Posts tagged ‘flash crash’

Ignoring Economics and Vital Signs

As stock prices sit near all-time record highs, and as we enter year nine of the current bull market, I remain amazed and amused at the brazen disregard for important basic economic concepts like supply & demand, interest rates, and rising profits.

If the stock market was a doctor’s patient, over the last decade, bloggers, pundits, talking heads, and pontificators have been ignoring the improving, healthy patient’s vital signs, while endlessly predicting the death of the resilient stock market.

However, let’s be clear – it has not been all hearts and flowers for stocks – there have been numerous -10%, -15%, and -20% corrections since the Financial Crisis nine years ago. Those corrections included the Flash Crash, debt downgrade, Arab Spring, sequestration, Taper Tantrum, Iranian Nuclear Threat, Ukrainian-Crimea annexation, Ebola, Paris/San Bernardino Terrorist Attacks, multiple European & Chinese slowdowns and more.

Despite the avalanche of headlines and volatility, we all know the net result of these events – a more than tripling of stock prices (+259%) from March 2009 to new all-time record highs. With the incessant stream of negative news, how could prices appreciate so dramatically?

Over the years, the explanations by outside observers have changed. First, the recovery was explained as a “dead cat bounce” or a short-term cyclical bull market within a long-term secular bear market. Then, when stock prices broke to new records, the focus shifted to Quantitative Easing (QE1, QE2, QE3, and Operation Twist). The QE narrative implied the bull advance was temporary due to the non-stop, artificial printing presses of the Fed. Now that the Fed has not only ended QE but reversed it (the Fed is actually contracting its balance sheet) and hiked interest rates (no longer cutting), outsiders are once again at a loss. Now, the bears are left clinging to the flawed CAPE metric I wrote about three years ago (see CAPE Smells Like BS), and using political headlines as a theory for record prices (i.e., record stock prices stem from inflated tax cut and infrastructure spending expectations).

It’s unfortunate for the bears that all the conspiracy theory headlines and F.U.D. (fear, uncertainty, and doubt) over the last 10 years have failed miserably as predictors for stock prices. The truth is that stock prices don’t care about headlines – stock prices care about economics. More specifically, stock prices care about profits, interest rates, and supply & demand.

Profits

It’s quite simple. Stock prices have more than tripled since early 2009 because profits have more than tripled since 2009. As you can see from the Macrotrends chart below, 2009 – 2016 profits for the S&P 500 index rose from $6.86 to $94.54, or +1,287%. It’s no surprise either that stock prices stalled for 18 months from 2015 to mid-2016 when profits slowed. After profits returned to growth, stock price appreciation also resumed.

Source: Macrotrends

Interest Rates

When you could earn a +16% on a guaranteed CD bank rate in the early 1980s, do you think stocks were a more or less attractive asset class? If you can sense the rhetorical nature of my question, then you can probably understand why stocks were about as attractive as rotten milk or moldy bread. Back then, stocks traded for about 8x’s earnings vs. the 18x-20x multiples today. The difference is, today interest rates are near generational lows (see chart below), and CDs pay near +0%, thereby making stocks much more attractive. If you think this type of talk is heresy, ignore me and listen to the greatest investor of all-time, Warren Buffett who recently stated:

“Measured against interest rates, stocks are actually on the cheap side.”

 

Source: Trading Economics

Supply & Demand

Another massively ignored area, as it relates to the health of stock prices, is the relationship of new stock supply entering the market (e.g., new dilutive shares via IPOs and follow-on offerings), versus stock exiting the market through corporate actions. While there has been some coverage placed on the corporate action of share buybacks – about a half trillion dollars of stock being sucked up like a vacuum cleaner by cash heavy companies like Apple Inc. (AAPL) – little attention has been paid to the trillions of dollars of stock vanishing from mergers and acquisition activities. Yes, Snap Inc. (SNAP) has garnered a disproportionate amount of attention for its $3 billion IPO (Initial Public Offering), this is a drop in the bucket compared to the exodus of stock from M&A activity. Consider the trivial amount of SNAP supply entering the market ($3 billion) vs. $100s of billions in major deals announced in 2016 – 2017:

