How much are you allocated in cash?

[Olmsted]

Locatevalue-thanks for sharing!

[original mungerville]

Bmichaud,

 

How are you getting to the below conclusion in quotes. I can kind of see the 2.5% dividend (which is distributed as a percentage of record earnings of corporate America as a percentage of GDP, so I wouldn't count on that 100% going forward necessarily ...), but where is this 5-6% coming from? If real GDP grows at 2% which I think is a stretch, and if you assume 2% inflation, that's 4% total. There is no way buybacks would add another 2 percent?

 

Even assuming no dividend cuts going forward, I can't get past 6.5% max for nominal and 4.5% max for real returns. Then, given you probably aren't going to hold the stock for 1000 years, and let's assume your hold period is 7 years, you need to factor in reversion to the mean in terms of corporate earnings relative to GDP, or corporate profit margins (take your pick) contracting to more normal levels. If they do that over 7 years (which is what Grantham factors in and which is likely over that period based on his back-testing) you are probably closer to something below 1% real return over 7 years from these levels...maybe a zero to negative real return could be expected.

 

IF the money printing continues, which seems likely, the returns would be OK but they will be all inflation and not material real returns from these levels over 7 years. That's what I get from looking at Buffet's 1999/2000 Fortune articles and combining with Jeremy Grantham's analysis method. Deductive reasoning (and not inductive reasoning which you are using) is required to forecast expected long-run equity returns over a 7-10 year period because the boundary conditions become very important over say 7 years (relative to a 100 to 1000 year holding period). For example, if stocks are double fair value at time 0, over 7 years, you can expect them to drop by 50% over 7 years or say something like an 8% compounded loss every year for 7 years. That 8% has to be deducted from the 7.5 to 8.5 prediction arrived at through using only an inductive approach. (Grantham's approach incorporates this effect and he backtests 7 years as a good timeframe for reversions to take place across various asset classes including stocks - down from his previous 10 years reversion period using in the early 2000s.) If we are talking about stocks at double fair value at time 0 but are holding until infinity, there is no reversion to the mean which needs to be built in (so the inductive approach you are using becomes more accurate) but your returns are still going to be lower because your initial yield is lower than it otherwise would have been (Buffet's simple approach used to make his point in Fortune 12 years ago uses mainly inductive reasoning; it was simple to get his main point across that equities were really overvalued but he knew it wasn't the full detailed answer).

 

"So purchasing the market here one could expect to earn 7.5% to 8.5%.

 

2.5% as income from the dividend and another 5% to 6% as capital gain from the growth in the dividend."

[ERICOPOLY]

 

I think as a whole, the SPX likely breaks even on buybacks - i.e. just offsets dilution.

 

 

I'm not sure if some of (or most of) the dilution is real dilution -- buying other companies with your stock.  Sure, diluted share count but the total entity owns more earning assets. 

 

Or are you saying executive compensation style dilution matches share repurchases?

[txitxo]

 

Hey! May I know what do your screens consist of?

 

The main parameter is a rank which combines several value ratios and financial solidness indicators (something which is present, one way or the other, in all value screens like Graham's Enterprising Investor or Piotroski's). Then I apply a moderate momentum selection (which helps to avoid falling knives, and reduces drawdowns) and try to buy the smallest possible companies (but always with enough liquidity).  I buy a bit every week and typically hold the stocks for at least a year.

 

 

Interesting. May I ask how it has worked for you?

 

Quite well, as shown by my investment allocation...

 

[CONeal]

0% cash 20% in a situation that will be complete before May 1st.  Plan on moving that to cash and suck my thumb until prices come to inline with the watch list.

 

0% cash 35% in special situation closing in March..I consider this as cash and move it to cash if gap closes or find a deep value

 

I have about 7% cash, another 8% in a special situation, and 21% in lvlt bond.

 

I haven't heard this argument yet so I will go out and say that S&P500 is at 1500 for the third time in 12 years and  this is the right one. No big decline in sight this time.

