Happy Thanksgiving everybody!
I know it’s easy to get lost in the chaos of the season, racing to get the house ready for a legion of guests, preparing all that food, and battling all the crowds on the busiest shopping weekend of the year. There’s a lot going on. But I think it’s because of the chaos that it’s all the more special when you take a moment to appreciate and give thanks for the things in life that truly matter. When we all sit down for dinner tomorrow night, we’ll look at each one of those glowing, smiling faces around the table and feel blessed. We’ll feel safe. Because so long as we’re in the presence of these loved ones, everything will be OK. All our other fears melt away.
Every week you guys honor me with your time. And every week more and more of you stop by. Frankly, I don’t know why. There are a billion other things you can do with your Thursday mornings than listen to me rant about Europe’s GDP or the LIBOR-OIS spread. But I want each of you to know that your attention is not lost on me. I do not take it for granted. I’m of the belief that there are few things in life more valuable than the time and attention of another person. It’s a rare commodity in this modern world and, by definition, one with finite supply.
Thank you all for reading. I am humbled and honored far more than you know.
Have a terrific weekend.
It’s been a busy couple of months. We’ve covered some really technical issues and shined the light on some under-appreciated concepts in the industry.
We posted an introductory guide to technical analysis. We talked about the risk on / risk off phenomenon and strategies investors can use to cope. But we also checked out the fundamentals at the heart of the market right now. Turns out, they aren’t really that bad (or good). We also looked at market valuations and investigated whether the current PE ratio really has anything to do with how much money you’ll make in the market in the future.
The good news is that it’s time to take a breather. Today we’re going to shift gears a little bit and have some fun. And next week there will just be a quick “giving thanks” update on Wednesday before the long weekend.
But first, a fast market recap featuring mostly charts. Feel free to skip it if you want to get straight to the fun stuff.
Market Recap
It’s been a strangely quiet week. Maybe the markets are getting ready for Thanksgiving, too.
Check out this little snippet from Dana Lyons of J. Lyons Fund Management (by way of Attain Capital’s blog).
Consider the recent 8 trading days below, for example. The following are actual daily headlines from a major financial news outlet along with the daily point change of the Dow Jones Industrial Average:
| October 17 |
Dow -248 |
U.S. Stocks Fall Sharply on Lower Europe Optimism |
| October 18 |
Dow +180 |
U.S. Stocks Lifted Further by Europe Report |
| October 19 |
Dow -72 |
U.S. Stocks Fall on Europe Unease |
| October 20 |
Dow +37 |
U.S. Stocks Tip Higher as Europe Exerts Pull |
| October 21 |
Dow +267 |
U.S. Stocks Rally on Hopes for Europe Plan |
| October 24 |
Dow +105 |
U.S. Stocks Rise on Europe |
| October 25 |
Dow -207 |
U.S. Stocks Drop on Europe |
| October 26 |
Dow +162 |
U.S. Stocks Rally on Europe-Related Reports |
Try figuring out what the market will do the following day from those headlines. Aside from the journalistic laziness, it is no wonder individual investors are disillusioned with the stock market. Making investment decisions based on news flow is a good way to lose capital very quickly. And yet, that is what many investors do, i.e., they “wing it”.
Pretty funny, huh?
This is exactly what I was talking about a couple weeks ago when I said the headlines follow the market, not the other way around. On most days, the market goes up or down for whatever reason and then we assign headlines in response to the move. If you think these generic headlines really matter, then you haven’t really been paying attention or you’re simply lost in the emotion of the narrative.
I remember one day a couple of weeks ago where the top headline on Bloomberg was something like the usual “Stocks fall sharply on fears in Europe.” But when I read that headline, the Dow was up 100 points on the day. It was one of those crazy days where it rallied 250 points in 60 minutes. The headlines hadn’t caught up yet. The market probably closed back down in negative territory that day, just as the editors were submitting their revised headlines.
Anyway, as you watch this market, keep this phenomenon in mind. On the trading desk here at our office, we don’t ever watch the news. We just watch the markets and listen to what they have to say.
Here are a few to listen to. These are charts of various bond yields.
So there you go. The bond market says, “Europe isn’t fixed and isn’t anywhere close.” Nobody has faith in the Italian technocrats yet. Greece is a joke that’s only funny if you aren’t a bondholder and aren’t Greek. Nobody’s talking about Spain, but if the headlines do start featuring Spain, it could get ugly. Any panic about France probably isn’t justified.
Feel free to ignore any news headlines that contradict those points.
As for the stock market, there doesn’t seem to be much bullish or bearish conviction.
There’s a big range right now and a whole lot of volatility in between. This is a market and an economy where a bunch of outcomes are in play.
And finally, did you know that commodity prices are really dropping?
Since QE2 started winding down, commodity prices have been deflating. It’s also probably worth asking whether these rumblings of economic concerns about China have any merit. Barring a miracle, the Eurozone will soon enter recession (it may even be in one now) and depending on the severity of that, the blowback in China may be significant. Contrary to popular belief, the U.S. isn’t China’s biggest trading partner. It’s the European Union.
