Posts filed under ‘Trading’

Re-Questioning the Death of Buy & Hold Investing

Article originally posted September 17, 2010: At the time this original article was written, the Dow Jones Industrial Average was hovering around 11,500. Last week, the Dow closed at 20,624. Sure there have been plenty of ups and downs since 2010, but as I suggested seven years ago, perhaps “buy and hold” still is not dead today?

In the midst of the so-called “Lost Decade,” pundits continue to talk about the death of “buy and hold” (B&H) investing. I guess it probably makes sense to define B&H first before discussing it, but like most amorphous financial concepts, there is no clear cut definition. According to some strict B&H interpreters, B&H means buy and hold forever (i.e., buy today and carry to your grave). For other more forgiving Wall Street lexicon analysts, B&H could mean a multi-year timeframe. However, with the advent of high frequency trading (HFT) and supercomputers, the speed of trading has only accelerated further to milliseconds, microseconds, and even nanoseconds. Pretty soon B&H will be considered buying a stock and holding it for a day! Average mutual fund turnover (holding periods) has already declined from about 6 years in the 1950s to about 11 months in the 2000s according to John Bogle.

Technology and the lower costs associated with trading advancements arre obviously a key driver to shortened investment horizons, but even after these developments, professionals success in beating the market is less clear. Passive gurus Burton Malkiel and John Bogle have consistently asserted that 75% or more of professional money managers underperform benchmarks and passive investment vehicles (e.g., index funds and exchange traded funds).

This is not the first time that B&H has been held for dead. For example, BusinessWeek ran an article in August 1979 entitled The Death of Equities (see Magazine Cover article), which aimed to eradicate any stock market believers off the face of the planet. Sure enough, just a few years later, the market went on to advance on one of the greatest, if not the greatest, multi-decade bull market run in history. People repudiated themselves from B&H back then, and while B&H was in vogue during the 1980s and 1990s it is back to becoming the whipping boy today.

Excuse Me, But What About Bonds?

With all this talk about the demise of B&H and the rise of the HFT machines, I can’t help but wonder why B&H is dead in equities but alive and screaming in the bond market? Am I not mistaken, but has this not been the largest (or darn near largest) thirty-year bull market in bonds? The Federal Funds Rate has gone from 20% in 1981 to 0% thirty years later. Not a bad period to buy and hold, but I’m going to go out on a limb and say the Fed Funds won’t go from 0% to a negative -20% over the next thirty years.

Better Looking Corpse

There’s no denying the fact that equities have been a lousy place to be for the last ten years, and I have no clue what stocks will do for the next twelve months, but what I do know is that stocks offer a completely different value proposition today. At the beginning of the 2000, the market P/E (Price Earnings) valued earnings at a 29x multiple with the 10-year Treasury Note trading with a yield of about 6%. Today, the market trades at 13.5 x’s 2010 earnings estimates (12x’s 2011) and the 10-Year is trading at a level less than half the 2000 rate (2.75% today). Maybe stocks go nowhere for a while, but it’s difficult to dispute now that equities are at least much more attractive (less ugly) than the prices ten years ago. If B&H is dead, at least the corpse is looking a little better now.

As is usually the case, most generalizations are too simplistic in making a point. So in fully reviewing B&H, perhaps it’s not a bad idea of clarifying the two core beliefs underpinning the diehard buy and holders:

1)      Buying and holding stocks is only wise if you are buying and holding good stocks.

2)      Buying and holding stocks is not wise if you are buying and holding bad stocks.

Even in the face of a disastrous market environment, here are a few stocks that have met B&H rule #1:

Maybe buy and hold is not dead after all? Certainly, there have been plenty of stinking losing stocks to offset these winners. Regardless of the environment, if proper homework is completed, there is plenty of room to profitably resurrect stocks that are left for a buy and hold death by the so-called pundits.

Investment Questions Border

Wade W. Slome, CFA, CFP®  

Plan. Invest. Prosper. 

www.Sidoxia.com

DISCLOSURE: At the time the article was originally written, Sidoxia Capital Management (SCM) and some of its clients owned certain exchange traded funds and AAPL, AMZN, ARMH, and NFLX, but at the time of publishing SCM had no direct position in GGP, APKT, KRO, AKAM, FFIV, OPEN, RVBD, BIDU, PCLN, CRM, FLS, GMCR, HANS, BYI, SWN (*2,901% is correct %), CTSH, CMI, ISRG, ESRX, or any other security referenced in this article. As of 2/19/17 – Sidoxia owned AAPL, AMZN, and was short NFLX. 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.

February 19, 2017 at 4:46 pm Leave a comment

Super Bowl Blitz – Dow 20,000

team

This article is an excerpt from a previously released Sidoxia Capital Management complimentary newsletter (February 3, 2017). Subscribe on the right side of the page for the complete text.

If you have been following the sports headlines, then you know the Super Bowl 51 NFL football championship game between the four-time champion New England Patriots and the zero-time champion Atlanta Falcons is upon us. It’s that time of the year when more than 100 million people will congregate in front of big screen TVs across our nation and stare at ludicrous commercials (costing $5 million each); watch a semi-entertaining halftime show; and gorge on thousands of calories until stomachs bloat painfully.