 

Okay, special situation people: you must have full allocations by now, so hook us up!  What looks interesting?

 

 

 

 

Sorry, I missed this comment.

My special situation is Metro PCS reverse merger to buy TMobile.

Its a very intresting special situtaion and need to start its own thread..but will provide higlights

1. I am very confident that this merger will gothru as for both parties its mandatory and without it,Its going to be difficult competing with larger comeptitiors like verizona and AT&T

2. Current price values merged company at 8Billion which is 1/2 the market cap i am expecting (Read thru the sec merger doc, PCS its very intresting reverse merger)..They will pay current shareholder $4 special dividend per share on closing of the deal and issure more stock as part of merger and the combined valuations as today price $10 taking out cash dividend is 8.2b and i think it should trade similar or more than sprint cosnidering they dont spend capex like sprint and good FCF.)

 

Don't consider mine as "special" as it's a drug company and seems out of scope for the board.

 

Navb is a drug company coming up for approval April 30th.  The drug received a CRL for the drug Lymposeek back in sept. For a qc problem at the manufacturing facility.  The CRL has been addressed is waiting for reinspection.  The drug actually works (breast cancer) and makes not only the dr's life easier when operating on a patient but the patient also has less complications.  A drug application was submitted on Europe back in nov  I believe for the same drug.  The EMA has already passed the manufacturing process for the drug.  Estimate of fair value is $7/share only looking at Lymposeek.  There are other drugs in the pipeline but not focusing on it.  Having Cardinal Health as the distributor also helps with market penetration.

[Olmsted]

Thanks!

[no_free_lunch]

I certainly can understand the reason for being cautious here.  I consider myself cautious despite being 0% cash.  I just implement my caution mainly via well-priced stocks with moats.  I disagree though with some of the arguments presented here based on metrics.

 

I had a look at the shiller PE ratio and I don't really think it is particularly meaningful as far as a gauge of future returns.  If you use 10 year returns, I will admit that at high PE levels the returns are poor.  However, if you use 5 year returns, with a PE of 23 you actually get very good returns. 

 

Below are the occasions that the market first hit shiller PE of 23, along with subsequent aggregate 5 year returns (dividends reinvested):

 

Sept 1928 :  -30%

Jan  1964 :  56%

July  1995 : 187%

Nov  2002 :  75%

Feb  2011 : 16% (period to date)

 

I would also note that the VIX levels in july 95 were in the 11-13 range, similar to how they are today.

 

Does this mean that the odds are that the market will go up?  NO!  Who knows?  It just goes to show that you have to be very careful in interpreting these numbers.  Much of the negative analysis of high shiller PEs uses all of the PE values above a certain point.  Why would you lump in results where the PE is in the 30's with a value of 23?

 

There is also the fact that we are not really comparing apples to apples as there are recessionary earnings in '03,'08,'09 without which the PE would probably be in the high teens.  Most of the preceding periods did not have these huge dips in their preceding earnings.

 

I would also note that while hedge funds are increasing their exposure to stocks, pension allocations to equities have been substantially reduced. 

 

My two cents.

[bmichaud]

Bmichaud,

 

How are you getting to the below conclusion in quotes. I can kind of see the 2.5% dividend (which is distributed as a percentage of record earnings of corporate America as a percentage of GDP, so I wouldn't count on that 100% going forward necessarily ...), but where is this 5-6% coming from? If real GDP grows at 2% which I think is a stretch, and if you assume 2% inflation, that's 4% total. There is no way buybacks would add another 2 percent?

 

Even assuming no dividend cuts going forward, I can't get past 6.5% max for nominal and 4.5% max for real returns. Then, given you probably aren't going to hold the stock for 1000 years, and let's assume your hold period is 7 years, you need to factor in reversion to the mean in terms of corporate earnings relative to GDP, or corporate profit margins (take your pick) contracting to more normal levels. If they do that over 7 years (which is what Grantham factors in and which is likely over that period based on his back-testing) you are probably closer to something below 1% real return over 7 years from these levels...maybe a zero to negative real return could be expected.

