The Myth Of The “Passive Indexing” Revolution | RIA

From Lance Roberts at RIA:

While the idea of passive indexing works while all prices are rising, the reverse is also true. The problem is that once prices begin to fall the previously “passive indexer” becomes an “active panic seller.” With the flood of money into “passive index” and “yield funds,” the tables are once again set for a dramatic and damaging ending.

Source: The Myth Of The “Passive Indexing” Revolution | RIA

The dangers of passive investing

There is a lot to be said for passive investing.

Key Takeaways from Morningstar’s Active/Passive Barometer Report:

  • Actively managed funds have generally underperformed their passive counterparts, especially over longer time horizons.
  • Failure tended to be positively correlated with fees.
  • Fees matter. They are one of the only reliable predictors of success.

Prof. Burton Malkiel, author of A Random Walk Dow Wall Street, writes in the WSJ:

During 2016, two-thirds of active managers of large-capitalization U.S. stocks underperformed the S&P 500 large-capital index. When S&P measured performance over a longer period, the results got worse. More than 90% of active manager underperformed their benchmark indexes of a 15-year period.

…..In 2016 investors pulled $340 billion out of actively managed funds and invested more than $500 billion in index funds. The same trends continued in 2017, and index funds now account for about 35% of total equity fund investments.

Volatility is also near record lows as the market grows less reactive to short-term events.

CBOE Volatility Index (VIX)

Lower fees and lower volatility should both improve investment performance, so what could possibly go wrong?

Investors could stop thinking.

If passive funds are the investment of choice, then new money will unquestioningly flow to these funds. In turn the funds will purchase more of the stocks that make up the index.

Prices of investment-grade stocks that make up the major indices are being driven higher, without consideration as to whether earnings are growing apace.

And the higher index values climb, the more investment flows they will attract. Driving prices even higher in relation to earnings.

More adventurous (some would say foolhardy) investors may even start using leverage to enhance their returns, reasoning that low volatility reduces their risk.

The danger is that this becomes a self-reinforcing cycle, with higher prices attracting more investment. When that happens the market is in trouble. Headed for a blow-off.

Investing in passive funds doesn’t mean you can stop thinking.

Don’t lose sight of earnings.

When prices run ahead of earnings, don’t let your profits blind you to the risks.

And start thinking more about protecting your capital.

The Quants Run Wall Street Now | WSJ

From Gregory Zuckerman and Bradley Hope:

For decades, investors imagined a time when data-driven traders would dominate financial markets. That day has arrived.

…. quantitative hedge funds are now responsible for 27% of all U.S. stock trades by investors, up from 14% in 2013, according to the Tabb Group, a research and consulting firm in New York.

Quants now dominate the short-term trading market but active managers (homo sapiens) are still very dominant in the much larger long-term investment market. And this is unlikely to change any time soon.

Source: The Quants Run Wall Street Now – WSJ

The Trouble With Chasing Hot Strategies | Josh Brown

This should be blindingly obvious, but amazing how often it is ignored. Great post from Josh Brown at Reformed Broker:

How do most investors (and many advisors) select funds or strategies to allocate to? They look at what’s been working, learn the story and get long…….
And then mean reversion shows up – outperforming managers subsequently underperform, hot themes become over-loved, winning strategies become too crowded to offer excess returns. “No problem,” says the advisor, I’ve got six new ideas to replace the six ideas that are no longer working!”

It’s sad to say, but this is exactly how it works. I’ve been watching this for almost 20 years…….

Research Affiliates has an interesting pair of charts demonstrating this phenomenon in a new note from Rob Arnott, Jason Hsu and Co. They illustrate that increasing fund flows are a decent predictor of subsequent underperformance and that performance-chasing is destructive to returns across all types of investment products:

Research Affiliates

S&P 500 Prime Momentum 12 month performance

S&P 500 Prime Momentum

The S&P 500 Prime Momentum strategy has now been running for twelve months, since November 2013, and returned 17.46%* for the period compared to 17.27% for the S&P 500 Total Return Index. This is below the average return for the 1996 to 2013 research period and is attributable to the sell-off of momentum stocks in recent months. Macroeconomic and volatility filters continue to indicate low to moderate risk typical of a bull market and we expect stocks to recover in the months ahead.

* Results are unaudited and subject to revision.

Are corporate profit margins sustainable?

Market capitalization as a percentage of (US) GNP is climbing and some commentators have been predicting a reversion to the mean — a substantial fall in market cap.

US Market Cap to GNP

But corporate profits have been climbing at a similar rate.

US Corporate Profits to GNP

Wages surged as a percentage of value added in the first quarter (2014) and profit margins fell sharply, adding fresh impetus to the bear outlook. But margins recovered to 10.6% in the second quarter.

