The Lesson. This is by far the biggest lesson learned over the past 5.5 years, which is fascinating because so many wise investors have this rule on the tip of their tongue, yet for 5.5 years I arrogantly believed that somehow I was bestowed with the ability to time the market on a consistent basis!! Truly unbelievable. It’s fascinating what type of behavior is embedded within the human psyche – though history has proven again and again that market timing is a horrendous endeavor, many, many investors worry about the market and act on those beliefs. There must just be something to market timing that so many people, myself included, cannot help but attempt in the face of advice to the contrary from the likes of Keynes, Buffett and Lynch. Perhaps there was a proverbial “tree of knowledge of market timing” that Eve ate from, cursing all future investors with the sin of market timing.
[Note. Two weeks after I wrote the draft for this post, I came across this old article buried in a folder near my bed: http://fortune.com/2012/11/21/are-these-the-new-warren-buffetts/. In 1989, ten years from the bubble peak, there were investors worried about the market getting out of control and thus were holding cash. 1989!!! More on TIME HORIZON later, but my gosh if you can zoom out and put the market in the context of even just 10 years – better yet 20 or 30 years – you can save yourself a lot of mental stress, as wonderful businesses become far more valuable over time than can be contemplated in the present, which is precisely why buying wonderful companies at “fair” prices outperforms over time.]
Buffett. To be a little fair to myself, my obsession with market risk was born out of my studies of Warren Buffett. In his hedge fund days, he was highly focused on constructing a portfolio that would significantly outperform in a market downturn. As such, he would allocate certain percentages of the portfolio between general long positions and safer “workout” positions depending upon where the general market was trading relative to its fair value. Additionally, fast forward to October 2008 when he penned his now famous “Buy American. I Am.” op-ed – he indicated that his personal portfolio had been invested solely in Treasury bonds. Perhaps I am just rationalizing my own position, but how could the greatest investor on earth not find something to do with a mere $500 million in a $10 trillion market? He is on record saying he could virtually guarantee 50% returns with a $1 million portfolio – you’re telling me he couldn’t do 20% with $500 million, when he’s done 20% with BRK’s massive capital base? I don’t buy it. I believe his 100% Treasury position was indicative of his view of general market valuation. That’s neither here nor there – the point is that when I began my investment career Buffett had just written that op-ed, thus I had firmly implanted in my head that worrying about general market valuation, or “market timing”, was of grave importance. On top of this, by mid-2010 I had read and studied many commentaries on the history of secular bull and bear markets and became quite convinced that we remained firmly entrenched in a secular bear. With the market trading over 20X earnings on a “Schiller” basis in the middle of secular bear, and my investment hero’s mantra of outperforming in down markets ringing in my ears, how could I possibly NOT worry about market risk?!?!
Well back to human psychology. While I may deserve a half an inch of slack, due to my inherently bearish nature with regard to overvalued assets I conveniently chose to ignore the other principles routinely espoused by Buffett:
- You have no clue what the market will do, ever, at any time, thus never bet as such
- If you wouldn’t worry about broker’s quote on a 100%-owned farm, why would you worry about the trading price of a fractionally owned business?
- DO NOT EVER make an investment decision based upon macroeconomic analysis
- Time is the friend of the wonderful business, the enemy of a mediocre one
- The risks to being OUT of the game far surpass the risks of being IN the game
It’s a lot like growing up – while you’re in recreational basketball your father can tell you all he wants about how important it is to hustle on the defensive end of the court, but until you miss the cut in middle school due to poor defensive hustle, the lesson really does not sink in. Same thing with Buffett’s principles – until you get your head handed to you from shorting the market while watching your wonderful individual stock ideas go up without you, the lesson does not fully sink in. Fortunately, I believe I’ve only missed the middle school cut – after studying my “father’s defensive hustle” principles, I should be ready for high school varsity beginning freshman year…after all, not many freshman have the ability to dunk 🙂
Observations. At this point, the more astute readers may conclude that somebody throwing in the towel on “market risk” after four years of intense worry and extensive hedging is a major sign we are at or near a market top. With the SPX at all-time highs, Investor Intelligence bulls at record highs, the VIX at historic lows, the Schiller PE at levels seen at all “tops” save the TMT bubble, and the market two-plus years deep without a 10% correction, there is more than enough reason to arrive at that conclusion. However…
Due to my obsessive personality, and the natural human instinct of confirmation bias that leads one to dig and dig and dig for information supporting one’s conclusions, I have studied market history rather extensively over the past five years. Three observations:
- Major market declines occur inside of recessions. These are declines greater than 35% that take multiple years to recover from.
