Going into a stock market bubble

[giofranchi]

It should be the *result* of your usual bottom-up investment activity: Depending on the available opportunities your cash allocation goes up or down.

 

Then, please, answer the question I asked anders just a few posts ago...

 

Gio

 

The answer is obvious and he already gave it to you. The point is that your initial post and how it's written suggests that you positioned yourself for a crash by having a high cash allocation and limiting your spectrum of investments as opposed to allocating cash "naturally".

I would argue that I have no idea whether we are in 1996 or 1999. For all I know the market could start a 30% slide tomorrow because [reasons that will be apparent only after the fact] or keep going for years. As long as there are compelling opportunities you should seize them and avoid forming a strong opinion about the market (à la Hussman) which can put a big part of your capital on the sidelines for a long time.

 

Ok, I will put again my question here below:

 

Let me give you two examples: BH selling at BVPS and LMCA selling below NAV are imo incredibly cheap today… Yet, I wouldn’t be surprised at all if in a market crash they both decline faster than the general market… And, though I do believe 10 years from now they will turn out to be great investments, I know I will have to wait a long time, before my thesis is finally validated. It will be far easier to wait, if in the meantime I am able to average down… So, the question is: I have 3 ideas that I think are very good businesses which could be purchased at fair/good prices today… Why am I only 70% invested in them, instead of 100%? Your answer might be: because you are wrong! Another answer might be: because of Mark’s pendulum…

 

If I have understood you well then, your answer is: because I am wrong. Right?

 

Thank you,

 

Gio

[giofranchi]

Why not just read a few of his articles and find out? The primary source is easily available. I think you'll be pleasantly surprised.

 

Here's a few to get you started:

 

http://www.philosophicaleconomics.com/2014/06/critique/

 

http://www.philosophicaleconomics.com/2013/12/shiller/

 

http://www.philosophicaleconomics.com/2014/01/cape/

 

http://www.philosophicaleconomics.com/2014/05/profit-margins-dont-matter/

 

Gio, its worth your time to read these articles. All they will do is help you better interpret Hussman's stuff and CAPE - I don't think they change the fact the market is overvalued right now but it may change your outlook on 1) how long it could take to mean revert on the "E" in the P/E (ie longer than in the past potentially), and also 2) some slight adjustments to interpreting CAPE/Shiller p/e. Its just helpful - one level more detailed - stuff to interpret Hussman etc, and (maybe?) understand why Marks, Buffett and Munger are not quite at the point where they want to call this a bubble (whereas Hussman is, and Grantham with another 10% rise in the S&P from here will be).

 

Truth be told, I had started reading those articles some time ago… But I remember quitting under this impression: looking for too much precision in something that is more instinct than true knowledge… Anyway, I might have judged too quickly, and therefore wrongly… I will give them another chance! ;)

 

Thank you,

 

Gio

 

[giofranchi]

Also wbr, Joel, and others, please tell me what you find so wrong about this statement of mine:

 

Not only: I think cash might be useful even in a rising market, at least for a portfolio as concentrated as mine. Given the fact I hold just a few companies, the volatility of my portfolio can often be much greater than the one of the general market. And cash helps me take advantage of opportunities that might arise irrespective of what the general market is doing.

 

In fact, all entrepreneurs I know, who run just one business, always have lots of cash ready at hand!

 

Cash might have no place in a widely diversified, statistically assembled portfolio of stocks… But you all already know that’s not what I am involved with… From a strictly entrepreneurial point of view, cash makes a lot of sense!

 

Gio

 

[Happy]

For me, it was an eyeopener to learn that Greenblatt was scared of the bubble in 2000 but remained fully invested and returned 100% that year even as the S&P dropped. I checked how other strong value investors did and most of them returned > 20% in 2000 (many even significantly more) and > 20% in 2001 with nobody losing much at all. As 2000 was the most scary time to look at market valuation in history and even then it would have turned out to be a big mistake for these value investors to not be fully invested despite the market dropping a lot, I have concluded for myself that it is just not worth it to try.

