Avoid market losses, and death, by understanding change

Change is good

-Yes, for the Greek too

Research of all kinds shows living an ever-changing “lateral life” improves happiness, general health, keeps brain diseases at bay, increases longevity, not to mention makes you smarter, better at learning (higher brain plasticity potential) and more experienced and skillful with the ability to connect the dots between diverse knowledge areas.

In short, change is good.

Keep changing preemptively and purposefully. You will anyway, just not in a beneficial way without some nudging (albeit not by the state).

 

This post is mirrored at the Swedish site for financial information, TradeVenue

 

Break out of homeostasis

In addition, change happens all around you. And, changing willfully primes you for identifying and embracing that change – makes it easier to break out of all sorts of homeostasis, rather than be broken down by it, as Ludvig at SGM might put it.

 

School induced homeostasis in me at an early age

The worst thing school did to me, apart from generally waste my time, was to fool me into believing in constant truths (not least in physics).

I learned that a planet was a planet, not just by a temporary definition. I learned that the four forces were just that, always were, always will be – rather than a temporary convention to describe certain phenomena within a quite wide but still limited range. I learned time flowed forward and more or less constantly, except for in relativistic experiments.

Not least I learned time in itself was indivisible and continuous, though possibly with a lower limit of Planck time (5*10^-44s). It was never proposed that time might be something else altogether that we only approximate with something called time, and that it was just convenient in our current paradigm to treat time as, … well the time as we know it today. It was quite preposterous really, to assume and teach that the approximately just 75-year old view of time was correct and would stay constant forever! 

It has taken me forever to relearn that everything changes, not just scientific paradigms – everything. Earth’s rotation changes (the leap second), the moon’s distance to earth changes, the discovery of dark matter and dark energy might in retrospect be just one small of thousands of discoveries over the coming thousand millennia and forward.

Moral and ethics change, maybe even the rules of logic (!).

You and I change – faster than you think, but we are protected by the narrative “I” that always claim everything is coherent and as it should be, and not least constant going forward. The “I” is lying. Actually, the I doesn’t even know the “me”, but more about that some other time (or read Nörretrander’s amazing book yourself. I recommend it highly!).

 

TED radio hour chimes in on time, change and happiness

The other day, I was listening to the (recommended) TED Radio hour’s pod cast on time (Shifting Time, 19 june 2015). As always several TED talks and aspects of change and time were discussed, but one topic regarding aging, personality change and happiness struck me particularly:

Almost all people have the experience of having grown into their real self.

We all [almost all – no spam or trolling please!] think we are finally the real me. We know we changed a lot growing up and aging, perhaps can hardly even stand for some of our earlier opinions and actions, but now finally have reached a stable self plateau.

And yet, research shows that we keep changing, morphing into somebody else over the course of 10 years, over and over again. It seems we know we could change in either direction along an infinite number of parameters (extroversion, e.g.) but since the potential changes even out, we instinctively expect status quo to reign. It’s like approaching a T-crossing expecting to stay there :)

 

So, expect change, and manage it

-That’s really all I’m saying.

That goes for companies and stocks too.

The current stock price will change, the price trend will change, sales and profits will change, valuation multiples of those fundamentals will change, competition will change, client preferences and demand will change, costs will change. All mentioned factors for the company’s peers/competitors will change.

If Apple could emerge from the grave and crush Nokia, Apple too can be Appled. Facebook, which crushed MySpace to oblivion, can be Facebooked. And Tesla can…, well Tesla hasn’t actually done anything yet, not at a profit anyway. Remember Kodak? Or when Dell, HP or IBM was all the rage?

My distillation of best practices in the market boils down to just two things to consider:

1. How is it now?

2. What will or must change? (fundamentals, perception…)

 

Expecto patronum! Or, rather, happiness

If that HP reference flew right over your head, never mind. It’s not important.

-You can expect time to save you, to make you happy (unless you get sick)

Research shows a trough in perceived well-being around the age of 50 (coincidentally not far from my age; 43), followed by a strong trend of improvement, leading to new all time highs just 20 years later. The risk of depression follows a similar (inverted) path.

One theory of why is that older people get happier with age because they are relieved of the burden of thinking about the future; relieved of change (despite the fact that they are facing the biggest change of them all… -on the other hand into a state of absolute stasis)

What about lateral living and homeostasis – is it good to become older and happier, or is that actually dying? I’m inclined to think the latter.

So keep changing and keep living – hopefully long enough to live forever (AI, genetics, nanotechnology, stem cells, robotics and all that. Huge changes are coming sooner than you think [WaitButWhy]).

Charts of happiness (and depression risk) show a trough around my age and then ever improving numbers into old age.

I’m thus more or less at my worst now, although I’ve never had it better, I think.

Either I’m just born that way, thinking every year is better than the last. Or, just maybe, my instinctive focus on incremental change and growth (just one more, always be investing etc.) rather than a point target (becoming financially independent, rich, the best, buying a particular item or any such thing) is key. 

 

Conclusion and summary

Just take this with you, no new practices, no new habits:

Be prepared for change, never status quo

Embrace it. Manage it. Master it. Don’t just sit on your favorite stock because it has done well. Analyze it; imagine things changing. Don’t hold on to your job or partner for dear life or by complacency. Proactively manage for change. Expect it. Perhaps even prevent undesired change by changing something else.

This post, and all my articles going forward, will be posted in parallel at the Swedish site for financial information TradeVenue

 

It’s different this time – can you profit from it?

