Category: Portfolio Management

Perceived Versus Real Risk Tolerance

Perceived Versus Real Risk Tolerance

Posted on by David Merkel
Picture Credit: Denise Krebs || What RFK said is not applicable to investing. ?Safety First! ?Don’t lose money!

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Investment entities, both people and institutions, often say one thing and mean another with respect to risk. ?They can keep a straight face with respect to minor market gyrations. ?But major market changes leading to the possible or actual questioning of whether they will have enough money to meet stated goals is what really matters to them.

There are six factors that go into any true risk analysis (I will handle them in order):

  1. Net Wealth Relative to Liabilities
  2. Time
  3. Liquidity
  4. Flexibility
  5. Investment-specific Factors
  6. Character of the Entity’s Decision-makers and their Incentives

Net Wealth Relative to Liabilities

The larger the surplus of assets over liabilities, the more relaxed and long-term focused an entity can be. ?For the individual, that attempts to measure the amount needed to meet future obligations where future investment earnings are calculated at a conservative level — my initial rule of thumb is no more than 1% above the 10-year Treasury yield.

That said, for entities with well defined liabilities, like a defined benefit pension plan, a bank, or an insurance company, using 1% above the yield curve should be a maximum for investment earnings, even for existing fixed income assets. ?Risk premiums will get taken into net wealth as they are earned. ?They should not be planned as if they are guaranteed to occur.

Time

The longer it is before payments need to be made, the more aggressive the investment posture can be. ?Now, that can swing two ways — with a larger surplus, or more time before payments need to be made, there is more freedom to tactically overweight or underweight?risky assets versus your normal investment posture.

That means that someone like Buffett is almost unconstrained, aside from paying off insurance claims and indebtedness. ?Not so for most investment entities, which often learn that their estimates of when they need the money are overestimates, and in a crisis, may need liquidity sooner than they ever thought.

Liquidity

High quality assets that can easily be turned into spendable cash helps make net wealth more secure. ?Unexpected cash outflows happen, and how do you meet those needs, particularly in a crisis? ?If you’ve got more than enough cash-like assets, the rest of the portfolio can be more aggressive. ?Remember, Buffett view cash as an option, because of what he can buy with it during a crisis. ?The question is whether the low returns from holding cash will get more than compensated for by capital gains and income on the rest of the portfolio across a full market cycle. ?Do the opportunistic purchases get made when the crisis comes? ?Do they pay off?

Also, if net new assets are coming in, aggressiveness can increase somewhat, but it matters whether the assets have promises attached to them, or are additional surplus. ?The former money must be invested coservatively, while surplus can be invested aggressively.

Flexibility

Some liabilities, or spending needs, can be deferred, at some level of cost or discomfort. ?As an example, if retirement assets are not sufficient, then maybe discretionary expenses can be reduced. ?Dreams often have to give way to reality.

Even in corporate situations, some payments can be stretched out with some increase in the cost of financing. ?One has to be careful here, because the time you are forced to conserve liquidity is often the same time that everyone else must do it as well, which means the cost of doing so could be high. ?That said, projects can be put on hold, realizing that growth will suffer; this can be a “choose your poison” type of situation, because it might cause the stock price to fall, with unpredictable second order effects.

Investment-specific Factors

Making good long term investments will enable a higher return over time, but concentration of ideas can in the short-run lead to underperformance. ?So long as you don’t need cash soon, or you have a large surplus of net assets, such a posture can be maintained over the long haul.

The same thing applies to the need for income from investments. ?investments can shoot less for income and more for capital gains if the need for spendable cash is low. ?Or, less liquid investments can be purchased if they offer a significant return for giving up the liquidity.

Character of the Entity’s Decision-makers and their Incentives

The last issue, which many take first, but I think is last, is how skilled the investors are in dealing with panic/greed situations. ?What is your subjective “risk tolerance?” ?The reason I put this last, is that if you have done your job right, and properly sized the first five factors above, there will be enough surplus and liquidity that does not easily run away in a crisis. ?When portfolios are constructed so that they are prepared for crises and manias, the subjective reactions are minimized because the call on cash during a crisis never gets great enough to force them to move.

A: “Are we adequate?”