  • Time Warner Inc. merger offer by AT&T Inc. (T) for $85 billion
  • Monsanto Co. merger offer by Bayer AG (BAYRY) for $66 billion
  • Reynolds American Inc. merger offer by British American Tobacco (BTI) for $47 billion
  • NXP Semiconductors merger offer by Qualcomm Inc. (QCOM) for $39 billion
  • LinkedIn merger offer by Microsoft Corp. (MSFT) for $28 billion
  • Jude Medical, Inc. merger offer by Abbott Laboratories (ABT) for $25 billion
  • Mead Johnson Nutrition merger offer by Reckitt Benckiser Group for $18 billion
  • Mobileye merger offer by Intel Corp. (INTC) for $15 billion
  • Netsuite merger offer by Oracle Corp. (ORCL) for $9 billion
  • Kate Spade & Co. merger offer by Coach Inc. (COH) for $2 billion

While these few handfuls of deals represent over $300 billion in disappearing stock, as long as corporate profits remain strong, interest rates low, and valuations reasonable, there will likely continue to be trillions of dollars in stocks being purchased by corporations. This continued vigorous M&A activity should provide further healthy support to stock prices.

Admittedly, there will come a time when profits will collapse, interest rates will spike, valuations will get stretched, sentiment will become euphoric, and/or supply of stock will flood the market (see Don’t be a Fool, Follow the Stool). When the balance of these factors turn negative, the risk profile for stock prices will obviously become less desirable. Until then, I will let the skeptics and bears ignore the healthy economic vital signs and call for the death of a healthy patient (stock market). In the meantime, I will continue focus on the basics of math and offer my economics textbook to the doubters.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

www.Sidoxia.com

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own AAPL, ABT, INTC, MSFT, T, and certain exchange traded funds, but at the time of publishing SCM had no direct position in SNAP, TWX, MON, KATE, N, MBLY, MJN, STJ, LNKD, NXPI, BAYRY, BTI, QCOM, ORCL, COH, RAI, Reckitt Benckiser Group,  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.

May 14, 2017 at 12:27 am Leave a comment

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 relevant 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 (left side of graph), speculators can make nearly as much profits as long-term investors. As famed long-term investor Benjamin Graham 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. Like a gambler/speculator dumping money into a slot machine in Las Vegas, the gambler may win in the short-run, but over the long-run, the “house” always wins.

Financial Institutions are notorious for throwing up strategies on the wall like strands of spaghetti. If some short-term outperforming products randomly stick, then financial institutions often market the bejesus out of the funds 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 3 billion people online and 5 billion people operating mobile phones globally, no wonder investors are getting overwhelmed with a massive amount of short-term data.

Next, trading costs have also declined dramatically in recent decades to the point where 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, any exploitable trend has already been exploited. In other words, the low-hanging profit fruits have already been picked, making long-term excess returns tougher to achieve.

There is rarely a scarcity of short-term fears. Currently, concerns vary between Federal Reserve monetary policy, political legislation,  Middle East terrorism, foreign exchange rates, inflation, and other fear-induced issues du jour. Markets may be overbought in the short-run, and/or an unforeseen issue may derail the current bull market advance. However, for investors who can put on their long-term thinking caps and understand the concept of time arbitrage, opportunistically buying oversold ideas and selling over-hyped ones should lead to significant profits.

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.

December 17, 2016 at 10:14 am Leave a comment

Sweating Your Way to Investment Success

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. 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 international geopolitics and presidential elections. Globalization, which has been accelerated by technology, has only increased correlations between domestic market and international markets. 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” 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.

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 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.

October 16, 2016 at 5:10 pm Leave a comment

Lewis Sells Flash Boys Snake Oil

Snake Oil

I know what you’re saying, “Please, not another article on Michael Lewis’s Flash Boys book and high frequency trading (HFT),” but I can’t resist putting in my two cents after the well-known author emphatically proclaimed the stock market as “rigged.” Lewis is not alone with his outrageous claims… Clark Stanley (“The Rattlesnake King”) made equally outlandish claims in the early 1900s when he sold lucrative Snake Oil Liniment to heal the ailments of the masses. Ultimately Stanley’s assets were seized by the government and the healing assertions of his snake oil were proven fraudulent. Like Stanley, Lewis’s over-the-top comments about HFT traders are now being scrutinized under a microscope by more thoughtful critics than Steve Kroft from 60 Minutes (see television profile). For a more detailed counterpoint, see the Reuters interview with Manoj Narang (Tradeworx) and Haim Bodek (Decimus Capital Markets).

