Posts filed under ‘Education’
The Pleasure/Pain Principle
The financial crisis of 2008-2009 was painful, not to mention the Flash Crash of 2010; the Debt Ceiling / Credit Downgrade of 2011; and the never-ending European saga. Needless to say, these and other events have caused pain akin to burning one’s hand on the stove. This unpleasant effect has rubbed off on investors.
Admitting one has a problem is half the battle of conquering a challenge. A key challenge for many investors is understanding the crippling effects fear can have on personal investment decisions. While there are certainly investors who constantly see financial markets through rose-colored glasses (my glasses I argue are only slightly tinted), Nobel Prize winner Daniel Kahneman and his partner Amos Tversky understand the pain of losses can be twice as painful as the pleasure experienced through gains (see diagram below).
Source: Investopedia
Said a little differently, faced with sure gain, most investors are risk-averse, but faced with sure loss, investors prefer risk-taking. Don’t believe me? Well, let’s take a look at some of Kahneman and Tversky’s behavioral finance work on what they called “Prospect Theory” (1979) – the analysis of decisions made under various risk scenarios.
In one specific experiment, Kahneman and Tversky presented groups of subjects with a number of problems. One group of subjects was presented with this problem:
Problem #1: In addition to whatever you own, you have been given $1,000. You are now asked to choose between:
A. A sure gain of $500
B. A 50% change to gain $1,000 and a 50% chance to gain nothing.
Another group of subjects was presented with this problem:
Problem #2: In addition to whatever you own, you have been given $2,000. You are now asked to choose between:
A. A sure loss of $500
B. A 50% chance to lose $1,000 and a 50% chance to lose nothing.
In the first group, 84% of the respondents chose A and in the second group, 69% of the respondents chose B. Both problems are identical in terms of the net cash outcomes ($1,500 for Answer A, and 50% chance of $1,000 or $2,000 for Answer B). Nonetheless, due the different “loss phrasing” in each question, Answer A sounds more appealing in Question #1, and Answer B sounds more appealing in Question #2. The results are irrational, but investors have been known to be illogical too.
In practical trading terms, the application of “Prospect Theory” often manifests itself via the pain principle. Due to loss aversion, investors tend to cash in gains too early and fail to allow their winning stocks to run higher for a long enough period.
The framing of the Kahneman and Tversky’s questions is no different than the framing of political and economic issues by the various media outlets (see Pessimism Porn). Fear can generate advertising revenue and fear can also push investors into paralysis (see the equity fund flow data in Fund Flows Paradox).
Greed can sell in the financial markets too. The main sources of financial market greed have been primarily limited to bonds, cash, and gold. If you caught those trends early enough, you are happy as a clam, but like most things in life, nothing lasts forever. The same principle applies to financial markets, and over time, capital in today’s winners will slowly transition into today’s losers (i.e., tomorrow’s winners).
A healthy amount of fear is healthy, but correctly understanding the dynamics of the “Pleasure/Pain Principle” can turn those fearful tears into profitable pleasure.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds (including fixed income ETFs), but at the time of publishing SCM had no direct position in GLD, 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.
Dividend Floodgates Widen
The recently reported lackluster, monthly employment report made stockholders grumpy (as measured by the recent -168 point decline in the Dow Jones Industrial index) and bondholders ecstatic (as measured by the surge in the 10-year Treasury note price and plunge in yield to a meager 1.88% annual rate). Stocks on the other hand are yielding a much more attractive rate of approximately 7.70% based on 2012 earnings estimates (see chart below) and are also offering a dividend yield of about 2.25%.
S&P 500 earnings yields trouncing bond yields despite historical correlation.
In my view, either stock prices go higher and drive equity yields lower; bonds sell off and Treasury yields spike higher; or a combination of the two. Either way, there are not many compelling reasons to pile into Treasuries, although I fully understand some Treasuries are needed in many investors’ portfolios for income, diversification, and risk tolerance reasons.
Not only are equity earnings yields beating Treasury yields, but so are dividend yields. It has been a generation, or more than 50 years, since the last time stock dividends were yielding more than 10-year Treasuries (see chart below). If you invested in stocks back when dividend yields outpaced bond yields, and held onto your shares, you did pretty well in stocks (the Dow Jones Industrial index traded around 600 in 1960 and over 13,000 today).
