A couple of weeks ago it was starting to look a little scary. We said, “relax, the world isn’t going to fall apart.” And it didn’t.
That wasn’t just a willy nilly call. There were good reasons for believing that the stocks would rally a bit and they did after successfully finding support in the 1,260′s. The S&P is in the low 1300′s right now and also kissing the 50-day moving average. It’s as good an out point as you can ask for if your time horizon is short.
Commodities still seem to be looking for a bottom. This is exactly what we warned about a couple of months ago when we started writing about the end of QE2. Turns out, those warnings had merit. I got a lot of hate mail for the suggestion that commodities would go down alongside the conclusion of QE2. But it goes to show that markets don’t move in the same direction all the time. Longer-term, the trend in commodities may still be higher, but I believe that the theory that QE2 was artificially overextending commodity prices is legit.
If pressed, I’d probably guess that crude oil heads back around where it was before QE2. On a technical basis, it seems to want to trade between $70 and $90 per barrel and most of the energy analysts I listen to seem to say the same sort of thing. For whatever it’s worth, refiners can’t really make money with oil below $70 and OPEC doesn’t want prices too far above $90. It’s a topic for an entirely different newsletter, but the whole crude oil problem is very long-term in nature. This is not a situation that will be resolving itself in the next several years.
It might be a little too early to make this call, but we may have been right about interest rates too. Maaaybe.
Rates have rocketed higher this week but the jury is still out on whether that’ll be a move that has legs. I still think it will, but I’ve been wrong about enough stuff in the past not to get too locked into that forecast.
My basic argument is that there are just too many other investments that are more attractive than loaning your money to the U.S. government for 10 years and getting only 3.1% in return. That’s on a nominal basis, too! After inflation, it’s an investment with basically zero return and a fair amount of risk.
Seriously, ask yourself the question: what’s the lowest interest rate you’d accept to lend the government money for the next decade? 4%? 5%? 10%
More Greek Drama
Most of the news headlines I’ve seen this week have been basically of the “market rallies on hope for Greece” sort.
If you’ve been reading this newsletter for any length of time there’s probably one thing you know above all others: there is no hope for Greece.
Sorry. I don’t say that to be mean. It doesn’t make me a hater or a perma-bear. It just means that there is basically one outcome for the Greeks. The details of that outcome are obviously difficult to know — maybe the current government works out a restructuring deal, maybe Papandreou gets the boot and the new government gives the EU the finger, or maybe something happens that nobody sees coming – but none of that matters. Regardless of how it plays out, the final outcome will be one that destabilizes the market.
There are two ways to look at this and two super-important things to understand.
The first is that you need to ask yourself how your portfolio is going to tolerate a destabilization event like that. I can hear what you’re saying. You’re saying, “so what, I’ll be able to re-position myself before that actually happens!” You might think you’ll be able to get out in time but I have news for you: you won’t. Timing on stuff like this is impossible to predict and The Draconian’s Draconian Law of Market Timing is that extremely inconvenient events will happen exactly when you are not expecting them and always when it’s least convenient for you.
Have the evacuation plan in place before the building catches fire.
The second super-important thing to understand is that you need to be prepared to go into the market and buy when this happens. This is every bit as easy to preach and difficult to practice as that first principle. Your gut will be telling you, “ugh, the world is falling apart, maybe I’ll just hang out and see what happens.”
Have a purchase plan at the ready. Make a list of companies you’d like to own for the next year or so. If you know that destabilization events make you nervous, adopt a strategy that takes that into consideration. Scale into these things slowly. Do some dollar cost averaging. Whatever. Just find something that works for you and roll with it. The point is that you should use what the market gives you.
The reason why I’m suggesting that the next big correction will be one worth buying on is because of what we talked about last week. Right now, the market is telling you that default of some form might be inevitable but that it will not translate into a full-blown banking crisis. On top of that, none of the leading economic indicators suggest that anything worse than a growth slowdown is up ahead.
So this two-tailed strategy that we’ve outlined here should work as long as the current environment persists. Pullbacks should be purchased.
Keep your eye on all these indicators. If Greece finally does hit something of an inflection point and credit spreads blow out to record wide levels, then this whole plan may go out the window. If these leading economic indicators start to hint that a recession might be in store some time in 2012 you’ll need to quickly move to Plan B.
It’s a fluid world. Stay flexible.
Lessons on flexibility
I play this game called Puerto Rico. In the oddball community of board game aficionados like myself it’s regarded as one of the best games, if not the best game, of the modern world.
I think this is a game that every investor should play. Serious investors might even want to spend some time to get seriously good at it. It’s an economic game where players develop a population of workers to produce and sell different types goods. But the economic theme is not why investors should play it. The game has some strange and unique mechanics which are incredibly relevant for anyone with a portfolio to manage.
The most peculiar thing that new players will notice is that there is no luck element. In Puerto Rico there are no mechanisms of randomness like rolling dice or drawing a hand of cards. On each turn players can choose between one of several actions which directly impacts both them and their opponents.
We talk about luck and randomness all the time in the market, but in truth, this stuff isn’t actually random. Any professional investor who’s been around for a while will tell you that it’s not a coin toss as to whether the market goes up or down on a given day. It’s not a roll of the dice to determine whether a company goes out of business or a country defaults on its debt. Even something like a terrorist strike doesn’t work in a true, mathematically random sense. It’s all driven by human behavior which works in an essentially unknowable way.
This makes life rather difficult. Believe it or not, random environments are easier to deal with than non-random ones with unknowable probabilities.
One of the major problems in the world of investing is that economists assumed that financial outcomes were normally distributed. We all thought we could nail down probabilities of things like whether a borrower would default on their home loan or whether a bucket of CDO’s would go bad. Then we built fantastic economic models based on these assumptions.
Investors thought they were playing a game like Craps where the odds are known and the distribution of outcomes adhered to an easy-to-model Gaussian pattern. It turned out, they weren’t. The market rolled snake eyes like a dozen times in a row. Everybody was baffled that something which could only happen once in a million years was not only happening right now, but also happened a decade prior and also a couple decades before that.
The dice weren’t betraying us. We were just playing the wrong game.
The market doesn’t play a game like Craps. The market plays a game like Puerto Rico. There isn’t any true luck or mathematical randomness, just illusions of it. The game is based entirely on the actions of humans. Sometimes it’s easy to predict other players’ behavior. But every once in a while they’ll throw you for a loop. It can have catastrophic consequences, too. You might think that investors will rationally follow principles of long-term value, but then they’ll panic and drag the whole market down with them.
Getting good at Puerto Rico is all about effectively adapting to your opponents moves. Sometimes you’ll think you can guess which way the player on your right will zig based on his board’s configuration, but then he’ll zag and do something completely unexpected. Unlike a lot of games — and exactly like the stock market — you have to react to the move your opponent does make rather than the move he should make.
