US stocks were overpriced in January. Late April feels like a bubble.

The stock market tracks GDP in the long run. To show this, I have plotted real GDP and the S&P500 index(both from multpl.com) since 1930 below.

RealGDP_vs_SnP500

Two things are apparent from the chart above:

  1. The two lines run roughly parallel on a log-scale over this 90-year period. Their ratio is therefore a mean-reverting quantity. If you think about it, it would be strange for the lines to diverge permanently.
  2. The stock market line is a lot more volatile than the GDP line. This means that stock price can fall far below what GDP would suggest (generally in a crisis) and rise far above towards the end of a bull market. The higher volatility of stocks is well-studied, e.g. under the heading of  excess volatility.

The ratio of stock market value to GDP serves as a useful valuation metric. The market is cheap when this ratio is low, and expensive when it is high. According to Warren Buffett, the percentage of total market capitalization relative to GNP is “probably the best single measure of where valuations stand at any given moment.” You can track its value on this link from GuruFocus. I have reproduced today’s chart below:Ratio_TotalMktCap_GDP

The above ratio falls as stocks crash. As you can see from the chart above, it stood near 70% at the stock bottom following the dot-com crash, and just over 50% at the bottom following the 2008-09 crash. The ratio was under 75% through much of the 1970s, 80s, and 90s.

By contrast, the ratio “fell” from over 150% to under 120% in March and stands at 133% as I write this. Such high valuation is surprising because we are in a lockdown caused by a pandemic that will bankrupt a lot of businesses unless they are bailed out. The stock market, after falling precipitously in March, made a rapid recovery in April. It is widely speculated that the recovery is due to purchases of securities by the Federal Reserve. Quantitative Easing (or QE, as such purchases are called) is quite possibly a contributing factor. Tom McClellan has a compelling chart (reproduced below) showing that periods after the start of QE in large doses saw stocks rise rapidly. The chart also suggests that the slowdown or ending of QE coincides with weak stock market performance.

QE_spx_Mar2020

The following article describes this behavior in more detail. As for whether we are undergoing QE “in large doses”, see the following chart. Notice the spike on the right? That’s the latest round of QE.

securities_held_by_Fed

If the Fed had not resorted to QE, the S&P500, which trades near 2860 today would probably trade closer to 2000. This is a rough guess based on earnings-per-share (EPS) projections and price-to-earnings (P/E) ratios in crises. Ed Yardeni expects 2021 earnings for the S&P500 to be 150, and applying a multiple of 13-14 gives us an index level of around 2000. An alternative explanation for the stock market’s April rise is that the market is pricing in a quick recovery and return to pre-crisis levels of profitability. This hypothesis seems less plausible because projections of GDP growth for 2020 and 2021 suggest that GDP growth will not be back to 2019 levels until 2022. I am using projections from the IMF, which can be found here. The path to recovery is uncertain with potential negative outcomes such as multiple waves of infections (which are likely, see this paper), and positive surprises such as cures and vaccines.

Another observation is narrow leadership in stocks. Even as companies at risk of bankruptcy continue to trade well below pre-crisis lows, the five largest stocks in the S&P500 have held their ground. The combined weight of the top five stocks has not been this high since 1980s. Urban Carmel posted a chart from Bianco Research showing how such concentration tends to coincide with market peaks. Caveat: the chart does not show “peak” concentration today. It shows rising concentration in the top five stocks, but the peak may be ahead of us.

Some of these observations, such as the scale of QE and the narrow market leadership, suggest a bubble. However, a bubble does not mean imminent collapse. The Federal Reserve, the Treasury, and all branches of US government have been taking unprecedented steps to prevent economic collapse. I wouldn’t be surprised if the Fed resorts to purchasing stocks, or to widespread debt forgiveness. A lot of critics will complain that such actions introduce moral hazard (encouraging bad behavior in layman’s terms), but 1. it is hard to stop the government, and 2. the government could argue that a business that saw its revenues collapse leading to crushing losses in a pandemic did not necessarily engage in bad behavior. The public stock of many businesses (such as retailers) is either worthless or worth something meaningful depending on how government chooses to act.

The focus of this article had been on the US economy and stock market. The US may succeed in propping up its economy/market, but some other countries may not be so fortunate. I suspect that we will see more businesses collapse worldwide as with each additional week of lockdown or decreased business, cash runs out. In times like this, having a high level of liquidity can be a boon for investors.