Source: The Financial Times
The Dynamic Dividend Payers
The problem with bond payments (coupons), in most cases, is that they are static. I have never heard of a bond issuer sending a notice to a bond holder stating they wanted to increase the size of interest payments to their investors. On the flip side, stocks can and do increase payments to investors all the time. In fact here is a list of some of the longest paying dividend dynamos that have incredible dividend hike streaks:
• Procter & Gamble (PG – 55 consecutive years)
• Emerson Electric (EMR – 54 years)
• 3M Company (MMM – 53 years)
• The Coca-Cola Company (KO – 49 years)
• Johnson & Johnson (JNJ – 49 years)
• Colgate-Palmolive Company (CL – 48 years)
• Target Corporation (TGT – 43 years)
• PepsiCo Inc. (PEP – 39 years)
• Wal-Mart Stores Inc. (WMT – 38 years)
• McDonald’s Corporation (MCD – 35 years)
This is obviously a small number of the long-term consecutive dividend hikers, but on a shorter term basis, more and more players are joining the dividend paying team. So far, in 2012 alone through April, there have been 152 companies in the S&P 500 index that have raised their dividend (a +11% increase over the same period a year ago). Of those 152 companies that increased the dividend this year, the average boost was more than +23%. Some notable names that have had significant dividend increases in 2012 include the following companies:
• Macy’s Inc. (M: +100% dividend increase)
• Mastercard Inc. (MA: +100%)
• Wells Fargo & Company (WFC: +83%)
• Comcast Corp. (CMCSA: +44%)
• Cisco Systems Inc. (CSCO: +33%)
• Goldman Sachs Group Inc. (GS: +31%)
• Freeport McMoran (FCX: +25%)
• Harley Davidson Inc. (HOG: +24%)
• Exxon Mobil Corp. (XOM: +21%)
• JP Morgan Chase & Co. (JPM: +20%)
Lots of Dividend Headroom
The nervous mood of investors is not much different from the temperament of uneasy business executives, so companies have been slow to hire; unhurried to acquire; and deliberate with their expansion plans. Rather than aggressively spend, corporations have chosen to cut costs, hoard cash, grow earnings, buy back shares, and pay out ever increasing dividends from the trillions in cash piling up.
When a company on average is earning an 8% yield on their stock price, there is plenty of headroom to increase the dividend. As a matter of fact, a company paying a 2% yield could increase its dividend by 10% for about 15 consecutive years and still pay a quadrupling dividend with NO earnings growth. Simply put, there is a lot of room for companies to increase dividends further despite the floodgate of dividend increases we have experienced over the last few years. If you look at the chart below, the dividend yield is the lowest it has been in more than a century (1900).
Source: The Financial Times
Perhaps we will experience another “Summer Swoon” this year, but for those selective and patient investors that sniff out high-quality, dividend paying stocks, you will be getting “paid to wait” while the dividend floodgates continue to widen.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds (including Treasury bond ETFs), CMCSA and WMT, but at the time of publishing SCM had no direct position in PG, EMR, MMM, KO, JNJ, CL, TGT, PEP, MCD, M, MA, WFC, CSCO, GS, FCX, HOG, XOM, JPM, 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 with the Sentiment Pendulum
Article is an excerpt from Sidoxia Capital Management’s complementary May 2012 newsletter. Subscribe on right side of page.
The last five years have been historic in many respects. Not only have governments and central banks around the world undertaken unprecedented actions in response to the global financial crisis, but investors have ridden an emotional rollercoaster in response to historically unparalleled uncertainties.
While the nature of this past crisis has been unique, experienced investors know these fears continually manifest themselves in different forms over various cycles in time. Despite the more than doubling in equity market values over the last few years, as measured by the S&P 500 index, the emotional pendulum of investor sentiment has only partially corrected. Investor temperament has thankfully swung away from “Panic,” but has only moved closer to “Fear” and “Skepticism.” Here are some of the issues contributing to investors’ current sour mood:
The Next European Domino: The fear of the Greek domino toppling the larger Spanish and Italian economies has investors nervously chewing their finger-nails, and political turmoil in France and the Netherlands isn’t creating any additional warm and fuzzies.
Job Additions Losing Steam: New job creation here in the U.S. weakened to a lethargic monthly rate of +120,000 new jobs in March, while the unemployment rate remains stubbornly high at an 8.2% level.
Domestic Growth Losing Mojo: GDP (Gross Domestic Product) growth of +2.2% during the first quarter of 2012 also opened the door for the pessimists. Consumers are still spending (+2.9% growth), but government spending, business investment, and housing are taking wind out of the economy’s sails.
Emerging Markets Submerging: Unspectacular growth in the U.S. is not receiving any favors from slowing emerging markets like China and Brazil, which took fiscal and monetary actions to slow inflation and housing speculation in 2011.
Humpty Dumpty Politics: Presidential elections, tax policy, and deficit reduction are all concerns that carry the possibility of pushing the economic Humpty Dumpty off the wall, and as a result potentially lead to a great fall. The determination of Humpty Dumpty’s fate will likely have to wait until year-end or 2013.
Any student of history knows these fears and other concerns never go away – they simply change. But like supply and demand, gravitational forces eventually swing the emotional pendulum in the opposite direction. As Sir John Templeton so aptly stated, “Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.” Or in other words, escalating bull markets must climb the proverbial “Wall of Worry” in order to sustain upward momentum. If there was nothing to worry about, then all the buyers would already be in the markets. We are nowhere close to experiencing “Euphoria” like we saw in stocks during the late-1990s or in the housing market around 2005.
Positively Climbing the “Wall of Worry”
With all this bad news out there, surprisingly there are some glimmers of hope chipping away at the “Wall of Worry.” Here are some of the positive factors helping turn pessimist frowns upside down:
Slow & Steady Wins the Race: The economic recovery has been weaker than hoped, but I can think of worse scenarios than 11 consecutive quarters of GDP growth and 25 straight months of private job creation, which has reduced the unemployment rate from 10.0% in October 2009 to 8.2% last month.
Earnings Machine Keeps Chugging Along: With the majority of S&P 500 companies having reported their quarterly results for the first quarter, three-fourths of the companies are beating forecasted earnings, which are currently registering in at a respectable +7.1% rate (Thomson Reuters). One company epitomizing this trend is Apple Inc. (AAPL). The near doubling in Apple’s profits during the quarter, thanks to explosive iPhone sales, pushed Apple’s shares over $600 and helped drive the NASDAQ index to its best day of the year.