 

IF the money printing continues, which seems likely, the returns would be OK but they will be all inflation and not material real returns from these levels over 7 years. That's what I get from looking at Buffet's 1999/2000 Fortune articles and combining with Jeremy Grantham's analysis method. Deductive reasoning (and not inductive reasoning which you are using) is required to forecast expected long-run equity returns over a 7-10 year period because the boundary conditions become very important over say 7 years (relative to a 100 to 1000 year holding period). For example, if stocks are double fair value at time 0, over 7 years, you can expect them to drop by 50% over 7 years or say something like an 8% compounded loss every year for 7 years. That 8% has to be deducted from the 7.5 to 8.5 prediction arrived at through using only an inductive approach. (Grantham's approach incorporates this effect and he backtests 7 years as a good timeframe for reversions to take place across various asset classes including stocks - down from his previous 10 years reversion period using in the early 2000s.) If we are talking about stocks at double fair value at time 0 but are holding until infinity, there is no reversion to the mean which needs to be built in (so the inductive approach you are using becomes more accurate) but your returns are still going to be lower because your initial yield is lower than it otherwise would have been (Buffet's simple approach used to make his point in Fortune 12 years ago uses mainly inductive reasoning; it was simple to get his main point across that equities were really overvalued but he knew it wasn't the full detailed answer).

 

"So purchasing the market here one could expect to earn 7.5% to 8.5%.

 

2.5% as income from the dividend and another 5% to 6% as capital gain from the growth in the dividend."

 

Original,

 

I should have caveated that statement with....one can expect a 7.5 to 8.5% return ASSUMING the market does to not compress to fair value.

 

For the 5 to 6% nominal I'm simply assuming dividends will grow at their long term average nominal rate. I imagine GMO assumes the same - for example, Hussman just said this week that his expected returns assume the long run nominal average of 6%.

 

I agree 100% that growth will likely be below average for the foreseeable future, along the lines of 4% as you point out.

 

As far as margin and PE mean reversion, that flows through my "fair value dividend yield" calculation. So if the required return on the market is 9% and you have nominal growth of 6%, then the market is fairly valued at a 3% dividend yield, or 1,250 assuming a 37.50 DVPS. I'm being generous with the dividend....

 

At the current DVPS of 31, the yield at 1,500 is 2.06%. At a FV DY of 3%, the market is fairly valued at 1,033. So at the current dividend, the 7 year projected nominal return works out to:

 

Change in valuation: .948

X

Growth: 1.06

X

Yield: 1.0206

= 1.026 - 1 = 2.6% nominal return

 

If you back out GMO's 2.2% inflation projection, the projected real return is .40% per annum. This is slightly higher than GMOs .30% at FYE12, but it is in the ballpark.

[bmichaud]

 

I think as a whole, the SPX likely breaks even on buybacks - i.e. just offsets dilution.

 

 

I'm not sure if some of (or most of) the dilution is real dilution -- buying other companies with your stock.  Sure, diluted share count but the total entity owns more earning assets. 

 

Or are you saying executive compensation style dilution matches share repurchases?

 

I meant comp dilution.

[bmichaud]

I certainly can understand the reason for being cautious here.  I consider myself cautious despite being 0% cash.  I just implement my caution mainly via well-priced stocks with moats.  I disagree though with some of the arguments presented here based on metrics.

 

I had a look at the shiller PE ratio and I don't really think it is particularly meaningful as far as a gauge of future returns.  If you use 10 year returns, I will admit that at high PE levels the returns are poor.  However, if you use 5 year returns, with a PE of 23 you actually get very good returns. 

