The perils of timing the market

[fenris]

We're not yet on to full greed

Why do you think that?

[constructive]

There's no performance benefit from ideological purity, i.e. "Market timing is bad and never works".

 

Lots of investing strategies work sometimes and fail sometimes. Market timing is no exception.

 

The way you use the term ideological purity makes it sound like a bad thing. It's definitely not a bad thing to believe in principles and follow them. When Buffett refused to invest in dot com stocks he was being ideologically pure even though the value strategy was not producing results. Yet in the long run he absolutely did get a performance benefit from being principled.

 

Around the same time Buffett bought 4000 tons of silver. His whole career he has argued against investing in precious metals (which don't generate any cash flows) and for investing in productive businesses. Does that seem ideologically pure to you? And he has clearly adjusted his asset mix based on interest  rates and valuations. Watch what he does, not just what he says.

 

Buffett is a great example of multiple mental models giving his approach hybrid vigor. If he only invested in one kind of situation (NCAV, arbitrage, cyclical, high ROIC, etc) he wouldn't be one of the wealthiest men on the planet.

 

There's a clear psychological benefit from ideological purity (other value investors agree with you, dopamines flood your system). But there's no performance benefit. If you have reason to believe a certain investment strategy will work, it doesn't matter whether other people classify it as value or not.

[stahleyp]

We're not yet on to full greed

Why do you think that?

 

I think it's fair to say that we're not at 2000 levels, ie everyone talking about the market and how they'll retire soon.

 

I think it's also fair to say that we're probably getting close to 2007's "greed". For one, CAPE is at 25 now but was at 27 then. There were a ton of people looking to buy emerging markets then and didn't worry too much about risk but, even then it' wasn't full on greed like 2000. I think people are somewhat more aware of risk now - though not prudent enough. People are expecting a "correction." I wouldn't be surprised if it's something more significant than that. With interest rates this low, people are branching out on the risk curve. This is pumping up prices and risk. Frankly, I don't see how it could end well. That doesn't mean it couldn't - I just don't see it.

 

The economy was doing quite well in 2006 (comparably) and that calms our nerves. Things have been rocky the past few years and I think that rockiness is quelling the greed factor a bit (as the okay years go on, that calming of the nerves - and increasing of risk - may continue).

 

The years 2006-2007 certainly weren't perfect though. There was quite a bit of talk bout how gas prices would bring down the economy or the war, etc. I'm doubtful we'll get to the 2000 level of greed (that usually only happens once every 70-80 years or so from what I've read) nor am I expecting a 2008 level meltdown either. Now, if valuations continue to stretch out, that wouldn't be outside of the realm of possibility. I see things like this and I get a little more cautious though

 

http://money.cnn.com/2014/03/23/investing/king-candy-crush-ipo/index.html?iid=HP_LN

 

"At that rate, the number of IPOs this year could rival last year's total of 222, which was the highest number since 2000."

[APG12]

Around the same time Buffett bought 4000 tons of silver. His whole career he has argued against investing in precious metals (which don't generate any cash flows) and for investing in productive businesses. Does that seem ideologically pure to you? And he has clearly adjusted his asset mix based on interest  rates and valuations. Watch what he does, not just what he says.

 

So what? If Buffett flipped directions and became a market timer it wouldn't make any difference. It's a statement of fact that his being ideologically pure allowed him to miss the destructive effects of the dot com bubble. Again, I don't care to argue whether Buffett is completely principled or not. Point is, his purity DID help him even when it appeared that value investing had stopped working.

 

There's a clear psychological benefit from ideological purity (other value investors agree with you, dopamines flood your system). But there's no performance benefit.

 

Again, there is definitely a performance benefit. Look at all the value investors who suffer during bull markets and make it back and then some on a relative basis during bear markets.

 

If you have reason to believe a certain investment strategy will work, it doesn't matter whether other people classify it as value or not.

 

I do agree with this to some extent. However, just because there is a minority of people who can time the market doesn't mean that you personally can throw your principles out the window when you feel like it. My opinion only applies to people that can't time the market or don't have a better way to make money investing. I think this includes 99% of investors. If you have some other rational way to make money- good for you!  :D But you are making statements that appear to apply to the general population of investors and I really don't think they do.