Super Ben to the Rescue: The Federal Reserve has already stated their intention of keeping interest rates near 0% until 2014. The potential of additional monetary stimulus spearheaded by Federal Reserve Chairman Ben Bernanke, in the form of QE3 (Quantitative Easing Part III), may provide further needed support to the stock market (a.k.a., the “Bernanke Put”).
Return of the IPO: Initial Public Offerings (IPOs) have gained steam versus last year with more than 53 already coming to market in the first four months of 2012. This is no 1999, but a good number of deals have done quite well over the last month. For example, data analysis company Splunk Inc. (SPLK) share price is already up around 100% and the value of leisure luggage company TUMI Holdings (TUMI) has climbed over +40%. In a few weeks, the highly anticipated blockbuster Facebook (FB) IPO is expected to begin trading its shares, so we can see if the chronicled deal can live up to all the hype.
Dividends Galore: Dividend payments to stockholders are flowing at an extraordinary rate so far in 2012. Companies like IBM (increased its dividend by +13%), Exxon Mobil – (XOM +21%); Goldman Sachs – (GS +31%) are but just a few of the dividend raisers this year. Through the first three months of the year, the number of companies increasing their dividend payments was up +45% as compared to the comparable number for all of 2011.
Emerging Growth Not Dead: While worriers fret over slowing growth in China, companies like Apple grew by more than +100% in this region and collected nearly 20% of its revenues from this Asian country (~$8 billion). Coincidentally, China is expected to surpass an incredible one billion mobile connections in May – many of those iPhones. In other related news, Starbucks Corp. (SBUX) plans to triple its workforce and number of stores in China over the next three years. China has also helped fuel a backlog of Caterpillar Inc. (CAT) that is more than triple the level of 2009. Emerging markets may have slowed down in 2011, but with inflation beginning to stabilize, emerging market central banks and governments are now beginning to ease policies and reduce red-tape. For example, Brazil and India have started to lower key benchmark interest rates, and China has started to reverse capital flow restrictions.
Stay Off the Trampled Path
The mantra of “Sell in May and go away” always gets a lot of playtime around this period of the year. Over the last few years, the temporary spring/summer sell-offs have only been followed by stronger price appreciation. Individuals attempting to time the market (see also Getting Off the Treadmill) generally end up in tears. And for those traders who boast about their excellent timing (like those suspicious friends who brag about always winning in Las Vegas), we all know the truth – nobody buys at the lows and sells at the highs…except for liars.
With all the noise and cross-currents flooding the airwaves, investing for individuals without assistance has never been so difficult. But before hiding in your cave or reacting to the next scary headline about Europe, the economy, or politics, do yourself a favor by reminding yourself these chilling news items are nothing new and are often great contrarian indicators (see also Back to the Future). The emotional pendulum is constantly swinging from fear to greed and investors stand to prosper by adjusting sentiment and actions in the opposite direction. To survive in the investing wild, it is best to realize that the grass is greener and the eating more abundant when you stay off the trampled path of the herd.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds and AAPL, but at the time of publishing SCM had no direct position in SPLK, TUMI, IBM, XOM, GS, SBUX, CAT, 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.
The Fund Flows Paradox
How is it that the stock market has more than doubled over the last three years, when investors have been dumping stocks like they are going out of style? If you don’t believe me, and you think jovial investors are jacking stocks higher, then please explain to me why billions of dollars are hemorrhaging out of equity funds on a monthly basis over the last five years (see Fund Flow data chart below)?
Source: Calafia Beach Pundit
If by small chance you buy my argument that skeptical investors continue to doubt the sustainability of the three-year doubling in the stock market, then why is the Volatility Index (VIX) trading like investors are sunbathing at the beach while licking lollipops? For those not keeping score on the VIX (see also The VIX and the Rule of 16), typically a reading below 20 is interpreted as investor overconfidence and/or complacency. On the flip side, readings above 20 usually indicate pessimism or fear.
As you can see from the chart below, we have spent a good portion of the last few years on both sides of the 20 mph VIX speed limit, and currently at a reading of about 17, investors have slowed down to enjoy the scenery.
Source: Yahoo! Finance
So with massive selling and a cheery reading on the VIX, how can these bipolar data-points be reconciled? Therein lies the “Fund Flows Paradox.”
Take Me Out to the Ballgame
If you equate equity investors to fans at a baseball stadium, the fund flow data clearly shows investors are tired of losing money and have been leaving the game in droves. Instead of staying at the equity baseball stadium, those fatigued stock investors have decided to head over to the adjacent bond arena. The equity stadium will never completely be empty because financial markets always have speculative traders. In baseball terms you can think of these short-term traders as the emotionally volatile die-hard fanatics, who will stick around regardless of whether the home team wins or loses.
So while sentiment gauges like the VIX, or sentiment surveys conducted by AAII (American Association of Individual Investors) may be temporarily flashing contrarian bearish signals, one should be cognizant that these data points do not include the petrified opinions of investors who have raced out of the stadium. Eventually when the home team’s winning streak is long enough, investors will return back to the stadium from the bond arena. While there is no sign of individual investors coming back to the stock game anytime soon, in the meantime patient and disciplined investors have had plenty of opportunities to take advantage of. With massive numbers of individual investors and sellers sitting on the sidelines, the markets require relatively little buying to push prices higher.
