Mad Libs for Investors

The emotions are really starting to heat up. During most of the typical stock market cycle, most investors are able to keep their emotions well in check. That is particularly true of our clients, who tend to be a patient, mature, and generally cerebral bunch.

But during certain parts of the cycle, the mass of investors, including even our cohort of unusually smart and even-tempered clients, begin to behave less as individuals and more as a herd. As emotions take over, reasoning ability becomes compromised. Vision narrows, blood pressure elevates, time horizons shorten, and calculation gives way to expectation; what is happening right now becomes all important, while what is likely to happen longer-term appears entirely unimportant. The chance for profits seems both immediate and certain, while the danger of loss appears theoretical and distant.

With the market making new highs day after day, we are beginning to get those phone calls, and have those conversations. The content of these discussions sound something like this:

“Everyone is getting rich! Why do I still have cash?”

“We need to buy now!”

“I’m tired of underperforming when the markets are going straight up. I need a better strategy.”

At market extremes, whether the market is making exciting new highs or scary lows, the emotions of the crowd are a deadly danger to our long-term financial interests. At those market inflection points, our job as financial advisors is to refuse to validate our clients’ emotions as a basis for action.

That sounds really harsh. I still remember, more than twenty years later, one of my favorite clients, a retired woman of unusual grace and poise, telling me in a profoundly wounded tone, “You don’t want me to have any feelings!”

I was trying to explain to her, at the depth of the 2000-2003 market decline, that she should not sell out at the market low, amid all the bad news, as she had done in the three prior bear markets.

When my kids were younger, they loved Mad Libs, and filling out those forms prompted great hilarity during long car rides. “I need a noun! Now a verb! An animal!”

So here is a very simple Mad Libs style exercise about the current exciting market. I’ll provide four phrases with blanks, and a choice of words to fill them in.

Active investors are advantaged if they ______ low and ______ high.

Right now, the market is at an all-time ______. The mass of investors are _______ing. We should be _______ing.

The four words to use to complete our Investor Mad Libs are:

Buy

Sell

High

Low

(One hint. You will need to use only three of the four words.)

Please let me know if this exercise makes sense to you, and if it changes your current thinking in any way.

Ponzi Redux

“What we mostly learn from history is that people are unable to learn from history.”

Warren Buffett

Back in the 1920s, Carlo (Charles) Ponzi got an entire class of financial fraud named after him, when he convinced greedy investors that he had a mechanism to double their money in a short period by buying international postal coupons at a discount and redeeming them at face value. Hundreds lost their life’s savings in his scheme.

A Ponzi scheme, also called a pyramid scheme, offers apparently superior returns through some kind of financial legerdemain, but actually pays early investors with the funds of later investors. Pyramid schemes inevitably collapse when there are too many early investors expecting cash flow, or demanding their money back, and not enough new money flowing in to keep the illusion going.

The financial press has just broken the story of the collapse of a Ponzi scheme based in New York City, in which investors were promised high returns from buying up blocks of theater tickets for hot shows, which would then be re-sold at higher prices. The big draw for many was the understanding that they’d be capitalizing on the success of Hamilton, one of the most popular musicals in Broadway history, with the highest ticket prices ever.

Of course, there was no actual buying of theater tickets. A money manager cooked up the scheme to reimburse investors whose money he had misappropriated in his investment firm. Three guys were arrested, one is pleading, and the other two will go to trial.

Who was taken in by this nonsense? Surely only credulous old ladies on Long Island or the equivalent?

Actually, not. Among the victims were billionaire computer titan Michael Dell, billionaire hedge fund manager Paul Tudor Jones, an executive at Och-Ziff Management Group (an investment firm) and 125 others.

The moral of the story is that simply following the crowd, even the famous and supposedly sophisticated crowd, is no guarantee of good results. Often it is precisely the richest and most sophisticated who are the victims of scam artists. (See Madoff, Bernie.) If it sounds too-good-to-be-true, it very probably isn’t, you know, true.

The Election and Your Money

In past years, I’ve written on this topic once the results of the Presidential election are known. This year, I’m posting prior to the election, because some of the potential short-term effects of the election results are worth considering, so as to be ready if market dislocation follows next Tuesday’s vote.