While Lewis may not be selling snake oil, the cash register is still ringing with book sales until the real truth is disseminated. In the meantime, Lewis continues to laugh to the bank as he makes misleading and deceptive claims, just like his snake oil selling predecessors.

The Inside Perspective

Regardless of what side of the fence you fall on, the debate created by Lewis’s book has created deafening controversy. Joining the jihad against HFT is industry veteran Charles Schwab, who distributed a press release calling HFT a “growing cancer” and stating the following:

“High-frequency trading has run amok and is corrupting our capital market system by creating an unleveled playing field for individual investors and driving the wrong incentives for our commodity and equities exchanges.”

 

What Charles Schwab doesn’t admit is that their firm is receiving about $100 million in annual revenues to direct Schwab client orders to the same HFT traders at exchanges in so called “payment-for-order-flow” contracts. Another term to describe this practice would be “kick-backs”.

While Michael Lewis screams bloody murder over investors getting fraudulently skimmed, some other industry legends, including the godfather of index funds, Vanguard founder Jack Bogle, argue that Lewis’s views are too extreme. Bogle reasons, “Main Street is the great beneficiary…We are better off with high-frequency trading than we are without it.”

Like Jack Bogle, other investors who should be pointing the finger at HFT traders are instead patting them on the back. Cliff Asness, managing and founding principal of AQR Capital Management, an institutional investment firm managing about $100 billion in assets, had this to say about HFT in his Wall Street Journal Op-Ed:

“How do we feel about high-frequency trading? We think it helps us. It seems to have reduced our costs and may enable us to manage more investment dollars… on the whole high-frequency traders have lowered costs.”

 

Is HFT Good for Main Street?

Many investors today have already forgotten, or were too young to remember, that stocks used to be priced in fractions before technology narrowed spreads to decimal points in the 1990s. Who has benefited from all this technology? You guessed it…everyone.

Lewis makes the case that the case that all investors are negatively impacted by HFT, including Main Street (individual) investors. Asness maintains costs have been significantly lowered for individual investors:

“For the first time in history, Main Street might have it rigged against Wall Street.”

 

In Flash Boys, Lewis claims HFT traders unscrupulously scalp pennies per share from retail investor pockets by using privileged information to jump in front of ordinary investors (“front-run”). The reality, even if you believe Lewis’s contentions are true, is that technology has turned any perceived detrimental penny-sized skimming scheme into beneficial bucks for ordinary investors. For example, trades that used to cost $40, $50, $100, or more per transaction at the large wirehouse brokerage firms can today be purchased at discount brokerage firms for $7 or less. What’s more, the spread (i.e., the profits available for middlemen) used to be measured in increments of  1/8, 1/4, and 1/2 , when today the spreads are measured in pennies or fractions of pennies. Without any rational explanation, Lewis also dismisses the fact that HFT traders add valuable liquidity to the market. His argument of adding “volume and not liquidity” would make sense if HFT traders only transacted solely with other HFT traders, but that is obviously not the case.

Regardless, as you can see from the chart below, the trend in spreads over the last decade or so has been on a steady, downward, investor-friendly slope.

How Did We Get Here? And What’s Wrong with HFT?

Similarly to our country’s 73,954 page I.R.S. tax code,  the complexity of our financial market trading structure rivals that of our government’s money collection system. The painting of all HFT traders as villains by Lewis is no truer than painting all taxpayers as crooks. Just as there are plenty of crooked and deceitful individuals that push the boundaries of our income tax system, so too are there traders that try to take advantage of an inefficient, Byzantine exchange system. The mere presence of some tax dodgers doesn’t mean that all taxpayers should go to jail, nor should all HFT traders be crucified by the SEC (Securities and Exchange Commission) police.

The heightened convoluted nature to our country’s exchange-based financial system can be traced back to the establishment of Regulation NMS, which was passed by the SEC in 2005 and implemented in 2007. The aim of this regulatory structure was designed to level the playing field through fairer trade execution and the creation of equal access to transparent price quotations.  However, rather than leveling the playing field, the government destroyed the playing field and fragmented it into many convoluted pieces (i.e., exchanges) – see Wall Street Journal article  and chart below.