The other headlines blasting across the media airwaves relate to the new all-time record milestone of 20,000 achieved by the Dow Jones Industrials Average (a.k.a., “The Dow”). For those people who are not glued to CNBC business television all day, the Dow is a basket of 30 large company stocks subjectively selected by the editors of the Wall Street Journal with the intent of creating an index that can mimic the overall economy. A lot of dynamics in our economy have transformed over the Dow’s 132 year history (1885), so it should come as no surprise that the index’s stock components have changed 51 times since 1896 – the most recent change occurred in March 2015 when Apple Inc. (AAPL) was added to the Dow and AT&T Inc. (T) was dropped.

20,000 Big Deal?

The last time the Dow closed above 10,000 was on March 29, 1999, so it has taken almost 18 years to double to 20,000. Is the Dow reaching the 20,000 landmark level a big deal in the whole scheme of things? The short answer is “No”. It is true the Dow can act as a fairly good barometer of the economy over longer periods of time. Over the 1998 – 2017 timeframe, economic activity has almost doubled to about $18 trillion (as measured by Gross Domestic Product – GDP) with the added help of a declining interest rate tailwind.

In the short-run, stock indexes like the Dow have a spottier record in correlating with economic variables. At the root of short-term stock price distortions are human behavioral biases and emotions, such as fear and greed. Investor panic and euphoria ultimately have a way of causing wild stock price overreactions, which in turn leads to poor decisions and results. We saw this firsthand during the inflation and subsequent bursting of the 2000 technology bubble. If that volatility wasn’t painful enough, last decade’s housing collapse, which resulted in the 2008-2009 financial crisis, is a constant reminder of how extreme emotions can lead to poor decision-making. For professionals, short-term volatility and overreactions provide lucrative opportunities, but casual investors and novices left to their own devices generally destroy wealth.

As I have discussed on my Investing Caffeine blog on numerous occasions, the march towards 20,000 occurred in the middle of arguably the most hated bull market in a generation or two (see The Most Hated Bull Market). It wasn’t until recently that the media began fixating on this arbitrary new all-time record high of 20,000. My frustration with the coverage is that the impressive phenomenon of this multi-year bull market advance has been largely ignored, in favor of gloom and doom, which sells more advertising – Madison Avenue execs enthusiastically say, “Thank you.” While the media hypes these stock records as new, this phenomenon is actually old news. In fact, stocks have been hitting new highs over the last five years (see chart below).

dji-07-17

More specifically, the Dow has hit consecutive, new all-time record highs in each year since 2013. This ignored bull market (see Gallup survey) may not be good for the investment industry, but it can be good for shrewd long-term investors, who react patiently and opportunistically.

Political Football

In Washington, there’s a different game currently going on, and it’s a game of political football. With a hotly contentious 2016 election still fresh in the minds of many voters, a subset of unsatisfied Americans are closely scrutinizing every move of the new administration. Love him or hate him, it is difficult for observers to accuse President Trump of sitting on his hands. In the first 11 days of his presidential term alone, Trump has been very active in enacting almost 20 Executive Orders and Memoranda (see the definitional difference here), as he tries to make supporters whole with his many previous campaign trail promises. The persistently increasing number of policies is rising by the day (…and tweet), and here’s a summarizing list of Trump’s executive actions so far:

  • Refugee Travel Ban
  • Keystone & Dakota Pipelines
  • Border Wall
  • Deportations/Sanctuary Cities
  • Manufacturing Regulation Relief
  • American Steel
  • Environmental Reviews
  • Affordable Care Act Requirements
  • Border Wall
  • Exit TPP Trade Deal
  • Federal Hiring Freeze
  • Federal Abortion Freeze
  • Regulation Freeze
  • Military Review
  • ISIS Fight Plan
  • Reorganization of Security Councils
  • Lobbyist Bans
  • Deregulation for Small Businesses

President Trump has thrown another political football bomb with his recent nomination of Judge Neil Gorsuch (age 49) to the Supreme Court in the hopes that no penalty flags will be thrown by the opposition. Gorsuch, the youngest nominee in 25 years, is a conservative federal appeals judge from Colorado who is looking to fill the seat left open by last year’s death of Justice Antonin Scalia at the age 79.

Politics – Schmolitics

When it comes to the stock market and the economy, many people like to make the president the hero or the scapegoat. Like a quarterback on the football field, the president certainly has influence in shaping the political and economic game plan, but he is not the only player. There is an infinite number of other factors that can (and do) contribute to our country’s success (or lack thereof).

Those economic game-changing factors include, but are not limited to: Congress, the Federal Reserve, Supreme Court, consumer sentiment, trade policy, demographics, regulations, tax policy, business confidence, interest rates, technology proliferation, inflation, capital investment, geopolitics, terrorism, environmental disruptions, immigration, rate of productivity, fiscal policy, foreign relations, sanctions, entitlements, debt levels, bank lending, mergers and acquisitions, labor rules, IPOs (Initial Public Offerings), stock buybacks, foreign exchange rates, local/state/national elections, and many, many, many other factors.

Regardless to which political team you affiliate, if you periodically flip through your social media stream (e.g., Facebook), or turn on the nightly news, you too have likely suffered some sort of political fatigue injury. As Winston Churchill famously stated, “Democracy is the worst form of government except for all the other forms that have been tried from time to time.”