This is my eleventh presidential election, and surely the most contentious. I won’t tell you how to vote, or even touch the arguments against the two major-party candidates. Good luck to all of us when we step into that booth and confront the duties of our citizenship.

What I will comment on is the investment implications of this election. You can also watch a recording of our recent webinar, The Markets & The Election Season. How will the results affect our portfolios? Is there anything we should do in advance of the election, either to protect ourselves or to maximize our opportunities? Are there actions we should be prepared to take after the election, depending on the result?

As always, let’s start by examining the data. We have really good data going back to the presidential election of 1952 about how U.S. financial markets have reacted in the short-term, over the two months on either side of presidential votes, to different election outcomes.

Here’s a summary of some of the key points:

  • Markets usually go up slightly in the two months bracketing the presidential election.
  • They go up more if the election is close.
  • If the election is a landslide, they go down a bit.
  • If the party in the White House changes, they go down. If the White House remains with the same party, they go up.
  • If a Democrat wins, markets decline, while a Republican victory sends markets up by exactly the same margin.
  • None of these historical moves averages as much as 2% in either direction.

So the best scenario for the markets is if the Democrats retain the White House by a slim margin, and a Republican wins the presidency. Which is clearly self-contradictory, and thus no help at all.

Does either party have a longer-term advantage? Yes, there is a slight advantage for Democrats in long-term returns. But if you deduct the market crash of 1929-1932, the Republicans have a slight edge. As investors, we really have no reason to prefer either candidate based on historical market reactions to partisan outcomes.

Is there a more reliable metric we could apply?

As we often do, we fall back on valuation. Economist Robert Shiller of Yale University won the Nobel Prize in Economics for his insight, captured in the Shiller CAPE (Cyclically-Adjusted Price Earnings ratio), that when stock market valuations are high, future returns are lower, and when valuations are low, future returns are higher.

The last two times the presidency changed hands, in 2000 and 2008, we used Shiller CAPE to inform our broad perspective on the markets.

In 2000, when George W. Bush finally won, valuations were high, and we warned that risks were high and prospective returns likely to be low. We took a defensive posture. As the tech crash continued through 2003, our portfolios largely avoided the market decline.

In 2008, when Barack Obama won a compelling victory in the midst of the worst stock market decline since the Great Depression, we observed that stock prices were below average. With risks lower and opportunities higher, we pounded on the table in favor of buying stocks. At the market bottom in 2009, our stock holdings were the highest ever. We were ultimately well-paid for owning stocks, as Barack Obama’s first term was one of the most profitable for U.S. stock market investors in a generation.

Today, market prices are high. With Shiller CAPE at 26.5 times trailing earnings, we are in the top 7% of historical valuations (93.6th percentile). Our portfolios are defensive, just as they were in 2000 when Bush 43 was elected.

A little more than a week ago, a Hillary victory with limited “coattails” appeared to be priced in.[1] A sharply different result—either a Trump victory or a Hillary victory with big coattails, giving the Democrats control of the House and Senate, would have been surprising, and thus likely to lead to a short-term market decline. (For what little it is worth, historically market returns have been highest with a Democrat in the White House and Republicans in control of Congress, just as we have now.) As Trump closed the gap, the U.S. stock market declined for nine straight sessions, the longest losing sequence since 1980. We have done limited buying during this decline, mostly for clients who were over-weight cash.

There is an aspect of our portfolio strategy that may intersect in interesting ways with the election results. While U.S. valuations are very high, all foreign stock markets are cheaper as measured by CAPE, without exception. We are overweight foreign equities.

To evaluate how this positioning might perform after the election, let’s examine the reaction of markets to the British vote on whether to leave the European Union (Brexit). Immediately before the vote, the final polls predicted Brexit would fail and Britain would remain in the EU. Markets rallied sharply. But Britons actually voted for Brexit, against polling predictions. Markets fell sharply, both in the U. S. and in Great Britain. But within weeks, markets fully recovered in both the U.S. and overseas. So far, so unremarkable.