B: “More than adequate. ?We might even be able to take advantage of the crisis…”

The only “trouble” comes when almost everyone is prepared. ?Then no significant crises come. ?That theoretical problem is very high quality, but I don’t think the nature of mankind ever changes that much.

Closing

Pay attention to the risk factors of investing relative to your spending needs (or, liabilities). ?Then you will be prepared for the inevitable storms that will come.

Estimating Future Stock Returns, March 2017 Update

Estimating Future Stock Returns, March 2017 Update

Posted on by David Merkel
26 paths, and all of them wrong

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I lost this post once already, hopefully it will be better-written this time. ?I’ve been playing around with the stock market prediction model in order to give some idea of how the actual results could vary from the forecasts.

Look at the graph above. ?it shows potential price returns that vary from -1.51%/year to 4.84%/year, with a most likely value of 2.79%, placing the S&P 500 at 3200 in March 2027. ?Add onto this a 2% dividend yield to get the total returns.

The 26 paths above come from the 26 times in the past that the model forecast total returns within 1% of 4.79%. ?4.79% is at the 90th percentile of expected returns. ?Typically in the past, when expected returns were in the lower two deciles, actual returns were lower still. ?For the 26 scenarios, that difference was 0.63%/year, which would imply 10-year future returns in the 4.16%/year area.

The pattern of residuals is unusual. ?The model tends to overestimate returns at the extremes, and underestimate when expected returns are “normal.” ?I can’t think of a good reason for this. ?If you have a good explanation please give it in the comments.

Now if errors followed a normal distribution, a 95% confidence interval on total returns would be plus or minus 3.8%, i.e., from 1.0% to 8.6%. ?I find the non-normal confidence interval, from 0.5% to 6.8% to be more plausible, partly because valuations would be a new record in 2027 if we had anything near 8.6%/year for the next ten years. ?Even 6.8%/year would be a record. ?That”s why I think a downward bias on results makes sense, with high valuations.

At the end of the first quarter, the model forecast total returns of 5.06%/year for the next ten years. ?With the recent rally, that figure is now 4.79%/year. ?Now, how excited should we be about these returns? ?Not very? ?I can buy that.

But what if you were a financial planner and thought this argument to be plausible? ?Maybe you can get 3.5%/year out of bonds over the next ten years. ?With 4.79% on stocks, and a 60/40 mix of stocks/bonds, that means returns of 4.27%. ?Not many financial planning models are considering levels like that.

But now think of pension plans and endowments. ?How many of them have assumptions in the low 4% region? ?Some endowments are there as far as a spending rule goes, but they still assume some capital gains to preserve the purchasing power of the endowment. ?Pension plans are nowhere near that, and if they think alternative investments will bail them out, they don’t know what they are doing. ?Alternatives are common enough now that the face the same allocative behavior from institutional investors, which then correlates their returns with regular investments in the future, even if they weren’t so in the past.

I don’t have much more to say, so I will close with this: if you want to study this model more, you need to read the articles in this series, and the articles referenced at the Economic Philosopher blog. ?Move your return expectations down, and diversify away from the US; there are better returns abroad — but remember, there are good reasons for home bias, so choose your foreign investments with care.

 

The Biggest Problems For Investors Today

The Biggest Problems For Investors Today

Posted on by David Merkel
What could be more a propos to investing than a bubble spinner?
What could be more ? propos to investing than a bubble spinner?

 

A letter from a “reader” that looked like he sent it to a lot of people:

Hello my name is XXX,
After looking through your website I have really been enjoying your content.
I am also involved in the investing space and wanted to ask a quick question.
I was curious as to what you think the biggest problems are for investors today?
For example do they not have enough investment choices? Do they just not have enough knowledge? Really anything that you have noticed.
I would love to hear your perspective on this. I really appreciate the help. If you have any questions feel free to ask. Thanks.

This was entitled “Love what your doing, my question will only take 2 minutes.” ?I wrote back:

This is not a 2 minute question.

