I consider myself a lesser light compared to many following Warren Buffett.? Yes, I am a value investor and an actuary, so I guess I have some punch in attempting to analyze the actions of one far greater than me.
The book is organized around two main trips that the author made to the Annual Meeting of Berkshire Hathaway, with some notes from the the 2011 tacked on.
This book tries to distill the ideas of Buffett into simple concepts, and largely succeeds.? It also alleges weaknesses? in Buffett’s reasoning.? Why not consolidate similar, less profitable businesses?? Why not invest a little more in existing businesses? I partially agree: I used to call Berkshire Hathaway “a grab bag of undermanaged businesses.”? But I’ve changed my mind, mostly.
The cost of doing the first of those could be considerable.? Buffett gets certain deals because the seller knows that he will leave the business alone.? The unique culture, friendships, family relationships will be maintained.? The seller doesn’t get top dollar, but he gets the satisfaction that he was true to those he worked with and served him.? Getting these businesses cheaply is a competitive advantage for Berkshire Hathaway, even if it means a certain amount of inefficiency.? Personally, I expect the next CEO or two will centralize the company, and turn it into a normal company.
As for investing more in existing businesses, all the manager has to do is put forth the case to his boss, Buffett.? Buffett will give him a quick decision.
But the author is right, in general, Buffett has not focused on organic growth.? He has acquired all of the businesses that the owns, aside from the reinsurance business.
This book has many strengths:
It recognizes that there is a cult following around Buffett.? He’s a bright guy, no doubt, but few questions get asked him by shareholders about his main duty, that of being CEO of Berkshire Hathaway.
It points out the significance of Charlie Munger, who got Buffett to think more broadly about value, served as a “Dr. No” to Buffett’s more optimistic demeanor.
It doesn’t spend a lot of time on Buffett as an investor in public equities, which has contributed much less to the growth of Berkshire than the acquisition of whole companies.
The demographics of Berkshire’s Annual Meeting are older and white, and in general, are the patient shareholders that Buffett likes.
Omaha is an unusual place for such a large company, but the isolation is a plus if you are trying to do something different.
Understands the basic safety rules of Buffett’s investing: margin of safety, patience, think like a businessman, simplicity, read a lot, be a good judge of character, think independently, get the big ideas right, the value of cash, don’t risk the firm, etc.
Notes the value of ethics at Berkshire, even when significant mistakes are made, like the handling of the David Sokol incident.? Reputation matters; you only get one reputation, and it affects all aspects of your business.
Quibbles
Berkshire is primarily an insurance company.? I would have spent more time on that.
I would have spent less time on non-business ethical issues, like abortion, religion, etc.? Buffett is no good guide there; he is merely justifying his past actions.
The bit about the Hoopa Indians was interesting, but when Buffett said, ?I agree that we will not exercise decisions except those ministerial in nature,? he was being very clear and simple.? Buffett is not a Christian, but he was raised in a Presbyterian household.? A minister is one who does things on behalf of another.? The issue is that there are 4 California hydroelectric plants that are old.? If the Federal government destroys them, it may help in salmon production, or farmers might like the extra water for their own use.? Buffett will simply do what the authorities want done if they are willing to pay to do it.? It is not his call in a regulated industry.
Buffett’s hypocrisy on taxation is not addressed.? He backs high estate taxes and high personal income taxes, but he doesn’t pay those.? The increase in his wealth though Berkshire, which does not pay a dividend is sheltered from tax, because he never sells a share.
Full disclosure: I bought the e-book with my own money.
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.
This post is for average 401(k) investors.? I’m going to let you in on a secret that is not so secret, but does not get talked about much.? It’s a simple idea as well, and would be common sense, if sense were common.
401(k) investors tend not to change their allocations often, except to panic when things are going bad, or arrive late in bull market, and buy near the top.? In general, if you don’t have a lot of investment knowledge, it is good to come to a place where you “set it, and forget it.”? Remember, those with no experience are far more prone to the errors of fear and greed than most experts are.? Those arrive late to a rise or a fall in the market, and say, “Look what I have missed out on,” or ‘Look at how much I have lost,” are going to make the wrong move again and again.
There are temptations as an investor to not diversify.
