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Best Tweets in August

Timing the Markets with Value and Trend

I like Five Thirty Eight.  Their data driven approach certainly appeals like a quant to me.  However, like many people out there, when they apply their logic to the stock market things start to go a little screwy.  They posted a piece titled :”Worried About The Stock Market? Whatever You Do, Don’t Sell.”

I think that is fine advice for a buy and holder willing to sit through big, long drawdowns.  We’re talking 50-90% losses here.  If buy and hold is your system, then by all means, stick to your system!  But realize the odds for buy and hold currently are very poor.

Even if your policy portfolio or approach is active instead of passive, nothing that would happen on any given day should change what you’re doing so 538’s advice “to do nothing” is correct.  And I agree with them that emotional responses to markets is the worst way investors can react.  Heck I run some buy and hold funds and realize that people trying to subjectively time the market is usually a disaster.  However, the agreement ends there.

I firmly believe timing the market is not only possible, it isn’t that difficult.  It is really quite simple and is based on common sense.  However, for those looking for the holy grail this article isn’t it.  Our market timing approaches work by reducing volatility and drawdowns.  This is one reason many think that market timing isn’t possible – all they do is focus on returns when basic market timing works by not doing really dumb things, such as buying into bubbles.

Anyways, 538’s article looks at some bizarro system that “sells any time the market loses 5 percent in a week, and buys back in once it rebounds 3 percent from wherever it bottoms out.” I’ve been a CMT for about 15 years and have never heard of anything like this (closest maybe the ValueLine 4% system?)  The author then decides to exclude dividends for some odd reason, and I’m assuming, also ignores investing the cash in T-bills or 10 year bonds.  He then doesn’t use a log Y-axis, distorting the results.

Instead, lets boil common sense market timing into two basic rules.  I posted a version of the below in April and September 2013, and even in our 2007 white paper so it’s nothing new.   Here are the basic rules:

Don’t invest in expensive markets (defined as CAPE ratio above rolling average which is similar to below something around 16)

Don’t invest in downtrending markets (defined as price < 10 month SMA)

Otherwise invest in 10 year bonds.

Unfortunately, both of which happening now – an expensive stock market that is downtrending.

Click to enlarge.

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An using a misleading Y-axis.

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There are many ways to improve this so test your own variants and see what you think!  But note they mainly work by reducing vol and drawdowns usually by 30-50%, but that’s a good thing!

Now, one could even go a step further, and instead of investing in the S&P500 sort individual companies by value and momentum as well.  So you have the best of both worlds – great companies sorted by value and momentum, but also protected when stocks are expensive.  To view these results go check out this awesome post on value and momentum from Alpha Architect.  Even when they penalize results with a whopping 3% in annual fees and costs (way too high in my mind), the stock screen beats the market, and the hedges reduce volatility and drawdown.  A nice combo for this sort of market!

Click to enlarge.

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Your Buy and Hold Allocation Doesn’t Matter

Not sure why I didn’t include this chart in my Global Asset Allocation book, but below is the basic return/vol chart.  It demonstrates how clustered the returns are.  If you exclude the permanent portfolio (high cash), they are all within 1 percentage point of each other! Red are assets, blue portfolios. 73-2014.

 

Coupling

Blog Redesign

I am told I need to do a blog redesign to make my website “mobile friendly”.  Since they are going to have to recode it anyway, is there anything you would like to see added or changed?  Suggestions?

 

Has Einhorn Lost His Mojo?

I send out a weekly hedge fund profile with 13F stock picks and results to The Idea Farm each week.  At the bottom of the post is the recent Greenlight Capital profile.

One of the big challenges with allocating to active (subjective, not quant) managers is you are betting on their process – their ability to continue to keep doing what is is they are doing, and doing it well.  So how does one know when to stop following a manager?  Perhaps style drift or lost enthusiasm. Resting on their laurels, or maybe a nasty divorce. Too many assets? Put in jail. Newer, younger, and hungrier managers. Lots of reasons to move on from some managers, but often the criteria can be subjective.

Below is an example with everyone’s favorite poker player and stock mover, David Einhorn.  (Note this is only examining his long book, and the 13F one at that.  Perhaps his shorts are adding value, etc.)

As you can see, he has absolutely crushed the market since 2000 by over 7 percentage points a year.  $100k invested in his 13F long picks would be worth about $600k vs. only about $200k in the S&P 500.  But his story is one that is really about two periods.  2000-2006 , and 2007-2015.  From 2000 – 2006, Einhorn beat the S&P500 every single year, on average by a whopping 27% per year!  Since then?  On average losing to the S&P 500 by about 4% a year.

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Greenlight Capital, David Einhorn

What I like is solving the puzzles. I think that what you are dealing with here is incomplete information. You’ve got little bits of things. You have facts. You have analysis. You have numbers. You have people’s motivations. And you try to put this together into a puzzle or decode the puzzle in a way that allows you to have a way better than average opportunity to do well if you solve on the puzzle correctly, and that’s the best part of the business.”

As an ace poker player (he has won millions in high stakes tournaments and donated his take to charity), David Einhorn knows how to read the table — when to go all in on a hand he trusts and when to bet against a bluffing opponent. He plays the stock market in much the same way.