Over the last few years, not only have equity valuations been broadly reasonable, volatility spikes during the last few summers have also created amplified opportunities. With the wall of worries currently blanketing traditional and new media headlines (i.e., European crisis, U.S. election uncertainty, unsustainable and slowing profits, pending tax cut expirations, Mideast turmoil, etc.) there is no sense of urgency to pile back in to the equity markets.
The doubling in stock prices have occurred on low volumes, largely on the backs of a smaller institutional investor base, not to mention high frequency traders and speculators. While sentiment surveys may currently provide some insight into short-term equity trader attitudes, don’t let these volatile and unreliable data cloud the true underlying pessimism of the masses who have left the stock stadium in large numbers. Trillions of dollars remain on the sidelines as potential fuel for future equity appreciation, once confidence returns.
Opinions are interesting, but actions speak louder than words. Spend more time looking at the actions of the fund flow data, rather than the opinions of various short-term sentiment surveys or short-term options trader statistics. Adjusting your focus to investor actions and behavior will provide a truer gauge of overall investor sentiment and assist you in solving the “Fund Flows Paradox.”
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in VXX, 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.
Cash Security Blanket Turns Into Tourniquet
Article is an excerpt from Sidoxia Capital Management’s April 2012 newsletter. Subscribe on right side of page.
That warm safety blanket of cash that millions of Americans have clutched on to during the 2008-09 financial crisis; the 2010 “Flash Crash”; and the 2011 U.S. credit downgrade felt cozy during the bumpy ride we experienced over the last three years. Now with domestic stocks (S&P 500) up +12% in the first quarter of 2012, that same comfy blanket of CDs, money market, and checking accounts is switching into a painful tourniquet, cutting off the lucrative blood and oxygen supply to millions of Americans’ future retirement plans.
Earning next to nothing by stuffing your money under the mattress (0.7% average CD rate – Bankrate.com) isn’t going to make many financial dreams a reality. The truth of the matter is that due to inflation (running +2% to +3% per year), blanket holders are losing about -2% per year in the true value of their savings.
Your Choice: 3 Years or 107 years?
If you like to accumulate money, would you prefer doubling your money in 3 years or 107 years? Although the S&P 500 has more than doubled over the last three years, based on fund flows data and cash balances at the banks, apparently more individuals prefer waiting until the year 2119 (107 years from now) for their money to double – SEE CHART BELOW.
Obviously the massive underperformance of CDs cherry picks the time-period a bit, given the superb performance of stocks from 2009 – 2012 year-to-date. Over 1999-2012 stock performance hasn’t been as spectacular, but what we do know is that despite the lackluster performance of stocks over the last 12 years, corporate profits have about doubled in a similar timeframe, making equity prices that much more attractive relative to 1999.
With the economy and employment picture improving, some doomsday scenarios have temporarily been put on the backburner. As the recovery has gained some steam, many people are opening their bank statements with the painful realization, “I just made $31.49 on my checking maximizer account last year! Wow, how incredible…I can now go out and buy a half-tank of gas.” Never mind that healthcare premiums are exploding, food costs are skyrocketing, and that vacation you were planning is now out of reach. If you’re a mega-millionaire, perhaps you can make these stingy rates work for you, but for most of the other people, successful retirements will require more efficient use of their investment dollars. Or of course you can always work at Wal-Mart (WMT) as a greeter in your 80s.
Rationalizing with a Teen
Some people get it and some don’t. Trying to time the market, by getting in and out at the right times is a losing battle (see Getting Off the Market Timing Treadmill). Even the smartest professionals in the industry have little accuracy and cannot consistently predict the direction of the markets. Rationalizing the ups and downs of the financial markets is equivalent to rationalizing the actions of a teenager. Sometimes the outcomes are explainable, but most of the times they are not.
What an astute investor does know is that higher long-term returns come with higher volatility. So while the last four years have been a bumpy ride for investors, this is nothing new for an experienced investor who has studied the history of financial markets. There have been a dozen or so recessions since World War II, and we’ll have a dozen or so more over the next 50-60 years. Wars, banking crises, currency crises, and political turmoil have been a constant over history. Despite all these setbacks, the equity markets have climbed over +1,300% over the last 30 years or so. The smartest financial minds on the planet (e.g., the Ben Bernankes and Alan Greenspans of the world) haven’t been able to figure it out, so if they couldn’t do it, how is an average Joe supposed to be able to time the market? The answer is nobody can predict the direction of the market reliably.
As my clients and Investing Caffeine followers know, for those individuals with adequate savings and shorter time horizons, much of this conversation is irrelevant. However, based on our country’s low savings rate and the demographics of longer Baby Boomer life expectancies, most individuals can’t afford to stuff all their money under the mattress. As famous investor Sir John Templeton stated, “The only way to avoid mistakes is not to invest – which is the biggest mistake of all.” Earning 0.7% on your nest egg is difficult to call investing.
Ignoring the Experts
Why is the investing game so difficult? For starters, individuals are constantly bombarded by so-called experts through television, radio, and newspapers. Not only did Federal Reserve Chairmen Alan Greenspan and Ben Bernanke get the economy, financial markets, and housing markets wrong, the most powerful and smart financial institution CEOs were dead wrong as well. Look no further than Lehman Brothers (Dick Fuld), Citigroup Inc. (Chuck Prince), and American International Group (Martin Sullivan), which were believed to house some of the shrewdest executives – they too completely missed the financial crisis.