- Non-recessionary bear markets tend to be contained to -20% and bounce back extremely quickly. Some examples are: 1962, 1998, 2010 and 2011. 1987 was greater than 20% and it occurred outside of a recession – however, two things: 1) as a friend pointed out, the market “crashed” upwards just as much as it crashed downward, and 2) the market ended flat on the year. The general point is that non-recessionary bear markets bounce back extremely quickly.
- Sentiment & Valuation work are virtually meaningless in a bull market.
- Sentiment works for very short-term market swings, but actually appears to confirm long-term trends – i.e. elevated sentiment persists in extended market advances, and depressed sentiment persists in extended market declines.
- Valuation tells you where you will end up – undoubtedly a highly important question – but is virtually useless in telling you WHEN…
The “When”. The “When” is what really put the nail in the coffin of my market risk/hedging/market timing endeavors. Not a week before my “graduation” from “residency”, I was thinking about how much more valuable SO MANY companies are now than they were at the height of the 2000 TMT bubble; companies that could have been purchased for fair multiples at that time despite the SPX trading at over 40X earnings. I thought about the hundreds of event-driven investments that could have been had since then. My gosh – Buffett’s unbelievable sense of time horizon HIT ME LIKE A TON OF BRICKS. I have the ability to pick stocks, analyze situations, pull the trigger quickly and can mentally embrace a declining stock price – WHY ON EARTH AM I STIFLING THAT ABILITY BY WORRYING ABOUT – AND WORSE YET, BETTING ON – A LARGE MARKET DECLINE??? From 2000 through 2009, one could have compounded capital at enormous rates of return despite two interim -50% declines. Likewise, even if the market is due for a 50% crash five years from now, I could be up 100% by then and at the time of the crash be invested in a portfolio of event stocks that only decline 30% or 40%. For fun, let’s walk through an example.
- Current Schiller EPS is ~$80
- 6% growth over five years, that’s $107 five years out
- Say the market tops out at a 30X PE, or 3210
- 3210 is 65% higher than 1950
- Say I double the market return, and a $100 portfolio turns into $230
- In a 50% decline the market ends at 1605, or 17.6% lower than where it started
- If I decline 40%, I end at $138, or 38% higher than where I started
- CONCLUSION: Obviously a 40% decline would not be fun, but the math of sitting out a portfolio of stocks that double the market return does not warrant sitting in cash for five years awaiting a 50% crash…
The “When” is a nasty bugger. She has bitten all of the greatest investors, even the ones that do not practice market timing. The “When” can make you overly cautious for years at a time, sapping not only potential returns but clients & AUM as well. Some examples of great investors worried about the market far in advance of the actual crash:
- Buffett. He called the market overvalued and high risk in his 1958 letter to investors. Other than a brief 20% decline in 1962, the market did not fully correct for another 16 years.
- Seth Klarman. Highly defensive in the mid-1990’s and most recently since early 2010.
- Prem Watsa. Thought we were in Depression 2.0 and went fully hedged in late 2009.
- Jeremy Grantham. Cautious in the mid-1990’s, and had a mass exodus of clients.
- John Hussman. ‘nough said…
It’s far too easy to roll out the oft-quoted Buffett phrase “be greedy when others are fearful, be fearful when others are greedy” and simply ignore the practical applications of it. Yes, of course, OBVIOUSLY as a margin-of-safety seeking investor your time in the sun comes when there is panic in the air, blood in the streets, and uneconomic selling going on around you. But what possible good does this panic do for you if you do not have the cash available to kindly offer to those looking to dump assets at fire-sale prices? The answer is NOTHING. The best you can do in that situation is, to use another oft-quoted phrase, “sell cheap to buy cheaper”. Well that’s just dandy. Sounds like loads of fun to watch your portfolio fall by 50%, sell out for the tax benefit, then reinvest into names that fell 70%. I want more out of my investment life than that. I want to keep my cake AND eat it too.
