Earlier this week I posted a piece entitled, The Coming Meltup: Was 2013 An Anomaly?, which discussed the collision of the Presidential and Decennial market cycles. In that post I stated:
"The decennial pattern is certainly suggesting that we take advantage of any major correction in 2014 to do some buying ahead of 2015. As shown in the chart above, there is a very high probability (83%) that the 5th year of the decade will be positive with an average historical return of 21.47%."
While the article was based around the historical statistical data, it got me to thinking about the average investor and where they are currently positioned in the markets today. More importantly, what are some of the risks that could derail the previous analysis. This is the basis for the things I am going to "Ponder This Weekend."
1) Howard Marks - Getting Lucky via OakTree Capital Management
Howard Marks is a must read by anyone. His insights are always intellectual and insightful, and his latest missive is no exception as he focuses on the role of luck in everything from the life one leads to investing. The most interesting part of his discussion was the focus on the inefficiency of the markets and why it is different now. Here is the key excerpt:
"The efficient market hypothesis is compelling...as a hypothesis. But is it relevant in the real world? (As Yogi Berra said, 'In theory, there is no difference between theory and practice, but in practice there is.') The answer lies in the fact that no hypothesis is any better than the assumptions on which it's premised.
I believe many markets are quite efficient...But I also believe some markets are less efficient than others. Not everyone knows about them or understands them. They may be controversial, making people hesitant to invest. They may appear too risky for some. They may be hard to invest in, illiquid, or accessible only through locked-up vehicles in which some people can't or don't want to participate. Some market participants may have better information than others...legally. Thus, in an inefficient market there can be mastery and/or luck, since market prices are often wrong, enabling some investors to do better than others.
It's hard to prove efficiency or inefficiency. Among other reasons, the academics say it takes many decades of data to reach a conclusion with 'statistical significance,' but by the time the requisite number of years have passed, the environment is likely to have been altered. Regardless, I think we must look at the changes listed above and accept that the conditions of today are less propitious for inefficiency than those of the past. In short, it makes sense to accept that most games are no longer as easy as they used to be, and that as a result free lunches are scarcer. Thus, in general, I think it will be harder to earn superior risk-adjusted returns in the future, and the margin of superiority will be smaller.
People often ask me about the inefficient markets of tomorrow. Think about it: that's an oxymoron. It's like asking, 'What is there that hasn't been discovered yet?' The markets are greatly changed from 25, 35 or 45 years ago. The bottom line today is that there's little that people don't know about, understand and embrace.
How, then, do I expect to find inefficiency? My answer is that while few markets demonstrate great structural inefficiency today, many exhibit a great deal of cyclical inefficiency from time to time. Just five years ago, there were lots of things people wouldn't touch with a ten-foot pole, and as a result they offered absurdly high returns. Most of those opportunities are gone today, but I'm sure they'll be back the next time investors turn tail and run.
Markets will be permanently efficient when investors are permanently objective and unemotional. In other words, never. Unless that unlikely day comes, skill and luck will both continue to play very important roles."
As I said, the entire piece is a must read.
2) The Financial Fire Next Time by Dr. Robert Shiller
In my post discussed above while discussed the probability of an advance into 2016, I also stated that:
"While the historical evidence suggests that 2014 will see a buying opportunity going into 2015, it is important to remember one simple phrase that is too often forgotten by the "bullish crowd:"
'Past Performance Is No Guarantee Of Future Results.'
There are plenty of reasons that the market could lapse into a far bigger correction sooner than the historical evidence would otherwise suggest. Such an event would not be the first time that an "anomaly" in the data has occurred."
This was the key point discussed by Robert Shiller:
"If we have learned anything since the global financial crisis peaked in 2008, it is that preventing another one is a tougher job than most people anticipated. Not only does effective crisis prevention require overhauling our financial institutions through creative application of the principles of good finance; it also requires that politicians and their constituents have a shared understanding of these principles...
One of our discussants, Joseph Tracy of the Federal Reserve Bank of New York (and co-author of Housing Partnerships), put the problem succinctly: 'Firefighting is more glamorous than fire prevention.' Just as most people are more interested in stories about fires than they are in the chemistry of fire retardants, they are more interested in stories about financial crashes than they are in the measures needed to prevent them. That is not a recipe for a happy ending."
