One of my clients asked me what I think is a hard question: When should I deploy capital? ?I?ll try to answer that here.
There are three?main things to consider in using cash to buy or sell assets:
What is your time horizon? ?When will you likely need the money for spending purposes?
How promising is the asset in question? ?What do you think it might return vs alternatives, including holding cash?
How safe is the asset in question? ?Will it survive to the end of your time horizon under almost all circumstances and at least preserve value while you wait?
Other questions like ?Should I dollar cost average, or invest the lump?? are lesser questions, because what will make the most difference in ultimate returns comes from ?the above three questions. ?Putting it another way, the?results of dollar cost averaging depend on returns after you put in the last dollar of the lump, as does investing the lump sum all at once.
Thinking about price momentum and mean-reversion are also lesser matters, because if your time horizon is a long one, the initial results will have a modest effect on the ultimate results.
Now, if you care about price momentum, you may as well ignore the rest of the piece, and start trading in and out with the waves of the market, assuming you can do it. ?If you care about mean reversion, you can wait in cash until we get ?the mother of all selloffs? and then invest. ?That has its problems as well: what?s a big enough selloff? ?There are a lot of bears waiting for rock bottom valuations, but the promised bargain valuations don?t materialize because others invest at higher prices than you would, and the prices?never get as low as you would like. ?Ask?John Hussman.
Investing has to be done on a ?good enough? basis. ?The optimal return in hindsight is never achieved. ?Thus, at least for value investors like me, we focus on what we can figure out:
How long can I set aside this capital?
Is this a promising investment at a relatively attractive price?
Do I have a margin of safety buying this?
Those are the same questions as the first three, just phrased differently.
Now, I?m not saying that there is never a time to sit on cash, but decisions like that are typically limited to times where valuations are utterly nuts, like 1964-5, 1968, 1972, 1999-2000 ? basically parts of the go-go years and the dot-com bubble. ?Those situations don?t last more than a decade, and are typically much shorter.
Beyond that, if you have the capital to spare, and the opportunity is safe and cheap, then deploy the capital. ?You?ll never get it perfect. ?The price may fall after you buy. ?Those are the breaks. ?If that really bothers you, then maybe?do half?of what you would ultimately do, but set a time limit for investment of the other half. ?Remember, the opposite can happen, and the price could run away from you.
A better idea might show up later. ?If there is enough liquidity,?trade into the new idea.
Since perfection is not achievable, if you have something good enough, I recommend that you execute and deploy the capital. ?Over the long haul, given relative peace, the advantage belongs to the one who is invested.
If you still wonder about this question you can read the following two articles:
There is the temptation when market prices move fast after they have been at recent highs to assume that things are going to fall apart. ?Well, guess what? ?That could happen.
I don’t think it is likely though, if falling apart means a scenario like 2008-9,?2000-2 or 1973-4. ?In order to have a significant drawdown in the market, you have to have a lot of leverage collapse, whether that is financial or operating leverage.
Financial leverage is bad debt. ?We have areas of that — student loans, agricultural loans, a modest amount of subprime lending for autos, and a decent amount of lending to junk-rated corporations, but not enough to create a self-reinforcing situation where bad debts can’t be borne by lenders, and lenders then collapse.
Operating leverage is bad assets — building up too much productive capacity such that there will not be enough demand to absorb it for the foreseeable future. ?Or, building capacity that isn’t productive… either way, assets will have to be written down.
There have been a number of parties kvetching about a lack of investment from US corporations, but let’s take this a different direction. ?There hasn’t been a lot of bad investment from US corporations… and part of that may be due to dividend and buyback policies. ?Yes, there are some IPOs that have come out that look marginal. ?I’ve looked at a variety of spin-offs where the underlying business is attractive, but they loaded the spin-off with a sizable slug of debt in order to pay a final dividend to the parent company saying farewell. ?But on the whole, I don’t see a lot of money being wasted by corporations on investments. ?That is another reason why profit margins are high.
Now, a lot of the furor in the markets stems from China, and the effects that slowing growth and/or bad debts in China will have on the US economy. ?Personally, I don’t think this is an issue to worry about, unless you have a lot of investments in China and other emerging markets. ?In general, US markets don’t get deeply hurt by slowdowns or even crises in other countries. ?Even if it means a slowdown in revenue growth for large US corporations, it would also likely mean that US interest rates might fall, which would often make equities fall less as bonds rally.
Also, for foreign affairs to affect the US in a big way, the US would have to have a lot of lending exposure to those nations that are struggling. ?(Think of the LDC nations in the early ’80s.) ?Maybe this is one of the benefits of running current account?deficits — we don’t have money to lend to foreign countries from our net export earnings.
Think of all the significant foreign crises of the last 30 years. ?LDC crisis, Plaza Accords leading to Japan’s lost decades, Mexico, Asian Crisis, European Union difficulties with their fringe nations, Iceland, Greece, Greece, Greece, China, etc. ?There was always temporary indigestion in US markets, but when did it ever weigh on the US markets for a long period? ?Really, it never did. ?So why are we concerned over China?