When it comes to your finances, getting excited over Dow 20,000 or despondent over politics is not a useful or efficient strategy. Rather than becoming emotionally volatile, you will be better off by focusing on building (or executing) your long-term investment plan. Not much can be accomplished by yelling at a political charged Facebook rant or screaming at your TV during a football game, so why not calmly concentrate on ways to control your future (financial or otherwise). Actions, not fear, get results. Therefore, if this Super Bowl Sunday you’re not ready to review your asset allocation, budget your annual expenses, or contemplate your investment time horizon, then at least take control of your future by managing some nacho cheese dip and handling plenty of fried chicken.

investment-questions-border

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

www.Sidoxia.com

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in AAPL, T, FB and certain exchange traded funds (ETFs), but at the time of publishing 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.

February 4, 2017 at 8:02 am Leave a comment

Dow 20,000 – Braking News or Breaking News?

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Investors from around the globe excitedly witnessed the Dow Jones Industrial Average index break the much-anticipated 20,000 level and set a new all-time record high this week. The question now becomes, is this new threshold braking news (time to be concerned) or breaking news (time to be enthused)? The true answer is neither. While the record 20,000 achievement is a beautifully round number and is responsible for a bevy of headlines splashing around the world, the reality is this artificial 20,000 level is completely arbitrary.

Time will tell whether this random numeric value will trigger the animal spirits of dispirited investors, but given all the attention, it is likely to jolt the attention span of distracted, ill-prepared savers. Unfortunately, the median family has only saved a meager $5,000 for retirement. For some years now, I have highlighted that this is the most hated bull market (see The Most Hated Bull Market Ever), and Gallup’s 2016 survey shows record low stock ownership, which also supports my view (chart below). Trillions of dollars coming out of stock funds is additional evidence of investors’ sour mood (see fund outflow data).

gallup-poll-2016

While investors have been selling stocks for years, record corporate profits, trillions in share buybacks, and trillions of mergers and acquisitions (in the face of a weak IPO market) have continually grinded stock prices to new record highs.

Pessimism Sells

The maligned press (deservedly so in many instances) has been quick to highlight a perpetual list of dread du jour. The daily panic-related topics do however actually change. Some days it’s geopolitical concerns in the Middle East, Russia, South China Sea, North Korea, and Iran and other days there are economic cries of demise in China, Brazil, Venezuela, or collapse in the Euro. And even when the economy is doing fine (unemployment rate chopped in half from 10%, near full employment), the media and talking heads often supply plenty of airtime to impending spikes of crippling inflation or Fed-induced string of choking interest rate increases.

I fondly look back on my articles from 2009, and 2010 when I profiled schlocks like Peter Schiff (see Emperor Schiff Has No Clothes) who recklessly peddled catastrophe to the masses. I guess Schiff didn’t do so well when he called for the NASDAQ to collapse to 500 (5,660 today) and the Dow to reach 2,000 (20,000 today).

Or how about the great forecaster John Mauldin who also piled onto death and destruction near the bottom in 2009 (see The Man Who Cries Wolf ). Here’s what Mauldin had to say:

“All in all, the next few years are going to be a very difficult environment for corporate earnings. To think we are headed back to the halcyon years of 2004-06 is not very realistic. And if you expect a major bull market to develop in this climate, you are not paying attention.” … “We are going to pay for that with a likely dip back into a recession.”

 

At S&P 856 (2,295 today) Mauldin added:

“This rally has all the earmarks of a major short squeeze…When the short squeeze is over, the buying will stop and the market will drop. Remember, it takes buying and lot of it to move a market up but only a lack of buying to create a bear market.”

 

Nouriel Roubini a.k.a. “Dr Doom” was another talking head who plastered the airwaves with negativity after the 2008-2009 financial crisis that I also profiled (see Pinning Down Roubini). For example, in early 2009, here’s what Roubini said:

“We are still only in the early stages of this crisis. My predictions for the coming year, unfortunately, are even more dire: The bubbles, and there were many, have only begun to burst.”

 

For long-term investors, they understand the never-ending doom and gloom headlines are meaningless noise. Legendary investor Peter Lynch pointed on on numerous occasions:

“If you spend more than 13 minutes analyzing economic and market forecasts, you’ve wasted 10 minutes.”

 

(see also Peter Lynch video)

The good news is all the media pessimism and investor skepticism creates opportunities for shrewd investors focusing on key drivers of stock price appreciation (corporate earnings, interest rates, valuations, and sentiment).

While the eternally, half-glass full media is quick to highlight the negatives, it’s interesting that it takes an irrelevant, arbitrary level to finally create a positive headline for a new all-time record high of Dow 20,000. Frustratingly, the new all-time record highs reached by the Dow in 2013, 2014, 2015, and 2016 were almost completely ignored (see chart below):

Source: Barchart.com

Source: Barchart.com

What happens next? Nobody knows for certain. What is certain however is that using the breaking news headlines of Dow 20,000 to make critical investment decisions is not an intelligent long-term strategy. If you, like many investors, have difficulty in sticking to a long-term strategy, then find a trusted professional to help you create a systematic, disciplined investment strategy. Now, that is some real breaking news.

investment-questions-border

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

www.Sidoxia.com

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing 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.

