Episode #40: “Listener Q&A”
Guest: Episode #40 has no guest, but is co-hosted by Meb’s co-worker, Jeff Remsburg.
Date Recorded: 2/14/16
Topics: We’ve had some great guests recently, and have many more coming up, so we decided to slip in a quick Q&A episode. No significant, recent travel for Meb, so we dive into questions quickly. A few you’ll hear tackled are:
- Some folks talk about how the inflation numbers are manipulated by the government, and how the calculations have changed. Is there any merit to this?
- What is your opinion on market neutral strategies? If you had to build a market neutral ETF, what strategy would you use?
- Your buddy, Josh Brown, indicates that a significant portion of valuations, specifically CAPE, are the confidence in the stability of the stock market, which will justify high valuations here in the U.S. This makes intuitive sense, but I’d like your thoughts.
- Have you given any thought to the application of a trend following approach over a lifetime? Specially, use buy-and-hold when younger, but move to trend as one approaches retirement?
- Based on your whitepapers, you’ve indicated that trend following is not designed to increase returns, but rather, to limit/protect your portfolio from drawdowns. If this is the case, how does an increase in the allocation toward trend in your Trinity portfolios correlate to a more aggressive portfolio? It seems if “more trend” is supposed to reduce drawdowns, it should be found in Trinity 1 instead of Trinity 6.
- Have you done any research on earnings growth rates compared with CAPE to get a more accurate indicator of expected returns? For example, while the CAPE for many countries in Europe is low, their growth rates are also considerably lower than the U.S., which could justify the lower CAPE as compared with the U.S. Your thoughts?
- Does your “down 5 years in a row” rule apply to uranium, or is it too small?
As usual, there’s plenty more, including a listener wondering why Meb didn’t challenge Rob Arnott on a discussion topic during Rob’s episode, why Meb is in a cranky mood (involves auditing), and a request for more gifts of tequila from listeners. All this and more in Episode 40.
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Transcript of Episode 40:
Welcome Message: Welcome to the “Meb Faber Show” where the focus is on helping you grow and preserve your wealth. Join us as we discuss the craft of investing and uncover new and profitable ideas all to help you grow wealthier and wiser. Better investing starts here.
Disclaimer: Meb Faber is the co-founder and chief investment officer at Cambria Investment Management. Due to industry regulations, he will not discuss and of Cambria’s funds on this podcast. All opinions expressed by podcast participants are solely their own opinions and do not reflect the opinion of Cambria Investment Management or its affiliates. For more information, visit cambriainvestment.com.
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Meb: Happy Valentine’s Day, podcast listeners, we got Jeff Remsburg in the studio for a co-host. Jeff, welcome.
Jeff: What’s happening?
Meb: Jeff that’s a new version.
Meb: I’m in somewhat of a foul mood, you seem to be in a pretty good mood. A reader sent in a bottle of tequila… Reader. I keep saying “reader”. Because I’ve been blogging for 10 years, I keep saying “reader”. A listener sent us a bottle of good tequila, so Jeff’s happy, he loves tequila. So you podcast listeners, keep sending Jeff booze, he’ll keep this podcast rolling.
Jeff: The rule is we have to drink it in the office, though, so.
Meb: Okay, well the…what was it? Was it Anejo, [SP] Blanco?
Jeff: I think it was Anejo, I believe, wasn’t Blanco.
Meb: You know what the third one is?
Meb: Reposado. It’s a desperado is what it is. I’m in a foul mood because we’ve been through a lotta audits recently and I’m now doing GIPS auditing and it’s just sort of mindless, terrible, miserable. But podcast has taken us away from that, we’ve had some good ones lately, Ed Thorp and John Bollinger’s I thought went great. Really interesting guys, old school market historians. You can listen to those and probably find 10 new things each time you listen to ’em. So we thought we’d break it up, do a Q&A episode. You guys remember to keep sending us questions, we’ve been having a lotta great ones, so we’ll read them on air live. And Jeff, looks like you got a whole stack, so why don’t we jump right in?
Jeff: Yeah, we got some great ones, so we’ll just dive in, see how far we can get.
Meb: And it’s firstname.lastname@example.org.
