“I found that the relationship between the Average and my individual stocks was confined within certain principles, but they could not be measured exactly. From then on I made up my mind to keep watching the Dow Jones Industrial Average, but only in order to determine whether I was in a strong or a weak market. This I did because I realized that a general market cycle influences almost every stock. The main cycles like a bear or bull market usual creep into the majority of them.”
-Nicolas Darvas, Nicolas . How I made 2,000,000 in the stock Market. Larchmont, NY: American Research Council, 1960.
It’s essential to make observations about the big picture to see what is going on, since the longer trends eventually have an impact on shorter trends.
Before March, the US economy was in the longest economic expansion on record. It was aged, to say the least. I pointed out several times the past year unemployment was at an all time historic low at 3% or so.
Now it’s 14.7%.
The stock market was in the longest bull market, ever. An uptrend in stocks is usually around 4-5 years before being interrupted by a -20% bear market decline.
This time it was 11 years.
Before March, I had been pointing out the S&P 500 was the second highest valuation going back over 140 years, according to Shiller.
The S&P 500 Shiller CAPE Ratio, also known as the Cyclically Adjusted Price-Earnings ratio, is defined as the ratio the the S&P 500’s current price divided by the 10-year moving average of inflation-adjusted earnings. The metric was invented by American economist Robert Shiller and has become a popular way to understand long-term stock market valuations. It is used as a valuation metric to forecast future returns, where a higher CAPE ratio could reflect lower returns over the next couple of decades, whereas a lower CAPE ratio could reflect higher returns over the next couple of decades, as the ratio reverts back to the mean.
Even after the S&P 500 stock index declined -34%, the S&P 500 Shiller CAPE Ratio is at a current level of 25.88, down from its 33.31 high in January 2018, but far from an undervalued level. In fact, it has so far just reverted to its 10 year average.
Long term bull markets have historically started at low levels, like 10. Bull markets historically end at high valuation levels, such as around 20. It’s far from a science and not a good market timing indicator. But, it helps us to understand the big picture risks/rewards. From a high starting point, we shouldn’t expect to see high capital gains from passive indexing.
Here is S&P 500 Shiller CAPE Ratio going back before 1900 to put it into context.
Even though the price to earnings ratio has fallen as the price fell, it isn’t anywhere near what we consider undervalued.
So, it is what it is.
If this is the early stage of a bigger bear market, it has plenty of room to fall before become “undervalued” and this may explain why
On Twitter today was some concern about the famous value investor Warren Buffett isn’t buying stocks. Instead, he’s selling stocks.
“Is it meaningful that Buffett has $137 billion in cash and $40 billion yearly in cash flows to deploy in Berkshire $BRK.B and he’s worried it might not be enough?”
Buffett is famous for buying stocks when others are panicking. But, he isn’t, et. The simple answer is the stock market in general remains at 25 times earnings by the Shiller measure, and it reached the lower teens in March 2009 and single digits before that before another secular bull market occurred.
Prices have to reach a low enough level to attract buying demand. As of now, we’re seeing it happened in March, considering the gains since the March 23rd low.
But, it looks like prices may have to fall a lot more before big value investors like Buffett get more invested.
An investment manager like me has much more flexibility. I’m far more quick and nimble, so I can make tactical decisions and then change my mind with liquidity.
If no buyers are willing and able to enthusiastically buy the stocks and bonds we’re selling, especially because we have to much of it, then;
Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical. Mike Shell and Shell Capital Management, LLC is a registered investment advisor focused on asymmetric risk-reward and absolute return strategies and provides investment advice and portfolio management only to clients with a signed and executed investment management agreement. The observations shared on this website are for general information only and should not be construed as advice to buy or sell any security. Securities reflected are not intended to represent any client holdings or any recommendations made by the firm. Any opinions expressed may change as subsequent conditions change. Do not make any investment decisions based on such information as it is subject to change. Investing involves risk, including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results. All information and data are deemed reliable but is not guaranteed and should be independently verified. The presence of this website on the Internet shall in no direct or indirect way raise an implication that Shell Capital Management, LLC is offering to sell or soliciting to sell advisory services to residents of any state in which the firm is not registered as an investment advisor. The views and opinions expressed in ASYMMETRY® Observations are those of the authors and do not necessarily reflect a position of Shell Capital Management, LLC. The use of this website is subject to its terms and conditions.
When a market is rising, we can let out the sail and enjoy the ride, but when the wind stops, we row, not sail.
I started using this analogy in 2005 after reading my friend Ed Easterling’s book Unexpected Returns, which is a fine example of the distinction in mindset between tactical and dynamic risk management decisions vs. traditional (passive) asset allocation.