In fact, this could be what the Chinese stock indexes have been telling us all summer.
Even after this latest rally, the Hang Seng is still 20% below its highs.
There. Now you’re up to speed.
Things I Learned from Playing Games
I’ve been playing games my entire life. I love playing games. I like to play games more than pretty much anything. I’ll play anything with rules and where even the slightest bit of strategy or tactics apply. I’ll play them with anyone.
I don’t care if you think I’m a geek. Games have taught me valuable lessons. And when I say “valuable,” I mean the kind of stuff that can make you money if you know how to translate it to other fields.
Here are some things I’ve learned.
Practice is essential.
Our parents told us to practice. We’ve been told to practice everything from our sums to our golf swing to our pleases and thank yous. We all know this, right?
But the problem with simply being told to practice or reciting stupid cliches like “practice makes perfect” is that the learning isn’t very visceral. It doesn’t really stick. We know what it means in the abstract, but the lesson doesn’t click at the gut level. This is ten times more important than you’d think.
When you play games, the act of practice is inseparable from the act of play. Every game you play is practice, and since it’s fun to play, you don’t even think about the work of practice. The thing that really drives this lesson home is the continual feedback a player gets through a series of games. Every game you play you will notice how much stronger a player you’re becoming. And you’ll understand — very deeply and very intuitively — that what’s making you better is your practice.
Folks, investing takes practice too. Don’t expect to be good at it right out of the gate. Also don’t think that you can just sit back and read and learn and listen and turn into a pro. You can read all the books you want about great chess openings and endgame theory, but you’re never going to be any good unless you sit down and actually play somebody. You won’t ever be a good investor until you start making investments.
If you play games, this all becomes second nature.
Play people who are better than you.
Look, if you want to get better you have to challenge yourself.
Back in the day I was a mediocre Scrabble player. Then in high school I became friends with some guys that were way out of my league. At first, I got steamrolled every game. But in time I learned how to work all the two-letter words, how to maximize the value of the bonus tiles, and most importantly, how to build several words with one play and shut the board off to the next player. My game improved dramatically and quickly. I never quite got better than them, but we had some pretty legendary Scrabble sessions and I got a few wonderful, lifelong friendships out of the deal too.
If you want to get good at anything in life, whether it’s running your business or being an investor, you’ve got to hang out with people that are better than you at it. Get over your insecurities as a player. It’s OK to be the weak hand at the table if you’re playing with people who are very good.
Find a really intelligent financial advisor who challenges your thinking, not a piker who just pushes the hot trend. Learn to speak the language of the industry. Jargon gets a bad rep, but jargon exists because it’s efficient. It’s how you communicate complicated concepts without having to slow down and explain it all. Hang out with people who know the language. Read publications from places that are having a higher-level discussion and playing a higher-level game.
If you want to get better, make peace with the fact that you aren’t very good and seek out those that are. Every game player understands this innately.
Don’t take it personally.
Look, the goal of the game is ultimately to beat the other guy. Sometimes you win. Sometimes he does. It’s not personal. It’s not because you hate him or he hates you or he’s bad person and you’re a good person. When he moves all his tanks into West Russia and starts attacking your German Eastern front, it has nothing to do with you. It’s because that’s how you’re supposed play when you’re the Allies.
The more games you play, the less you’ll take stuff like this personally. This is an insanely valuable skill in the business world. Sometimes, business is just business. It’s not personal.
One of the things you have to understand as an investor is that, invariably, the market will screw you. You’ll get crappy fills, other traders will take you to the cleaners, and the noise will knock you down. It has nothing to do with who you are as a person. The market doesn’t hate you. The market doesn’t care.
We all understand the “business isn’t personal” concept in abstract. This is not a new lesson. But the problem is that we don’t really accept it deep down inside.
Playing games desensitizes you to this stuff. You learn it at the gut level. When your competitor outfoxes you, good game players don’t feel angry and irrational about it. Instead of taking it personally and getting upset, they develop some counter-strategies. They naturally just move on to their next move. That’s much more useful than personal self-pity.
Games teach you emotional control.
When I was a kid, I always wanted things to go my way. I wanted to win. And when I didn’t win or things wouldn’t go my way, I’d get mad.
When you’re a kid, that’s OK. But at some point you turn into an adult. And if there’s one thing that we adults all hate, it’s playing (or doing business) with people who get all bent out of shape when things don’t go their way. Don’t be that guy.
Emotional control is one of the most important traits that an investor can have. In fact, if I had to pick a single characteristic that correlates the most strongly with long-term investing success, it’d be emotional control. Warren Buffet and John Henry are about as different as two investors can be. But these guys have been making great investments for decades because they never let their emotions get the best of them. Look at all the incredibly successful people you know in your own lives. How many of them are really good at keeping their emotions in check? My guess is almost all of them.
Emotion is the enemy of investing. Emotion is what causes you to load up on real estate in 2005 or tech stocks in 1999 and emotion is what makes you sell into the panic and fear of a month like March 2009. It is the key to your portfolio’s undoing.