One final word. I am grateful for what I have today. Being able to work from home is a privilege. COVID-19 and the policy response to it is inflicting excruciating pain on millions worldwide. The critically under-resourced have very little say in policies that dictate their survival. I made a small donation here yesterday. Give what you can wherever your heart desires.

Cash Allocations Fall to 17½-Year Low

Cash Allocations Fall to 17½-Year Low. So says the Allocation Survey of the American Association of Individual Investors.

Why are individual investors holding so little cash?

Holding cash is painful. Cash returns nothing. Its purchasing power erodes due to inflation. But we are in a low-return environment, and inflation is low, so holding cash ought to be less painful now due to reasons of yield and inflation than at most times in history.

Is the search for yield driving people towards riskier assets? That may be part of what’s going on.

Are investors staying in risky assets because nothing bad is happening to them (yet)? Possibly.

Some of the pain of staying in cash may be due to relative deprivation, meaning we are surrounded by people who have made good money in risky assets such as stocks in recent years.

Quoting from the following article: “Specifically, the July 2017 reading of investor cash came in at 14.5%. This was the lowest level in the survey since January 2000. In fact, the only lower readings in the survey’s history back to 1987 occurred in January-April 1998, July 1999 and November 1999-January 2000.”

Looks like the only time people had less cash in their portfolios than now was shortly before the peak of the dot-com bubble. In retrospect, holding on to more cash and fewer tech stocks back then would very likely have worked better.

Would it be a wild conjecture to say that those with the patience to sit out this market in cash will be rewarded? Probably not, but I would also not be surprised if the holders of cash find that their patience is being tested further before the next crash relieves them.

DISCLAIMER: The information on this forum is provided without any express or implied warranty of any kind. This information does NOT constitute financial or investment advice. The information is general in nature, and is not specific to the reader. YOU SHOULD NOT MAKE ANY DECISION, FINANCIAL, INVESTMENTS, TRADING OR OTHERWISE, BASED ON ANY OF THE INFORMATION PRESENTED ON THIS FORUM WITHOUT UNDERTAKING INDEPENDENT DUE DILIGENCE AND CONSULTATION WITH A PROFESSIONAL BROKER OR COMPETENT FINANCIAL ADVISOR.

Catching bottoms

I recently came across an article titled “Ten Rules For Catching A Bottom“.

Market timing is hard enough that no one can do it consistently but the rewards of success are high enough that it piques interest. Besides, the question “when should I buy?” is on the mind of every investor/trader simply because it affects outcomes.

Of the rules themselves:

  • My experience agrees with rules 3 (wait for a higher low) and 4 (wait for a longer term moving average to stabilize).
  • Rule 7 (keep your trades small) is vital, and I wrote about this in a recent post.
  • Rule 10 (step in slowly) is dangerous if one doesn’t understand how it affects rule 7. If you keep investing 1% of your portfolio repeatedly into a stock that keeps dropping and eventually goes to zero, you could lose 5-10% of your portfolio.
  • Rule 6 about using stop losses is not very useful if one follows rule 7 to keep trades small. In my experience, Rule 6 (use stop losses) can hurt outcomes. I would sell only if new information says that the stock isn’t worth holding; otherwise, I would hold. I’ll explain this with an example. Here are three stocks that were in the news last year, and the gurus who owned them:
  1. Valeant (VRX): Ackman
  2. Sun Edison (SUNE): Einhorn
  3. Horsehead (ZINC): Pabrai

Of these, VRX bottomed and then nearly doubled, but Ackman sold near the bottom. The other two (SUNE and ZINC) went to zero. If these hedge fund managers, with their extensive resources, could not predict survival, it is fair to say that most individuals cannot accurately predict outcomes either. A stop loss gives up a potentially large gain from a rebound for a small but certain avoidance of loss. If an investor wishes to avoid losses, bottom fishing isn’t the place to be to begin with, but once in the game with a tiny bet (e.g. 1%, all trades inclusive), getting out of the game with 0.2% remaining may not be a good idea.

DISCLAIMER: I own VRX stock. In the past, I have owned SUNE and ZINC stocks. The information on this forum is provided without any express or implied warranty of any kind. This information does NOT constitute financial or investment advice. The information is general in nature, and is not specific to the reader. YOU SHOULD NOT MAKE ANY DECISION, FINANCIAL, INVESTMENTS, TRADING OR OTHERWISE, BASED ON ANY OF THE INFORMATION PRESENTED ON THIS FORUM WITHOUT UNDERTAKING INDEPENDENT DUE DILIGENCE AND CONSULTATION WITH A PROFESSIONAL BROKER OR COMPETENT FINANCIAL ADVISOR.