Jeff: All right, number one, one that I thought was pretty insightful here. Based on your white papers, blog, and podcasts you’ve indicated that trend following is not designed to increase returns but rather to limit and protect your portfolio from massive drawdowns at buy and hold experiences. If this is the case, how does an increase in allocation toward trend following and the six Trinity Portfolios correlate to more aggressive return seeking portfolio? It would seem that if trend following is designed to reduce drawdowns rather than increase returns, an increase in trend following allocation would be present in Trinity 1 versus Trinity 6. Love your input.
Meb: Well, you know, same trend following alone is…we often say it’s like saying “dog”, where, you know, a Dachshund looks different than a Rottweiler and so there’s a lot of different flavors of trend following. At its core, if you just overlay a moving average on something, historically speaking, on one asset class, yes, that likely what it’s gonna do is reduce risk and volatility. It may increase returns, it may hurt returns, but in general it improves your Sharpe ratio, decreases volatility in drawdown. So it’s risk reduction. But there’s lots of ways you can do trend following as a way [inaudible 00:04:12] shops do it, a more concentrated approach where say for example you’re using a dual momentum approach, what a lotta people talk about now, where you sort on momentum and concentrate in what’s going up the most and then overlay the trend following, and that is actually much more of an out performance style strategy historically.
So there’s a lotta different ways you could do it. The base case when I say it’s not return enhancing, I mean, at its core, overlaying a moving average on say one asset class is not return enhancing. So, if you put together a portfolio, and we did this on our white paper Trinity Portfolio near the appendix, and if you read the first version, you probably wanna update and read the second version, the 2.0, because it, I think, left out some of these charts and tables that we put in there after a lotta people had requested them, is that if you have a spectrum of portfolios and on the left side it’s the most in buy and hold and on the right side it’s the most in trend following, you know…and another way to think about it that we do in practice is on the left side is the most in bonds and the right is the least in bonds and the most in trend following, same sorta thing. Philosophically speaking, yes, in general, trend following has had a lower drawdown than buy and hold. However, bonds have also historically had a lower drawdown than equities. And so there’s sorta two main levers and when you combine them, I think you still end up on the correct spectrum. It’s how much do you have in low vol fixed-income or bonds and how much do you have in traditional buy and hold assets versus trend following assets. And so as you move to the right on that spectrum, you start to look a lot different. You know, it’s not necessarily that it’s gonna be more risky, though it is more volatile, the spectrum goes from low volatility to high volatility as measured by standard deviation, the drawdown…
Jeff: But if you’re using trend following to try to reduce some of that to get you out of markets that are rapidly changing directions assuming you’re not being whipsawed around, wouldn’t you sort of step out of the way some of that volatility?
Meb: Theoretically yes, but you gotta remember that’s coming at the expense of bonds. So bonds are lower vol than the asset class exposure that the trend following funds are targeting. So, you know, 5 year T-bills, low…you know, 10 year even bonds probably lower vol than the trend following portfolio in general. It just depends. Now the problem with this is that people are gonna look at the next month, three years, five years, and it’s gonna completely color their experience. And so whether or not the aggressive portfolios have lower or higher draw…and same thing if you just did a traditional equities and bonds split. I mean, you could have a scenario where the 100% equities or 80% equities, 20% bonds has a lower drawdown than 80% bonds and 20% equities. I mean, look at last year probably, I don’t know that, I’m just speaking off the top of my head, bonds got whacked over a certain period when they bottomed…interest rates bottomed I think maybe in the summer and started running up and then equities did just fine. So if you had a portfolio that was heavy on bonds which you expected to be lower vol or drawdown, that’s not what happened. Over the long-term, it’ll be interesting to see. But it’s a good question. I don’t like to say that by the way, I don’t like to say, “That’s a good question.”
Jeff: Well done, listener.
Meb: I was told by our PR people in the early days, they said when someone asks you a question, don’t immediately say that’s a good question, because you’re buying time. And then it also implies that all the other questions are terrible, but now I’ve gotten in the mindset to never say “good question”. So good question.
Jeff: Well on a side note, you mentioned applying the strategy to basically equities and the fact that bonds are…they would dampen the portfolio a bit or dampen the volatility. Have you ever thought about using trend following on bonds?