Employee Compensation and Profits as Percentage of Gross Value Added

Further gains in the third quarter would suggest that profits are sustainable. Research by Morgan Stanley supports this view, revealing that improved profit margins are largely attributable to the top 50 mega-corporations in the US:

Mega cap companies (the largest 50 by size) have been able to pull their margins away from the smaller companies through globalization, productivity, scale, cost of capital, and taxes, among other reasons. We argue against frameworks that call for near-term mean reversion and base equity return algorithms off the concept of overearning. Why? The margins for the mega cap cohort in the last two downturns of 2001 and 2008 were well above the HIGHEST margins achieved during the 1974-1994 period. To us, this is a powerful indication that the mega cap cohort is unlikely to mean revert back to the 1970s to 1990s average level.

(From Sam Ro at Business Insider)

Also interesting is The Bank of England’s surprise at the lack of inflation in response to falling unemployment. One would expect wage rates to rise when slack is taken up in the labor market, but this has failed to materialize. It may be that unemployment is understated — and a rising participation rate will keep the lid on wages. If this happens in the US it would add further support for sustainable profit margins.

Australian investors

Australian stocks have taken a bit of a beating over the last few weeks, including a few of the momentum stocks in our portfolio. Risk of a bear market remains low, but a falling Aussie Dollar has prompted international investors to scale back exposure to Australian equities.


This tends to become self-reinforcing as falling stock prices then prompt further sell-offs. And repatriation causes further weakness in the Aussie Dollar. The down-trend is likely to continue if support at $0.8650/$0.8700 is breached.

Investors who split their portfolio between the S&P 500 and the ASX 200 have been cushioned from the fall, with their US portfolio showing strong appreciation in Australian Dollar terms.

Risk versus volatlity

Ben Carlson cites Howard Marks on the difference between volatility and risk:

Volatility is the academic’s choice for defining and measuring risk. I think this is the case largely because volatility is quantifiable and thus usable in the calculations and models of modern finance theory.

However, while volatility is quantifiable and machinable – and can also be an indicator or symptom of riskiness and even a specific form of risk – I think it falls short as “the” definition of investment risk. In thinking about risk, we want to identify the thing that investors worry about and thus demand compensation for bearing. I don’t think most investors fear volatility…. What they fear is the possibility of permanent loss.

Read more at A Role Reversal For Stocks and Bonds | Pragmatic Capitalism.

Fidelity Reviewed Which Accounts Did Best And What They Found Was Hilarious | Business Insider

From Miles Udland:

[James O’Shaughnessy of O’Shaughnessy Asset Management] relays one anecdote from an employee who recently joined his firm that really makes your head spin.

O’Shaughnessy: “Fidelity had done a study as to which accounts had done the best at Fidelity….They were the accounts [of] people who forgot they had an account at Fidelity.”

There are numerous studies that explain why this happens. And they almost always come down to the fact that our minds work against us. Due to our behavioural biases, we often find ourselves buying high and selling low.

I have always called this “the Siemens effect” from an example I came across, in a completely different field, about 30 years ago. German electronics giant Siemens built a telecommunications exchange in a sealed container, where no human could have access and all maintenance was conducted from an outside control panel. The exchange experienced only a small fraction of the equipment failures experienced in a normal telecommunications exchange, leading to the conclusion that human intervention by maintenance staff caused most of the faults.

Likewise in investment, if you build the equivalent of a sealed system. Where there is no direct human intervention, you are likely to experience better performance than if there is constant tinkering to “improve” the system.

The caveat is, during an electrical storm it may be advisable to shut the telecommunications exchange down from the control panel. Likewise, with stocks, when macroeconomic and volatility filters warn of elevated risk, the system should move to cash or assets (e.g. government bonds) with low or negative correlation to stocks.

Read more at Fidelity Reviewed Which Accounts Did Best And What They Found Was Hilarious | Business Insider.

The Unintended Consequences of Risk Avoidance | Pragmatic Capitalism

Cullen Roche on risk avoidance:

Many investors have learned the hard way that trying to beat the market over shorter time frames can be more trouble than it’s worth. A singular mission to outperform can actually lead to underperformance. The same logic applies when trying to minimize losses. A sole focus on downside protection usually leads to the opportunity cost of no upside participation.

An illusion of safety in the short-term can lead to problems in the long-term. Judging your portfolio or your financial advisor over a six month period is a recipe for failure. No strategy can be assessed over that short of a time frame.

Also, while fees are important over the long haul, investor behavior is much more important. Investors need to make sure they aren’t sacrificing other areas of portfolio management in a push to only reduce fees. Lower investment fees are only one of the many risk management techniques needed for a successful portfolio.

Read more at The Unintended Consequences of Risk Avoidance | Pragmatic Capitalism.

When to sell and when to buy?

