The Difference Between Then and Now

I read stuff from young commentators today and wonder how they could write such insightful commentary. It is hard for me to remember the quality and depth of insight I had when I was a similar age.

But as I reflect upon some of my writings and insights from when I first entered the industry, the quality and depth of those insights were not all that much different from the good stuff I see from young commentators today.

What has changed for me is a more honed approach toward investing (stripping away the dross) and a greater skepticism toward smart people based on those 25+ years of experience. Whereas I was trying to work out what works and what doesn't back then, today I have a greater appreciation for messiness of life.

Peak China

I am not saying China has peaked. Far from it. China will do nothing but continue to grow in size and influence throughout the 21st century. The 21st century is the Chinese century (22nd century is India's).

What I am saying is the current reverence and awe for China and its seeming infallibility in the face of Western incompetence and decline reminds me of peak Japan back in the 80s. On the face of it China appears to have pulled off a seemingly perfect emergence.

Beneath the surface there are many cracks (overcapacity, overindebtedness) and with increasing commitments both at home and worldwide, China will be found to be fallible.

Just sayin!

Equity Glide Path and Sequence of Return Risks

Being new to retirement issues, I find this area very interesting.

A counterintuitive idea is to increase the equity glide path once retirement hits, ie. increase equity exposure over time. Start at say 20% equity exposure and increase it 1% or 2% per year (by redeeming cash/bonds for withdrawals). One of the benefits of such an approach is not getting caught out on the sequence of risk issue associated with poor equity returns early in retirement. I kinda like that idea. (but only in a high valuation environment)

"These results indicate that the optimal equity glide path (as well as the decision about whether to use T-bills or bonds) is in fact quite sensitive to the market valuation at the start of retirement (and indirectly, to expected market returns). While the accelerated rising equity glide path worked best in some scenarios, the fixed 60% equity portfolio did better in most. The rising equity glide path should only be considered in unfavorable valuation environments. Notably, though, the “traditional” steady declining equity glide path is still inferior to some other strategy in all valuation environments. Based on historical data, more aggressive portfolios are rewarded in favorable (undervalued) and neutral environments, and rising equity glide paths performed better in unfavorable market environments, which were the situations that generated the overall historical SafeMax."

Definitely food for thought.

Graham and Dodd tactical allocation rules based on market PE

From Kitces and Pfau in AAII.

Though there are a multitude of ways to define an undervalued or overvalued market, we rely on the switching rules developed long ago by Graham and Dodd (“Security Analysis: The Classic 1940 Second Edition,” McGraw-Hill, 1940). They suggested maintaining the neutral asset allocation when valuations fall within a range between two-thirds and four-thirds of their historical average value. Graham and Dodd increase the stock allocation when valuations are less than two-thirds of their average, and decrease the stock allocation when valuations are more than four-thirds of their average. These numerical bounds correspond to evolving CAPE values of approximately 10 and 21 over time. Given the volatility of the CAPE ratio, these bounds also roughly correspond with the bottom and top quintiles of the historical valuation distribution, which are CAPE values of 11.1 and 21.2 (see Figure 1).

These results suggest that the valuation-based approach is generally superior to the rising equity glide path approach and the fixed equity allocation portfolios, as the valuation-based scenarios produce comparable-to-slightly-better results across the board. 

Average Market Multiple and Its Standard Deviation

Was playing around with Shiller's CAPE database and was curious what the standard deviation of the market multiple was.

Arbitrarily choosing the period 1965 to 2015 the long term average CAPE was 19.7x with a standard deviation of 8.2 (hi = 44.2x, lo = 6.4x).

Using the same period but using a naive PE (ie. non-smoothed), the average market multiple over the period was 18.9x with a standard deviation of 12.6 (hi = 123.7x, lo = 6.8x).