 

Below are the occasions that the market first hit shiller PE of 23, along with subsequent aggregate 5 year returns (dividends reinvested):

 

Sept 1928 :  -30%

Jan  1964 :  56%

July  1995 : 187%

Nov  2002 :  75%

Feb  2011 : 16% (period to date)

 

I would also note that the VIX levels in july 95 were in the 11-13 range, similar to how they are today.

 

Does this mean that the odds are that the market will go up?  NO!  Who knows?  It just goes to show that you have to be very careful in interpreting these numbers.  Much of the negative analysis of high shiller PEs uses all of the PE values above a certain point.  Why would you lump in results where the PE is in the 30's with a value of 23?

 

There is also the fact that we are not really comparing apples to apples as there are recessionary earnings in '03,'08,'09 without which the PE would probably be in the high teens.  Most of the preceding periods did not have these huge dips in their preceding earnings.

 

I would also note that while hedge funds are increasing their exposure to stocks, pension allocations to equities have been substantially reduced. 

 

My two cents.

 

All super good points regarding the perils of relying solely upon valuation for gauging market risk. This got me into trouble early last year so I had to learn how to incorporate more factors into my risk analysis.....

 

Sentiment, sentiment, sentiment.

 

Not just the VIX, but a composite look at where market participants are sentiment-wise. You pointed out hedge funds having increased exposure - while in and of itself this is not hugely significant.....if you look at the industry as a whole at market turning points, it is a wonderful gauge of sentiment, at the 2011 bottom, in aggregate HFs were 0% long if not net short....now they are at the highest net long exposure in years.....

 

Margin debt as a percentage of GDP is at levels typically signifying market peaks.

 

And the Citi Economic Surprise Index has now rolled over significantly, which when combined with sentiment etc... is a pretty good risk gauge.

 

This isn't market timing - just risk/reward analysis to see I'd the odds are in your favor. Sanjeev does this precise thing!! He raised cash and bought puts in BAC at the market peak in early 2012 and now he is 40% cash....YET BAC, AIG and MBI are at phenomenal long run levels! As Sanjeev likes to say, this is just as much art as it is science.

[original mungerville]

bmichaud,

 

Sounds like we are in agreement: once factoring in some reversion to the mean, basically we are at 0-1% real returns over 5-7 years. Of course the conundrum is that that could be a better return, in nominal terms, than cash or bonds. 

 

Cheers.

[bmichaud]

bmichaud,

 

Sounds like we are in agreement: once factoring in some reversion to the mean, basically we are at 0-1% real returns over 5-7 years. Of course the conundrum is that that could be a better return, in nominal terms, than cash or bonds. 

 

Cheers.

 

Taking GMO's projections literally, yes absolutely cash and/or bonds are inferior to stocks. However, what their projections don't account for is the highly valuable "optionality" cash provides in a down market. Stating the obvious, even if you lose 2% real per annum over the next three years, one will more than make up for the loss in purchasing power by buying stocks at levels more commensurate with long-run averages.

[original mungerville]

You make a very good point on the important option value of cash for a buyer of stocks over the medium term.

[ERICOPOLY]

And when interest rates rise, the prices of every asset class fall.

 

Residential real estate never fell in value in the 1970s or 1980s.

 

Not even one year.

 

That didn't happen until the 2006 onwards period -- when interest rates were crushed.

[ERICOPOLY]

 

I think as a whole, the SPX likely breaks even on buybacks - i.e. just offsets dilution.

 

 

I'm not sure if some of (or most of) the dilution is real dilution -- buying other companies with your stock.  Sure, diluted share count but the total entity owns more earning assets. 

 

Or are you saying executive compensation style dilution matches share repurchases?

 

I meant comp dilution.

 

Anyways, I suppose it's not worth discussing because it all comes out in the wash (whether dilution or not, it's measurment gets appropriately measured within the dividend per share growth rate).  So to keep it simple, it's just dividend yield and the rate at which it grows.  Really everything else is noise.