Rather than listening to shoddy predictions from pundits who have little to no investing experience, it makes more sense to listen to successful long-term investors who have survived multiple investment cycles and lived to tell the tale. Those people include the great fund manager Peter Lynch who said it is better to “assume the market is going nowhere and invest accordingly,” rather than try to time the market.
What You Hear
As the market has more than doubled over the last 37 months, here are some clouds of pessimism that these same shoddy economists, strategists, and analysts have described for investors:
* Europe and Greece’s impending fiscal domino collapse
* Excessive money printing at the Federal Reserve through quantitative easing and other programs
* Imminent government disintegration due to unresolved structural debts and deficits
* Elevated unemployment rates and pathetic job creation statistics
* Rigged high frequency trading and “Flash Crash”
* Credit downgrade and political turmoil in Washington
* Looming Chinese real estate bubble and subsequent hard economic landing
Unfortunately, many investors got sucked up in these ominous warnings and missed most, if not all, of the recent doubling in equity markets.
What You Don’t Hear
What you haven’t heard from the popular press are the following headlines:
* 10 consecutive quarters of GDP growth
* Record corporate profits and profit margins
* Equity valuations attractively priced below 50-year average (14.4 < 16.6 via Calafia Beach Pundit)
* Rising dividends with yields approaching 3%, if you consider recent bank announcements
* Record low interest rates and moderate inflation make earnings streams and dividends that much more valuable
* Four million new jobs created over the last three years
* S&P Smallcap near all-time highs (21 years); S&P Midcap index near all-time highs (20 years); NASDAQ is at 11-year highs; Dow Jones Industrials and S&P 500 near 4-year-highs.
* Record retail sales with a consumer that has reduced household debt
Source: Calafia Beach Pundit
Given the massive upward run in the stock market over the last few years (and a complacent short-term VIX reading of 15), stocks are ripe for a breather. With that said, I would advise any blanket holders to not get too comfy with that money decaying away in a CD, money market, or savings account. Waiting too long may turn that security blanket into a tourniquet – forcing investors to amputate a portion of their future retirement savings.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds and WMT, but at the time of publishing SCM had no direct position in C, AIG, RATE, Lehman Brothers, 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.
Time Arbitrage: Investing vs. Speculation
The clock is ticking, and for many investors that makes the allure of short-term speculation more appealing than long-term investing. Of course the definition of “long-term” is open for interpretation. For some traders, long-term can mean a week, a day, or an hour. Fortunately, for those that understand the benefits of time arbitrage, the existence of short-term speculators creates volatility, and with volatility comes opportunity for long-term investors.
What is time arbitrage? The concept is not new and has been addressed by the likes of Louis Lowenstein, Ralph Wanger, Bill Miller, and Christopher Mayer. Essentially, time arbitrage is exploiting the benefits of moving against the herd and buying assets that are temporarily out of favor because of short-term fears, despite healthy long-term fundamentals. The reverse holds true as well. Short-term euphoria never lasts forever, and experienced investors understand that continually following the herd will eventually lead you to the slaughterhouse. Thinking independently, and going against the grain is ultimately what leads to long-term profits.
Successfully executing time arbitrage is easier said than done, but if you have a systematic, disciplined process in place that assists you in identifying panic and euphoria points, then you are well on your way to a lucrative investment career.
Winning via Long-Term Investing
Legg Mason has a great graphical representation of time arbitrage:
Source: Legg Mason Funds Management
The first key point to realize from the chart is that in the short-run it is very difficult to distinguish between gambling/speculating and true investing. In the short-run, speculators can make money just as well as anybody, and in some cases, even make more profits than long-term investors. As famed long-term investor Benjamin Graham so astutely states, “In the short run the market is a voting machine. In the long run it’s a weighing machine.” Or in other words, speculative strategies can periodically outperform in the short run (above the horizontal mean return line), while thoughtful long-term investing can underperform.
Financial Institutions are notorious for throwing up strategies on the wall like strands of spaghetti. If some short-term outperforming products spontaneously stick, then the financial institutions often market the bejesus out of them to unsuspecting investors, until the strategies eventually fall off the wall.
Beware o’ Short-Termism
I believe Jack Gray of Grantham, Mayo, Van Otterloo got it right when he said, “Excessive short-termism results in permanent destruction of wealth, or at least permanent transfer of wealth.” What’s led to the excessive short-termism in the financial markets (see Short-Termism article)? For starters, technology and information are spreading faster than ever with the proliferation of the internet, creating a sense of urgency (often a false sense) to react or trade on that information. With more than 2 billion people online and 5 billion people operating mobile phones, no wonder investors are getting overwhelmed with a massive amount of short-term data. Next, trading costs have declined dramatically in recent decades, to the point that brokerage firms are offering free trades on various products. Lower trading costs mean less friction, which often leads to excessive and pointless, profit-reducing trading in reaction to meaningless news (i.e., “noise”). Lastly, the genesis of ETFs (exchange traded funds) has induced a speculative fervor, among those investors dreaming to participate in the latest hot trend. Usually, by the time an ETF has been created, the cat is already out of the bag, and the low hanging profit fruits have already been picked, making long-term excess returns tougher to achieve.