Regarding the Fed, I abstract from this old post, which quoted a 2005?piece on Fed policy at RealMoney.com, and what blew up at the end of each tightening cycle. ?I list blow-ups up to that point, and mention that I think US Housing is next:
2000 ? Nasdaq
1997-98 ? Asia/Russia/LTCM, though that was a small move for the Fed
1994 ? Mortgages/Mexico
1989 ? Banks/Commercial Real Estate
1987 ? Stock Market
1984 ? Continental Illinois
Early ?80s ? LDC debt crisis
So it moves in baby steps, wondering if the next straw will break some camel?s back where lending has been going on terms that were too favorable. The odds of this 1/4% move creating such a nonlinear change is small, but not zero.
But on the bright side, the odds of a 50 basis point tightening at any point in the next year are even smaller. The markets can?t afford it.
Some worry now about future Fed policy — what will blow up when the Fed tightens too much? ?I would encourage everyone to relax. ?First, we don’t know that the Fed will do anything soon. ?Second, we don’t know if they will do anything much. ?Third, we don’t even know if the Fed has a coherent theory of monetary policy anymore. ?Face it: Yellen has never tightened rates once. ?Bernanke never tightened rates aside from finishing out Greenspan’s plan to invert the yield curve at the beginning of his Chairmanship. ?Almost no one on the FOMC has any significant practical experience with tightening rates. ?What will guide them out of their zero interest rate policy? ?What will be enough?
Even so, tightening cycles usually end with something blowing up. ?Maybe this time it is the emerging markets. ?I don’t see a large concentration of US-based bad debt that the Fed might inadvertently blow up, at least not yet. ?(Maybe the day will come when the US Treasury might complain about rising financing rates. ?After all, debt is high, but affordable while rates are low.)
Valuation is the main issue as I see it at present, as I commented in my recent piece “Stocks or Bonds?” ?When stocks are priced at a level that discounts 4.5%/year returns over the next 10 years, you don’t have a lot of margin for error, especially when you can create a safer bond portfolio that yields the same.
Now, since I wrote that piece, the S&P 500 is down around 10.5%. ?The bond portfolio is down around 4.5% (it was a risky portfolio, and some of the emerging markets bonds hurt), while the Barclays’ Aggregate is up 1%. ?High-yield bond spreads have widened over that time by ~1.2%.
The anticipated return on the S&P 500 has maybe risen by 1%/year over the next 10 years, to 5.5%. ?That said, so has the yield on the risky bond portfolio. ?I see the selloff as being in-line with the yields of risky debt, which at some higher level of spread, will attract buyers, given that there have been no significant defaults recently.
The US stock market could go down another 20% from here, but I think it will be less. ?My main point is that we shouldn’t get a big washout, but just a correction of valuation levels that got too high relative to other risky assets, like junk bonds.
So don’t panic. ?You could still move some assets from stocks to bonds if you want to sleep better, but don’t do anything severe.
This is a story of triumph and tragedy. ?Jesse Livermore is notable as one of the few people who ever made it into the richest tiers of society by speculating — by trading stocks and commodities — betting on price movements.
This is three stories in one. ?Story one is the clever trader with an intuitive knack who learned to adapt when conditions changed, until the day came when it got too hard. ?Story two is the man who lacked financial risk control, and took big chances, a few of which worked out spectacularly, and a few of ruined him financially. ?Story three is how too much success, if not properly handled, can ruin a man, with lust, greed and pride leading to his death.
The author spends most of his time on story one, next most on story two, then the least on story?three. ?The three stories flow naturally from the narrative that is largely chronological. ?By the end of the book, you see Jesse Livermore — a guy who did amazing things, but?ultimately failed in money and life.
Let me briefly summarize those three aspects of his life so that you can get a feel for what you will run into in the book:
The Clever Trader
Jesse Livermore came to the stock market in Boston at age 14, and was a very quick study. ?He showed intuition on market affairs that impressed the most of the older men who came to trade at the brokerage where he worked. ?It wasn’t too long before he wanted to invest for himself, but he didn’t have enough money to open a brokerage account, so he went to a bucket shop. ?Bucket shops were gambling parlors where small players gambled on stock prices. ?He showed a knack for the game and made a lot of money. ?Like someone who beats the casinos in Vegas, the proprietors forced him to leave.
He then had more than enough money to meet his current needs, and set up a brokerage account. ?But the stock market did not behave like a bucket shop, and so he lost money while he learned to adapt. ?Eventually, he succeeded at speculating on both stocks and commodities, leading to his greatest successes in being short the stock market prior to the panic of 1907, and the crash in 1929. ?During the 1920s, he started his own firm to try to institutionalize his gifts, and it worked for much of the era.
After the crash in 1929, the creation of the SEC and all the associated laws and regulations made speculating a lot more difficult, to the point where he could not make significant money speculating anymore.
