Financial markets are trendy and?noisy in the short-run, sensible in the long-run, and perverse in the intermediate-term.

What do I mean?

Something like this:?short-run movements are news-driven, and driven by people trying to catch up with the latest data. ?Many people imitate the behavior of others, and over the intermediate-term, some stock prices get out of whack. ?Some subset of industries, factors, and/or companies gets out of alignment, and are mispriced. ?In the long run, those pricing errors get corrected, but it takes years to get there.

Here’s an example. to make this tangible and understandable. ?As a factor, value has been bad for eight years or so, and as evidence I quote?Rob Arnott, from his article entitled, ?How Can ?Smart Beta? Go Horribly Wrong??

The value effect was first identified in the late 1970s, notably by Basu (1977), in the aftermath of the Nifty Fifty bubble, a period when value stocks were becoming increasingly expensive, priced at an ever-skinnier discount relative to growth stocks. More recently, for the past eight years, value investing has been a disaster with the Russell 1000 Value Index underperforming the S&P 500 by 1.6% a year, and the Fama?French value factor in large-cap stocks returning ?4.8% annually over the same period. But, the value effect is far from dead! In fact, it?s in its cheapest decile in history.

And then later he says:

How many practitioners who rely on the value factor take the time to gauge whether the factor is expensive or cheap relative to historical norms? If they took the time to do so today, they would find value is currently cheaper than at any time other than the height of the Nifty Fifty (1972?73), the tech bubble (1998?2003), and the global financial crisis (2008?09).

The underlining is mine, to give emphasis. Now I would like to quote from a very old article of mine, The Fundamentals of Market Tops that was originally published at RealMoney.com back in 2004:

You?ll know a market top is probably coming when:

a) The shorts already have been killed. You don?t hear about them anymore. There is general embarrassment over investments in short-only funds.

b) Long-only managers are getting butchered for conservatism. In early 2000, we saw many eminent value investors give up around the same time. Julian Robertson, George Vanderheiden, Robert Sanborn, Gary Brinson and Stanley Druckenmiller all stepped down shortly before the market top.

Point (b) is what I want to highlight? not that we have had many value managers forced into retirement recently, but value funds of all kinds have been losing clients. It?s like being fired fractionally, a sliver at a time, but it adds up to a lot.

Combine that with Arnott?s insight that the valuations of value stocks are at exceptionally low levels ? this gives me some hope that we are in the seventh inning or later in this market cycle regarding value investing.

Going Back a Step

Value isn’t the only cheap area presently — European stocks and emerging market stocks look cheap as well. ?When areas of the market with bad relative performance have a lot of people giving up on them to pursue recently successful strategies, that?helps to put in the bottom on the underperformers, and the top on the outperformers.

You can’t tell exactly when the process will end, but those jumping from one strategy to another, chasing performance, will just add a new set of losses to the old ones. ?The trick is to try to anticipate when the cycle will turn for a given market strategy, factor or industry. ?No one can do it perfectly, but it makes sense to act when relative valuations are in your favor.

Minimally, those that stick with a valid strategy through thick and thin can benefit from the strategy over the long-term… and that takes some courage, because there are times when your strategy will be out of favor. ?That’s what I do with value investing.

Maximally, you would sell a?strategy that you were invested in that was topping out in relative terms to buy a strategy?that has been trashed for a while, and might be ready to outperform. ?That’s even more difficult than sticking with one strategy through thick and thin. ?Everyone wants to buy a past winner, and nobody wants to buy a past loser. but that is what would offer large returns if the timing could be right. ?Another way of phrasing it, is to always look half a cycle ahead, to where a strategy will be when the excesses correct, or as is more likely, overcorrect, and take the appropriate action now.

Doing that is beyond me. ?I’m just grateful that the period of relative underperformance of value may be nearing its end.

At Abnormal Returns, over the weekend, Tadas Viskanta featured a free article from Credit Suisse called the?Credit Suisse Global Investment Returns Yearbook 2015. ?It featured articles on whether the returns on industries as a whole mean-revert or have momentum, whether there is a valuation effect on industry returns, “social responsibility” in investing, and the existence of equity discount rate for the market as a whole.