Breaking the period into 5 yr, 7 yr and 10 year rolling periods to simulate various cycles the PE and standard deviations came out to:

		CAPE				Naïve PE
	5 Year	7 Year	10 Year		5 Year	7 Year	10 Year
Average	19.29	19.26	19.20		19.05	18.82	18.49
Standard Deviation	7.83	7.71	7.52		7.64	7.08	6.80
Hi	36.50	33.48	31.10		33.16	30.76	31.43
Lo	8.59	8.87	9.39		8.10	8.81	9.37

Pressure Points In The Market

I just took a look at areas of prospective bubbles in the market the other day and concluded there was nothing significant poking its head out. But I wanted to revisit that question and articulate or expand on a couple more pressure points in the market today:

1. The large decline in oil prices has crushed the energy sector which had been one of the drivers of growth in the US. There may be more risk and implications there than what the market is indicating.
2. The large decline in commodity prices, predicated on the slowdown in China, which has crushed Australia, Brazil and Canada. Australia, China, Canada and the UK have large residential real estate bubbles.
3. ECB QE and the financial repression of NIRP is leading to a recalibrating of currencies and a fight to the bottom. 
4. Japan QE and rebalancing could push Japan over the edge as the curtain is finally pulled back.
5. Geopolitical risks could escape beyond borders and proxies - Ukraine, Syria.

More On The Purpose and Role of Active Management

Most retirement plans offer a menu of index funds and active funds. The active funds typically comprise brand name, "institutional quality" managers. They are in essence a safe bet from a performance, business and career risk perspective. They will likely deliver somewhere between 1% outperformance to -2% underperformance (which incidentally is acceptable). They are the proverbial closet indexers. You may wonder what is their role. If they can't and aren't trying to generate genuine outperformance (alpha), then why use them. I think the reason is as alluded to previously (business, career and performance risk management) but also because they serve several other important purposes.

Namely, they provide the potential for outperformance (an important psychological factor). And they do provide some degree or potential of downside mitigation. Both of which meet the needs of most investors to believe that their fund is being managed by an expert and provides them with a positively skewed opportunity set.

Hard to know whether this is a cynical take on active managements role or simply the reality, which although it is unlikely to deliver alpha, actually does provide investors with a degree of comfort.

If plan providers were to offer "genuinely active" managers then the outcomes could be a real mess. The hit rate on finding and getting a genuinely active manager who then outperforms is pretty low. Not worth the risks and hassles associated with it.

Genuinely active = relatively new fund (less than 3 years old), concentrated bets, small amount of assets under management.

A Rationale For Active Management

Active managers are throwing in the towel. They haven't demonstrated an ability to beat the market and are now re-evaluating their value and their selling proposition to investors.

http://www.thinkadvisor.com/2015/04/06/the-real-point-of-active-investing 

I need to think about this some more. There may be a viable rationale to active management beyond trying to beat the market.

Do I want a plane flown only on auto pilot or do I want a plane piloted by a person who may be able to react in an emergency. The analogy may not work because there may be times when a plane flown by a person takes emergency action for no reason whatsoever.

Losing Money Easier Than Making Money

Making money through your investments always seems a lot harder (read that takes longer and does not generate as much) as losing money on your investments.

Just my experience!

Bubble, bubble toil and trouble

Julian Robertson in an interview today speaks about a bubble being blown by the Fed. Like everyone else, he doesn't know when it is going to pop, but he knows it is going to pop.

A bubble is a serially correlated error on a mass scale perpetrated by a blinded marketplace. Herding if you will.

Which leads me to ask myself the question (which I ask periodically), where do I see bubble characteristics?

What are the characteristics to begin with? Substantial increase in leverage and laxity of constraints wrt to access to cheap capital - leads to misallocation of resources and increase in valuation. Unsustainable and undefensible increase in valuation. Area attracts a large flow of new capital. Industry/sector/country is systematically important due to its size and spreading effects throughout the economy. 

In financials? No. Capital has been rebuilt. Lending standards have improved.

In energy? No. The bubble, and there was one in shale, has been popped already. There are dead men walking, but no systematic risk impact on the market.

In technology? No. Not if you look at the balance sheets and valuation of the majors (AAPL, MSFT, SAP, ORCL, QCOM, etc.). I definitely see a bubble in next generation tech (TSLA, NOW, CRM, NFLX, N, etc.) but even many of those have seen their valuations shrink as they grow and market price have come off the boil.

