Posts filed under ‘Behavioral Finance’
Stocks Winning vs. Weak Competitors
This article is an excerpt from a previously released Sidoxia Capital Management complementary newsletter (June 2, 2014). Subscribe on the right side of the page for the complete text.
Winning at any sport is lot easier if you can compete without an opponent. Imagine an NBA basketball MVP LeBron James driving to the basket against no defender, or versus a weakling opponent like a 44-year-old investment manager. Under these circumstances, it would be pretty easy for James and his team, the Miami Heat, to victoriously dominate without even a trace of sweat.
Effectively, stocks have enjoyed similar domination in recent years, while steamrolling over the bond competition. To put the stock market’s winning streak into perspective, the S&P 500 index set a new all-time record high in May, with the S&P 500 advancing +2.1% to 1924 for the month, bringing the 2013-2014 total return to about +38%. Not too shabby results over 17 months, if you consider bank deposits and CDs are paying a paltry 0.0-1.0% annually, and investors are gobbling up bonds yielding a measly 2.5% (see chart below).
The point, once again, is that even if you are a skeptic or bear on the outlook for stocks, the stock market still offers the most attractive opportunities relative to other asset classes and investment options, including bonds. It’s true, the low hanging fruit in stocks has been picked, and portfolios can become too equity-heavy, but even retirees should have some exposure to equities.
As I wrote last month in Buy in May and Dance Away, why would investors voluntarily lock in inadequate yields at generational lows when the earnings yield on stocks are so much more appealing. The approximate P/E (Price-Earnings) ratio for the S&P 500 currently averages approximately +6.2% with a rising dividend yield of about +1.8% – not much lower than many bonds. Over the last five years, those investors willing to part ways with yield-less cash have voted aggressively with their wallets. Those with confidence in the equity markets have benefited massively from the approximate +200% gains garnered from the March 2009 S&P 500 index lows.
For the many who have painfully missed the mother of all stock rallies, the fallback response has been, “Well, sure the market has tripled, but it’s only because of unprecedented printing of money at the QE (Quantitative Easing) printing presses!” This argument has become increasingly difficult to defend ever since the Federal Reserve announced the initiation of the reduction in bond buying (a.k.a., “tapering”) six months ago (December 18th). Over that time period, the Dow Jones Industrial Average has increased over 800 points and the S&P 500 index has risen a healthy 8.0%.
As much as everyone would like to blame (give credit to) the Fed for the bull market, the fact is the Federal Reserve doesn’t control the world’s interest rates. Sure, the Fed has an influence on global interest rates, but countries like Japan may have something to do with their own 0.57% 10-year government bond yield. For example, the economic/political policies and demographics in play might be impacting Japan’s stock market (Nikkei), which has plummeted about -62% over the last 25 years (about 39,000 to 15,000). Almost as shocking as the lowly rates in Japan and the U.S. and Japan, are the astonishingly low interest rates in Europe. As the chart below shows, France and Germany have sub-2% 10-year government bond yields (1.76% and 1.36%, respectively) and even economic basket case countries like Italy and Spain have seen their yields pierce below the 3% level.
Source: Dr. Ed’s Blog
Suffice it to say, yield is not only difficult to find on our shores, but it is also challenging to find winning bond returns globally.
Well if low interest rates and the Federal Reserve aren’t the only reasons for a skyrocketing stock market, then how come this juggernaut performance has such long legs? The largest reason in my mind boils down to two words…record profits. Readers of mine know I follow the basic tenet that stock prices follow earnings over the long-term. Interest rates and Fed Policy will provide headwinds and tailwinds over different timeframes, but ultimately the almighty direction of profits determines long-run stock performance. You don’t have to be a brain surgeon or rocket scientist to appreciate this correlation. Scott Grannis (Calafia Beach Pundit) has beautifully documented this relationship in the chart below.
Supporting this concept, profits help support numerous value-enhancing shareholder activities we have seen on the rise over the last five years, which include rising dividends, share buybacks, and M&A (Mergers & Acquisitions) activity. Eventually the business cycle will run its course, and during the next recession, profits and stock prices will be expected to decline. A final contributing factor to the duration of this bull market is the abysmally slow pace of this economic recovery, which if measured in job creation terms has been the slowest since World War II. Said differently, the slower a recovery develops, the longer the recovery will last. Bill McBride at Calculated Risk captured this theme in the following chart:
Despite the massive gains and new records set, skeptics abound as evidenced by the nearly -$10 billion of withdrawn money out of U.S. stock funds over the last month (most recent data).
I’ve been labeled a perma-bull by some, but over my 20+ years of investing experience I understand the importance of defensive positioning along with the benefits of shorting expensive, leveraged stocks during bear markets, like the ones in 2000-2001 and 2008-2009. When will I reverse my views and become bearish (negative) on stocks? Here are a few factors I’m tracking:
- Inverted Yield Curve: This was a good precursor to the 2008-2009 crash, but there are no signs of this occurring yet.
- Overheated Fund Inflows: When everyone piles into stocks, I get nervous. In the last four weeks of domestic ICI fund flow data, we have seen the opposite…about -$9.5 billion outflows from stock funds.
- Peak Employment: When things can’t get much better is the time to become more worried. There is still plenty of room for improvement, especially if you consider the stunningly low employment participation rate.
- Fed Tightening / Rising Bond Yields: The Fed has made it clear, it will be a while before this will occur.
- When Housing Approaches Record Levels: Although Case-Shiller data has shown housing prices bouncing from the bottom, it’s clear that new home sales have stalled and have plenty of head room to go higher.
- Financial Crisis: Chances of experiencing another financial crisis of a generation is slim, but many people have fresh nightmares from the 2008-2009 financial crisis. It’s not every day that a 158 year-old institution (Lehman Brothers) or 85 year-old investment bank (Bear Stearns) disappear, but if the dominoes start falling again, then I guess it’s OK to become anxious again.