Meb: There’s a couple things in there. One is… So not to get too complicated, because on these podcasts it’s a little hard to talk about without numbers. You wanna go step farther and talk about those…the spectrum of returns for portfolios, with equities, and bonds, it gets even more complicated when you start talking about real returns. Because bonds, you know, for example, 10 year U.S. bonds you say on a nominal basis maybe only have a 20% drawdown and stocks is 80 plus. On a real basis, bonds have declined 50% because of inflation. They look much more risky when you think in terms of real, and then once you think in portfolio terms of real, it evens it out even more. So it’s an even more complicated question that I think that the reader even intended.
Trend following on bonds, look, everyone does it, fixed income, different markets, all the trend following funds do it. It’s historically if you’re just trend following in an account, not using futures, not using leverage on, like, 10 year bonds and less, I don’t think matters at all. I think it’s probably a waste of time. It may matter in the short-term, you may miss a rise in rate environment, but they’re just not volatile enough. Now if you’re leveraging them, if you’re doing them as part of the leverage portfolio, that’s different, but say junk bonds, emerging market debt, corporate bonds, it works great, trend following has. But those are also more and more volatile.
Jeff: Be curious to see in, you know, a decade or two if we look back at now as an inflection point where if you were using it, you would get outta the way of a significant rise in rate environment for a while.
Meb: Well, that’s what everyone’s been expecting for about 10 years, but you also gotta think about the flipside. What if interest rates continue declining? What if we see…
Meb: What if we see negative rates in the U.S.? You know, I mean that’s what no one really expects, but I don’t see why that’s not at least a possibility.
Jeff: Well speaking of inflation, that segues into another question which is good. You hear some folks, for instance, Shadowstats or Zero Hedge talk about how the inflation numbers are manipulated and how the calculations have changed. Is there any merit to this?
Meb: All of our conspiracy theory listeners’ ears just perked up. Look, have the calculations changed over time, the same as GDP, the same as valuation metrics, almost anything? Yes. And I think at some point you have to take a honest assessment, has it done enough to make a difference? And one of my favorite examples of this was a project, I think it was MIT, where it was called Price Stats maybe or the Price Discovery Project or something. I’m murdering this, I apologize, we’ll put it in the show notes. Where it was a group that was started to measure inflation just by comparing… Oh, The Billion Price Project I think it’s what it called. And they would just look at prices on the Internet for various goods and then compute CPI basket. And lo and behold, guess what? PEG [SP] CPI, almost exactly in the U.S. And so a lot of the people that, you know, are freaking out about the government and all the manipulation is trying to do for whatever reason, you know, turned out that it’s actually a pretty fairly accurate measure. And someone bought them, and I think it’s Sachsen [SP] or Credit Suisse, one of the banks now has it. But…because I think it’s called Price Stats, and it’s a pretty cool indicator and it’s also likely a leading indicator because I think it’s comes out more than CPI, and you can see in real time when it’s moving up or moving down. But we’ll added it to the show notes, I can’t remember the exact name of it. So I don’t sweat it, but, you know, I also don’t spend a ton of time…it’s not something I would spend a ton of time with.
Jeff: I remember years ago in my past life, we were writing an article on this and there’s a “Forbes” article back in I think 2014 maybe, said that the government has changed how they calculate inflation more than 20 times in the past 30 years. That’s not to say it’s been consequential ever single time, could be just tweaks, but they’re definitely manipulating it.
Meb: Well, they kicked out horseback riding as a means of transportation and everything else. I mean, of course it’s gonna change, I just…I don’t know that it’s like some conspiracy theory that it’s under reported by 5% a year.
Jeff: What’s interesting, other people’s takes on it, I think one of your past guests, Porter, I might butcher this, but I think he has his own somewhat proprietary or sort of rule of thumb heuristic. He just looks at like the Ford F-150, the cost of it, and uses that sort of as a proxy for various inflation measures.
