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Archive for June, 2012

Research Affiliates’ Jason Hsu has a new article Selling Hope (.pdf) in which he discusses the reason investors persist in the seemingly irrational behavior of paying high fees for active management despite the numerous studies that show most active managers fail to deliver “alpha” over time net of fees:

The empirical evidence that the average fund manager underperforms and the recent top-performing funds do not outperform subsequently are irrefutable. Why, then, do investors insist on paying for investment management expertise, which isn’t all that useful? Perhaps investors are not really that interested in holding their investment managers accountable for outperformance. The Economist’s Buttonwood column 5 argues that investors might only be interested in securing advice that confirms their own investment beliefs. The false sense of security that comes from hearing a “professional” concurring with one’s own opinions on unpredictable affairs makes the randomness that is inherent in investing almost tolerable. Clearly, not all aspects of investment management are related to generating outperformance; many managers and advisors are really in the business of preventing their clients from making bad financial decisions, such as overconcentrating the portfolio, trading excessively or making decisions under emotional distress. Barber and Odean, in their 2000 Journal of Finance paper, found that aggressive self-directed investors underperform the market by an average of 6.5% per annum.6 These investors simply own too few stocks and trade too much due to overconfidence in their own stock-picking and market-timing skills. Jason Zweig, in his 2002 investigative report, documented that retail mutual fund investors underperformed the average mutual fund by 4.7% per annum.7 Again, this poor result is driven by investors actively switching between funds and market-timing their investment contributions.

Read the article here (.pdf).

See an earlier post on fundamental indexation.

H/T Tom Brakke’s @researchpuzzler

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Greenbackd has been quiet over the last few days while I finished “Simple But Not Easy,” my latest white paper for Eyquem (embedded below). If you want to receive similar future missives, shoot me an email at greenbackd at gmail dot com. Thoughts, criticisms, and questions are all welcome too.

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Greenbackd was honored to be one of the bloggers asked to participate in Abnormal Returns “Finance Blogger Wisdom” series. Tadas asked a range of questions and will publish them on Abnormal Returns over the course of the week. The first question is, “If you had a son or daughter just beginning to invest, what would you tell them to do to best prepare themselves for a lifetime of good investing?

I answered as follows:

Inspired by Michael Pollan’s edict for healthy eating (“Eat food. Not too much. Mostly plants.”), for good investing I’d propose “Buy value. Diversify globally. Stay invested.”

I feel that I should justify the answer a little in the context of the “What to do in sideways markets” post about Vitaliy Katsenelson‘s excellent book “The Little Book of Sideways Markets“. To recap, Vitaliy’s thesis is that equity markets are characterized by periods of valuation expansion (“bull market”) and contraction (“bear market” or “sideways market”). A sideways market is the result of earnings increasing while valuation drops. Historically, they are common:

We’ve clearly been in a sideways market for all of the 2000s, and yet the CAPE presently stands at 21.22. CAPE has in the past typically fallen to a single-digit low following a cyclical peak. The last time a sideways market traded on a CAPE of ~21 (1969) it took ~13 years to bottom (1982). The all-time peak US CAPE of 44.2 occurred in December 1999, all-time low US CAPE of 4.78 occurred in December 1920. The most recent CAPE low of 6.6 occurred in August 1982. I’m fully prepared for another 13 years of sideways market (although, to be fair, I don’t really care what the market does).

If you subscribe to Vitaliy’s thesis – as I do – that the sideways market will persist until we reach a single-digit CAPE, then it might seem odd to suggest staying fully invested. In my defence, I make the following two points:

First, I am assuming a relatively unsophisticated beginner investor.

Second, this chart:

Source: Turnkey Analyst Backtester.

A simple, quantitative, “cheap but good” value strategy has delivered reasonable returns over the last decade in a flat market. I don’t think these returns are worth writing home about, but if my kids can dollar cost average into an ~11-12 percent per year in a flat market, they’ll do fine over the long run.

The other responses are outstanding. See them here.

