument about radiation levels, but watch the mercury $$ Sep 06, 2013
President Tyler?s Grandson on Being Alive http://t.co/X3AX9vchEn Long generations 63 & 75 yrs, he’s ~84. 1790 + 63 + 75 + 84 = 2012 $$ Aug 31, 2013
The Rubber-Band Millionaire http://t.co/8uHOqQJPbB The pit in the stomach, staring @ a ton of rubber bands in garage, bot w/kids college $$ Aug 31, 2013

Retweets, Replies & Comments

Thanks @garyvee @DonnyGoines for being top new followers in my community this week 🙂 | insight by http://t.co/sern3wLA13 Sep 06, 2013
Thanks @moneyscience @japhychron for being top engaged members in my community this week 🙂 | insight by http://t.co/sern3wLA13 Sep 05, 2013
“There are many more AAA companies in the US, but they aren’t publicly traded; only 4 publiclytraded.” ? David_Merkel http://t.co/mcv5KS3AsK Sep 03, 2013
Thanks @garyvee @OGMarcusC for being top new followers in my community this week 🙂 | insight by http://t.co/sern3wLA13 Sep 03, 2013
Thanks @GaelicTorus @The_Analyst for being top engaged members in my community this week 🙂 | insight by http://t.co/sern3wLA13 Sep 02, 2013
There is little proof that price inflation will drive real growth. The result could be stagflation which… http://t.co/wEehl1ryyZ Aug 31, 2013
@felixsalmon Fisk away, there is a lot of low-hanging fruit. Aug 31, 2013
RT @jake_f: Niederhoffer down 11% in July. Managed futures has been just brutal past three years. Time for an industry reboot. http://t.co/? Aug 31, 2013 *

On Alternative Investments

Posted on 6 September 2013 by David Merkel

What makes an investment alternative?? Typically, it is because not many institutional investors own it.? But why don?t they own alternatives?? What attributes can characterize them?

Lower Liquidity ? this can take the form of long lockups for private equity, liquidity limitations on hedge funds, Real Estate LPs, etc.
Limited market for trying to sell out of limited partnership interests early
Can go both long and short financial instruments, use derivatives
Can hold commodities and collectibles (Art, wine, who knows?)

Typically, the form of the investment is a limited partnership.? The limited partnership can own all manner of assets, and short some of them also.

As with most valid investment ideas, those that get there first do the best.? You don’t want to be the last one to the party — you buy into a saturated market at an overvalued price.? Far better to avoid the market than to be the last one in.

You have to understand, there is nothing truly different about alternative investments.? They may invest in private businesses, and lever them up, but the returns aren’t greater than if we levered up public companies to the same degree.

They may go long and short, but there are so many trying to do it that the limits of arbitrage are tested, which is a major reason for why hedge funds are doing so badly.? When you have a lot of parties trying to make differential bets, the reward to the exercise declines.

Briefly, while working for Finacorp before it liquidated, I had the opportunity to give advice to some large pension plans that were charging into alternative investments in 2009.? I counseled them to stick to more liquid investments, because alternative investments had become common.? Alternatives are not magic — you have to evaluate them like any business, and ask whether the entry price discounts a high return or a low return.? Are the commodities/collectibles in over- or under-supply?? What possibility might you face of needing to raise liquidity at an inopportune time?

There are two matters affecting any investment:

Underlying behavior of the asset in term of its relative value, and
Behavior of those who hold the investment, their perception of relative value, and their need for liquidity.

To give an absurd example, think of Bernie Madoff.? The actual value of the assets never did anything.? But parties owning interests in Madoff’s “fund” needed to raise liquidity when the public equity markets plunged in 2008, which led to the insolvency.

Investor behavior affects asset prices.? Big surprise, not.? This is Ben Graham’s voting machine.? The weighing machine eventually catches up when there are liquidity events where investment vehicles get dissolved for cash or other securities.

