Another person who generally has the same effect, and like Jeremy was a true hero to clients who really listened over the last decade, is James Montier. First at Dresdner Kleinwort, and then Société Générale (with another gem, his colleague Albert Edwards) James expounded on value investing, behavioral finance and the perils of modern finance. Not that the bankers of Société Générale listened.

In a career move that makes perfect sense James has now joined Jeremy at GMO. With James and Ben Inker the GMO team will deserve respect long after Jeremy is gone.

Which gets me back to WoW!

James has produced an analysis of the crisis and its aftermath that is close to perfect. Not only are the ten points and his discussion enlightening in and of themselves, but the wisdom of other great investors is liberally sprinkled throughout. This is one of those pieces that says exactly what I think about a host of issues, but better. Here are a few highlights:

Lesson 1: Markets aren’t efficient.

One would think this would be obvious by now, but no, it isn’t to many.

Lesson 2: Relative performance is a dangerous game.

Personally I believe that it is to the benefit of those of us who refuse to play the relative performance game, but managers, consultants and the industry in general conspire against looking at things differently.

On the subject of the industries obsession with deciding how to categorize returns as alpha or beta or any number of ever finer benchmarks:

Sadly, these concepts are nothing more than a distraction from the true aim of investment, which as the late, great Sir John Templeton observed is, “Maximum total real returns after tax.”

Such a simplistic mind you have James worrying about what ends up in the bank account rather than beating a benchmark or proving your results are “alpha” rather than beta.

It is also nice to see James noticing studies which show managers can beat an index, they bizarrely choose not to. Go figure.

Lesson 3: The time is never different.

We better hope it is this time, because the history of collapsing credit bubbles certainly argues for several years of economic distress.

Lesson 4: Valuation matters.

Ultimately nothing has a greater impact on returns in the stock market than the price you pay. This is consistently denigrated but consistently proves true over time:

Oh, and in case you were wondering, we presently reside on the expensive end of that chart.

Lesson 5: Wait for the fat pitch.

The problem with this is that investors are impatient:

As tempting as it may be to be a “man of action,” it often makes more sense to act only at extremes. But the discipline required to “do nothing” for long periods of time is not often seen. As noted above, overt myopia also contributes to our inability to sit back, trying to understand the overall investment backdrop.

Waiting for the “fat pitch” as Warren Buffett calls it requires one to realize:

1. cash is a position
2. that it is okay not to do as well as everyone else while waiting for the right opportunity
3. the necessity of investing in opportunities not dependent on the stock markets direction
4. that you should respect dividends
5. you need to act when everyone else is in a state of panic
6. that it is only useful to panic if you do so before everyone else!

Warren Buffett often speaks of the importance of waiting for the fat pitch – that perfect moment when patience is rewarded as the ball meets the sweet spot. However, most investors seem unable to wait, forcing themselves into action at every available opportunity, swinging at every pitch, as it were.

Lesson 6: Sentiment matters.

The more enthusiastic investors are, the more cautious you should be, and vice versa.

Lesson 7: Leverage can’t make a bad investment good, but it can make a good investment bad!

In and of itself modest leverage can help a good investment, but only if you can live with the volatility long enough for the good investment to pay off. Excessive leverage destroys the ability to hold.

Lesson 8: Over-quantification hides real risk.

James quotes the great Ben Graham:

Mathematics is ordinarily considered as producing precise and dependable results; but in the stock market the more elaborate and abstruse the mathematics the more uncertain and speculative are the conclusions we draw there from … Whenever calculus is brought in, or higher algebra, you could take it as a warning that the operator was trying to substitute theory for experience, and usually also to give to speculation the deceptive guise of investment.

This lesson especially appeals to me. As a long time fan of the “Its Bigger Than a Bread Box” school of investing I cannot agree more with the false sense of certainty and its dangers in applied investing. What I mean by “bigger than a bread box” goes back to lesson 6 and it paying most to act at extremes. Precision is not only unattainable then, but irrelevant. Look for something so important that getting it exactly right isn’t important. Everything else will likely amount to no more than short term noise.

I remember an investment committee meeting in early 2008 as the downturn we had been preparing for was in its early innings. The debate was going back and forth over how bad things might get. I decide it was time to cut to the chase:

Debating how bad things might get is like arguing after you have fallen off a building whether it is a 30 or 60 story fall. Either way you are dead. The real solution is the same either way, don’t fall off the damn building!

We moved on to how we should protect our capital and hopefully even profit from the coming collapse.

Here is another gem from James on how trying to mathematically calculate risk distracts us from what really matters:

In a depressing parody of the “build it and they will come” mentality, the risk management industry seems to believe “measure it, and it must be useful.” In investing, all too often risk is equated with volatility. This is nonsense. Risk isn’t volatility, it is the permanent loss of capital. Volatility creates opportunity. As Keynes noted, “It is largely fluctuations which throw up the bargains and the uncertainty due to fluctuations which prevents other people from taking advantage of them.”

We would be far better off if we abandoned our obsession with measurement in favor of understanding a trinity of risks. From an investment point of view, there are three main paths to the permanent loss of capital: valuation risk (buying an overvalued asset), business risk (fundamental problems), and financing risk (leverage). By understanding these three elements, we should get a much better understanding of the true nature of risk.

Interestingly, it is valuation risk which has proved hardest to avoid, and causes the most lasting damage to investors portfolios.

Lesson 9: Macro matters.