“I’ll just hold all my assets in a money market fund.? I don’t want to lose anything.”? Money market funds preserve value at best.? They won’t help you build value.
“I’ll just hold all my assets in gold.? I don’t want to lose anything.”? Gold preserves value at best.? It won’t help you build value.
“This manager is the greatest.? I’m putting it all on him.”?? Sadly, managers have hot and cold streaks.? Many people join in near the end of hot streaks.? The quote I heard this from was a professional in 1999, deciding to invest all his money with Bill Miller.? Bad timing.
“Stocks win in the long run.? I am investing only in stocks.”? If you have a really long time horizon, and you are certain that your nation will not go through a revolution, or something close to it, that will work.? Otherwise, you are taking a risk.
There are more, but I think you get the point.? In most of life, those who do the best are the ones that take prudent risks.? Prudent risks are where the likely rewards outweighs the likely risks.
Think of it: in business, the guy who never takes risk does not do well.? The guy who takes huge risks blows up frequently, and does not do well on average.? The guy who takes moderate, prudent risks tends to do well.
The same is true of bond investing.? Those who invest in bonds of medium risk (BBB/Baa) tend to do best, those that play it safe or risk it all do less well.
The same is true of stock investing.? Stock investing is risky by nature, and in general, those who take less risk tend to earn better returns over time.? Ignore the canard: more risk, more return.? It ain’t so.
So what would I do if I were a 401(k) investor facing a limited menu of choices?
Put 60-70% in conservative, value-oriented stock funds. (US and Foreign)
And 25-35% in moderately risky bond funds. (US and Foreign)
And 5% in cash.
And rebalance yearly.? Do it after you complete your taxes, or something like that.
Avoid complexity.? Even if the plan offers a wide number of choices, winnow it down to a few funds, say five at most.? Over the long run, your investments should prosper, because you are doing things that few investors will do, and enjoy? returns from bearing risk successfully.
We can’t rely on US Treasuries?? If so, what can you do to preserve purchasing power?? I will ignore a variety of exotic strategies/derivatives and focus on things that can be executed by individuals and small institutions.
The first idea that comes to mind is gold, silver and commodities.? Commodities don’t lie, they just sit there.? But the prices don’t just sit there.? They go up and down with demand and supply.? I’m not an expert there, so I would say keep positions small, enough for diversification relative to volatility.
Idea two is foreign debt of unquestionable solvency.? Well, that takes much of the world off the table, leading to investment in the developed fringe currencies — Canada, Australia, New Zealand, Norway, Sweden, and the Swiss Franc.? Toss in the Yen, though it isn’t fringe.? Not a very large group, and their currencies have run like mad.? Could they fall?? Imagine a US default, where aggregate demand drops across the world because the Treasuries in the banks of other nations are only worth 70% of face value.? Deflation would drive commodities and fringe currencies lower.
Idea three is an echo of two — buy the debts of emerging markets with more orthodox economics than the US, Eurozone, and China.? Nice, but their currencies are high as well.? Same problem as two.
Idea four is buy high quality equities that pay dividends.? There’s a plus and a minus here.? Minus: Equities are highly sensitive to confidence / trends in aggregate demand.? Plus: equities, if conservatively financed have positive optionality, subject to the same problem you have: what is a good store of purchasing power?
Even buying needed resources ahead might not work because demand conditions might be lower going forward.
Idea five is buying high quality non-Treasury domestic debt.? Along with ideas 2, 3 and 4, this seems to be Pimco’s strategy.? But our payments system is interconnected.? Any non-payment, or serious threat of non-payment will disrupt the ability and willingness of others to pay.
Idea six is stay in US Treasury debt — where else can you go?? You’ll get paid back eventually, with interest, most likely…? Hey, TIPS could work in an inflationary scenario.
Idea seven is hold physical US cash.? That should retain value of a sort until the debt ceiling situation is settled.
My main point is that there is nowhere to hide with certainty.? There are places to diversify into, and maybe you should consider some of them as part of a broader asset management strategy.? But avoid changes motivated by panic.? They almost never work.
In a debt-driven world, with fiat currencies, everything is confusing because there is no obvious store of value offering some small (but not near-zero) yield.? A small positive inflation adjusted return is healthy for savers, and good for the economy.? Let the Fed adjust its policy, and then the hiding place would be simple — CDs.