This is not to say that there is no superior management talent with respect to alternative investments, but that it is subject to the same limits as public investments.? As more capital is allocated to a manager, he moves down his list and says, “Okay, what’s the next best thing to which I can allocate capital?”? Too much money kills even the best of managers.

Perhaps the best way to go is to focus on the Seth Klarmans and Howard Marks of our world, and be opportunistic.? Hold cash when it makes sense, or send it back to the limited partners, but invite them back and invest heavily when conditions warrant.

My view is this: given the wide level of investing in alternative investments, there is no reason why they should outperform, and no reason why they should be uncorrelated with other risk assets, because the same owners own both.

On Voluntarism

Posted on 5 September 201320 June 2017 by David Merkel

One of the great things about the US is that people give their time and effort for things that benefit society.? It is a secular offshoot of the Puritan idea of creating a Holy Commonwealth.? We are out to save the World from itself, but now, without anything like Yahweh/Jesus telling us to do it.

I must admit that I serve in both spheres — I am an elder in my Bible-believing Presbyterian congregation.? I also serve on the Baltimore CFA society’s board, and may become a part of the board that oversees the pension plans for Howard County, should the county executive so choose me.? (As an aside, I applied for similar posts at the Maryland State level, but I fear that I am either too controversial, or too qualified.? I suspect that they don’t want people who really know the business.)

When I came to Baltimore, my boss had a number of things to teach me:

When someone asks you for help finding work, give him help.
Break off time to aid the broader interests of your industry, in this case, the CFA Society.
Where you have the opportunity, favor the local financial community if it doesn’t cost a lot to do so.
Help students and young professionals where you can.

I have made an effort to do this.? I aid people who are looking for opportunities, and I advise them.? I may not be the best, but I have been around the block a few times.? I really enjoy aiding people to find jobs in investing.? I love spending time with students, and encouraging them to think broadly about how investing works.? It is not a simple formula.

Thus I find my time pulled many different directions, and my dear wife wonders at how I do it.? The truth is, I don’t do it.? I have as many hours as all those who are alive.? It is just a question of the distractions that you block out in an internet era.

Thanks for reading me, and as Program Chair for Baltimore CFA, if you have any great speaker ideas for me, please send them to me. Thanks.

On Human Fertility, Part 3

Posted on 3 September 2013 by David Merkel

I write about this every now and then, because human fertility is falling faster then most demographers expect.? Using the CIA Factbook for data, the present total fertility rate for the world is 2.45 births per woman that survives childbearing.? That is down from 2.50 in 2011, and 2.90 in 2006.? At this rate, the world will be at replacement rate (2.1), somewhere between 2020 and 2030.? That?s a lot earlier than most expect, and it makes me suggest that global population will top out at 8.5 Billion in 2030, lower and earlier than most expect.

Have a look at the Total Fertility Rate by group:

The largest nations for each cell are listed below the graph.? Note Asian nations to the left, and African nations to the right.

Africa is so small, that the high birth rates have little global impact.? Also, AIDS consumes their population, as do wars, malnutrition, etc.

The Arab world is also slowing in population growth.? When Saudi Arabia is near replacement rate at 2.21, you can tell that the women are gaining the upper hand there, which is notable given the polygamy is permitted.

In the Developed world, who leads in fertility?? Israel at 2.65.? Next is France at 2.08 (Arabs), and the US and New Zealand at 2.06, slightly below replacement.? We still grow from immigration, as does France.

Quoting from my prior piece, why is this happening?? There are many reasons why the total fertility rate is declining:

Educating females makes many of them want to have fewer kids, whether the reason is pain, effort, wanting to work outside the home, etc.

Contraception is more widely available.

The marriage rate is declining globally.? Willingness to have children is positively correlated with marriage.

Governments provide an illusion of support, commonly believed, that the government can support people in their old age, so people don?t have kids for old age support.

The rapidly slowing rate of childbearing will have global population peak in the early 2030s at a level in the lower 8 billions, unless there is some further change to attitudes on children that makes people have more or even fewer kids.