Investors are faced with the same emotional tug-of-war at every correction: Do I sell and abandon my positions or do I sit tight and ride out the storm? Here are a couple of useful perspectives:

What is your investment time frame?

Do you plan to invest for the long-term (5 to 10 years) or is your investment horizon a matter of months or weeks? If your investment horizon is long-term, you are investing for the primary trend. Your intention is unlikely to be to time secondary market movements.

Is timing secondary corrections profitable?

Our research shows that the average re-entry point, after brokerage and slippage is higher than the exit point and erodes performance.

Has the earning capacity of stocks you hold been affected by the correction?

A correction is a wave of negative sentiment, normally caused by an external shock — like the prospect of higher interest rates, oil prices, some new conflict or a threat to international trade. Where the market decides that earnings are unaffected and there is no permanent loss of value, it tends to recover fairly quickly. If, however, the market decides that there is a long-lasting effect on earnings then stocks are likely to be re-rated — resulting in a long-lasting drop in value. The probability of the former is far higher than the latter: the ratio of primary to secondary adjustments is low.

When is the best time to hold Momentum stocks?

We have not done a wide-ranging study of this, but the best two months performance for our ASX200 Prime Momentum strategy in the last two years were July 2013 (11.00%) and February 2014 (9.04%) — both in the middle of corrections.

ASX 200 Corrections

Attempt to time the correction and you may miss the best-performing months.

Bubble, Bubble, Toil and Trouble: The Costs and Benefits of Market Timing

The following article was originally published in Musings on Markets and is reproduced with kind permission of the author, Aswath Damodaran. Aswath is a Professor of Finance at the Stern School of Business at NYU and teaches classes in corporate finance and valuation.

The essay is lengthy, but shows great insight into the current discussion on market valuation, analyzing the motives of various groups (“bubblers”) who have been predicting the demise of the current bull market, and the relationship of Price-Earnings ratios (or its inverse, ERP) to long-term interest rates. His graph of Treasury Bond Rates and Implied ERP, particularly, demonstrates that current market valuations include a higher-than-normal risk premium. And his summation of the current state of affairs at the end is worth close attention.

Click on the images for a larger view. I hope that you enjoy it.

Monday, June 16, 2014

Bubble, Bubble, Toil and Trouble: The Costs and Benefits of Market Timing

If you believe that the stock market is in a bubble, you have lots of company. You have long-time market watchers, the New York Times and even a Nobel Prize winner in your camp. But what exactly is a bubble? How can you tell if you are in one?  And if you do believe you are in a bubble, what is your best course of action? Not only are these questions difficult to answer, but the answers can vary across markets, investors and time. 

The Bubble Machine

Every market has a bubble machine, though it is less active in some periods than others, and that machine creates an ecosystem of metrics and experts, as well as warnings about bubbles about to burst, corrections to come and actions to take to protect yourself against the consequences. In periods like the current one, when the bubble machine is in over drive and you are confronted by “bubblers” with varying credibilities, motives and methods, you may find it useful to first categorize them into the following groups.
  1. Doomsday Bubblers have been warning us that the stock market is in a bubble for as long as you have known them, and either want you to keep your entire portfolio in cash or in gold (or bitcoins). They remind me of this character from Winnie the Pooh and their theme seems to be that stocks are always over valued.
  2. Knee Jerk Bubblers go into hibernation in bear markets but become active as stocks start to rise and become increasingly agitated, the more they go up. They are the Bobblehead dolls of the bubble universe, convinced that if stocks have gone up a lot or for a long period, they are poised for a correction.
  3. Armchair Psychiatrist Bubblers use subtle or not-so-subtle psychological clues from their surroundings to make judgments about bubbles forming and bursting. Freudian in their thinking, they are convinced that any mention of stocks by shoeshine boys, cab drivers or mothers-in-law is a sure sign of a bubble.
  4. Conspiratorial Bubblers believe that bubbles are created by small group of evil people who plan to profit from them, with the Illuminati, hedge funds, Goldman Sachs and the Federal Reserve as prime suspects. Paranoid and ever-watchful, they are convinced that stocks are manipulated by larger and more powerful forces and that we are all helpless in the face of this darkness.
  5. Righteous Bubblers draw on a puritanical streak to argue that if investors are having too much fun (because stocks are going up), they have to be punished with a market crash. As the Flagellants in the bubble world, they whip themselves into a frenzy, especially during market booms.
  6. Rational Bubblers uses market metrics that are both intuitive and widely used, note their divergence from historical norms and argue for a correction back to the average. Viewing themselves as smarter than the rest of us and also as the voices of reason, they view their metrics as infallible and mean reversion in markets as immutable.
There are three things to keep in mind about bubblers. The first is that bubblers will receive disproportionate attention in the media, for the same reasons that a reality show about a dysfunctional family will have higher ratings than one about a more normal family. The second is that even the most misguided bubblers will be right at some point in time, just as a broken clock is right twice every day. The third is that being right is often the worst thing that can happen to bubblers, because it seems to feed into the conviction that they are always right and leads to increasingly bizarre predictions. It is no coincidence that every market correction in history has created its gurus (who called that correction right) and those gurus have almost always found a way to discredit themselves ahead of the next one.