- Better Opportunities: The beauty about my practice at Sidoxia is that we can invest anywhere. So if we find more attractive opportunities in emerging market debt, convertible bonds, floating rate notes, private equity, or other asset classes, we have no allegiances and will sell stocks.
Every recession and bear market is different, and although the skies may be blue in the stock market now, clouds and gray skies are never too far away. Even with record prices, many fears remain, including the following:
- Ukraine: There is always geopolitical instability somewhere on the globe. In the past investors were worried about Egypt, Iran, and Syria, but for now, some uncertainty has been created around Ukraine.
- Weak GDP: Gross Domestic Product was revised lower to -1% during the first quarter, in large part due to an abnormally cold winter in many parts of the country. However, many economists are already talking about the possibility of a 3%+ rebound in the second quarter as weather improves.
- Low Volatility: The so-called “Fear Gauge” is near record low levels (VIX index), implying a reckless complacency among investors. While this is a measure I track, it is more confined to speculative traders compared to retail investors. In other words, my grandma isn’t buying put option insurance on the Nasdaq 100 index to protect her portfolio against the ramifications of the Thailand government military coup.
- Inflation/Deflation: Regardless of whether stocks are near a record top or bottom, financial media outlets in need of a topic can always fall back on the fear of inflation or deflation. Currently inflation remains in check. The Fed’s primary measure of inflation, the Core PCE, recently inched up +0.2% month-to-month, in line with forecasts.
- Fed Policy: When are investors not worried about the Federal Reserve’s next step? Like inflation, we’ll be hearing about this concern until we permanently enter our grave.
In the sport of stocks and investing, winning is never easy. However, with the global trend of declining interest rates and the scarcity of yields from bonds and other safe investments (cash/money market/CDs), it should come as no surprise to anyone that the winning streak in stocks is tied to the lack of competing investment alternatives. Based on the current dynamics in the market, if LeBron James is a stock, and I’m forced to guard him as a 10-year Treasury bond, I think I’ll just throw in the towel and go to Wall Street. At least that way my long-term portfolio has a chance of winning by placing a portion of my bets on stocks over bonds.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
Searching for the Market Boogeyman
With the stock market reaching all-time record highs (S&P 500: 1900), you would think there would be a lot of cheers, high-fiving, and back slapping. Instead, investors are ignoring the sunny, blue skies and taking off their rose-colored glasses. Rather than securely sleeping like a baby (or relaxing during a three-day weekend) with their investment accounts, people are biting their fingernails with clenched teeth, while searching for a market boogeyman in their closets or under their beds.
If you don’t believe me, all you have to do is pick up the paper, turn on the TV, or walk over to the office water cooler. An avalanche of scary headlines that are spooking investors include geopolitical concerns in Ukraine & Thailand, slowing housing statistics, bearish hedge fund managers (i.e., Tepper Einhorn, Cooperman), declining interest rates, and collapsing internet stocks. In other words, investors are looking for things to worry about, despite record corporate profits and stock prices. Peter Lynch, the manager of the Magellan Fund that posted +2,700% in gains from 1977-1990, put short-term stock price volatility into perspective:
“You shouldn’t worry about it. You should worry what are stocks going to be 10 years from now, 20 years from now, 30 years from now.”
Rather than focusing on immediate stock market volatility and other factors out of your control, why not prioritize your time on things you can control. What investors can control is their asset allocation and spending levels (budget), subject to their personal time horizons and risk tolerances. Circumstances always change, but if people spent half the time on investing that they devoted to planning holiday vacations, purchasing a car, or choosing a school for their child, then retirement would be a lot less stressful. After realizing 99% of all the short-term news is nonsensical noise, the next important realization is stocks are volatile securities, which frequently go down -10 to -20%. As much as amateurs and professionals say or think they can profitably predict these corrections, they very rarely can. If your stomach can’t handle the roller-coaster swings, then you shouldn’t be investing in the stock market.
Bear-markets generally coincide with recessions, and since World War II, Americans experience about two economic contractions every decade. And as I pointed out earlier in A Series of Unfortunate Events, even during the current massive bull market, a recession has not been required to suffer significant short-term losses (e.g., Flash Crash, Greece, Arab Spring, Obamacare, Cyprus, etc.). Seasoned veterans understand these volatile periods provide incredible investment opportunities. As Warren Buffett states, “Be fearful when others are greedy, and be greedy when others are fearful.” Fear and panic may be behind us, but skepticism is still firmly in place. Buying during current skepticism is still not a bad thing, as long as greed hasn’t permeated the masses, which remains the case today.
Overly emotional people that make investment decisions with their gut do more damage to their savings accounts than conservative, emotional investors who understand their emotional shortcomings. On the other hand, the problem with investing too conservatively, for those that have longer-term time horizons (10+ years), is multi-pronged. For starters, overly conservative investments made while interest rate levels hover near historical lows lead to inflationary pressures gobbling up savings accounts. Secondly, the low total returns associated with excessively conservative investments will result in a later retirement (e.g., part-time Wal-Mart greeter in your 80s), or lower quality standard of living (e.g., macaroni & cheese dinners vs. filet mignon).
Most people say they understand the trade-offs of risk and return. Over the long-run, low-risk investments result in lower returns than high risk investments (i.e., bonds vs. stocks). If you look at the following chart and ask anyone what their preferred path would be over the long-run, almost everyone would select the steep, upward-sloping equity return line.
Source: Betterment.com / Stocks for the Long Run
Yet, stock ownership and attitudes towards stocks remain at relatively low and skeptical levels (see Gallup survey in Markets Soar and Investors Snore). It’s true that attitudes are changing at a glacial pace and bond outflows accelerated in 2013, but more recently stock inflows remain sporadic and scared money is returning to bonds. Even though it has been over five years, the emotional scars from 2008-2009 apparently still need some time to heal.