Some of those changes may come from:

governments looking to stem a shrinking population that is causing a future problem with their social welfare programs.? (Note: in general, whatever governments offer, people don?t have materially more kids. Once women are convinced that kids are more of a burden than an advantage, they do not easily shift from that view, even if that view is wrong.)
Various religious leaders realizing that the women are not with the program of growing their ranks, where contraception has become quietly common.? I am speaking mostly of Catholics and Muslims here.
Abortion, especially for sex selection reasons becomes more or less common.? Growth in future population depends heavily on the level of fertile women, and if they are being killed or not at birth in places like China, India, the satellite countries of the former Soviet Union, etc? fewer women means a lower growth rate, and unhappier societies 20+ years out.

As I close, I want to list a few nations that are below replacement rate, that would surprise some people:

Libya
Vietnam
Iran
Qatar
Lebanon
Chile
Uzbekistan
Brazil
Thailand
Russia
Azerbaijan
Georgia
Tunisia
North Korea
South Korea

And those the are close to replacement rate:

Bangladesh
South Africa
Peru
Burma
Morocco
Colombia
Turkey
Indonesia
UAE
Saudi Arabia (Wahabism is less strong than believed)
India
Mexico
Venezuela
Argentina

One last point, because the demographics profession has been slow to pick up on these shifts, if present trends continue, within 10 years, I believe you will see a scad of articles talking about the likely leveling off of global population and even future shrinkage of global population, and the effects thereof.? Always something to worry about?

Libya

The Rules, Part LI

Posted on 2 September 201320 June 2017 by David Merkel

65% of the time, the rules work.? 30% of the time, the rules don’t work. 5% of the time, the opposite of the rules works.

When I wrote that to Cramer in 2003, his comment was that he loved it.? To me, this meta-rule about market rules in general expresses how markets work.? Re-expressing the three periods:

1) There are rules, and they work most of the time.? Value and Momentum strategies work on average.? So do many other strategies that work off accounting quality, distress, neglect, company quality, low volatility, etc.

2) But they don’t work all of the time.? Sometimes it seems that there is no discernible reward to a strategy, and performance is market-like.

3) But even valid strategies occasionally attract too many followers.? Too many foxes versus rabbits, means that foxes will die.? During those times, you think that the world is coming to an end, but these times are usually mercifully short.

In early 2000, a lot of great value investors got fired.? They had just suffered the worst period of relative performance in a decade, and investors were fed up.? Those firings were a sign that things were about to improve for value investing.? Near market troughs, qualitative signals occur to show that people are giving up because the rules have been reversed.

What does this mean for us regarding portfolio management?? The first and easiest solution is to stick to your discipline no matter what, and ride out the hard times.? After all, the rules work most of the time; you will get rewarded following them.

It is like what Max Heine said to Michael Price during Price’s younger days (extreme paraphrase from memory): If you follow this method, you will earn 15% per year on average.? One year out of ten, you will look like a genius.? One year out of ten, you will look like a loser.? Be mentally prepared for that.

And perhaps, that is the main message here.? Be prepared, like a good Boy Scout.? Be prepared for the days when your strategies, so strong in the past, go dead, or even become corrosive.? That is not a reason to abandon strategies that have a strong argument behind them, like momentum, value, etc.? It is a time to show courage, and buy the best stocks you can find.? Crises test investors, and the best stick to their guns and concentrate on the best opportunities.

The irregularity of the markets exists to shake out market players that cannot handle losses.? Those that cannot handle losses had unrealistic expectations.? Markets are perverse, and they suck in amateurs near peaks, and the amateurs leave near troughs.? They help provide the excess performance of the best.

The second message is to realize there are no strategies that work year-after-year, and that you have to accept years where your normally valid strategies? don’t work, or worse, become toxic. Don’t lose heart.

The third message is after a strategy has had a long run of success, don’t be afraid to lighten up.?? Eventually the evil days come, when the results of investing at high prices relative to value are punished.

Follow the rules, then, and be ready to absorb losses during the fleeting bad times.