But one market fell sharply and has continued to fall in reaction to Brexit—the currency market for the British pound, which fell by 6.0% the next day and has fallen another 10.4% since, with no sign of recovery.

What is the similar scenario in the U.S.? It would be a Trump victory, against the indications of the majority of polls. If we followed the Brexit path afterwards (no guarantees of that at all), we would see a sharp decline in the S&P 500, followed by a full recovery in stock prices, but we would also see a sharp and persistent  decline in the value of the U.S. dollar.

That single, entirely speculative scenario would actually benefit our target portfolios, because we are strongly over-weight foreign equities. A falling dollar increases the price of foreign stocks. Of course, there are multiple other scenarios under which we would not benefit.

Our advice is to exercise your franchise in line with your moral, political, and philosophical convictions, and to expect markets to react to the election results in unpredictable ways. Know that our portfolios are defensive and diversified, that we have cash available to invest in the event of a large market decline, and that we remain committed to a global perspective on investing. As always, we are devoted to your lifetime financial success, and none of our personal political perspectives will ever deflect us from making decisions solely based on what we believe to be your best long-term interests.

[1] A President’s election is said to have “coattails” when it also results in large gains for down-ticket candidates for Congress, Governorships, or state-house races. Examples during my lifetime were Johnson in 1964, Reagan in 1980, and Obama in 2008.

Brexit or Bust

As it happened, my wife and I were in Europe when the Brexit vote took place, and had several conversations with bemused Britons, Scots and Italians about the vote and its potential consequences. I was out of the office until July 5, so I missed the sharp market decline and equally sharp recovery, though I followed both the commentary and the market activity quite carefully.

The Economist, the English-speaking world’s most reliable source of utterly conventional wisdom, called the Brexit Leave vote “a senseless, self-inflicted blow.” Nigel Farage, head of Britain’s nationalist UKIP party, called it “a victory for ordinary people, for decent people.” Wealthy London, home to the UK’s powerful finance sector, voted to Remain, as did poorer, welfare-dependent Scotland. Most of the rest of the country voted to Leave.

The contrast says much of what one needs to know about the two closely-balanced factions throughout the West. Bureaucratic elites, finance types  and wards of the state versus strained working and middle classes struggling with a moribund global economy and stagnant wages.

The immediate consequences for the markets were negative. Worldwide, equity markets fell sharply, then rallied. For the second time this year, bears cried havoc and were proved wrong…or at least, premature.Markets dislike uncertainty, but amid record low interest rates on cash, stocks remain the preferred asset class. The dollar strengthened against both the pound (significantly) and the Euro (slightly).

A key investment principle is that disorder creates opportunity. The V-shaped market action (sudden fall, quick recovery) has been a pattern in recent years, as one market break after another has failed to transition into a true bear market. As usual, we took careful advantage of the market break to buy low in accounts with excess cash.

What will Brexit mean long term? That is very hard to predict. Protectionism weakens economic growth, but the UK leaving the EU does not necessarily mean adopting higher tariffs. All that must be negotiated.

Brexit is a very different proposition from Grexit. In the case of Greece, a net recipient of Eurozone transfers required immediate financial assistance in order to avoid defaulting on its obligations and possibly suffering a chaotic exit from the common currency. Brexit, on the other hand, contemplates one of the Eurozone’s wealthiest members, a net payer into the system, exiting the common market but not the common currency. (Britain never joined the Euro, keeping the pound.) Further, the Leave vote represents a mandate without a mechanism. There are provisions within the Lisbon agreement for member states to leave, but they have never been tested. Britain’s departure is likely to be a protracted process of negotiation and compromise. There could even be another vote repudiating the Leave vote.

We appear to be witnessing the end of the post-war project of economic and political integration in the Western democracies. That project paid great dividends, both in rising wealth and  (more important) in two generations of peace in Europe. (Or at least Europe’s core. The Balkans wars of the 1990s demonstrated the inability of united Europe to deal with even minor security issues, absent American leadership.)

Free trade and free markets create wealth, as Adam Smith argued centuries ago. But not everyone wins from globalization. In recent years, the economic benefits of a more-connected world have been concentrated in the hands of the finance sector and government. They have almost entirely bypassed the working and traditional middle classes. For those voters, Brexit was a rational rejection of the status quo.