My explanation for this is the following: The more overvalued the market becomes, the less does its risk profile reflect the risk profile of a carefully selected concentrated value portfolio. So it makes less sense to get scared about your attractive businesses just because most other stocks are expensive.

 

I find it helpful to remind myself that if I could buy part of a good operating business in my town at an attractive price, it would be crazy not to do it because the stock market is overpriced. And buying attractive stocks of good companies is just the same thing. So as long as I can find enough opportunities that seem to meet my hurdle I think that I would just own myself over time and be worse off if I didn't remain fully invested and held a cash position based on my thinking about the market.

[anders]

I will jump back in the discussion again..lol

 

Gio, this is what you wrote.

As it seems we are slowly but inexorably going into a stock market bubble, I have decided to concentrate my capital....To weather the consequences of what inevitably follows a stock market bubble, I want to be very concentrated, and to hold a significant amount of cash.

 

Strategy a) I define this statement as; I believe X might happen in the market and, as a corollary I decide to do Y and Z with my portolio.

 

Strategy b) My thinking goes, I do not act on a view on what X might be in the market, therefore Y and Z should be based on finding opportunities.

 

Im NOT saying you might do poorly, or that you are wrong in positioning yourself into these investments. But, I truly believe "strategy b)" will provide better returns over time, so in that sense, Yes I think you are making a mistake if you make portolio strategy based on market predictions.

 

Then to your question:

Let me give you two examples: BH selling at BVPS and LMCA selling below NAV are imo incredibly cheap today… Yet, I wouldn’t be surprised at all if in a market crash they both decline faster than the general market… And, though I do believe 10 years from now they will turn out to be great investments, I know I will have to wait a long time, before my thesis is finally validated. It will be far easier to wait, if in the meantime I am able to average down… So, the question is: I have 3 ideas that I think are very good businesses which could be purchased at fair/good prices today… Why am I only 70% invested in them, instead of 100%? Your answer might be: because you are wrong! Another answer might be: because of Mark’s pendulum…

 

Let me answer your question with a question to the extreme to further illustrate my point: If an algo went bananza tomorrow and suddenly put the BRK A share price at 25'000, wouldnt you buy for 100% regardless of CAPE or level in the market??

 

Rgds,

[giofranchi]

Let me answer your question with a question to the extreme to further illustrate my point: If an algo went bananza tomorrow and suddenly put the BRK A share price at 25'000, wouldnt you buy for 100% regardless of CAPE or level in the market??

 

Rgds,

 

The answer to your question is: yes, of course!!

 

But I don’t think that catches the perspective of my question correctly… So many shades of gray… And they matter a lot!... Uncomfortable… as it is supposed to be! ;)

 

Gio

 

[jb85]

For me, it was an eyeopener to learn that Greenblatt was scared of the bubble in 2000 but remained fully invested and returned 100% that year even as the S&P dropped. I checked how other strong value investors did and most of them returned > 20% in 2000 (many even significantly more) and > 20% in 2001 with nobody losing much at all. As 2000 was the most scary time to look at market valuation in history and even then it would have turned out to be a big mistake for these value investors to not be fully invested despite the market dropping a lot, I have concluded for myself that it is just not worth it to try.

My explanation for this is the following: The more overvalued the market becomes, the less does its risk profile reflect the risk profile of a carefully selected concentrated value portfolio. So it makes less sense to get scared about your attractive businesses just because most other stocks are expensive.

 

I find it helpful to remind myself that if I could buy part of a good operating business in my town at an attractive price, it would be crazy not to do it because the stock market is overpriced. And buying attractive stocks of good companies is just the same thing. So as long as I can find enough opportunities that seem to meet my hurdle I think that I would just own myself over time and be worse off if I didn't remain fully invested and held a cash position based on my thinking about the market.