The Poor Financial Risk Manager
Amid the successes, he tended to aim for greater wins after his largest successes, which led to him losing much of what he had previously made. ?One time he was cheated out of much of what he had while trading cotton.
Amid all of that, he was well-liked by most he interacted with in a business context. ?Even after great losses, many wanted him to succeed again, and so they bankrolled him after failure. ?Before?the Great Depression, he did not disappoint them — he succeeded in speculation and came roaring back, repaying all of his past debts with interest.
In one sense, it was live by the big speculation, and?die by the big speculation. ?When you play with so much borrowed money, it’s hard for results to not be volatile.
A?Rock Star of His Era
When he won big, he lived big. ?Compared to many wealthy people of his era, he let spending expand far more than many who had ?more reliable sources of income. ?Where did the money go? ?Yachts, homes, staff, wives, women, women, women… ?Aside from the last of his three wives, his marriages were troubled.
His last wife was a nice woman who was independently wealthy, and after Livermore lost?it all in the mid-’30s, he increasingly relied on her to stay afloat. ?When he could no longer be the hero who could win a good living out of the market via speculation, his deflated pride led him to commit suicide in 1940.
A Sad Book Amid Amazing Successes
Sadly, his son and grandson who shared his name committed suicide in 1975 and 2006, respectively. ?On the whole, the story of Jesse Livermore’s?life and legacy is a sad one. ?It should disabuse people of the notion that wealth?brings happiness. ?If anything, it teaches that money that comes too easily tends to get lost easily also.
The author does a good job?weaving the strands of his life into a consistent whole. ?The book is well-written, and probably the best book out there on the life of the famous speculator that so many present speculators admire. ?A side benefit is that in passing, you will learn a lot about the development of the markets during a time when they were less regulated. ?(The volatility of markets was obvious then. ?It not obvious now, which is why people get surprised by it when it explodes.)
Quibbles
None.
Summary / Who Would Benefit from this Book
This is a comprehensive book that explains?the life and times of Jesse Livermore, one of the greatest speculators in history. ?It will teach you history, but it won’t teach you how to speculate. ?If you want to buy it, you can buy it here: Jesse Livermore – Boy Plunger: The Man Who Sold America Short in 1929.
Full disclosure:?I?received a?copy from a kind PR flack.
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.
The following may be controversial. It also may be dull to the point that you might not care. Here’s why you should care: quarterly reporting is a useful and productive use of corporate resources, and it would be a shame to lose it because some people with a patina of intelligence think it is harmful. Who knows? Losing it might even make you poorer.
Influential law firm Wachtell, Lipton, Rosen & Katz has an idea that may be music to the ears of its big corporate clients and a nightmare for some investors and analysts: end quarterly earnings reports.
Wachtell on Tuesday called on the Securities and Exchange Commission to consider allowing U.S. companies to do away with the obligatory updates, one of the most important rituals on Wall Street and in corporate America, suggesting that they distract executives from long-term goals.
The basic case is that quarterly earnings lead companies to behave in a short-term manner, and underinvest for longer-term growth, thus hurting the US economy. ?I disagree. There are at least four?things that are false in the arguments made in the article, and in books like?Saving Capitalism from Short-Termism:
Quarterly earnings don’t produce value in and of themselves
Quarterly earnings cause most corporations to ignore the long-term.
Ending quarterly earnings will end activism, buybacks, and dividends.
Buybacks and dividends are bad uses of capital, and more capital investment, especially for long-dated projects, is necessarily a good thing.
Most of the value of a Corporation on a going concern basis stems from the future earnings of the company.? Investors want to have an estimate of forward earnings so that they can gauge whether the company is growing at an appropriate rate.
Now, it wouldn?t matter if the system were set up by third-party sell side analysts, by buyside analysts, by companies themselves, or by a combination thereof.? The thing is investors are forward-looking, and they want a forward-looking estimate to allow them to estimate whether the companies are doing well with their current earnings or not.
Don’t think of the quarterly earnings in isolation. ?A good or bad quarterly earnings number conveys information not about the current period only, but about all future periods. ?A bad earnings number?lowers the estimates of all future earnings, telling market players that the long-term efforts of the company are not going to be so great. ?Vice-versa for a good number.
Now, in some cases, that might not be true, and the management team will say, “But we still expect our future earnings to reach the levels that we expected before this quarter.” ?That still leaves the problem of getting to the high future earnings, which if missed will lead the market to reprice the stock down.
They might also use a non-GAAP measure of earnings to explain that earnings are not as bad as they might seem. ?In the short-run the market may accept that, but if you do that often enough, eventually the markets factor in the many “one-time” adjustments, and lower the earnings multiple on the stock to reflect the reduced quality of earnings.
In addition, having shorter-term targets causes corporations to not get lazy in managing expenses and capital. ?When the measurement periods get too long, discipline can be lost.