Big macro economic events can destroy what seems normal when it comes to valuation. The big risks need to be accounted for, even when they seem unlikely (bonus wisdom from the great Jean Marie Eveillard:

It often pays to remember the wise words of Jean-Marie Eveillard. “Sometimes, what matters is not so much how low the odds are that circumstances would turn quite negative, what matters more is what the consequences would be if that happens.” In terms of finance jargon, expected payoff has two components: expected return and probability. While the probability may be small, a truly appalling expected return can still result in a negative payoff.

[...]

Neither top-down nor bottom-up has a monopoly on insight. We should learn to integrate their dual perspectives.

Lesson 10: Look for sources of cheap insurance.

If low probability but disastrous events need to be accounted for, then finding ways to cheaply mitigate, or even profit from, them is important. Even if it is in the short term a drag on performance. Quality balance sheets in your stock holdings are cheap insurance right now, so are other strategies. We are closely looking at where cheap insurance can be found.

Read Ten Lessons Not learnt

Technorati Tags Ben Graham, GMO, James Montier, Jeremy Grantham, value investing

For some of the best and most insightful financial writing around I recommend combing through his archives. I occasionally do. Revisiting past musings of the greats may not be as immediately useful as some things, but longer term it allows a perspective that will serve you well over time. distributed raman amplifier

As one of the few who saw this crisis coming and how it might play out across the board, not just in particular areas, he deserves a listen. As one of the most successful investors of the last 30 years he would warrant a listen anyway.

Watch the whole thing.

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Technorati Tags Asset Allocation, credit crisis, Emerging Markets, equities, Housing Market, investing, Jeremy Grantham, Risk, value investing

Buried around a truism, the New York Times has produced a misleading and rather silly piece on the value of “predictions.”

The thrust of the piece is that predicting the markets and the economy, especially in the short term, is fraught with peril. True enough. That is why whenever giving our view of the future it is in terms of the risks one takes relative to the returns one might get. Hence the name of this site.

However, some things can be said, and often with a great deal of confidence. Timing is an issue, the magnitude can cover quite a bit of ground, but things can still be said. The problem for investors is that in a world filled with conflicts of interest and myopia how to tell which views on those tradeoffs to which one should pay attention? It is not that “predictions” (which is a term they use loosely) are to be ignored.

Anyway, that is the stated context for the article. The subtext however is the denigration of “outlandish” predictions, by which they mean those emanating from us negative nellies. Thus, the somewhat cautious claim of Bill Gross of a trillion dollars in losses related to the credit crisis is trivialized:

But despite this decidedly mixed track record, forecasters still enjoy a rapt audience, particularly at a moment when so much in the markets depends on the uncertain course of the housing market and the broader economy.

At investment and commercial banks, losses tied to bad mortgage investments, which now exceed $450 billion, are certain to rise further if home prices continue to decline and more
people default on their mortgages. Last week, Bill Gross, a prominent bond fund manager, offered another forecast for the final bill: $1trillion. Some market watchers say the figure could be even higher.

Obviously we will not know for sure until some time down the road, but it is interesting that Gross, as well as a number of others who have been hooted down for their alarmism, have consistently been proven to be too optimistic. The 450 billion dollar figure which everyone recognizes will go dramatically higher (that is math, not opinion) is already dramatically higher than we have been repeatedly told would be the most the losses would be.

Our firm, as well as a number of others, are not band wagoning here. We “predicted” that we would be fortunate if the losses didn’t reach a trillion or more. No precision, no claim to knowledge we didn’t have, just a little simple math which showed it would be “bigger than a breadbox.”

Despite that obvious track record which shows that some people saw at least the general outline, if not the exact shape of things, we get this kind of piffle:

Ideally, predictions on companies and stocks would be “thoughtful, nontheatrical forecasts that take a look at long-term fundamentals,” said Abby Joseph Cohen, a longtime strategist at Goldman Sachs.

But, Ms. Cohen added, less dramatic forecasts rarely make headlines. “If what is being provided to viewers and readers are these theatrical forecasts, that is what many people will pay attention to because that’s what they have available.”

Abby may be a wonderful person to have over to dinner, and a dear friend to have, but she is also someone who has led more investors over a cliff than any major strategist of the last ten years. Abby has been the outlandish one, as anyone who was unfortunate enough to listen to her in 1999 and 2000. I am sure she views the thoughts of those who have consistently stressed the risk levels and overvaluation of stocks over the last 10-12 years as being outlandish in their claims. However, look at the returns of the market over the last 10+ years (10 year return for the S&P500: 2.55%.) Pitiful.

“We have gone from an abnormally calm period, and we’ve blown right through normal volatility,” Ms. Cohen said. “We are in an exceptionally volatile period.”

Does anyone fact check at the Times? That is an outlandish claim. It is most decidedly not true. For those who wish to get a more accurate description of volatility today versus history, the essential Ed Easterling of Crestmont Research will bring you up to speed (pdf.) Listen to Abby at your peril.

This however tales the cake. First, the truth:

Another source of investment guidance used to come from research analysts, who try to predict quarterly earnings at companies. But there is a great deal of guesswork involved here, too. Analysts correctly predict earnings only a fifth of the time. Nearly two-thirds of quarterly earnings beat estimates, and the rest come in too low, according to data from Thomson Reuters. Many companies, of course, try to defuse overly optimistic forecasts to manage investors’ expectations and deliver “better-than-expected” results.