January 29, 2017 at 2:34 am Leave a comment

When Genius Failed

when-genius-failed-book-cover

It has been a busy year between work, play, family, and of course the recent elections. My work responsibilities contain a wide-ranging number of facets, but in addition to research, client meetings, conference calls, conferences, trading, and other activities, I also attempt to squeeze in some leisure reading as well. While it’s sad but true that I find pleasure in reading SEC documents (10Ks and 10Qs), press releases, transcripts, corporate presentations, financial periodicals, and blogs, I finally did manage to also scratch When Genius Failed by Roger Lowenstein from my financial reading bucket list.

When Genius Failed chronicles the rise and fall of what was considered the best and largest global hedge fund, Long Term Capital Management (LTCM). The irony behind the collapse makes the story especially intriguing. Despite melding the brightest minds in finance, including two Nobel Prize winners, Robert Merton and Myron Scholes, the Greenwich, Connecticut hedge fund that started with $1.3 billion in early 1994 managed to peak at around $140 billion before eventually crumbling to ruin.

With the help of confidential internal memos, interviews with former partners and employees of LTCM, discussions with the Federal Reserve, and consultations with the six major banks involved in the rescue, Lowenstein provides the reader with a unique fly-on-the-wall perspective to this grand financial crisis.

There have certainly been plenty of well-written books recounting the 2008-2009 financial crisis (see my review on Too Big to Fail), but the sheer volume has burnt me out on the subject. With that in mind, I decided to go back in time to the period of 1993 – 1998, a point at the beginning of my professional career. Until LTCM’s walls began figuratively caving in and global markets declined by more than $1 trillion in value, LTCM was successful at maintaining a relatively low profile. The vast majority of Americans (99%) had never heard of the small group of bright individuals who started LTCM, until the fund’s ultimate collapse blanketed every newspaper headline and media outlet.

Key Characters

Meriwether: John W. Meriwether was a legendary trader at Salomon Brothers, where he started the Arbitrage Group in 1977 and built up a successful team during the 1980s. His illustrious career is profiled in Michael Lewis’s famed book, Liar’s Poker. Meriwether built his trading philosophy upon the idea that mispricings would eventually revert back to the mean or converge, and therefore shrewd opportunistic trading will result in gains, if patience is used. Another name for this strategy is called “arbitrage”. In sports terms, the traders of the LTCM fund were looking for inaccurate point spreads, which could then be exploited for profit opportunity. Prior to the launch of LTCM, in 1991 Meriwether was embroiled in the middle of a U.S. Treasury bid-rigging scheme when one of his traders Paul Mozer admitted to submitting false bids to gain unauthorized advantages in government-bond auctions. John Gutfreund, Salomon Brothers’ CEO was eventually forced to quit, and Salomon’s largest, famed shareholder Warren Buffett became interim CEO. Meriwether was slapped on the wrist with a suspension and fine, and although Buffett eventually took back Meriwether in a demoted role, ultimately the trader was viewed as tainted goods so he left to start LTCM in 1993.

LTCM Team: During 1993 Meriwether built his professional team at LTCM and he began this process by recruiting several key Salomon Brothers bond traders. Larry Hilibrand and Victor Haghani were two of the central players at the firm. Other important principals included Eric Rosenfeld, William Krasker, Greg Hawkins, Dick Leahy, Robert Shustak, James McEntee, and David W. Mullins Jr.

Nobel Prize Winners (Merton & Scholes): While Robert C. Merton was teaching at Harvard University and Myron S. Scholes at Stanford University, they decided to put their academic theory to the real-world test by instituting their financial equations with the other investing veterans at LTCM. Scholes and Merton were effectively godfathers of quantitative theory. If there ever were a Financial Engineering Hall of Fame, Merton and Scholes would be initial inductees. Author Lowenstein described the situation by saying, “Long-Term had the equivalent of Michael Jordan and Muhammad Ali on the same team.” Paradoxically, in 1997, right before the collapse of LTCM, Merton and Scholes would become Nobel Prize laureates in Economic Sciences for their work in developing the theory of how to price options.

The History:

Founded in 1993, Long-Term  Management Capital was hailed as the most impressive hedge fund created in history. Near its peak, LTCM managed money for about 100 investors and employed 200 employees. LTCM’s primary strategy was to identify mispriced bonds and profit from a mean reversion strategy. In other words, as long as the overall security mispricings narrowed, rather than widened, then LTCM would stand to profit handsomely.

On an individual trade basis, profits from LTCM’s trades were relatively small, but the fund implemented thousands of trades and used vast amounts of leverage (borrowings) to expand the overall profits of the fund. Lowenstein ascribed the fund’s success to the following process:

“Leveraging its tiny margins like a high-volume grocer, sucking up nickel after nickel and multiplying the process a thousand times.”

 

Although LTCM implemented this strategy successfully in the early years of the fund, this premise finally collapsed like a house of falling cards in 1998. As is generally the case, hedge funds and other banking competitors came to understand and copy LTCM’s successful trading strategies. Towards the end of the fund’s life, Meriwether and the other fund partners were forced to experiment with less familiar strategies like merger arbitrage, pair trades, emerging markets, and equity investing. This diversification strategy was well intentioned, however by venturing into uncharted waters, the traders were taking on excessive risk (i.e., they were increasing the probability of permanent capital losses).