There are no surprises in the articles — it is all “dog bites man.” ?They find that:

• Industry returns exhibit momentum
• There is a valuation component in industry returns
• Socially responsible investing doesn’t necessarily produce or miss excess returns
• There is an overall equity discount rate, which is levered about 20-25 times, i.e., a 1% increase in the rate lowers valuations by 20-25%.

The first two are well-known for individual stocks, so it isn’t surprising that it happens at the industry level. ?The third one has been written about ad nauseam, with many conflicting opinions, so that there is little effect is no big surprise. ?The last one resembles research I saw in the mid-90s, where the effect of changes in real interest rates has about that impact on stocks. ?Again, nothing new — which is as it should be.

But now some more on industry returns. ?They found that industry return momentum was significant. ?Industries that did well one year were likely to do well in the next year. ?The second finding was that industries with cheap valuations also tended to do well, but it was a smaller effect.

So, using one-year price returns as my momentum variable and book-to-market as a valuation variable (both suggested in the article), I divided industries for companies trading in the US into quintiles (also suggested in the article) for momentum and valuation. ?(Each quintile has roughly 20% of the total market cap.) ?Here is the result:

Low valuations are at the right, high at the left. ?Low momentum at the top, high momentum at the bottom. ?Ideally by this method, you would look for industries in the southeast corner.

To me, Agriculture, Information Technology, Security, Waste, Some Retail, and Some Transportation look interesting. ?One in the far southeast that is not so interesting for me is P&C Insurance. ?Yes, it has done well, and compared to other industries, it is cheap. ?But industry surplus has grown significantly, leading to more competition, and sagging premium rates. ?Probably not a great time to make new commitments there.

Anyway, the above table should print out nicely on two sheets of letter-sized paper. ?Not that it would be a substitute for your own due diligence, but perhaps it could start a few ideas going. ?All for now.

As part of a continuing quest to turn up stock ideas in the midst of a market hitting new highs, I wanted to trot out a less commonly used statistic called “range.” ?Range is the distance that a company’s stock price is between its 52-week low and 52-week high. ?0% means the current price is at the 52-week low, and 100% means?the current price is at the 52-week ?high. ?So far, simple, right? ?How might industries look if their weighted average range statistics were calculated, weighted by market cap?

The top zone, which is shaded light red, are industries that are above the median?range statistic in the market which is around 78.5% (average is around 72.2%). ?The industries shaded yellow represent industries where the stocks are closer to their 52-week high than their 52-week low, but are have average range statistics lower than the median of the market. ?Finally, the industries shaded green, what few there are, their current prices are closer to their 52-week low on average.

Personally, I would be inclined to look through the industries toward the bottom of the list, looking for misunderstood companies that have good potential of future outperformance. ?That said, someone thinking that this rally would have a long way to go would be incented to look for companies at the top of the list who have trends that are underdiscounted.

As it is, this is where the industries are priced in terms of the past 52 weeks. ?You could?look at the industries with the view of finding things that are out of place, and prices could shift in the future to reflect it.

If nothing else, this is food for thought. ?Technology, Utilities and Healthcare look strong. ?Basic materials, Capital Goods, and Consumer Durables look weaker.

All for now. ?Be careful.

My main industry model is illustrated in the graphic. Green industries are cold. Red industries are hot. If you like to play momentum, look at the red zone, and ask the question, ?Where are trends under-discounted?? Price momentum tends to persist, but look for areas where it might be even better in the near term.

If you are a value player, look at the green zone, and ask where trends are over-discounted. Yes, things are bad, but are they all that bad? Perhaps the is room for mean reversion.

My candidates from both categories are in the column labeled ?Dig through.?

You might notice that I have no industries from the red zone. That is because the market is so high. I only want to play in cold industries. They won?t get so badly hit in a decline, and they might have some positive surprises.

If you use any of this, choose what you use off of your own trading style. If you trade frequently, stay in the red zone. Trading infrequently, play in the green zone ? don?t look for momentum, look for mean reversion. I generally play in the green zone because I hold stocks for 3 years on average.