Investing in stocks can be very scary and hazardous to your health. For those millions of investors who realize they do not hold the emotional fortitude to withstand the ups and downs, leave the worrying responsibilities to the experienced advisors and investment managers like me. That way you can focus on your job and retirement, while the pros can remain responsible for hunting and slaying the boogeyman.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold long positions in certain exchange traded funds and WMT, but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
Buy in May and Tap Dance Away
This article is an excerpt from a previously released Sidoxia Capital Management complementary newsletter (May 1, 2014). Subscribe on the right side of the page for the complete text.
The proverbial Wall Street adage that urges investors to “Sell in May, and go away” in order to avoid a seasonally volatile period from May to October has driven speculative trading strategies for generations. The basic premise behind the plan revolves around the idea that people have better things to do during the spring and summer months, so they sell stocks. Once the weather cools off, the thought process reverses as investors renew their interest in stocks during November. If investing was as easy as selling stocks on May 1 st and then buying them back on November 1st, then we could all caravan in yachts to our private islands while drinking from umbrella-filled coconut drinks. Regrettably, successful investing is not that simple and following naïve strategies like these generally don’t work over the long-run.
Even if you believe in market timing and seasonal investing (see Getting Off the Market Timing Treadmill ), the prohibitive transaction costs and tax implications often strip away any potential statistical advantage.
Unfortunately for the bears, who often react to this type of voodoo investing, betting against the stock market from May – October during the last two years has been a money-losing strategy. Rather than going away, investors have been better served to “Buy in May, and tap dance away.” More specifically, the S&P 500 index has increased in each of the last two years, including a +10% surge during the May-October period last year.
Nervous? Why Invest Now?
With the weak recent economic GDP figures and stock prices off by less than 1% from their all-time record highs, why in the world would investors consider investing now? Well, for starters, one must ask themselves, “What options do I have for my savings…cash?” Cash has been and will continue to be a poor place to hoard funds, especially when interest rates are near historic lows and inflation is eating away the value of your nest-egg like a hungry sumo wrestler. Anyone who has completed their income taxes last month knows how pathetic bank rates have been, and if you have pumped gas recently, you can appreciate the gnawing impact of escalating gasoline prices.
While there are selective opportunities to garner attractive yields in the bond market, as exploited in Sidoxia Fusion strategies, strategist and economist Dr. Ed Yardeni points out that equities have approximately +50% higher yields than corporate bonds. As you can see from the chart below, stocks (blue line) are yielding profits of about +6.6% vs +4.2% for corporate bonds (red line). In other words, for every $100 invested in stocks, companies are earning $6.60 in profits on average, which are then either paid out to investors as growing dividends and/or reinvested back into their companies for future growth.
Source: Dr. Ed’s Blog
Hefty profit streams have resulted in healthy corporate balance sheets, which have served as ammunition for the improving jobs picture. At best, the economic recovery has moved from a snail’s pace to a tortoise’s pace, but nevertheless, the unemployment rate has returned to a more respectable 6.7% rate. The mended economy has virtually recovered all of the approximately 9 million private jobs lost during the financial crisis (see chart below) and expectations for Friday’s jobs report is for another +220,000 jobs added during the month of April.
Source: Bespoke
Wondrous Wing Woman
Investing can be scary for some individuals, but having an accommodative Fed Chair like Janet Yellen on your side makes the challenge more manageable. As I’ve pointed out in the past (with the help of Scott Grannis), the Fed’s stimulative ‘Quantitative Easing’ program counter intuitively raised interest rates during its implementation. What’s more, Yellen’s spearheading of the unprecedented $40 billion bond buying reduction program (a.k.a., ‘Taper’) has unexpectedly led to declining interest rates in recent months. If all goes well, Yellen will have completed the $85 billion monthly tapering by the end of this year, assuming the economy continues to expand.
In the meantime, investors and the broader financial markets have begun to digest the unwinding of the largest, most unprecedented monetary intervention in financial history. How can we tell this is the case? CEO confidence has improved to the point that $1 trillion of deals have been announced this year, including offers by Pfizer Inc. – PFE ($100 billion), Facebook Inc. – FB ($19 billion), and Comcast Corp. – CMCSA ($45 billion).
Source: Entrepreneur
Banks are feeling more confident too, and this is evident by the acceleration seen in bank loans. After the financial crisis, gun-shy bank CEOs fortified their balance sheets, but with five years of economic expansion under their belts, the banks are beginning to loosen their loan purse strings further (see chart below).
The coast is never completely clear. As always, there are plenty of things to worry about. If it’s not Ukraine, it can be slowing growth in China, mid-term elections in the fall, and/or rising tensions in the Middle East. However, for the vast majority of investors, relying on calendar adages (i.e., selling in May) is a complete waste of time. You will be much better off investing in attractively priced, long-term opportunities, and then tap dance your way to financial prosperity.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in PFE, CMCSA, and certain exchange traded funds (ETFs), but at the time of publishing SCM had no direct position in FB or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
Passive vs. Active Investing: Darts, Monkeys & Pros
Bob Turner is founder of Turner Investments and a manager of several funds at the investment company. In a recent article he reintroduces the all-important, longstanding debate of active management (“hands-on”) versus passive management (“hands off”) approaches to investing. Mr. Turner makes some good arguments for the active management camp, however some feel differently – take for example Burton Malkiel. The Princeton professor theorizes in his book A Random Walk Down Wall Street that “a blindfolded monkey throwing darts at a newspaper’s stock page could select a portfolio that would do just as well as one carefully selected by experts.” In fact, The Wall Street Journal manages an Investment Dartboard contest that stacks up amateur investors’ picks against the pros’ and random stock picks selected by randomly thrown darts. In many instances, the dartboard picks outperform the professionals. Given the controversy, who’s right…the darts, monkeys, or pros? Distinguishing between the different categorizations can be difficult, but we will take a stab nevertheless.