[StubbleJumper]

bmichaud,

 

Sounds like we are in agreement: once factoring in some reversion to the mean, basically we are at 0-1% real returns over 5-7 years. Of course the conundrum is that that could be a better return, in nominal terms, than cash or bonds. 

 

Cheers.

 

Taking GMO's projections literally, yes absolutely cash and/or bonds are inferior to stocks. However, what their projections don't account for is the highly valuable "optionality" cash provides in a down market. Stating the obvious, even if you lose 2% real per annum over the next three years, one will more than make up for the loss in purchasing power by buying stocks at levels more commensurate with long-run averages.

 

 

You are assuming that the overvaluation (~30% overvalued) will resolve itself through a relatively quick draw-down in equity prices.  However, there are any number possible ways that overvaluation can work itself out that do not result in an opportunity to buy back in:

 

1) Market trades more or less sideways for about 6 years, then we're pretty much at "fair value."

2) Market goes up 15% in 2013 and then trades sideways from 2014 through 2021, then we're pretty much at fair value.

3) Market goes down 5% during 2013 but you don't buy back in because it's still overvalued, and then it trades sideways for 4 years.

4) Market goes up by 2% per year for 10 years and finishes at roughly fair value.

5) et cetera...you are only limited by your imagination.

 

All that to say that cash has optionality, but the option might finish out of the money.  For me, I'm holding securities that I believe are absolutely cheap irrespective of the level at which the S&P500 trades.

 

 

SJ

[bmichaud]

bmichaud,

 

Sounds like we are in agreement: once factoring in some reversion to the mean, basically we are at 0-1% real returns over 5-7 years. Of course the conundrum is that that could be a better return, in nominal terms, than cash or bonds. 

 

Cheers.

 

Taking GMO's projections literally, yes absolutely cash and/or bonds are inferior to stocks. However, what their projections don't account for is the highly valuable "optionality" cash provides in a down market. Stating the obvious, even if you lose 2% real per annum over the next three years, one will more than make up for the loss in purchasing power by buying stocks at levels more commensurate with long-run averages.

 

 

You are assuming that the overvaluation (~30% overvalued) will resolve itself through a relatively quick draw-down in equity prices.  However, there are any number possible ways that overvaluation can work itself out that do not result in an opportunity to buy back in:

 

1) Market trades more or less sideways for about 6 years, then we're pretty much at "fair value."

2) Market goes up 15% in 2013 and then trades sideways from 2014 through 2021, then we're pretty much at fair value.

3) Market goes down 5% during 2013 but you don't buy back in because it's still overvalued, and then it trades sideways for 4 years.

4) Market goes up by 2% per year for 10 years and finishes at roughly fair value.

5) et cetera...you are only limited by your imagination.

 

All that to say that cash has optionality, but the option might finish out of the money.  For me, I'm holding securities that I believe are absolutely cheap irrespective of the level at which the S&P500 trades.

 

 

SJ

 

Correct. Which is why I try to look at the whole picture versus only valuation to better assess the risk/reward opportunity..... As I said in another response, sentiment, sentiment, sentiment. See attached.

Investors_Stock_Sentiment.bmp

NAAIM_Long_Exposure.bmp

Hulbert_NASDAQ_Sentiment.bmp

Credit_Suisse_Global_Risk_Appetite.bmp

[original mungerville]

Ericopoly,

 

Sorry for butting in, but its 1) the dividend, 2) the rate it grows (ie the rate earnings grow assuming a constant P/E which equals the rate of stock price growth), but I would factor in 3) reversion to the mean over 7 years like Grantham (which is critical and means you need to know 3i) where we are now versus 3ii) the mean over time). So to keep it simple, those 4 data points. 

 

You always need the 4 main drivers: a current yield (whether dividends or earnings or sales with current profit margins), the future growth in the current yield, and where we are now relative to the mean we are likely to revert to over say 7 years.