 

agree with you...but I do think its a bit different this time.  In 2000 there were two main market segments that were very undervalued in relative terms:  Small caps, and value stocks, with small value stocks being particularly undervalued.  Looking through the backtests of greenblatts magic formula, the small cap screen crushed the market in 2001 and 2003.  I don't see those type of inbalances now.  Maybe there's another market segment i'm not looking at, but seems to me that when looking at P/B of large vs small caps, they are in a somewhat normal range.  I'm still fully invested, but not going to see 60+% annual returns as we did in the small cap value stocks in 2001-2003

 

check out page 2 below for historical P/B of Russell 2000 vs 1000

 

http://www.principalglobal.com/us/download.aspx?id=105519

[giofranchi]

http://www.philosophicaleconomics.com/2014/06/critique/

 

I really HATE articles like that one!

 

I have spent the time needed to read 20 pages of statistical reasonings, trying to convince me of what?... That the very same valuation metrics we use to gauge if our investments are undervalued, fairly valued, or overvalued:

- Price / adjusted earnings

- Price / sales

- Price / replacement cost

cannot be applied to a portfolio of 500 companies…

 

And why? Because they inevitably entail some errors and show some lack of precision!

Well, thank you very much, but I already knew that valuation is an imprecise art! And I don’t need anyone to write such a complicated article to remind me of how much future returns calculated on the basis of valuation metrics could deviate from the actual truth!

 

But I also know that (Price / adjusted earnings), (Price / sales), and (Price / replacement cost) are the best metrics we have at our disposal to at least try assigning a valuation to our portfolio of businesses. In fact, do the author of the article suggest something better? Absolutely not! And you know why? Because there is nothing which is better!

 

So, do you want to have an idea where the pendulum is at any given time? Do you think valuations might be useful in that regard? If the answer to both questions is yes, then (Price / adjusted earnings), (Price / sales), and (Price / replacement cost) is what you should use… And to the results you get you should apply whichever margin of safety you deem appropriate! To finally draw one of these conclusions: undervalued, fairly valued, or overvalued.

 

In other words, value investing applied to a portfolio of 500 companies!

 

I like Hussman because his analysis makes a lot of sense… surely not because I think his numbers are 100% correct! ;)

 

Gio

 

[TwoCitiesCapital]

http://www.philosophicaleconomics.com/2014/06/critique/

 

I really HATE articles like that one!

 

I have spent the time needed to read 20 pages of statistical reasonings, trying to convince me of what?... That the very same valuation metrics we use to gauge if our investments are undervalued, fairly valued, or overvalued:

- Price / adjusted earnings

- Price / sales

- Price / replacement cost

cannot be applied to a portfolio of 500 companies…

 

And why? Because they inevitably entail some errors and show some lack of precision!

Well, thank you very much, but I already knew that valuation is an imprecise art! And I don’t need anyone to write such a complicated article to remind me of how much future returns calculated on the basis of valuation metrics could deviate from the actual truth!

 

But I also know that (Price / adjusted earnings), (Price / sales), and (Price / replacement cost) are the best metrics we have at our disposal to at least try assigning a valuation to our portfolio of businesses. In fact, do the author of the article suggest something better? Absolutely not! And you know why? Because there is nothing which is better!

 

So, do you want to have an idea where the pendulum is at any given time? Do you think valuations might be useful in that regard? If the answer to both questions is yes, then (Price / adjusted earnings), (Price / sales), and (Price / replacement cost) is what you should use… And to the results you get you should apply whichever margin of safety you deem appropriate! To finally draw one of these conclusions: undervalued, fairly valued, or overvalued.

 

In other words, value investing applied to a portfolio of 500 companies!