Then this nonsense:

This year, Wall Street’s crystal balls have performed even worse than in the past. As earnings season for the second quarter winds down, 67 percent of companies reported earnings higher than what analysts had predicted, and 22 percent reported earnings that were worse. Only 10 percent of companies matched analysts’ expectations.

We go from a decent point about how wrong analysts are to this misleading………

Okay, I will attempt not to get steamed. The problem with analysts is they are consistently too bullish, and by huge amounts. Exactly the opposite of what that statement implies. Yes, companies consistently beat the estimates when they are finally reported, but only after analysts slash those estimates almost down to the day the reports are made. This year companies have consistently failed to make estimates that were made just weeks earlier. Compared to what was “predicted” 3, 6 or twelve months ago the earnings have been dramatically lower. There is a problem with analyst predictions, and investors should be warned. However, this just muddies the issue of what those problems are. Conflicts of interest, behavioral biases, being too optimistic about the particular industries they cover (even when not conflicted) etc. It is not that they are too cautious about earnings prospects.

Then, to add insult to injury, we get this:

Poor predictions are nothing new in the financial world: in 1999, a pair of prognosticators — James K. Glassman and Kevin A. Hassett —published a book titled “Dow 36,000”; the blue-chip index closed last week at 11,370.

But investors seeking light in a dark period may just have to stick with no one’s predictions but their own.

That helps investors. We get evidence that some of the silliest predictions of the past were wrong; a false implication that analysts are often wrong, but too bearish; a plea from one of the most disastrously bullish strategists of our era not to listen to outlandish claims from people who have been proven correct; and people who make valid points (such as Taleb) are placed in a context with which I am sure they are uncomfortable; all in the service of a message that no one’s advice is worth taking. Never mind that most of the greatest investors of the past half century warned repeatedly that returns were likely to be unsatisfactory, regardless of this present crisis. Never mind that many, if not most, of those same voices warned repeatedly that the housing market was set for a fall, that a credit crisis was likely imminent, and on and on.

No, we shouldn’t listen to anybody.

Since the Times doesn’t want to tell you this, or examine it, I’ll jot down a few things to keep in mind.

• Analysts are almost always too bullish.
• As one of her sources, Taleb, would likely agree, economic models based on assumptions of equilibrium (essentially all of them) unsurprisingly almost always (until the horse is out of the barn) predict some sort of equilibrium, or at least a tendency to move back towards it. Thus economic activity is often well outside of their predictions. More importantly, “fat tail,” or extreme, events occur at rates far more frequent than their models assume. There are literally dozens of market and economic events which have occurred over the last century, when statistically (according to the assumptions of modern finance and economics) it was unlikely even one would happen.
• The real returns from stocks are much lower than most market commenters and professionals realize.
• You can with a fair degree of confidence predict most asset class returns over 5-10 years of time. I said with a fair degree, not certainty. Unfortunately most attempts to do so use unrealistic assumptions or historic returns. The first problem is obvious, but requires knowledge of what is reasonable. Most people use the latter, historic returns, as their guide. Big mistake.
• Also, somewhat off topic, though important nonetheless, stocks are not cheap yet, but they may still go up.
• I think it is unlikely they will not go lower from here.
• For Clients: If stocks do go up smartly and we don’t do as well as we could have, we have had a pretty darn good 12 months (or five years for that matter.) Trailing a bit now would hardly be a crisis, and as last year proved, we may not trail even then.

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Technorati Tags forecasts, media, New York Times, Risk

Jeremy never falls out of favor here, but then, we are a client.

Inevitably when he is early, as he generally is, people take it as a sign he is wrong, and note the returns he gives up when he frequently goes against the tide. However, the true test of what makes one right is where an investor ends up at the end of the day, not right after breakfast. The same goes for other irritating party poopers (nobody minds when they are positive) such as John Hussman, Ed Easterling and Rob Arnott. Their outstanding results over time are enough for some, others not so much

Their clients are pretty happy with their outstanding long term results. Trailing some years by a small amount and then whomping most people when what they expect to happen comes true leads to some pretty compelling returns, both in relative and absolute terms.

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Technorati Tags bears, Ed Easterling, Jeremy Grantham, John Hussman, Rob Arnott

Individuals who cannot master their emotions are ill-suited to profit from the investment process.

-Benjamin Graham

Technorati Tags Benjamin Graham, Great Investors, quotes

You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.

-Benjamin Graham

Technorati Tags Benjamin Graham, Great Investors, quotes

“The four most dangerous words in investing are ‘This time it’s different.’”-Sir John Templeton

Made more dangerous by the fact that occasionally, in some respects, it is. On that thin reed much damage has been done to investors.

Technorati Tags Great Investors, quotes, Sir John Templeton

Bottoms in the investment world don’t end with four-year lows; they end with 10- or 15-year lows.

-Jim Rogers

Technorati Tags Jim Rogers, quotes

As I wrote in April 2000, bear market psychology typically evolves something like this:

“This is my retirement money. I can’t afford to be out of the market anymore!”

“I don’t care about the price, just get me in!!”

“It’s a healthy correction”

“See, it’s already coming back, better buy more before the new highs”

“Alright, a retest. Add to the position – buy the dip”

“What a great move! Am I a genius or what?”

“Uh oh, another selloff. Well, we’re probably close to a bottom”

“New low? What’s going on?!!”

“Alright, it’s too late to sell here, I’ll get out on the next rally”

“Hey!! It’s coming back. Glad that’s over!”

“Another new low. But how much lower can it go?”