That said, it’s a decent question. ?Here are my thoughts:

  • The biggest problem for investors is low future returns. ?Bonds have low rates of returns, and equities have high valuations. ?You’ll see more about equity valuations in my next post.
  • The second largest problem is investment monoculture — there is a handful of large cap growth stocks that dominate the major indexes, and there is a self-reinforcing cycle of cash flow going on now that is forcing their prices well above what can be justified in the long run.
  • Third is inadequate ability to diversify. ?This is largely a function of the two problems listed before, and benchmarking and indexing, which has been correlating the markets more and more. ?I’m not talking about short-term correlations — diversification applies of the time horizon of the assets, which is long.
  • Fourth is bad government and central bank policy. ?The growth in government debt is the growth in unproductive capital, which drives the first problem.
  • Fifth, too many people are relying on investments to fund their future spending — that also exacerbates the first problem.

That’s all — if you can think of more, leave your suggestion in the comments.

PS — my apology to those I tweeted to on Friday about a post on equity valuations. ?That will appear Saturday night. ?Thanks.

Goes Down Double-Speed (Update 4)

Goes Down Double-Speed (Update 4)

Posted on by David Merkel
Photo Credit: eric lynch

Markets always find a new way to make a fool out of you. ?Sometimes that is when the market has done exceptionally well, and you have been too cautious. ? That tends to be my error as well. ?I’m too cautious in bull markets, but on the good side, I don’t panic in bear markets, even the most severe of them.

The bull market keeps hitting new highs. ?It’s the second longest bull market in the last eighty years, and the third largest in terms of cumulative price gain. ?Let me?show you a graph that simultaneously shows how amazing it is, and how boring it is as well.

The amazing thing is how long the rally has been. ?We are now past 3000 days. ?What is kind of boring is this — once a rally gets past two years time, price return results fall into a range of around 1.1-2.0%/month for the rally as a whole, averaging around 1.4%/month, or 18.5% annualized. ?(The figure for market falling more than 200 days is -3.3%/month, which is slightly more than double the rate at which it rises. ?Once you throw in the shorter time frames, the ratio gets closer to double — presently around 2.18x. ?Note that the market rises are 3.2x as long as the falls. ?This is roughly similar to the time spans on the credit cycle.)

That price return rate of 1.4%/month isn’t boring, of course, and is?close to?where the stock market prediction model would have predicted back in March 2009, where it forecast total returns of around 16%/year for 10 years. ?That would have implied a level a little north of 2500, which is only 3% away, with 21 months to go.

Have you missed the boat?

If you haven’t been invested during this rally, you’ve most like missed more than 80% of the?gains of this rally. ?So yes, you have missed it.

?The Moving Finger writes; and, having writ,
Moves on: nor all thy Piety nor Wit
Shall lure it back to cancel half a Line,
Nor all thy Tears wash out a Word of it.?

? Omar Khayy?m?from The Rubaiyat

In other words, “If ya missed the last bus, ya missed the last bus. ?Yer stuck.”

We can only manage assets for the future, and only our decrepit view of the future is of any use. ?We might say, “I have no idea.” and maintain a relatively constant asset allocation policy. ?That’s mostly what I do. ?I limit my asset allocation changes because it is genuinely difficult to time the market.

If you are tempted to add more money now, I would tell you to wait for better levels. ?If you can’t wait, then do half of what you want to do.

A wise person knows that the past is gone, and can’t be changed. ?So aim for the best in the future, which at present means having at least your normal percentage of safe assets in your asset allocation.

(the closing graph shows the frequency and size of market gains since 1928)

Operating vs Financial Cash Flows

Operating vs Financial Cash Flows

Posted on by David Merkel
Photo Credit: Daniel Broche || To the victor goes the spoils, or, does a victory get spoiled?

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I was at a CFA Baltimore board meeting, and we were talking before the meeting. ?Most of us work for value investors, or, growth-at-a-reasonable-price investors. ?One fellow who has a business model somewhat like mine, commented that all the money was flowing into ETFs which were buying things like Facebook, Amazon and Google, which was distorting the market. ?I made a?comment that something like that was true during the dot-com bubble, though it was direct then, not due to ETFs, and went to a different group of stocks.

Let’s unpack this, starting with ETFs. ?ETFs are becoming a greater proportion of the holders of stocks, and other assets also. ?When do new shares of ETFs get created? ?When it is profitable to do so. ?The shares of the ETF must be worth more than the assets going into the ETF, or new shares will not get created.