Meb: Yeah. I mean, either way it feels…you know, and it’s also…it’s highly dependent on what your lifestyle is and what you’re spending on, you know, whether it’s healthcare, education. If you’re buying a computer and TV, it’s been…tech has a massive deflationary impact in general. And, you know, there’s other areas, college education, etc., that’s had high inflation. So there is no one just inflation basket so a wealthy person has a totally different inflation rate then someone who makes 20 grand a year. So you can look at the broad based economic inflation, but it’s also very hugely individual exposed depending on what you spend money on.
Jeff: Yeah, there’s a heavy skew with that technology. There’s some story anecdote about somebody complaining about the fact that inflation wasn’t capturing the rise in cost of living. And some expert had said, “Well, you know, look at your new iPad. You have twice the computing power that you did, you know, 10 years ago or 2 years ago even.” And the guy said, “Well I can’t eat my iPad.” All right, next question. What is your opinion on market neutral strategies? If you had to build a market neutral ETF, what strategy would you use?
Meb: Ed Thorp essentially in the last episode, if you haven’t listened to it, it’s great, you know, built his entire career around market neutral strategies.
Jeff: Back up just for anybody who’s not really fully aware. Just give a quick definition.
Meb: No, I’m not… Oh, I thought that you said give a overview of that, I said too bad, you’re gonna have to go listen to the podcast. I mean, market neutral is essentially…the goal is to have no overall exposure beta to the market. So if you’re a hedge fund that had a 100% long book and 100% short book, the goal being way back all the way to Alfred Winslow Jones in the 30s whenever he did his first hedge fund…is it Alfred Winslow Jones? Man, I’m mispronouncing words right and left today. You know, he started the world’s truly first hedged fund because the goal was to have a long position and a short position, they cancel out the overall effects in the market, and if you’re a good stock picker, you should make money no matter which way the market goes. Theoretically it’s great idea, right? The challenge of course is that it’s not that easy and it’s gotten harder over the years to be able to pick both longs and shorts, but it doesn’t mean that there’s not ways it couldn’t be done. I mean, we’ve written posts on this in the past. We wrote one…gosh, called something along the lines of, you know, “A Market Neutral System and How to Fix It” or something. And the problem with most market neutral systems is that they have no market beta exposure and the market goes up 5%, 10% a year, right? So there’s a natural headwind.
So you want in general, I think, a intelligent exposure to that tailwind. And so here’s an example. So I think the test we ran was a very common factor, something like buying high momentum stocks and short and low momentum stocks, very common, well known factor. You can get data on this back to the ’20s, same thing with value on the [inaudible 00:15:36] database, it’s free. You can download the monthly returns, and I think I did something like this, I said, “All right, if the market’s at an all-time high, you’re totally market neutral.” And for every 10% the market goes down, you reduce to short book. So the theory being is that when the market’s down 50%, you don’t wanna still be 100% short, you wanna be reducing your short. And the market’s down 80%, you really, really don’t wanna have huge short exposure because usually at market bottoms, the shorts, the really junky stuff, the stuff that’s down to a dollar, you know, is gonna rip, and it’s gonna double, and triple and that you have a lotta pain on the short side.
So we ran that test and it worked out great. So, I mean, that’s an example of a dynamic sorta market neutral. The problem you run into then of course, is you lose a little bit of the comfort of it being market neutral. So, you know, let’s say you start reducing all your shorts when you’re down 40%, 50% and all of a sudden the market goes down 50% again, like in Greece, or Russia, or Brazil, or something. So, you know, I don’t think there’s any magical solution, there’s a lotta different flavors to it. I don’t have any problem with it. I don’t think I will allocate to any market neutral systems, but I would [inaudible 00:16:50], I would totally be happy to.
Jeff: Well how would you balance a market neutral strategy in a broader portfolio where you might wanna also have specific factor-based strategies? I mean, is it just up to the engineer to say, “Well all right, let’s say 20% it’s gonna be market neutral, 80% when you go to XYZ,”?
Meb: Well the market neutral could be factor-based, so you could do a market neutral fund that buys value stocks and shorts expensive ones. That’s a factor-based market neutral. You can also buy a portfolio that’s just long value stocks and that’s 100% exposed long. So you could design it in any way you want, and there’s…you know, a lotta family offices prefer long/short equity and market neutral because it’s a little lower volatility. You know, the challenge, like anything, is finding ones that outperform, is can you find a long/short equity manager strategy or market neutral that can outperform, otherwise why not just buy bonds and be done with it?