Johnny Drama would make a terrible investor.
There’s a corollary, too: don’t get too excited when you win. Emotional control cuts both ways. Excitement can lead to overconfidence and that’s the kind of thing that can wipe an investor all the way out.
Games teach you emotional control. These lessons will help you slice through the fear and greed of the marketplace.
Sometimes the right play works out in the wrong way.
In most of the games that I play like Puerto Rico or Agricola, it’s often difficult to know what the right move is. Those types of games are heavily dependent on strategy and player interaction and aren’t really driven by luck and chance.
But there are a lot of games where probabilities play a gigantic role. Fantasy baseball is one of those games. Poker is another. In these games, when you study the positional odds, the dominant moves become very clear. If you’re dealt a 7H & 2C in the hole, the right move is to fold. Sure, the flop could contain another 7 and a pair of 2′s. But that doesn’t mean you should play the hand. The probabilities suggest that you should fold and even though it might work out better if you don’t, it doesn’t change the fact that folding is still the right move.
Playing games this way is part of who I am. I’ve played a thousand games where I made what I knew was the right move, only to have it blow up in my face. One time I was playing Mrs. Draco in Monopoly. I spent my last $200 on New York Avenue to own all the orange ones. The orange ones are the best, you know, and I thought I had the game in the bag. I probably grinned a smug little grin and offered her the chance to resign with her dignity still intact.
But immediately after that I landed on her Marvin Gardens, the only property on the entire freakin’ board that had any houses. I would have been OK if I’d had that little bit of cash on hand, but I had to mortgage half my properties to pay her. I never recovered. Oh well. Buying New York Avenue was still the right move. It just didn’t work out.
I can’t tell you how important a lesson this is in the world of investing. When it comes to investing, one right move is to not have all of your money in stocks. But it’s amazing how heavily people load up on stocks in the late stages of a rally. Amidst all of that enthusiasm, something snaps in investors’ brains that makes them think, “well, shoot, if the market is going to go up another 25%, I’ll make more money if I have all of my money invested in it!”
Experienced game players understand the difference between the right plays and the wrong ones.
They know that the right play doesn’t always turn out favorably but that shouldn’t keep you from making it.
Some guys always make the right moves.
It’s OK to lose.
I follow professional sports. I’m actually a pretty big fan. Honestly, I’ve never understood the “winning is everything” mantra. You always hear champions and elite athletes talk about this, how nothing is more important than winning. Just win, baby!
Well, in my book, nothing is more important than learning. Maybe that makes me a new age pinko. Whatever. I don’t care. It’s more important to me that I play better the next time I take the match than winning the current one. And learning is what makes us better players. There is every bit as much to be learned — usually more – from losing a match than winning.
Now, if my entire sense of self-worth was derived from whether I succeeded or failed, I suppose I might have to change my mantra. If I’m a rookie quarterback thrust into the starting job, I might not have the luxury of carefully, thoughtfully learning how to get better.
It isn’t about encouraging and cheering your son after he hits a home run. Nor is it about coddling him after he strikes out. It’s about helping him to understand outcomes and the linkage between cause and effect. A home run is just a home run if you hit it and move on. Same with a strikeout. But if you can learn more about why you hit the home run or about why you struck out, it can translate into something tangible in the future. Something of real value.
If you’re not interested in hitting more home runs and striking out less in the future, then feel free to disregard this advice. But if you want to be a better investor, then understand that it’s OK to make some bad trades so long as you identify why it was you lost money and take steps to rectify it for next time.
Focus on the process, not the outcome. That’s what will help you be a better investor.
Don’t buy into your own success.
Sometimes you’ll win. Even if you’re not very good. Sometimes you’ll win a few in a row. The worst thing you can do is start to think you’re hot stuff.
I saw a lot of people buy a lot of houses in the boom years. Most of them thought they had real talent. They thought they had “the touch.” Every property they bought and flipped was a winner. They were awesome like Donald Trump! So they kept buying more and kept buying bigger because they were mini moguls and success was their destiny.
But it turned out that they had nothing to do with their success. Just about all of their success was actually attributable to the magical happenstance of simply being alive during an environment when a bunch of different variables all lined up to create a generational bubble in real estate.
It turned out that they weren’t very good real estate investors after all. It turned out that they couldn’t identify shifts in the market and it turned out that they couldn’t navigate a market moving the other direction. They blew up. Sure, a lot of legitimately skillful real estate investors lost money too. But they lost a whole lot less on a relative basis.
Do not — I repeat — DO NOT mistake luck for skill. Never buy too much into your own success because your success may have a lot less to do with you than you may be comfortable admitting.
Nowhere is this more true than the world of investing. And nowhere is it easier to buy into your own success than in trading the capital markets. But don’t do it. Don’t buy into your own hype.
Games provide an efficient, safe, and high-feedback environment to learn this lesson and learn it for good.
You’ll never know it all.
I think these are all pretty good lessons. They’ve served me reasonably well over the course of my young life. I’ve found them useful and broadly applicable. I think you might feel the same way.