Complacency

“THE STRIKING PRICE” is a weekly feature in Barron’s magazine. It has a few charts that I find informative. Here are last week’s charts:

ON-CD549_bCBOE0_NS_20170526193030

from the Barron’s article:

http://www.barrons.com/articles/its-time-for-investors-to-pounce-on-banks-1495858728

Here’s why I find this interesting. The top right chart (EQUITY ONLY PUT-CALL RATIO) is showing the lowest value I have seen in recent years. People generally buy PUT options to protect against rapid stock market declines. This is a 21-day weighted PUT-CALL ratio, as explained here, which is to say that, in the last 3 weeks, investors have reckoned that the chance of a crash is pretty low. Low volatility has also made the news is recent weeks (see the top left chart above).

Yet, investors are not bullish. In fact, the AAII sentiment survey shows that very few investors (just 27%) expect a rise in the overall stock market in the next 6 months. Rather, investors feel “neutral”.

I sense complacency, which is a sign that there’s probably an unpleasant surprise around the corner.

Warren Buffett vs. the bond king

I came across two news items today. In one, Warren Buffett said that US stocks are not expensive. In the other, Jeff Gundlach trashed the S&P500 (deprecating passive investing in  general) and suggested buying emerging markets instead. On the surface the opinions seem to be at odds, but the two gurus are providing pieces of a jigsaw that makes sense if we find and put together the missing pieces.

Buffett was responding to a question on the overvaluation of US stocks as measured by the “Market Cap to GDP ratio” and the “Cyclically Adjusted PE ratio”. His answer was that ratios are informative without being absolute. Further to Buffett’s point, early signs of a recession are conspicuously absent. Buffett no doubt sees this through the reports Berkshire Hathaway receives. Granted this could change quickly, but for now the economy is doing well. Buffett prefers stocks because their expected return is much higher than that of treasuries. Two points struck me as essential to complete the picture, yet not clearly stated:

  1. Buffett is a stock picker. I’m not surprised he is finding good value in US stocks, because there are enough companies whose stocks are cheap in relation to their future cash generation potential. However, the US stock market also has plenty of companies that will do far worse (many will go bankrupt) than treasuries. Investing in a stock market index may not be a good idea because one ends up buying the good and the bad.
  2. Which is what Gundlach (google “bond king”) was saying at the SOHN conference: Investing in a stock market index (such as the S&P500) is a bad idea. His point is that stock pickers (like Warren Buffett) will do much better than a market index. But he is also implicitly saying something else: that we are not constrained to invest inside the US alone. It’s not “do we invest in US stocks or US treasuries?”. There’s an entire universe of securities that we have access to. Gundlach sees good returns – even without stock picking – in emerging markets.

It would be fair to say that those with the talent for picking stocks globally will do quite well.

SciPre portfolio : Apr 1, 2017

Here’s what the SciPre portfolio looks like as of 4/1/2017.

Asset class Ticker Allocation
Australia stock EWA 4.0%
Brazil stock EWZ 4.0%
Chile stock ECH 4.0%
China stock FXI 4.0%
Commodity basket DBC 5.0%
Egypt stock EGPT 4.0%
Emerging Markets local bond EBND 10.0%
Emerging Markets USD bond VWOB 10.0%
Global value GVAL 4.0%
Gold GLD 5.0%
Gold miner stock GDX 5.0%
Greece stock GREK 4.0%
Hong Kong listed China stock FXI 4.0%
Intermediate-Term Corporate bond VCIT 5.0%
Italy stock EWI 4.0%
Nigeria stock NGE 4.0%
Poland stock EPOL 4.0%
Russia stock RSX 4.0%
South Korea stock EWY 4.0%
Spain stock EWP 4.0%
Turkey stock TUR 4.0%
Total 100.0%

First things first. I do not recommend this portfolio to anybody. Each individual’s risk appetite is specific to that individual, and one portfolio could not possibly serve all.

The portfolio above is different than the one posted on 1/1/2017 in a few ways. Equity (stock) exposure is reduced. The portfolio has more bonds and now includes exposure to a commodity basket. This is a move towards safer assets, and also leads to greater diversification. The portfolio is also exposed to China now, mainly because Chinese equities are significantly undervalued on some key metrics.