The Timeline

  • 1994 (28% return, 20% after fees): After attempting to raise capital funding in 1993, LTCM opened its doors for business in February 1994 with $1.25 billion in equity. Financial markets were notably volatile during 1994 in part due to Federal Reserve Chairman Alan Greenspan leading the first interest rate hike in five years. The instability caused famed fund managers Michael Steinhardt and George Soros to lose -$800 million and $650 million, respectively, all within a timespan of less than a week. The so-called “Mexican Tequila Crisis” that occurred at the end of the year also resulted in a devaluation of the Mexican peso and crumbling of the Mexican stock market.
  • 1995 (59% return, 43% after fees): By the end of 1995, the fund had tripled its equity capital and total assets had grown to $102 billion. Total leverage, or the ratio of debt to equity, stood around 28 to 1. LTCM’s derivative contract portfolio was like a powder keg, covering positions worth approximately $650 billion.
  • 1996 (57% return, 41% after fees): By the spring of 1996, the fund was holding $140 billion in assets, making it two and a half times as big as Fidelity Magellan, the largest mutual fund on the planet. The fund also carried derivatives valued at more than $1 trillion, all financed off a relatively smaller $4 billion equity base. Investors were loving the returns and financial institutions were clamoring to gain some of LTCM’s business. During this period, as many as 55 banks were providing LTCM financing. The mega-returns earned in 1996 came in large part due to profitable leveraged spread trades on Japanese convertible bonds, Italian bonds, junk bonds, and interest rate swaps. Total profits for the year reached an extraordinary level of around $2.1 billion. To put that number in perspective, that figure was more money generated than the profits earned by McDonalds, Disney, American Express, Nike, Xerox, and many more Fortune 500 companies.
  • 1997 (25% return, 17% after fees): The Asia Crisis came into full focus during October 1997. Thailand’s baht currency fell by -20% after the government decided to let the currency float freely. Currency weakness then spread to the Philippines, Malaysia, South Korea, and Singapore. As Russian bond spreads (prices) began to widen, massive trading losses for LTCM were beginning to compound. Returns remained positive for the year and the fund grew its equity capital to $5 billion. As the losses were mounting and the writing on the wall was revealing itself, professors Merton and Scholes were recognized with their Nobel Prize announcement. Ironically, LTCM was in the process of losing control. LTCM’s bloated number of 7,600 positions wasn’t making the fund any easier to manage. During 1997, the partners realized the fund’s foundation was shaky, so they returned $2.7 billion in capital to investors. Unfortunately, the risk profile of the fund worsened – not improved. More specifically, the fund’s leverage ratio skyrocketed from 18:1 to 28:1.
  • 1998 (-92% return – loss): The Asian Crisis losses from the previous year began to bleed into added losses in 1998. In fact, losses during May and June alone ended up reducing LTCM’s capital by $461 million. As the losses racked up, LTCM was left in the unenviable position of unwinding a mind-boggling 60,000 individual positions. It goes almost without saying that selling is extraordinarily difficult during a panic. As Lowenstein put it, “Wall Street traders were running from Long-Term’s trades like rats from a sinking ship.” A few months later in September, LTCM’s capital shrunk to less than $1 billion, meaning about $100 billion in debt (leverage ratio greater than 100:1) was supporting the more than $100 billion in LTCM assets. It was just weeks later the fund collapsed abruptly. Russia defaulted on its ruble debt, and the collapsing currency contagion spread to global markets outside Russia, including Eastern Asia, and South America.

The End of LTCM

On September 23, 1998, after failed investment attempts by Warren Buffett and others to inject capital into LTCM, the heads of Bankers Trust, Bear Stearns, Chase Manhattan, Goldman Sachs, J.P. Morgan, Lehman Brothers, Merrill Lynch, Morgan Stanley Dean Witter, and Salomon Brothers all gathered at the Federal Reserve Bank of New York in the heart of Wall Street. Presiding over this historical get-together was Fed President, William J. McDonough. International markets were grinding to a halt during this period and the Fed was running out of time before an all-out meltdown was potentially about to occur. Ultimately, McDonough was able to get 14 banks to wire $3.65 billion in bailout funds to LTCM. While all LTCM partners were financially wiped out completely, initial investors managed to recoup a small portion of their original investment (23 cents on the dollar after factoring in fees), even though the tally of total losses reached approximately $4.6 billion. Once the bailout was complete, it took a few years for the fund to liquidate its gargantuan number of positions and for the banks to get their multi-billion dollar bailout paid back in full.

  • 1999 – 2009 (Epilogue): Meriwether didn’t waste much time moping around after the LTCM collapse, so he started a new hedge fund, JWM Partners, with $250 million in seed capital primarily from legacy LTCM investors. Regrettably, the fund was hit with significant losses during the 2008-2009 Financial Crisis and was subsequently forced to close its doors in July 2009.
Source: The Personal Finance Engineer

Source: The Personal Finance Engineer

 

Source: The Personal Finance Engineer

Source: The Personal Finance Engineer

Lessons Learned:

  • The Risks of Excessive Leverage: Although the fund grew to peak value of approximately $140 billion in assets, most of this growth was achieved with added debt. When all was said and done, LTCM borrowed more than 30 times the value of its equity. As Lowenstein put it, LTCM was “adding leverage to leverage, as if coating a flammable tinderbox with kerosene.” In home purchase terms, if LTCM wanted to buy a house using the same amount of debt as their fund, they would lose all of their investment, if the house value declined a mere 3-4%. The benefit of leverage is it multiplies gains. The downside to leverage is that it also multiplies losses. If you carry too much leverage in a declining market, the chance of bankruptcy rises…as the partners and investors of LTCM learned all too well. Adding fuel to the LTCM flames were the thousands of derivative contracts, valued at more than $1 trillion. Warren Buffett calls derivatives: “Weapons of Mass Destruction.”
  • Past is Not Always Prologue for the Future: Just because a strategy works now or in the past, does not mean that same strategy will work in the future. As it relates to LTCM, Nobel Prize winning economist Merton Miller stated, “In a strict sense, there wasn’t any risk – if the world had behaved as it did in the past.” LTCM’s models worked for a while, then failed miserably. There is no Holy Grail investment strategy that works always. If an investment strategy sounds too good to be true, then it probably is too good to be true.
  • Winning Strategies Eventually Get Competed Away: The spreads that LTCM looked to exploit became narrower over time. As the fund achieved significant excess returns, competitors copied the strategies. As spreads began to tighten even further, the only way LTCM could maintain their profits was by adding additional leverage (i.e., debt). High-frequency trading (HFT) is a modern example of this phenomenon, in which early players exploited a new technology-driven strategy, until copycats joined the fray to minimize the appeal by squeezing the pool of exploitable profits.
  • Academics are Not Practitioners: Theory does not always translate into reality, and academics rarely perform as well as professional practitioners. Merton and Scholes figured this out the hard way. As Merton admitted after winning the Nobel Prize, “It’s a wrong perception to believe that you can eliminate risk just because you can measure it.”
  • Size Matters: As new investors poured massive amounts of capital into the fund, the job of generating excess returns for LTCM managers became that much more difficult. I appreciate this lesson firsthand, given my professional experience in managing a $20 billion fund (see also Managing $20 Billion). Managing a massive fund is like maneuvering a supertanker – the larger a fund gets, the more difficult it becomes to react and anticipate market changes.
  • Stick to Your Knitting: Because competitors caught onto their strategies, LTCM felt compelled to branch out. Meriwether and LTCM had an edge trading bonds but not in stocks. In the later innings of LTCM’s game, the firm became a big player in stocks. Not only did the firm place huge bets on merger arbitrage, but LTCM dabbled significantly in various long-short pair trades, including a $2.3 billion pair trade bet on Royal Dutch and Shell. Often the firm used derivative securities called equity swaps to make these trades without having to put up any significant capital. As LTCM experimented in the new world of equities, the firm was obviously playing in an area in which it had absolutely no expertise.

As philosopher George Santayana states, “Those who fail to learn from history are doomed to repeat it.” For those who take investing seriously, When Genius Failed is an important cautionary tale that provides many important lessons about financial markets and highlights the dangers of excessive leverage. You may not be a genius Nobel Prize winner in economics, but learning from Long-Term Capital Management’s failings will place you firmly on the path to becoming an investing genius.

investment-questions-border

Wade W. Slome, CFA, CFP®

www.Sidoxia.com

Plan. Invest. Prosper.

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), DIS, JPM, and MCD, but at the time of publishing had no direct position in AXP, NKE, XRX, RD, GS, MS, Shell, 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

November 21, 2016 at 1:44 am 2 comments

Technical Analysis – Astrology or Lob Wedge?

Investing comes in many shapes and sizes. And like religion (see Investing Religion article), most investment strategies are built on the essential belief that following certain rules and conventions will eventually lead to profit enlightenment. When it comes to technical analysis (TA), a discipline used with the principal aim of predicting future prices from past patterns, some consider it a necessity for making money in the market. Others, regard the practice of TA as a pseudoscience, much like astrology.

I feel  there is a proper place for TA on selective basis, which I will describe later, but for the most part I agree with some of the legendary investors  who have chimed in on the subject:

Warren Buffett: “I realized technical analysis didn’t work when I turned the charts upside down and didn’t get a different answer.”

Peter Lynch: “Charts are great for predicting the past.”

Technical Analysis Linguistics

Fundamental analysis, the antithesis of technical analysis, strives to predict future price direction by analyzing facts and data surrounding a company, industry, and/or economy. It too comes with its own syntax and versions, for example: value, growth, top-down, bottom-up, quantitative, etc.

I do not claim to be a TA expert, however in my many years of investing I have come across a smorgasbord of terms and flavors surrounding the discipline. Describing and explaining the density of material surrounding TA would encompass too large of a scope for this article, but here are some prevalent terms one should come to grips with if you want to become a technical analysis guru:

Technical Analysis Approaches

  • Elliot Wave
  • Relative strength / Momentum (see Momentum Investing article)
  • MACD (Moving Average Convergence / Divergence)
  • Fibonacci retracement
  • Dow Theory
  • Stochastics
  • Bollinger bands

Price Patterns

  • Head and shoulders
  • Double bottom
  • Cup and handle
  • Channels
  • Breakouts
  • Pivot points
  • Candlesticks
  • Resistance/Support
  • Dead cat bounce (my personal favorite)

Each of these patterns are supposes to provide insight into the future direction of price. At best, I would say the academic research surrounding the subject is “inconclusive,” and at worst I’d say it’s considered a complete “sham.”