The new Reg NMS competition came in the form of exchanges like BATS and Direct Edge (now merging), but the new multi-faceted structures introduced fresh loopholes for HFT traders to exploit – for both themselves and investors. More specifically, HFT traders used expensive, lightning-fast fiber optic cables; privileged access to data centers physically located adjacent to trading exchanges; and then they integrated algorithmic software code to efficiently route orders for best execution.

Are many of these HFT traders and software programs attempting to anticipate market direction? Certainly. As the WSJ excerpt below explains, these traders are shrewdly putting their capitalist genes to the profit-making test:

Computerized firms called high-frequency traders try to pick up clues about what the big players are doing through techniques such as repeatedly placing and instantly canceling thousands of stock orders to detect demand. If such a firm’s algorithm detects that a mutual fund is loading up on a certain stock, the firm’s computers may decide the stock is worth more and can rush to buy it first. That process can make the purchase costlier for the mutual fund.

 

Like any highly profitable business, success eventually attracts competition, and that is exactly what has happened with high frequency trading. To appreciate this fact, all one need to do is look at Goldman Sachs’s actions, which is to leave the NYSE (New York Stock Exchange), shutter its HFT dark pool trading platform (Sigma X), and join IEX, the dark pool created by Brad Katsuyama, the hero placed on a pedestal by Lewis in Flash Boys. Goldman is putting on their “we’re doing what’s best for investors” face on, but more experienced veterans understand that Goldman and all the other HFT traders are mostly just greedy S.O.B.s looking out for their best interests. The calculus is straightforward: As costs of implementing HFT have plummeted, the profit potential has dried up, and the remaining competitors have been left to fend for their Darwinian survival. The TABB Group, a  financial markets’ research and consulting firm, estimates that US equity HFT revenues have declined from approximately $7.2 billion in 2009 to about $1.3 billion in 2014.  As costs for co-locating HFT hardware next to an exchange have plummeted from millions of dollars to as low as $1,000 per month, the HFT market has opened their doors to anyone with a checkbook, programmer, and a pulse. That wasn’t the case a handful of years ago.

The Fixes

Admittedly, not everything is hearts and flowers in HFT land. The Flash Crash of 2010 highlighted how fragmented, convoluted, and opaque our market system has become since Reg NMS was implemented. And although “circuit breaker” remedies have helped prevent a replicated occurrence, there is still room for improvement.

What are some of the solutions? Here are a few ideas:

  • Reform complicated Reg NMS rules – competition is good, complexity is not.
  • Overhaul disclosure around “payment-for-order-flow” contracts (rebates), so potential conflicts of interest can be exposed.
  • Stop inefficient wasteful “quote stuffing” practices by HFT traders.
  • Speed up and improve the quality of the SIP (Security Information Processor), so the gaps between SIP and the direct feed data from exchanges are minimized.
  • Improve tracking and transparency, which can weed out shady players and lower probabilities of another Flash Crash-like event.

These shortcomings of HFT trading do not mean the market is “rigged”, but like our overwhelmingly complex tax system, there is plenty of room for improvement. Another pet peeve of mine is Lewis’s infatuation with stocks. If he really thinks the stock market is rigged, then he should write his next book on the less efficient markets of bonds, futures, and other over-the-counter derivatives. This is much more fertile ground for corruption.

As a former manager of a $20 billion fund, I understand the complications firsthand faced by large institutional investors. In an ever-changing game of cat and mouse, investors of all sizes will continue looking to  execute trades at the best prices (lowest possible purchase and highest possible sales price), while middlemen traders will persist with their ambition to exploit the spread (generate profits between the bid and ask prices). Improvements in technology will always afford a temporary advantage for a few, but in the long-run the benefits for all investors have been undeniable. The same undeniable benefits can’t be said for reading Michael Lewis’s Flash Boys. Like Clark Stanley and other snake oil salesmen before him, it will only take time for the real truth to come out about Lewis’s “rigged” stock market claims.

 

www.Sidoxia.com

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold long positions in certain exchange traded funds (ETFs), but at the time of publishing SCM had no direct position in GS, SCHW, ICE, 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.