Like gold, cash is special because it doesn’t do anything.? Even money market funds do nothing, or almost nothing.? It just sits there, waiting.? It waits for the day when the Fed is forced to raise rates because inflation is running faster, even though the economy is still underemployed.? It waits for the day when bond yields rise and stock prices fall, where there are good opportunities to use the cash.
Having cash on hand allowed my church to buy a building cheaply in March 2009, and allowed me to help rescue a friends business, as well as buy some cheap stocks.? The same was true for me in October 2002, when I fully deployed my cash into stocks.
Cash is flexibility.
Cash says, “I don’t know.”
Cash says, “I don’t care.”
Cash says, “I’m ready.”
When opportunities are numerous, I am more than willing to part with my cash.? But when yields are low, and valuations are high if profit margins mean-revert, I would rather have more of a cash buffer.
For my account, and client accounts, I did buy some stock last week.? If the weakness had persisted, I would have bought more.
I still have an above average amount of cash (for me).? I am waiting for opportunities to get better before I deploy it.
There are many people out there following aggressive investment strategies, but they want to be covered if things go wrong.? Why not sell down the positions a little and buy some high quality short-to-intermediate-term bonds?
What!?! Give up the upside?!? They would rather buy some insurance — something that will pay off big if things go bad.
But think of the other side of the trade.? What does the one offering you insurance have to do?? It depends if they are scrupulous or unscrupulous.
Scrupulous: Set aside money or high quality assets in reserve, and treat the premiums as part of the the return on a high-yield money market fund, albeit with the possibility of a severe loss.
Unscrupulous: Don’t set anything aside.? Write as many contracts as you can.? It’s free money because there won’t be any crash.? And if there is a crash, declare bankruptcy.? After all, many others will be doing the same thing — you will have company.
Even if the contracts in question are exchange-traded, with margin posted, still the one writing the contracts and taking the risk should be ready to pay the whole wad in the disaster scenario.? Maybe the exchange will make up a few small defaults, but even exchanges can go broke if the situation is severe enough.
In order for tail risk to be mitigated fairly, someone must keep a supply of slack high quality assets.? Rather than the insurer doing that, why not have the investor do so?? The insurer brings along his own cost structure.? Why not self insure and bring down the risk level directly.? Someone has to hold high-quality assets to mitigate risk; let the investor be that party; embracing simplicity and enjoying reduced risk without the possibility of counterparty failure.
Quaint, huh?? And it doesn’t involve a single disgusting derivative, unlike those that would create a “Black Swan” ETF.
Simplistic financial plans assume a smooth return that the client will earn.? Why?? No nefarious reason, but planners don’t know the future, so they either:
1) Assume an average rate as a baseline for calculations, or
2) Display the average, median, or some? percentiles from a series of randomly estimated possible futures.
But life isn’t that way.? Markets are lumpy.? High and low returns happen more frequently than average returns.? What’s worse, returns tend to streak over years and decades.? So much for the Efficient Markets Hypothesis.
So what to do?? Better to be like the great moral philosopher Linus van Pelt, who carried a candle at night, and his sister Lucy asked him why he was doing so.? Linus replied, “It is better to light a single candle than to curse the darkness.”? After Linus left, Lucy mused for a moment, and shouted, “YOU STUPID DARKNESS!”
Volatility is a fact of life, and even the volatility is volatile, with regions of seeming stability, and regions of extreme booms and busts.
My “single candle” is simple — it is an adjustment of expectations, which involves reasoning that when things have been horrible, after some amount of time, it is time to take risk again, before it is perfectly obvious to do so.? Same thing when things are great, it may be time to take risk off the table.? I would add that delay in doing so is not a failure — lumpiness means that trends run further than would be reasonable.? But when the momentum wanes it is time to change.
I’ve been in the situation multiple times, but it is really difficult to get permabulls or permabears to recognize that something has shifted.? I wrote about this a number of times in my series “The Education of a Corporate Bond Manager.”? I was constantly fighting those who were hanging onto the old trend too long.
And at another firm, I could not convince my boss to go long once the nadir of the credit crisis had passed.? He expected more trouble to come, while I looked at the bond market and found an absence of distressed credits.