Reducing regulation and bureaucracy, making markets more free and hence more dynamic and productive, could have widespread benefits. But higher growth would come at the cost of reducing both the power and the compensation of entrenched, unaccountable elites in both Europe and the United States. We’ll see whether those members of the New Class get the message.

The China Syndrome

Twice within the first week’s trading in 2016, Chinese stock markets were halted by a 7% “circuit breaker” designed to pause trading to allow panic selling to calm. When it became clear that denying investors liquidity for their shares was feeding panic, not calming it, Chinese officials wisely suspended the circuit breaker yesterday, on Thursday, January 7, 2016. Friday, Chinese markets inched higher, and most world markets followed.

China’s market problems immediately spread to the rest of the world. Here in the U.S., we had the worst first four days of trading in a new year since 1950. (Both 2008 and 1991 saw sharper declines, though they took five and six days respectively.) Those first four days alone officially qualify as a market correction for both the Dow and the NASDAQ, though not for the S&P 500.

There are several lessons here:

For years, there has been a disconnect between financial markets and the real economy, driven by monetary stimulus and access to easy credit. Rising stock prices became the self-fulfilling justification for further rises, largely decoupled from economic fundamentals. China’s problems with bad debts and malinvestment have been visible for five years or more, but the Chinese stock market continued to rise, finally peaking in June of 2015 after an astonishing 150% over seven months.

Though the combination of public and private borrowing, combined with cheap and easy money, can drive speculative excesses for shockingly long periods, they cannot do so indefinitely. In China, in Japan, in Brazil and Greece, we see again and again the ultimate consequences of stupid public- and private-sector investments fueled by borrowed funds. (Put another way, both Tom Friedman and Paul Krugman are idiots, though Krugman’s idiocy is fueled by ideology, not genuine stupidity.)

A heavily indebted world awash in cheap money is unable to generate sustained economic growth at a pace sufficient to lift incomes. More debts and more liquidity will not solve a problem caused by the destruction of both financial prudence and the possibility of rational price discovery. Durable prosperity depends on the action of free markets, with capital flowing toward projects with the highest economic returns. Empty, roofless cities in China, a train to nowhere in California, billions diverted to the private pockets of public officials in Brazil–none of these can provide a solution to stagnant global growth, but all can absorb capital, attention, and human creativity that would earn much higher rewards chasing genuine progress.

To return to robust global growth, we need a return to more normal interest rates and a reduction in the size and regulatory scope of government. (Who in the U.S. political system understands this? Certainly Fiorina, probably Paul and Cruz, perhaps Kasich and Rubio. Clinton? Surely not Trump or Sanders.)

Enough economic commentary. What are the implications of China’s meltdown for investment strategy?

For much of the last two years, our portfolio strategy has been defensive while U.S. stock prices (at least through mid-2015) continued to advance, with that advance highly concentrated in speculative tech stocks. We under-performed. Now that markets are falling sharply, our diversified, cash-heavy portfolios are holding value better than stocks in general.

We live in an interconnected global economy. That means there is no safe place to hide, while still earning positive real returns. (In a low-inflation world, you can hide in cash, but it surely will not provide returns sufficient to buy lunch, gas up the car, or put a roof over your head.) Here is the good news: globalization also means we have the ability to flow capital toward areas of genuine economic opportunity, across national borders, and between industries and asset classes.

There is a fundamental difference between 2007 (the market peak before the 2008 financial crisis) and today. Back then, nothing was either absolutely or relatively cheap. Today, there are huge divergences from historical price relationships, particularly between growth and value (value is cheaper than at any time since 1929, with the exceptions of 1998 and 1999), and between U.S. and foreign stocks. (U.S. stocks are more expensive than foreign developed-market stocks by a larger margin than we’ve ever observed, going back to the creation of the MSCI EAFE Index in 1969.)

Our long-term strategy remains the same. Avoid permanent impairment of capital; don’t own stupid, over-priced assets. Own more of those quality assets that are cheap according to robust historical measures. If the market crashes and they get really cheap, buy more.