Arguments for Active Management
Turner contends, active management outperforms in periods of high volatility and he believes the industry will be entering such a phase:
“Active managers historically have tended to perform best in a market in which the performance of individual stocks varies widely.”
He also acknowledges that not all active managers outperform and admits there are periods where passive management will do better:
“The reason why most active investors fail to outperform is because they in fact constitute most of the market. Even in the best of times, not all active managers can hope to outperform…The business of picking stocks is to some degree a zero-sum game; the results achieved by the best managers will be offset at least somewhat by the subpar performance of other managers.”
Buttressing his argument for active management, Turner references data from Advisor Perspectives showing an inconclusive percentage (40.5%-67.8%) of the actively managed funds trailing the passively managed indexes from 2000 to 2008.
The Case for Passive Management
Turner cites one specific study to support his active management cause. However, my experience gleaned from the vast amounts of academic and industry data point to approximately 75% of active managers underperforming their passively managed indexes, over longer periods of time. Notably, a recent study conducted by Standard & Poor’s SPIVA division (S&P Indices Versus Active Funds) discovered the following conclusions over the five year market cycle from 2004 to 2008:
- S&P 500 outperformed 71.9% of actively managed large cap funds;
- S&P MidCap 400 outperformed 79.1% of mid cap funds;
- S&P SmallCap 600 outperformed 85.5% of small cap funds.
Read more about the dirty secrets shrinking your portfolio. According to the Vanguard Group and the Investment Company Institute, about 25% of institutional assets and about 12% of individual investors’ assets are currently indexed (passive strategies). If you doubt the popularity of passive investment strategies, then look no further than the growth of Exchange Traded Funds (ETFs – see chart), index funds, or Vanguard Groups more than $1 trillion dollars in assets under management.
Although I am a firm believer in passive investing, one of its shortcomings is mean reversion. This is the idea that upward or downward moving trends tend to revert back to an average or normal level over time. Active investing can take advantage of mean reversion, conversely passive investing cannot. Indexes can get very top-heavy in weightings of outperforming sectors or industries, meaning theoretically you could be buying larger and larger shares of an index in overpriced glamour stocks on the verge of collapse. We experienced these lopsided index weightings through the technology bubbles in the late 1990s and financials in 2008. Some strategies may be better than other over the long run, but every strategy, even passive investing, has its own unique set of deficiencies and risks.
Professional Sports and Investing
As I discuss in my book, there are similarities that can be drawn between professional sports and investing with respect to active vs. passive management. Like the scarce number of .300 hitters in baseball, I believe there are a select few investment managers who can consistently outperform the market. In 2007, AssociatedContent.com did a study that showed there were only 22 active career .300 hitters in Major League Baseball. I recognize in the investing world there can be a larger role for “luck,” which is difficult, if not impossible, to measure (luck won’t help me much in hitting a 100 mile per hour fastball thrown by Nolan Ryan). Nonetheless, in the professional sports arena, there are some Hall of Famers (prospects) that have proved they could (can) consistently outperform their peers for extended durations of time. Experience is another distinction I would highlight in comparing sports and investing. Unlike sports, in the investment world I believe there is a positive correlation between age and ability. The more experience an investor gains, generally the better long-term return achieved. Like many professions, the more experience you gain, the more valuable you become. Unfortunately, in many sports, ability deteriorates and muscles atrophy over time.
Size Matters
Experience alone will not make you a better investor. Some investors are born with an innate gift or intellect that propels them ahead of the pack. However, most great investors eventually get cursed by their own success thanks to accumulating assets. Warren Buffet knows the consequences of managing large amounts of dollars, “gravity always wins.” Having managed a $20 billion fund, I fully appreciate the challenges of investing larger sums of money. Managing a smaller fund is similar to navigating a speed boat – not too difficult to maneuver and fairly easy to dodge obstacles. Managing heftier pools of money can be like captaining a supertanker, but unfortunately the same rapid u-turn expectations of the speedboat remain. Managing large amounts of capital can be crippling, and that’s why captaining a supertanker requires the proper foresight and experience.
Room for All
As I’ve stated before, I believe the market is efficient in the long run, but can be terribly inefficient in the short-run, especially when the behavioral aspects of emotion (fear and greed) take over. The “wait for me, I want to play too” greed from the late 1990s technology craze and the credit-based economic collapse of 2008-2009 are further examples of inefficient situations that can be exploited by active managers. However, due to multiple fees, transaction costs, taxes, not to mention the short-term performance/compensation pressures to perform, I believe the odds are stacked against the active managers. For those experienced managers that have played the game for a long period and have a track record of success, I feel active management can play a role. At Sidoxia Capital Management, I choose to create investment portfolios that blend a mixture of passive and active investment strategies. Although my hedge fund has outperformed the S&P 500 in 4 of the last 5 years, that fact does not necessarily mean it’s the appropriate sole approach for all clients. As Warren Buffet states, investors should stick to their “circle of competence” so they can confidently invest in what they know. That’s why I generally stick to the areas of my expertise when I’m actively investing in stocks, and fill in the remainder of client portfolios with transparent, low-cost, tax-efficient equity and fixed income products (i.e., Exchange Traded Funds). Even though the actively managed Turner Funds appear to have a mixed-bag of performance numbers relative to passively managed strategies, I appreciate Bob Turner’s article for addressing this important issue. I’m sure the debate will never fully be resolved. In the meantime, my client portfolios will aim to mix the best of both worlds within active and passive management strategies in the eternal quest of outwitting the darts, monkeys, and other pros.
Read the full Bob Turner article on Morningstar.com
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds but had no direct position in stocks mentioned in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Aaaaaaaah: Turbulence or Nosedive?