In materials? No. If anything, the bubble has been popped already in that space. Just look at gold, copper, coal, etc.

In industrials? No. Valuation is stretched, but not out of this world.

In consumer discretionary? No.

In healthcare? Don't know. It has had a huge run. Definitely biotech side of sector. But biotech is not a systematically important part of the economy.

In utilties? No.

Dollar. No. That is good for everyone else and the US can handle it. Although if it were to throw the US into recession then that would be bad for everyone. 

In bonds? Possibly. Massive move to bonds over last six years. But bonds don't really pose a systematic risk unless the underlying defaults. And most of the new debt is govt.

In China? Possibly. But I've been calling that one for years, so I have zero credibility. Like Julian Robertson I believe there is a bubble (in China), I just don't know when it will burst.

China looks to me as the best potential for a "bubble." The massive run in the Chinese stock market may be a sign of things getting out of control, or it may simply be a sign of a soft landing.

Or, it could be the whole global system which has increased its leverage significantly in the last six years and susceptible to a rise in interest rates.

Perhaps that is it. Interest rate risk is the largest risk out there.

Is The Market Efficient?

I have asked this question a time or two before. But I have thought about it in a different way and have decided for today that the market is not efficient. At least not efficient in the sense that it adheres to some average valuation level.

The problem is the market is overvalued and undervalued for long periods of time. It is hard for an investor to know when it will revert to the mean, and in all likelihood overshoot on the other side.

Overshoot and undershoot are a structural aesthetic of the market. The duration and magnitude of overshoot or undershoot is not well understood.

I would say the market is virtually never efficient. At least not from a valuation perspective.

It seems to me that there are times when the market is overvalued. The implication is market participants are expecting better things in the future. And there are times when the market is undervalued. The implication being market participants are expecting worse things in the future. But throughout, regime changes and overshoot are a function of changing expectations, money flows, fear/greed levels, and liquidity. 

Over and undervaluation point to correlated mistakes.  Paul Samuelson said something to the effect, markets are macro inefficient but micro efficient. That is probably right although it doesn't make much sense.

Just as correlations and assumptions of normal distributions are non-stationary and change over time, so to does the market average valuation line. With that being the case, one would presume that more recent data (valuation levels) would be more relevant for ascertaining the "modern" average valuation level as compared to a longer term mean. This may or may not be a good assumption to make. Only time will tell ('tis the answer to everything).

Drawback of Cap Weighted Indexing

The main drawback with cap weighted investing is that you have bought the market. We know from history and experience the market is not always a good deal. There are times when the market is overvalued. Your entry point (level) into the market is very important for both your short and long term returns. Buying into the market when it is overvalued is likely to result in less than average returns. If you are worried about the valuation level of the market, then perhaps the best approach if you have a lump sum to invest is to set a disciplined schedule to invest those monies over time based upon either a time target being reached, ie. invest 1/4 now, 1/4 in three months, 1/4 in six months, etc., and/or dependent upon the market level path, ie. if the market goes down 10% invest 1/4, if down another 5% then another 1/4, etc.

If you are young and likely to be putting regular savings into the market, then don't worry about trying to finesse your entry. You've got time and the lion's share of your likely accumulated wealth in front of you and there is no time like the present to start investing.

Optimal Withdrawal Strategy in Retirement

The general rule of thumb is that retirees should draw down their taxable accounts first, followed by their tax deferred accounts (401k and Individual IRA), before finally accessing their tax exempt accounts (corporate Roth and Individual Roth).

Kirsten Cook, William Meyer and William Reichenstein make the case in, "Tax Efficient Withdrawal Strategies" in the latest Financial Analyst Journal that conventional wisdom may be wrong and in fact using a more flexible approach based on marginal tax rates and pushing drawdowns in tax deferred accounts (and/or converting TDA funds to Roth accounts) could extend portfolio longevity significantly (15% more).

Essentially, using up a combination of all account types in relation to current and likely marginal tax rates, enables an extension of portfolio duration.