It is the opposite for ETFs if their shares get liquidated. That only happens?when it is profitable to do so. ?The shares of the ETF must be worth less?than the assets going out of?the ETF, or shares will not get liquidated.

Is it likely that the growth in ETFs is driving up the price of shares? Not much; all that implies is that people are willing to pay somewhat more for a convenient package of stocks than what they are worth separately. ?Fewer people want to own individual assets, and more like to hold bunches of assets that represent broad ideas. ?Invest in the stock market of a country, a sector, an industry, a factor or a group of them.

The creators and liquidators of ETF shares typically work on a hedged basis. ?They are long whatever is cheaper, and short whatever is more expensive — but on net flat. ?When they have enough size to create or liquidate, they go to the ETF and do that. ?Thus, the actions of the creators/liquidators should not affect prices much. ?Their trading operations have to be top-notch to do this.

(An aside — long-term holders of ETFs get nipped by the creation and liquidation processes, because both diminish the value of the ETF to long-term holders. ?Tax advantages make up some or more than all of the difference, though.)

Does the growth in ETFs change the nature of the stickiness of the holding of the underlying stocks? ?Does it make the stickiness more like a life insurer holding onto a rare “museum piece” bond that they could never replace, or like a day trader trying to clip nickels? ?I think it leans toward less stickiness; my own view of ETF holders is that they fall mostly into two buckets — traders and investors. ?The investors hold a long time; the traders are very short term.

As such, more ETFs owning stocks probably makes the ownership base more short-term. ?ETFs are simple looking investments that mask the underlying complexity of the individual assets. ?There is no necessary connection between a bull market and and growth in ETFs, or vice-versa. ?In any given market cycle there might be a connection, but it doesn’t have to be that way.

ETFs don’t create or retire?shares of underlying stocks or bonds. ?And, the ETFs don’t necessarily create more net demand for the underlying assets. ?Open end mutual fund holders and direct holders shrink and ETFs grow, at least for now. ?That may make a holder base a little more short-term, but it shouldn’t have a big impact on the prices of the underlying assets.

My friend made a common error, confusing primary and secondary markets. ?No money is flowing into the corporations that he mentioned. ?Relative prices are affected by greater willingness to pay a still greater amount for the stock of growthy, highly popular, large companies relative to that of average companies or worse yet, value stocks.

Now the CEOs of companies with overvalued shares may indeed find ways to take advantage of the situation, and issue stock slowly and quietly. ?The same might apply to value stocks, but they would buy back their stock, building value for shareholders that don’t sell out. ?In this example, the secondary markets give pricing signals to companies, and they use it to build value where appropriate — secondary markets leads primary markets here. ?The home run would be that the companies with overvalued shares would buy the companies with undervalued shares, if the companies were related, and it seemed that management could integrate the firms.

What we are seeing today is a shift in relative prices. ?Growth is in, and value is out. ?What we aren’t seeing is the massive capital destruction that took place when seemingly high growth companies were going public during the dot-com bubble, where cash flowed into companies only to get eaten by operational losses. ?There will come a time when the relative price of growth vs value will shift back, and performance will reflect that then. ?It just won’t be as big of a shift as happened in the early 2000s.

Arconic Arguments

Arconic Arguments

Posted on by David Merkel

There’s a lot of bits and bytes spilled in the war between Elliott Associates (and those that favor their position) and the current board of Arconic. ?I want to point out a few things, having held Alcoa since prior to the breakup, and added to my positions in both new Alcoa and Arconic post-breakup.

  • Profitability will likely improve more if Elliott’s nominees are elected to the board, and Larry Lawson is CEO.
  • The existing management team does not deserve credit for the recent rise in the stock price for two reasons: a decent amount of the rise in Arconic’s stock price anticipates a rising probability that the board and management team will be replaced. ?Second, a decent amount of the increase in the stock price of Alcoa has been due to a rise in the price of aluminum, for which no single entity?can take credit. ?Current Arconic benefited from that, at least until it sold its whole stake in Alcoa.
  • To their discredit, the existing management team and board resisted the breakup of the company into upstream and downstream for years. ?(See point 2 of this Elliott letter,?Was Dr. Kleinfeld the Driving Force Behind the Separation?)
  • Existing management was not a good capital allocator.
  • Prior to the agitation by Elliott, Alcoa and Arconic sold at low valuations, because earnings prospects were poor. ?Now new Alcoa is in better hands, and that might be true for Arconic in the future, which may further improve valuation.
  • The existing board has low ownership in Arconic. ?Many of the existing board members have been around too long.
  • The current board are late to the party of improving corporate governance. ?Though their proposals are good, it looks like they were dragged there by the activists, and therefore, can’t be trusted to maintain these improvements.