 

Buffett is a great example of multiple mental models giving his approach hybrid vigor. If he only invested in one kind of situation (NCAV, arbitrage, cyclical, high ROIC, etc) he wouldn't be one of the wealthiest men on the planet.

 

I agree, but all of these strategies are value strategies (ie. strategies that treat stocks as businesses). They don't contradict anything Graham wrote or Buffett believes. Timing the market, on the other hand, does.

[constructive]

There's a clear psychological benefit from ideological purity (other value investors agree with you, dopamines flood your system). But there's no performance benefit.

 

Again, there is definitely a performance benefit. Look at all the value investors who suffer during bull markets and make it back and then some on a relative basis during bear markets.

 

To put it another way, your performance depends on the investment decisions you make, nothing more, nothing less. It doesn't depend on the strategies you exclude.

 

On average value investing is the most profitable set of mental models I have found, but that doesn't mean every situation classified as value investing is more likely to be profitable than every situation classified as market timing or speculation. If you are deciding between two investments do you choose the one which falls under value investing or do you evaluate both using the mental models at your disposal and choose the one which offers greater risk adjusted return?

 

So what? If Buffett flipped directions and became a market timer it wouldn't make any difference. It's a statement of fact that his being ideologically pure allowed him to miss the destructive effects of the dot com bubble. Again, I don't care to argue whether Buffett is completely principled or not. Point is, his purity DID help him even when it appeared that value investing had stopped working.

 

I find it hard to believe that Buffett would not have been successful at tech investing if he had applied himself to it.  After all he has been successful at metals, currency and interest rate speculation. I would argue he is "completely principled" in the sense of using rational mental models, but his mental models are not an exact match for value investing.

[moody202]

 

He mentioned it here

 

http://brooklyninvestor.blogspot.ca/2014/03/email-updates-not-working.html

 

RSS still works, though.

 

What's the RSS link? I can't seem to find it!

[stahleyp]

The Buffett piece was a good article. However, if Buffett doesn't "time" what would you call this?

 

"This is my personal account I’m talking about, in which I previously owned nothing but United States government bonds. "

 

http://www.nytimes.com/2008/10/17/opinion/17buffett.html/

[vinod1]

Does anyone else strike it as odd that we're not really paying for our mistakes?

 

The point you mentioned above, is really the key difference between bulls and bears at this time.

 

Almost all who are bearish at this time, Klarman, Rodriguez, Watsa, Hussman, Grant, Grantham, etc bring some version of morality/justice into their equation. For all of them it boils down to justice not being done, for the sinners (who participated in the bubble) got bailed out, the profilgate debtors who got their burden reduced by low interest rates, the prudent savers who are getting punished, the unemployed who did not benefit from fed policies while the rich investors who have stock holdings have gained massively. It does not seem fair. Watsa codes it as "7 lean years and 7 fat years", others are more direct but morality is a common ground for all these investors. Hussman in particular seems to have expected some version of great depression to play out and was caught by surprise when the historical script did not play out.

 

I did incline towards moralists for a long time, but I am coming to the conclusion that while Market serves lots of purposes, enforcing morality is not one of them. It is interesting that the most hyper rational investor of all, Buffett, does not ever mention any of these.

 

Vinod

 

 

 

[Liberty]

 

He mentioned it here

 

http://brooklyninvestor.blogspot.ca/2014/03/email-updates-not-working.html

 

RSS still works, though.

 

What's the RSS link? I can't seem to find it!

 

http://brooklyninvestor.blogspot.com/feeds/posts/default

[stahleyp]

Good point, vinrod. Liberty brought that up a bit before but thanks for fleshing it out more. Opens up my eyes a bit. Thanks for that guys.

[vinod1]

I had been in 60% or more in cash since early 2012 (reminds me of stones and glass houses...), though my stock exposure is around 80-110% due to LEAPS. So I am very much on the fence.