“No, really, how much lower can it go?”

“Good Grief! How much lower can it go?!?”

“There’s no way I’ll ever make this back!”

“This is my retirement money. I can’t afford to be in the market anymore!”

“I don’t care about the price, just get me out!!”

Heh, well I don’t think I see that kind of attitude yet. He makes some other points which I have discussed before, but bear repeating:

But as I’ve frequently noted, most bear markets are not simply one-way movements. Bear markets typically comprise two, three or more separate 10-20% declines, punctuated by fast, furious rallies. It’s easy to forget that the 2000-2002 bear included three bear market advances of 20% from intra-day low to intra-day high, as well as numerous smaller advances, all of which were surrendered in subsequent plunges to new lows.

What about earnings growth? I don’t think we will see much this year, but even if I am wrong I would suggest not getting too comfortable:

At the January 1973 market peak, earnings had hit a new high, and stock prices were selling at a P/E multiple of 20, which is extreme on the basis of record earnings. Over the next 2 years, corporate earnings grew by 56%, yet the market fell by half. The 73-74 bear market teaches that stock prices can decline from rich valuations even if earnings grow dramatically:

How that worked out is gone into in detail and with a bit of sass. As I said, well worth reading. Market history does not prove what will happen in the future, but it does prove that some beliefs cannot be counted upon.

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Technorati Tags Bear markets, history, Valuation

Secondly, this occurred at a time of what I believe is the first global bubble in pretty well all asset prices, so there is a much greater degree of broad-based vulnerability.

This is why traditional, long only diversification is likely to be less effective than in the last downturn, and even tactical, long only measures will be difficult to implement. What do you over weight if everything is expensive? In 2000 it was real estate, value, especially small cap value (like home builders) emerging markets, bonds, etc. Does anyone see those as a place to hide now?

People think the Federal Reserve can stop a bear market because they can throw money at it and lower interest rates. It is even more certain we can collectively stop a bear market if some fiscal stimulus is thrown in. To which I say, ‘Oh, you mean like 2000 and 2002?’ — when they threw what I call the greatest stimulus in American history, an unparalleled series of interest-rate cuts, cumulating in two, almost three, years of negative real returns, real interest rates coupled with a really substantial tax cut, which would never have happened without 9/11.

The combination would have gotten the dead to walk, and it stopped the bear market eventually. But the Standard & Poor’s 500 was down 50% and the Nasdaq — which was all anyone talked about back then — went down 78%. And a puny five to six years later, people are saying there is not going to be a bear market because the Fed is going to lower rates and because the government is going to have a stimulus package. But we have just been there, done that, and we had a nice bear market.

As stated here before, I watched a lot of people “not fight the fed” all the way to large losses last time around. Can we learn anything?

What about places to hide?

That isn’t something we can laugh off. Last time, there were plenty of opportunities: Bonds were cheap and TIPS (Treasury-inflation protective securities) were brilliant; real estate was cheap and REITs were brilliant. Even within equities, emerging markets were much cheaper than U.S. equities, and within U.S. equities, value stocks were only a little expensive and small-caps were only a little expensive and small-cap value was actually a little bit cheap. So you could really hide and could reasonably expect to make money, which we did in each of the three years of the bear market.

Uh, already addressed this, but let us look at another couple of themes of ours:

Profit margins, the great prop to the market, surprisingly defied the laws of gravity for three years in the developed world and, particularly, in the emerging world and even in Japan. That was because the global economy was stronger than any corporation counted on and, in the U.S., consumption was always higher and our savings rate was always lower than any corporate economist would have suggested, going into negative territory. But there are a few near certainties in this business — not many, but a few — and one of them is that abnormally high profit margins will go back to normal. The timing is unfortunately shrouded in fog. The other near certainty is that house prices will go back to a normal multiple of family income. In the end, we, the people, have to be able to afford the houses and they are affordable at something around 2.8 times family income. When they peak in Boston at 6 times and nationally at 3.9 times, you know you are in for tough times.

What about the magic elixir of lowering rates boosting economic growth?

It doesn’t have that much of a powerful effect on the economy. If it had any more profound effect, there would be a positive relationship between debt increasing and GDP growth, and there is none.

It doesn’t?

I have an exhibit that shows the 30 years prior to 1982 when the debt-to-gross domestic product ratio was completely flat at 1.2 times. Total debt is defined as government debt, personal debt, corporate debt and financial debt. Then in the 25 years after 1982, the flat line goes up at a 45 degrees angle from 1.2 times to 3.1 times GDP. Massive. In the first 30 years, when debt is flat, annual GDP growth is its usual battleship, growing at 3.5% and hardly twitching. After the massive increase in debt, GDP, far from accelerating, grew at 3%. So debt in the aggregate does not drive the economy. The economy is driven by education, man-hours worked, capital investment and technology. It is not driven by what I owe you and you owe me.

Of course it could have an effect elsewhere:

It drives down the dollar, which is inflationary, and, eventually, it could be seriously inflationary.

I think we have mentioned that we aren’t too hot on private equity as a diversifier for the moment, and we suspect it is in a bubble of its own. Jeremy nails down why:

I have yet to meet a private-equity firm that put into its spreadsheet the assumption that system-wide profit margins could decline by 20% to 30%. They have taken the current, abnormally high profit margins as a given and then determined to improve them by, let’s say, 15% and assume everything works out pretty well.