Quarterly Earnings Don’t Cause Most Firms to Neglect the Long-Term
Firms aren’t interested in only the current period’s earnings, but about the entire future path of earnings. ?Even if?the current period’s earnings meet the estimates, the job is not done. ?If there aren’t plans to grow earnings for the next 3-5 years, eventually earnings won’t meet the expectations of investors, and the price of the stock will fall. ?The short-term is just the beginning of the long-term. ?It is not either/or but both/and. ?A company has to try to explain to investors how it is?growing the value of the firm — if present targets aren’t being met, why should there be any confidence that the future will be good?
Think of corporate earnings like a long-term project which has a variety of things that have to be done en route to a significant goal. ?The quarterly earnings measure?whether the progress toward completing the goal is adequate or not. ?Now, the measure is not perfect, but who can think of a better one?
Ending Quarterly Earnings Would Not?End Activism, Buybacks, and Dividends
I can think of an area in business where earnings estimates don’t play a role — private equity. ?Are the owners long-term oriented? Yes. ?Are they short-term oriented? ?Yes. ?Is?capital managed tightly? ?Very tightly. ?All excess capital is dividended back — it as if activists run the firms permanently.
If there were no quarterly earnings in the public equity markets, firms would still be under pressure to return excess capital to shareholders. ?Activists would still analyze companies to see if they are badly managed, and in need of change. ?If anything, when companies would release their earnings less frequently, the adjustments to the market price of the stock would be more severe. ?Companies that disappoint would find the activists arriving regardless of the periodicity of the release of earnings.
On the Use of Excess Capital
Investing, particularly for the long-term, is not risk-free. ?In an environment where there is rapid technological change, like there is today, it is difficult to tell what investments will not be made obsolete. ?In such an environment, it can make a lot of sense to focus on shorter-term?investments that are more certain as to the success of the project. ?It is also a reason why dividends and buybacks are done, as capital returned to shareholders is associated with higher stock prices, because the capital is used more efficiently. ?Companies that shrink their balance sheets tend to outperform those that grow them.
As an example, large acquisitions tend not to benefit shareholders, while small acquisitions that lead to greater organic growth do tend to benefit investors. ?The same is true of large versus small investments for organic growth away from M&A. ?Most management teams can adequately estimate and plan for the growth that stems from incremental action. Large revolutionary investments are another thing. ?There is usually no way to estimate how those will work out, and whether the prospects are reasonable or not.
In one sense, it’s best to leave those kinds of investment projects to highly focused firms that do only that. ?That’s how biotech firms work, and it is why so many of them fail. ?The few winners are astounding.
Or, think about how progressive Japanese firms were viewed to be in the 1980s, as they pursued long-term projects that had very low returns on equity. ?All of that failed, to a first approximation, while the derided American model of shareholder capitalism prospered, as capital was used efficiently on projects with high risk-adjusted?returns, and not wasted on speculative projects with uncertain returns. ?The same will prove true of China over the next 20 years as they choke on all of their bad investments that yield low returns, if indeed the returns are positive.
Remember, bad investments are just expenses in fancy garb — it just takes the accounting longer to recognize the losses. ?Think of Enron if you need an example, which brings up one more point: good investing focuses on accounting quality. ?Accrual items on the asset side of the balance sheets of corporations get higher valuations the shorter the accrual is, and the more likely it is to produce cash. ?Most long term projects tend to be speculative, and as such, drag down the valuation of the stock, because in most cases, it lowers the long-term earnings of the company.
Conclusion
If quarterly earnings are abolished, intelligent corporations won’t change much. ?Investment won’t go up much, and the time horizon of most management teams will not rise much. ?If you need any proof of that, look at how private equity and large mutual insurers manage their firms — they still analyze quarterly results, and are conservative in how they deploy capital.
The only great change of eliminating quarterly earnings will be a loss of quality information for equity investors. ?Bond investors and banks will still require more frequent financial updates, and equity investors may try to find ways to get that data, perhaps through the rating agencies.
Suppose you wanted a comprehensive book on all of the ways that there are to get excess returns from the stock market as a type of value investor (as of year-end 2013), and you wanted it in one slim volume. ?This is that book. ?As with most desires there is the “be careful what you wish for, you just might get it” effect. ?This book is not immune.
At Aleph Blog, I try to write book reviews that always include what sort of reader might benefit from a given book. ?Because this book packs so much into such a small space, it is not a?book for beginners unless they are?prodigies. ?If you are a beginner, better to warm up with something like The Intelligent Investor, by Ben Graham. ?Beginners need time to see concepts described in greater detail, and more slowly.
Though it is a book on value investing, it is expansive in what it considers value investing. ?It includes topics as varied as:
Behavioral Economics
Market-timing from a valuation standpoint
Growth at a reasonable price [GARP] investing
Private investing
Shorting
Event-driven investing
Barriers to considering investments that keep others from buying them at attractive prices
In a book of around 300 pages, this is ambitious. ?It gives you one or two passes over important topics, so you are only getting a taste of the ideas involved. ?This is also predominantly a book on qualitative investing. ?Pure quantitative value investing doesn’t get much play. ?Non-value anomalies don’t get much coverage.