April 11, 2014 at 1:04 pm 3 comments

Surviving a Series of Unfortunate Events

Disaster

My children grew up reading a Series of Unfortunate Events by Lemony Snicket’s (the pseudonym for Daniel Handler). The award winning 13 book series began at the turn of the century (1999) with the Bad Beginning and seven years later, Handler ended the stories with The End (2006). The books chronicle the stories of three orphaned children (Violet, Klaus, and Sunny Baudelaire) who experience increasingly terrible events after the alleged death of their parents and burning of their house by a man named Count Olaf.

Crime, violence and hardships not only occur in novels, but also in real life. Stock market investors are no strangers to unfortunate events either. Within the last five years alone, investors have endured an endless stream of bad news, including the following:

  • Flash Crash
  • Debt Ceiling Debate
  • U.S. Debt Downgrade
  • European Recession
  • Arab Spring
  • Potential Greek Exit from EU
  • Uncertain U.S. Presidential Elections
  • Sequestration
  • Cyprus Financial Crisis
  • Tax Increases
  • Fed Talks of Stimulus Tapering
  • Syrian Civil War / Military Threat
  • Gov. Shutdown 
  •  Obamacare Rollout Glitches
  •  Iranian Nuclear Threat

This is only a partial list, but wow, this never ending crises list sounds pretty ominous, right? I wonder how stocks have fared amidst this horrendous avalanche of negative headlines? The short answer is stocks are up a whopping +170% since the March 2009 lows as measured by the S&P 500 index, and would be significantly higher once accounting for reinvested dividends. A bit higher return than your CD, money market, or savings account rate.

CLICK TO ENLARGE

SP500 History 2009-2013

As you can see from the chart above, the gargantuan returns achieved over this period have not occurred without some volatility. Investors have consumed massive quantities of Tums during the five highlighted corrections (averaging -13%) to counteract all the heartburn. As I’ve written in the past, with higher risk comes higher rewards. Those investors who cannot stomach the volatility shouldn’t go cold turkey on stocks though, but rather diversify their holdings and reduce the portfolio equity allocation to a more palatable level.

Doubting Thomases

Many people I bump into remain “Doubting Thomases” as it relates to the stock market recovery and they expect an imminent crash. Certainly, the rocket-like trajectory of the last year (and five years) is not sustainable, and historically stocks correct significantly twice a decade – equal to the number of recessions occurring each decade. There is no denying that this economic recovery has been the slowest since World War II, but could this be good news? From the half-full glass lens, a slower recovery may actually equate to a longer recovery.

Just like skeptical investors, business executives have been slow to hire and slow to accelerate spending as well. Typically business cycles come to an end when overinvestment happens – recall the 2000 tech bubble and 2007 housing bubble. There may be pockets of investment bubbles (e.g., Twitter Inc [TWTR] and other money-losing speculative stocks), but as you can see from the chart below, corporate profits have skyrocketed and are at record highs. It should therefore come as no surprise that record profits have coincided with record stock prices (see also It’s the Earnings Stupid)

SP500 Earnings 2003-2014

Over the period of 2003-2013 stock prices largely followed the slope of earnings, and excluding the enormous losses in the banking sector, non-financial stocks suffered much less.

History is on Your Side

If you are in the camp that says this last five years has been an anomaly, history may beg to differ. Over the last 50 years we have experienced wars, assassinations, currency crises, banking crises, terrorist attacks, recessions, SARs, mad cow disease, military engagements, tax hikes, Fed rate hikes, and yes, even political gridlock. As the chart below shows, the stock market is volatile over the short-run, but quite resilient and lucrative over the long-run (+6,863% over 49 years). In fact, from January 1960 to October 2013 the S&P 500 index has catapulted +14,658%, including reinvested dividends (Source: DQYDJ.net).

SP500 History 1960-2008

Rather than getting caught up in the political or CNBC headline du jour, investors will be better served by creating a customized, long-term diversified portfolio that can meet long-standing goals and objectives. If you don’t have the discipline, interest, or time to properly create a personalized investment plan, then find an independent investment advisor like Sidoxia Capital Management (www.Sidoxia.com), so you can experience a series of fortunate (not unfortunate) events.