Are these lessons you learn elsewhere in life? Yeah, some of them. But these are lessons that are explicit and obvious if you play games. When you play games these things are beaten into your head. And you have fun while it’s happening.
The other neat thing about playing games is that they always show you how much left you have to learn. Every time I bring out the chess board or hit the golf course, I’m reminded of the fact that I could dedicate the rest of my life to mastering the game and never know it all. It’s a humbling realization, but it’s also kind of comforting.
As an investor, I have a lot left to learn. Games taught me that that was OK.
Games taught me that I’ll never be a master, but that what really mattered was to keep working towards it.
It’s baaack.
Actually, it’s been back all summer. Since Congress freaked out the entire planet with their debt ceiling brinkmanship and the subsequent ratings downgrade by S&P, it’s been a risk-on/risk-off world.
One day everything goes up. The next day everything goes down. The up and down nature of the problem isn’t what investors should really be concerned about. It’s that when things move, everything moves in the same direction.
There’s a word for this: correlation.
If you haven’t had your morning coffee yet, don’t panic. ”Correlation” is just a fancy way of saying that two assets tend to move together. When one investment goes up, the other goes up. When one goes down, the other is likely to go down as well. We’re going to take an in-depth look at that today.
Market Valuations
But first, let me direct your attention to an article I wrote for Seeking Alpha earlier in the week. It’s about stock market valuations. I looked at a bunch of past data and tried to see if it had any predictive worth. Is the Price/Earnings ratio really relevant when it comes to making money in the future? Click over to find out. The answer may disturb you.
The article was awarded their Editor’s Choice distinction, which they give to just a couple of articles (out of hundreds) every day. I also posted it over at the RIA-favorite Advisor Perspectives website and it got picked up in another post over at the popular Pragmatic Capitalism.
If I’d known that it would get that kind of distribution, I would have spent more time on the research! I would have conducted a more statistically robust study with multi-factor analysis, additional regressions, and broadened both my time windows and variable inputs. But then again, nobody really wants to read anything like that.
Anyway, to the matter at hand. Correlation!
The Myths of Divsersification
Back in the day, what clever portfolio managers would do is build an investment portfolio with assets that didn’t correlate with one another. That meant that if an asset went down one month there was a good chance that some other assets in the portfolio may have gone up. A portfolio of uncorrelated investments has the pleasant side effect of lower volatility and greater return per unit of risk.
It works with investment strategies as well. Investors like volatile strategies because volatile strategies tend to generate higher rates of return. But if you combine uncorrelated, volatile strategies with one another you can keep the same high rates of return with lower volatility.
Here’s a graphic we use with our investors to illustrate the difference.
In the world of portfolio management this is an extremely important concept. It was a concept that was pioneered and formalized in the 1950s by Harry Markowitz, and later on he would receive a Nobel Prize for this groundbreaking work. He called it “Modern Portfolio Theory.” I would have called it Markowitz’s Awesome Model to Reduce Risk and Reap Rewards. But to each his own.
The trouble with Modern Portfolio Theory is that it hinges on this notion of combining uncorrelated assets. That’s problematic in environments like today where nearly everything in the market seems to be moving in lockstep.
Don’t believe me that everything is moving in lockstep? Here’s a correlation matrix for the last year:
Red means high correlation.
As you can see, it’s basically impossible to find assets within the U.S. market that go up when everything else is going down. Instead of a smooth steady performance line like that one above on the right, multi-strategy portfolios are looking a lot more like the single-strategy graph on the left. That’s not to say that you shouldn’t allocate to specific sectors or overweight some sectors over others. It just means that on any given day your entire portfolio will be moving in the same direction no matter what stocks you own.
This domestic correlation been going on for a long time. So a while back, investors started going overseas to get some real diversification. Sometimes stocks in Europe or Japan or some emerging market would go up when U.S. stocks went down.
But that’s not the case anymore, either. Here’s another matrix from Assetcorrelation.com showing the correlation between a bunch of different international markets.
You can see that nowadays everything correlates with the S&P. And all these international markets all correlate with each other as well.
Some markets do better than others, obviously. So there’s still value in being able to identify which markets will be the better ones. But on any given day, your supposedly-diversified portfolio of international stocks are almost certainly all moving in the same direction.
This wasn’t always the case.
It used to be that you could go to the international markets to find some investments that didn’t correlate. But that all changed. Since the financial crisis everything has correlated almost perfectly. And the long-term trend has been toward tighter correlation.
There’s a reason for that, I think. It’s a globalized world now.
Our economy today is much more directly linked to China’s economy, to Japan’s economy, to Europe’s economy, and even emerging economies. If your company slows down and you lose your job, it hurts businesses like Target because you spend less money on the goods they sell. It means you don’t buy that new house, which means less new home construction is needed. That means that builders don’t buy the copper they’d need to build it, which hurts copper prices and copper exporters like Australia. You have to erase any previous dreams of buying a new TV from Japan or getting a new iPad that’s made in China. The Italian leather handbag that your wife wanted for Christmas? Forget about that, too.