The other?thing the book lacks is a way to pull it all together in a practical way. ?Yes, the last chapter tries to pull it all together, but given the breadth of the material, it gets pulled together in terms of the attitudes you need to do this right, but less of a “how do you structure an overall investment process to put these principles into practical action.” ?Providing more examples could have been useful, and really, the whole book could have benefited from that.
Additional Resources
Now, if you want a greater taste of the book without buying it, I’ve got a deal for you: this is a medium-sized slide presentation that summarizes the book. ?Pretty sweet, huh? ?It represents the book well, so if you are on the fence, I would look at it — after that you would know if you want to buy it.
Full disclosure:?I?received a?copy from the author.
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.
If you want to know what is the core problem of the average person approaching the market (though this applies more to males than females, women have more native caution on average), it is chasing a hot idea. ?This can take a number of forms:
Getting tips from friends who have bought some?stock?that is currently popular in the market.
Doing the same thing with investors who talk or write about investing. ?The best investment advice is not flashy, and does not make for good video.
Looking at charts and buying something that is rising rapidly, because popular media say?this is “The Next Big Thing.”
Buying the mutual fund or other pooled vehicle of some manager who has done very well in the past, and seems to never fail. ?(If you buy a mutual fund, don’t buy one that has had a lot of money pile into it recently… usually a bad sign. ?Spend more time to see if the manager thinks in a businesslike way about assets that he buys.)
Going to a broker who is very well-dressed and confident, and talks really well, but who has no obligation to act in your best interests. ?If you don’t know how he is earning his money from you, avoid him, because it usually means investments with high fees or hidden ways that you can lose, e.g. structured notes that offer a nice yield, but where possibilities to lose are more significant than you think. ?At best, he will give you consensus ideas and managers that deliver him above average remuneration.
Buying the newsletter of some overly confident person who claims to know the secrets of the market, which he will share with you and 100,000 other close friends for a mere $299/year! ?(Please read Mark Hulbert before buying a newsletter.)
Worse yet, giving into the fakery of those who try to bring you into a hidden opportunity. ?It can be a Ponzi scheme, a promoted stock, but they suggest returns that are huge… or, like Madoff, decent but not exorbitant returns that are altogether too regular.
Many of these appeal to our desire to get something for nothing, which is endemic — we all have it to some degree, and marketers play off this regularly by offering us “free” this, and “free” that. ?Earning returns from your investable?assets is a business in its own right, and there are costs to doing it well. ?You should not be surprised that doing well with it will take some time and effort.
You also have to avoid the impulse that there is some hidden knowledge, or group of insiders that have found an easy road to riches. ?The markets aren’t rigged in any material way. ?The principles of investing are well-known, but applying them takes creativity, time and effort. ?There are no significant players with a new theory?who make amazing money investing in secondary markets for stocks and bonds.
Most of the things that I listed above involve low-thought imitation of others. ?There is little advantage in investing to mimicry. ?Even if it worked for someone else, the prices are different now, and easy gains have been made. ?You will do worse than the one you are trying to imitate with virtual certainty, and likely worse than average. ?You need to plan to take an independent course, and learn enough such that if you do choose to use advice of any sort, that you can evaluate it rationally. ?If you choose to do it yourself, you will need to learn more than that. ?It takes effort, but that effort will pay off, if not in investing itself, but there are spillover effects in intelligent management of your finances, and in improving your abilities in the businesses that you serve.
In most areas of life, most things that pay off well take effort. ?If people?present you with easy or hidden ways to make above average money, be skeptical. ?Doing it right takes discipline and effort. ?(If you want the easy route while avoiding all the pitfalls see the postscript. ?It is boring, but it works.)
Postscript
As an aside — you can always index, and beat most average investors over the long haul. ?Buy broad funds that invest in a large fraction of all of the stocks that there are, and those that replicate the bond market as a whole. ?Make sure they have low fees. ?Buy them, hold them, and be done. ?You will still face one hurdle: will you be able to maintain your strategy when everything is in a crisis, or when your friends tell you they are earning a lot more than you, and it is easy to do it? ?Size the bond portion of your assets to the level where you can sleep soundly in all circumstances, and you will be fine.
A few days ago, I was trying to buy a little bit of a defense company that I own for myself and clients. ?It was relatively inexpensive, and had fallen out of favor. ?Now, it’s not the most liquid beastie on the US market, so I put in an order to buy 2000 shares, while showing 100 shares, offering to buy at the current bid of $25.50 while allowing purchases at up to $25.57, while the ask was at $25.65. ?I then shifted away from my trading application, and went to do other work.
After an hour, I went back to my trading screen, and saw that 1200 shares had executed between $25.50 and 25.57, but now the price was much higher, and by the end of the day, higher still. ?It is even higher now.
At the time, I took a look, and lo and behold: I got the bottom tick — the lowest price on that stock ever (for now). ?I also noted that I had almost all of the volume when it went down to the low price. ?But 1200 shares is small compared to the total trading in the name, and $30,000 is also a small amount of money. ?I concluded that it was a happy accident that I got the bottom tick.