The Lob Wedge

As I’ve stated earlier, I fall in the skeptical camp when it comes to TA, since fundamental analysis is the main engine I use for generating and tracking my investment ideas. For illustrative purposes, you may consider fundamental analysis as my group of drivers and irons. I do, however,  utilize selective facets of TA much like I use a lob wedge in golf for a limited number of specific situations (e.g., shots over high trees, downhill lies, and fast greens). When it comes to trading, I do believe there is some value in tracking the relationship of extreme trading volume (high or low), especially when it is coupled with extreme price movement (high or low). The economic laws of supply and demand hold true for stock trades just as they do for guns and butter, and sharp moves in these components can provide insights into the psychological mindset of investors with respect to a security (or broader market). Beyond trading volume, there are a few other indicators that I utilize as part of my trading strategies, but these tactics play a relatively minor role, since most of my core positions are held on a multi-year time horizon.

Overall, there is a stream of wasteful noise, volatility, and misinformation that permeates the financial markets on a daily basis. A major problem with technical analysis is the many false triggered signals, which in many cases lead to excessive trading, transaction costs, and ultimately subpar investment returns.  Although I remain a skeptic on the subject of technical analysis and I may not read my horoscope today, I will continue to keep a lob wedge in my golf bag with the hopes of finding new, creative ways of using it to my advantage.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

www.Sidoxia.com

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own exchange traded funds and various securities, including BRK.B, but at time of publishing had no direct position in BRK.A or any company 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.

July 9, 2016 at 9:45 am 1 comment

Cleaning Out Your Investment Fridge

moldy cheese

This article is an excerpt from a previously released Sidoxia Capital Management complimentary newsletter (June 1, 2016). Subscribe on the right side of the page for the complete text.

Summer is quickly approaching, but it’s not too late to do some spring cleaning. This principle not only applies to your cluttered refrigerator with stale foods but also your investment portfolio with moldy investments. In both cases, you want to get rid of the spoiled goods. It’s never fun discovering a science experiment growing in your fridge.

Over the last three months, the stock market has been replenished after a rotten first two months of the year (S&P 500 index was down -5.5% January through February). The +1.5% increase in May added to a +6.6% and +0.3% increase in March and April (respectively), resulting in a three month total advance in stock prices of +8.5%. Not surprisingly, the advance in the stock market is mirroring the recovery we have seen in recent economic data.

After digesting a foul 1st quarter economic Gross Domestic Product (GDP) reading of only +0.8%, activity has been smelling better in the 2nd quarter. A recent wholesome +3.4% increase in April durable goods orders, among other data points, has caused the Atlanta Federal Reserve Bank to raise its 2nd quarter GDP estimate to a healthier +2.9% growth rate (from its prior +2.5% forecast).

Consumer spending, which accounts for roughly 70% of our country’s economic activity, has been on the rise as well. The improving employment picture (5.0% unemployment rate last month) means consumers are increasingly opening their wallets and purses. In addition to spending more on cars, clothing, movies, and vacations, consumers are also doling out a growing portion of their income on housing. Housing developers have cautiously kept a lid on expansion, which has translated into limited supply and higher home prices, as evidenced by the Case-Shiller indices charted below.

case shiller 2016

Source: Bespoke

Spoiling the Fun?

While the fridge may look like it’s fully stocked with fresh produce, meat, and dairy, it doesn’t take long for the strawberries to get moldy and the milk to sour. Investor moods can sour quickly too, especially as they fret over the impending “Brexit” (British Exit) referendum on June 23rd when British voters will decide whether they want to leave the European Union. A “yes” exit vote has the potential of roiling the financial markets and causing lots of upset stomachs.

Another financial area to monitor relates to the Federal Reserve’s monetary policy and its decision when to further increase the Federal Funds interest rate target at its June 14th – 15th meeting. With the target currently set at an almost insignificantly small level of 0.25% – 0.50%, it really should not matter whether Chair Janet Yellen decides to increase rates in June, July, September and/or November. Considering interest rates are at/near generational lows (see chart below), a ¼ point or ½ point percentage increase in short-term interest rates should have no meaningfully negative impact on the economy. If your fridge was at record freezing levels, increasing the temperature by a ¼ or ½ degree wouldn’t have a major effect either. If and when short-term interest rates increase by 2.0%, 3.0%, or 4.0% in a relatively short period will be the time to be concerned.

10 yr

Source: Scott Grannis

Keep a Fresh Financial Plan

As mentioned earlier, your investments can get stale too. Excess cash sitting idly earning next-to-nothing in checking, savings, CDs, or in traditional low-yielding bonds is only going to spoil rapidly to inflation as your savings get eaten away. In the short-run, stock prices will move up and down based on frightening but insignificant headlines. However, in the long-run, the more important issues are determining how you are going to reach your retirement goals and whether you are going to outlive your savings. This mindset requires you to properly assess your time horizon, risk tolerance, income needs, tax situation, estate plan, and other unique circumstances. Like a balanced diet of various food groups in your refrigerator, your key personal financial planning factors are dependent upon you maintaining a properly diversified asset allocation that is periodically rebalanced to meet your long-term financial goals.

Whether you are managing your life savings, or your life-sustaining food supply, it’s always best to act now and not be a couch potato. The consequences of sitting idle and letting your investments spoil away are a lot worse than letting the food in your refrigerator rot away.

investment-questions-border

www.Sidoxia.com

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 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.