What is a bubble? The lazy definition is that any time you see a large market correction, it is the result of a bubble bursting, but that is neither a useful definition, nor is it true. To me, a bubble reflects a market disconnect from fundamentals, where prices go up steeply, with no help from the fundamentals. The best way of illustrating this is to go back to an intrinsic value model, where the value of stocks can be written as a function of three fundamentals: the base year cash flows that investors are receiving, the expected growth in these cash flows and the risk in the cash flows:

If cash flows increase, growth rates surge, risk free rates drop or macroeconomic risk subsides, stocks should go up, and sometimes steeply, and there is no bubble.  At the other extreme, if stock prices go up as cash flows decrease, growth rates become more negative and risk free rates and equity risk increase, you have a bubble. It is far more likely, though, that you will be faced with a more ambiguous combination, where shifts in one or more fundamentals (higher growth, higher cash flows, a lower risk free rate or lower macroeconomic risk) may explain the increase in stock prices and you will have to make judgments on whether the increase is larger than warranted. 

Detecting a Bubble
The benefits of being able to detect a bubble, when you are in its midst rather than after it bursts, is that you may be able to protect yourself from its consequences. But are there any mechanisms that detect bubbles? And if they exist, how well do they work?

a. PE and variants

The most widely used metric for detecting bubbles is the price earnings (PE) ratio, with variants thereof that claim to improve its predictive power. Thus, while the conventional PE ratio is estimated by dividing the current price (or index level) by earnings in the last year or twelve months, you could consider at least three modifications. The first is to clean up earnings removing what you view as extraordinary or non-operating items to come up with a better measure of operating earnings. In 2002, in the aftermath of accounting scandals, S&P started computing core earnings for US companies which can differ from reported earnings significantly. The second is to average earnings over a longer period (say five to ten years) to remove the year-to-year volatility in earnings. The third is to adjust the earnings from prior periods for inflation to get a inflation-consistent or real PE ratio. In fact, Robert Shiller has a time series of PE ratios for US stocks stretching back to 1871, that uses normalized, inflation-adjusted earnings.

In the graph below, I report on the time trends between 1969 and 2013 in four variants of the PE ratios, a PE using trailing 12 month earnings (PE), a PE based upon the average earnings over the previous ten years (Normalized PE), a PE based upon my estimates of inflation-adjusted average earnings over the prior ten years (My CAPE) and the Shiller PE. 

Normalized PE used average earnings over last 10 years & My CAPE uses my inflation adjusted normalized earnings. Shiller PE is as reported in his datasets
While the Shiller PE has become the primary weapon wielded by those who believe that we are in a bubble, perhaps because of the pedigree of its creator,  the reality is that all four measures of PE move together much of the time, with a correlation of close to 90%. (If you are wondering why my time series starts in 1969, I use the S&P 500 and earnings on the index and I was unable to get reliable numbers for the latter prior to 1960. Since I need ten years of earnings to get my normalized values, my first estimates are therefore in 1969.)
To examine whether any of these PE measures do a good job of predicting future stock returns and thus market crashes, I computed the correlation of each PE measure with annual returns on the S&P 500 over one-year, two-year and three-year periods following the computation.

T statistics in italics below each correlation; numbers greater than 2.42 indicate significance at 2% level

First, the negative correlation values indicate that higher PE ratios today are predictive of lower stock returns in the future. Second, that correlation is weak with one-year forward returns (notice that none of the t statistics are significant), become stronger with two-year returns and strongest with three-year returns. Third, there is little in this table to indicate that normalizing or inflation adjusting the PE ratio does much in terms of improving its use in prediction, since the conventional PE ratio has the highest correlation with returns over time periods

Defenders of the PE or one its variants will undoubtedly argue that you don’t make money on correlations and that the use of PE is in detecting when stocks are over or under price. For instance, one rule of thumb suggests that a Shiller PE above 15 would indicate an over valued market, but that rule would have kept you out of US equities since 1988. To create a rule that is more reflecting of the 1969-2013 time period, I computed the 25th percentile, the median and the 75th percentile of each of the PE ratio measures for this period.
PE measures: 1969-2013
I then broke my sample down into four quartile classes with each PE ratio, from lowest to highest, and computed the annual stock market returns in the years following:
One-year and Two-year stock returns
The predictive power improves for PE ratios with this test, since returns in the years following high PE ratios are consistently lower than returns following low PE ratios. Normalizing the earnings does help, but more in detecting when stocks are cheap than when they are expensive. Finally, the inflation adjustment does nothing to improve predictive returns.