 

Vinod

 

 

[giofranchi]

Does anyone else strike it as odd that we're not really paying for our mistakes?

 

The point you mentioned above, is really the key difference between bulls and bears at this time.

 

Almost all who are bearish at this time, Klarman, Rodriguez, Watsa, Hussman, Grant, Grantham, etc bring some version of morality/justice into their equation. For all of them it boils down to justice not being done, for the sinners (who participated in the bubble) got bailed out, the profilgate debtors who got their burden reduced by low interest rates, the prudent savers who are getting punished, the unemployed who did not benefit from fed policies while the rich investors who have stock holdings have gained massively. It does not seem fair. Watsa codes it as "7 lean years and 7 fat years", others are more direct but morality is a common ground for all these investors. Hussman in particular seems to have expected some version of great depression to play out and was caught by surprise when the historical script did not play out.

 

I did incline towards moralists for a long time, but I am coming to the conclusion that while Market serves lots of purposes, enforcing morality is not one of them. It is interesting that the most hyper rational investor of all, Buffett, does not ever mention any of these.

 

Vinod

 

Vinod,

Among the list of bears you forgot to mention Mr. Soros… If we are talking about market timing, Mr. Soros’ point of view is not one you want to dismiss…!!

Besides, even Mr. Buffett has allocated 76% of BRK’s assets in ways that are much insulated from what the stock market will do in the future… I think I have shown this in the LRE thread. Like they say: pay attention to what they are doing, not to what they are saying! ;)

 

Morality/justice have nothing to do with this. Prices are information. When prices get too much distorted and out of whack with values, people get false information. When people get false information, they do dumb things. When people do dumb things, few other people, those who are great judgers of values, get worried.

 

Imo there is nothing wrong about getting worried. It all depends on how you decide to act on your worries: Mr. Buffett, for instance, decides to concentrate on building earning power for BRK, instead of investing in the stock market; Mr. Klarman decides to give back capital to his investors; Mr. Watsa decides to hedge 100% FFH’s exposure to the stock market… Given the results of the last three years, I might agree with you Mr. Buffett and Mr. Klarman chose the wisest courses of action. ;)

 

Gio

 

[james22]

We go through, allegedly, the worst recession since the Great Depression and 6.5 years from the height would have only underperformed market averages, in real terms by about 2%.

 

Despite years of Fed-induced hope and speculation that has brought the S&P 500 to its recent heights, we easily expect the completion of the present market cycle to leave the total return of the S&P 500 no greater than the return from Treasury bills for the entire period since early 1998, with annual total returns averaging less than 2% over something like an 18-year span of time. It stands repeating that a run-of-the-mill cyclical bear market in a secular bear market period (which clearly began in 2000 and remains incomplete on the basis of nearly every historically reliable valuation measure) comprises a market loss of about 38%. Hussman

[yitech]

I had been in 60% or more in cash since early 2012 (reminds me of stones and glass houses...), though my stock exposure is around 80-110% due to LEAPS. So I am very much on the fence.

 

Vinod

 

This sounds like pretty much full equity exposure (or 80-110%) with 40% OTM put protection or protective puts strategy... Not sure this means you are on the fence here... Cash is not really cash in regular speak when you have a portfolio of cash and derivatives (I assume you meant LEAP calls here). It more resembles synthetic equity position, but with 40% OTM put protection.

[SpecOps]

The follow up article to this is a great read too

 

http://brooklyninvestor.blogspot.ca/2014/03/buffett-market-timer-part-1-partnership.html

 

It is interesting to see that Buffett didn't really time the market with cash. Personally I dont do this myself but notice at times I have more cash just because there aren't enough ideas (well I havent tried hard enough)

 

For a small investor with access to micro caps there are never really going to be too few opportunities to require large cash holdings, but obviously mere mortals like us will struggle to find them in frothy markets if we have a day job too.

[vinod1]

Does anyone else strike it as odd that we're not really paying for our mistakes?

 

The point you mentioned above, is really the key difference between bulls and bears at this time.