When our economy slows down, we buy less stuff from other countries. That slows their economies down and decreases the amount of stuff they buy from other countries. It’s a chain reaction. On top of that, nearly every major corporation today has a global footprint, whether their labor is sourced overseas or their products are sold overseas. These are the fundamental side effects of globalization. It’s one of the reasons why all these markets move together.
It’s why the U.S. markets freak out when Italian bonds start looking dodgy.
Maybe this all changes, though, if we embark on another major growth cycle. Maybe some economies decouple from the rest in terms of market performance. We portfolio managers can dream…
The noble goal
Investors shouldn’t give up hope in their search for assets that don’t correlate. It’s a noble goal, and perhaps the most important of all when it comes to assembling an investment portfolio. It’s how you get better returns per unit of risk. As a lifelong resident of the alternative investment world, I’m naturally programmed to see everything in risk-adjusted terms. A return stream means nothing to me without a relating it to risk and volatility.
It’s still possible to find things that don’t correlate. If you look hard you can add investments to your portfolio that will raise your risk-adjusted returns and lower your overall volatility. In the past, I’ve written a lot about relative value strategies. In fact, I even wrote a whole book about it.
— !! UH OH, SHAMELESS PLUG ALERT !! —
The Trade of the Decade is all about building a big, long-term, relative value portfolio. In a world where all the risky assets move the same direction but some do better than others, this is how you smooth out your return stream. You sell short (or avoid) the risky sectors, countries, and asset classes that you think will underperform, and you buy the risky sectors, countries, and asset classes that you think will outperform.
With a long/short portfolio like that, your returns will never be as exciting (or depressing) in any given year. But over the long run, if you’re successful in your fundamental analysis, you will probably have made more money. And you almost certainly will have experienced lower volatility than an outright directional bet on a single market. Getting a good night’s sleep is an under-appreciated aspect of investing.
Understanding the concept of relative value is one strategy that investors can utilize to get better long term returns and lower risk. But if you look hard, you can still find individual assets that don’t correlate and employ the tactic of bundling several of them together.
What doesn’t correlate makes you stronger
There is one major asset that doesn’t correlate. It has never really correlated with the global stock markets, and during this summer, this lack of correlation has become even more obvious.
I’m talking about Treasuries, of course.
This summer, Treasuries have actually demonstrated rather strong inverse correlation with stocks. Inverse correlation is really cool. In fact, nothing gets me more excited than two assets that are negatively correlated that also both go up in value over the long run. Those are two assets you want to own in tandem.
It makes sense that Treasuries and the stock market would be so inversely correlated this summer. Stocks are risky, of course. And Treasuries represent risk-off. In a risk-on / risk-off world, investors are constantly hopping back and forth between the two.
One day they want one, the next day, the other. In a sense, those are really the only two options for most investors. All the risky stuff is basically the same, at least in terms of day-to-day co-movement. And there’s only one place to go for the non-risky stuff.
Find the sweet spot
So how do you build a truly diverse portfolio when there only consists of two investments: risky and non-risky?
THE ANSWER: In a risk-on, risk-off world, the prudent strategy is to own both. It shouldn’t be a question of whether you need to be in the market or out of the market. It should be a question of finding how much of the risk-on stuff you’re comfortable holding and filling out the rest of your portfolio with the risk-off stuff.
Once you’ve done that, you can start adding some of these fringe assets that also don’t correlate. Gold, of course, is the obvious one. Gold doesn’t correlate with anything. Hedge funds and alternative assets are another thing that can add value and lower correlation IF 1) your net worth is high enough and 2) you know how to navigate those waters.
Long-term investors should focus on finding the right mix for them. When it comes to the equity bucket in their portfolio, they probably need less diversification than they think. It’s extremely difficult — maybe even impossible — to meaningfully reduce the volatility of a portfolio by staying only within the equity space.
Read that sentence again. Wait, allow me:
It’s almost impossible to meaningfully reduce the volatility of a portfolio by staying only within the equity space.
If you do want to reduce your portfolio’s volatility, you’ve got to include some other asset classes as well. When it comes to your investments in the equity space just pick some stocks or sectors. Pick the ones you like or the ones you’ve done a lot of research on. Pick the ones you think will perform better over the long run, because some of them certainly will. Pick the ones your advisor suggests. Pick some at random. Pick ones with funny ticker symbols.
The point is that the more you diversify the equity portion of your portfolio the more that two things will happen:
- You reduce the risk that a single position blows you up.
- Your returns match the broad market.
But volatility reduction is not something you’ll see, at least not in a meaningful sense. And in the risk-on / risk-off world, isn’t less volatility what we’re all looking for?
The bad news
Look, I get it. Everybody is starving for yield and what Treasuries offer is pretty skimpy.
The 10year Treasury is yielding a whisker above 2%. The 30-year Treasury is parked around 3%. Forget about T-Bills. The yield on those is indistinguishable from zero.