 

 

Prediction vs. Valuation

Two weeks ago we hosted a quarterly investor call, discussing our strategy and our viewpoint on the financial markets. Afterwards we took questions.

The first question we got was, “When will the Fed raise rates and what will happen when they do?”

Our answer was to quote Warren Buffett’s observation: as investors, we are better at valuation than prediction. We can’t know what will happen in the future, no matter how badly we wish to, but even if we could confidently predict a future event, we would still be unable to reliably forecast its effects.

This past week, events demonstrated Buffett’s acumen yet again, and our borrowed wisdom in aping his viewpoint. With many investors publicly worried that the Fed would raise rates, and that the end of free money would hurt the markets, instead the Fed chose to stand pat on rates.

So the market went up, right? No, the market went down, concerned that the Fed’s restraint proved the world economy was in worse shape than we thought. (We are not the first to observe that the Fed is trapped in a Catch-22 of its own making.)

There are two takeaways here. First, forget about predicting. Second, markets that want to go up will interpret most news as bullish, while markets biased toward decline will go down on a similarly broad span of news. Right now the markets see the glass half-empty. Which helps us not at all, since sentiment can swing from greed/bullishness to fear/bearishness with shocking speed and unpredictability.

This leaves us with valuation. U.S. stocks remain very expensive by the long-term measures we find most persuasive, though another week or two of declines would change “very expensive” to merely “quite expensive,” with some limited implications for asset allocation. Foreign stocks are, relatively speaking, unusually, even extraordinarily cheap. That we can act on, never mind the Fed.

How’s My Crystal Ball?

Prediction is dangerous, especially when it involves the future.”

Yogi Berra                                   

Greece appears to be moving steadily toward implementation of the brutal terms imposed by the troika (EU, ECB, and IMF) as conditions for the provision of more liquidity to Greek banks and a new ESM loan to the government. There can always be further twists and turns to the Greek tragedy, but we’ve come far enough to assess the accuracy of my prior predictions in this blog. By my count, I got one of my three predictions mostly wrong, and a second correct in principle but wrong on magnitude. Here’s my scoring:

1) Who’s on First? I thought Greece’s new Syriza leadership (Prime Minister Tsipras and Finance Minister Varoufakis) entirely misunderstood the strength of their negotiating position. When you are going hat-in-hand to someone to whom you have previously lied when borrowing money, in order to borrow more money you simply must have in order to survive, you cannot possibly expect to dictate terms. Germany’s Angela Merkel was the key player on the other side, and she was never going to make any deal that would leave her constituents paying indefinitely for Greeks to enjoy better public-sector benefits than they themselves received. Score this one correct.

2) Outside looking in. I predicted that Greek hubris and miscalculation would place them outside the Euro by midsummer. I missed this one on two grounds. First, I underestimated the utter determination of much of the Eurozone to keep Greece in, despite the endless provocations of Tsipras and company. Second, I did not anticipate the ultimate complete surrender to austerity by Tsipras. While we can’t entirely discount the possibility of Tsipras and company snatching even-worse-defeat from the jaws of defeat, I score this one wrong.

3) Buy on the cannons. My final prediction was that significant market dislocation attendant on a Grexit would provide a buying opportunity for European equities, followed by a strong rally. I’ll score this one both semi-correct and unresolved. European markets declined but did not crash, making a low on July 8, then rallied a bit more than 6%. We’ll have to wait and see where European stocks go in the coming years, compared to U.S. equities.

There is one poorly understood aspect of the Greek drama I got substantially correct. The central problem for Europe was keeping Greece within the Euro while simultaneously discouraging the growth of anti-austerity parties in other Eurozone nations. Greece’s comprehensive failure to improve its position by electing a radical-Left government has been noted in other countries, such as Spain, where anti-austerity party Podemos has been losing support.

A quick aside. One of Warren Buffett’s fundamental principles of investing is that we are much better at understanding today’s values than we are at predicting tomorrow’s outcomes. In this respect, it is worth pointing out that my commentary on Europe’s crisis is intended to provide context for understanding our investment strategy, which remains entirely driven by relative prices and relative yields, and not by predictions–mine or anyone else’s.