 

Almost all who are bearish at this time, Klarman, Rodriguez, Watsa, Hussman, Grant, Grantham, etc bring some version of morality/justice into their equation. For all of them it boils down to justice not being done, for the sinners (who participated in the bubble) got bailed out, the profilgate debtors who got their burden reduced by low interest rates, the prudent savers who are getting punished, the unemployed who did not benefit from fed policies while the rich investors who have stock holdings have gained massively. It does not seem fair. Watsa codes it as "7 lean years and 7 fat years", others are more direct but morality is a common ground for all these investors. Hussman in particular seems to have expected some version of great depression to play out and was caught by surprise when the historical script did not play out.

 

I did incline towards moralists for a long time, but I am coming to the conclusion that while Market serves lots of purposes, enforcing morality is not one of them. It is interesting that the most hyper rational investor of all, Buffett, does not ever mention any of these.

 

Vinod

 

Vinod,

Among the list of bears you forgot to mention Mr. Soros… If we are talking about market timing, Mr. Soros’ point of view is not one you want to dismiss…!!

Besides, even Mr. Buffett has allocated 76% of BRK’s assets in ways that are much insulated from what the stock market will do in the future… I think I have shown this in the LRE thread. Like they say: pay attention to what they are doing, not to what they are saying! ;)

 

Morality/justice have nothing to do with this. Prices are information. When prices get too much distorted and out of whack with values, people get false information. When people get false information, they do dumb things. When people do dumb things, few other people, those who are great judgers of values, get worried.

 

Imo there is nothing wrong about getting worried. It all depends on how you decide to act on your worries: Mr. Buffett, for instance, decides to concentrate on building earning power for BRK, instead of investing in the stock market; Mr. Klarman decides to give back capital to his investors; Mr. Watsa decides to hedge 100% FFH’s exposure to the stock market… Given the results of the last three years, I might agree with you Mr. Buffett and Mr. Klarman chose the wisest courses of action. ;)

 

Gio

 

Gio,

 

1. I do understand that it not simply morality/justice with the bears. But having this paradigm in the back of the head seems to be corrupting the mind to see the market impartially. Many of the those I mentioned are great investors and they are likely to do very well despite this. Klarman with 50% cash is nearly certain to beat mere mortals like me even in bull markets and even if I am 100% invested.

 

I am not so sure it is strictly about price vs. value, Hussman would have been invested heavily in stocks during the crisis and Watsa would not have started worrying about the market when S&P was in the 1000 range (I understand he is short Russell 2000).

 

Morality influences the way we perceive value via (a) profit margins and (b) interest rates.

 

Profit margins are mean reverting but they is no divine rule that says profits should always revert to 6% margins (let us call the 6% profit margins the Hussman constant). The mean for profit margins could be higher or lower than the Hussman constant in future and revert around that higher or lower level. Munger I think admitted to as much. Some perceive higher profit margins as immoral as they take away income from people and transfer them to corporations. I do not think anyone can come to a strong conclusion on profit margins at this time. There are so many countervailing forces that given all the uncertanity, one is inclined to believe what they want to believe. If you think profit margins would go back to 6% levels that we are vastly overvalued and at pretty dangerous market levels.

 

Same goes to interest rates. Why should rates be higher? Why cant they remain low for a long time as they have been in the past? If rates stay low for say the next 10-20 years 10-year treasury is below 3% then stocks are a decent alternative. If one is not agnostic about this, and see this in moral terms and think interest rates should be higher, that influences what you think about the stock market as well.

 

Prices are information. When prices get too much distorted and out of whack with values, people get false information. When people get false information, they do dumb things. When people do dumb things, few other people, those who are great judgers of values, get worried.

 

Do you really think Watsa was worried that people are doing dumb things in 2011? People are being as conservative as can be. I cannot think of a time when consumers and businesses were behaving as prudently as after the financial crisis.

 

2. I too was worried about the market since 2011, but due to a lucky coincidence banking stocks got super cheap at that time and I was able to move into a barbell type portfolio with LEAPS/heavy cash and around 100% long portfolio exposure. If these are not available at that time, I shudder to think what I would have done. I was wrong but got lucky.