There is never a shortage of short-term fears, and today the 2008-09 financial crisis; “Flash Crash”; debt downgrade; European calamity; upcoming presidential elections; expiring tax cuts; and structural debts/deficits are but a few of the fear issues du jour in investors’ minds. Markets may be overbought in the short-run, and a current or unforeseen issue may derail the massive bounce from early 2009. For investors who can put on their long-term thinking caps and understand the concept of time arbitrage, buying oversold ideas and selling over-hyped ones will lead to profitable usage of investment time.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in any 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.
Happy Birthday Bull Market!
Birthdays are always fun, but they are always more fun when more people come to the party. The birthday of the current bull market started on March 9, 2009, and as many bears point out, volume has been low, with a relatively small number of investors joining the party with hats and horns. This skepticism is not unusual in typical bull markets because the psychological scars from the previous bear market are still fresh in investors’ minds. How can investors get excited about investing when we are surrounded by record deficits, political gridlock, a crumbling European Union, slowing China, and peak corporate margins?
Bears Receive Party Invite but Stay Home
Perma-bears like Peter Schiff, Nouriel Roubini, John Mauldin, Mohamed El-Erian, and David Rosenberg have been consistently wrong over the last three years with their advice, but in some instances can sound smart shoveling it out to unassuming investors.
While nervous investors and bears have missed the 125%+ rally (see table below) over the last three years (mitigated by upward but underperforming gold prices), what many observers have not realized is that the so-called “Lost Decade” (see also Can the Lost Decade Strike Twice?) has actually been pretty spectacular for shrewd investors. Even if you purchased small and mid cap stocks at the peak of the market in March 2000, that large swath of stocks is up over +100%…yes, that’s right, more than doubled over the last 12 years. If you consider dividends, the numbers look significantly better.
Doubters of the equity market rally also ignore the three-year +135% advance in the NASDAQ (see also Ugly Stepchild) in part because the 11-year highs being registered still lag the peak levels reached in March 2000. Even though the NASDAQ increased 9-fold in the 1990s, if you bought the NASDAQ index in the first half of 1999, you would have still outperformed the S&P 500 index through the 2012 year-to-date period. Irrespective of how anyone looks at the performance of the NASDAQ index, it still has outperformed the S&P 500 index by more than +200% over the last 25 years, even if you include the bursting of the 2000 technology bubble.
CLICK TO ENLARGE
The point of all these statistics is to show that if you didn’t buy technology stocks at the climax of late 1999 or early 2000 prices, then the amount and type of available opportunities have been plentiful. The table above does not include emerging markets like Brazil, Mexico, and India (to name a few) that have also about doubled in price from the 2000 timeframe to 2012.
Heartburn can Accompany Sweet Treats
Being Pollyannaish after a doubling in market prices is never a wise decision. After three years of massive appreciation, those participating in the bull market run have eaten a lot of tasty cake. Now the question becomes, will investors also get some ice cream and a gift bag to go before the party ends? With the sweetness of the cake still being digested, there are still plenty of scenarios that can create investor heartburn. Obviously, the sovereign debt pig still needs to work its way through the European snake, and that could still take some time. In addition, although macroeconomic data (including employment data) generally have been improving, the trajectory of corporate profits has been decelerating – due in part to near record profit margins getting pressured by rising input costs. Domestically, structural debt and deficit issues have not gone away, and perpetual neglect will only exacerbate the current problems. On the psychology front, even though investors remain skittish, those still in the game are getting more complacent as evidenced by the VIX index now falling to the teens (a negative contrarian indicator).
Despite some of these cautionary signals, the good news is that many of these issues have been known for some time and have been reflected in valuations of the overall large cap indexes. Moreover, trillions of dollars remain idle in low yielding strategies as investors wait on the sidelines. Once prices move higher and there is more comfort surrounding the sustainability of an economic recovery, then capital will come pouring back into equity markets. In other words, investors will have to pay a premium cherry price if they wait for a comforting consensus to coalesce.
Limited Options
The other advantage working in investors’ favor is the lack of other attractive investment alternatives. Where are you going to invest these days when 10-year Treasuries and short-term CDs are yielding next to nothing? How about investing in risky, leveraged, illiquid real estate, just as banks unload massive numbers of foreclosures and process millions of short sales? If those investments don’t tickle your fancy, then how about pricey insurance and annuity products that nobody can understand? Cash was comforting in 2008-2009 and during volatility in recent summers, but with spiking food, energy, leisure, and medical costs, when does that cash comfort turn to cash pain?
Easy money and low interest rate policies being advocated by Federal Reserve Chairman Ben Bernanke and other global central bankers have sucked up available investment opportunities and compelled investors to look more closely at riskier assets like equities. With the large run in equities, I have been trimming back my winners and redeploying proceeds into higher dividend paying stocks and underperforming sectors of the market. Skepticism still abounds, and we may be ripe for a short-term pullback in the equity markets. For those rare birthday party attendees who are called long-term investors, opportunities still remain despite the large run in equities. The cake has been sweet so far, but if you are patient, some ice cream and a gift bag may be coming your way as well.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds (including emerging market, international, and bond/treasury ETFs), but at the time of publishing SCM had no direct position in VXX, MXY, 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.