One thing they point to is leaving some funds in one's tax deferred account for a lot latter in life to pay for large end of life medical bills which can potentially reduce the effective tax rate to close to zero.

Everyone is a long term investor, until...

Everyone is a long term investor, until the market tanks.

A Fundamental Misunderstanding

If you believe your financial advisor needs to be fully informed about what is going on in the market so that they can better look after things for you, then you have a fundamental misunderstanding about what the markets are, what somebody can do for you, and what are reasonable expectations.

A long term investment horizon strips away the need to know what is going on in the here and now. 99% of the sturm und drang created by the markets is simply noise.

More on KISS

When simple rules suffice and when in fact simplicity gives you the best odds, why mess with added complexity?


KISS is really a euphemism for a modern rules of finance approach to investing:

Be diversified,
Keep costs low,
Be long term,
Be disciplined,
Be patient.

KISS is not an end. It is a means to an end.

What Period Does Today Look Like

Riffing off a recent post on the performance of a 50/50 portfolio on A Wealth of Commonsense blog.

Today looks like no period specifically and all periods generally. Whether it is wars and famines and unrest and lousy politicians and economics worries or existential concerns. Today looks like virtually ever other period of time.

But that is not the question or the perspective I am looking at it from.  I am thinking in terms of general financial market characteristics. And in that regard, today looks very much like the end of the sixties. Interest rates were very low and the stock market was very high. The 70s were not kind to either. Perhaps a portent of things to come.

Growth Is Confusing

In the world of investing the word 'Growth' can mean different things and sometimes it is hard to know what meaning is meant.

Growth can be a reference to an investment philosophy, ie. they are a growth manager.

Growth can also be a reference to the characteristics of an asset class, ie. equities and real estate are growth assets.

Main Reasons To Keep It Simple

The main reasons to ‘keep it simple’ in the realm of investing are: (1) Added complexity does not necessarily add value. (2) A simple approach focuses on the most important factors. (3) Keeping it simple reduces the clutter and strips out the noise. (4) Something simple is easier to understand and manage. (5) Keeping it simple promotes transparency which facilitates trust. (6) Complexity/sophistication is associated with additional cost(s). (7) Complexity/sophistication speaks more to the ego than the head. (8) A simple approach helps take emotions out of the investing equation. (9) Simplicity reduces the temptation to make changes. (10) A simple plan allows you to more easily determine whether the advertised benefit is actually being delivered. 

Keep It Simple

With more than 5,000 stocks, 7,700 mutual funds, 1,700 ETFs, 600 closed-end funds, 11,000 hedge funds and 3,000 private equity firms to choose from, investors could be excused for feeling a little overwhelmed. Throw in the industry jargon, the myriad investment approaches and the plurality of slick salesmen and investors are understandably intimidated by the financial markets and the financial services industry.

With that being the case, it is all the more important to cut through the clutter and reduce the investment equation to a manageable exercise. And so it doesn't hurt the case that the primary reason to ‘keep it simple’ is due to the fact that added complexity does not necessarily translate into added returns in the investment realm.

At a base level, the most simple form of investing is the passive index fund. You buy all the companies in the index in proportion to their weight. There is no attempt to beat the index. There is no attempt to pick stocks. It does not require selecting an active manager. It is simply “getting the market.” Beyond index funds everything else increases in complexity and sophistication (and cost). 

What 50 years of theory, research and empirical evidence point to is the inability of active management on average to beat the market. In fact, given the market is a zero sum game (one investor’s gain in another investor’s loss) it is a mathematical tautology that the average active manager will under perform the index by their fees over time. The industry is expert at adding layers to obfuscate and increase charges. 

With these facts known, the question then becomes why do most investors continue to pursue active management. The answer lies not in the evidence presented, but in the nature of man and the desire to ‘beat the market.’ The industry knows this and preys upon it. In fact, the industry expertise has always resided in sales and marketing. Investment management and the promise of returns is simply the cart by which the industry fastens itself to investors in order to generate high returns for itself and its shareholders. 