Whatever you do, be consistent in your methods regarding momentum/mean-reversion, and only change methods if your current method is working well.

Huh? Why change if things are working well? I?m not saying to change if things are working well. I?m saying don?t change if things are working badly. Price momentum and mean-reversion are cyclical, and we tend to make changes at the worst possible moments, just before the pattern changes. Maximum pain drives changes for most people, which is why average investors don?t make much money.

Maximum pleasure when things are going right leaves investors fat, dumb, and happy ? no one thinks of changing then. This is why a disciplined approach that forces changes on a portfolio is useful, as I do 3-4 times a year. It forces me to be bloodless and sell stocks with less potential for those with more potential over the next 1-5 years.

I like some technology stocks here, some industrials, some healthcare and consumer stocks, particularly those that are strongly capitalized.

I?m looking for undervalued industries. I?m not saying that there is always a bull market out there, and I will find it for you. But there are places that are relatively better, and I have done relatively well in finding them.

At present, I am trying to be defensive. I don?t have a lot of faith in the market as a whole, so I am biased toward the green zone, looking for mean-reversion, rather than momentum persisting. The red zone is pretty cyclical at present. I will be very happy hanging out in dull stocks for a while.

That said, some dull companies are fetching some pricey valuations these days, particularly those with above average dividends. This is an overbought area of the market, and it is just a matter of time before the flight to relative safety reverses.

The Red Zone has a Lot of utilities and other dividend-paying industries; as I said, be wary. ?What I find fascinating about the red momentum zone now, is that it is loaded with cyclical companies.

In the green zone, I picked almost all of the industries. If the companies are sufficiently well-capitalized, and the valuation is low, it can still be an rewarding place to do due diligence.

Will cyclical companies continue to do well? Will the economy continue to limp along, or might it be better or worse?

But what would the stock screening model suggest that I have displayed the last few times I have done this post?

Wish I could tell you. ?In an “upgrade” Value Line’s stock screener can’t do the Value Line subscription that it used to, because its 3-5 Year Projected Annual Total Return field is blank for the screening software.

Maybe next time, but until then, play it conservative in your industry and stock selections — look for companies that can easily survive if industry conditions worsen. ?Once weaker players are marginalized, they will do well.

I received a survey in the mail on Trading/Investing. ?I felt that if I was going to answer it, I may as well do it for my readers. ?Here goes:

1) How long have you been trading?

I’ve been investing for my own account for 25 years. ?During that time, I’ve done a lot of different things:

• Played around with closed-end funds, and shorted overvalued companies 1989-1993
• Value investing for myself 1993-98, with a lot of microcap value thrown in. ?(Weird stuff, and very illiquid.)
• Created multiple manager funds for group pension business 1995-1998 — got to interview many of the best managers at that time.
• Set investment policies for a some major life insurers 1993-2003
• For major life insurers — Mortgage bond manager 1998-2001, Corporate bond manager 2001-2003, Investment risk manager 1993-2003.
• Small deal arbitrage for myself 1998-2000
• Settled on my current value investing strategy, as expressed by my eight rules 2000-2014
• Buy side analyst for a financials only hedge fund 2003-2007. ?Managed the firm’s profit sharing and endowment monies using my value investing strategy.
• Started my RIA in 2011, to offer clients my value strategy — they get a clone of what I own in my value strategy. ?I am my largest client, and I eat my own cooking.

2) What style of trading / investing do you practice (technically driven, fundamental, systematic, a combination etc)?

Mostly fundamental. ?Most of my trading is governed by these rules:

Rebalance the portfolio whenever a stock gets more than 20% away from its target weight. Run a largely equal-weighted portfolio because it is genuinely difficult to tell what idea is the best. Keep about 30-40 names for diversification purposes.

I tend to resist momentum in the intermediate term. ?From my era of hiring managers, those that used this technique said it added 1-3% to performance. ?I think that’s about right.

Make changes to the portfolio 3-4 times per year. Evaluate the replacement candidates as a group against the current portfolio. New additions must be better than the median idea currently in the portfolio. Companies leaving the portfolio must be below the median idea currently in the portfolio.