Note, though, that this test is biased by the fact that the quartiles were created using data from the period on which the test is run. Thus, the conclusion that you can draw from this table is that if you had known, in 1969, what the distribution of PE ratios for the S&P 500 would look like for the next 45 years (which would suggest amazing foresight on your part), you could have made money by buying when PE ratios were in the bottom quartile of the distribution and selling in the top quartile.

b. EP Ratios and Interest Rates

One of the biggest perils of using the level of PE ratios as an indicator of stock market pricing, as we have in the last section, is that it ignores the level of interest rates. If  interest rates are lower, PE ratios should be higher and ignoring that relationship will lead us to conclude far too frequently (and erroneously) that stocks are over priced in low-interest rate environments. The link between PE ratios and interest rates is best illustrated by looking at how the EP ratio (the inverse of the PE ratio) moves with the T.Bond rate over time. In the figure below, I graph the movements of all four variants of EP ratios as the T.Bond rates changes between 1969 and 2013:

It is clear that EP ratios are high when interest rates are high and low when interest rates are low. In fact, not controlling for the level of interest rates when comparing PE ratios for a market over time is an exercise in futility.

This insight is not new and is the basis for the Fed Model, which looks at the spread between the EP ratio and the T.Bond rate. The premise of the model is that stocks are cheap when the EP ratio exceeds T.Bond rates and expensive when it is lower. To evaluate the predictive power of this spread, I classified the years between 1969 and 2013 into four quartiles, based upon the level of the spread, and computed the returns in the years after (one and two-year horizons):

The results are murkier, but for the most part, stock returns are higher when the EP ratio exceeds the T.Bond rate.

c. Intrinsic Value
Both PE ratios and EP ratio spreads (like the Fed Model) can be faulted for looking at only part of the value picture. A fuller analysis would require us to look at all of the drivers of value, and that can be done in an intrinsic value model. In the picture below, I attempt to do so on June 14, 2014:

Intrinsic valuation of S&P 500: June 2014
It is true that this intrinsic value is a function of my assumptions, including the growth rate and the implied equity risk premium. You are welcome to download the spreadsheet and try your own variations.

If your concern is that I have used too low an equity risk premium, you can solve, as I do at the start of each month, for an implied equity risk premium (by looking for that equity risk premium that will give you the current index level) and then comparing that value to historical values for that input:

The current implied ERP of 4.99% is well above the historic average and median and it clearly is much higher than the 2.05% that prevailed at the end of 1999.

Are we in a bubble?
In the table below,  I summarize where the market stands today on each of the metrics that I discussed in the last section:

If you focus on PE ratios, it is true the current levels in the market put it in the danger zone, given past history. However, bringing the level of interest rates into the measure (in the EP spreads) reverses the diagnosis, since stocks look under valued on these measures. Finally, expanding the assessment to look at growth and risk as well in the intrinsic value and ERP measures reinforces suggests that stocks are fairly valued. 
While there are some who are adamant in their belief that the market is in a bubble, I remain unconvinced, especially given the level of rates today. To those who argue that earnings could drop, growth could turn negative, interest rates could go up or that there could be another global crisis lurking around the corner, has there ever been a point in time in stock market history where these concerns have not existed? And even if they do exist, the reason we demand an equity risk premium in the first place is for the uncertainty that we feel about macroeconomic variables driving value.

Bubble Belief to Bubble Action: The Trade Off

While I believe that the risk that we are in a bubble is over stated by PE ratio comparisons, you may come to a very different conclusion. Even if you do, though, should you act on that belief? The answer is not clear cut, since there are two ways you can respond to a bubble. The first, which I will term the passive defense, is to reduce the amount of your portfolio allocated to equity to a lower number than you would normally hold (given your age, liquidity needs and risk aversion). The second which I term the active defense is to try to profit off the market correction by selling short (or buying puts). The trade off is then between the cost and the benefit of acting:
  • The cost of acting: If you decide to act on a bubble, there is a cost. With the passive defense,  the money that you take out of equities has to be invested somewhere safe (earning a risk free rate, or something close to it) and if the correction does not happen, you will lose the return premium you would have earned by investing stocks. With an active defense, the cost of being wrong about the correction is even greater since your losses will increase in direct proportion with how well stocks continue to do. (Note that using derivatives to protect yourself against market corrections or for speculation will deliver variants of these defenses.)
  • The benefit of acting: If you are right about the bubble and a correction occurs, there is a payoff to acting. With the passive defense, you protect your investment (or at least that portion that you shift out of equities) from the drop. With the active defense, you profit from the drop, with the magnitude of your profits increasing with the size of the correction.
The trade off then becomes a function of three variables: how certain you feel about the existence of a  bubble, how big a correction you see occurring as a result of the bubble bursting and how soon you see the correction coming.