Box Wine, Facebook and PEG Ratios
I’m no wine connoisseur, but I do know I would pay more for a bottle of Dom Pérignon champagne than I would pay for a container of Franzia box wine. In the world of stocks, the quality disparity is massive too. In order to navigate the virtually infinite number of stocks, we need to have an instrument in our toolbox that can assist us in accurately comparing stocks across the quality spectrum. Thank goodness we have the handy PEG ratio (Price/Earnings to Growth) that elegantly marries the price paid for a stock (as measured by the P/E ratio) with the relative quality of the stock (as measured by its future earnings growth rate).
Famed investor Peter Lynch (see Inside the Brain of an Investing Genius) understood the PEG concept all too well as he used this tool religiously in valuing and analyzing different companies. Given that Lynch earned a +29% annual return from 1977-1990, I’ll take his word for it that the PEG ratio is a useful tool. As highlighted by Lynch (and others), the key factor in using the PEG ratio is to identify companies that trade with a PEG ratio of less than 1. All else equal, the lower the ratio, the better potential for future price appreciation. Facebook Vs. Eastman Kodak
To illustrate the concept of how a PEG ratio can be used to compare stocks with two completely different profiles, let’s start by answering a few questions. Would a rational investor pay the same price (i.e., Price-Earnings [P/E] ratio) for a company with skyrocketing profits as they would for a company going into bankruptcy? Look no further than the lofty expected P/E multiple to be afforded to the shares of the widely anticipated Facebook (FB) initial public offering (IPO). That same rational investor is unlikely to pay the same P/E multiple for a money losing company like Eastman Kodak Co. (EKDKQ.PK) that faces product obsolescence. The contrasting values for these two companies are stark. Some pundits are projecting that Facebook shares could fetch upwards of a 100x P/E ratio, while not too long ago, Kodak was trading at a P/E ratio of 4x. Plenty of low priced stocks have outperformed expensive ones, but remember, just because a “value” stock may have a lower absolute P/E ratio in the recent past, does not mean it will be a better investment than a “growth” stock sporting a higher P/E ratio (see Fallacy of High P/Es).
Price, Earnings, and Dividends
As I’ve written in the past, a key determinant of future stock prices is future earnings growth (see It’s the Earnings Stupid). The higher the P/E multiple, the more important future earnings growth becomes. The lower the future growth, the more important valuation and dividends become.
We can look at various money-making scenarios that incorporate these factors. If my goal were to double my money in 5 years (i.e., earn a 100% return), there are numerous ways to skin the profit-making cat. Here are four examples:
1) Buy a non-dividend paying stock of a company that achieves earnings growth of 15%/year and maintains its current P/E ratio over time.
2) Buy a stock of a company that has a 5% dividend and achieves earnings growth of 11%/year and maintains its current P/E ratio over time.
3) Buy a value stock with a 5% dividend that achieves earnings growth of 5%/year and increase its P/E ratio by 10% each year.
4) Buy a non-dividend paying growth stock that achieves earnings growth of 20%/year and decreases its P/E ratio by about 5% each year.
I think you get the idea, but as you can see, in addition to earnings growth, dividends and valuation do play a significant role in how an investor can earn excess returns.
Lynch’s Adjusted PEG
Peter Lynch added a slight twist to the traditional PEG analysis by accounting for the role of dividends in the denominator of the PEG equation:
PEG (adjusted by Lynch) = PE Ratio/(Earnings Growth Rate + Dividend Yield)
This “adjusted PEG” ratio makes intuitive sense under various perspectives. For starters, if two different companies both had a PEG ratio of 0.8, but one of the two stocks paid a 3% dividend, Lynch’s adjusted PEG would register in at a more attractive level of 0.6 for the dividend paying stock.
Looked at under a different lens, let’s suppose there are two lemonade stands that IPO their stocks at the same time, and both companies use the exact same business model. Moreover, let us assume the following:
• Lemonade stand #1 has a P/E of 14x and growth rate of 15%.
• Lemonade stand #2 has a P/E of 12x and growth rate of 8%, but it also pays a dividend of 3%.
Given this information, which one of the two lemonade stands would you invest in? Many investors see the lower P/E of Lemonade stand #2, coupled with a nice dividend, as the more attractive opportunity of the two. But as we can see from Lynch’s “adjusted PEG” ratio, Lemonade stand #1 actually has the lower, more attractive value (.9 or 14/15 vs 1.1 or 12/(8+3)).
This analysis may be delving into the weeds a bit, but this framework is critical nonetheless. Valuation and earnings projections should be essential components of any investment decision, and with record low interest rates, dividend yields are playing a much more important role in the investment selection process. Regardless of your purchase decision thought process, whether deciding between Dom Perignon and box wine, or Facebook and Kodak shares, having the PEG ratio at your disposal should help you make wise and lucrative decisions.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in FB, EKDKQ.PK, 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.
Sweating Your Way to Investment Success
Source: StopSweatyArmpits.com
There are many ways to make money in the financial markets, but if this was such an easy endeavor, then everybody would be trading while drinking umbrella drinks on their private islands. I mean with all the bright blinking lights, talking baby day traders, and software bells and whistles, how difficult could it actually be?
Unfortunately, financial markets have a way of driving grown men (and women) to tears, usually when confidence is at or near a peak. The best investors leave their emotions at the door and follow a systematic disciplined process. Investing can be a meat grinder, but the good news is one does not need to have a 90% success rate to make it lucrative. Take it from Peter Lynch, who averaged a +29% return per year while managing the Magellan Fund at Fidelity Investments from 1977-1990. “If you’re terrific in this business you’re right six times out of 10,” says Lynch.