“Weight of the Evidence”. For the past three years I have had the extremely good fortune of being exposed to what I consider to be, BY FAR, the greatest market research firm on the planet. As with all brilliance, their approach is simple and straight forward, yet extremely powerful. It is as follows:
- The big money is made by getting in harmony with big trends
- Don’t fight the tape. Don’t fight the Fed. Certainly don’t fight both.
- Utilize a “weight of the evidence” approach: valuation, technicals, economy, monetary, sentiment, etc…
While value guys typically cringe at the thought of anything related to trend-following, the historical data strongly supports this approach. It is a well-known and well-documented – even celebrated – characteristic of value investing that value guys buy and sell too early. The great Bruce Berkowitz affectionately refers to early buying as “premature accumulation”. This trait feeds over from individual stock picking into general portfolio management when managers declare the market environment “risky” due to overvaluation (see examples above of great managers worried about the market too early). In my opinion, this phenomenon is relatively easily explained by trend-following. There are typically more trend-oriented market participants than there are strict value-oriented fundamentalists. As such, just when a particular asset rises or falls to a level a value manager deems unattractive or attractive, the trend followers jump in to either buy or sell based on the belief that the recent rise or fall confirms the fundamental story and will thus continue in its current direction.
While historical results support both value and trend-following approaches, both sides bash the other as if it has zero historical merit. This is precisely why the “weight of the evidence” approach practiced by my market research friends is so brilliant…it takes the best of both approaches and overlays it with economic, monetary and cycle analyses. Analyzing the history of this firm’s recommendations since the mid-1990’s confirms its brilliance – while strict value guys suffered huge opportunity cost in the mid- to late-1990’s, this firm had clients firmly in line with the bullish trend until 1999.
The “Market Mosaic”. Throughout my “residency” I assembled the building blocks for what I call the “Market Mosaic”. In short, it’s the value investor’s “weight of the evidence” approach to market risk management. The model is as follows:
- Market Model: 30% weight
- SPX Price/200dma: 20
- SPX 200dma Trend: 20
- Economy: 20
- Monetary: 10
[Note. As with everything in investing, while principles are vital, the process must be iterative. Thus it is likely this model will evolve over time as I continue the learning process.]
- Market Model. I developed this model largely by accident after reading an interesting analysis of the relationship between the market and its 200dma. The writer posited that the market is dangerous when it gets upward of 10% over its 200dma. After studying this relationship over history, I found it to be virtually useless (the writer was looking at an extremely small span of time). I found that in massive bull markets, a ratio greater than 10% is the market’s proverbial rocking chair. This metric, in and of itself, doesn’t become highly useful until it rises above 15%. Even then, it merely tells you to “watch out” versus get out of the market entirely.
- Long proprietary story short, I eventually built a model that accounts for valuation, price/200dma, 200dma relative to 50dma and the market’s moving average growth rate (all for the S&P 500). The results were shocking, to say the least, and I’ve paid dearly for not following it since I developed it in early 2012. However, as is to be expected, the model is not perfect, thus I view it as a highly important weight within a broader set of indicators.
- Price/200dma. As explained above, while best used within a broader set of indicators such as the Market Model, at positive extremes this metric is a useful gauge of medium-term market risk. For example, in the rally leading up to the August 1987 peak this metric reached 18% above the 200dma. So while the Market Model was on a BUY signal, which was highly useful long-term, the Price/200dma metric warned of some froth medium-term. But again it’s not perfect – it’s more of a “hey watch out, perhaps take some off the table” type of warning. Conversely, a Price/200dma that is less than 1.00X by a decent margin tends to be a negative for the market.
- 200dma Trend. In trend-following land, a falling 200dma is considered a negative. This metric, along with Price/200dma, acts as a governor on the Market Model, which can be late to trend changes if the market has a very high moving average growth rate and/or is highly undervalued.
