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.