3) Beer Googles by Richard Fisher via Dallas Federal Reserve
Today, I want to muse aloud about whether QE has indeed put beer goggles on investors and whether we, the Fed, can pass the camel of massive quantitative easing through the eye of the needle of normalizing monetary policy without creating havoc.
When money available to investors is close to free and is widely available, and there is a presumption that the central bank will keep it that way indefinitely, discount rates applied to assessing the value of future cash flows shift downward, making for lower hurdle rates for valuations. A bull market for stocks and other claims on tradable companies ensues; the financial world looks rather comely.
Market operators donning beer goggles and even some sober economists consider analysts like Boockvar party poopers. But I have found myself making arguments similar to his and to those of other skeptics at recent FOMC meetings, pointing to some developments that signal we have made for an intoxicating brew as we have continued pouring liquidity down the economy's throat.
Among them:
• Share buybacks financed by debt issuance that after tax treatment and inflation incur minimal, and in some cases negative, cost; this has a most pleasant effect on earnings per share apart from top-line revenue growth.
• Dividend payouts financed by cheap debt that bolster share prices.
• The "bull/bear spread" for equities now being higher than in October 2007.
• Stock market metrics such as price-to-sales ratios and market capitalization as a percentage of gross domestic product at eye-popping levels not seen since the dotcom boom of the late 1990s.
• Margin debt that is pushing up against all-time records.
• In the bond market, investment-grade yield spreads over "risk free" government bonds becoming abnormally tight.
• "Covenant lite" lending becoming robust and the spread between CCC credit and investment-grade credit or the risk-free rate historically narrow.
And then there are the knock-on effects of all of the above. Market operators are once again spending money freely outside of their day jobs. An example: For almost 40 years, I have spent a not insignificant portion of my savings collecting rare, first-edition books. Like any patient investor in any market, I have learned through several market cycles that you buy when nobody wants something and sell when everyone clamors for more.
I want to make clear that I am not among those who think we are presently in a 'bubble' mode for stocks or bonds or most other assets. But this much I know: Just as Martin knew by virtue of his background as a noneconomist who had hands-on Wall Street experience, markets for anything tradable overshoot and one must be prepared for adjustments that bring markets back to normal valuations."
4) When Will Corporate Profit Margin Contract via Pragmatic Capitalist
The key bullish argument for a continued rise in the stock market is continued expansion of corporate earnings. In history, analysts have consistently overshot earnings estimates by roughly 33% while never forecasting a reversion of earnings or margins. Cullen Roche made a good point relative to the reversion process.
"But this isn't a question of if. It's a question of when. Profit margins will mean revert at some point. But they could also stay high for many years and you could miss huge gains like 2013 waiting for the mean reversion to actually occur."
"One thing we know is that recessions are devastating for corporations. And they're not only devastating for corporations, they're often devastating for markets. In the last 60 years all of the year over year 30%+ declines in the S&P 500 have occurred inside of a recession. In other words, outlier tail risk type returns tend to occur inside of a recession. And if we look at profit margins we find something similar. They almost always contract inside of a recession or within a few months of a recession."
5) Half In U.S. Wary Of Investing by Gallup
I thought this poll from Gallup was interesting. The rally in the markets over the last 5 years has often been dubbed the "most hated rally" because individual investors stayed out.
"Half of Americans say investing $1,000 in the stock market right now would be a bad idea, even though the Dow Jones Industrial Average and Standard & Poor's 500 index have recently hit record highs. Forty-six percent of Americans say investing $1,000 in the stock market would be a good idea."
"Despite a Dow closing record high of 16,576 this past New Year's Eve, and an average that has stayed well above 16,000 throughout January, Americans appear skittish about pouring money into what appears to be a bull market, according to a Gallup poll conducted Jan. 5-8. In January 2000, when the Dow was at a then-record high of 11,500, Americans were much more likely to say investing in the stock market was a good idea than they are today. A record-high 67% of Americans that month said investing was a good idea."
This recent poll jumped out at me because it really speaks to two things about individual investors today:
1) They have been so financially destroyed by the previous two bear markets that they have lost trust in the financial markets and advisors who so poorly guided them, and/or;
2) This is that complacency period (as in 2004-2006) before the final "mania phase" sets in.
The Gallup poll is an interesting when juxtaposed to the American Association of Individual Investors survey, which I discussed recently in Charts Every Market Bull Should Consider as shown below:
What are you "pondering" this weekend?