The promise of returns and beating the market is much more alluring that honestly conveying the odds of that endeavor and the reality of helping investors wait patiently. But there are other reasons why keeping it simple is a great principle to subscribe to. In a world of increasing complexity, a more simple approach is not only more reasonable and provides better odds of success, but is much easier to understand and manage (not to mention measure performance against). Complexity and added sophistication goes hand in hand with lower transparency and higher costs. And a vast body of research demonstrates, that all else being equal, higher costs equal lower long term returns. 

In summary, a simple approach increases the odds of success, is easier to manage, creates understanding and engenders greater trust. It isolates the factors that count and strips away the ancillary noise as it gets to the heart of the matter.

Inherent Conflict of Interest In Financial Services (and virtually any for profit endeavor)

Keep in mind that when you are dealing with a financial services firm you are dealing with a for profit entity. The goal of every for profit entity is to maximize its return to shareholders. Financial services firm’s balance their ability to take advantage of human nature (which they are very good at and have a lot of knowledge of) with seeking to maximize their own profits. There is an inherent, built-in conflict of interest. 

That is not to say that some financial services companies and financial services providers aren’t helpful or don’t really try to do the best for their clients, it is only to say that there is a temptation – usually embedded in the incentive structures – to lead with your own self interest vs the self interest of the client. 

The Paradox of Skill

With all the amazing changes and “advancements” in finance over the last thirty years, you would think they had figured out how to beat the market. In fact, it is getting harder and harder to beat the market. We call this the “paradox of skill.” 

As more and more technology and more and more expertise is applied to beating the market, this increase in skill paradoxically makes it more and more difficult to beat the market. 

Just as athletes today are bigger and stronger compared to athletes of yesteryear, so to investment managers of today are smarter and quicker than ever before. However, unlike improvements in athletic performance, there are no discernible improvements in alpha (beating the market) by market participants. And not only that, but it requires an incredibly long performance history to gather sufficient data to make any statistical inferences as to whether outperformance was a result of skill vs luck. 

Good luck with that. 

The Trap That Is The Financial Markets

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Whenever you deal with the future, you are dealing with the unknown and uncertainty. Multiply that by millions of moving parts and you have the financial markets. 

The financial markets are something that offers hope and excitement, all the while enticing you to make any number of cognitive mistakes - much like a casino.

A Rough Estimate

At a pinch, I would guess that the financial services industry has spent more than $2 trillion dollars on information systems, computing power, and investment expertise over the last thirty years. The end result has been a net decline in alpha. Every penny spent has actually resulted in a net decrease in ability to produce above market results. Notch that up to the "paradox of skill."

What would be interesting also, is to gauge how much the industry has spent on sales and marketing. 

One day I am going to take a much closer look at these areas and get a better idea of the money spent (compared to the amount of value added for investors).

 

Should Investing Be Fun?

Should investing be fun? Yes, in the sense that seeing your money grow is fun. But no, investing should not be pitched as a fun thing because it cannot deliver on that promise. Nobody has control over the markets and as a result, if your fun is conditional upon positive outcomes, then you are setting up for disappointment.  

The industry is prone to overpromising and underdelivering. It cannot deliver on any promise of performance (just look at the disclaimer on every investment product sold). And yet, investors are sold on outperformance and the hope they have the right manager. This is an easy sale. Much easier than educating investors what are realistic expectations and how things actually work.

Some Notes On The Financial Services Industry and the Investor Experience

Most investors do not want a professional to help them. They are afraid they will be sold to and are happy avoiding that awkward situation. They are comfortable managing their accounts online and are just as happy to avoid a salesman when managing their investment affairs. There is an inherent skepticism toward the industry, its institutions and the representatives of the industry.

Parts of the investment advising function are getting commoditized by technology, including risk assessment, asset allocation, account aggregation, rebalancing, tax optimization and reporting. Parts of the investment management function are also getting commoditized by technology including, security selection, portfolio construction, evaluation, performance measurement, and portfolio attribution.

The key to success in investment advisory is creating a great customer experience. This requires not only problem solving skills and the development of financial solutions, but education skills, communication skills, and listening and empathy skills. 

***inspired by an article in CFA Institute Magazine