That’s my short summary; it is not meant to be detailed, as Elliott’s arguments are. ?In general, I agree with the arguments over at New Arconic, and will be voting the blue proxy card. ?If you disagree, then you should vote the white proxy card sent out by the existing board.

I’m not telling you what to do. ?Vote the proxy that reflects your view of what will improve Arconic the most.

Full disclosure: long AA & ARNC for my clients and me (Note: Aleph Investments, LLC, is?dust on the scales in this fight, representing less than 0.01% of outstanding shares.)

Four Simple Investment Strategies That Work

Four Simple Investment Strategies That Work

Posted on by David Merkel
Photo Credit: Lenore Edman

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This will be a short post, though I want to toss this question out to readers: what investment strategies do you know of that are simple, and work on average over the long-term?

Here are four (together with posts of mine on the topic):

1) Indexing

Index Investing is not Inherently Socialistic

Why Indexes are Capitalization-Weighted

Why do Value Investors Like to Index?

On Bond Investing, ETFs, Indexes, and the Current Market Environment

2) Buy-and-Hold

Buy-and-Hold Can?t Die

Buy-and-Hold Can?t Die, Redux

Buy and Hold Will Return?? 2/15/2009 (what a time to write this)

Patience and a Little Courage

Risk vs Return ? The Dirty Secret

3) The Permanent Portfolio

The Permanent Portfolio

Can the ?Permanent Portfolio? Work Today?

Permanent Asset Allocation

4) Bond Ladders

On Bond Ladders

I chose these because they are simple. ?Average people without a lot of training could do them. ?There are other things that work, but aren’t necessarily simple, like value investing, momentum investing, low volatility investing, and a few other things that I will think of after I hit the “Publish” button.

That said, most people don’t need to work on investing. ?They need to work on cash management, and I have written a small fleet of articles there. ?Managing cash is simple, but it takes self-control, and that is what most people lack in their financial lives.

But for those that have gotten their cash under control, with a full buffer fund, the above strategies will help, and they aren’t hard.

Final note: I realize valuations are high now, so buy-and-hold is not as attractive as at other times. ?I realize that interest rates are low, so bond ladders aren’t so great, seemingly. ?Indexing may be overused. ?Most?of the elements of the Permanent Portfolio look unappealing.

But what’s the alternative, and simple enough for average people to do? ?My answer is simple. ?If they can buy and hold, these strategies will pay off over time, and far better than those that panic when things get bad. ?There are few regularities in the markets more reliable than this.

Estimating Future Stock Returns, December 2016 Update

Estimating Future Stock Returns, December 2016 Update

Posted on by David Merkel

What a difference a quarter makes! ?As I said one quarter ago:

Are you ready to earn 6%/year until 9/30/2026? ?The data from the Federal Reserve comes out with some delay. ?If I had it instantly at the close of the third quarter, I would have said 6.37% ? but with the run-up in prices since then, the returns decline to 6.01%/year.

So now I say:

Are you ready to earn 5%/year until 12/31/2026? ?The data from the Federal Reserve comes out with some delay. ?If I had it instantly at the close of the fourth?quarter, I would have said 5.57% ? but with the run-up in prices since then, the returns decline to 5.02%/year.

A one percent drop is pretty significant. ?It stems from one main factor, though — investors are allocating a larger percentage of their total net worth to stocks. ?The amount in stocks moved from 38.00% to 38.75%, and is probably higher now. ?Remember that these figures come out with a 10-week delay.

Remember that the measure in question covers both public and private equities, and is market value to the extent that it can be, and “fair value” where it can’t. ?Bonds and most other assets tend to be a little easier to estimate.

So what does it mean for the ratio to move up from 38.00% to 38.75%? ?Well, it can mean that equities have appreciated, which they have. ?But corporations buy back stock, pay dividends, get acquired for cash which reduces the amount of stock outstanding, and places more cash in the hands of investors. ?More cash in the hands of investors means more buying power, and that gets used by many long-term institutional investors who have fixed mandates to follow. ?Gotta buy more if you hit the low end of your equity allocation.