Sometimes your opponent does stupid, irrational, or intentionally vindictive things. If you aren’t able to calmly adjust and head off in a different direction, you’ll fall behind.
The way you win at Puerto Rico is to stay flexible. After you play a number of games you begin to learn all the different ways in which it is possible to win. There are probably four or five broad strategies that work very well and one in particular that is quite popular with many players. But the next thing you’ll notice in Puerto Rico is that none of those are guaranteed winners in each game. There is no strategy like betting the Pass Line and taking full odds that’s guaranteed to get you the best results in any game with any mix of players.
In Puerto Rico you’ll start off playing one strategy only to realize that it’s doomed because of what your opponents are doing. If you’re playing against really skilled opponents, they’ll see what strategy you’re using and intentionally try to derail it. In those situations, you can certainly try to keep forcing your initial strategy. You can hold out hope that it’ll work out in the end. But it doesn’t. It’s a recipe for failure.
It works the same way when it comes to investing in the market. You can play the buy-and-hold strategy or always follow a strict mix of asset allocation, but there are times when that stuff is guaranteed to disappoint. You have to adjust or accept defeat.
It’s not all fun and games
I like to play games. Games are probably one of my favorite things in the whole world.
I play board games, card games, word games, dice games, computer games, solitaire games, social games, mind games, war games, brain games, sports games, role-playing games, casino games, and games you can play in the middle of summer on your back lawn after a pitcher of sangria.
I like games because they give me a chance to interact socially in an environment where the etiquette & expectations are clearly defined. That’s much more comfortable for us introverts than something like a cocktail party. But I also like games also give my brain an opportunity to indulge in exercises of strategy.
When I was a youth, winning was the only thing that mattered. Today that attitude seems silly. Winning has little to do with it. The goal is to always get better, to become a stronger player.
Investing is one big game. Or at least that’s how I see it.
It’s one with infinite complexity, too. And I play it the way I play most games. I start with small bets until I feel familiar enough with the rules. I learn everything I can about the different ways to win. I watch my opponents carefully and learn from them. I learn about them. I try to not only anticipate their moves and make the right counters, but I try and predict the moves they’ll use to counter my counters. After a while I settle down with a handful of strategies that I find particularly appealing or happen to have a knack for.
For me, a lot of those investment strategies were value strategies and contrarian strategies. They were what felt right to me and they were what I was good at. This is why we spend so much time on here talking about things that are cheap and things that everybody else hates. Nobody reads this newsletter for tips on how to day-trade momentum stocks.
As an investor, you have to do the same thing. You have to play all the games and explore all the strategies to find stuff that feels right and gets you satisfactory results. Sometimes it’s work and sometimes it’s fun.
This weekend is the 4th of July. My favorite holiday of the year. All your friends and family will be over for the BBQ and sangria.
What better opportunity to dust off your favorite game?
- If you happened to buy the market when it was looking scary a couple weeks ago, now might be a time to close out that trade if your horizon is short.
- Keep your eyes on interest rates over the next couple of weeks. The higher they go, the less attractive stuff like the stock market will look to investors. In this world of negative real rates, this is the #1 most important mandatory-to-understand dynamic. It’s all relative.
- You can learn a lot by playing games if your mind is open to it. Many of these lessons translate to the world of investing.
SEMANTIC NOTE: It occurred to me that the above discussion of randomness might seem strange. I totally understand how the market can seem random — like a drunkard’s walk down the alley — to most people. But when I talk about true, mathematically random environments, I’m speaking of a game like craps where there are a known set of outcomes and known probabilities associated with those outcomes. The market’s action may satisfy one definition of “random,” but it fails to satisfy our technical definition. Sorry, I minored in computer programming and took a lot of weird math classes in college so I get fussy about the semantics of things like randomness.
Last week we outlined a little strategy to play a quick bounce in the market. It worked out pretty well. The S&P rallied for 4 straight days and a bit more than +2.5% as the oversold condition cleared.
Sometimes we get lucky!
But really, it underscores the general point we were trying to make. When it looks scary in the marketplace like it did last week, it’s often a good time to buy. Here in the office we always joke around about a mechanical trading system that takes every trade we want to do and then reverses it. When our gut tells us to get out of the market, the system gets us in.
Last week’s quick trade is over and the market is back to selling off again. Keep your eye on crucial levels of technical support and be careful — the market is not oversold now the way it was last week. If the S&P violates last week’s lows, the March lows, or its 200-day moving average, it could go substantially lower.
But if it hangs in there, the market could rally a little further. The volatility index is still at sleepy levels, which is astonishing to me given the bullet we dodged Tuesday night with the confidence vote in Greek Prime Minister George Papandreou. But the market is what it is right now. Despite the declines of the last several weeks, it is almost completely unafraid.
LIBOR-OIS, one of my favorite gauges of fear in the credit market, was slowly inching upwards from the end of last year. But since April – before the stock market started to sell off — LIBOR-OIS has been steadily improving.
The TED spread (Treasury-Eurodollar spread) has been doing the same thing.
The only thing that’s flashing warning signs are European bond spreads. But that’s nothing new:
Look, what’s going on in Europe is a huge deal. ”Greece” is to 2011 as “subprime” was to 2007. It’s the thing that we know is a problem but ignore and ignore and ignore until the wheels fall completely off. Then we all freak out and wonder WTF just happened as the market collapses.
The bond market is telling you that Greece, Portugal, and Ireland will almost certainly, in some way, default on their debt. European banks hold most of this debt and its why stronger countries like Germany and France keep pushing the Greeks to take the bailouts and kick the can further down the road. These healthy countries don’t want their banks to take a bath the way U.S. banks did during the subprime crisis.
BUT! And this is the key point: the credit markets do not believe that this will translate into another banking crisis. It’s a strange dichotomy. The market says all this debt is no good. But it also says that it won’t be a problem for the banking system. For better or worse, you can probably count on the European Union adopting the Fed’s playbook if things over there spiral out of control. Banks will get bailed out, economies will get stimulated, and the currency and the taxpayer will bear the cost.
It’s one more reason why you probably don’t want to own the Euro long-term or be heavily invested in their economy for the next decade. One way or another, this mess translates to a long-term claim on economic growth. It has to.
These are the exact same reasons why I’m concerned about the future of the U.S. economy. I consider myself a secular bear, but I cannot argue with all of the data at present. The market is simply not worried nor is it flashing any indication of a major correction. Call it complacency or call it confidence in the powers that be to navigate the choppy waters ahead. However troublesome the next 10 years may look, the next 10 weeks don’t look so bad.
That’s assuming they’re able to keep kicking that Greek can…
Back to the market
This weird dichotomy could explain the latest market sell-off. The market has just slowly drifted lower for almost two months now and its done it without much panic or volatility. It’s completely different from every drawdown we’ve seen since the days of the crisis. All of the market drops since late-’08 have been sharp, quick plunges, fueled by fear that the world might again be falling apart. But this one is different.