I’ve had the same experience working at a hedge fund. ?I would occasionally get the bottom tick when buying, or the top tick when selling, and most of the time I ended up saying that it had to happen to someone — it was us that day. ?That said, the total amount of volume was almost always low near the top or bottom, so getting that versus a trade nearby was not worth that much.
To have a lot of volume near a top or bottom, you need two or more determined and anxious traders with large capacity to trade, a need for speed, and opposite opinions. ?That happens sometimes, but in experience, not that often. ?Near a peak, you would need a buyer anxious to buy a lot more NOW. ?Near a trough, a seller wanting to sell it all NOW.
Most of the time, large institutional investors are cautious, and try to minimize their impact on market prices — being too aggressive will likely give them a worse result than being patient. ?The exception would be someone who thinks he knows a lot more than the market, but feels that edge will erode soon, and therefore has to do the trade in full NOW.
That doesn’t happen often. ?Practically, that means to not be so picky about levels in buying and selling. ?If you are getting the trade off and there is decent volume at a price near where you want to do the trade, do the trade, and don’t worry much about the small amount of profit that you might be giving up. ?Better to focus on ideas that you think have long term potential for profit, than to waste time trying to squeeze the last bit of profit out of a trade where incremental returns will be minuscule.
I’m not going to argue for any particular strategy here. My main point is this: every valid strategy is going to have some periods of underperformance. ?Don’t give up on your strategy because of that; you are likely to give up near?the point of maximum pain, and miss the great returns in the?bull phase of the strategy.
Here?are three?simple bits of advice that I hand out to average people regarding asset allocation:
Figure out what the maximum loss is that you are willing to take in a year, and then size your allocation to risky assets such that the likelihood of exceeding that loss level is remote.
If you have any doubts on bit of advice #1, reduce the amount of risky assets a bit more. ?You’d be surprised how little you give up in performance from doing so. ?The loss from not allocating to risky assets that return better on average is partly mitigated by a bigger payoff from rebalancing from risky assets to safe, and back again.
Use additional money slated for investing?to rebalance the portfolio. ?Feed your losers.
The first rule is most important, because the most important thing here is avoiding panic, leading to selling risky assets when prices are depressed. ?That is the number one cause of underperformance for average investors. ?The second rule is important, because it is better to earn less and be able to avoid panic than to risk losing your nerve. ?Rule three just makes it easier to maintain your portfolio; it may not be applicable if you follow a momentum strategy.
Now, about momentum strategies — if you’re going to pursue strategies where you are always buying the assets that are presently behaving strong, well, keep doing it. ?Don’t give up during the periods where it doesn’t seem to work, or when it occasionally blows up. ?The best time for any strategy typically come after a lot of marginal players give up because losses exceed their pain point.
That brings me back to rule #1 above — even for a momentum strategy, maybe it would be nice to have some safe assets?on the side to turn down the total level of risk. ?It would also give you some money to toss into the strategy after the bad times.
If you want to try a new strategy, consider doing it when your present strategy has been doing well for a while, and you see new players entering the strategy who think it is magic. ?No strategy is magic; none work all the time. ?But if you “harvest” your strategy when it is mature, that would be the time to do it. ?It would be similar to a bond manager reducing exposure to risky bonds when the additional yield over safe bonds is thin, and waiting for a better opportunity to take risk.
But if you do things like that, be disciplined in how you do it. ?I’ve seen people violate their strategies, and reinvest in the hot asset when the bull phase lasts too long, just in time for the cycle to turn. ?Greed got the better of them.
Markets are perverse. ?They deliver surprises to all, and you can be prepared to react to volatility by having some safe assets to tone things down, or, you can roll with the volatility fully invested and hopefully not panic. ?When too many unprepared people are fully invested in risky assets, there’s a nasty tendency for the market to have a significant decline. ?Similarly, when people swear off investing in risky assets, markets tend to perform really well.
It all looks like a conspiracy, and so you get a variety of wags in comment streams alleging that the markets are rigged. ?The markets aren’t rigged. ?If you are a soldier heading off for war, you have to mentally prepare for it. ?The same applies to investors, because investing isn’t perfectly easy, but a lot of players say that it is easy.
We can make investing easier by restricting the choices that you have to make to a few key ones. ?Index funds. ?Allocation funds that use index funds that give people a single fund to buy that are?continually rebalanced. ?But you would still have to exercise discipline to avoid fear and greed — and thus my three example rules above.
If you need more confirmation on this, re-read my articles on dollar-weighted returns versus time-weighted returns. ?Most trading that average people do loses money versus buying and holding. ?As a result, the best thing to do with any strategy is to structure it so that you never take actions out of a sense of regret for past performance.
That’s easy to say, but hard to do. ?I’m subject to the same difficulties that everyone else is, but I worked to create rules to limit my behavior during times of investment pain.
Your personality, your strategy may differ from mine, but the successful meta-strategy is that you should be disciplined in your investing, and not give into greed or panic. ?Pursue that, whether you invest like me or not.