About sailing, he said:
Most investors, especially those with traditional stock and bond portfolios, profit when the market rises, and lose money when the market declines. They are at the mercy of the market, and their portfolios prosper or shrink as the market’s winds blow favorably or unfavorably. They are, in effect, simple sailors in market waters, getting blown wherever the wind takes them…
In sailing with a fixed sail, the boat moves because it grabs the wind; it grabs the environment and advances or retreats because of the environment. Relative return investing corresponds to this fixed-sail approach to sailing. When market winds are favorable, portfolios can increase in value rapidly. When the winds turn unfavorable, losses can accumulate quickly. Bull markets are the friends of relative return sailors, and catching the favorable bull market winds and continuing to ride them are the secrets to making money in a bull market.
About rowing, he said:
Rowing, as an action-based approach to boating, is analogous to the absolute return approach to investing. The progress of the boat occurs because of the action of the person doing the rowing. Similarly, in absolute return investing, the progress and profits of the portfolio derive from the activities of the investment manager, rather than from broad market movements.
Around 2005 I taught a course to portfolio managers via DWA Global Online University on presenting global tactical investment management and dynamic risk management to investors because it was challenging to get clients to understand why we row, not sail.
For example, we use a chart like this one to illustrate the secular bull and bear market periods are made up of several years of uptrends followed by several years of crushing downtrends.
It doesn’t matter if you gain 100% or 200% in an uptrend if you lose your gains in a -50% downtrend.
The foundation of my ASYMMETRY® Investment Program that focuses on asymmetric risk/reward is a deep understanding of the mathematics of loss. Most of the investment industry tells investors they should hold on through losses. However, I believe investors’ natural instinct to limit loss is mathematically correct.
As we show in more detail on ASYMMETRY® Managed Portfolios: As investors are loss averse, losses are also asymmetric. So, the natural instinct to avoid large losses is mathematically correct.
A -50% decline requires a gain of 100% just to get back to where it started.
For example, the more than -50% loss in U.S. stock indices from October 9, 2007, to March 9, 2009, wasn’t recovered until late 2013, nearly six years after it started.
The -50% loss took a 100% gain and six years to recover.
As losses increase, more gain is necessary to recover from a loss. The larger the loss, the harder it becomes to get back to the starting point before the loss. This asymmetry of loss is in direct conflict with investors’ objectives and provides us with a mathematical basis for active risk management and drawdown control.
This is why I row, not sail.
When a market is rising, we can let out the sail and enjoy the ride, but when the wind stops, I get out the oars and start rowing.
I prefer not to sink to the bottom.
The last bear market may be becoming a distant memory of investors, but those who forget the past are doomed to repeat it.
It doesn’t matter how much the return is if the downside is so high you tap out before it’s achieved.
Mike Shell and Shell Capital Management, LLC is a registered investment advisor focused on asymmetric risk-reward and absolute return strategies and provides investment advice and portfolio management only to clients with a signed and executed investment management agreement. The observations shared on this website are for general information only and should not be construed as advice to buy or sell any security. Securities reflected are not intended to represent any client holdings or any recommendations made by the firm. Any opinions expressed may change as subsequent conditions change. Do not make any investment decisions based on such information as it is subject to change. Investing involves risk, including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results. All information and data are deemed reliable but is not guaranteed and should be independently verified. The presence of this website on the Internet shall in no direct or indirect way raise an implication that Shell Capital Management, LLC is offering to sell or soliciting to sell advisory services to residents of any state in which the firm is not registered as an investment advisor. The use of this website is subject to its terms and conditions.
It takes at minimum a full market cycle including both bull/bear markets to declare an edge in an investment management track record.
But we also have different regimes. For example, each bull market can be different as they are driven by unique return drivers. Some are more inflationary from real economic expansion driving up prices. Others are driven by external manipulation, like the Fed intervention.
I’ve been managing ASYMMETRY® Global Tactical for fourteen years. It’s an unconstrained, flexible, adaptable, go-anywhere global tactical program without the limitations of a fixed benchmark. I pursue absolute returns applying dynamic risk management and unconstrained tactical trading decisions across a broad universe of global currency, bonds, stocks, and commodities.
So, I can tell you the bull market 2003-07 was a regime of rising commodities, foreign currency, and international producers of commodities. In this bull market, U.S. equities have dominated. We can see that in the chart below. If your exposure up until 2008 was only U.S. stocks, you would be disappointed as Emerging Markets countries like China and Brazil were much stronger as was commodities. We can also see how those markets have lagged since the low in 2009.
Everything is impermanent, nothing lasts forever, so this too shall change eventually. Those who believe the next decade will be like the past do not understand the starting point matters, the return drivers, and how markets interact with each other. Past performance is never a guarantee of future results.
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Investment results are probabilistic, never a sure thing. Past performance is no guarantee of future results.
Most investors and their advisors seem to speak mostly about the stock market. When they mention “the market” and I ask “what market?” they always reply “the stock market”.
Why so stock market centric?
It must be that it gets the most media attention or stocks seem more exciting?. After all, other markets like bonds may seem boring and few know much about the many commodities markets or the foreign exchange markets. There are many different markets and two sides to them all.