 

3. I do not follow Soros but maybe I should.

 

Vinod

 

[vinod1]

I had been in 60% or more in cash since early 2012 (reminds me of stones and glass houses...), though my stock exposure is around 80-110% due to LEAPS. So I am very much on the fence.

 

Vinod

 

This sounds like pretty much full equity exposure (or 80-110%) with 40% OTM put protection or protective puts strategy... Not sure this means you are on the fence here... Cash is not really cash in regular speak when you have a portfolio of cash and derivatives (I assume you meant LEAP calls here). It more resembles synthetic equity position, but with 40% OTM put protection.

 

Equity exposure I think is in the 70% range now as I moved out a little from the LEAP calls to direct stock but cash is still pretty high.

 

Vinod

[giofranchi]

Prices are information. When prices get too much distorted and out of whack with values, people get false information. When people get false information, they do dumb things. When people do dumb things, few other people, those who are great judgers of values, get worried.

 

Do you really think Watsa was worried that people are doing dumb things in 2011? People are being as conservative as can be. I cannot think of a time when consumers and businesses were behaving as prudently as after the financial crisis.

 

You know what they say: “a recession doesn’t destroy capital, it merely reveals the extent to which it had already been destroyed during the previous boom years”… or something like that…

I think Mr. Watsa in 2000 started to get worried about both the level of indebtedness and the level of the stock market in developed economies. And I think he knew the process to decrease both indebtedness and stock market prices is a slow and tortuous one. A process that would probably take the best part of two decades! And he decided he would heavily expose FFH to the stock market only in those instances when stock market prices were at or below intrinsic value: 2003 and 2009. The rest of the time he decided to stay hedged.

Therefore, no, he certainly wasn’t worried about how people were behaving in 2011… He still was worried about how people behaved in the ‘80s and the ‘90s, and how they behaved from 2003 to 2007. I guess he is worried now about how people have behaved in 2012 and 2013…

It is really a two decades picture… And I guess you simply cannot judge it referring to any given year.

 

This being said, I also would have liked that his caution about debt levels and the stock market level would have translated into more action in purchasing whole high quality businesses a la Mr. Buffett… Actually, they have been very opportunistic in buying insurance companies around the world, companies that imo will prove to be great platforms for future growth! Yet, there is no point in denying the fact they might have been much more aggressive (like Al has often said!). I think it simply is not in their DNA yet… But they are working on it… And I think they will get there sooner or later (let’s hope sooner rather than later). In the meantime they have worked hard on improving their underwriting performance, something that imo will lead to interesting financial results in the not too distant future. ;)

 

Gio

 

[giofranchi]

2. I too was worried about the market since 2011, but due to a lucky coincidence banking stocks got super cheap at that time and I was able to move into a barbell type portfolio with LEAPS/heavy cash and around 100% long portfolio exposure. If these are not available at that time, I shudder to think what I would have done. I was wrong but got lucky.

 

I need to see what I call “an entrepreneurial force” before investing. And I don’t see such a thing at the head of any mega bank around the world. Therefore, I missed the bank stocks rally. I don’t mind. Just like Mr. Buffett doesn’t mind having missed Apple or Google.

Instead, I focused on improving the performance of my operating businesses, and juicing their results a bit with some stock market returns.

It has worked quite well until now. And I think it is a strategy that will lead to further gains in my firm’s BV, at least until stock market prices become reasonable again. :)

 

Gio

 

[Liberty]

You know what they say: “a recession doesn’t destroy capital, it merely reveals the extent to which it had already been destroyed during the previous boom years”… or something like that…

I think Mr. Watsa in 2000 started to get worried about both the level of indebtedness and the level of the stock market in developed economies. And I think he knew the process to decrease both indebtedness and stock market prices is a slow and tortuous one. A process that would probably take the best part of two decades! And he decided he would heavily expose FFH to the stock market only in those instances when stock market prices were at or below intrinsic value: 2003 and 2009. The rest of the time he decided to stay hedged.