Einhorn’s multi-billion Greenlight Capital runs a concentrated portfolio heavily skewed toward his top positions, and the top six accounted for more than half of invested positions in the first quarter of 2015, according to his SEC filings. But for someone with that much money riding on companies he likes, Einhorn tends to get much more attention for the companies he hates.

An Einhorn short generates major headlines and can have the power to move a stock’s price. Companies on the receiving end of one of his short plays are said to be “Einhorned,” a term he joked about in a 2012 conference with the line, “Apparently now I’m a verb.”

He was once investigated by the SEC for market manipulation after discussing his short position against finance firm Allied Capital; his comments at a 2002 conference about his short generated so much activity in the stock that trading was temporarily suspended.

It took years to resolve, but Einhorn was eventually vindicated and the company taken to task by the SEC. Allied was subsequently bought out and taken private, and Einhorn wrote a book about the experience, Fooling Some of the People Some of the Time.

There have been a number of other high-profile campaigns against companies since then. He argued that Lehman Brothers was using suspicious accounting and overly risky practices; the company collapsed in 2008 and during the economic meltdown. He presented a 100-page attack on Green Mountain Coffee Roasters in 2012 and delivered a 66-page  presentation in 2014 explaining his short against Athena Health. That presentation concluded with a vintage line from Einhorn:  “We believe that there are serious risks to this business model that are being mostly ignored by bullish investors and sell-side analysts.”

That comment belies the ferocity with which Einhorn often pursues his prey.  A profile in the New York Daily News quoted an unnamed source in describing how Einhorn works:  “He does deals where he rips your face off. If he had a fin, he’d be swimming in the ocean.”

While it may be uncomfortable to be on the receiving end of an Einhorn short, it can be quite profitable to place money with him. He doesn’t always come out on top, but the thesis behind each investment – long or short — is based on such deep research and intensive analysis that even other hedge fund managers are impressed. One hedge fund manager described what Einhorn does as “extraordinarily detailed work.”

A graduate of Cornell University with a degree in government, Einhorn interned with the SEC, considered joining the CIA, but wound up taking a job at investment bank Donaldson, Lufkin and Jenrette (which was later bought out by Credit Suisse). Two years later he left for a job at hedge fund Siegler Collery & Co., and in 1996 launched Greenlight with a colleague from that firm.

Greenlight has since grown from less than $1 million in assets to more than $10 billion, while Einhorn has himself become a billionaire and earned a reputation as a masterful short seller. But that reputation tends to overlook his other skill as a long investor running a highly concentrated portfolio.

Click any chart to enlarge.

FIGURE X  –13F Holdings, 6/30/2015

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Source:  AlphaClone

 

FIGURE X – 13F Performance, 2000- 2014

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Source:  AlphaClone

 

July Tweets of the Month

APPENDIX F – THE LARRY SWEDROE PORTFOLIO

This excerpt is from the book Global Asset Allocation now available on Amazon as an eBook.   If you promise to write a review, go here and I’ll send you a free copy.

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Larry Swedroe is one of my favorite writers and researchers.  With 15 books to his name, his focus on evidence based investing fits in well with how we view the world. We debated about including this portfolio in the book since it requires using a value tilt, but think it is an important example of how a simple smart beta strategy may be beneficial to the overall portfolio.

The biggest difference between the allocation and others in this book is that he allocates to small cap value.  Small cap value stocks have outperformed broad small caps by about four percentage points a year, which is a lot.  The value stocks have slightly more volatility and a higher drawdown as well.

 

FIGURE 57 – Larry Swedroe Eliminate Fat Tails Portfolio 

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Source: Swedroe

Below are the portfolios returns for comparison.

Swedroe’s unusual allocations are another example of a consistent performer due to including a mix of stocks, bonds, and real assets.  We include the performance of including small cap as well as small cap value to illustrate the improvement in performance.  The portfolio with the value tilt results in the highest Sharpe ratio of any portfolio in the book.

 

FIGURE 58 – Asset Class Returns, 1973-2013

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Source: Global Financial Data

APPENDIX E – THE WILLIAM BERNSTEIN PORTFOLIO

This excerpt is from the book Global Asset Allocation now available on Amazon as an eBook.   If you promise to write a review, go here and I’ll send you a free copy.

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William Bernstein is a retired doctor based in Oregon and is well-known for his writing on asset allocation with at least 10 books as well as a blog and investment advisory.

Below is his suggested allocation.  Not surprisingly, with an allocation of 75% in stocks, the portfolio returns are very similar to the broad stock market.

 

FIGURE 55 – William Bernstein Portfolio 

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Source: The Intelligent Asset Allocator, 2000

 

FIGURE 56 – Asset Class Returns, 1973-2013

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Source: Global Financial Data

APPENDIX D – THE 7TWELVE PORTFOLIO

This excerpt is from the book Global Asset Allocation now available on Amazon as an eBook.   If you promise to write a review, go here and I’ll send you a free copy.

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The 7Twelve allocation was proposed by Craig Israelsen in 2008.  Craig is the author of three books and is a principal at Target Dale Analytics.

7Twelve is one of the more consistent portfolios, having made positive real returns in every decade.

 

FIGURE 53 – 7Twelve Portfolio 

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Source: 7Twelve Website, 2008

 

Figure 54 – Asset Class Returns, 1973-2013

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Source: Global Financial Data


 

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