Even if you go a little beyond the straight Treasury space, what you find is rather depressing. The Dow Jones Corporate Bond index is at around 3.5%. TIPS are giving you a negative yield if you can wrap your brain around that concept. You can’t go to Japan for yield (too low) and you can’t go to Brazil either (too much inflation). Nobody understands emerging market debt, much less devleoped European debt. Junk bonds are yielding around 8% right now. Junk bonds! Junk bonds were yielding 8% in early 2007. Do you remember what it was like early 2007? I do. Everything was awesome.
There aren’t many options out there for investors. It’s a cold, cruel world.
Investors have no choice but to take risk and chase risky assets. And you can see just how committed they truly are. Clearly, they feel awkward about taking the risk. They’re in one day and out the next. They’re trying to milk what returns they can and then step aside before the crash they know is inevitable.
It’s like Frogger. For some reason, investors feel compelled to cross the road, to eke out a marginally higher rate of return. They know there are dangerous trucks, slippery logs, and angry turtles. They know there are risks abound. But, whatever. They think they can get across without going splat. They think they have the skill that’s required. So it’s a lot of in-out, in-out and I don’t mean that in a Clockwork Orange sense.
This is a really weird dynamic. I’ve never seen anything quite like it in my career. I’m not sure many of the old timers have, either.
My guess is that so long as this dynamic persists — so long as the only decision that investors can make is Risk or No Risk — it’ll be a volatile and correlated world. That sucks for all the amateur investors. But let me tell you something.
Us professionals really hate it too.
- Pretty much everything within the U.S. stock market correlates. For the most part, stocks and sectors move in the same direction. The same thing is happening in the international markets too (it didn’t used to be this way).
- You can’t build an equity portfolio and use diversification to meaningfully lower your volatility. To use correlation to bring down your portfolio volatility, you have to include other asset classes.
- Investors who can’t decide whether they want to have risk-on or risk-off are probably best off owning some of each.
It’s a risk on, risk off world. One day everything is up. The next day everything is down.
We’ll actually take a closer look at that risk-on/risk-off phenomenon next week. But before we do, we need to drill down and get a clear read on the fundamentals. Let’s throw away all the headlines about Greece and MF Global and these goofy dudes who want to be president.
Let’s turn off the noise and look at some data.
Step one
We’ll start at the very top. U.S. GDP.
At the end of October, the Bureau of Economic Analysis announced their first estimate for GDP in the third quarter. It was an annual rate of 2.5%. Check out the release for yourself. 2.5% isn’t worth getting really excited about, but it was double the rate of the previous quarter. Durable goods orders bounced back in a big way and personal consumption expenditures showed decent strength.
Remember how I wrote last week about how consumers aren’t behaving in a way that’s consistent with sentiment? Here’s another example of that. The third quarter was one of the scariest I can remember in the investment markets. Yet GDP actually increased from the previous quarter.
GDP figures get revised a lot. People forget about that once the headlines of the first estimate have been distributed. So watch to see if there’s any revisions to this Q3 GDP figure.
GDP is OK right now. Way better than everybody was expecting, but not what anyone would call “great.”
In the midst of all that earlier pessimism, it’s possible that somebody may have seen that coming. The wonkishly-named Consumer Metrics Institute.
This is their daily growth index. I used this chart back in early August when the planet really started freaking out. I was pretty concerned too, but of my myriad concerns, the U.S. Consumer was not one of them. This index from the Consumer Metrics Institute tracks consumer demand for discretionary durable goods.
The blue line in that chart measures the 2010 contraction. Demand dwindled for a long time. But something happened after this index bottomed in late May. It stopped getting worse at an increasingly bad rate. Then, a couple of months ago, it actually started improving in an absolute sense.
This is what they wrote back in early August:
Remember that real-world consumers transact with practically no attention to political drama or economic pundits. They do what is best for them, and they respond to their own personal circumstances. They are basically 100 million loose household cannons. Stay tuned, but the upturn we see has most likely resulted from a real bottom in housing demand (but sadly not tightening supply — and not by a long shot) and the moderation of pain at the gas pump.
The curse of being way ahead of the dips in any economic cycle is that the people still on the down-slope think that you’ve completely lost your mind. Maybe we have. Just like we did in late November 2008 when we saw the on-line consumer demand bottom some 4 months before the early March 2009 market bottom.
But it sure is nice to finally be reporting (however delusionally) something other than unending gloom. We can at last see the glimmer of the other side of the chasm. To bad that the rest of the world won’t see it for some time.
From the perspective of economic fundamentals, it’s not unending gloom anymore.
We’ve officially progressed into boredom!
The best news is that since August, this daily gauge has continued to increase farther into positive territory. This could be an indication that the little recovery we saw in the third quarter could continue through the fourth quarter.
The markets would have you think differently, however:
The thing you have to remember about the markets is that they are forward looking. The stock market doesn’t care what GDP was in the third quarter of 2011. That’s, like, over! The market is concerned about what GDP is going to look like in 2012. That’s what moves it around.
The market is also concerned about things like Italy struggling with its debt. So while I encourage you to listen to what the market has to say about the future of the economy, I also warn you that its mania/depression can be a little difficult to parse.