I limit changes to the portfolio, because it takes time for investment ideas to play out. ?I turn over the portfolio at a ~30% rate. ?I try to be as businesslike as possible when I sell a?company and buy another. ?Investors can be very good at evaluating whether a company or group of companies, is better than another company or group of companies. ?What is harder is asking, “Would I rather hold cash than this company?”

3) How do you feel when a trade goes against you?

Good. ?I get to buy a little more at a lower price, after I check my investment thesis, which if it does not check out, I sell the whole thing. ?For the few trades that do badly for a long time — 20 of them over the last 25 years, of course it hurts, but the gains far outweigh the losses, so I ignore those, except to memorialize why the failure happened, and feed that back into my investing processes. ?Every time I have lost badly, it was because I violated at least one of my rules.

4) How do you feel when a trade goes for you?

I like it, but I let my rules govern my trading. ?Everything is done by rules; there is almost no discretion in my trading.

5) How have these feelings changed over your trading career? ?(Can you recall how you originally used to feel and elaborate on how this has changed over time?)

When I was 20-25 years younger, every move in the markets would make me excited. ?By the mid-90s, I got my emotions under control. ?I learned to focus on eliminating risk on the front end, so that I would have fewer problems on the back end.

6) Do you have any practices that you do away from the trading screen to help you mentally and emotionally handle trading??(e.g. meditation, yoga, running, Tai Chi, kicking the dog, hitting the bottle etc)

I pray to Jesus Christ every day, but that is not a means to handle trading. ?I ask Him to guide?my decisions, and that I would do my investing to glorify Him.

Because I use my rules, there is little, if any, stress over trading. ?My processes are designed to take my emotion out of my infrequent buying and selling.

7) Have you always done this??

I’ve done this for the last 14 years. ?Prior to that, I was experimenting and developing my methods.

My time managing bond assets for life insurers taught me a lot about trading 1998-2003. ?I traded over $10 Billion in bonds over that short window of time. ?I was far more active as a bond manager, because it was simpler to ascertain when value-enhancing trades could be done. ?That fed into my value investing processes, which are designed to mimic the way a bond trader would look at stocks.

8) If not, how have you learnt to deal with the feelings that come up when trading?

Look, first, it’s only money. ?If you don’t take some significant losses during your life, you probably aren’t taking enough risk.

Second, investing takes time. ?I hold my positions three years on average, and the longest positions have been there for 5-10 years. ?A tree in my backyard won’t grow any faster if I worry about it. ?The same is true of my stocks. ?I review them quarterly. ?Between those times, I try to muffle the nose, aside from rebalancing trades which resist the market.

9) Can you describe a time in your trading life which really rammed home the point that so much of trading comes down to psychological factors?

As a value investor, I don’t worry much about trading. ?In 2000 & 2008, I did detailed studies of my trading. ?In 2000, I found that many of my best trades stemmed from getting the industry right. ?In 2008, I found that my top 11 gains paid for all of my losses, 2000-2008. ?That was with a 70/30 win/loss ratio, and 180-190 stocks held over the period.

10) If you could give aspiring traders one piece of advice about emotionally handling the market what would it be?

If we are talking traders, it would be this: start out each morning looking at the disasters of the day, and then wait for volume to climax, and price to nadir. ?Wait about 5-10?minutes, and then buy. ?Close out the trade within a week, maybe at the end of that day.

That said, I would encourage traders become investors. ?There is too much competition at the short time horizons of the market, and not so much over 3+ year periods. ?Study the greats: Graham, Buffett, Munger, Klarman, Price, Heine, Neff, Soros, Dalio, and many others. ?Learn to recognize long-term value, and wait for it to be realized. ?There are no barriers of entry to trading. ?Long-term value investing has natural barriers to entry, because it is work, and as such, few do it.

I don’t worry about my stock portfolio. ?Because my time horizon is long, day-to-day fluctuations don’t mean much. ?That makes me free to research ideas that can benefit me and my investors in the future. ?That’s a great place to be.

Closing

“Richard Chignell of Embrace The Trend asked me to take part in his Pro’s Process series.? Here are the first couple of answers and for the whole thing please read it here: www.embracethetrend.com“.