And the opposite is true if new money gets put into businesses, whether through private equity, Public IPOs, etc. ?One of the reasons this ratio went so high in 1998-2001 was the high rate of business formation. ?People placed more money at risk as they thought they could strike it rich in the Dot-Com bubble. ?The same was true of the Go-Go era in the late 1960s.

Remember here, that average returns are around 9.5%/year historically. ?To be at 5.02% places us in the 88th percentile of valuations. ?Also note that I will hedge what I can if expected 10-year returns get down to 3%/year, which corresponds to a ratio of 42.4% in stocks, and the 95th percentile of valuations. ?(Note, all figures in this piece are nominal, not inflation-adjusted.) ?At that level, past 10-year returns in the equity markets have been less than 1%, and in the short-to-intermediate run, quite poor.)

You can also note that short-term and 10-year Treasury yields have risen, lowering the valuation advantage versus cash and bonds.

I have a few more small things to add. ?Here’s an article from the Wall Street Journal:?Individual Investors Wade In as Stocks Soar. ?The money shot:

The investors? positioning suggests burgeoning optimism, with TD Ameritrade clients increasing their net exposure to stocks in February, buying bank shares and popular stocks such as Amazon.com Inc. and sending the retail brokerage?s Investor Movement Index to a fresh high in data going back to 2010. The index tracks investors? exposure to stocks and bonds to gauge their sentiment.

?People went toe in the water, knee in the water and now many are probably above the waist for the first time,? said JJ Kinahan, chief market strategist at TD Ameritrade.

This is sad to say, but it is rare for a rally to end before the “dumb money” shows up in size. ?Running a small asset management shop like I do, at times like this I suggest to clients that they might want more bonds (with me that’s short and high quality now), but few do that. ?Asset allocation is the choice of my clients, not me. ?That said, most of my clients are long-term investors like me, for which I give them kudos.

Then there is this piece over at Bloomberg.com called:?Wall Street’s Buzz Over ‘Great Leader’ Trump Gives Shiller Dot-Com Deja Vu. ?I want to see the next data point in this analysis, which won’t be available by mid-June, but I do think a lot of the rally can be chalked up to willingness to take more risk.

I do think that most people and corporations think that they will have a more profitable time under Trump rather than Obama. ?That said, a lot of the advantage gets erased by a higher cost of debt capital, which is partly driven by the Fed, and partly by a potentially humongous deficit. ?As I have said before though, politicians are typically limited in what they can do. ?(And the few unlimited ones are typically destructive.)

Shiller’s position is driven at least partly by the weak CAPE model, and the rest by his interpretation of current events. ?I don’t make much out of policy uncertainty indices, which are too new. ?The VIX is low, but hey, it usually is when the market is near new highs. ?Bull markets run on complacency. ?Bear markets plunge on revealed credit risk threatening economic weakness.

One place I will agree with Shiller:

What Shiller will say now is that he?s refrained from adding to his own U.S. stock positions, emphasizing overseas markets instead.

That is what I am doing. ?Where I part ways with Shiller for now is that I am not pressing the panic button. ?Valuations are high, but not so high that I want to hedge or sell.

That’s all for now. ?This series of posts generates more questions than most, so feel free to ask away in the comments section, or send me an email. ?I will try to answer the best questions.

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Late edit: changed bolded statement above from third to fourth quarter.

We Get New Highs More Frequently After New Highs

We Get New Highs More Frequently After New Highs

Posted on by David Merkel

This post may fall into the “Dog bites Man” bucket, but I will see if I can’t shed a little more light on the phenomenon. ?Here’s the question: “When do we see new highs in the stock market most often?” ?The punchline: “After a recent new high.”

The red squares above show the probability of hitting a new high so many days after a new high. ?The black line near it is a best fit power curve. ?The blue diamonds?above show the probability of hitting a new high so many days after not hitting a new high. ?The green triangles?above show the ratio of those two probabilities, matching up against the right vertical axis. The black line near it is a best fit power curve.