But if the base declines by 20%, even if they end up improving margins by 15%, they are going backwards. And if they pay the 25% premium up front, which was normal, and if they leverage 4-to-1, which was normal, then they almost precisely wipe out all of the clients’ money, all of the 20% in equity and if, perish the thought, they don’t add 15%, but add perhaps zero to 5%, then they do more than wipe out the equity, they leave the underlying debt in ragged disarray. That is the next shoe to drop on the credit side.

Jeremy was wise enough to avoid financials like the plague, and we took his advice last year. Thank goodness. Thank goodness we not only listened, but have a significant amount of assets invested with him. That, combined with our hedges, has turned out to be a profitable move.

His prediction, which seems about right given the numbers I have been watching, on the housing market:

It has a lot to go. It still has to drop 20% to 25% to reach more normal levels, or if you prefer, it could wait five years for income to catch up, barring no big recessions. With the housing market gone, people turned to credit cards and with economic times slowing down — whether there’s a recession or not — consumers are going to slow down a lot, are slowing down or have slowed down a lot.

Update: For those without a subscription, Seeking Alpha has the beginning of the interview.

Technorati Tags Barron's, bubbles, debt, Federal Reserve, Housing Market, Jeremy Grantham, profit margins, stimulus, stock market, Valuation

On the investment merits however, stocks in general are at extreme levels only exceeded significantly by the recent tech bubble. Only by comparison to the elevated levels of the last 15 years can the S&P 500 be considered even reasonable, much less inexpensive. Unlike 2000 when many asset classes were reasonable, and only cap weighted indexes and a few components were expensive, almost all asset classes are overvalued. In many ways, from a valuation standpoint, this is a far more tenuous situation than 2000 when you could easily select assets that had not taken part in the bubble. Now there are few places to hide.

So no, the market hasn’t “discounted” a recession. Even the idea that the U.S. economy is in recession is contentious. The S&P 500 is off only about 10% from its record highs, recession concerns and a weakening of profit margins are not reflected in market prices. At best, they are discounting a slowdown based on the assumption that recent earnings growth and profit margins can be extrapolated longer term once we get past it.

John Hussman put it well (my emphasis)

Similarly, in stocks, analyst estimates reflect a quick return to record profit margins about 50% above their historical norms. If those assumptions disappoint and it becomes clear that profit margins will not be forever sustained at record highs, it doesn’t only imply near-term earnings disappointments – it implies that the whole stream of future earnings impounded into stock prices is wrong.

Since I believe this has been a long term issue, how bad has the valuation penalty been so far? Since April of 1998 the return of the S&P 500 has been below that of Treasury bills. That is almost 10 years! Since 2000 the S&P 500 has trailed inflation. In fact, the S&P500 has trailed treasury bills since Nov. of 2005 as well.

Is the market significantly cheaper than in 1998? No. Should we expect better going forward? No. The likely path is we will get similar or worse returns in an interesting way.

So, who will make money with real returns that an investor might consider satisfactory? The lucky, savvy speculators, the hedgers (I put my money on L/S guys in the vein of Julian Robertson) tactical asset allocators who hedge and protect capital (using some of the above) etc. Indexers, closet indexers and other low tracking error portfolios will disappoint.

Vitaliy Katsenelson, author of Active Value Investing: Making Money in Range-Bound Markets (Wiley Finance)points out some of the reason’s markets aren’t as cheap as they seem (and even then we are talking about p/e ratios well above “average.”)

Unfortunately, the cheapness argument falls on its face once we realize that pretax profit margins are hovering at an all-time high of 11.9%, almost 40% above their average of 8.5% since 1980. Once profit margins revert to their historical mean, the “E” in the P/E equation will decline. If the market made no price change in response, its P/E would rise from 17 to 23.8 times trailing earnings.

Maybe profit margins will stay high?

Profit margins revert to the mean not because they pay tribute to mean-reversion gods, but because the free market works. As the economy expands, companies start earning above-average profits. The competition reacts to fat margins like bees sensing sugar water. They want some, too, so they fly in and start cutting into these above-average margins. This always has happened in the past, and it will happen again and again in the future.

Let us see a chart, we all love charts:

Vitaliy deals with the most common reason’s people believe “it will be different this time.” So read the whole thing.

Let us move on to the misuse of forward operating earnings. Comparing the historical PE ratio to forward earnings estimates fails the smell test in a number of ways. The proper comparison would be to historical forward PE’s, not trailing PE’s. On that basis we end up with a lot lower forward PE to call “average.” Throw in the elevated profit margins and we get some really scary numbers for the market to get to “average.” John Hussman:

Now, to the issue of P/E ratios based on forward operating earnings. As noted above, it’s clear that forward operating earnings are generally much higher than the record level for trailing net earnings to-date, and of course, record earnings are always equal to or higher than raw trailing earnings.

Investors are used to the idea that “normal” P/E ratios are typically in the range of 14 to 16. But as Cliff Asness of AQR has repeatedly stressed, those norms are based on raw trailing earnings. If you calculate P/E ratios based on earnings figures that are higher, you clearly obtain lower P/E ratios.

As it happens, the long-term historical norm for the P/E ratio based on forward operating earnings would be about 12.

Of course, that means we get a chart:

Look closely. Exactly when has the market been more expensive on the basis of forward earnings? The mid 60’s, which led to one of the worst periods for stock returns in market history. 1987 which corrected in a day and of course the entire late 90’s to now. All periods of severe under performance.