To illustrate the trade off, consider a simple (perhaps simplistic) scenario, where you are fully invested in equities and believe that there is 20% probability of a  market correction (which you expect to be 40%) occurring in 2 years. In addition, let’s assume that the expected return on stocks in a normal year (no bubble) is 7.51% annually and that the expected annual return if a bubble exists will be 9% annually, until the bubble bursts. In the table below, I have listed the payoffs to doing nothing (staying 100% in equities) as well as a passive defense (where you sell all your equity and go invest in a  risk free asset earning .5%) and an active defense (where you sell short on equities and invest the proceeds in a risk free asset):

Future value of portfolio in 2 years (when correction occurs)

If you remain invested in equities (do nothing), even allowing for the market correction of 40% at the end of year 2, your expected value is $1.0672 at the end of the period.  With a passive defense, you earn the risk free rate of 0.5% a year, for two years, and the end value for your portfolio is just slightly in excess of $1.01. With an active defense, where you sell short and invest int he risk free rate, your portfolio will increase to $1.3072, if a correction occurs, but the expected value of your portfolio is only $0.9528, which is $0.1144 less than your do-nothing strategy.

If you feel absolute conviction about the existence of a bubble and see a large correction coming immediately or very soon, it clearly pays to act on bubbles and to do so with an active defense. However, that trade off tilts towards inaction as uncertainty about the existence of the bubble increases, its expected magnitude decreases and the longer you will have to wait for the correction to occur. I know that I am pushing my luck here but I tried to assess the trade off in a spreadsheet, where based upon your inputs on these variables, I estimate the net benefit of acting on a bubble for the passive act of moving all of your equity investment into a risk free alternative:

Payoff to Passive Defense against Bubble (Correction of 40% in 2 years)

The net payoff to acting on a bubble generates positive returns only if your conviction that a bubble exists is high (with a 20% probability, it almost never pays to act) and even with strong convictions, only if the market correction is expected to be large and occur quickly.

On a personal note, I have never found a metric or metrics that  allow me to have the combination of conviction that a bubble exists, that the correction will be large enough and/or that the correction will happen within a reasonable time frame, to be a market timer. Hence, I don’t try! You may have a better metric than I do and if it yields more conclusive results than mine, you should be a market timer.

Bubblenomics: My perspective
It is extremely dangerous to disagree with a Nobel prize winner, and even more so, to disagree with two in the same post, but I am going to risk it in this closing section:

  1. There will always be bubbles: Disagreeing with Gene Fama, I believe that bubbles are part and parcel of financial markets, because investors are human.  More data and computerized trading will not make bubbles a thing of the past because data is just as often an instrument for our behavioral foibles as it is an antidote to them and computer algorithms are created by human programmers.
  2. But bubbles  are not as common as we think they are: Parting ways with Robert Shiller, I would propose that bubbles occur infrequently and that they are not always irrational. Most market corrections are rational adjustments to real world shifts and not bubbles bursting and even the most egregious bubbles have rational cores.
  3. Bubbles are more clearly visible in the rear view mirror: While bubbles always look obvious in hindsight, it is far less obvious when you are in the midst of a bubble. 
  4. Bubbles are not all bad: Bubbles do create damage but they do create change, often for the better. I do know that the much maligned dot-com bubble changed the way we live and do business. In fact,  I agree with David Landes, an economic historian, when he asserts that  “in this world, the optimists have it, not because they are always right, but because they are positive. Even when wrong, they are positive, and that is the way of achievement, correction, improvement, and success. Educated, eyes-open optimism pays; pessimism can only offer the empty consolation of being right.” In market terms, I would rather have a market that is dominated by irrationally exuberant investors than one where prices are set by actuaries. Thus, while I would not invest in Tesla, Twitter or Uber at their existing prices, I am grateful that companies like these exist.
  5. Doing nothing is often the best response to a bubble: The most rational response to a bubble is to often not change the way you invest. If you believe, as I do, that it is difficult to diagnose when you are in a bubble and if you are in one, to figure when and how it will dissipate, the most sensible response to the fear of a bubble is to not change your asset allocation or investment philosophy. Conversely, if you feel certain about both the existence of a bubble and how it will burst, you may want to see if your certitude is warranted given your metric.

To sell or not to sell?

Recent acquisition Northern Star Resources [NST] in the ASX 200 portfolio is a great example of the conundrum faced by long-term investors when a new stock leaps out of the starting blocks. Profit-taking is evident from the tall shadows/wicks early in the week and in the decline of 21-day Twiggs Money Flow. Medium-term selling pressure suggests the stock is likely to retrace and give back some of the gains of the last two weeks. The temptation must be great to sell the stock and lock in profits of close to 30 percent.