One of the constants in investing is that average investors show up late to the party or to the crisis. ?Unlike many gatherings where it may be cool to be fashionably late, in investing it tends to mean you earn less and lose more, which is definitely not cool.
One reason why this happens is that information gets distributed in lumps. ?We don’t notice things in real time, partly because we’re not paying attention to the small changes that are happening. ?But after enough time passes, a few people notice a trend. ?After a while longer, still more people notice the trend, and it might get mentioned in some special purpose publications, blogs, etc. ?More time elapses and it becomes a topic of conversation, and articles make it into the broad financial press. ?The final phase is when?general interest magazines put it onto the cover, and get rich quick articles and books point at how great fortunes have been made, and you can do it too!
That slow dissemination and?gathering of information is paralleled by a similar flow of money, and just as the audience gets wider, the flow of money gets bigger. ?As the flow of money in or out gets bigger, prices tend to overshoot fair value, leaving those who arrived last with subpar returns.
There is another aspect to this, and that stems from the way that people commonly evaluate managers. ?We use past returns as a prologue to what is assumed to be still?greater returns in the future. ?This not only applies to retail investors but also many institutional investors. ?Somme institutional investors will balk at this conclusion, but my experience in talking with institutional investors has been that though they look at many of the right forward looking indicators of manager quality, almost none of them will hire a manager that has the right people, process, etc., and has below average returns relative to peers or indexes. ?(This also happens with hedge funds… there is nothing special in fund analysis there.)
For the retail crowd it is worse, because?most investors look at past returns when evaluating managers. ?Much as Morningstar is trying to do the right thing, and have forward looking analyst ratings (gold, silver, bronze, neutral and negative), yet much of the investing public will not touch a fund unless it has four or five stars from Morningstar, which is a backward looking rating. ?This not only applies to individuals, but also committees that choose funds for defined contribution plans. ?If they don’t choose the funds with four or five stars, they get complaints, or participants don’t use the funds.
Another Exercise in Dollar-Weighted Returns
One of the ways this investing shortfall gets expressed is looking at the difference between time-weighted (buy-and-hold) and dollar-weighted (weighted geometric average/IRR) returns. ?The first reveals what an investor who bought and held from the beginning earned, versus what the average dollar invested earned. ?Since money tends to come after good returns have been achieved, and money tends to leave after bad returns have been realized, the time-weighted returns are typically higher then the dollar-weighted returns. ?Generally, the more volatile the performance of the investment vehicle the larger the difference between time- and dollar-weighted returns gets. ?The greed and fear cycle is bigger when there is more volatility, and people buy and sell at the wrong times to a greater degree.
(An aside: much as some pooh-pooh buy-and-hold investing, it generally beats those who trade. ?There may be intelligent ways to trade, but they are always a minority among market actors.)
HSGFX Dollar and Time Weighted Returns
That brings me to tonight’s fund for analysis: Hussman Strategic Growth [HSGFX]. John Hussman, a very bright guy, has been trying to do something very difficult — time the markets. ?The results started out promising, attracting assets in the process, and then didn’t do so well, and assets have slowly left. ?For my calculation this evening, I run the calculation on his fund with the longest track record from inception to 30 June 2014. ?The fund’s fiscal years end on June 30th, and so I assume cash flows occur at mid-year as a simplifying assumption. ?At the end of the scenario, 30 June 2014, I assume that all of the funds remaining get paid out.
To run this calculation, I do what I have always done, gone to the SEC EDGAR website and look at the annual reports, particularly the section called “Statements of Changes in Net Assets.” ?The cash flow for each fiscal year is equal to the?net increase in net assets from capital share transactions plus the net decrease in net assets from distributions to shareholders. ?Once I have?the amount of money moving in or out of the fund in each fiscal year, I can then run an internal rate of return calculation to get the dollar-weighted rate of return.
In my table, the cash flows into/(out of) the fund are in millions of dollars, and the column titled Accumulated PV is the?accumulated present value calculated at an annualized rate of -2.56% per year, which is the dollar-weighted rate of return. ?The zero figure at the top shows that a discount rate -2.56% makes the cash inflows and outflows net to zero.
From the beginning of the Annual Report for the fiscal year ended in June 2014, they helpfully provide the buy-and-hold return since inception, which was +3.68%. ?That gives a difference of 6.24% of how much average investors earned less than the buy-and-hold investors. ?This is not meant to be a criticism of Hussman’s performance or methods, but simply a demonstration that a lot of people invested money after the fund’s good years, and then removed money after years of underperformance. ?They timed their investment in a market-timing fund poorly.
Now, Hussman’s fund may do better when the boom/bust cycle turns if his system makes the right move?somewhere near the bottom of the cycle. ?That didn’t happen in 2009, and thus the present state of affairs. ?I am reluctant to criticize, though, because I tried running a strategy like this for some of my own clients and did not do well at it. ?But when I realized that I did not have the personal ability/willingness to?buy when valuations were high even though the model said to do so because of momentum, rather than compound an error, I shut down the product, and refunded some fees.