If it’s risk-adjusted returns you want, you may be surprised to find where you should have invested your money the past 15 years. To make the point, below is a comparison of the total return of the Vanguard S&P 500 stock index (the orange line) compared to the Vanguard Bond Index (the blue line). Yes, you are seeing that correctly. Using these simple index funds as a proxy, bonds have achieved the same total return as stocks, but with significantly less volatility and drawdowns. This is why we never look at just “average” return data without considering the path it took to get there. A total return percentage gain chart like this one presents a far more telling story. Take a close look at the path they took.
Created with http://www.ycharts.com
I showed the chart to one investment advisor who commented “It looks like the stock market is catching up”. If that’s what you think of when you view the chart, you may have a bias blind spot: ignoring the vast difference in the risk between the two markets.
Looking at the total return over the period identifies the obvious difference in the path the two return streams took to achieve their results, but below we see the true risk difference. Drawdowns are declines from a higher value to a low value and a visual representation of how long it took to recover the lose of capital. When we observe a drawdown chart like the one below, it’s like a lake. These charts together also help illustrate the flaw of averages. The average return of the stock and bond index have ended at about the same level and have the same average return, but the bond index achieved it with much less drawdown. You wouldn’t know that if you only looked at average returns. If you tried to walk across the stock market lake, you may have drowned if you couldn’t handle swimming in 40′ of water for so long. If that one didn’t get you, the 55′ may have. The stock index declined about -40% from 2000 – 2002 and took years to recover before it declined -55%.
Created with http://www.ycharts.com
You have to be wondering: why didn’t you just invest in bonds 15 years ago? Maybe you were focused on the prior period huge average returns in stocks?
Before I continue, let me place a very bold disclaimer here: PAST PERFORMANCE DOES NOT GUARANTEE FUTURE RESULTS. Another way that is stated is that PAST PERFORMANCE IS NO ASSURANCE OF FUTURE RESULTS. One more version is PAST PERFORMANCE MAY NOT BE AN INDICATION OF FUTURE RESULTS. If you remember, the 1990’s were a roaring bull market in stocks. People focus on the past expecting it to continue. That’s probably why you never thought to invest in bonds instead of stocks.
Some of the largest and most successful hedge funds in the world have done that very thing over this period and longer. But, they didn’t just invest in bonds. They leveraged bonds. We’ve seen in this example that a bond index fund has achieved just as much total return as stocks. If you are a stock market centric investor: one that likes the stock market and makes it your focus, then you necessarily had to be willing to endure those -40% to -55% declines and wait many years to recover from the losses. If you are really willing to accept such risk, imagine if you had used margin to leverage bonds. The bond index rarely declined -10% or more. It was generally a falling interest rate period, so bonds gained value. If you were willing to accept -40% to -55% declines in stocks, you could have instead leveraged the bonds 400% or 500%. If you had done that, your return would be 4 or 5 times more with a downside more equal to that of stocks.
Why so stock centric?
Of course, at this stage, the PAST PERFORMANCE IS HIGHLY UNLIKELY TO REPEAT INTO THE FUTURE. Just as the roaring stocks of the 1990’s didn’t repeat. To see why, read Stage and Valuation of the U.S. Stock Market and Bonds: The Final Bubble Frontier?.
From my observations of investors performance and their advisors, most people seem to have poor results the past decade or so, even after this recent bull market. An investment management consultant told me recently that investors and their advisors who are aware of the current stage of stocks and bonds feel there is no place to turn. I believe it’s a very important time to prepare to row, not sail. For me, that means focus on actively managing risk and look for potentially profitable trends across a very global universe of markets; currency, bonds, stocks, commodities, and alternatives like volatility, inverse, etc . That’s my focus in ASYMMETRY® | Managed Accounts.
In The REAL Length of the Average Bull Market last year I pointed out different measures used to determine the average length of a bull market. Based on that, whether you believe the average bull market lasts 39 months, 50 months, or 68 months, it seems the current one is likely very late in its stage at 73 months. It’s one of the longest, ever.
I normally don’t consider valuations levels like P/E ratios, but they do matter when it comes to secular bull and bear markets (10 to 20 year trends). That’s because long-term bull markets begin at low valuation levels (10 or below) and have ended at historically high levels (around 20). Currently, the S&P 500 is trading at 27. That, along with the low dividend yield, suggests the expected return for holding that index going forward is low.
Ed Easterling of Crestmont Research explains it best:
The stock market gyrated since the start of the year, ending the first quarter with a minimal gain of 0.4%. As a result, normalized P/E was virtually unchanged at 27.3—well above the levels justified by low inflation and interest rates. The current status remains near “significantly overvalued.”
In addition, the forecast by Standard and Poor’s for 2015 earnings per share (EPS) recently took a nosedive, declining 17% during one week in the first quarter. Volatility remains unusually low in its cycle. The trend in earnings and volatility should be watched closely and investors should remain cognizant of the risks confronting an increasingly vulnerable market.
It’s always a good time to actively manage risk and shift between global markets rather than allocate to them. To see what that looks like, visit: http://www.asymmetrymanagedaccounts.com/global-tactical/