Jeff: Well just sorta pushing for a new super conservative investors out there, you know, retail investors, what’s sort of a good conservative market neutral approach they could apply to, you know, try not to suffer any significant drawdowns and still stay somewhat long?
Meb: Buy some CDs. I’m serious, I don’t think most people should be going and buying expensive…and most would be expensive. Look, I’m sure there’s a lot of alt funds out there, and I spend almost zero time researching them, so it’s not like I can say, “Hey, you need to buy this fund from research affiliates, or AQR, LSV, or, like, one of these shops.” You know, I just…I don’t…I’m not that familiar. I’m sure there’s some good ones out there. And then…but market neutral can also mean something, you know, much more nefarious. It could be something like long-term capital that leverages up 50 or 100 to 1 and theoretically is market neutral, but because of the leverage, all of the sudden becomes a very aggressive fund. So it’s not…just saying market neutral doesn’t mean aggressive or conservative, it just means people are trying to line up positions on each side, and the best way…so, like, talking about Thorp’s, that’s the dream market neutral portfolio, that it goes on for 20 years, it has 3 down months out of whatever it was, 230, and those down months were all less than 1%. Like, that’s the market neutral portfolio you what.
The problem is because of Ed Thorp and everyone like him, there’s 10,000 quants with PhDs from MIT that all wanna make hundreds of millions as well. So they all now have the same database, and we talked about this a little bit on, I think the podcast, when he said you type in a traditional multi-factor stock that’s attractive from a multi-factor model that’s cheap, and high quality, and good momentum, and it’s got all the good factors, and every single quant shop owns it. So the edge there is gone and it’s harder, and so you need to start thinking about either more esoteric asset classes and factors or to try to be…we have a friend that says the alpha in this world of hyperactive trading and all the edges having been worn away by these, you know, PhDs and quant shops, is to actually get more dumb. Meaning, move out to a time frame that you can still take advantage of the large behavioral biases of large bear markets and people acting foolishly in crowds at extremes. Problem is that just plays out on a much longer time horizon. So if you can find a good RRB, mail us in, we’ll add it to the podcast.
Jeff: You mentioned research affiliates and your response there, so I’m just honing in on keywords, that leads us to another question. A listener is listening to our past podcasts, and the one with the Rob Arnott from Research Affiliates, Rob had said something which the listener found interesting which you Meb didn’t challenge. The listener wants your thoughts on it. Rob’s quote was, “Managed futures are not an investment in any asset class. People think of it as a commodities investment, it’s not, it’s zero. It’s long some commodities, short other commodities. For most managed future strategies, what it really is is a momentum strategy that chases what’s newly beloved and has performed well on a bet on manager skill. And if you got a great managed futures manager, it’s gonna be marvelous. If you’ve got an average managed futures manager, it’s gonna go nowhere for you. It’s not an asset class, it’s a bet on whether the manager or the algorithm has merit.”
Meb: I’m gonna channel Charlie Munger who I’m going to see tomorrow, at the meeting he’s the chairman at the newspaper he owns, I forget what it’s called. Anyway, I’m gonna channel him and just say I actually agree with him.
Jeff: Done and done?
Meb: No, well, yeah, I can, I always wanna add more. I mean, look, I agree it’s not an asset class. It’s…there’s really only four asset classes: stocks, bonds, commodities, and currencies, and almost everything else is an amalgamation of those or an active strategy using those four. So you could argue that real estate is an asset class, but really it’s a mix of equity and debt, same thing with corporate bonds. Managed futures is simply trading positions long and short on, you know, that many try to do 50 to 100 global asset classes, and industries, and sectors, you know, does that approach which..and again, managed futures means many things, but 80% of managed futures is probably trend following. So does trend following have an inherent return structure? And I think it does, but yes, it will be dependent on the system and algorithm or manager you pick and how much you pay for it.