One thing I can say with reasonable confidence, though: the low returns of the past by themselves are not a reason to not invest in Mr. Hussman’s funds. ?Past returns by themselves tell you almost nothing about future returns. ?The hard questions with a fund like this are: when will the cycle turn from bullish to bearish? ?(So that you can decide how long you are willing to sit on the sidelines), and when the cycle turns from bearish to bullish, will Mr. Hussman make the right decision then?
Those questions are impossible to answer with any precision, but at least those are the right questions to ask. ?What, you’d rather have the answer to a simple question like how did it return?in the past, that has no bearing on how the fund will do in the future? ?Sadly, that is the answer that propels more investment decisions than any other, and it is what leads to bad overall investment returns on average.
PS — In future articles in this irregular series, I will apply this to the Financial Sector Spider [XLF], and perhaps some fund of Kenneth Heebner’s. ?Till then.
Liquidity is positively influenced by the quality of an?asset
Liquidity is positively influenced by the simplicity of an?asset
Liquidity is negatively influenced by the price momentum?of an?asset
Liquidity is negatively influenced by the level of fear (or overall market price volatility)
Liquidity is negatively influenced by the length of an asset’s cash flow stream
Liquidity is negatively influenced by concentration of the holders of an asset
Liquidity is negatively influenced by the length of the?time horizon?of the holders of an asset
Liquidity is positively influenced by the amount of information available about an asset, but negatively affected by changes in the information about an asset
Liquidity is negatively influenced by the level of indebtedness of owners and potential buyers of an asset
Liquidity is negatively influenced by similarity of trading strategies?of owners and potential buyers of an asset
Presently, we have a lot of commentary about how the bond market is supposedly illiquid. ?One particular example is the so-called flash crash in the Treasury market that took place on October 15th, 2014. ?Question: does a moment of illiquidity imply that the US Treasury market is somehow illiquid? ?My answer is no. ?Treasuries are high quality assets that are simple. ?So why did the market become illiquid for a few minutes?
One reason is that the base of holders and buyers is more concentrated. ?Part of this is the Fed holding large amounts of virtually every issue of US Treasury debt from their QE strategy. ?Another part is increasing concentration on the buyside. ?Concentration among banks, asset managers, and insurance companies has risen over the last decade. ?Exchange-traded products have further added to concentration.
Other factors include that ten-year Treasuries are long assets. ?The option of holding to maturity means you will have to wait longer than most can wait, and most institutional investors don’t even have an average 10-year holding period. ?Also, presumably, at least for a short period of time, investors had similar strategies for trading ten-year Treasuries.
So, when the market had a large influx of buyers, aided by computer algorithms,?the prices of the bonds rose rapidly. ?When prices do move rapidly, those that make their money off of brokering trades take some quick losses, and back away. ?They may still technically be willing to buy or sell, but the transaction sizes drop and the bid/ask spread widens. ?This is true regardless of the market that is panicking. ?It takes a while for market players to catch up with a fast market. ?Who wants to catch a falling (or rising) knife? ?Given the interconnectedness of many fixed income markets who could be certain who was driving the move, and when the buyers would be sated?
For the crisis to end, real money sellers had to show up and sell ten-year Treasuries, and sit on cash. ?Stuff the buyers full until they can’t bear to buy any more. ?The real money sellers had to have a longer time horizon, and say “We know that over the next ten years, we will be easily able to beat a sub-2% return, and we can live with the mark-to-market risk.” ?So, though they sold, they were likely expressing a long term view that interest rates have some logical minimum level.
Once the market started moving the other way, it moved back quickly. ?If anything, traders learning there was no significant new information were willing to sell all the way to levels near the market opening levels. ?Post-crisis, things returned to “normal.”
My Conclusion
I wouldn’t make all that much out of this incident. ?Complex markets can occasionally burp. ?That is another aspect of a normal market, because it teaches investors not to be complacent.
Don’t leave the computer untended.
Don’t use market orders, particularly on large trades.
Be sure you will be happy getting executed on your limit order, even if the market blows far past that.
Graspy regulators and politicians see incidents like this as an opportunity for more regulations. ? That’s not needed. ?It wasn’t needed in October 1987, nor in May 2009. ?It is not needed now.
Losses from errors are a great teacher. ?I’ve suffered my own losses on misplaced market orders and learned from them. ?Instability in markets is a good thing, even if a lot of price movement is just due to “noise traders.”
As for the Treasury market — the yield on the securities will always serve as an aid to mean-reversion, and if there is no fundamental change, it will happen quickly. ?There was no liquidity problem on October 15th. ?There was a problem of a few players mistrading a fast market with no significant news. ?By its nature, for a brief amount of time, that will look illiquid. ?But it is proper?for those conditions, and gave way to a normal market, with normal liquidity rapidly.
That’s market resilience in the face of some foolish market players. ?That the foolish players took losses was a good thing. ?Fundamentals always take over, and businesslike investors profit then. ?What could be better?