I wonder if this is similar to what we saw in mid-2007. Back then the market started going down because it was concerned about regular ol’ slowing economic growth, not a financial apocalypse. The decline was steady and measured. Yes, the buzzwords of the real estate bubble and “subprime” were circulating in the background, but like Greece today, nobody expected it to metastasize into as systemic problem.
I think what we’ve seen since late April is unique. This is unlike any market action we’ve seen since the days pre-crisis when the cyclical bear market began.
This is what the market looked like from 2007 through the middle of 2008:
Anyway, I’ll be watching this very closely through the summer. Watch for lower highs and lower lows and a banded trading range.
What’s expensive? What’s cheap?
We’re also going to embark on a new journey this summer. We’re going in search of things that are cheap. This will be our theme for the summer: stuff that’s cheap on a historical basis. Maybe we’ll make a shopping list of some of these things and do a little buying if the market decisively turns bearish and things get really nasty.
There are a million different ways to assess whether something is cheap or expensive. For now I don’t want to get too far into the weeds of fundamental analysis and things like earnings yields and price multiples. So we’ll just stick to price.
The important thing to understand about the concept of “cheap price” is context. All this study will tell us is whether something is cheap or expensive on a historical basis. But sometimes there is a reason why things are cheap. I saw that the median price of a home in Detroit was like $9,000. But most of Detroit is a high-crime, impoverished ghetto. The city’s population has been shrinking since the 1950′s.
You can buy that exact house today for $7,000. See, here’s the listing!
I’m fairly certain that $7,000 for a 3-bedroom house qualifies as “cheap” regardless of whose benchmarks we use. Does that mean you should invest in it? I’m not sure you could pay me $7,000 to spend a night in that house. I’d probably wind up like Stringer Bell.
For our study today we won’t have to worry about specific details like that. We’ll be sticking to the big picture. But context is always important, even when you’re looking at wide chunks of history. Broad fundamentals do change over time.
Here’s a chart that looks at the history of three important assets: stocks, gold, and real estate. Instead of looking at raw price, we’re going to relate price to incomes. We’re going to calculate the number of hours an average person needs to work to buy one unit of these assets.
Ultimately, the prices of all things have to be supported by incomes. Prices can’t go up forever unless incomes follow, and over time the relationship between prices and incomes tends to fluctuate around a trendline. So when you look at that chart you need to understand that those lines cannot move up or down ad infinitum the way that a nominal price chart can.
On this basis — relating the price of a particular good to hourly income — we can come to a couple of conclusions.
Conclusion #1: Real estate is historically cheap.
Relative to wages, the price of the median home is cheaper than it’s been in over thirty years. It only requires about 8,000 hours of work to buy a median home. That’s about 2.5 years less than it was at the peak (not that discussing the peak is helpful for anything other than illustrating how crazy psychology gets in market bubbles).
There’s a reason why homes are cheap right now. There’s a glut of supply and not enough current demand to soak it up. We discussed this a couple of weeks ago so I won’t spend much time on it. For an updated and expanded version of how and why to start considering real estate as an investment, check out this article that I wrote for Seeking Alpha.
Another thing about this chart: real estate also got progressively more expensive (relative to average wages) for about five decades. I’m not entirely sure why this is. It’s not inflation. Both data sets are in nominal terms and when we use them to make a ratio it automatically adjusts for inflation.
Over the decades it became easier to get a mortgage and that allowed people to buy progressively more expensive houses. That could account for the slow and steady rise in home prices relative to wages. Interest rates have also been going straight down since 1980 and that means that less income is required to support a house. Another thing is that we’re looking at average hourly wages and median home prices. Incomes are less normally distributed today than they used to be. Also, in the last several decades we’ve seen the slow death of the single-income household. Families can afford more expensive homes today because its more likely that both parents are working.
Anyway, who knows. The conclusion is still the same. Houses are cheap today relative to incomes.
I know it’s a scary time to buy or invest in this space, but as we saw from our trade last Thursday, the scary times are when you should be investing.
Conclusion #2: Gold is historically expensive.
There has been only one occasion in modern history when gold was this expensive. It was in the midst of what we today realize was a speculative bubble.
And also similar to the last speculative bubble in gold, there are a bunch of different voices seeking to justify why it’s so expensive. Things like…
- “the inflation is going to get out of control”
- “the Dollar is becoming worthless”
- “gold is the only true currency”.
People were saying the exact same things back in 1980.
This doesn’t mean that gold is going to burst or that gold can’t go to $2,000/oz. It just means it’s very expensive right now.
Conclusion #3: Stocks are sort of expensive.
Yes, it takes many more hours of work to buy a unit of the S&P than it did back in the 80′s or 90′s. But it’s substantially better than it was during the tech and credit bubbles.
This chart also underscores that it hasn’t just been a secular bear market since 2007. The secular bear market in stocks actually goes back to the beginning of the decade.
Notice that this is also the same thing that happened between 1965 and 1982. It goes to show that stocks can get a lot cheaper from here and that they can trend downward relative to incomes for a long, long time.
As for why they’re expensive and popular, well, what sort of competition do they have?
A 3% yield on the 10-year? A real estate market that people are terrified of?
Stocks are the only game in town. I’ve written repeatedly over the last year or so that if you want to get exposure to equities, use a strategy that is focused and stock-specific. Don’t buy the broad market the way you used to back in the days of the long boom. Buy specific stocks in specific industries.
I’m a fan of high-quality right now, especially if they are companies that pay good dividends and have a track record of raising said dividend. Some of these names are very fairly priced. The market may be a little on the expensive side, but there are lots of individual companies out there that represent very compelling value.
- The quick trade from last week is over. But look for an opportunity to reload if the market hangs in there above its technical support. If it violates the 200-day moving average or the lows from March you’ll want to be long gone and growing your cash position.
- It’s weird. The bond market is telling us that the debt of Greece, Ireland, and Portugal is no good. It’s pricing in a default. But other credit barometers like LIBOR-OIS and the TED Spread are telling us that there isn’t going to be a banking crisis. If the PIGS aren’t going to create a crisis then the only way I can reconcile these signals is that they will turn into a long-term claim on economic growth. I’m not a fan of the Euro or the European equity market for the next decade.
- Relative to average hourly wages, real estate is historically cheap, gold is historically expensive, and stocks are somewhere in between. That’s not meant to dissuade you or persuade you, but simply to paint you a picture of how things stand. The data is the data.
We’ll get to the markets in just a minute. There’s a lot of interesting data to discuss, some of it really concerning. It’s been a volatile and scary week because of Greece but we went over all that a while back. What we’ve seen this week and in the weeks since then is exactly what we were talking about. None of this should surprise you.
Today we’re going to break some of this information down from a different angle. We’re going to look beyond the data at some factors that are far, far more important than ugly headlines. I’ll also outline what I think could be a very intriguing trade opportunity. It’s a quick one with what I believe are very attractive risk/reward characteristics.