It is important, however, to stick to the plan. We are investing for a longer time frame in anticipation of much larger gains. There is no guarantee that any individual stock, including NST, will deliver. But I can guarantee you that they will not deliver long-term gains if you sell within the first few weeks.

Investors in S&P 500 stock Micron Technology [MU] faced a similar conundrum in July 2013. The stock had put in a good run from $9.00 before encountering profit-taking as it approached $15.00. 21-Day Twiggs Money Flow retreated below zero and the stock fell back to $12.50. Many investors would have taken this as a sign to get out.

MU July 2013

With hindsight, the decision to stay the course looks easy: support held at $12.50 and MU is now trading at $33.00. But I am sure that there were many investors who forgot their original plan and took profits at $12.50.

MU 2013/2014

….They just aren’t bragging about it.

Understanding Momentum

Understanding Momentum

Since its initial discovery by DeBondt & Thaler in 1985, the momentum effect has been documented and researched in many markets worldwide. Stocks which have outperformed in the recent past tend to continue to perform strongly over the months ahead.

Research conducted by Dr Bruce Vanstone and me indicates that Momentum significantly outperforms the major benchmark indices in both US and Australian markets. Investors, however, tend to focus on the annual rate of return without considering the accompanying volatility. Consider our simulation of Twiggs Momentum on the S&P 500 for the period January 1996 to June 2013 as an example.

S&P 500 TMO Equity Curve: click to enlarge

Dark green areas represent cash holdings, when market risk is identified as elevated. The blue line represents the benchmark S&P 500 index. Click on the image if you need a larger view.

Investment Strategy: Twiggs Momentum Buy & Hold
Starting Capital (USD): $100,000 $100,000
Ending Capital (USD): $4,871,686.27 $258,649.35
Annualized Gain: 24.89% 5.58%
Total Commission Paid (at 5 BPS): $66,194.35 $49.96
Number of Investments: 331 1
Win Rate: 54.38% 100.00%
Average Profit: 44.16% 158.79%
Average Loss: 10.15% 0.00%
Maximum Drawdown: 38.64% 56.77%
Maximum Drawdown Date: 9/11/2006 3/9/2009
Sharpe Ratio: 0.98 0.42

Investors tend to focus on the annualized gain of 24.89% p.a. without really applying their minds to the other statistics in the table. Maximum Drawdown of 38.64%, while lower than the index, means the portfolio is still subject to gut-wrenching volatility. Soaring gains are often followed by sharp falls and it takes strong resolve to stick with the strategy after one of these setbacks. Many investors would have abandoned ship after the first major drawdown in early 2000.

Another factor is the Win Rate of just above 54% which means that over 45% of all stocks purchased are sold at a loss. These are typical statistics for a momentum strategy, but investors can expect a high percentage of stocks to be cut from the portfolio for failing to adhere to the expected growth path. The strength of the strategy, however, is the expected gains on stocks that do adhere to the momentum growth path, with average profits exceeding average losses by a ratio of almost 4 to 1. That is where the excess returns are generated and is the reason why the strategy outperforms the benchmark index.

There are also extended periods where the portfolio remains in cash — long enough for doubts to grow as to whether momentum still works in the markets. My own view is that momentum strategies have been shown to outperform the Dow over the last 100 years and are likely to remain viable for as long as we have stock market cycles.

Coping with the emotional roller-coaster ride of investing in stocks is never easy, but here are some hints.

  • Focus on your investment time horizon of at least 5 years.
  • Check stock prices no more than once a week. Tracking prices daily or more frequently tends to cloud your judgement.
  • Welcome gains ahead of long-term averages, but expect them to fade over time.
  • If something unusual occurs, step back from the market, examine the long-term history, and ask: “Is this really unexpected or were my expectations unrealistic.”

That’s all for today. Take care.

How does R&I compare to other investment channels?

DIY investors have several alternative channels for investing in equities. The most hands-off is to invest in managed funds, or a managed discretionary account (MDA), where all investment decisions and actions are made for you. On the other extreme is to purchase investment software that offers a proven investment strategy, where you are responsible for your own investment decisions and execution. In the middle-ground is Research & Investment, where no decision-making is required — other than to invest in a subscription — but you are required to execute your own trades in the market.

Here we compare the relative costs and effort required for each investment channel using a standard investment of $100,000:

Investment Alternative: R&I MDA Software
Upfront cost: $0 $0 $2,000 to $3,000
Ongoing monthly cost: $95 $100 to $200 $50 to $100
Performance fees (above index benchmark): None Up to 22% None
Time & Effort required: 2 to 3 hours/month 0 to 1 hours/month 2 to 3 hours/day
Complexity: Low Very Low High
Mobility & Freedom of movement: High Very High Low
Detachment & Freedom from emotional pressure and external influences: Medium High Low
Investment Timeframe 5 to 10 years
Recommended Leverage: None
Typical Number of Stocks: 10 to 20 Varies Varies
Tax Implications: Suitable for lower tax vehicles such as super funds.
Subscriber Limit: 500 to 1000 Varies Unlimited
Performance: Medium to High Low to High Low to High

Upfront costs are for purchase of investment software.