The lesson of both cases is that opportunities to earn total returns or preserve capital are lumpy.? If the market is longing for safety now, it will likely do so for a while, and the same is true for bull markets.
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Many retirees say “I just need a certain reliable income of X%/year. Please get that for me.”? We may as well tell these people to buy a CD or annuity, except that Fed policy makes the rates inadequate for their needs.? And yes, this is a deliberate policy of the Fed, picking on the elderly and the conservative in order to fund marginal lending that might? result in some tiny increment of growth.
It is far better to ask three questions:
1) Where are we now in the credit risk cycle? Rising, Peak, Falling, or Trough?
2) Where are yields on high-grade corporate bonds now?
3) Can you afford to spread your yield needs over five years?
Bond investors need to realize that most returns of the bond market are earned at three times: first, after the nadir of the credit cycle, credit-sensitive bonds soar.? Second, during deflationary times, buying long-dated Treasuries.? Third, when inflation is running, rolling over short-dated fixed income claims.? Beyond that, one can clip bond coupons during abnormal times of stability.
By asking the above first two questions, we can ascertain whether it is a favorable time to take risk or not, and what sort of risks to take.? The last question is more of a reasonableness check on the client.? If he has to have the return every year without fail, tell him to seek it at a bank or insurer, and see if he is pleased with the results.
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But now take it one step further.? When will our stupid economists and politicians get it through their heads that lumpy economic growth is normal, and even that it is desirable that growth is not smooth?? Effort to produce a smooth economy led to a debt build-up, which ultimately sabotaged growth.? Far better to let small recessions do their work, and leave the Fed funds rate high until marginal investments are repriced, with the attendant bankruptcies.
The US economy grew more rapidly when there were no efforts at stimulus.? Yes, there were severe recessions, but the booms thereafter more than made up for it.? Though it would hurt a lot in the short-run, far better to end the deficits of the US government, and the pitiful efforts of the Fed, giving greater certainty to the private sector, that businessmen could make long-term decisions without worries that taxes, regulations, or interest rates might change dramatically.
Like it or lump it, some say.? Why choose?? Learn to like the lumpiness of the asset markets and the economy in general, and many things will go more easily for you.
Rapid money supply growth with no consumer price inflation can only really occur within the confines of an asset price bubble, or else, where does the money go?? Interest rates are low at such a time because of the incredible liquidity, and complacency of lenders that they will get an equal amount of purchasing power back.? Perhaps another possibility is when a country?s currency is being used more and more as a shadow currency, like the US in the Third World.? But even that will come home someday.
I wrote this sometime prior to 2003.? But can it be more relevant than today, aside from my comment about being a shadow currency?? Alas, the US Dollar is not a store of value anymore.? It is only a unit of exchange, like trading cigarettes in a prison camp.
The Federal Reserve may pretend that it is the guardian of stability, but it is not so with respect to asset values.? The Fed stays within its mandates: labor unemployment and goods price inflation.? Those are not much affected by Fed policy at present.? But asset values are inflated.
What should we expect of monetary policy?? Additional creation of money or credit should affect the prices of something.? If the Fed does not intend on affecting a price somewhere, what is it up to?? The economy is prices.? What is the Fed if it does not affect prices?? Next press conference, ask Ben what set of prices he is trying to affect.? If he mumbles, as he usually does, you can know that he is without knowledge, or lying.? All monetary policy affects prices, and it is either dishonest or stupid to say otherwise.
That’s all for now.? We are in a rough situation because of errors in government and central bank policy, as well as cultural errors that have favored spending over saving.? Ignore the idiots who talk of the paradox of thrift.? They rely on short-term models which are not relevant in the real economy.? Saving is a good thing, but maybe save in currencies that are not subject to government discretion, like gold.
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.
Quibbles
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.
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:
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.
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.
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.
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.)
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.
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.
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.
Preliminaries
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
Momentum
Valuation
Down 4
0.03%
Down 3
0.07%
Down 2
1.87%
Down 1
17.59%
5.93%
Same
61.58%
88.08%
Up 1
16.71%
5.99%
Up 2
2.02%
Up 3
0.07%
Up 4
0.05%
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:
Bonds
Stocks
Strategy
Return
4.67%
8.78%
10.79%
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?
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.