Summary: It’s different. You’re screwed.

This is what you’re getting into: Endless bearish rambling of historical market performance over various half and full cycles. In short: you’re screwed.

Graphs galore: You’ll also via several charts, learn how things are different this time – and not in a good way. Debts, profit margins, sentiment, volumes, algo trading, money printing, inflation, price moves, global synchronization, junk bond issuance, stock buy backs, valuations, fiscal and monetary stimulus in the U.S. and abroad are all at historical extremes. Normalization or a full pendulum swing would spell disaster.

Central punks: At the heart of it all sit the central banks, not least the Fed, and their financial repression, pushing savers into overpriced risky assets and inflationary consumption behavior. Zero interest rates have papered over unsustainable debt levels and hollowed out the economy through malinvestments. What’s left is record folly on all accounts, sometimes seemingly appearing to support the house of cards it really is, but is tantamount to having run over a cliff (but not yet plunged) or lifting yourself by the hair.

No silver lining: I offer no solutions (except maybe the one about creating real value, and the other about how to get 20% return per year and an extra marshmallow), no way out, but to wait and hope it’s not too different this time and that there’ll come a decent investment opportunity down the road

Crazy or delusional – your choice

In the previous post we explored a handful of ways to build an investment  portfolio. 3 out of 4 basically meant throwing in the towel, closing your eyes and just go for it. The fourth takes a delusional mind, thinking it actually is possible to time markets.

Markets will move. Will you?

There is no doubt that markets do move significantly up and down.

Everybody knows markets sometimes halve in value and single stocks fall by 75-90% or go out of business completely. Nobody is oblivious of the fact that markets dropped by around 50% twice in just the first decade this century.

It’s just the timing part that’s difficult. Most resign before the task and simply buy, hoping it’ll work out okay over time – fully aware that there will come a halving in fortune sooner or later. Others, retarded types like yours truly, still believe it’s better to wait for good (better) opportunities to buy, i.e., practice market timing. In particular after 6 years of rising prices.

It’s the ratios, stupid

It’s not that stocks have to go down nominally, it’s the valuation of probable future cash flows that I have a beef with. I can pay a million dollars for a steak as long as I get a billion in monthly pay. Likewise I’m happy to pay 500$ per Amazon share, as long as prospective annual free cash flows average at least 35$ per share.

Stocks and markets fluctuate between cheap and expensive, and I want to buy cheaply even if it means waiting. There is never a hurry to invest. Opportunities will cycle back. Presently, ratios between pay, prices, profits, sales, debt, risk etc. are more out of whack than usual, leading to the conclusion that…

This time it’s different

I’m not joking. It is different. To see how so we first need a little perspective (even if I think 20 years is too little to truly get perspective on the stock market).

Sure, the 2000 peak in S&P 500 was followed by a 50% plunge, and the 2007 peak ended even worse; setting a lower low in 2009 than in 2003. And, yes, for the 13 years between 1996 and 2009 the most important stock market index in the world got nowhere.

However, the market soared gloriously in between: +250% from 1995 to 2000 and +100% from 2003-2007, not to mention the most recent tripling (+200%) since 2009.

7.5% real return per year

A long term investor that got in right before the central bank-propelled rallies started in 1995, was rewarded by a nice and round +350% increase in (real, assuming dividend=inflation) value over just 20 years or 7.8% per year. Let’s call it 7.5% (since actual inflation probably was a little higher than the average dividend yield).

7.5% per year, every year?! Who wouldn’t want that kind of return? Let’s buy some shares right away!

Just a little note of caution: that return was achieved from trough to peak (presumably) over two and a half cycles. It also took us to the current extreme and utterly unsustainable situation (see more below about how it’s different this time). For the complete two cycles 1995-2009 the annual return was ‘just’ 2.5% per year over 14 years.

Can you really get 2.5% per year over a cycle?

Hey, 2.5% is still much better than current interest rates, let’s go, I’m calling my broker now. (I’m obviously talking to an idiot that just can’t get that the 2.5% return was still predicated on buying at the 1995 generational bottom, albeit selling at a bottom too). There are no guarantees whatsoever you’ll get as good a return as 2.5% per year over an arbitrary cycle.

Before you make the call, let’s look at negative half-cycles first, just to get a feel for the “worst case” scenario. From the peak of 2000 to the second trough of 2009 the total return was a negative 57% or 9-10% real fall per year for 9 years.

If we happen to be near a peak right now and we experienced a similar 1.5 cycles, your 100 would be worth 43 in the year 2024. Obviously it could be even worse, considering the height of the current peak and that the downturn in 2009 was cut short by remarkable political interventions that will prove hard to repeat.

From there (2024) you would need an increase in value by (at least) 133% just to get back to your 2015 par value of 100. That might be done in 5 years time (just look at 1995-2000 and 2003-2007, as well as 2009-2015) but could also take longer (if investors have wisened ever so little over time and don’t fall as easily for bubble blowing the next time round).

Assuming a historically impressive 10% return per year from 2024, it would take 9 years, i.e. until 2033 for you to get back to your current 100 (if we are near a peak now and history repeats, and you then get 10% per year for 9 years in a row). All numbers in real terms and assuming dividends equal inflation.

Are you ready to wait until 2040 for zero returns?