 

If you are holding for infinity, you probably can get away with only the first two! Or if stocks are crazy expensive like in 1999/2000, you can write an article in Fortune only focused on the first two in order to prove your point without needing to get into reversions to the mean (as Warren did).

 

[ERICOPOLY]

Ericopoly,

 

Sorry for butting in, but its 1) the dividend, 2) the rate it grows (ie the rate earnings grow assuming a constant P/E which equals the rate of stock price growth), but I would factor in 3) reversion to the mean over 7 years like Grantham (which is critical and means you need to know 3i) where we are now versus 3ii) the mean over time). So to keep it simple, those 4 data points. 

 

You always need the 4 main drivers: a current yield (whether dividends or earnings or sales with current profit margins), the future growth in the current yield, and where we are now relative to the mean we are likely to revert to over say 7 years.

 

If you are holding for infinity, you probably can get away with only the first two! Or if stocks are crazy expensive like in 1999/2000, you can write an article in Fortune only focused on the first two in order to prove your point without needing to get into reversions to the mean (as Warren did).

 

I agree with you.  I simplistically stated it the way I did, but I should have qualified that whoever buys the index here is only going to get those implied returns if they sell at a similar market valuation.  And that's really what you guys are talking about -- there won't be many similar opportunities to sell at such levels, so most people buying today will likely earn less than the implied return (they'll sell at a lower overall market valuation).  There will be slippage that will erode returns.

 

I just figure I'm in the opposite situation.  I'm holding mostly BAC and wondering if there will be another opportunity in the coming decade to get in this cheap.  I doubt it.  However I've been gradually shifting some into the AIG warrants (now at 15% of net worth).

[original mungerville]

Ericopoly,

 

I can't buy either but I wish I could! I am glad you and the board are doing well on those. With my day job, I have many conflicts of interest re global financials - which is really not good, it is a little ridiculous.

[ERICOPOLY]

Ericopoly,

 

I can't buy either but I wish I could! I am glad you and the board are doing well on those. With my day job, I have many conflicts of interest re global financials - which is really not good, it is a little ridiculous.

 

I'm sorry, that is painful.

[stahleyp]

Hmmmm...frothy?

 

Props to valuewalk:

 

http://video.cnbc.com/gallery/?video=3000146541#eyJ2aWQiOiIzMDAwMTQ2NTQxIiwiZW5jVmlkIjoiVjFSZXd3TzdGMVhRekhacnRuaVNuUT09IiwidlRhYiI6ImluZm8iLCJ2UGFnZSI6MSwiZ05hdiI6WyLCoExhdGVzdCBWaWRlbyJdLCJnU2VjdCI6IkFMTCIsImdQYWdlIjoiMSIsInN5bSI6IiIsInNlYXJjaCI6IiJ9

[siddharth18]

Hmmmm...frothy?

 

Props to valuewalk:

 

http://video.cnbc.com/gallery/?video=3000146541#eyJ2aWQiOiIzMDAwMTQ2NTQxIiwiZW5jVmlkIjoiVjFSZXd3TzdGMVhRekhacnRuaVNuUT09IiwidlRhYiI6ImluZm8iLCJ2UGFnZSI6MSwiZ05hdiI6WyLCoExhdGVzdCBWaWRlbyJdLCJnU2VjdCI6IkFMTCIsImdQYWdlIjoiMSIsInN5bSI6IiIsInNlYXJjaCI6IiJ9

she shuns speculation and yet that's exactly what she does. hmm...wtf?

[Palantir]

An attractive 16 yr old girl saying the words "overbought, oversold, technicals".

 

 

Not too shabby.

[siddharth18]

An attractive 16 yr old girl saying the words "overbought, oversold, technicals".

 

 

Not too shabby.

 

Not bad for a 16 yr old. She better hope it doesn't end badly. Lemmings are the first to get crushed in a stampede caused by speculative frenzy!