Monthly costs include R&I subscriptions, management and platform fees for MDAs (from 1.2% to 2.4% of net assets), and data costs for investment software.

Performance fees are calculated on outperformance above a suitable benchmark like the ASX 200 Accumulation Index.

Time required for R&I is to review the update and implement the portfolio changes, normally once a month. A managed account merely requires you to review performance. Investment software normally requires daily scans of the market, review of charts and placing trades with your broker.

Complexity with R&I is limited to reading the updates and placing trades with your broker. A managed account merely requires you to review performance. But investment software requires complex installation and mastery of the operating rules.

Mobility is a problem if you are on holiday or work away from home and need to access your system. R&I requires you to login once a month to receive updates and then place any trades with an online broker. A managed account requires no monthly intervention. Investment software normally requires daily access to the database on your computer to perform scans and daily access to an online broker.

Detachment is achieved if you have a managed account: someone else makes the decisions for you. R&I is a rules-based strategy and requires you to ignore external influences and adhere to the system, implementing all trades. Because of the level of involvement required with investment software, detachment is difficult and investors often stray from the prescribed rules.

Investment time frame is the same for all three vehicles.

Recommended leverage is zero because of volatility of returns.

Typical number of stocks is 10 to 20. R&I is a high conviction strategy, selecting a smaller number of stocks in order to achieve outperformance. Some funds and software follow a similar path, while some erode performance through over-diversification (di-worsification as Warren Buffett calls it).

Tax implications are the same: active strategies do not maximise capital gains tax concessions and require a low tax vehicle such as a SMSF.

Subscriber limits are enforced by R&I to protect performance: too many investors using the same system would affect entry/exit prices and erode returns. Some managed funds are closed or capped, but most are not.

Performance of all three investment alternatives is variable, but by pursuing a high conviction strategy and following a strict, rules-based approach, R&I investors are more likely to outperform the relevant index benchmarks.

We hope you find this comparison useful. To find out more:

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Is the market overpriced? Episode III

US markets look pricey when we compare market capitalization to GDP. Why is the market ignoring this?

The S&P 500 is trading on a reasonable forward Price-Earnings Ratio (PE) of 15.17, but this forecasts a 23% jump in earnings over the next 12 months. Current as reported PE of 18.64 also assumes strong earnings growth.

S&P 500

Margins are growing:
S&P 500

But sales growth close to zero warns that earnings may falter:
S&P 500

Book value is surprisingly growing faster than sales, suggesting that corporations are hoarding assets rather than distributing profits to shareholders:
S&P 500

Causing asset turnover (sales/book value) to fall:
S&P 500

Which is why the valuation metric of Price to Book Value remains within reasonable bounds:
S&P 500

If management are unable to improve asset turnover — through improved sales or new investment — stockholders will start clamoring for higher distributions. Which may be one reason for high stock prices.

The second reason is that, with interest rates, tax rates and real wages at historic lows, corporations are likely to make fat profits over the next few years and stocks remain reasonably buoyant. But at least one of these factors can be expected to change in the next decade: recovery of the housing market would cause the Fed to lift interest rates; a revision of the tax code by a President who can work with both sides of the House; or a dramatic fall in exchange rates placing upward pressure on (real) wages as manufacturers regain export markets. The impact of any change will depend on how well the economy has recovered.

I will be watching sales growth, profit margins and asset turnover with interest over the next few quarters to see how this plays out.

Research & Investment: Performance at 30 April 2014

Our ASX200 Prime Momentum strategy returned +30.04%* for the 12 months ended 30th April 2014, outperforming the benchmark ASX200 Accumulation Index by +19.58%.

ASX200 Prime Momentum

The S&P 500 Prime Momentum strategy has been running six months, since November 2013, and returned 7.79%* for the period, compared to 8.36% for the S&P 500 Total Return Index.

A sell-off of momentum stocks affected performance in April, but macroeconomic and volatility filters indicate low risk typical of a bull market and we see current weakness as a buying opportunity.

* Results are before fees, unaudited and subject to revision.

Research & Investment performance update

Our ASX200 Prime Momentum strategy returned +42.10%* for the 12 months ended 31st March 2014, compared to +13.46% for the benchmark ASX200 Accumulation Index.

* Results are unaudited and subject to revision.

ASX200 Prime Momentum

The S&P 500 Prime Momentum strategy has only been running five months, since November 2013, but returned 8.73%* for the period, compared to 6.28% for the S&P 500 Total Return Index.