We’ve all been there on that rocky plane ride…clammy hands, heart beating rapidly, teeth clenched, body frozen, while firmly bracing the armrests with both appendages. The sky outside is dark and the interior fuselage rattles incessantly until….whhhhhssssshhh. Another quick jerking moment of turbulence has once again sucked the air out of your lungs and the blood from your heart. The rational part of your brain tries to assure you that this is normal choppy weather and will shortly transition to calm blue skies. The irrational and emotional, part of our brains (see Lizard Brain) tells us the treacherous plane ride is on the cusp of plummeting into a nosedive with passengers’ last gasps saved for blood curdling screams before the inevitable fireball crash.
Well, we’re now beginning to experience some small turbulence in the financial markets, and at the center of the storm is a collapsing Argentinean peso and a perceived slowing in China. In the case of Argentina, there has been a century-long history of financial defaults and mismanagement (see great Scott Grannis overview). Currently, the Argentinean government has been painted into a corner due to the depletion of its foreign currency reserves and financial mismanagement, as evidenced by an inflation rate hitting a whopping 25% rate.
On the other hand, China has created its own set of worries in investors’ minds. The flash Markit/HSBC Purchasing Managers’ Index (PMI) dropped to a level of 49.6 in January from 50.50 in December, which has investors concerned of a market crash. Adding fuel to the fear fire, Chinese government officials and banks have been trying to reverse excesses encountered in the country’s risky shadow banking system. While the size of Argentina’s economy may not be a drop in the bucket, the ultimate direction of the Chinese economy, which is almost 20x’s the size of Argentina’s, should be much more important to global investors.
At the end of the day, most of these mini-panics or crises (turbulence) are healthy for the overall financial system, as they create discipline and will eventually change irresponsible government behaviors. While Argentinean and Chinese issues dominate today’s headlines, these matters are not a whole lot different than what we have read about Greece, Ireland, Italy, Spain, Portugal, Cyprus, Turkey, and other negligent countries. As I’ve stated before, money goes where it’s treated best, and the stock, bond, and currency vigilantes ensure that this is the case by selling the assets associated with deadbeat countries. Price declines eventually catch the attention of politicians (remember the TARP vote failure of 2008?).
Is This the Beginning of the Crash?!
What goes up, must come down…right? That is the pervading sentiment I continually bump into when I speak to people on the street. Strategist Ed Yardeni did a great job of visually capturing the last six years of the stock market (below), which highlights the most recent bear market and subsequent major corrections. Noticeably absent in 2013 is any major decline. So, while many investors have been bracing for a major crash over the last five years, that scenario hasn’t happened yet. The S&P chart shows we appear to be due for a more painful blue (or red) period of decline in the not-too-distant future, but that is not necessarily the case. One would need only to thumb through the history books from 1990-1997 to see that investors lived through massive gains while avoiding any -10% correction – stocks skyrocketed +233% in 2,553 days. I’m not calling for that scenario, but I am just pointing out we don’t necessarily always live through -10% corrections annually.
Source: Dr. Ed’s Blog
Even though we’ve begun to experience some turbulence after flying high in 2013, one should not panic. You may be better off watching the end of the airline movie before putting your head in between your legs in preparation for a nosedive.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
Controlling the Investment Lizard Brain
“Normal fear protects us; abnormal fear paralyses us.”
– Martin Luther King, Jr.
Investing is challenging enough without bringing emotions into the equation. Unfortunately, humans are emotional, and as a result investors often place too much reliance on their feelings, rather than using objective information to drive rational decision making.
What causes investors to make irrational decisions? The short answer: our “amygdala.” Author and marketer Seth Godin calls this almond-shaped tissue in the middle of our head, at the end of the brain stem, the “lizard brain” (video below). Evolution created the amygdala’s instinctual survival flight response for lizards to avoid hungry hawks and humans to flee ferocious lions.
Over time, the threat of lions eating people in our modern lives has dramatically declined, but the human’s “lizard brain” is still running in full gear, worrying about other fear-inducing warnings like Iran, Syria, Obamacare, government shutdowns, taxes, Cyprus, sequestration, etc. (see Series of Unfortunate Events)
When the brain in functioning properly, the prefrontal cortex (the front part of the brain in charge of reasoning) is actively communicating with the amygdala. Sadly, for many people, and investors, the emotional response from the amygdala dominates the rational reasoning portion of the prefrontal cortex. The best investors and traders have developed the ability of separating emotions from rational decision making, by keeping the amygdala in check.
With this genetically programmed tendency of constantly fearing the next lion or stock market crash, how does one control their lizard brain from making sub-optimal, rash investment decisions? Well, the first thing you should do is turn off the TV. And by turning off the TV, I mean stop listening to talking head commentators, economists, strategists, analysts, neighbors, co-workers, blogger hacks, newsletter writers, journalists, and other investing “wannabes”. Sure, you could throw my name into the list of people to ignore if you wanted to, but the difference is, at least I have actually invested real money for over 20 years (see How I Managed $20,000,000,000.00), whereas the vast majority of those I listed have not. But don’t take my word for it…listen or read the words of other experienced investors Warren Buffett, Peter Lynch, Ron Baron, John Bogle, Phil Fisher, and other investment titans (see also Sidoxia Hall of Fame). These investment legends have successful long-term investment track records and they lived through wars, recessions, financial crises, and other calamities…and still managed to generate incredible returns.
Another famed investor, William O’Neil, summed this idea nicely by adding the following:
“Since the market tends to go in the opposite direction of what the majority of people think, I would say 95% of all these people you hear on TV shows are giving you their personal opinion. And personal opinions are almost always worthless … facts and markets are far more reliable.”