But first, a poem. Stick with me, now: it’s relevant.
I
Among twenty snowy mountains,
The only moving thing
Was the eye of the blackbird.
II
I was of three minds,
Like a tree
In which there are three blackbirds.
III
The blackbird whirled in the autumn winds.
It was a small part of the pantomime.
IV
A man and a woman
Are one.
A man and a woman and a blackbird
Are one.
-excerpted from Wallace Stevens’ Thirteen Ways of Looking at a Blackbird
I’ll confess to never being a big fan of poetry. Sure, I can appreciate the works of the American masters Robert Frost and T.S. Eliot as much as the next guy. And I’ve been to Alaska where everybody becomes an instant fan of the hyper-masculine, gritty Yukon poetry of Robert Service. Beyond that, I don’t have much interest in the art form. Perhaps because I don’t know enough about it.
Still. Thirteen Ways of Looking at a Blackbird is one of the most fascinating and maddening things ever committed to paper. (Why thirteen ways? Are they the only ways of looking at a blackbird? Why a blackbird, anyway? Why the austere language and deliberate line breaks? I have no idea. Go ask someone with a degree in poetry!) Poetry major or not, reading the whole thing is certainly worth your time. Read it a couple times.
My favorite is the powerhouse final stanza:
XIII
It was evening all afternoon.
It was snowing
And it was going to snow.
The blackbird sat
In the cedar-limbs.
In the global economy right now, it is an afternoon of evening. Normally, the sun would be shining. We should all be enjoying a pleasant afternoon and reveling in healthy GDP growth.
But what we have is evening, a rapidly darkening sky before the night. It’s one of those days that we here in the Sierras understand all too well. It’s a day where the sun briefly peeks out at 1 or 2 o’clock and then disappears behind the black clouds. It’s the kind of day where it’s already dark when you get home from work, even though you know that just above those mountains and just behind that cloud cover there is a sun that is shining.
Last year we had a peek at a little bit of good economic data. But our sunshine was cut short, much shorter than we would have expected from the typical economic cycle. Most of latest economic data have disappointed and despite being at a spot on the timeline where growth is supposed to be accelerating, everybody on Wall Street is lowering their forecasts. The clock says afternoon, but the sky says evening.
Right now, it’s snowing.
And it’s going to snow.
Stocks in a slump
The current statistic du jour is that the market has been down for six straight weeks. The chart isn’t pretty, collapsing through the 50-day moving average and flirting with the 200-day moving average.
Who knows whether it’ll buck the trend this week. But this is the longest weekly losing streak since 2002. I think what makes this one so strange is that, for the most part, it’s been orderly. The market only dropped around -7.5%. It did it without any real panic selling and it did it without a gigantic spike in the volatility index. Even after yesterday, the VIX barely moved above 21! Given the pattern of market behavior of the last several years — steady appreciation followed by a short period panic selling — the recent drop definitely qualifies as abnormal.
So what does it mean for the road ahead?
Here’s a big table that I stole from The Chart Store by way of The Big Picture. Both those guys do awesome work.
The following table shows what has happened to the market after it’s been down for at least six straight weeks. Could it be a possible roadmap?
You can probably interpret that chart in any manner that you want. After a six week slump the market can experience a huge rally or it can endure a huge decline.
Or it could go nowhere.
What about this chart? What do you see in the next chart? I made a couple of scribbles to help you make up your mind.
Alternatively, you could look at it like this.
Those charts are identical. I’ve just marked them up in different ways depending on how someone with an inherently bullish perspective might look at the data and how someone who’s inherently bearish might see it.
To others it looks like this:
The bottom line is that you’ll see whatever you want to see in that data. There are at least thirteen ways of looking these charts and probably thirteen-hundred more. Statistical data isn’t as romantic as a blackbird, but the lesson from Mr. Stevens definitely has application for investors.
Crazy, huh? Today you just learned something about investing that came from the world of poetry.
Anyway, I’d call this questionable current environment “The Rorschach Market,” but I think that condition might apply all the time.
So much noise
Unfortunately, most of the investment research done in this industry is totally useless. That’s not to say its existence isn’t justified. Relax, analysts. Your work matters. It’s well constructed, informative stuff. It just isn’t as useful as you might think it is. This is why we aim to be informative and entertaining on this newsletter instead of just useful.
I’m one of the most boring, least entertaining guys around, but I can tell you this: it’s a lot tougher to be truly useful. I’m sure you agree. Perhaps this is why, as humans, our self-esteem gets such a huge boost when we know we’re fulfilling a need. Knowing we are of use is much more emotionally and psychologically satisfying than telling a funny joke or dropping a cool factoid. Usefulness is where true job satisfaction comes from (not money), and it’s why we do things like volunteer for charity or selflessly give ourselves up to the needs of our children.
Because the future is impossible to predict, it’s very difficult for investment research to be truly useful. But each of us has a story to tell or a story we want to be told. We desperately search for data that helps us realize it. It doesn’t matter if it’s a story about the markets, politics, ethics, religion, or law. We have our deeply entrenched beliefs, carefully-constructed paradigms, and we fit the data to conform to them.
We do this because doing it the other way around — looking objectively at the data — is both terrifying and exhausting. It’s scary to look at data objectively because there exists the possibility that it might tell us that our preconceived notions are wrong. It might also tell us nothing, as the table up top probably suggests. That can be a little disturbing, doing all this work and digging up all this data only to come to the conclusion that you just can’t say anything about it. At least, you know, not conclusively.
And it’s exhausting, too. It’s exhausting to gather all this data and parse it objectively for trends or patterns.
The other day I had to buy a new dishwasher. For some reason, I had it in my head that a Bosch was the best brand to buy. Some happy Bosch customer probably planted that seed in my brain long ago. Who knows.
I could have purchased the Bosch and then sought some positive reviews or feedback from the salesman to help me feel like I made the right choice. I could have had many years of clean dishes and confidence in my ability as a savvy consumer. But instead, I started from a blank slate. I spent an entire day researching dishwashers anywhere I could get information and data. I sorted out all the unique features and read industry reports about brand quality. I inspected physical models at three different stores. I made a spreadsheet!
It was exhausting.
And at the end of my epic dishwasher search, do you know what conclusion I came to? There were two:
- You get what you pay for.
- Pretty much all of the dishwashers in the medium- to high-end are close enough in terms of quality.
Not very helpful. At various points I was totally sold on five different models from four different brands. Eventually I picked a Samsung because I’d never heard of a Samsung dishwasher before and I like things that are different.
But I probably could have made an equally good decision by ignoring all the junky low-end stuff and then throwing darts.