Uh, John gives us a caveat:

Of course, that average of 12 includes the heights of the late 1990’s bubble. The historical average was just 10.6 prior to that point.

I am inclined myself to throw out the late 1990’s (we do all agree now that the valuations of that period were insane, whatever we said at the time, right? So should insanity be used to justify anything?) Your mileage may vary. Back to those profit margins (my emphasis)

It gets worse. Currently, profit margins are at the highest level in history, which further reduces the P/E multiple we observe. If investors wish to use that observed P/E ratio as their standard of value without normalizing for profit margins, they should be aware that they are implicitly assuming that profit margins will remain at current levels indefinitely.

Okay, another chart:

The following chart presents the ratio of forward operating earnings to S&P 500 revenues (net profit margins are even more volatile).

Chart: Historical Profit Margins (Forward Operating Earnings / Revenues)

You’ll notice that prior to 1995, there were only a few instances when operating profit margins exceeded 8%. At those points, prior to the late-1990’s bubble, the forward operating P/E for the S&P 500 averaged just 8. That’s not a typo.

No, I am not predicting an 8 PE down the road. I am saying that in any historical sense the markets are not, and have not, been cheap. That is why returns have been low, below that of treasury bills for a very long time, and likely to be so over any reasonably long term interval going forward.

Go ahead and read John demolish the “Fed Model” of valuing the stock market while you are at it. In fact, Go ahead and read this from John on that very subject as well.

For further thoughts, check out Barry Ritholtz’s similar demolition. He gives us another chart on the ridiculousness of forward operating earnings from the Wall Street journal:

Look at that. How do we get from 3% and 4% for the first two quarters (which I find unlikely in and of themselves, but maybe) to 16% for the year? From Barry (my emphasis)

Analysts are unflaggingly inaccurate at turning points. Example: Q3 S&P500 earnings consensus were +8% — S&P500 earnings came in at -8%. Q4 has been similarly lowered, undercutting the earlier forecasts of undervaluation.

Now let’s look at 2008. S&P 500 forward earnings over the next 4 quarters are as follows: Q1 = 3%; Q2 = 4%; Q3 = 20%; Q4 = 50%, according to UBS.

Earnings explosions like the ones above generally only occur after earnings collapses. Earnings grow reliably at about a peak of 6% over the long term, and the average is lower. In fact, the average is only around 1% over inflation depending on your point of measuring (it looks a bit higher now, it was a good bit lower at the trough of the last earnings collapse.)

Since clients may read this I want to reiterate that seeing the challenges ahead are exactly what this site, and our investment policy, is all about. The reason we have done so well, especially over the last year, is that we have expected and accounted for these, and other, factors we have been covering. The danger is for those investors, or their advisors, who haven’t faced up to the implications of high valuations.

We’ll deal with the Fed Model in more depth here at Risk and Return in the near future. John and Barry hit some of the highlights, but there are fundamental issues which I think deserve more exploration.

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Technorati Tags Asset Allocation, Fed model, indexes, John Hussman, Julian Robertson, operating earnings, return, Risk, S&P500, Valuation, Vitaliy Katsenelson

First, Jeff tackles the subject of stock buybacks and the piece echoes some of the issues I brought up in my post, The False Promise of Buybacks. Except, his version is more entertaining. So go read The Shareholder Letter You Should, But Won’t, Be Reading Next Spring which is part of his post “The Great Private Equity Cash Robbery of 2007.” I will note two interesting points he made prior to the shareholder letter:

So, was yesterday morning’s 400-point opening decline the selling climax?

[...]

Well, as far as NotMakingThisUp is concerned, the most obvious thing missing in all of yesterday’s headlines was this: no share buybacks were announced by any major company before, during or after the brief morning sell-off.

Not one.

During the panic of October 1987, grey-beards will recall, the tape was clogged not only with headlines of trading-halts amidst the worldwide rush to sell, but also with a steady stream of share buyback announcements by U.S. companies.

Coke, P&G and many others that week and in weeks subsequent to the Crash of ’87 used the substantial cash on their balance sheets to take advantage of the market dislocations that caused even the good stocks to be sold with the bad, and cannily bought their own stock back at deep discounts to its inherent worth.

Why then, were there no share buy-backs announced yesterday?

Could it be that the Great Private Equity Cash Robbery of 2007, in which previously healthy companies either “cleared” their balance sheets of cash—to use the euphemism employed by Steve Odlund, the Chief Cash Clearer at Office Depot—by buying back their own stock at bull-market peaks or faced the prospect of having it cleared for them by the Private Equity Cash Robbers?

I guess Jeff agrees with my friend Tim on this one.

My next recommendation is that you read the entire series he has put up on Warren Buffett’s purchase of Dairy Queen.

I am of course a great fan of Mr. Buffett, but like Jeff I am under no illusions about what the great hedge fund manager is doing. He is making money. He is interested in protecting his company’s shareholders interests, not those of the shareholders from whom he is acquiring his companies. Value investing means underpaying.

The series is a great introduction into looking at a transaction from multiple perspectives. It is a human story, and a financial story, with fascinating characters. Jeff’s biting wit makes it all the more enjoyable.

Part I, Part II, Part III.