If the economy would slow compared to trend, or inflation or interests rise, making dividends dry up somewhat your outcome would be worse. And, in case you lost track, that would take us to a new peak and you would be required the wherewithal to sell at that peak after 9 strong years in a row just to bag ZERO return between 2015-2033. Well that is if we even get a 133% appreciation after 2024, AND that the fall from now to 2024 is as ‘mild’ as the 2000-2009 bear market. We might have to go through yet an entire 7-year cycle (2038-2040?) to get to or above the 2015 par value.

Uhhh, you’re so damn negative. What about a peak in the year 2022, what would I get between now and then?

Well, you got nothing between the peaks of 2000 and 2007, despite 2007 being a new all time high, inflated by irrational hopes on the BRICS (Brazil, Russia, India, China and South Africa) – such a peak that it had to be followed by a plunge of 60% in the S&P 500, before the largest money printing (and not least very shady new banking accounting legislation) effort in history managed to turn things around.

And you got nothing (actually a negative return) between the troughs (i.e., full cycle) of 2003 and 2009.

Even buying at bottoms is no guarantee for profits

Yes, true story, even if you bought perfectly at the bottom of 2003, you would have lost money by holding on to your investments for 6 years (I just hope that hypothetical investor didn’t buy anything at higher prices in between).

Today’s peak (if that’s what it is – hint: it is) stands 1/3 higher than the 2007 peak, and since 2007 a lot of things have changed (for the worse)… and I am coming to that in a bit. Hence, it would be quite a stretch to hope for the next peak to surpass the current one, considering how ridiculous circumstances are right now.

Buying at peaks all but guarantee no profits for a long time

My best guess is that, peak-to-peak 2015-2022 will produce a flat to negative return (and possibly much worse if inflation takes hold – not unreasonable given the ubiquitous money printing). But the next peak, in 2030-33 just might reach today’s level :D ! Ahhh, is that a smile I see on your face? Even that, however, would take a creative mind, so let’s aim for 2040 instead. :(

If nothing else, perhaps the pre-singularity reverberations (immense advancements in technology and productivity) will lift stock prices to new highs by then. Or money won’t matter at all, but let’s not assume things will be that different just yet.

But, but, but, you said it was different; it sounds as if you’re expecting exactly the same kind of crashes as after 2000 and 2007.

No, it is different. Just much worse. Here’s how:

As brief as I can be: Very particular and unusual circumstances and set of factors have converged and resonated, to elevate stocks to today’s levels (I will soon get to the point of how it’s different – see charts below).

These conditions are not likely to be repeated for a very long time, thus ruling out consecutive epic peaks like the last three (2000, 2007 and 2015), delaying and diminishing coming peaks (2024, 2032, 2040).

Quite to the contrary, these simultaneous overshoots will undershoot, possibly synchronized, to create a generational bottom before normalizing (meaning, recovering from the bottom, but not approaching bubble-like peaks for a while – you really shouldn’t count on every peak being the stupidest bubble ever).

I don’t care if I sound like a broken record. This is how I see it, and if I don’t tell it, then who will? Sure, I’ll play the mentally challenged for some time, but I’d rather look like a fool before the event than after.

Buy stocks if you want, there could be 2% in it per year until 2030 or so

-if that peak turns out as insane as this one

Also, I don’t mean to discourage anybody from buying stocks (yes, I do). I just want to set the record straight, to make sure you know what it is investors actually got from the market historically and under which conditions.

It’s all to easy to see nothing but the recent 200% surge (20% per year for 6 years), or 7.5% annually since 1995, and extrapolate from there, despite even veteran buyers from 15 years back just got 2% per year on average by holding on all the way up to today.

Bull talk: +3.5% per year until 2023 – any takers?

One bullish note, before moving on to the “this time it’s different” charts: If you start buying carefully now, and throughout the downturn and recovery, you might achieve an average price 25% below current levels by the time we hit the next peak (well, if it reaches the current crazy levels).

That’s not too bad; it could amount to +33% return over let’s say 8 years, or 3.5% per year. Just don’t be fully invested right now, but aim for averaging over the full cycle (remember you have already abandoned all hope of timing cycles, so don’t expect to think differently at the bottom).

Everything that’s different

Finally, here it is – everything that’s different.

Debt

All that really needs to be said is that there is more debt and credit sloshing around than ever before. Sooner or later the piper needs to be paid, and there just isn’t enough assets to go around. Once selling starts, the higher the debts the worse the eventual fall.

Stock purchases are financed with debt. NYSE margin debt is at its all time high (downturns in levered long trades do not bode well – selling begets forced selling and so on). Margin debt has tripled since 2009 and is higher than the peaks of 2000 and 2007. Is anybody paying attention?

Money printing has lifted spirits and leaked into markets in an unprecedented manner. Fed’s balance sheet has quintupled since the last downturn commenced. That’s 3.7 tn dollars extra. There is a long way down for both the economy and stock markets, if the monetary support wanes (keeping it up is also risky; inflation, dollar crash, import and other trade issues).

Japan has truly gone full retard (“if 20 years of QE doesn’t do it, let’s try harder…”)

Household debt and corporate debt are also at highs, leaving total debt at dizzying heights How does 60 tn USD sound (3.5x GDP)?

There is nothing wrong with debt in itself. As long as the debt is used to finance productive investments that return more than the cost of debt (risk adjusted) you should borrow.

However, when interest rates are close to zero, investors, politicians and entrepreneurs turn to ever lower quality projects and the ratio of value-destroying malinvestments increases.

Corporations are issuing more “high yield” junk bonds than ever and they are using the money for stock buybacks and other poor investments. This practice is building a house of cards of stocks with elevated valuations and companies with high debt that can’t be serviced at normalized interest rates.