 

I like Hussman because his analysis makes a lot of sense… surely not because I think his numbers are 100% correct! ;)

 

Gio

 

I actually enjoy these well thought out arguments. Much of what he says is well reasoned, and often contrary to what I have generally accepted. That being said, it seems most of the anays IS more complicated and time consuming and it generally doesn't  suggest much different.  For example the CAPE article suggests that with the proper adjustment we're  only 20-25% above long term averages instead of 60% as reported by the CAPE. I understand that there is a difference but I'm ok with being "approximately right" without having to spend all of my time making these adjustments. I'm doing this kind of stuff after work and don't have the time to spend doing all of these adjustments and comparisons - I'd rather just have a quick and dirty analysis with the knowedge that it's  slightly flawed.

[Liberty]

The difference between 25% and 60% might be like the difference between someone who's 6-foot 4 inches and someone who's 7-foot 4 inches, though. Both are tall, but one's a lot more extraordinary and rare than the other. I don't think the difference can be hand-waved away.

 

I don't use this stuff to invest at all. Macro's too hard (who predicted the recent oil moves?). I just find it interesting because so many people cite Hussman and Schiller, and base investing decisions on their work as if it was gospel, so it's nice to see their stuff scrutinized by someone smart.

[cobafdek]

I really HATE articles like that one!

 

No lack of precision (or passion) here!  As always, I enjoy reading and thinking about your incisive and opinionated posts.

 

I really LOVE articles by both Hussman and "Jesse Livermore."  I don't see them as incompatible, as "Livermore" states that Hussman is compelling and may indeed by right, but that he might be right for the wrong reasons or despite a flawed analysis.  I think this particular philosophicaleconomics.com post is a tour de force, as it precisely and cogently shows how "historical reliability" may in fact fall into a kind of narrative fallacy trap.

 

I don't see the classic Graham value metrics as ever losing their validity any time soon, if ever.  But Graham himself writes in the intro to The Intelligent Investor (1st Ed.), ". . . just as the precepts crystallized out of experience before the First World War became largely obsolete in later years, so our present views, based on the experience of 1914-1948, may not stand the test of future developments.  That risk cannot be avoided.  But by bearing it clearly in mind we may succeed in reducing it."

 

Sophisticated and thoughtful mathematical analyses of financial data increases my understanding of the "simple" measures like Price/AdjustedEarnings, Price/Sales, and Shiller CAPE.  Reading Hussman, "Livermore," et al., keeps me thinking.  And, as Buffett/Munger said, the ultimate risk reduction tool is thinking.

[giofranchi]

One idea that I have found interesting in that article is that even after as long a time as 10 years definitely is valuations could still not revert to the mean (FV). Nothing new, but it made me think:

 

It seems to me that’s the best argument anyone can bring up in support of the relevance and great importance of following the pendulum!

 

After all, if on average the price of 500 companies stays away from fair value, it must imply that the majority of those companies, taken as a single entity, keep having prices that diverge from values even after 10 years. As a consequence, the following argument “I buy undervalued stocks, no matter where the pendulum is, because 10 years from now only valuation will matter” must be false and misleading!

 

The fact, instead, is that argument worked very well during the last 20 years, because policy makers were able to engineer an almost permanent state of overvaluation for the markets. And both times markets corrected seriously, they were prompted up again to lofty prices in a matter of just one or two years.

 

The thought “well, the state of things which has prevailed during the last 20 years will go on” might be true, but it is just another way of gauging where the pendulum is and trying to follow it! ;)

 

Imo there is no escaping the fact we all are subject to the pendulum… No matter we are aware or unaware of it… No matter we follow or disregard what happens around us… And those who find themselves going in the opposite direction, run the risk of experiencing unsatisfactory investment results for a very long time.

 

Gio

 

PS

Following the pendulum has nothing to do with profiting from a crash in the price of oil! The latter is what I call “macro investing”, the former is something I consider useful even if all you do is investing in a bunch of companies you think you know well at good prices! Which is what I try to do! :)

 

[giofranchi]

And, as Buffett/Munger said, the ultimate risk reduction tool is thinking.

 

Agreed!

 

And I will go on reading that blog… Probably, I started with the wrong article… But I really HATE ( ;D ;D) statistical analysis! For two reasons:

 

1) I don’t think it adds much to good investing,

2) It is not contestable, nor verifiable… unless I decide to devote a disproportionate amount of time to something I believe doesn’t add much to good investing!