Fix your broken brain
Our brains aren’t really wired to constantly parse data and form continually new conclusions in real-time. There’s just far too much information all around us for this kind of decision making. Instead, we look for shortcuts. We subscribe to narratives and we develop preconceived notions about how everything works. We look for patterns, yes, but the only patterns that are obvious to us are the ones that support our beliefs. What’s more, we actively discard those that don’t jive with our current beliefs. It’s called confirmation bias.
I know that GDP, bond yields, and market corrections all matter. They’re important. But I’m telling you: understanding the psychology behind this stuff is even more important to being a successful, well-rounded investor.
Data comes and goes. But knowledge about the fundamentals of human behavior is enduring.
Here’s a helpful exercise that I employ from time to time. Like any exercise — physical or mental — it requires practice. You have to work at it and strengthen your brain muscles.
- Wipe away all of your thoughts and biases about the market. Abandon everything and hold the idea of the tabula rasa in your mind. I know, it’s hard to do. If you’d consider yourself a market bull, try and imagine, as a purely hypothetical exercise, how someone who’s bearish might see the market. And vice versa.
- Once you feel like your brain is in a place where it’s seeing things objectively, then start parsing some information. Ignore your usual favorite sources of information and try and gather data from somewhere new. Avoid opinion and editorials and focus strictly on raw information. Try and come to your own conclusions.
It’s OK if it’s something small and it’s OK if you only hold this blank slate for an hour or so. Practice with other things that aren’t market-related or tied to fields where you already have strong beliefs. That’s a little easier. Like me, you probably don’t have much of an opinion about dishwashers. Forget everything you know about dishwashers and see if you can find the best one.
The point is simply to become aware of any biases you may have and help your brain work towards viewing things from an alternate perspective.
So where’s this market going?
I use both fundamental analysis and technical analysis in my work.
The long-term fundamentals of the U.S. economy are weak. We talk about this all the time and so far I haven’t found a line of research and reasoning strong enough to convince me that the next decade will be one where the U.S. grows at a rate above trend. My mind is open to it, though. The short-term fundamentals were pretty good for a while but that is now changing and it looks highly likely to continue to change. A lot of this short-term stuff has been priced into the market already and after this six week slump the market is now oversold. Both the RSI and stochastics made new yearly lows this week.
The technicals of the market have been fantastic. But that could be changing too. The market has been locked in a solid straight-up-trend for what seems like forever (but really just since QE2 started). I haven’t seen quite enough to get me totally bearish, but it wouldn’t take much more. A drop under the 200-day moving average or the 1250 level we saw in March — each a little more than 2% away — would be enough to get me totally out of the market.
I actually think there’s a terrific risk/reward trade setting up. I think you can probably buy this market right now. Like, today.
If the S&P drops another -2%, below the technical support, then you pull the plug and walk away. That’s your unemotional out point. If the trade works out and the bull trend stays intact, you could see a run all the way back towards a new high above 1370. That’s a move of roughly +10%.
I think that risk of around 2% for a shot at a 10% move over the course of a few months is pretty attractive. But that’s just me. Don’t do this stuff unless you know what you’re doing or work with a financial advisor.
The good thing is that this trade doesn’t require you to be inherently bullish or bearish on the market. Whether you’re biased or not, all it requires is an understanding of a few basic technical and fundamental concepts and recognition that the market is oversold on a short-term basis. If you’re already bullish, you’re already looking for spots to get long(er). If you’re bearish, these are the kind of quick trades that can help you out here and there without putting too much at risk.
It’s the kind of trade Wallace Stevens would have approved of.
And before you give all this poetry talk one final poo-pooh, know that Wallace Stevens was a true badass and Renaissance man. Not only is he widely regarded as one of the most important American poets of the 20th century, he graduated from Harvard, practiced law in New York City for over a decade, and had a very successful business career as a vice-president of a fairly large insurance company. He won the Pulitzer Prize in 1955, but what’s even more impressive is that one time he actually picked a fight with and took a swing at Ernest Hemingway, one of the toughest dudes in history.
Stevens was a man’s poet. And after a review of some of his poetry, I think he would have made a heck of an investor.
- Every once in a while we talk about movies or philosophy or poetry on this newsletter because it relates. It is all connected.
- The long-term fundamentals of the U.S. economy are still really concerning. The short-term fundamentals are changing, as are the short-term technicals.
- Despite that, there’s opportunity for a quick trade to the upside as the market temporarily corrects its oversold condition.
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Market Recap
As of right now the market is in a -6.5% drawdown. Six straight days of losses, too.
It’s done it without creating any major headlines, either. I mean, unless you really pay attention to this stuff – and read The Draconian every week! — I doubt you’re aware that the market and the economy are flashing major signals of deterioration.
Tactically speaking, the market’s probably worth a short-term buy at some point. There isn’t any evidence of panic selling right now which means that its OK to step in and buy if you have a good reason for doing so and have clearly defined your risk in advance.
If there is one thing in the world that I believe in it is the power of mean reversion. Markets always move too far in either direction. They do it over the long run and they do it over shorter windows. Over this shorter window it’s moved a little bit too far.
If my time horizon was longer than a couple of months, I’d just stay away altogether. The economic fundamentals really concern me here, as does the higher volatility and economic weakness that are beginning to look like realities for the second half of the year.
But if you’re an active trader looking for a quick in-and-out, this is a dip you can buy on. The market is still above its 200 day moving average, and the cyclical trend is still higher. On a short-term basis the market is oversold. Don’t get too greedy, though.
The weakness I was alluding to
We got the jobs report last week. It wasn’t good.
You guys all know that I pay virtually no attention to the monthly payroll numbers. It’s one of the most volatile economic data points out there. Not only is it subject to constant revision, it’s subject to crazy revision. I’ve seen months of decent gains turn into months of losses and vice versa. I haven’t done the math but I think the mean and the standard deviation are almost the same which makes it frustratingly worthless as an indicator.
When it comes to the labor market, what I look at are broad measures and broad trends. The month-to-month movement is almost entirely noise. I ignore that. There’s something like 150 million people in the U.S. labor force. Movement of a few hundred thousand either direction each month just isn’t enough to move the needle of concern/excitement. The broad trends are what matter.
The broad trend is that the economy just isn’t creating enough jobs. Sorry about that. I know this is not a surprise for you. Even with all of the massive economic stimulus, the economy has been creating jobs at a lower rate than would have been expected at this point of the economic cycle. On top of that, the latest report from the National Federation for Independent Business (NFIB) is that small businesses are also changing their plans for future hiring, too. They’re planning on hiring fewer people now.
When it comes to broad measures of unemployment, it doesn’t get much bigger than U-6. If you can believe it, the wonks at the BLS measure six different types of unemployment. You’re probably saying — especially if you’re out of a job — “But I thought there was only one kind of unemployment, unemployed!”
In normal-person language, U-6 is everybody that:
- can’t find work,
- can’t find enough work, or
- wants work but has given up trying to find it.
It’s a much bigger bucket, obviously, and probably more in line with your intuitive definition of “unemployed”. Now go and dazzle all of your friends with your more robust understanding of the labor market!