Interest rates

They have never been lower. In many places interest rates are even going negative now. What’s really different is that it’s happening at a peak of a business and stock market cycle. What’s supposed to happen in the coming downturn?

The downturn surely will exhibit some different features this time, considering the starting point with maximum debt and zero interest rates.

Banks often run into trouble in downturns, in particular after debt binges. Then tax payers bail them out, adding to the national debt. This time that would occur on top of already record high debt – levels that many already consider unsustainable.

Can this situation with zero interest rates last? What incentive does anybody have to save (which is needed to invest)? Hardly anybody wants to save and many are led to speculate/malinvest, eroding the real base and growth potential of the economy.

Even the Japanese have stopped saving. That’s different this time. Instead the BOJ has to buy all the debt the Japanese treasury issues.

Here is what has happened everywhere:

Bailouts and ever lower interest rates created the impression of very low risk. Investors consequently piled on more risk, pushing up prices on assets (like the stock market). This in turn made stocks seem like the only game in town, almost forcing everybody and their dogs (not my Ronja though) to abandon zero interest bank accounts and treasuries in favor of stocks, pushing the market even higher.

Low interest rates, easy loans (car loans, student loans, mortgages) also fueled consumption despite stagnant wages (the median wage is still at the 1998 level in the U.S.). Hell, you wouldn’t want one idle cent at a zero interest account when everybody else were making big bucks on Apple shares, so you went out and bough a couple of iPhones and some Apple stock. Everybody did that.

This has made sales and profits look better, has caused corporations to hire more people (poorly paid, and part-time, but still hired) and push down official unemployment numbers. With a job it’s easier to get a loan and shop more…

So, low interest rates have made fundamentals (sales, profits, employment) look better while at the same time pushing up valuation multiples (P/E 10 has gone to 17) of those fundamentals through debt financed buybacks and panicked investors feeling left behind.

 

In the background debt has silently been piled on debt – unnoticed due to near zero interest rates, and borrowed money has been used for consumption and poorly considered investments that will turn sour when interest rates rise or consumers become more fearful.

The climb to the peak continues, as long as risk aversion is low, as long as returns are positive, as long as interest rates are low, as long as debts can be serviced (requiring a solid job market and low interest rates or at least rising stocks).

A system fraught with fingers of instability

The lower the interest and the higher the debt (both are at new historic extremes) the more sensitive the system. The more uncertain and poorly paying jobs (stagnant wages since 1998, albeit higher than 2009; real underemployment at the highest level in decades) and the more interest rate dependent the economy (debt financed consumption, debt financed companies and projects), the more sensitive the system.

Underemployment is at highs:

Usually debt ratios are low and interests rates high before a downturn. In a slowdown interest rates fall, mitigating the debt burdens. Some debtors still default but thanks to the low starting point the resulting debt level isn’t disastrous. This time it’s very different:

Leaving new monetarism and extreme QE aside, any little thing could topple the current situation. Falling stock prices could trigger an avalanche of stop losses and more sell orders.

If investors demand higher interest rates to buy treasuries (as they rightly don’t like the money printing that’s eroding the dollar’s value), the government would need to tighten its budget and lay off people. Squeezed consumers (living off loans) would spend less due to lay-offs and higher interest rates, causing the private sector to streamline (more lay offs…).

Did I mention the market didn’t care about easier money the last two market crashes? (charts from Hussman, showing how the Fed eased all the way down)

Corporate profit margins are at all time highs. Over the last few hundred years, profit margins have been strongly mean reverting due to competition and wage cost/disposable income dynamics for costs, sales and profits.

Right now automation and cheap loans (fueling consumption, i.e. sales, and reducing borrowing costs for the companies themselves) have enabled more sales and higher profit margins from fewer and cheaper employees. In addition, banks are the biggest beneficiaries of all, since they make their living on debt and there is record amounts of it to go around now.

Actually, the digital era that started in earnest 20 years ago, but accelerated further 8 years ago with the milestone product the iPhone, has meant faster churn among the Fortune 500 companies (companies leaving the list), not to mention much higher brand disaster risk (the risk of a 20% drop in brand value in a single quarter over a period of 5 years). This should mean less barriers to entry, more competition, less pricing power, lower margins over time, shorter company and production life spans. This sounds really stupid right now (at current record high margins), but corporate margins should undershoot their average level significantly going forward.

Google, Apple and Amazon might seem invincible and eternal right now but so did Steinway and Kodak at one time.

Valuations are higher than ever (median P/E, EV/EBITDA, P/S, e.g.), based on record high margins expected to last forever, based on low interest rates and only very low-yielding direct projects left on the table all but forcing money into stocks instead (at any price, to not be left behind). Oh, and record buybacks as well (debt-financed at record low interest rates).

 

Picture source

When growth falls, profits undershoot, interest rates normalize, buybacks dry up and the public’s penchant for stock market speculation diminishes, valuations are likely to undershoot too. Well, they have to unless the historic average has shifted upward permanently.

It’s different (right now). That doesn’t mean it will continue to be – it usually doesn’t

Picture from zerohedge

 

Chart from Hussman that shows probable forward looking annual returns:

All lines ending in 2015 project the expected annual return over the coming 10 years 2015-2025. Right now it’s around 0% total nominal return per year, meaning the S&P 500 index is expected to be lower in 2025 than today and the difference made up by dividends. The line ending in 2005 at around 8% is the actual 10-year average annual return over the 10 years 2005-2015. That’s about twice the projected level of 4%. Historically such unexpected overshoots have been followed by periods of undershooting the projection. A repeat would mean much worse returns than the projected 0% per year, over the coming 10 years.