Therefore, no, he certainly wasn’t worried about how people were behaving in 2011… He still was worried about how people behaved in the ‘80s and the ‘90s, and how they behaved from 2003 to 2007. I guess he is worried now about how people have behaved in 2012 and 2013…

It is really a two decades picture… And I guess you simply cannot judge it referring to any given year.

 

I've read all the FFH letters and I never got the impression that this was a multi-decade bearish view and that their stock-picking was dependent on their macro views. Maybe I need to read again.

 

Personally, I'm more with Buffett. I believe that people wake up every day and try to find new ways of making things better; building new factories, inventing better machinery, creating new services and ways to delivers them, etc. That's why the lower middle-class today has access to things that only rich people had not so long ago, if at all (cheap air travel, safe and reliable cars, big screen color TVs, large music and film collections, appliances that do a lot of housework, wirelessly networked pocket supercomputers, etc).

 

We can expect a lot of value to be created over the next 10-20-30 years.

 

It's certainly possible to make good macro calls and avoid big catastrophes, as Fairfax did with the CDS during the GFC (though it's also possible to be wrong in such calls...). But being hedged for years and years in a symmetrical way (unlike the CDS) with no ceiling on how much can be lost doesn't make sense to me. You're betting against history and human industry. Even if the market was to drop by 33% (which means we'd be 50% overvalued), this likely wouldn't make up for the lost opportunity of the past few years, and what are the chances of perfectly timing the bottom and removing the hedges at the right time? All the money that went into the hedges up to now could've been used to buy great operating businesses that could easily survive a big recession with Fairfax's backing. Heck, just buying more WFC rather than selling it would probably have been a good idea, as WFC isn't going away any time soon. Anyway, this has been discussed elsewhere so I'll stop now.

[Liberty]

Part 2: http://brooklyninvestor.blogspot.ca/2014/03/buffett-market-timer-part-2-berkshire.html

 

It includes this interesting aside:

 

Warren Buffett Library of Corporate Annual Reports

So here I go again on a tangent.  What if there was a library funded by a really wealthy guy that wants to improve financial intelligence in this country?  And what if this library contained the one thing this wealthy guy keeps telling people to read? 

 

Yeah, wouldn't it be cool if there was "Warren Buffett Library of Corporate Annual Reports"? Imagine being able to go online and reading the Coca Cola annual reports (including the financials) in the 1920's and 1930's.  Imagine reading Securities Analysis and then actually digging up the annual reports and financials of the companies mentioned?

 

If Google is scanning every book ever published (?), why can't the value investing community support a similar project for annual reports?

 

And Buffett would be a perfect sponsor of such a thing.  He always tells people to read annual reports!  He says that he has read the annual report of Bank of America every year for the past fifty years.  What if there was such a place online that gives other aspiring value investors (and students) a chance to do the same?  I'm sure the expensive business schools have extensive libraries of corporate reports, but why shouldn't kids (elementary, middle and high school) and others be able to access the same?

[Liberty]

And for those who have been following the series, part 3, 4 and 5:

 

http://brooklyninvestor.blogspot.ca/2014/03/buffett-market-timer-part-3-berkshire.html

 

http://brooklyninvestor.blogspot.ca/2014/03/buffett-market-timer-part-4-berkshire.html

 

http://brooklyninvestor.blogspot.ca/2014/03/buffett-market-timer-part-5-berkshire.html

[peter1234]

Here is an interesting (and funny) perspective  :)

 

http://www.valuewalk.com/2014/04/womack-investing-like-pig-farmer/

 

....

 

Now during the 30 year period had he started with $25,000 his stock portfolio, assuming no additions and the dividends being spent shamelessly, he would be worth roughly $640,000 now. The historical record shows us that if he had focused on dividend paying stocks that traded at a discount book value he would have likely done much better but we will assume the base case for our purposes.

 

That’s a 30 year compound return of about 11.5% compared to the stock market compound return of 8.50% over the same 30 years. He was only invested about half the time so we can add a few percentage points for interest earned during the off years and of course we still have not accounted for dividends. When you add those factors in you are knocking on the door of twice the rate of return of buy and hold investing in the stock market.