June 4, 2016 at 8:00 am Leave a comment

Playing the Field with Your Investments

For some, casually dating can be fun and exciting. The same goes for trading and speculating – the freedom to make free- wheeling, non-committal purchases can be exhilarating. Unfortunately the costs (fiscally and emotionally) of short-term dating/investing often outweigh the benefits.

Fortunately, in the investment world, you can get to know an investment pretty well through fundamental research that is widely available (e.g., 10Ks, 10Qs, press releases, analyst days, quarterly conference calls, management interviews, trade rags, research reports). Unlike dating, researching stocks can be very cheap, and you do not need to worry about being rejected.

Dating is important early in adulthood because we make many mistakes choosing whom we date, but in the process we learn from our misjudgments and discover the important qualities we value in relationships. The same goes for stocks. Nothing beats experience, and in my long investment career, I can honestly say I’ve dated/traded a lot of pigs and gained valuable lessons that have improved my investing capabilities. Now, however, I don’t just casually date my investments – I factor in a rigorous, disciplined process that requires a serious commitment. I no longer enter positions lightly.

One of my investment heroes, Peter Lynch, appropriately stated, “In stocks as in romance, ease of divorce is not a sound basis for commitment. If you’ve chosen wisely to begin with, you won’t want a divorce.”

Charles Ellis shared these thoughts on relationships with mutual funds:

“If you invest in mutual funds and make mutual funds investment changes in less than 10 years…you’re really just ‘dating.’ Investing in mutual funds should be marital – for richer, for poorer, and so on; mutual fund decisions should be entered into soberly and advisedly and for the truly long term.”

No relationship comes without wild swings, and stocks are no different. If you want to survive the volatile ups and downs of a relationship (or stock ownership), you better do your homework before blindly jumping into bed. The consequences can be punishing.

Buy and Hold is Dead…Unless Stocks Go Up

If you are serious about your investments, I believe you must be mentally willing to commit to a relationship with your stock, not for a day, not for a week, or not for a month, but rather for years. Now, I know this is blasphemy in the age when “buy-and-hold” investing is considered dead, but I refute that basic premise whole-heartedly…with a few caveats.

Sure, buy-and-hold is a stupid strategy when stocks do nothing for a decade – like they have done in the 2000s, but buying and holding was an absolutely brilliant strategy in the 1980s and 1990s. Moreover, even in the miserable 2000s, there have been many buy-and-hold investments that have made owners a fortune (see Questioning Buy & Hold ). So, the moral of the story for me is “buy-and-hold” is good for stocks that go up in price, and bad for stocks that go flat or down in price. Wow, how deeply profound!

To measure my personal commitment to an investment prospect, a bachelorette investment I am courting must pass another test…a test from another one of my investment idols, Phil Fisher, called the three-year rule. This is what the late Mr. Fisher had to say about this topic:

“While I realized thoroughly that if I were to make the kinds of profits that are made possible by [my] process … it was vital that I have some sort of quantitative check… With this in mind, I established what I called my three-year rule.” Fisher adds, “I have repeated again and again to my clients that when I purchase something for them, not to judge the results in a matter of a month or a year, but allow me a three year period.”

Certainly, there will be situations where an investment thesis is wrong, valuation explodes, or there are superior investment opportunities that will trigger a sale before the three-year minimum expires. Nonetheless, I follow Fisher’s rule in principle in hopes of setting the bar high enough to only let the best ideas into both my client and personal portfolios.

As I have written in the past, there are always reasons of why you should not invest for the long-term and instead sell your position, such as: 1) new competition; 2) cost pressures; 3) slowing growth; 4) management change; 5) valuation; 6) change in industry regulation; 7) slowing economy; 8 ) loss of market share; 9) product obsolescence; 10) etc, etc, etc. You get the idea.

Don Hays summed it up best: “Long term is not a popular time-horizon for today’s hedge fund short-term mentality. Every wiggle is interpreted as a new secular trend.”

Peter Lynch shares similar sympathies when it comes to noise in the marketplace:

“Whatever method you use to pick stocks or stock mutual funds, your ultimate success or failure will depend on your ability to ignore the worries of the world long enough to allow your investments to succeed.”

Every once in a while there is validity to some of the concerns, but more often than not, the scare campaigns are merely Chicken Little calling for the world to come to an end.

Patience is a Virtue

In the instant gratification society we live in, patience is difficult to come by, and for many people ignoring the constant chatter of fear is challenging. Pundits spend every waking hour trying to explain each blip in the market, but in the short-run, prices often move up or down irrespective of the daily headlines. Explaining this randomness, Peter Lynch said the following:

“Often, there is no correlation between the success of a company’s operations and the success of its stock over a few months or even a few years. In the long term, there is a 100% correlation between the success of a company and the success of its stock. It pays to be patient, and to own successful companies.”

Long-term investing, like long-term relationships, is not a new concept. Investment time horizons have been shortening for decades, so talking about the long-term is generally considered heresy. Rather than casually date a stock position, perhaps you should commit to a long-term relationship and divorce your field-playing habits. Now that sounds like a sweet kiss of success.

investment-questions-border

Wade W. Slome, CFA, CFP® 

Plan. Invest. Prosper. 

www.Sidoxia.com

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.

August 9, 2015 at 12:33 pm Leave a comment

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