As you can see, debt and interest rates infiltrate every corner of the economy and feeds on itself, giving rise to more consumption, higher profits, more speculation & buybacks and higher valuations, while undermining the real economy (lower growth potential ahead) with negative return malinvestments and speculation instead of innovation, investments and production. 

Forward Price Earnings ratio is at highs

At some point between the current extreme and a future point, it’s possible that the economy, sentiment, sales, profits and valuations all undershoot at the same time.

If not, it’s bad enough if they normalize at the same time. Heck, even if only one variable normalizes or undershoots over the coming 3 years, stocks are in for a deep dive. In fact, if markets were free to find the clearing price for interest rates, the other variables would normalize automatically

How did we get to this extreme situation, where all important variables have ended up in la la land?

  • The Fed’s money printing and ZIRP (zero interest rate policy) have fueled both profits and various forms of speculation, driving reported unemployment lower, profits higher and valuations higher
  • Bail-outs causing moral hazard (excessive risk taking since you’ll book the gains and tax payers the losses).
  • Algorithmic trading (most don’t care about absolute levels, meaning stocks can drift arbitrarily far from fundamentals)
  • Record world participation: China, Japan, the US, UK, Europe, Brazil, Russia – every major economy is stimulating their economies at the same time. The developing world is more important than ever thanks to two decades of high growth. The flip side is that the entire world is facing the same problems at the same time. The strong comeback 2003-2007 depended on the BRICS (not least infrastructure [stimulus] spending in China, Brazil’s and Australia’s commodity boom and Russia’s oil bonanza). That trick is spent now. That’s what’s different this time.

Stock market volumes are dominated by algo trading, HFTs. Some estimates point to 70-85% of all stock market trades being done by autonomous computer programs. Measured as the number of placed (and withdrawn) orders it’s more like 99.99%. It’s not real money out there, don’t try to make sense of what’s happening. It’s just machines playing games with each other.

Much of the remaining 15% real money trading will disappear too if/when algo trading collapses. Despite all computer based trading, volumes are shrinking. And try to fit the 15% real money in these charts:

 

A week ago, one HFT firm (A) filed a suit against another one (B). The suit was based on firm B’s market manipulating algos hindering firm A’s algos from manipulating markets in its desired fashion.

As another example, a few years ago a person was charged with tricking a market manipulating algo into making mistakes that the person thus benefited from.

We can see the HFT presence in the record high frequency of “market breaks” when exchanges crash.

Other different or ominous developments:

The oil price collapse

The Baltic Dry collapse to all time lows

Record bull advance (length, height). There is a limit to how long investors can become more optimistic every day.

US macro surprise index

On the bright side (no irony) the US economy can only surprise less negatively going forward

Record low number of negative investors

-that’s why stocks have been able to climb so far. Bears have converted to bulls. But it’s no indication of further increases – quite the opposite.

Record weak China house price development

Record high junk bond issuance

Of course companies issue as much junk bonds they can during this search for yield phase. Wouldn’t you? It’s basically money for free. Some saturation can however already be discerned – signalling increasing risk aversion which often is followed by plunging markets.

Junk bond yield signals are not so different

This chart is simply too stupid. Nobody is that crazy:

The USD (DXY index)

Paradoxically getting stronger but first and foremost more mobile – be careful when currencies move faster than usual.

Oh, it’s different

To summarize, it’s different alright; much worse, volatile and inherently unstable than earlier pre crash episodes. In short, it’s the worst time ever to invest. Hussman’s chart below shows (vertical lines) when his thoroughly back-tested ‘ensemble’ of valuation and timing methods have signalled strong sell. Q1 2015 is worse than ever.

Taxes next?

The Fed can’t keep funding the deficit, since the dollar would collapse sooner or later – causing all sorts of hell (imported inflation, energy crisis, trade wars). They can go on for a long time, but not indefinitely.

Hence, either inflation erodes savers’ money in order to get debt/gdp under control, or increased taxes will have to deal with the primary deficit problem – unless the U.S. wants to default (unthinkable?).

Perhaps increased taxes (they are at lows), or cut in welfare spending (unlikely), will be the proverbial straw on the camel’s back? Well, better that than revolution or war as Paul Tudor Jones warns.

What to do?

I’m waiting. Shorting and waiting, hoping the fall won’t be too cataclysmic or different (or take to long to get going, which could be the same thing).

If you can’t stand waiting, I unfortunately have very little comfort or advice to offer (see previous post for some more or less desperate possibilities).

Build real value:

  • Have fun and live now, before the feces hit the air conditioner. Happiness is real.
  • Invest in yourself (skills, experiences, fun) – prepare for the next round
  • Build a business, a real business – not speculation. Make other people’s lives better and you’ll make a profit.
  • Make sure your debt is strategic, not just built on hopes of eternally low interest rates. Amortize, fix the rate for 5-10 years, use the money for real value building investments, not a bigger house or consumption.
  • If you feel you must invest, buy something others don’t. Look among the losers and the small, not the hyped giants. Imagine you buy the entire company and take it private, actually getting its cash flow, not just hoping to sell the stock at a profit to a bigger fool.