As time goes to infinity, both probabilities converge to the same number, which is presently estimated to be 6.8%, the odds that we would hit a new high on any day between 1951 and 2015. ?Here’s the table that corresponds to the above graph:

Probability of a new high after Days after no new high Days after new high Probability Ratio
1st day 3.1% 57.3% 18.29
2nd day 4.2% 43.3% 10.39
3rd day 4.6% 36.7% 7.90
4th day 4.8% 33.8% 6.99
5th day 5.1% 30.0% 5.87
6th day 5.2% 28.2% 5.37
7th day 5.5% 24.2% 4.36
8th day 5.7% 22.5% 3.97
9th day 5.6% 23.4% 4.18
10th day 5.6% 22.6% 4.00
11-15 5.9% 19.0% 3.22
16-20 6.0% 17.2% 2.86
21-30 6.1% 16.4% 2.71
31-40 6.2% 14.5% 2.35
41-50 6.2% 15.2% 2.47
51-60 6.3% 14.2% 2.28
61-75 6.3% 13.9% 2.21
76-90 6.3% 13.6% 2.16
91-105 6.3% 12.8% 2.02
106-120 6.4% 12.5% 1.96
121-140 6.4% 12.0% 1.87
141-160 6.5% 11.3% 1.75
161-180 6.4% 11.5% 1.79
181-200 days 6.4% 11.8% 1.84

 

E.g., as you go down the table the probability 43.3% represents the probability that you get a new high?on the second day after a new high.

Here’s an intuitive way to think about it: if you are not at a new high, you are further away from a new high than if you were at a new high recently. ?Thus with time the daily probability of hitting a new high gets higher. ?If you were at a new high recently, you daily odds of hitting a new high are quite high, but fall over time, because?the odds of drifting lower at some point increase. ?Valuation is a weak daily force, but a strong ultimate force.

That said, the odds of hitting new highs a long time away from a new high are significantly higher than the odds of hitting a new high where there has been no new high for the same amount of time.

Closing Thoughts

I could segment the data another way, and this could be clearer: If you are x% away from a new high, what is?the odds you will hit a new high n days from now? ?As x gets bigger, so will the numbers for n. ?Be that as it may, when you have had new highs recently, you tend to have more of them. ?New highs clump together.

The same is true of periods with no new highs — they tend to clump together and persist even more.

Valuation and momentum are hidden variables here — momentum aids persistence, and valuation is gravity, eventually causing markets that don’t fairly price likely future cash flows to revert to pricing that is more normal. ?Valuation is powerful, but takes a long while to act, often waiting for a credit cycle to do its work. ?Momentum works in the short-run, propelling markets to heights and depths that we can only reach from human mimickry.

That’s all.

Good, Not Average, Not Great

Good, Not Average, Not Great

Posted on by David Merkel

I was reading through The Wall Street Journal’s Daily Shot column, done by the estimable @SoberLook, and saw the following graph and text:

The S&P 500 move this year is completely outside the historical seasonal trends.

Graph Credit: Deutsche Bank via @SoberLook at The Wall Street Journal

Averages reveal, but they also conceal. ?When I look at a graph like this, I know that any given year is highly likely to look different than an average of years. ?So, no surprise that the returns on the S&P 500 are different than the averages of the prior 11 or 19 years.

But how has the S&P 500 fared versus the last 68 years? ?At present this year is 20th out of 68, which is good, but not great or average. ?But look at the graph at the top of this article: up until the close of the 25th trading day of the year (February 7th) the market had performance very much like a median year. ?All of the higher performance has come out of the last nine days. ?(For fun, it is the ninth best out of 68 for that time of year; even that is not top decile.)

I can tell you something easy: you can have a lot of different occurrences over nine days in the market. ?The distribution of returns would be quite wide. ?Therefore, don’t get too excited about the returns so far this year — they aren’t that abnormal. ?You can be concerned as you like about valuation levels — they are high. ?But 2017 at present is a “high side of normal” year compared to past price performance.

And, if you want to be concerned about a melt-up, it is this kind of low positive momentum that tends to persist, at least for a while. ?Trading behavior isn’t nuts, even if valuations are somewhat steamy.

I’m around 83% invested in equity accounts, so I am conservative, but I’m not thinking of hedging yet. ?Let the rally run.

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