If you want to get a less-noisy read on what the economy is going to look like, you have to look at some other indicators.
Next, let’s check in with the Three Amigos.
Capacity utilization is hanging in there. This is the one that measures how much of our total production capacity our economy is using. Historically, it’s at below-normal levels. But for the “new normal” economy, it’s certainly within acceptable parameters. It’s not signalling contraction yet, but I’d be highly skeptical of any robust economic recovery that doesn’t involve some additional strength in capacity utilization. Manufacturing has been a relative bright spot for the U.S. economy this year but it has a ways to go before we can stop worrying about a slowdown.
If I had to pick only one economic indicator to take with me to the desert island, it’d be the ISM Purchasing Managers index. Every month they solicit actual data from several hundred purchasing & supply executives at major companies around the country. It’s not a read of sentiment, nor is it a read of what people think is going to happen. It’s a measure of what is actually happening in businesses right now. Are companies ordering more stuff or less? Are their customers ordering more stuff or less? What kind of prices are they paying? All of this actual data gets wrapped into the ISM PMI.
And this index is telling a similar story. It’s way off the highs of the year and teetering just above the break-even threshold. Remember that readings above 50 indicates growth, while those below signal contraction. I’m not panicking on this yet either, nor am I willing to go on record that we’re out of the woods. If I saw the ISM PMI roll under 50 in conjunction with drop off in the Consumer Metrics Institute’s daily gauge, I’d buckle up for more pain ahead. But until that happens, panic about what’s going to happen to the economy in the next 6 months is difficult to justify. Same with enthusiasm. The data doesn’t support that, either. Caution is the only rational approach here.
Junk bonds are telling a more dramatic story, but they also tend to be the furthest forward-looking. Junk bonds work like this: their yield goes up when investors get more worried about a default, and the odds of a default always go up in a slowing economy. You can see that they’ve spiked lately. Investors are getting more picky about which junk to add to their trunk.
Earlier in the year, the amigos were all looking pretty good. But that has completely changed in the last few months. They’re not at levels that warrant panic, but they are at levels that warrant closer attention. The Three Amigos won’t help you invest through next Thursday, but they will provide some useful background if your investment horizon goes out further than a couple of quarters.
More leading indicators
The ECRI does a way more complicated analysis of the economy than my buddies Dusty Bottoms, Lucky Day, and Ned Nederlander. The ECRI incorporates a whole bunch of leading indicators into one composite index. Their recent forecast is that a recession is essentially guaranteed.
I wrote about this a couple of weeks ago. This was their biggest, loudest, and most publicized call. When I first started writing about the ECRI, nobody in the industry really cared about them. Now the whole world is watching.
Another thing to keep in mind is that Mark Zandi, of Moody’s Analytics, is pegging the probability of recession at 40%. Zandi has been one of the most consistently optimistic economists of the last several years and when he looks ahead into his world and sees a 40% chance of recession, it makes me wonder.
I think David Rosenberg has the odds at like 99%.
What about valuations
The last thing to look at is whether stocks are expensive or cheap right now.
When asking that question about long-term investment horizons, I like to relate current prices to long-term, normalized earnings.
On a historical basis, looking at average trailing earnings, you can see that stocks are still somewhat expensive.
But this statement carries three maaajor caveats:
- That’s not to say that there aren’t individual stocks that are cheap. I think there are a bunch of stocks out there trading at sensible multiples. Investors that are willing to do a lot of leg work can assemble a portfolio today that I believe has a very high probability of outperforming the broad market over the next decade.
- We must also consider a bit of historical context. The stock market as a whole may be a little on the expensive side, but the market is as cheap as it has been in almost 20 years. With the exception of the crisis lows, of course.
- We must also consider its competition. You may wonder why investors today are buying a stock market that’s historically expensive, but when the chief alternative, bonds, are paying laughably low interest rates, investors are clearly willing to ignore valuations and fixate on hopes of a better yield.
I’m the type of guy who gets more conviction the closer things get to an extreme. As a contrarian, my faith is based on the concept of “reversion to mean.” Right now, we’re kind of in the middle. Over the long term, I have relatively little conviction about where the market winds up.
There’s another way to measure valuations. You can relate current prices to the previous 12 months’ earnings.
This is the more common way to calculate a P/E ratio. It’s what you were taught back in school.
I drew a red line at the 112 year average, which is 15.7. You can see that right now, on a historical basis, stocks are neither egregiously expensive nor crazy cheap. The conclusion is similar to above. Stocks are certainly as cheap as they’ve been in a long time, but it’s based on the assumption that this very high level of earnings will continue to grow.
There is a correlation between buying at low valuations (on a ttm earnings basis) and getting a better total return over the subsequent 5 years. But the correlation is not as tight as you might think.
Looking at trailing 12-month P/E ratios isn’t as helpful as the industry may lead you to believe. At a 15 multiple, pretty much any outcome is in play.
Oh yeah, also: if we do enter a recession and earnings fall, the PE ratio will necessarily spike unless prices fall proportionately. That’s why stocks usually go down between 20-40% in a recession.