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Technorati Tags Dairy Queen, private equity, stock buybacks, Warren Buffett

All About Alpha reviewed some of his points a little over a year ago, and I suggest reading the whole thing, but I particularly like these two takeaways:

In his opinion, alpha/beta bifurcation is somewhat of a red herring and we should just accept returns for what they are. (North American readers may be reminded of that old Reese’s Peanut Butter Cups commercial where a person eating chocolate bumps into a person eating peanut butter and they both declare that the (fortuitous) combination “tastes great!”. But in this case, Arnott might re-write it: “First guy: Hey, you got alpha in my beta! Second guy: No, you got beta in my alpha! Together: Mmmm, performs great!”)

and

In conclusion, Arnott accuses the finance industry of being too quick to hold onto theory in the face of conflicting empirical data. In the field of physics, he explains, scientists rejoice when conflicting empirical data is uncovered since it gives them an opportunity to advance their theories and create new ones. But in finance, Arnott says we tend to question conflicting data sets and conclude that they are either flawed or simply too small.

Because experience so conflicts with academic theory, advice, especially in the media, tends to often fall in the category of “pretty good advice that isn’t really true.” Advice that keeps investors (professional and amateur) from doing things which are likely to blow up in their face and/or give in to fear and greed.

However, instead of just saying “you can’t be trusted with the truth,” an unwelcome piece of advice, they instead lean on academic theories which justify that we have no insight on the future, act as if returns and risk are always correlated positively, that past returns are pretty good guides to future returns (even as they say past performance isn’t a guide) etc.

More on examples of this type of thing in coming days.

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Technorati Tags alpha, beta, finance, investing, investment advice, Rob Arnott

To paraphrase [value investing pioneer] Ben Graham, the markets seem high, they are high, and they are as high as they seem.

-Jean-Marie Eveillard

I know, I know. This isn’t what you here, but they are.

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Technorati Tags Jean-Marie Eveillard, Valuation

The great paradox of our business is that reducing or avoiding real risk in portfolios can seriously increase career and business risk, which rises with any deviation from standard behavior. So everyone has to manage his or her own career risk, and being too extreme or ‘wrong on your own’ has cost many people their jobs, however right they might eventually have been.

[...]

By exceeding the client’s tolerance for short-term underperformance and getting fired, you commit a substantial disservice to yourself as a manager, but even more so to the client, who has not only underperformed with you, but then in addition often transfers into a stronger performing alternative, usually doomed to suffer the consequences of a mean-reverting world by falling badly just as the investment strategy they terminated recovers. And we have certainly been there and done that!

-Jeremy Grantham

Needless to say that is the concern of myself and Jeremy, I certainly do not expect many of our readers to care about our fate. However, the lesson applies to our individual behavior as well. We wish to go with the herd, especially when the ride is fun, when we can talk with our coworkers about our gains and adventures. When we lose we can all commiserate over our losses together. Not doing well when everybody else is, is what we at all costs wish to avoid. That is how we are wired as human beings. It is an important aspect of our humanity, but it can be disastrous for investing.

Some delude themselves they are different, the wisest know they are not and establish ways to compensate and check this unprofitable impulse. Those of us who invest for others have to manage that risk very carefully, from both ourselves, and our clients.

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Technorati Tags career risk, investing, Jeremy Grantham, underperformance

Finally it is the long-term investor, he who most promotes the public interest, who will in practice come in for most criticism, wherever investment funds are managed by committees or boards or banks. For it is in the essence of his behaviour that he should be eccentric, unconventional and rash in the eyes of average opinion. If he is successful, that will only confirm the general belief in his rashness; and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy . Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally
-John Maynard Keynes

Random Roger wants to know what his readers think of the strategy of trying to replicate the type of portfolio that David Swensen of Yale has created.

It is certainly a good question, as Yale’s returns are stunning. His interest is peaked by taking a look at this article in Registered Rep magazine.

So what do I think? I suspect regular readers, and our clients, know we are enthusiastic about the approach, though we do tackle it a bit differently. So Let’s take a look at what Yale does, and David Swensen recommends for retail investors:

YALE ENDOWMENT ASSET ALLOCATION TARGETS

Real Assets 27%
Absolute Return 25%
Private Equity 17%
Foreign Equity 15%
Domestic Equity 12%
Fixed Income 4%

Source: Yale Corporation

SWENSEN’S RETAIL ASSET ALLOCATION TARGETS

Domestic Equity 30%
Foreign Developed Market Equity 15%
Foreign Emerging Market Equity 5%
Real Estate 20%
Short-Term U.S. Treasuries 15%
Inflation-Protected U.S. Treasuries 15%

Source: David Swensen

Actually, not a bad strategic allocation on the retail side, and according to Registered Rep it did pretty well through last Summer. What it lacks is any direct hedging similar to the absolute return option, Real assets other than Real Estate, and Private Equity.

Real Assets can be replicated to some extent through ETF’s and some mutual funds. Absolute Return vehicles can include long/short funds, Managed Futures, and for some, actual hedge funds. In addition, direct hedges from mutual funds can be used where appropriate. You will not have access to the favorable cost structure that Yale gets.

A word about Private Equity.

David Swensen speaks to this in his book Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment but some of the lack of volatility is a statistical artifact present in some of his real assets and private equity. Since they are illiquid, the value of these investments often cannot be known, it is estimated or marked to model, rather than to the market. In reality Private Equity is both very volatile, and likely very correlated to the public equity market.

What Private Equity really provides to Yale, is higher returns. Swensen believes they can get top managers, but he admits that if you don’t have top managers that Private Equity does not even outperform once adjusted for risk. He feels though that the dispersion of skill is higher, and that with proper due diligence it can be identified. His results seem to confirm that.