Sweating Way to Success
If investing is so tough, then what is the recipe for investment success? As the saying goes, money management requires 10% inspiration and 90% perspiration. Or as strategist and long-time investor Don Hays notes, “You are only right on your stock purchases and sales when you are sweating.” Buying what’s working and selling what’s not, doesn’t require a lot of thinking or sweating (see Riding the Wave), just basic pattern recognition. Universally loved stocks may enjoy the inertia of upward momentum, but when the music stops for the Wall Street darlings, investors rarely can hit the escape button fast enough. Cutting corners and taking short-cuts may work in the short-run, but usually ends badly.
Real profits are made through unique insights that have not been fully discovered by market participants, or in other words, distancing oneself from the herd. Typically this means investing in reasonably priced companies with significant growth prospects, or cheap out-of-favor investments. Like dieting, this is easy to understand, but difficult to execute. Pulling the trigger on unanimously hated investments or purchasing seemingly expensive growth stocks requires a lot of blood, sweat, and tears. Eating doughnuts won’t generate the conviction necessary to justify the valuation and excess expected return for analyzed securities.
Times Have Changed
Investing in stocks is difficult enough with equity fund flows hemorrhaging out of investor accounts like the asset class is going out of style (See ICI data via The Reformed Broker). Stocks’ popularity haven’t been helped by the heightened volatility, as evidenced by the multi-year trend in the schizophrenic volatility index (VIX) – escalated by the “Flash Crash,” U.S. debt ceiling debate, and European financial crisis. Globalization, which has been accelerated by technology, has only increased correlations between domestic market and international markets. As we have recently experienced, the European tail can wag the U.S. dog for long periods of time. In decades past, concerns over economic activity in Iceland, Dubai, and Greece may not even make the back pages of The Wall Street Journal. Today, news travels at the speed of a “Tweet” for every Angela Merkel – Nicolas Sarkozy breakfast meeting or Chinese currency adjustment, and eventually results in a sprawling front page headline.
The equity investing game may be more difficult today, but investing for retirement has never been more important. Stuffing money under the mattress in Treasuries, money market accounts, CDs, or other conservative investments may feel good in the short run, but will likely not cover inflation associated with rising fuel, food, healthcare, and leisure costs. Regardless of your investment strategy, if your goal is to earn excess returns, you may want to check the moistness of your armpits – successful long-term investing requires a lot of sweat.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in ETFC, VXX, 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.
The Rule of 20 Can Make You Plenty
There is an endless debate over whether the equity markets are overvalued or undervalued, and at some point the discussion eventually transitions to what the market’s appropriate P/E (Price-Earnings) level should be. There are several standard definitions used for P/Es, but typically a 12-month trailing earnings, 12-month forward earnings (using earnings forecasts), and multi-year average earnings (e.g., Shiller 10-year inflation adjusted P/E – see Foggy P/E Rearview Mirror) are used in the calculations. Don Hays at Hays Advisory (www.haysadvisory.com) provides an excellent 30+ year view of the historical P/E ratio on a forward basis (see chart below).
Blue Line: Forward PE - Red Line: Implied Equilibrium PE (Hays Advisory)
If you listen to Peter Lynch, investor extraordinaire, his “Rule of 20” states a market equilibrium P/E ratio should equal 20 minus the inflation rate. This rule would imply an equilibrium P/E ratio of approximately 18x times earnings when the current 2011 P/E multiple implies a value slightly above 11x times earnings. The bears may claim victory if the earnings denominator collapses, but if earnings, on the contrary, continue coming in better than expected, then the sun might break through the clouds in the form of significant price appreciation.
Just because prices have been chopped in half, doesn’t mean they can’t go lower. From 1966 – 1982 the Dow Jones Industrial index traded at around 800 and P/E multiples contracted to single digits. That rubber band eventually snapped and the index catapulted 17-fold from about 800 to almost 14,000 in 25 years. Even though equities have struggled at the start of this century, a few things have changed from the market lows of 30 years ago. For starters, we have not hit an inflation rate of 13% or a Federal Funds rate of 20% (~3.5% and 0% today, respectively), so we have some headroom before the single digit P/E apocalypse descends upon us.
Fed Model Implies Equity Throttle
Hays Advisory exhibits another key valuation measurement of the equity market (the so-called “Fed Model”), which compares the Treasury yield of the 10-year Note with the earnings yield of stocks (see chart below).
Blue Line: 10-Yr Treasury - Red Line: Forward PE (Hays Advisory)
Regardless of your perspective, the divergence will eventually take care of it in one of three ways:
1.) Bond prices collapse, and Treasury yields spike up to catch up with equity yields.
2.) Forward earnings collapse (e.g., global recession/depression), and equity yields plummet down to the low Treasury yield levels.
AND/OR
3.) Stock prices catapult higher (lower earnings yield) to converge.
At the end of the day, money goes where it is treated best, and at least today, bonds are expected to treat investors substantially worse than the unfaithful treatment of Demi Moore by Ashton Kutcher. The Super Committee may not have its act together, and Europe is a mess, but the significant earnings yield of the equity markets are factoring in a great deal of pessimism.
The holidays are rapidly approaching. If for some reason the auspice of gifts is looking scarce, then review the Fed Model and Rule of 20, these techniques may make you plenty.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, 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.
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