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 SCM had no direct position in TWTR, 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. Chart construction done by Kevin D. Weaver.

November 16, 2013 at 10:52 pm 4 comments

Sitting on the Sidelines: Fear & Selective Memory

Sidelines.sxc

Fear is a motivating (or demotivating) emotion that can force individuals into suboptimal actions.  The two main crashes of the 2000s (technology & housing bubbles) coupled with the mini-crises (e.g., flash crash, European crisis, debt ceiling, sequestration, fiscal cliff, etc.) have scared millions of investors and trillions of dollars to sit on the sidelines. Financial paralysis may be great in the short-run for bruised psyches and egos, but for the passive onlookers, the damage to retirement accounts can be crippling.

Selective memory is a great coping mechanism for those investors sitting on the sidelines as well. Purposely forgetting your wallet at a group dinner may be beneficial in the near-term, but repeated incidents will result in lost friends over the long-run. Similarly, most gamblers frequenting casinos tend to pound their chests when bragging about their wins, however they tend to conveniently forget about all the losses.  These same reality avoidance principles apply to investing.

A recent piece written by CEO Bill Koehler at Tower Wealth Managers, entitled The Fear Bubble highlights a survey conducted by Franklin Templeton. In the study, investors were asked how the stock market performed in 2009-2012. As you can see from the chart below, perception is the polar opposite of reality (actual gains far exceeded perceived losses):

Source: Franklin Templeton via Tower Wealth Managers

Source: Franklin Templeton via Tower Wealth Managers

With so many investors sitting on the sidelines in cash or concentrated in low-yielding bonds and gold, I suppose the results shouldn’t be too surprising. Once again, selective memory serves as a wonderful tool to bury the regrets of missing out on a financial market recovery of a lifetime.

Humans also have a predisposition to seek out people who share similar views, even though accumulating different viewpoints ultimately leads to better decisions. Morgan Housel at The Motley Fool just wrote an article, Putting a Gap Between You and Stupid,  explaining how individuals should seek out others who can help protect them from harmful biases. A scientific study referenced in the article showed how the functioning of biased brains literally shuts down:

“During the 2004 presidential election, psychologist Drew Westen of Emory University and his colleagues studied the brains of 15 “committed” Democrats and 15 “committed” Republicans with an MRI scanner. Each group was shown a collection of contradictory statements made by George W. Bush and John Kerry. Not surprisingly, the partisans were quick to call out contradictions made by the opposing party, and made up all kinds of justifications to rationalize quotes made by their own side’s candidate. But here’s what’s scary: The participants weren’t just being stubborn. Westen found that areas of their brains that control reasoning and logic virtually shut down when confronted with a conflicting view of their preferred candidate.”

 

Rather than letting emotions rule the day, the proper approach is to stick to unbiased numbers like valuations, yields, fees, and volatility. If you continually make mistakes; you aren’t disciplined enough; or you don’t like investing; then find a trusted advisor who uses an objective financial approach.  Opportunistically taking advantage of volatility, instead of knee-jerk reactions is the preferred approach. For those people sitting on the sidelines and using selective memory, you may feel better now, but you will eventually have to get in the game, if you don’t want to lose the retirement account game.

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, SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is the information to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.

October 26, 2013 at 7:41 pm Leave a comment

Time to Trade in the Investment Tricycle

Boy on Tricycle

This article is an excerpt from a previously released Sidoxia Capital Management’s complementary newsletter (May 1, 2013). Subscribe on the right side of the page for an entire monthly update.

As the stock market continues to set new, all-time record highs and the Dow Jones Industrial index nears another historic milestone (15,000 level), investors remain cautiously skeptical of the rebound – like a nervous toddler choosing to ride a tricycle instead of a bicycle. Investors have been moving slowly, but stock prices have not – the Dow has risen +13% in 2013 alone. What’s more, over the last four years the S&P 500 index (which represents large companies) has climbed +140%; the S&P 400 (mid-sized companies) +195%; and the S&P 600 (small-sized companies) +200%.