Now, my belief is that most of them do the same thing. You know, could you pick one that does terrible and one that does amazing. And if you look at the dispersion in 2016 for example, managed futures didn’t have a very good year. I think the average return was probably somewhere around zero, if not negative. But there was funds that put up plus 10%, 20%, minus 10%, 20% on each side. So very clearly their trading different markets have different algorithms. But in general if you pull up charts of the mutual funds or hedge funds that do it, they have on average, a fairly similar equity curve over time, particularly if you compare it to a traditional asset class like stocks or bonds.
Jeff: Wait, was that dispersion based upon…you’re saying different asset classes or was that purely based upon different manager skill level? Because it’s a little frightening to think that you could have a range of…
Meb: Your manager skill for most these guys is an algorithm. It’s not, you know, Paul Tudor Jones showing up tomorrow and saying, “You know what? We need to short gold.” In his case it might be, but for the managed future shops, it’s traditionally not, it’s an algorithm. So for Harding, and Winton, and, you know, Dunn and these guys, they have systems and so it’s one of them may target 20 markets with 50% in interest rates and fixed income, another may target 100 market…global markets with only 10% to fixed income. So it’s the same as if you said, “Hey, look, there’s 100 equity managers that are very concentrated and active, and one was up 20 last year and one was down 20.” You could come up with a quant system that would be in either of those scenarios, but the vast majority of them tend to move together.
Jeff: Buyer beware.
Meb: Well it’s same with anything. I mean, you buy a quant stock fund. So it’s…let’s say you have a quant stock fund that picks 10 stocks out of the S&P 500. One is dogs of the Dow, buys the 10 highest dividend stocks. Another is what we called cash cows of the Dow, shareholder yield, right? Another one is does that stock begin with the letter A?
Jeff: To what extent are the managed futures algorithms as transparent as buying dogs of the Dow? I mean, can you get 100% awareness of what they’re doing strategy-wise…
Meb: Some of them.
Jeff: …or are you kind of guessing?
Meb: I mean some of them. Like some of the funds are index-based and pretty darn transparent about it. So like ETFs, you can look up their holdings every day. Mutual funds, you can look them up, you know, once a quarter. And so they’re…like, if you go into AQRs or any of these sites that have managed future fact sheets, they’ll say, “Look, here’s our asset allocation, we’re gonna target 25% risk in each of these four buckets. Here’s the contracts we’re gonna trade and here’s what we’re gonna do.” You know, and will they say, “Look, here’s our exact system,”? Probably not. But most of them, you know, are fairly transparent about their process. Now some aren’t, and then the ones that…there’s also plenty of managed futures [inaudible 00:25:36] shops that also have a subjective element. So they’re not all pure algorithmic either.
Jeff: Well that’s what sorta freaks me out just a little bit, is, I mean, at Thorp you asked him a question, how do you know when your factor has lost efficacy and it’s time to bail versus when will reversion to the mean kick in? And if you’re dealing with a managed future strategy that’s largely black box in nature and you can’t really tell the definition of what they’re doing, then how do you know whether down times are reflective of what’s within the normal rate of possibility for a loss versus when is something materially changed?
Meb: Well you looked at history and you can come up with simulations, but, I mean, again, equity’s lost over 80%. So, you know, the U.S. stocks in 1930s, would you then claim that equities are a broken asset class that you should never allocate to?
Jeff: Yeah, I’d be out since the ’30s.
Meb: Yeah, you definitely would. You would’ve been knocked out in ’29 by selling options and on…
Jeff: Then long calls.
Meb: Who knows what.
Jeff: All right, next question is a bit long so I’m gonna condense it a little bit. It has to do with your stocking investment from this past Christmas. You know what it is?
Meb: My stocking?
Jeff: Uranium. Quick takeaway from the listener question is that he’s unclear whether or not the rules of an asset class being down for several years in a row, and then the ensuing potential for a reversion to the mean to have it be a ripper, [SP] whether that applies to uranium. Because it’s very small as a sector. So Meb, do the same rules apply here when you’re dealing with something that’s a sector as small as uranium?
