“The individual investor should act consistently as an investor and not as a speculator.”
– Ben Graham
Ben’s admonition is always true, but it’s more true at some times than others. It’s very true today, as investors go on riding the Balloon of No Hard Landings into the stratosphere, clinking their champagne glasses and avoiding looks down over the side of the basket as terra firma recedes ever further. My friend Michael Lebowitz of 720Global has already parachuted out of the balloon, and in today’s Outside the Box he tells us exactly why.
He begins with one of his favorite themes, the contrast between investment conditions in the early 1980s – when an unconventional president had just been elected to tackle a dicey economy and generally shake things up – and today. Conclusion? “The risk-return profile of 1981 is the polar opposite to that of today.”
When – not if – the balloon springs a leak and loses a lot of gas, how will those on board react? If they have waited too long to jump off, they may go kersplat before their chutes can deploy: permanent loss of capital. But it can be quite unnerving to be slung under a leaky bag of volatile gas, with your basket rocking wildly as it’s buffeted by heavy winds, knowing that the hard, stony ground of a market bottom is approaching at an ever-accelerating rate.
I went to add a few comments to Michael’s. Ed Easterling just shot me a note with the observation that we may about to have the third day in a row when the VIX closes below 10. There have been only 11 days out of some 6900, going back almost 28 years, when we’ve had a sub-10 VIX. When I look carefully at those dates, the word complacency leaps to mind.
Current implied volatility is at a level that has been experienced only 0.22% of the time since 1990, and it has almost halfed from its long-term average.
I’m going to be writing about this in two weeks, but the current massive move into passive investing is distorting the markets. Noted value investor Seth Klarman described it this way in his recent letter to clients: “One of the perverse effects of increased indexing and ETF activity is that it tends to ‘lock in’ today’s relative valuations between securities. Thus today’s high-multiple companies are likely to also be tomorrow’s, regardless of merit, with less capital in the hands of active managers to potentially correct any mispricings.”
The movement into passive investing is resulting in active managers’ losing their edge because of their inability to discern between overvalued and undervalued companies. There has been a great deal of whining and teeth-gnashing over this by active managers, and I guess I understand their sentiments, except that blaming the market for your lack of alpha is pointless. The market is what the market is, and as a manager you have to deal with it.
Which is why I want to start talking to you about how to handle what I’m calling the Great Reset in our future. But for now, let’s pay close attention to what Michael has to share.
For those of you coming to my Strategic Investment Conference in two weeks, let me mention that there will be private breakfasts available Tuesday, Wednesday, and Thursday. Tuesday and Wednesday will be hosted by Altegris Investments and will be available only to qualified investors, which means a net worth of $5 million or more. Tuesday I will be interviewed on my actual portfolio as it exists today, which is something I've never talked about. Wednesday will feature a very famous hedge fund manager. On Thursday we’ll be joined by a local friend, a successful oil exploration entrepreneur who will talk about what is happening in the Permian Basin in West Texas. What they’re doing is truly amazing, and those of you who are interested in oil technology and exploration will find it fascinating. On top of an already fascinating conference.
Tonight David Shepherd, of the eponymous firm based in Boston, is bringing some of his cohorts down; and instead of making the traditional steakhouse run, he has asked me to cook chili. I think I will surprise them with a little prime and some of my mushrooms, and maybe Shane and I will whip up a few other delightful items, too. A few of my friends have encouraged me to have a cameraman come in and document my culinary skills and post it on YouTube so that you too can re-create what is universally acclaimed to be the best prime and mushrooms anywhere. In Texas, no one can claim to have the greatest chili. It’s an intensely and endlessly debated topic, and what constitutes “best” is a highly personal and subjective matter.
It will be a fine night for chili and prime and great conversation. David tells me he is bringing the wine. In that regard, David is kind of like Jeremiah the Bullfrog – he always has some mighty fine wine.
You have a great week and spend some of it with friends. Great conversation and good friends always make the food and wine taste even better.
Your already working up an appetite analyst,
John Mauldin, Editor
Outside the Box
The Deck Is Stacked
Putting Risk and Reward into Perspective
“The individual investor should act consistently as an investor and not as a speculator.” - Ben Graham.
We are frequently told that valuation analysis is irrelevant because fundamentals do not signal turning points in markets. Scoffers of valuation analysis are correct, as there is no fundamental statistic or for that matter, technical or sentiment indicator that can provide certainty as to when a market trend will change direction.
Despite being humbled by recent market gains and the difficulties associated with timing the market to call a precise top, we remain resolute about the merits of a conservative investment posture at this time. At some point, current equity market valuations will succumb to financial gravity and the upward trend of the last eight years will reverse. When that day arrives, it will not be because a valuation ratio hit a certain level or because the market formed a well-known technical pattern. It will simply be the day that selling pressure overcomes demand.
In prior articles, we compared the current economic landscape to the early 1980’s. Let’s revisit that contrast to further quantify the risk and reward associated with the U.S. stock market during both time periods.
As Graham so eloquently stated, speculating and investing are two vastly different endeavors, and we prefer the practice of investing.
Investors contemplating a new investment or evaluating an existing holding are typically faced with two basic but essential questions:
- How much of my wealth am I willing to risk?