 

Therefore, how could I judge statistical analysis other than a waste of time? ???

 

Gio

 

[Liberty]

http://thefatpitch.tumblr.com/post/103291720776/are-low-interest-rates-responsible-for-high-stock

 

As if macro wasn't hard enough to predict, some widely held views don't even seem true...

[yadayada]

I think it has more to do with enourmous amount of money being pumped in the system. That basicly has nowhere to go. Interest rates can be low without that. So That is probably why it is not correlated.

[Packer16]

Gio,

 

I am surprised you are not allocating any to Howard Marks and company with a potential $1.5 trillion of distressed debt by 2016 to 2019, he will be minting fees.

 

Packer

[giofranchi]

I am surprised you are not allocating any to Howard Marks and company with a potential $1.5 trillion of distressed debt by 2016 to 2019, he will be minting fees.

 

I agree! And if I were in the States, OAK would be a very large investment of mine! Unfortunately, their distribution policy is prohibitive for Italian investors, because almost 50% is withdrawn as taxes… What would you do in my stead?

 

Gio

 

[Packer16]

Gio,

 

The tax situation sounds pretty bad.  I would look for distressed investors like Wilbur Ross' SPAC (WLRH).

 

Packer

[cobafdek]

And I will go on reading that blog…

 

My *Mission Impossible* accomplished!

 

But I really HATE ( ;D ;D) statistical analysis!

1) I don’t think it adds much to good investing,

 

Not sure I agree, but I think I know what you mean.  Take your sister the doctor.  I'm sure she would say that basic medical research and clinical trials, which depend heavily on statistical analysis, are essential to the field, even if applications are not readily apparent to daily clinical practice.  (And I bet she would be more circumspect and never say she "HATES statistical analysis," let alone say so with emoticons!)  But beyond a certain point, spending too much time away from the clinic, reading this stuff, may detract from being a good physician, which is more about common sense than it is about knowing all the precise fine points of the latest statistical analysis.  Maybe that's why Hussman's not such a great investor?!

 

2) It is not contestable, nor verifiable…

 

Therefore, how could I judge statistical analysis other than a waste of time? ???

 

Uh oh . . . don't let the research universities see this statement!  You've just questioned their very ragion d'essere!

[Liberty]

ragion d'essere

 

Is this phonetic french from memory, or some other language I don't know?  :)

 

Raison d'être translates literally to "reason to exist". I get no credit for knowing that since french is my native language.

[cobafdek]

ragion d'essere

 

Is this phonetic french from memory, or some other language I don't know?  :)

 

Raison d'être translates literally to "reason to exist". I get no credit for knowing that since french is my native language.

 

It's Italian.  I cheated with Google Translate.  Just trying to impress gio, but you blew my cover.

[james22]

Dent:

 

This is a bubble. It looks like a bubble, quacks like a bubble and tracks every bubble in history.

 

...

 

This market is not going to crash 10% or 20%. It's going to crash worse than it did in 2008 and 2001 and 1930 and 1973. This is going to be the biggest crash ever.

 

http://www.theaureport.com/pub/na/16382

[giofranchi]

Maybe that's why Hussman's not such a great investor?!

 

Right! Because investing imo is all about finding the best entrepreneurs, who have built and run the best businesses, and partnering with them at the best prices possible!

Then, imo you should also acknowledge the fact you are investing in the stock market, and everything in the stock market is somehow linked together, sometimes with stronger ties, other times with ties that are a bit weaker… But to imagine you might be an island is simply not true and therefore dangerous!