Meb: Well first of all, uranium’s not a sector, uranium is an industry. So the way that most shops do the classification is that there’s about 10 sectors, you know, it’s healthcare, tech, utilities, stuff like that, they just added real estate as a sector. But there’s about 10 of those and those are much more broad and have a lot more depth. And then industries are much more concentrated, so maybe something like biotech stocks, or medical device equipment makers, or uranium stocks. And so there’s depending on the classification scheme, I don’t know, 50 of those? And so it’s the same thing as if you said with almost any market there’s increasing levels of granularity, and so this piece that the listener’s referring to which is about asset classes, and we’ve done a lot of posts here on both asset classes, industries, countries, sectors, what happens when they go down a lot, so 60% to 90%, and also what happens when they go down many years in a row, so when they go down 1, 2, 3, 4, 5, 6 years in a row. And the… I mean, this…we published this in our first book back in ’06, ’07, whenever it came out, ’07, ’08, IV [SP] portfolio. And there’s a chart in there and it talks about…it says, look, at the asset class level when things go down a few years in a row, it’s usually a good time to buy, and at a sector or an industry level because they’re smaller, more concentrated and thus more volatile, you need to stretch that out a bit. And so instead of it maybe going down two or three years in a row, you want it to go down three, four, or five years in a row.
It’s the same thing of comparing maybe a U.S. government bond to equities. And we talked about, like, really bad months. So the…and I’m gonna murder the statistics, but let’s say it was like the worst 1% of bad months in stocks was like a 10% down month, and so usually when you bought after a 10% down month and held it for 3 months you get a good little bit of outperformance, and then…but the bond trigger was 5%. So you had to adjust. You know, so you can’t consider cash or bond-like instruments the same as you would stock. So same thing with being sectors and industries, and the whole uranium and coal stuff is meant to be a fun kind of diversion, I’m not going and loading 100% of my portfolio in uranium stocks at Christmas. Now, that we…however, now that we’ve seen us write this post two years in a row, I guarantee you it’s gonna happen. We’re gonna get all these crazy Shadowstat hedge fund…or Zero Hedge followers, they’re gonna wait till December and find out what our next pick is for the coal in the stockings and then go big, and then, you know, be down 80%.
Jeff: Any idea off the top of your head?
Meb: Because there’s nothing…I mean, look, in my mind there is nothing preventing something down six years in a row to go down seven, or eight, or nine, you know? I get that, it’s just in general, it’s like a rubber band when things go down that much and it’s universally hated, and it’s disgusting, and no one wants it, you really only need some something to go right or almost to go less wrong. And in this case, I don’t know, it was a handful of things, but, you know, it usually I think pays to at least start sniffing around things when they’re down 80% and down 6 years in a row.
Jeff: It’s, you know, it’s like your buddy Steve Sjuggerud talking about how he loves investments that are hated and in a slight uptrend. Speaking of these types of investments, you did coal a couple years ago. Any idea…
Meb: By the way, someone…and I actually didn’t notice this, someone had sent me a chart and said, “By the way, Meb, emerging market local debt on a five year basis is still, I think, has negative returns even though it ripped last year.” I have to look into it. Anyway, keep going.
Jeff: Any idea where coal is we…after…
Meb: I don’t. We’d have to…we…you know what we need? We need a assistant, and during the podcast live shows, to be putting…
Jeff: Show stats?
Jeff: Just looking up stats for us.
Meb: No, to be putting up charts, you know, like on on TV where, like…we need this to turn into a little more than two guys in a broom closet with tequila. I think we need a we need a TV and an assistant that put up charts and be able to…let’s start recording this on video.
Jeff: You heard it here, send in resumes.
Meb: So I don’t know what coal’s doing, I have no idea.
Jeff: All right, let’s see here. What about…
Meb: You know why I don’t have any idea is because Bloomberg did a redesign of their iPhone app and it is atrocious. Did you ever use it?
Jeff: [inaudible 00:32:02]…
Meb: The old one was great. Did you download the new one? It’s unusable. So I don’t even actually have a good quotes app. So listeners, if you know a really good quotes app, email us. I need something to use.
Jeff: Another trend following question here. Have you given any thought to the application of trend following across time, for example, a lifetime to capture the higher gains of buy and hold when you’re young, provided you’ve got the fortitude for drawdowns, and the moving to trend following when older to avoid the drawdowns and volatility?