Our twist upon this theme

So, whether we are talking about non accredited, or accredited, investors, how does our approach differ and can it be replicated? We add a tactical element. That goes for private equity as well. In our discussions we have been very wary of private equity, we didn’t think money being invested over the recent past was being invested in a way likely to generate much return, and possibly it would be disastrous. In essence we saw a Private Equity bubble about to pop.

The returns had been reasonably good mostly due to leverage built on easy access to credit. Leverage is fine if you know what you are buying, our suspicion is that most people didn’t realize the risk they were facing if the market turned south, credit dried up, recession, etc. To put it another way, the risk vs. return ratio was out of whack. I think our fear during that time of greed was as usual a good thing to have. We may get a bit greedier when there is a lot more fear in general.

Yale has a pure strategic asset allocation, in essence the managers in the Real Asset and Absolute Return spaces make the tactical decisions. We do the same, but we also tactically increase and decrease (within the constraints of the Investment Policy Statement of our clients) our net exposure to any given traditional benchmark, or beta. We are quite willing to hedge our exposure to US stocks for example, or to go short one part of the market, long another. That is, if we see the expected gap in performance over a two to three year time span as being quite large. We don’t want to be operating in the area where random noise can eliminate that potential return. “Fat pitches” only need apply when it comes to such strategies.

In addition, when upside returns look low, and the potential downside looks high, we increase our allocation to absolute return managers and strategies.

That goes to the problem I have with the strategic retail portfolios I see discussed by Roger and his links (including in the comments.) While over the long haul I believe a portfolio such as the ones examined might do better than more traditional allocations with consistent rebalancing (they have in the past) I don’t think it will get investors where they want to be over the nearer term, say the next five years, and it will take some awfully good years for them to ever catch up to the type of compounded rate of return investors expect.

Unlike 2000-2006, a period that started with a few over valued areas and many components of the market ranging from reasonably priced to under priced, nothing as an asset class is cheap right now. The reasons Real Estate (in the form of REIT’S) was such a fine diversifier are not as applicable now. Traditional asset class diversification may help (though adding huge slugs of Real Estate, something until recently we have always had, made little sense when the article Roger is discussing was written) but it will likely lead to very low returns relative to history. After eight years of low returns another five to seven more is likely to really alter people’s financial plans.

Rather, we suggest adding in diversification of strategies as well. That means portable alpha, or portable alpha inspired strategies, hedges and other strategies to emphasize absolute returns at the portfolio level until markets go through an extended cathartic sell off. Until that happens, whether over the next six months or three years, permanent returns are likely to be hard to get with a mix of diverse, but over valued securities. The eventual sell off will likely eliminate most of the returns gained during any upturns, leaving the investor with returns barely above, and quite possibly below, the rate of inflation. The most over valued areas should likely just be avoided or used as a hedge.

Of course, as Jeremy Grantham recently pointed out, cash isn’t such a bad thing either.

To put it another way, the publicly traded diversifiers of the past have been bid up in price and are now likely very correlated, at least on the downside.

What is the longer term problem with tactical approaches?

They are difficult to do. Both from a knowledge standpoint, and psychologically. Most investors, including professionals, have no idea what the historical valuation of the market is, or what return the market is priced to deliver in various asset classes. Essential information to adequately pursue this kind of strategy.

As the quote I began this post with states, the largest constraint is the psychological will to allow themselves returns that do not track the larger market. We say we want non correlation, but what we mean is we don’t want to go down with the market. The idea of not tracking the market on the upside is not what we want to hear. Even tremendously successful investors, like Jeremy Grantham, Rob Arnott and John Hussman suffer for the impatience of their clients, no matter their great track records and the logic of what they are doing.

Yet, unless one has the ability to time pretty closely the market, that is exactly what you have to do to carry off such a strategy. That will also be true of the type of replicated portfolios Swensen and others are proposing. The goal is performance over several years time. Hedges which over time turn out hugely profitable will not be received kindly during the upward marches which populate even extreme bear markets. Intelligent active asset allocation is therefore the province of the few and the thick skinned, thus the popularity of static strategic asset allocation.

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Technorati Tags Asset Allocation, bonds, Commodities, David Swensen, Hedge Funds, portfolio management, private equity, real assets, real estate, Risk, stocks, Yale

Now celebrating 10 years of predicting the end of the world, George Soros takes a huge dive into the pool of confirmation bias

Go read what he is referring to. Not only is that a compelling image and well written sentence, he is right.

I know, I know. In most circles I am the prophet of doom, and have been for quite some time, with the exception of a brief respite starting in the summer of 2002. However, that is because of valuation. Crises, panics, speculative excess, recessions, fraud, bull markets, economic booms and general foolishness are what makes investing so interesting. It is also ultimately profitable for those of us willing to resist the markets siren song and invest with an eye to the actual economic return of financial assets rather than the daily movements and fads. Those things work out.

Low returns overall, my definition of a bear market, as opposed to the gyrations of intervening days, months and years, are driven by valuation. Financial assets are generally over valued, so I expect the risk in any of our foolishness, whether I identify it or not, to be rather high.

Soros however really believes actual honest to goodness doom is around the corner, and has for a looong time, not just low returns.

Oh, and clients, I promise you, we don’t expect low returns for you. I hope our results over the last two years, and even in this New Year, demonstrate it is not a vain hope. If this site seems rather pessimistic, I must remind you of one key truth, to solve a problem one must first recognize that there is one.

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Technorati Tags bear market, george Soros, recession