A lot has changed over the last few decades with how we measure unemployment — for political reasons, natch. To politicians, the unemployment rate holds the key to job security. There’s a lot of monkey business, spin, and skulduggery when it comes to the national headline rate, both in how it’s calculated and what these yo-yos do with the data. All the more reason why it makes for such a problematic data point.
What people always like to do with the unemployment rate is compare it to previous points in history. Like: “It sucks [now], but is it as bad as it was [back then]?” And because the way we measure it has changed over time it’s best to use the biggest and broadest measure possible for comparisons. Today’s U-6 is much closer to how the government measured employment during the Great Depression than the headline number that all the politicians and news anchors talk about.
For historical context, a U-6 level under 10% is pretty good. At the height of the tech-boom, it was 6.9%. During the Great Depression the unemployment rate averaged about 18%.
Today it’s 15.9%.
Now you can get a sense about how big a risk another economic shock or crisis represents. If we get another nasty recession next year or the year after, or if Europe spirals out of control, or, god forbid, if the world decides it doesn’t want to lend the U.S. government money at 3% or even 5%, we could wind up at or dangerously close to historic highs in unemployment.
It’s not much fun, especially if you’re struggling to find work, but this is a unique bit of history we’re living through. NPR had a nice little story about all this last week: 25 million Americans Are Unemployed Or Can’t Find Full-Time Work.
Good news in unexpected places
Amidst all of this ugliness there is a bit of legitimately good news. I think it’s a really big deal, too, and I haven’t heard many people talking about it.
For the first time since 2005, growth in residential construction employment will probably be positive. And it looks like residential investment will probably make a positive contribution to GDP this year for the first time since 2005.
Financial crisis and Wall Street-specific issues aside, the number one drag on the economy in the last few years has been housing and construction. This is the industry that cuts a broad swath through the heart of the labor force, and housing-related woe is the biggest anchor around the neck of the middle class. Unemployment in the construction industry is nearly double the national rate.
I know it’s not a popular perspective right now, but this industry is clearly stabilizing.
New housing starts literally cannot go much lower. At some point, as crazy as it seems, this country is going to have to start building houses again. It will be forced to for demographic reasons. This will require resources and it will require labor. It will create jobs and it will strengthen the economy.
I saw CNBC flash a banner last week that said “Why Housing Will Never Recover.”
Never?! Seriously…
‘I’d like to flash my own banner that says “Why Can’t People Think About Markets Rationally?”
(For more on that, check out this excellent article in the Washington Post from Rational Idol, Barry Ritholtz.)
Anyway, CNBC is interested in what’s going to happen, like, tomorrow. So I probably shouldn’t fault them for their short term bias. In their world the word “never” has a half life of about 3 weeks.
The reality is that growth in housing will not take hold until the supply/demand imbalance in the market clears — and it will clear. Everybody wants to know when that’s going to be. Most of the random people that I talk to about economic stuff ask, “when is housing going to get better?!?” Look, housing isn’t going to get better until demand and supply are in balance. It’s that simple.
If you want to try and forecast when that will be, look at the trends in supply. Compare them with the trends in demand. We’re getting close, but are still a couple of years away from normal growth. At least they’re each finally moving in the right direction.
Anyway, the point with this latest data is that the internals of the housing industry are stabilizing. It’s not growing gangbusters, but it’s finding support. This is after five years of epic deterioration. Simply eliminating this drag is one of the best bits of legitimately good economic news I’ve seen. Barring economic disaster, it’s reasonable to think that sometime by 2013 or so this industry could be growing back in line with its historical trend.
How to play it
For what it’s worth, a recovery in housing is an investable thesis.
I know that probably sounds highly distasteful, but that’s how these things go. The whole world hates real estate right now and if you want to make money in this sector you have to chin up and ignore what everybody else thinks. Initiating investments in this space requires an understanding of several factors.
The first is price. Prices in real estate are still falling. One of our predictions for 2011 was that real estate would double dip and make a new low. I also think that it finds its ultimate bottom during this current dip. Most likely, it’ll be a nominal bottom, and real, inflation-adjusted prices may struggle for a while after that. But I think this is phase where prices finally go splat.
If you’re going to buy a house in a declining market you have to be really, really careful about the price you pay. You’ve got to have a nose for value. You have to understand your local market and know which properties represent values that are above market and which are below market. Basically: you need to be aggressive (or patient) and get a good deal.
There’s certainly risk when market prices are going down. I wish I could say exactly how much further real estate has to fall. It’s tough to guess at. Based on some math and some forecasts we’ve done in prior newsletters, I think the worst case scenario is somewhere around 15%. Maybe 20% if some sort of financial reckoning day arrives. Since I generated those original estimates, prices have fallen about 5%, so there could be an additional 10% or so below here. Your local market obviously varies.
If you’re looking for a home to live in for a long while and can get a good deal on something priced below market value, I say go for it. I think you’ll really be glad you did 10 or 15 years from now. Housing affordability is near record highs on virtually any metric you choose to use.
You can go to the crazy-biased NAR and check out their Housing Affordability Index. It looks pretty good.
Personally, I like to relate prices to incomes and that ratio hasn’t been this favorable since the 1970′s. This is an important chart for cash buyers to look at.
You can also just look at measures of raw price and compare them with some sort of historical trendline.
Or if you want to get a different picture that incorporates the current interest rate environment, you can look at the inflation-adjusted median mortgage payment. In this chart you’ll notice a huge spike in the late 1970′ — the 30year mortgage rate was a 15%! I have no idea if people were actually getting 15% mortgages back then and surely they must have refinanced them on the way down. But still, it hasn’t been this cheap in a while to finance a house.
Pretty much any way you slice it, prices are low, rates are low, and affordability is high. And in a great twist of American irony, most buyers are unable to act on it or flat out unwilling.
As far as I can tell, the key argument against real estate is that it will continue to go down in price and never stop. That’s an important debate to have and a legitimate concern. But each day prices go down that argument weakens. Don’t forget about reversion to mean.
Anyway, the second crucial factor to understand is that making money in real estate is not about buying a home and holding it while the price goes up. That is not an investment strategy. Over the long-term, housing prices basically appreciate at the inflation rate plus a little bit which accounts for real wealth appreciation. Real estate does not work like the stock market. It doesn’t naturally grow at GDP + Dividends.
So you have to make your own GDP + Dividends.
You have to work the property to make it pay. That means leasing it out. If you want to get a sense of how people are making money in real estate, check out this article from Fortune Magazine. Or check out this one from the Wall Street Journal. This is a historic opportunity for people with this skill set.
If you happen to live here in Northern Nevada and you want to think about doing something like this, give my buddy Bob Getto a call or check out his website. He can help you out. He’s a licensed Realtor but unlike a lot of those guys, he has a very realistic view about the local market and knows where the value is and how to write a lowball offer. His background is in construction and architectural design, so he can also tell you which houses are garbage and which houses will make for attractive rentals. Tell him I sent you.