The Harmful Consequence of Brain on Pain
Besides forcing damaging decisions, another consequence of our lizard brain is its ability to distort reality. Behavioral economists Daniel Kahneman (Nobel Prize winner) and Amos Tversky through their research demonstrated the pain of $50 loss is more than twice as painful as the pleasure from $50 gain (see Pleasure/Pain Principle). Common sense would dictate our brains would treat equivalent scenarios in a proportional manner, but as the chart below shows, that is not the case:
Source: Investopedia
Kahneman adds to the decision-making relationship of the amygdala and prefrontal cortex by describing the concepts of instinctual and deliberative choices in his most recent book, Thinking Fast and Slow (see Decision Making on Freeways).
Optimizing Risk
Taking excessive risks in technology stocks in the 1990s or in housing in the mid-2000s was very damaging to many investors, but as we have seen, our lizard brains can cause investors to become overly risk averse. Over the last five years, many people have personally experienced the ill effects of unwarranted conservatism. Investment great Sir John Templeton summed up this risk by stating, “The only way to avoid mistakes is not to invest – which is the biggest mistake of all.”
Every person has a different perception and appetite for risk. The optimal amount of risk taken by any one investor should be driven by their unique liquidity needs and time horizon…not a perceived risk appetite. Typically risk appetites go up as markets peak, and conservatism reaches a fearful apex near market bottoms – the opposite tendency of rational decision making. Besides liquidity and time horizon, a focus on valuation coupled with diversification across asset class (stocks/bonds), geography (domestic/international), size (small/large), style (value/growth) is critical in controlling risk. If you can’t determine your personal, optimal risk profile, then find an experienced and knowledgeable investment advisor to assist you.
With the advent of the internet and mobile communication, our brains and amygdala continually get bombarded with fearful stimuli, leading to disastrous decision-making and damaging portfolio outcomes. Turning off the TV and selectively choosing the proper investment advice is paramount in keeping your amygdala in check. Your lizard brain may protect you from getting eaten by a lion, but falling prey to this structural brain flaw may eat your investment portfolio alive.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
Confusing Fear Bubbles with Stock Bubbles
With the Dow Jones Industrial Average approaching and now breaking the 16,000 level, there has been a lot of discussion about whether the stock market is an inflating bubble about to burst due to excessive price appreciation? The reality is a fear bubble exists…not a valuation bubble. This fear phenomenon became abundantly clear from 2008 – 2012 when $100s of billions flowed out of stocks into bonds and trillions in cash got stuffed under the mattress earning near 0% (see Take Me Out to the Stock Game). The tide has modestly turned in 2013 but as I’ve written over the last six months, investor skepticism has reigned supreme (see Most Hated Bull Market Ever & Investors Snore).
Volatility in stocks will always exist, but standard ups-and-downs don’t equate to a bubble. The fact of the matter is if you are reading about bubble headlines in prominent newspapers and magazines, or listening to bubble talk on the TV or radio, then those particular bubbles likely do not exist. Or as strategist and investor Jim Stack has stated, “Bubbles, for the most part, are invisible to those trapped inside the bubble.”
All the recent bubble talk scattered over all the media outlets only bolsters my fear case more. If we actually were in a stock bubble, you wouldn’t be reading headlines like these:
From 1,300 Bubble to 5,000
If you think identifying financial bubbles is easy, then you should buy former Federal Reserve Chairman Alan Greenspan a drink and ask him how easy it is? During his chairmanship in late-1996, he successfully managed to identify the existence of an expanding technology bubble when he delivered his infamous “irrational exuberance” speech. The only problem was he failed miserably on his timing. From the timing of his alarming speech to the ultimate pricking of the bubble in 2000, the NASDAQ index proceeded to more than triple in value (from about 1,300 to over 5,000).
Current Fed Chairman Ben Bernanke was no better in identifying the housing bubble. In his remarks made before the Federal Reserve Board of Chicago in May 2007, Bernanke had this to say:
“…We believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system. The vast majority of mortgages, including even subprime mortgages, continue to perform well.”
If the most powerful people in finance are horrible at timing financial market bubbles, then perhaps you shouldn’t stake your life’s savings on that endeavor either.
Bubbles History 101
Each bubble is unique in its own way, but analyzing previous historic bubbles can help understand future ones (see Sleeping Through Bubbles):
• Dutch Tulip-Mania: About 400 years ago in the 1630s, rather than buying a new house, Dutch natives were paying over $60,000 for tulip bulbs.
• British Railroad Mania: The overbuilding of railways in Britain during the 1840s.
• Roaring 20s: Preceding the Wall Street Crash of 1929 (-90% plunge in the Dow Jones Industrial average) and Great Depression, the U.S. economy experienced an extraordinary boom during the 1920s.
• Nifty Fifty: During the early 1970s, investors and traders piled into a set of glamour stocks or “Blue Chips” that eventually came crashing down about -90%.
• Japan’s Nikkei: The value of the Nikkei index increased over 450% in the eight years leading up to the peak of 38,957 in December 1989. Today, almost 25 years later, the index stands at about 15,382.
• Tech Bubble: Near the peak of the technology bubble in 2000, stocks like JDS Uniphase Corp (JDSU) and Yahoo! Inc (YHOO) traded for over 600x’s earnings. Needless to say, things ended pretty badly once the bubble burst.
As long as humans breathe, and fear and greed exist (i.e., forever), then we will continue to encounter bubbles. Unfortunately, we are unlikely to be notified of future bubbles in mainstream headlines. The objective way to unearth true economic bubbles is by focusing on excessive valuations. While stock prices are nowhere near the towering valuations of the technology and Japanese bubbles of the late 20th century, the bubble of fear originating from the 2008-2009 financial crisis has pushed many long-term bond prices to ridiculously high levels. As a result, these and other bonds are particularly vulnerable to spikes in interest rates (see Confessions of a Bond Hater).