As before, allocations are deliberately simplified.

Finally, the tickers are usually those of ETFs that serve the mentioned asset class. I include tickers so that the perfomance of the SciPre portfolio can be tracked. I am not recommending these specific ETF products. In each asset class, there may be mutual funds and ETFs that have lower costs or more desirable features.

Disclaimer: The opinions expressed here are mine alone. I am not offering advice or recommending any product. I may own some of the asset classes and tickers mentioned above, but may not own others. Consult your financial advisor befor making financial decisions.

“If You Bet Too Much, You’ll Almost Certainly Be Ruined” – Ed Thorp

I follow a few blogs regularly. One is mebfaber.com. Meb uses simple, clear language to share data and insights. His recent podcast covered an interview with Ed Thorp, a pioneer in more ways than I can describe here. Listen to it if you have one hour to spare. If not, just read the summary.

The title of the podcast is also the title of this blog post. The consideration of “bet size” has been on my mind recently. Each year, I place a few bets that have small odds of producing large payouts. “Small odds” means that most of these bets don’t win. This is to be expected, but the process of identifying, placing, and following through on such bets is both mathematically complex and emotionally demanding. Ed Thorp is one of the world’s foremost experts on this kind of betting. And at age 84 he has a boatload of experience to share.

Ed says that if you bet too little, it won’t make an impact on your portfolio, which is obvious, but if you bet too much you’ll almost certainly be ruined. The second part of the statement – the part about losing a lot of money – is interesting for two reasons.

First, for a favorable bet with known odds, the Kelly criterion gives us the optimum bet size. The Kelly criterion is optimum in the sense that if the same bet is placed repeatedly, then the Kelly bet size will grow money faster than any other betting method. To illustrate the problem with large bet sizes, consider the following two bets.

  • In the first bet (Bet 1), we have a 1% chance of increasing the betting money 200-fold, and a 99% chance of losing everything we’ve bet.
  • In the second (Bet 2), we have a 50% chance of quadrupling our money, and a 50% chance of going bust.

Both bets have the same expected return. “On average”, both bets will double our money after a single bet, but stating it in this way is misleading. Here’s why. Kelly says that it is optimum to bet ~0.5% of our wealth if presented with the Bet 1, and ~33.3% of our wealth if presented with Bet 2. Intuitively, this is because the first bet doesn’t win very often, so we bet only small amounts and once in a blue moon we hit the jackpot. With the first bet, the maximum rate of compounding achievable in the long run is less than 0.2%, whereas the with the second bet, we can achieve 14.4%. These numbers can be calculated using some simple formulas that can be found here.

The conclusion from the above is that it is best to bet tiny amounts on profitable bets with rare large payouts (e.g. Bet 1), and one bet of this sort doesn’t contribute very much to long-term growth. This conclusion is perhaps counterintuitive, and in stark contrast to the excitement that the prospect of a 200-fold gain produces. A high-risk high-return bet resembles a lottery, and many people bet on lotteries even though they know that “on average” lotteries lose money. The less obvious point is that even Bet 1 and Bet 2, which have positive expected returns, will lose money if we bet too much.

This brings me to the point about “being ruined” in the title of this post. If, instead of betting the Kelly amount, we bet our favorite amount, say 10% of our wealth, on each bet. The first bet will lose money at a compounded rate of 7.4%. In fact, any bet size larger than 1.26% will lose money on the first bet. Betting less than the Kelly bet size is suboptimal, so it leaves some gains unutilized, but it doesn’t lose money.

There is another consideration here that is perhaps as important. In real life, the odds of profitable bets are seldom known. The odds of some games are known, but the universe is producing an endless stream of opportunities to profit whose odds can only be imperfectly estimated. Human nature messes with our ability to estimate these odds. Placing Kelly bets on mis-estimated odds can also lead to rapid loss of wealth. The fix is simple: be less greedy. By placing smaller bets than we otherwise would, we’ll have a better chance of coming out ahead.

A 40% drop?

Barron’s magazine published an article in this week’s issue : A Skeptic’s View of the Trump Rally – Dreyfus Global Real Return manager sees stocks falling 40% or more once long-term trends reassert themselves. The article expresses the view of fund manager Suzanne Hutchins. I agree with her, although I don’t necessarily see such a drop in stock prices as imminent.