I think it’s easy to see the opportunity in real estate right now. But it’s weird; in my entire life I’ve never thought of the real estate market as one with opportunity. I’ve never liked it as an investment. This is totally new. We’ll see how it goes.
In a psychological sense, we’re all still lost in the black abyss. Hatred for real estate has only intensified this year. Posts like this from Calculated Risk are what I’m talking about. Even David Leonhardt, one of the high priests of popular economics, is feeling the hate. This doesn’t mean that we’re at the bottom yet, but it does mean we are getting close. It’s normal for people to be deathly afraid of markets that are bottoming. Do a Google search for “recency bias” if you want to understand the science as to why.
If you have the ability to work a property and make it generate cash flow and you’re smart about the price you can pay, I think there’s a lot of money to be made. Not all of the gains will come right away, but if you start getting busy, there’s a good chance a portfolio of solid rental properties could be a very valuable asset 5-6 years down the road.
It’s gotta be better than a bag of 10-year Treasuries yielding 3% or a stock market with a low yield and expensive multiple, right?
- The economy has been quietly deteriorating during the last six weeks and stocks have followed along. That being said, the market is now in oversold territory and nimble traders can play a quick bounce.
- The labor market is also getting worse. The biggest, broadest measure of unemployment ticked up to 15.9%. That’s closer to Great Depression territory than you’ll want to believe.
- The whole world hates real estate right now and this year the hatred has gotten even worse. As predicted at the beginning of the year, we’re now in the middle of a second dip for home prices. This dip won’t be as bad as the first, but it will take us to fresh lows in price.
- During the next 12-18 months, fearless investors with long-term horizons will want to figure out how to initiate some investment positions in this space. Average folks on the street with cash at the ready should feel good about buying a home if they need a place to live in for the next decade or so.
Things are turning around.
For the last couple of months we’ve been discussing the fact that the economy is growing but doing it at a rate lower than hoped and lower than what would be expected at this point in the business cycle. We’ve discussed many of the risks the economy may face but none of these seem to have materialized on a large scale yet. Given the latest round of economic data, it appears this all may be changing.
The stock market has reacted accordingly. Yesterday was the worst day since August and the S&P sold off over 2%. For the last month it has been carving out the disturbing pattern of lower highs and lower lows.
It’s down again this morning and I’ll be watching closely to see if it violates the April low of 1294.
If you can believe it, the 10-year Treasury note is now yielding under 3%. I guess this is what happens when both the public and the Fed get hungry for Treasuries.
I wish I had the answer for how low yields can get. But I don’t.
All I know is that the higher that Treasuries rally and the lower that yields fall, the greater the skew between risk and reward in this space. There might be one more rally out there for Treasuries — a deflationary death rattle — but I’m not entirely convinced it’ll be worth it. There are high quality U.S. companies with strong balance sheets that are trading a decent valuations right now that also happen to pay dividends that yield quite a bit more than U.S. Treasuries. To the private investor who is simply trying to balance risk and return, how is this not a more attractive proposition?
Economic data
The reason for all this volatility is that the latest round of economic data is concerning.
One of my favorite indicators and ringleader of the much-ballyhooed “Three Amigos” is the ISM Purchasing Managers Index. It’s a big, broad measure of the current state of manufacturing in the U.S. You might think it’s silly to give much importance to a manufacturing indicator in the U.S., but manufacturing is still an important component of our economy that a lot of other sectors cue off of.
The ISM PMI fell off a cliff in May, coming in at 53.5 vs the consensus estimate of 57.1 and below last month’s level of 60.4. This manufacturing index is now at the lowest level since 2009.
The good news is that a reading of over 50 means the (manufacturing) economy is growing. A reading below 50 means that it’s contracting. So we’re still moving in the right direction, just not as quickly as we should or want to be.
It’s not time to panic about entering a recession. We are not at the brink of a recession. The word that people are starting to throw around right now is “soft patch”. By August I’m guessing you’ll be sick of hearing it.
In the meantime, we’ll keep our eyes on the amigos. When capacity utilization is falling and the manufacturing sector is contracting and junk bond yields are on the rise, it’s a baaad sign. Right now only one of the amigos is waving a yellow flag. Hopefully all three don’t switch to red.
Where’d the GDP go?
First quarter GDP growth was revised down to 1.8%. Yikes! Do you guys remember all the hoopla and enthusiasm back in January? The world was rockin’! We were coming off a fantastic holiday shopping season and pretty much everybody on Wall Street was calling for like 4% GDP growth.
Uhh… what happened?
Now every economist out there is lowering their GDP forecast for 2011.
If you’ll recall, we didn’t buy into the hype at the beginning of the year. I just couldn’t figure out how a year of rising commodity prices, stagnant incomes, and a troubling public sector, was supposed to translate to above-trend economic growth. It sounds like those initial concerns are now becoming reality. The recent spike in commodity prices shook up the average consumer and forced him to cut back a little bit. Unemployment has remained high and is capping the potential for growth. And public workers all around the country are now dealing with reductions in salary, reduced benefits, and outright layoffs. Plus, all the stimulus is starting to slow and main street is smarting from a double dip in home prices.
The average consumer is probably correct to retrench a bit. It’s a tough environment. Americans are less confident about the economy than they have been in quite some time. Earlier this week the University of Michigan Consumer Confidence Index fell to 60.8, the lowest reading since early 2009.
Wow! Are consumers really feeling as bad as they were in March of 2009? That was the black pit of doom & gloom, in case you had forgotten.
Here’s a comic from 2008, which, strangely, is more relevant than ever:
The most disturbing thing about the latest consumer sentiment survey is that the expectations are that it’s going to get worse. Consumer confidence is an interesting data point, but to my knowledge nobody’s ever figured out a good way to invest or trade around it. It’s just one of those “FYI” indicators. It lets you know what the current mood is and how people feel.
What’s an investor to do?
Really, it’s up to you.
I happen to hold a lot of cash right now though that will change as opportunities in the market present themselves and this is the type of environment where that can happen. I’ll share one of these next week and will discuss additional ones as I find them. Everything else I own is invested in the hedge funds that our firms manage. I can’t talk about that with much specificity, but one is aligned very defensively and the other is designed to capitalize on very long-term term trends in inflation, sluggish economic growth, and a disappointing stock market.
We’ve been preaching a message of caution regarding this summer, and it’s starting to appear as though that will be a prudent call.
Answers From a Hedge Fund Manager
Thank you to everyone that submitted questions! Our first installment of “Ask a Hedge Fund Manager” went really well. Unfortunately, I won’t be able to publish all the questions in this space but I’ll get back to everybody else individually. I’m pretty good about email. Feedback@TheDraconian.com goes straight to my desk.