Stocks, bonds, metals, commodities – forget it, you simply won’t be long term enough to stand the downturn that most likely is just around the corner. If you are thinking about being fully invested NOW, you most likely will be all out 50-60% down from here.

Silver lining

There is always a silver lining. If you can handle waiting for a normal time to invest, you should get 10% per annum for quite a while after that. Markets almost always dip below levels that promise that kind of returns for a decade.

If you are lucky enough to wait out an epic bottom (don’t hold your breath though – even if I think that’s exactly what’s coming) you could get twice that for several years.

If you can be different, if you can wait, you’ll get two marshmallows instead of just one. How’s that for being optimistic?

How to build a professional investment portfolio

In this article you will get a beginner’s guide to building your own investment portfolio (4 different methods). In the next article you’ll see how you’re screwed anyway. But first this:

Burying the grand piano

Pianos were all the rage in the early 1900’s. The iconic Steinway & Sons thrived together with hundreds of other piano companies.

You would almost be forgiven for investing your pension in Steinway as part of your BAH, Trend, Quattro or BLSH portfolio strategy (more about these four classes of investment methods last in this article).

Then, quite suddenly actually, recorded music stole their march, and the dying piano company had to use its aging wood inventory for building coffins (!) for war casualties.

Peak piano was reached quickly and early.

Since then the recorded music industry of course has expanded rapidly, and employs many more than ever worked in piano related jobs*. It’s only fitting that the futurologist Ray Kurzweil was responsible for the final nail in the coffin by inventing the piano synthesizer.

(*it’s not every day I use the word “piano related jobs” in a sentence, but when I do it’s glorious)

Peak everything

Malthusians have throughout history predicted peak food, peak wood, peak oil, peak energy, peak jobs and other catastrophic developments associated with the growing global infestation called humanity.

Right now, it’s automation that piques the doomsayers’ interest.

Is it different this time? It might be. Will unemployment rise uncontrollably, or will the advent of increasingly competent machines (as always before) just result in relieving humans of boring, heavy and dangerous work, rather than create an irreversible increase in unemployment?

Could the accelerating speed with which new inventions are made make a difference vs. history? Companies like Amazon and Google, e.g., have replaced labor intensive industries with machines and machine intelligence. Where are those laid off supposed to go? Unless they acquire new sets of skills, probably straight into long term unemployment. It really could be different this time with technology causing massive unemployment (not necessarily a negative development though).

A recent Freakonomics podcast episode elaborated on the death of the middle class, where clerical and blue collar employees in repetitive jobs risk being replaced by robots and AIs. Only work requiring a responsive and adaptive human touch, both in the low end (massage therapists, dog walkers) and high end (business managers, creative artists, psychologists, physicians, marketing) are safe (for now). The process of automation is speeding up and machines are increasingly crowding out humans from the middle and out.

Note: whatever career path you choose, make sure it’s creative and change resistant, preferably something where you utilize the rapidly evolving technological tools to ride upon into the future, rather than being replaced by them.

How is it different this time?

This article is neither about the death of jobs, nor about the future of technology. It’s not even about the new version (with a disturbing duplo picture of me) of my book The Retarded Hedge Fund Manager (free for newsletter subscribers).

It’s not about asking if various aspects of today are different from similar historic episodes. It’s about asking in which way it is different this time. Not least regarding the economy, money, wealth and in particular the financial markets.

The stock market is different this time

Okay, read-bait, I admit. But still, the market is different, everything is different. The question is only how. More about that later (my next article which I will publish shortly). Here is what is not different: investing.

The principles of investing remain the same as always, i.e. postpone consumption for productive endeavors, as opposed to gambling and speculation (buying things at any price, hoping for luck or a bigger fool). Investment is about value, true intrinsic value that is likely to be realized and compensate for the risk involved. You should approach investments in the stock market and investments in your own business in the same manner.

Four classes of investment methods

These are four of the most common investment methods:

  • Buy And Hold
    • Main local index
    • Global
    • Selective
  • Trend Following
    • Long only
    • Long and Short
  • Quattro Stagione (recommended)
    • Static
    • Adaptive
  • Buy Low Sell High
    • Long only
    • Long and Short

 Let’s go through the models in more detail below.

Buy And Hold

It couldn’t be more easy: Buy stocks any time and every time. Hold on to the stocks forever. Live off of the dividends and reinvest what you don’t need right now.

Over time (100 years, and most 25 year intervals) BAH has produced real returns of around 6 per cent per year. But remember that even the fantastic cycles of 1994-2003 and 1995-2015 only returned 7% per year (including dividends and adjusted for inflation)

The best things with BAH are:

  • It’s super easy, no maintenance at all
  • The returns are decent, as long as you don’t start investing too late in life and happen to get in near a peak
  • You’ll ride every bubble all the way to the peak, periodically making you feel like a genius

The main drawbacks are:

  • Sometimes the return is negative over 10-20 years
  • You have to stay calm when your portfolio halves in value every now and then, since you’ll ride every crash all the way to the bottom, making you feel exactly like the schmuck you probably are :)
    • (e.g., 2001-2002 and 2007-2009. In addition, before that, a BAH investor had to live through the downturn of 1998, the 1987 overnight crash, not to mention the crashes of the 1970s, which was an era eerily reminiscent of the current period since the year 2000)
  • The last 20 years leading up to your death can be hard to manage – the method has no guidance as to how or when to sell

If you want to try to improve on the model, you could be selective in which stocks to buy and hold, e.g.:

  • You could choose last year’s worst performing stocks and hope they rebound. This is most famously known as Dogs of the Dow, but it can really be the “dogs” of anything.
  • You could choose high growth stocks, e.g. stocks with the highest historical or projected growth rates or measured any other way you like.
  • You could choose particular industries, such as high tech only, media only or pharmaceuticals only or any combination that suits your preferences
  • You could choose your main national index – or some other country, or diversify globally.
  • You could churn your portfolio annually and replace your most expensive stocks with the cheapest stocks, or cheapest markets based on any valuation method or methods you fancy: P/S, EV/EBIT, market cap/GDP, various forms of P/E

In short, with BAH you’ll get low single digit returns over time (typically 2-6% real return per year depending on when you buy and how long you stay invested), while experiencing dizzying doublings, triplings as well as gut wrenching halvings. If you are lucky enough to buy near a trough and eventually sell at a peak, your average returns will of course be much higher.

The coming years any BAH investor should expect the S&P 500 index to dip below the peak level of year 2000, thus producing negative returns over 16-18 years, depending on when the downturn and subsequent recovery occur.

S&P 500 index 1994-2015

Green line: 600 day moving average

Trend Following

Device a trend identifying model (e.g., based on a moving average), calibrate and back test. Consider fees, trading too often on false signals and missing turning points by a mile. Then set your alarms and start trading.

Trend Following takes more work than BAH, at least initially, and it can be stressful when the model doesn’t deliver. In return, a well calibrated model can deliver (much) better than BAH. The hedge fund Lynx within the Brummer group (the same group as my fund Futuris), e.g., has delivered spectacularly well with its trend following models in all conceivable asset classes (stocks, bonds, currencies etc) over the last 15 years.

Look at the chart above and imagine you base your trend discovery and trading on the 600 day moving average for the S&P 500 index. Let’s say you decide to buy when the index breaks through the moving average from below and not just sell but go short when it breaks through from above. After one signal you have to wait one year (1 yr filter to avoid false signals) before trading again and then you buy or sell (or stay put) depending on which side of the MAV the index is by then.

With that extremely simple and non-optimized model you would achieve the same return over 1995-2015 as a buy and hold strategy. However, you would only experience one episode of -32% return, instead of two -50% crashes. With my settings above you unfortunately wouldn’t have caught the current rally until 1400-1450 and if a downturn starts soon you wouldn’t sell higher than around 1750, thus only bagging some 20%-points of the recent 200% rally. On the other hand, if the rally continues you would stay invested.

The best with Trend Following models is that they can produce higher returns with less downside risk than a BAH strategy.

The worst is that it can be difficult to trust one’s models fully. Back testing is not the same as future testing.

Quattro Stagioni

The four seasons model of portfolio building is a simple diversification model. Invest one quarter of your assets in, e.g., respectively stocks, treasuries, corporate bonds and gold. The asset classes can be complemented with real estate, soft commodities or longer shorter maturities for government bonds. Other adaptions include the same as for BAH (local, global, selective industries, laggards [aka dogs], cheap, growth etc.)

Reset the asset weights to 25% once a year or semi annually on fixed dates. Usually 2-3 of the asset classes will perform decently every year and make up for the one(s) lagging.

A more adaptive model, that I strongly advocate, increases the stock weights by 15%-points for every consecutive negative year on the stock market: 25%, 40%, 55% etc all the way up to 100% after five consecutive negative years (at which point you would have zero weight for the other three asset classes). Halve the stock weight after the first up-year but with a floor at 25%.

Another (daring) amendment could be reducing the stock weight by 6% points for every consecutive up-year that returns above 25%. After five such years you would be 5% net short in stocks. Or, set a floor at 0%, prohibiting yourself from going short.

The Quattro model takes a fair bit of work, in particular if you want to control the type of stocks and corp bonds in the portfolio rather than just pick the main index constituents. Perhaps you should avoid too much detailed work that eats into your quality time and might produce negative returns unless you know exactly what you’re doing.

The diversification reduces volatility. Adaptive weights both improves performance and reduces volatility. The Quattro model thus is better than both the BAH and Trend models, in particular on a risk adjusted basis (which also means you could try leveraging up, i.e. using borrowed money to invest more than your actual net worth).

In summary, the Quattro takes some work (as much as you like really), but it’s still simple enough for most. The draw downs are small (no crashes), the stress much less than for trend followers that doubt their own models, and the average return is at least as good as for BAH. This is the model most amateurs should adhere to.

Buy Low Sell High, a.k.a. the bullshit (BLSH) model

It really should be called Buy Cheaply and Sell Expensively, but old habits die hard.

Sounds good? Too good? Anybody calling “bullshit” on buying low and selling high? How do you do it?

Choose an objective valuation parameter (or combine several) for the stock exchange. Consider e.g. Price/Sales, CAPE (cyclically adjusted Price/Earnings ratio) and Market cap/GDP.

Over a century of market data, BLSH has performed consistently and remarkably well, for investments with a full business cycle’s (7-10 years) investment horizon. The returns have been at least as good as for the other three strategies and with much lower volatility and draw downs, thus opening up for using leverage (borrowing to increase the return).

Just make sure you do some serious back testing to identify appropriate trading levels. Decide whether to allow for going net short or not. Set alarms and start trading. 

You probably should combine the pure fundamental valuation signals with trend measures (e.g., uniformity among industries) and other technicals (such as junk bond yields) that could help signal peaks and troughs when valuation already is extreme. Just look at John Hussman’s trouble in the current cycle, where ridiculously high valuations have gone stratospheric, leaving him stranded with a fully hedged portfolio (and me fully short!).