Rather than chasing bubbles and nervously fretting over sensationalistic headlines, you will be better served by devoting your attention to the creation of a globally diversified investment portfolio. Own a portfolio that integrates a wide range of asset classes, and steers clear of popularly overpriced investments that the masses are talking about. When fear disappears and everyone is clamoring to buy stocks, you can be confident the stock bubble is ready to burst.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing SCM had no direct position in TWTR, JDSU, YHOO or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
Sitting on the Sidelines: Fear & Selective Memory
Fear is a motivating (or demotivating) emotion that can force individuals into suboptimal actions. The two main crashes of the 2000s (technology & housing bubbles) coupled with the mini-crises (e.g., flash crash, European crisis, debt ceiling, sequestration, fiscal cliff, etc.) have scared millions of investors and trillions of dollars to sit on the sidelines. Financial paralysis may be great in the short-run for bruised psyches and egos, but for the passive onlookers, the damage to retirement accounts can be crippling.
Selective memory is a great coping mechanism for those investors sitting on the sidelines as well. Purposely forgetting your wallet at a group dinner may be beneficial in the near-term, but repeated incidents will result in lost friends over the long-run. Similarly, most gamblers frequenting casinos tend to pound their chests when bragging about their wins, however they tend to conveniently forget about all the losses. These same reality avoidance principles apply to investing.
A recent piece written by CEO Bill Koehler at Tower Wealth Managers, entitled The Fear Bubble highlights a survey conducted by Franklin Templeton. In the study, investors were asked how the stock market performed in 2009-2012. As you can see from the chart below, perception is the polar opposite of reality (actual gains far exceeded perceived losses):
Source: Franklin Templeton via Tower Wealth Managers
With so many investors sitting on the sidelines in cash or concentrated in low-yielding bonds and gold, I suppose the results shouldn’t be too surprising. Once again, selective memory serves as a wonderful tool to bury the regrets of missing out on a financial market recovery of a lifetime.
Humans also have a predisposition to seek out people who share similar views, even though accumulating different viewpoints ultimately leads to better decisions. Morgan Housel at The Motley Fool just wrote an article, Putting a Gap Between You and Stupid, explaining how individuals should seek out others who can help protect them from harmful biases. A scientific study referenced in the article showed how the functioning of biased brains literally shuts down:
“During the 2004 presidential election, psychologist Drew Westen of Emory University and his colleagues studied the brains of 15 “committed” Democrats and 15 “committed” Republicans with an MRI scanner. Each group was shown a collection of contradictory statements made by George W. Bush and John Kerry. Not surprisingly, the partisans were quick to call out contradictions made by the opposing party, and made up all kinds of justifications to rationalize quotes made by their own side’s candidate. But here’s what’s scary: The participants weren’t just being stubborn. Westen found that areas of their brains that control reasoning and logic virtually shut down when confronted with a conflicting view of their preferred candidate.”
Rather than letting emotions rule the day, the proper approach is to stick to unbiased numbers like valuations, yields, fees, and volatility. If you continually make mistakes; you aren’t disciplined enough; or you don’t like investing; then find a trusted advisor who uses an objective financial approach. Opportunistically taking advantage of volatility, instead of knee-jerk reactions is the preferred approach. For those people sitting on the sidelines and using selective memory, you may feel better now, but you will eventually have to get in the game, if you don’t want to lose the retirement account game.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing, SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is the information to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
Investing: Coin Flip or Skill?
The Sidoxia Monthly Newsletter will be released in a few days (subscribe on right side of the page), so here is an Investing Caffeine classic to tide you over until then:
Everyone believes they are above-average drivers and most investors believe successful investing can be attributed to skill. Michael Mauboussin, author and Chief Investment Strategist at Legg Mason Capital Management, tackles the issue of how important a role luck plays in various professional activities, including investing (read previous IC article on Mauboussin) in his meaty 42-page thought piece, Untangling Skill and Luck.
Skill Litmus Test
Whenever someone becomes successful or a sports team wins, doubters often respond with the response, “Well, they are just lucky.” For some, the intangible factor of luck can be difficult to measure, but for Mauboussin, he has a simple litmus test to evaluate the level of skill and luck credited to a professional activity:
“There’s a simple and elegant test of whether there is skill in an activity: ask whether you can lose on purpose. If you can’t lose on purpose, or if it’s really hard, luck likely dominates that activity. If it’s easy to lose on purpose, skill is more important.”
Mauboussin uses various sports and games as tools to explain the relative importance that skill (or lack thereof) plays in determining an outcome. At one extreme end of the spectrum you have a brain game like chess, in which a skillful chess pro could beat an amateur 1,000 times in a 1,000 matches. In the field of professional sports, at the other end of the spectrum, Mauboussin hammers home the relative significance luck contributes in professional baseball:
“In major league baseball the worst team will beat the best team in a best-of-five series about 15 percent of the time.“
Here is a skill-luck continuum provided by Mauboussin:
Source: Legg Mason Capital Management
Streaks vs. Mean Reversion
Mr. Mauboussin spends a great deal of time exploring the implications of skill and luck in relation to streaks and mean reversion. In the streak department, Mauboussin uses Joe DiMaggio’s record 56-consecutive game hitting stretch. He acknowledges the presence of luck, but skill is a prerequisite:
“Not all skillful performers have streaks, but all long streaks of success are held by skillful performers.”
When detailing streaks, Mauboussin may also be defending his fellow Legg Mason colleague Bill Miller (see Revenge of the Dunce), who had an incredible 15 consecutive year of besting the S&P 500 index before mean reverting back to lousy human-like returns.
This is a nice transition into his discussion about mean reversion because Mauboussin basically states this reversion concept dominates activities laden with luck (as shown in the Skill-Luck Continuum chart above). Time will tell whether Miller’s streak was due to skill, if he can put together another streak, or whether his streak was merely a lucky fluke. Unlike the judicial world, investment managers are often treated as guilty until proven innocent. For now, Miller’s 1991-2005 streak is being treated as luck by many in the investment community, rather than skill.