Are there any “hard and fast” rules that hedge fund managers follow? With so much uncertainty about when to get in and when to get out, what rules do managers use to eliminate emotional roadblocks? - Dale
Emotion is probably the one thing that does the most damage to investors’ performance. One of the key differences that separate professional fund managers from the average investor at home is that the pro is typically less far less prone to getting emotional about his results. He doesn’t get too excited when he has a great year and he doesn’t get too down when he struggles. When a trade feels scary he still has the ability to act on it if it’s sensible and if the trade feels too easy he’s able to question it if it’s a sub-optimal opportunity.
That being said, there’s still a fair amount of emotion in this business — pit traders and the guys at the prop desk have a reputation for being volatile, emotionally-aggressive personalities. (Check out the brilliant documentary, Floored, to get a sneak peak into the world of the pit trader.) Turnover with those types tends to be very high and star traders have a knack for burning very brightly for only a short period of time.
Most hedge fund managers — regardless of their size or strategy — have hard limits on how big a loss they’re willing to take on a single trade. Some use a simple stop loss while others employ a more complicated system that incorporates several statistical measures of risk. But the bottom line is the same. The professional trader goes into every trade with a well-defined sense of how much he’s willing to lose. When he hits that threshold, he pulls the plug and walks away.
Amateur investors buy an investment with hopes about how much they can make. That’s great if the investment works out, but in most cases the amateur has no idea about what kind of loss he should expect or even personally tolerate. It’s a recipe for disaster. If the market starts going down he starts rationalizing the investment and usually winds up riding the thing all the way down to the bottom where he panics and sells.
What’s a good strategy for the next ten years in terms of asset class distribution? Also, how does an international investor maximize income and manage exchange rate risk? – Cesar
I think that diversification will be the name of the game for the coming decade. Especially for those in or approaching retirement. Stay tuned because I actually have a whole lot more to say about this in the coming weeks.
Maximizing income is the number one challenge right now for every investor on the planet. Everybody wants yield. I do. Cesar does. All of you do too.
A year or two ago I outlined a totally different way to look at this problem of yield. Rather than chasing securities with high enough yields to support your lifestyle, I felt it more prudent to adjust your lifestyle in accordance with the generally-lower-yielding environment. I understand that’s a really difficult thing to do — nobody wants to lower the standards of their living. I like shopping at Whole Foods too, but I’ll switch to Wal-Mart if it means I’m reducing or erasing the risk that I might get permanently stuck at the dollar store down the road.
The fact of the matter is that the level of return associated with a set level of risk 5-6 years ago is totally different than the level of return associated with that same set level of risk today. In the business, we call this concept “risk premium”. It’s the amount of extra return an investor receives for taking on additional risk.
Right now it’s very low and it’s low because the entire world is desperate for yield. The problem with risk is that most people don’t understand what it means until it’s slapping them in the face and their investments are going down more than they expected. Risk is a very abstract concept for most investors. It’s easy to just ignore it and focus on the more-concrete “return” side of the equation.
The other strategy I’ve discussed to manage this low-yield environment is equally distasteful: push back your retirement. Your job is probably your most valuable asset. Why throw that away until you have to? I understand that’s a very personal choice, but it’s worth thinking about. Like any other environment challenge in life, you can’t change this high-risk/low-yield world but you can change how you react to it.
Exchange rate risk is a tricky thing to manage, even for professionals. The good news is that anybody can set up an account at a futures brokerage and work with a financial professional to develop any kind of rate hedge that one feels is appropriate.
Cesar asked specifically about Brazil, which does indeed warrant special attention. Right now, inflation is really cooking in Brazil. Did you guys read the article about the rising cost of the Brazilian Bikini Wax?
It’s actually serious business. Service prices in Brazil are up double digits over the last year. Extreme moves like this aren’t usually seen in the economies of the major currencies — Dollar, Euro, Yen, Pound — but double digit inflation can be a legitimate risk in the emerging markets. It’s something that international investors in particular need to be sensitive to. Holding a diversified basket of currencies or setting up basic hedges in the futures or options markets can help.
I feel bearish, but I don’t want to sit with my arms crossed and miss out on another upward move in the market. It keeps grinding higher and it must be doing so because of some sort of fundamental reason. But I do not understand what the fundamental reason is behind what appears to be another leg higher in the market? - Ben
This is a really interesting comment and I selected it because it perfectly encapsulates the way a lot of investors feel right now. A lot of investors out there are really concerned about the economic fundamentals of the future and their cautious outlook has led them to adopt a conservative investment strategy. But since early 2009 the market has gone straight up and it’s really frustrating to miss out on a move of that magnitude.
I think the rally of the last two years has been driven by three major factors.
The first is simple mean reversion. The market swung a little too far to the downside based on fears that half the major banks in the world were insolvent and that the financial system was going to completely collapse. Thanks to a couple of epic bailouts and an accounting rule change everything stabilized (though not without a cost). Once that panic condition cleared the market was free to rally back towards a historical mean for purely technical reasons. The market has now advanced well beyond that point and is heading back into territory where one should begin looking for a reversionary move back the other way.
The second reason for the cyclical bull market was legitimately improving fundamentals. S&P earnings bounced back from generational lows to just short of historic highs. It turned out the world wasn’t over for big business and these major firms bounced right back. Low interest rates played a huge role in this. Thanks to cheap credit readily available to large business, these firms were able to invest, hire, and grow. Some sectors made out better than others. With such a steep yield curve this has been a nice environment for the financial sector, but I think they’ll be struggling for a while to recapture the profitability they knew in the glory days. Other sectors like energy will move right on to new cyclical highs.
The third is all of the stimulus. One of the publicly-stated goals of the QE2 program was to help boost asset prices. And QE2 has done that. It might be artificial, but asset prices are definitely higher thanks to quantitative easing.
If investors want to participate in a broadly rising market they’re welcome to do so. But it’s probably best to do it in a manner that isn’t so dependent on the factors that caused the run up. In other words, don’t buy companies that are currently overbought or overvalued and at risk for a technical reversal towards a historical mean. Stay away from companies that are at risk for having all of their earning power wiped out by a sharp recession and would need a bailout to get back on track. And avoid companies that are heavily dependent on any dimension of the stimulus, whether that’s super-cheap credit or rising asset prices.
Fewer companies than you’d think fit that mold. Those that do should allow investors opportunity to participate on the upside of a continued market advance and would offer a better margin of safety if everything falls apart. I guess you’d say it’s the prudent way to bet on another leg higher in the market.
On a final note, I tend to hear these types of comments and feel this type of sentiment from the public when the market is approaching a short or medium term peak. I remember last April speaking with many investors who were upset they got out of the market near the bottom and missed out on a subsequent 50% bounce. But the first round of the EU debt crisis and a 17% correction quickly silenced that line of complaining.
A little bit of greed seems to be seeping back into the retail market and that greed is manifesting itself as frustration.