The number 40% reminds me of a simple calculation I performed in my mind recently. The Shiller PE ratio (inverse of the earning yield) of the US stock market reverts to its mean in the “long-term”. The long-term mean for the Shiller PE ratio is 16.7. Right now, the Shiller PE is at ~28. A return to historical mean would imply a drop of (28-16.7)/28 = 40.4%. That’s pretty close to the 40% number in the article.

shiller-pe-87cab6b279fa9ea8

There are many other considerations though.

First, in the language of statistics, the distribution of the Shiller PE ratio isn’t stationary. It demonstrates trends lasting decades. Its mean is strongly influenced by interest rates among other factors. In a low interest rate regime, considerations of opportunity cost would induce the Shiller PE to remain higher (stocks would maintain a lower earning yield) than its long-term mean. This has happened in recent decades thanks to an extended low interest rate environment. So, one could question the premise that the Shiller PE would return to its long-term mean. It isn’t hard to see from the chart above that recent decades have supported average Shiller PE values above 20. A drop from 28 to 20 is a big drop, but closer to 30% instead of 40%.

Second, when the market crashes, it doesn’t crash to the mean of historic patterns, it usually overshoots, i.e.,  crashes further down, so a large crash can be expected.

Third, major market crashes begin in anticipation of recessions, and the market hits bottom often when the recession in underway. In a recession, earnings are lower than in boom time e.g. today. Doing the math, if the PE ratio were to go down to its historic mean of 16.7 during a recession when earnings were, say 25% lower than they are now, then we would see a market drop of 55% from present levels.

Finally, and worth repeating: while I see such a drop as probable, I don’t necessarily see it as imminent. In the last two major market crashes 1. post the dot-com bubble, and 2. post the housing bubble, the market crashes were predicted and anticipated by many, but the decline did not start until long after people started predicting it. Signs of economic stress were felt for years even though the market did not crash. The St. Louis Fed publishes a Financial Stress Index, which is a composite of several indicators of economic stress (below).

fredgraph

Looking at the chart above tells us that stress levels were above zero since 1994 even though the market, driven by euphoria, went to bizarre highs all the way to the end of the 1990s. And post the housing bubble, although stress started to spike up in late 2007, the big crash only happened in late 2008. Right now, the stress index reads negative (i.e. low stress), and not just barely negative but its value is easily in the bottom quartile of values since 1994. The economy is doing fine. That’s one reason why I don’t see a crash as imminent.

Of course, there’s always the risk of unforeseen events (e.g. natural or manmade catastrophes) or harebrained policy actions triggering market collapses prematurely.

Of tenbaggers and 100 baggers

A tenbagger is an investment that grows tenfold. A 100-bagger is – you guessed it. I recently read a book with the title 100 Baggers: Stocks That Return 100-to-1 and How To Find Them. I save such books for long flights. 🙂

Searching for tenbaggers or 100-baggers isn’t a substitute for a sound investment plan, but the book highlights the importance of being patient with investments. It is extremely hard to predict which stocks will do the best in the long run. Taking quick profits is a sure way for an investor to ensure that none of his/her positions will ever grow very big. My words lack the eloquence with which Peter Lynch said it in his book One Up On Wall Street:

“The point is, there’s no arbitrary limit to how high a stock can go, and if the story is still good, the earnings continue to improve, and the fundamentals haven’t changed, “can’t go much higher” is a terrible reason to snub a stock. Shame on all those experts who advise clients to sell automatically after they double their money. You’ll never get a ten-bagger doing that.

Frankly, I’ve never been able to predict which stocks will go up tenfold, or which will go up fivefold. I try to stick with them as long as the story’s intact, hoping to be pleasantly surprised. The success of a company isn’t the surprise, but what the shares bring often is.”

Sage advice from an all-time investment great. According to Wikipedia, Lynch averaged a 29.2% annual return between 1977 and 1990, more than doubling the S&P 500 market index.

The author of 100 Baggers suggests an alternative he calls the “coffee can” method. The name is a throwback to a time when stocks were paper certificates. The idea is to stuff certificates into a coffee can and store it in a place where it will stay forgotten for years – quite the opposite of the “online brokerage” method where we can watch the fluctuations of our wealth all day long.

The outcome of the coffee can method is pleasantly often the following. Most stocks do unremarkably, but a few do reasonably well, and one does extraordinarily well making the returns of all others look paltry by comparison. The book has some entertaining anecdotes revolving around this theme.