Nobel-prize winner Paul Samuelson may believe differently since he concedes the existence of skillful investing:
“It is not ordained in heaven, or by the second law of thermodynamics, that a small group of intelligent and informed investors cannot systematically achieve higher mean portfolio gains with lower average variabilities. People differ in their heights, pulchritude, and acidity. Why not their P.Q. or performance quotient?”
Peter Lynch’s +29% annual return from 1977-1990 is another streak on which historians can chew (read more on Lynch). I, like Samuelson, will give Lynch the benefit of the doubt.
Creating a Skillful Analytical Edge
Unlike the process of mowing lawns, in which more applied work time generally equates to more lawns cut (i.e., more profits), the investment world doesn’t quite work that way. Many people could work all day, stare at their screen for 23 hours, trade off of useless information, and still earn lousy returns. When it comes to investing, more work does not necessarily produce better results. Mauboussin’s prescription is to create an analytical edge. Here is how he describes it:
“At the core of an analytical edge is an ability to systematically distinguish between fundamentals and expectations.”
Thinking like a handicapper is imperative to win in this competitive game, and I specifically addressed this in my previous Vegas-Wall Street article. Steven Crist sums up this indispensable concept beautifully:
“There are no “good” or “bad” horses, just correctly or incorrectly priced ones.”
A disciplined, systematic approach will incorporate these ideas, however all good investors understand the good processes can lead to bad outcomes in the short-run. By continually learning from mistakes, and refining the process with a constant feedback loop, the investment process can only get better. On the other hand, schizophrenically reacting to an endless flood of ever-changing information, or fearfully chasing the leadership du jour will only lead to pain and sorrow. Fortunately for you, you have skillfully completed this article, meaning financial luck should now be on your side.
Read full Mauboussin article (Untangling Skill and Luck) here
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing, SCM had no direct position in any other security referenced in this article. Radio interviews included opinions of Wade Slome – not advice. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is the information to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
The Most Hated Bull Market Ever
Life has been challenging for the bears over the last four years. For the first few years of the recovery (2009-2010) when stocks vaulted +50%, supposedly we were still in a secular bear market. Back then the rally was merely dismissed as a dead-cat bounce or a short-term cyclical rally, within a longer-term secular bear market. Then, after an additional +50% move the commentary switched to, “Well, we’re just in a long-term trading range. The stock market hasn’t done a thing in a decade.” With major indexes now hitting all-time record highs, the pessimists are backpedaling in full gear. Watching the gargantuan returns has made it more difficult for the bears to rationalize a tripling +225% move in the S&P 600 index (Small-Cap); a +214% move in the S&P 400 index (Mid-Cap); and a +154% in the S&P 500 index (Large-Cap) from the 2009 lows.
For the unfortunate souls who bunkered themselves into cash for an extended period, the return-destroying carnage has been crippling. Making matters worse, some of these same individuals chased a frothy over-priced gold market, which has recently plunged -30% from the peak.
Bonds have generally been an OK place to be as Europe imploded and domestic political gridlock both helped push interest rates to record-lows (e.g., tough to go lower than 0% on the Fed-Funds rate). But now, those fears have subsided, and the recent rate spike from Ben Bernanke’s “taper tantrum” has caused bond bulls to reassess their portfolios (see Fed Fatigue). Staring at the greater than -90% underperformance of bonds, relative to stocks over the last four years, has been a bitter pill to swallow for fervent bond believers. The record -$9.9 billion outflow from Mr. New Normal’s (Bill Gross) Pimco Total Return Fund in June (a 26-year record) is proof of this anxiety. But rather than chase an unrelenting stock market rally, stock haters and skeptics remain stubborn, choosing to place their bond sale proceeds into their favorite inflation-depreciating asset…cash.
Crash Diet at the Buffet
I’ve seen and studied many markets in my career, but the behavioral reactions to this most-hated bull market in my lifetime have been fascinating to watch. In many respects this reminds me of an investing buffet, where those participating in the nourishing market are enjoying the spoils of healthy returns, while the skeptical observers on the sidelines are on a crash diet, selecting from a stingy menu of bread and water. Sure, there is some over-eating, heartburn, and food coma experienced by those at the stock market table, but one can only live on bread and water for so long. The fear of losses has caused many to lose their investing appetite, especially with news of sequestration, slowing China, Middle East turmoil, rising interest rates, etc. Nevertheless, investors must realize a successful financial future is much more like an eating marathon than an eating sprint. Too many retirees, or those approaching retirement, are not responsibly handling their savings. As legendary basketball player and coach John Wooden stated, “Failing to prepare is preparing to fail.”
20 Years…NOT 20 Days
I will be the first to admit the market is ripe for a correction. You don’t have to believe me, just take a look at the S&P 500 index over the last four years. Despite the explosion to record-high stock prices, investors have had to endure two corrections averaging -20% and two other drops approximating -10%. Hindsight is 20-20, but at each of those fall-off periods, there were plenty of credible arguments being made on why we should go much lower. That didn’t happen – it actually was the opposite outcome.
For the vast majority of investing Americans, your investing time horizon should be closer to 20 years…not 20 days. People that understand this reality realize they are not smart enough to consistently outwit the market (see Market Timing Treadmill). If you were that successful at this endeavor, you would be sitting on your private, personal island with a coconut, umbrella drink.
Successful long-term investors like Warren Buffett recognize investors should “buy fear, and sell greed.” So while this most hated bull market remains fully in place, I will follow Buffett’s advice comfortably sit at the stock market buffet, enjoying the superior long-term returns put on my plate. Crash dieters are welcome to join the buffet, but by the time they finally sit down at the stock market table, I will probably have left to the restroom.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), including IJR, and IJH, but at the time of publishing, SCM had no direct position in BRKA/B, Pimco Total Return Fund, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
Investing Caffeine 