- Economy. As with my good fortune in coming in contact with my market research friends, I count myself lucky to have followed one of the greatest economic minds in finance today for the past four years. He has worked on the “Street” as an equity analyst and managed a hedge fund, so he is by no means a market-senseless academic. His macro framework was born out of intense study and focus on the monetary system and how the Fed & Treasury interact within our fiat monetary system. What really put him on the map for me was his calm, cool, and collected yet powerful refutation of the ECRI’s emphatic call for a US recession in late 2011. Week after week he cited the still-positive US intermodal rail carloads 12-week moving average YOY growth rate as evidence the economy was not tipping into recession. Stealing directly from my economist friend, the two key leading indicators monitor for potential economic weakness are: Jobless Claims (4-week moving average), and Intermodal Carloads (12-week moving average YOY growth rate).
- Monetary. Throughout my career, my guess is that this category will be the most puzzling. If it were not for my market research friends’ mantra of “don’t fight the Fed”, I probably would not include it within the Mosaic, since my hunch is that monetary effects likely find their way into market price action pretty quickly. Again, this is the most subjective area in my opinion, and as of right now, the indicators I monitor are: Credit Spreads, Real Rates, Credit Growth, and Fed Policy
- Market Risk Score. In order to come up with an actionable gauge of market risk, I go through each indicator and rank it between -100 and +100 in increments of ‘50’, then I multiply it by its weight in the Market Model. Here is how it currently shakes out:
- MARKET MODEL +100 (score) x 30% (weight) = +30 (weighted-average score) – The model just recently transitioned to a HOLD from a BUY. While this normally would warrant a +50, since the BUY signal was so recent, I am taking the liberty to keep it at +100
- PRICE/200dma +100 x 20% = +20 – At around 1.08X, this metric is right in the sweet spot of not too hot and not too cold
- 200dma TREND +100 x 20% = +20 – Strongly upward
- ECONOMY +100 x 20% = +20 – Jobless claims declining; Carloads 12ma YOY growth rate solidly positive
- MONETARY +100 x 10% = +10 – Credit spreads low and stable; Real rates largely negative out to 10 years, slightly positive beyond; Credit growth beginning to pick up as consumers begin to re-leverage and corporations borrow to fund capex; and Fed policy easy, to say the least
- MARKET RISK SCORE +100
Final Thoughts. No question these roughly six pages appear to indicate I am FAR too focused on the market for someone who claims to be a diehard value guy. This very well may prove true over time, especially if I am unable to shake the market timing bug. Perhaps the market is about to embark on a 30% correction that my “Market Mosaic” is not picking up on, and after a demoralizing defeat I will throw in the towel on investing all together. I highly doubt all of the above, and would strongly bet against it…
My market timing dissertation is primarily therapeutic. After 5.5 years of intensive stock picking and market analysis, it helps tremendously to be able to sit back, think and write about what I’ve learned and how I want to apply it moving forward. I have known for awhile now that I have a knack for picking stocks and analyzing catalytic, event-driven situations – the main problem with my performance has been my obsession with market risk as I’ve outlined here today. I am a naturally aggressive investor, thus when I have a high conviction idea I tend to concentrate in it. For the past several years I had huge conviction that the market was seriously at risk, thus I way over-traded in an attempt to get out of my longs at the right time AND I overly concentrated in index hedges. In a nutshell, I view me as an investor as American Express during the salad oil scandal, or Geico pre-Buffett rescue – a company with a durable franchise but with an excisable cancerous tumor, as Munger says. This dissertation was part of the surgery, if you will.
And while it appears I suddenly flipped a switch from worrying about the market to not (i.e. if so, I would be susceptible to a change in psychology in a market decline, as I would regret my decision to stop worrying about the market), the end of my “residency” has actually been a long time coming. To use one more stupid market analogy – I made a series of “lower highs” last year as I waffled between worrying about the market and not worrying about it, then my final washout low came this June as I continued to average up on my market short position.
My “Market Mosaic” answer to market risk/market timing is not nearly precise as it may appear. It’s merely a way for me to zoom out and look at things over the medium to long term in order to free up my mind and time to focus on finding individual stocks, which is by far my favorite thing to do. I could not possibly be more excited about the future, and would not pass up on the last 5.5 years for anything in the world. It scares me to think what my approach would be going forward had I simply been 300% long the last five years riding the bull straight up – I would have thought investing was one of the easiest things in the world, and how could I ever go wrong. I’m not saying the next five years will be smooth sailing without many mistakes and lessons learned, I just know that I’ve experienced FAR more in 5.5 years than many have experienced in two decades, and am mentally prepared to do with almost anything that comes at me.