- What returns do I expect in exchange for that risk?
When Ronald Reagan took office in 1981, investors needed to evaluate whether his fresh economic policies could spur sustainable economic growth. In the decade preceding his election, the economy was hampered by significant inflation, double-digit interest rates, and a steadily rising unemployment rate. The Dow Jones Industrial Average (DJIA), essentially flat over the prior decade, was resting at levels similar to those seen 17 years earlier in 1964. Valuations over this period were equally stagnant, with the Cyclically Adjusted Price to Earnings (CAPE) ratio, as an example, ranging between 7 and 9. Despite the bargain basement equity prices, few investors believed that market trends would reverse. Equity valuations had been low and falling for so many years to that point, the trend became a permanent state in many investors’ minds by way of linear extrapolation.
Contrast that with today. As in early 1981, there is a new president in office with a non-typical background presenting non-conventional economic ideas to aid a struggling economy. Unlike Reagan, however, public support for Donald Trump is marginal. Trump was not elected by a majority, he lacks Reagan’s humility, optimism, good humor and diplomacy and his approval rating historically ranks among the worst of incoming presidents. Additionally, while Reagan’s and Trump’s economic policies may have similarities, there are stark differences between the economic landscapes that prevailed in the early 1980s and today. (Please read The Lowest Common Denominator for a full write up on what the current administration is up against.)
Equity investors betting on Reagan in 1981 were investing in an environment where the probabilities of success were asymmetrically high. With Cyclically Adjusted Price-to-Earnings (CAPE) ratios below 10, investors could buy in to a stock market whose valuation on this basis had only been cheaper 8% of the time going back to 1885. Given the likelihood of success as inferred from valuations, investors did not need much help from Reagan’s policies. Current equity market valuations require investors to believe beyond all doubt that Trump’s policies can produce strong economic growth and overcome hefty economic and demographic headwinds. More bluntly, the risk-return profile of 1981 is the polar opposite to that of today. To highlight this stark difference, the following graph compares five-year average total returns and the maximum drawdowns that have occurred over the last 60 years at associated CAPE readings.
Data Courtesy: Robert Shiller -http://www.econ.yale.edu/~shiller/data.htm
Based on the graph above, investors in the first years of Reagan’s presidency should have expected annual returns, including dividends, of nearly 20%, while simultaneously risking a maximum drawdown of less than 5%. Today, investors should expect returns over the next five years, including dividends, to be near zero. Worse, during the next five years the S&P 500 is likely to experience a drop of nearly 30%. That is quite a risk investors are shouldering for a return they can easily attain with a risk-free 5-year U.S. Treasury note.
Beyond the obvious, there are a couple of problems with the current risk-return profile. In a best case scenario, it is likely an equity investor will earn a return that could be attained by putting cash under one’s mattress. Although it occurred an eternal nine years ago, the financial crisis of 2008, is still a faint memory for investors. If the market does indeed drop by 30%, will investors keep their cool and not sell? If they do sell, they will lock in a permanent loss. One of the demographic headwinds we have discussed in prior articles is the growing number of retirees that are heavily reliant on their retirement accounts to meet their living expenses. Will they be able to keep their collective heads under the duress of a major correction? What if prices do not rebound as quickly as they did in the post-financial crisis years?
The hard truth of this scenario is that humans always panic when faced with severe market drawdowns. The back-testing of “what-if” scenarios for buy-and-hold analysis are irrelevant because investors do not HOLD – they sell, and usually at the worst time after abandoning all hope for a durable bounce. The anxiety that retirees will face in such a scenario, many of whom can barely maintain their standard of living on an optimistic outlook, will be paralyzing.
If someone were to offer you a unique investment opportunity forecast to pay 0% annual returns over the next five years, would you sign up? What if they added that, at some point over that period, the value of your investment may drop by 30%? High volatility, low return investments do not get serious attention among even the most foolish of investors, so we would venture to guess there would be very few takers.
Interestingly, based upon the CAPE analysis above, the U.S. stock market is currently offering that very same probability of return and risk and buyers cannot seem to get enough. Given these dynamics, not only is investor behavior perplexing, it seems to us altogether incoherent which in our view provides further evidence bubble behavior is upon us. For the sake of illustration, the graph below provides three random scenarios showing how such an expected return and drawdown could play out over the next five years. None of these, nor the infinite myriad of other possible paths, appeal to us.
In a sinister rhyme to that of the early 1980’s, equity market valuations have been rising so steadily for so many years now that the trend has become a permanent state in many investors’ minds. The “investors” identified in Ben Graham’s quote do not acquiesce to the crowd or bet on whims. Instead, they carefully assess an investment’s potential risk and expected return to make calculated decisions. The virtue of this time-honored practice of cost-benefit analysis does not reveal itself every day but avoiding the pitfalls, even if it means foregoing additional speculative gains, has a long and proven track-record of compounding wealth over time.
720Global is an investment consultant, specializing in macroeconomic research, valuations, asset allocation, and risk management. Our objective is to provide professional investment managers with unique and relevant information that can be incorporated into their investment process to enhance performance and marketing. We assist our clients in differentiating themselves from the crowd with a focus on value, performance and a clear, lucid assessment of global market and economic dynamics.
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