The gains have been staggering, but like the experience of riding a bicycle, the bumps, scrapes, and bruises suffered during the 2008-2009 financial crash have caused investors to abandon their investment bikes for a perceived safer vehicle…a tricycle. What do I mean by that? Well, over the last six years, investors have pulled out more than -$521,000,000,000 from stock funds and piled those proceeds into bonds (Calafia Beach Pundit chart below). For retirees and billionaires this strategy may make sense in certain instances. But for millions of others, interest rate risk, inflation risk, and the risk of outliving your money can be more hazardous to financial well-being, than the artificially perceived safety expected from bonds. The fact of the matter is investing inefficiently in cash, money markets, CDs, and low-yielding fixed income securities can be riskier in the long-run than a globally diversified portfolio invested across a broad set of asset classes (including equities). The latter should be the strategy of choice, unless of course you are someone who yearns to work at Wal-Mart (WMT) as a greeter in your 80s!

Fund Flows Data - Calafia Beach Pundit

Investor Training Wheels

Training Wheels I don’t want to irresponsibly flog everyone, because investing attitudes have begun to change a little in 2013, as investors have added $66 billion to stock funds (data from ICI). Effectively, some investors have gone from riding their tricycle to hopping on a bike with training wheels. With this change in mindset, surely people have commenced selling bonds to buy stocks, right? Wrong! Investors have actually bought more bonds (+$69 billion) than stocks in the first three months of the year, which helps explain why interest rates on the 10-year Treasury are only yielding a paltry 1.67% (near last year’s record summer low) – remember, bond buying causes interest rates to go down. If you really want to do research, you could ask your parents when rates were ever this low, but some readers’ parents may not even had been born yet. The previous record low in interest rates, according to Bloomberg, at 1.95% was achieved in 1941.

Over the last five years the news has been atrocious, and as we have proven, investing based off of current headlines is a horrible investment strategy. As we’ve seen firsthand, there can be very long, multi-year periods when stock performance has absolutely no correlation with the positive or negative nature of news reports. To better make my point, I ask you, what types of headlines have you been reading over the last four years? I can answer the question for you with a few examples. For starters, we’ve endured financial collapses in Iceland, Ireland, Dubai, Greece, and now Cyprus. At home domestically, we’ve experienced a “flash crash” that temporarily evaporated about $1 trillion dollars in value (and 1,000 Dow points) within a few minutes due to high frequency algorithmic traders. How about unemployment data? We’ve witnessed the slowest, jobless U.S. recovery in a generation (since World War II), and European countries have it much worse than we do (e.g., Spain just registered a 27% unemployment rate). What about political gridlock and brinksmanship? We’ve seen debt ceiling stand-offs lead to a historic loss of our country’s AAA debt status; a partisan presidential election; a deafening fiscal cliff debate; and now mindless sequestration. Nevertheless, large cap stocks and small cap stocks have more than doubled and tripled, respectively.

Fear sells advertising, and sounds smarter than “everything is rosy,” but the fact remains, things are not as bad as many bears claim. Corporations are earning record profits, and hold trillions in cash (e.g., Apple Inc.’s recent announcement of more than $50 billion in share repurchase and $11 billion in annual dividend payments are proof). Moreover, central banks around the globe are doing whatever it takes to stimulate growth – most recently the Bank of Japan promised to inject $1.4 trillion into its economy by the end of 2014, in order to kick-start expansion. Lastly, the U.S. employment picture continues to improve, albeit slowly (7.6% unemployment in March), allowing consumers to pay down debt, buy more homes, and spend money to spur economic growth.

Dangers of Being Informed

Mark TwainHopefully this clarifies how useless and futile newspaper headlines are when it comes to effective investing. As Mark Twain astutely noted, “If you don’t read the newspaper, you are uninformed. If you do read the newspaper, you are misinformed.” It’s perfectly fine to remain in tune with current events, but shuffling around your life’s savings based on this information is a foolish plan.

If the concerns and worries du jour have you nervously riding a tricycle, just realize that you may not reach your investment destination with this mode of transportation. I understand that it is not all hearts and flowers in the financial markets, and there are plenty of legitimate risks to consider. However, excessive exposure in low-rate asset classes may be riskier than many realize. If you’re still riding your investment tricycle, you’re probably better off by grabbing a helmet and pads (i.e., globally diversified portfolio) and jumping on a bike – you are more likely to reach your financial destination.

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), WMT and AAPL, 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.

May 4, 2013 at 8:18 am 1 comment

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