As I’ve written a million times, I think stocks will go up and down and up and down for the next decade and when it’s all said and done, investors will wonder if it was worth all the heartburn. But there will be unique places in the next decade that will warrant more conviction. Investors who stay on top of it and funds that employ skillful tactics will probably take advantage of some of these moments.
So where does that put us?
We’ve covered a lot today. Pat yourself on the back if you stuck through it.
Headlines aside, I think the data is telling a very convincing story right now. All the economic fundamentals suggest a market that should be really boring — one that allows for the possibility of modest growth, but also one that also warrants a fair amount of caution.
Yet that’s not what we have right now. What we have right now is a market that’s all over the map. It’s up 300 points one day and down 300 points the next. One day the world is falling apart and the next day we’re all in the clear.
The economy is teetering between slow, but acceptable, growth, and possible contraction. It could go either way, and if I was pressed, I wouldn’t guess it goes very far in either direction. That’s not what you want to hear, but it’s the truth. I don’t see anything indicating a robust economic expansion, nor do I see signs of imminent meltdown.
It’s really boring.
If the markets weren’t so darn volatile because of Europe — which I have been bearish on and concerned about — we’d all probably be talking about where Albert Pujols will sign or why nobody wants to stay married to Kim Kardashian.
Right now, I think the bulls and bears have equal amount of ammunition with which to arm their case. The question that each investor needs to ask themselves is whether their investment forecast — whatever that may be — is worth the current volatility.
For some, the answer is “yes.” For others, “no.”
One last dynamic to watch
I mentioned that the reason for the current volatility is all this news headline risk. One thing to keep in mind as you watch the market from day to day — whether you do so casually or whether you follow the daily action intently — is that the market doesn’t always follow the headlines. In fact, I’d say that most of the times the headlines follow the market.
There’s a lot that happens within the course of the trading day that has very little to do with fundamentals. In fact, the market action between 9:30am and 4pm EST has almost nothing to do with economic fundamentals. It’s driven by things like order flow and technical moves. Big players need to buy big positions, and that moves the market. ETFs need to rebalance their portfolios and their collective selling moves the market lower. High-frequency traders exacerbate intra-day swings. Large hedge funds push things one direction or another. Sometimes when the market opens up big, investors freak out that they’ll miss the move and so they buy as fast as they can, and that buying pushes the market up further, which only makes everybody else want to buy more.
Investors like to buy things that are going up. It feels better and it’s easier to explain to their clients.
As an example, look at this stock. This stock was the easiest thing in the world to buy. It was easy because the way the human brain works is to look at the recent past and project it indefinitely into the future. It was one of the most widely owned stocks on the Street. Every single bit of news was positive. People who criticized it were publicly flogged.
That’s Netflix, of course. Investors who bought because it felt good and because everybody else was buying it probably got burned. Investors who drilled down into the fundamentals and ignored the herd probably stayed away. Investors like Whitney Tilson who focused maybe a little bit too much on the fundamentals and the future outlook and tried to short the stock also got burned. Oh, the irony…
(Full disclosure: neither me nor my firm has a position in Netflix, I just used it because it was a good example.)
More often than not, the headlines follow the market. The way I like to think of it is that the market acts as a filter for the headlines. Rising market? Every headline, no matter what the fundamental reality, is reported with a positive spin. Crashing market? All the major headlines are re-interpreted in a negative context. Even the stories which are technically good.
This is part of the reason why Europe became such a big deal this year. We’ve had persistent volatility in the market, and everyone is scrambling for reasons to explain it. Everyone pointed to Europe and started telling a story about how the market is nervous about who’s exposed to whom.
This is a legitimate risk right now, but remember that Europe is in basically the same situation it was in last year. It’s in the same position it was back in Februrary when everything in the markets was hunky dory. Nothing has really changed in Europe. Not fundamentally, and not in any way that really matters. There’s still a boatload of stinky debt and countries with little hope of paying it back.
Why weren’t we this concerned about EU debt fallout in February? Why weren’t we this concerned about some of the fundamental risks associated with Netflix’s business model?
Anyway, I bring this up simply to remind you of one of the major shortcomings of the human species. We’re really bad at dealing with the unknown and unknowable. It’s why people have turned to religion for answers and guidance for thousands of years. It’s why the existential uncertainty of death exerts such powerful influence over our lives. It’s why the writings of H.P. Lovecraft and his creatures that are beyond our capacity for understanding are so damn scary.
We see this every day in the markets.
We react accordingly.
- The fundamentals of the U.S. economy right now suggest a market that should be pretty boring. But anyone who has been watching the market knows that it’s nowhere near boring.
- Almost everything that happens within the course of the day is noise. The majority of what happens during the week is also noise. It’s even worth asking how much of what takes place during a calendar year is just momentum-driven noise. This year the market has traded inside a range of almost 25%. 25%!!
- Major economic fundamentals won’t help you invest through the daily noise, but they’re very useful for providing context for longer investment horizons.
- And over the really long run, fundamentals are, by definition, one of the only two things that matter (the other being general investor appetite for risk).