 

So, what does statistical analysis have to do with investing? Will it help me understand if Watsa, Malone, and Biglari are great at what they do? Will it help me understand if FFH, LMCA, and BH are good businesses? Will it help me understand if I have paid a fair price for them? Will it help me understand if the permanently high plateau for stock prices engineered by policy makers during the last 20 years is sustainable? Mmm… Sorry, but I just don’t see how…

 

I have also read the Shiller CAPE article: though I have liked it much better than the article on Hussman, statistical analysis always gets in the way and the conclusion the author draws from it bothers me… The author starts the article on the premise the Shiller CAPE has broken down, because since 1990 it has spent 98% of the time above its historical average… Imo this simply doesn’t prove anything! What you must ask yourself is the following: what if policy makers have been successful in engineering permanently high prices for the stock market since 1990? And what if they won’t be as successful in the future?

 

Don’t forget that those permanently high prices for stocks have been achieved only in the US: what about Japan? What about Asia in general? What about Europe? Take Italy for example: do you think you might have an easy time making money in the Italian stock market? Which is stuck at almost the same level for 10 years now? Well, good luck! I can still hear my father complaining “this insurance company cannot remain priced at 0.3xBV!”… A complain that has been going on for the last few years! And still goes on!

 

Furthermore, when you dabble too much with statistical analysis, you might happen to lose sight of the most basic, and imo important, things: the author suggests how to fix the Shiller CAPE, using Pro-Forma earnings, instead of GAAP earnings. And he says that way the stock market looks less expensive. But he completely forgets to tackle another very important issue: valuation by different metrics! We all know how important it is to use and compare different valuation metrics, and ascertain they give us similar results. So, why do the Shiller CAPE, the (Price / Sales), and the (Price / Replacement Cost) hint to almost the exact overvaluation for the stock market, while the “Fixed” Shiller CAPE gives us a different number? Have the (Price / Sales) and the (Price / Replacement Cost) broken down too? If so, how to fix them? The article doesn’t even touch these questions… Yet, I think they are more important than any statistical analysis!

 

Finally, as far as medicine is concerned, I can only say that each discipline has its own practices and needs. The fact statistical analysis might be useful in medicine doesn’t say anything about its usefulness (or lack thereof) in investing.

 

Gio

 

[giofranchi]

I get no credit for knowing that since french is my native language.

 

If French is your native language, I envy you… Michel Rio is imo the greatest author of “philosophical novels” alive today. And he writes in French! Unfortunately, I was able to find just few novels of his translated either in Italian, or in English, or in Spanish (the three languages that I know)… And I must use Google Translate to read the rest… You might imagine the pleasure of reading gets much diminished that way! :(

 

If I were you, I would visit Amazon.ca, and order all the novels by Michel Rio I could find!

 

Cheers,

 

Gio

 

[Liberty]

I get no credit for knowing that since french is my native language.

 

If French is your native language, I envy you… Michel Rio is imo the greatest author of “philosophical novels” alive today. And he writes in French! Unfortunately, I was able to find just few novels of his translated either in Italian, or in English, or in Spanish (the three languages that I know)… And I must use Google Translate to read the rest… You might imagine the pleasure of reading gets much diminished that way! :(

 

If I were you, I would visit Amazon.ca, and order all the novels by Michel Rio I could find!

 

Cheers,

 

Gio

 

Merci pour la suggestion. Thanks for the recommendation, I will check out his work  :)

 

The author starts the article on the premise the Shiller CAPE has broken down, because since 1990 it has spent 98% of the time above its historical average… Imo this simply doesn’t prove anything

 

On a purely pragmatic level, it's hard to recommend using a tool that told you not to invest in early 2009, or that might have kept someone on the sidelines for decades.

 

http://finance.yahoo.com/echarts?s=HSGFX+Interactive#%7B%22range%22%3A%2210y%22%2C%22scale%22%3A%22linear%22%2C%22comparisons%22%3A%7B%22%5EDJI%22%3A%7B%22color%22%3A%22%23cc0000%22%2C%22weight%22%3A1%7D%2C%22%5EIXIC%22%3A%7B%22color%22%3A%22%23009999%22%2C%22weight%22%3A1%7D%7D%7D