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From Michael Lewis’s Princeton University 2012 Baccalaureate Remarks:

The “Moneyball” story has practical implications. If you use better data, you can find better values; there are always market inefficiencies to exploit, and so on. But it has a broader and less practical message: don’t be deceived by life’s outcomes. Life’s outcomes, while not entirely random, have a huge amount of luck baked into them. Above all, recognize that if you have had success, you have also had luck — and with luck comes obligation. You owe a debt, and not just to your Gods. You owe a debt to the unlucky.

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I have recently read Vitaliy Katsenelson‘s excellent The Little Book of Sideways Markets. Vitaliy’s thesis is that equity markets are characterised by periods of valuation expansion (“bull market”) and contraction (“bear market” or “sideways market”). I think it’s a compelling thesis, but I am well and truly in the choir. I’m open to counterarguments. Here’s the Cliff Notes version of Vitaliy’s thesis:

Sideways Markets

A sideways market is the result of earnings increasing while valuation drops. Historically, they are common (this is one of many charts Vitaliy provides in support of his thesis):

Equity markets are going sideways

Equity markets are presently experiencing an extended period of valuation contraction, manifesting as increasing earnings, falling cyclically adjusted price-to-earning ratios (“CAPE”) and a sideways market.

While the S&P500 TR is approximately flat for the period from December 1999 to the present, valuations have fallen 52 percent, from a CAPE of 44 in December 1999 to a CAPE of 20.56 presently (via Multpl).

Shiller PE Ratio Chart

20.56 is not cheap.

Despite over a decade of dropping valuations, a CAPE of 20.56 is presently still well-above long-term averages (the long-run mean is 16.43 and the long-run median is 15.84), indicating that the market is still 25 percent to 30 percent above those averages.

The market probably wont stop at the averages. CAPE has in the past typically fallen to a single-digit low following a cyclical peak

Sideways markets can continue for some time. The last time a sideways market traded on a CAPE of ~21 (1969) it took ~13 years to bottom (1982). The all-time peak US CAPE of 44.2 occurred in December 1999, all-time low US CAPE of 4.78 occurred in December 1920. The most recent CAPE low of 6.6 occurred in August 1982.

What Would Vitaliy Do? Buy and Sell

Vitaliy advocates a systematic approach, buying stocks that meet his “QVG” or “Quality, Value, Growth,” framework, and selling, rather than holding. He deals with this in some detail in the book.

The book is excellent. I highly recommend it. You can purchase a copy here.

Full Disclosure: I received from the publisher a copy of Vitaliy’s book gratis. I would have bought it if I had not.

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Mark Spitznagel, CIO of Universa, released in May a prescient white paper called “The Austrians and the Swan: Birds of a Different Feather” in which he discussed the theory behind the “Equity Q Ratio,” a variation of Tobin’s Q ratio, and the expected returns to the market from various levels of Equity Q Ratio.

Tobin’s Q ratio is the ratio between the market value of the stock market and against the aggregate net worth of the constituent stocks measured at replacement cost.

It can be defined to include or exclude debt. We exclude debt for ease of calculation, and refer to it in this form as “Equity Q”.

Spitznagel observes that the aggregate US stock market has suffered very few sizeable annual losses (which Spitznagel defines as “20% or more”). By definition, we can categorize such extreme stock market losses “tail events.”

However, when the Equity Q ratio is high, large losses are “no longer a tail event, but become an expected event.”

Equity Q ratios over 0.9 lead to some very ugly results. So where are we now?

Ugly.

H/T Zero Hedge.

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Meb Faber’s World Beta has a great series of posts on  Graham / Shiller PEs globally as at May 24:

Meb says:

If you look at the history of country CAPEs, they tend to bottom out in single digits around 7. Bull markets can push this number up into the 40s, with the median around 18. These may be slightly skewed by most of these markets being in existence since 1970. (Note: All time lows register at 3 (Thailand and Korea) and top out near 100 (Japan).

Belgium, Netherlands, France, Spain, Russia, and Italy are all trading at CAPEs below 10. Generational buying opportunity or prelude to more pain?

The market has moved a little since Meb posted these. The S&0 500 stands this morning at 20.66, down from 21.76 on May 24. It’s still well above its long term mean of 15.48, and median of 14.45.

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