BLSH takes a great deal of work. It’s difficult to set fixed levels for trading signals. It’s difficult to once and for all pin down what is expensive and what is cheap. In addition, extreme valuations can be sustained for years depending on the level of investors’ risk tolerance/aversion. The model performs nominally in line with the other models, but (potentially much) better on a risk adjusted-basis.

The best thing with the model is that it intuitively feels right, and like true investing, to buy things that are priced below their intrinsic value and that thus can be bought and hold indefinitely for a good return. And then sell (even go short) at levels where investor euphoria has driven prices above any reasonable measure of true value.

The next best thing is that the returns will be less volatile than BAH and thus allow for leverage (or simply sleeping tight)

The worst thing is that it requires real work (as all real investing does). Buying low and selling high can be made just as complicated as you like.

In addition you will miss riding bubbles to their peaks, thus making you look stupid in the final years of every mania.

The last 20 years of bubble blowing, and in particular the last 6 years, have given the BLSH a bad rep, whereas BAH has gotten the upper hand. Since I think both models will continue to hold up over time, it’s time for the tables to turn now, and let BLSH catch up to BAH the coming decade or so.

I personally prefer to use the BLSH model as a guidance for entire stock markets (right now it’s screaming SELL for the S&P 500) and short or stay neutral the market in the down phase.

Once markets are reasonably valued or getting cheap, I’ll start accumulating individual stocks, that I like and know particularly well, and stick to them until my market model signals SELL again (mainly based on big picture variables such as market wide P/S, complemented with risk aversion signals in the bond market and narrowing advance/decline ratios in the stock market).

In addition, I complement my stock portfolio in a Quattro Stagion-like fashion with gold and commodities, fixed income (lending to individuals and companies, buying convertibles etc.) as well as counting my living quarters as a real estate investment.

When to choose which model

  • If you are lazy but calm and composed, go for Buy and Hold.
  • If you are a little more easily stressed, and willing to do a minimum of work, go for the Quattro Stagione.
  • If you are somewhat more industrious, first check if the market is extremely expensive. Wait if that’s the case. Once it’s less extreme, start buying and holding. If you’re a Quattro guy, just adjust the stock weight appropriately – perhaps to 13-19% currently instead of 25%.
  • The next level, no matter if you started out with BAH or Quattro, is to keep a lookout for when the market is becoming extremely highly valued (like now). Then sell your holdings and wait for more reasonable times. That, however, takes constant surveillance – at least annual check points.
  • If you like to gamble and think you might be able to improve on billions of dollars’ worth of trend research, try your own trend following models. It’ll probably work like a charm for a while. And then you’ll go broke. Good luck.
  • If you’re really into investing and not easily stressed go for BLSH; stocks only.

I‘m somewhere between the Quattro and the BLSH type of investor.

A note on switching models:

If you have two models, like BAH (Buy and Hold) and BLSH that have both performed more or less equally well over a hundred years of investing, then you should switch from the one that has outperformed in the most recent 5-10 year period to the one that has underperformed. Well, unless you think the table really has turned and that it is fully different this time and going forward.

The last 2-3 years, BLSH has performed poorly, while BAH has been a spectacular success. Some might get an urge to switch from the lagging BLSH to the better performing BAH. That would, however, probably end in tears, as the BLSH is bound to catch up with BAH over the coming years, unless a hundred years of investing information suddenly has become worthless.

State of play – summary

I would advice against trying trend following. You’re up against mighty opponents and it has nothing to do with actual investing. It’s pure speculation.

Do go for buy and hold, but be prepared for 10 years of no or negative returns first (with a couple of halvings in between), before you start getting any rewards for your risk.

The market is currently more expensive than it has ever been (on some important measures for the median stock – more about that in my next article). That is not a good time to start investing in stocks.

I would thus recommend building a Quattro Stagione inspired portfolio of gold and safe corporate bonds and keep money in the bank, money market or short term treasuries. Given 6-7 years of consecutive bull years, I would keep the stock component to a minimum (rather than the standard 25% weight) until we see a significant correction (at least -25% from the peak). Personally I’m short the stock market now, but that’s not for everyone.

When the stock market is more reasonably valued on a P/S or market cap/GDP basis, and some market technicals turn more positive (dispersion, advance/decline, junk bonds), I would increase the stock weight to 25% (normal Quattro).

Since I am a stock guy at heart, if stocks fall deeply for 2-3 years, similarly to the troughs of 2003 and 2009, I’ll go 100% long in stocks only, going full retard BLSH until markets look expensive again, where I’ll switch to a Quattro strategy.

What do you do now?

There it is, four (three) time tested investment models, but really all boiling down to the Quattro Stagione  – perhaps complemented with the Rothschild advice of buying (more) when there’s blood in the streets. See any revolutions on the horizon?

And right now? Buy gold, keep cash, perhaps try buying some oil (I don’t have any right now, March 15, 2015), but stay away from U.S. stocks in general (unless you have some special, unloved, single stocks the market has forgotten about).

Wait. Study. Pounce (next year perhaps – stay tuned by subscribing to my newsletter if you want to make sure to get a note when I start buying stocks again). Continue reading the next post to see how things are different, and what it means for your potential investment returns.

Disclaimer: Nothing above constitutes any kind of recommendation to buy or sell financial instruments or engage in any kind of investing behavior