Meb: So there’s a lot in that question, some of which I don’t know that I agree with, but some of which if I did distill his question, it meant, “Meb, do you think that it makes to make sense to use trend following more when you’re older, because I think that it has more of a chance to protect you when you’re older and avoid drawdowns.” Does that make more sense?
Jeff: It sounds right, yeah.
Meb: You know, I mean, look, I don’t know that…I mean, I don’t know that young people who are learning to invest are gonna be, like, anymore rational or the lessons they learn. And when you say, do buy and hold as a young person and lose a ton of money, I mean, look at Japan where they went through this 20 year bear market. There’s probably an entire generation of young people like, “I’m never gonna…buy and holds, it’s moronic, why would I ever do that,” you know? And so I…and on the flipside, you know, one of the false insecurities that an older investor may have is they may think that trend following is guaranteed to protect them and it’s not. You know, trend following in general helps protect against long bear markets but there’s no guarantee. And you could have a market that were in right now where almost everything is going up and bomb goes off, whatever, who knows, and the markets all go down 40% tomorrow. That’s…trend following is not gonna protect you. You know, most of it’s…it doesn’t have time to react. So, you know, for most people when you’re talking about this kinda…if you want security, if you want to not worry, sell down to your sleeping point and just hold more in cash and short-term investments.
Jeff: Fair enough.
Meb: Take…if you wanna avoid the risk, then don’t take in it in the first place.
Jeff: That kinda reminds me of I think something you’d said or in one of the podcasts where the portfolio that you need to grow wealthy is not the same portfolio you need to maintain your wealth. So I guess it’s up to the investor over time to figure out where he sits on that spectrum and make the necessary tweaks.
Meb: I was just reading a great story about…see if I can find it on Twitter, where we talk…have talked a number of times on the podcast about Batista, the Brazilian guy who was once the top five wealthiest men in the world, and then due to concentration and all of the things that got him to be in the…he was over 30 billion, to be that rich he continued to do the same things and then eventually lost it all. And there’s a “Bloomberg” article about Eike Batista, and I’m just gonna read it real quick. The quote said, “According to allegations in the proceedings is that Batista acting on the advice from a spiritual advisor,” named something I can’t pronounce, “tossed about $130,000 worth of gold coins into the Atlantic last year from the deck of a yacht festooned with flowers and perfumes for the occasion.” Quote, “All those riches that everyone talked about his guru said in a phone interview from Rio, I don’t think that brought him good fluids. So the guru explained, ‘He advised Batista to make amends with the sea goddess Emenaha [SP] by giving gold back to nature after his years of mineral extraction.'”
Jeff: How much are you gonna throw away this year in the ocean?
Meb: I’ll think about it. I’m more interested in throwing away money into my 1960s Land Cruiser. That seems to be a perfectly useful bottomless pit.
Jeff: I drove past your place the other day and saw the “For Sale” sign sitting out there.
Meb: Yeah, I need buyers. By the way, podcast listeners, you want a 1967 Land Cruiser that runs on occasion, let me know.
Jeff: All right, next question here. After reading an article this week from your buddy Josh Brown, he indicates that a significant portion of valuations, specifically Cape [SP], are the confidence and stability of the stock market which will justify relative high valuations, for instance here in the U.S., Japan, and Switzerland while discounting the emerging markets. This does make intuitive sense, but I wanted to see your thoughts on it.
Meb: I disagree consistently with my friends there on this topic. And by the way, Josh, and Barry, and Crew [SP] are hosting their evidence-based investing conference West at some point this summer, I think down at Newport, I’ll be down at it. So if you wanna come hang out and drink beers in Newport this summer or spring, you have to look it up, I don’t know when it is, but we’ll be there. I can consistently disagree with them on Cape in general, looking at foreign markets because my comment there is that you get so caught up in the short-term and, look, the U.S. is in a big, fat, awesome bull market right now, and the Dow, it’s arguably the second longest ever, S&P, it’s one of the longest ever. I mean, we’re approaching, you know, 8 years bull market and there’s only been a handful that of hit, I think, 10 years and pretty nice returns. And so it’s easy to take a step back and say, “Man, times are good,” and just throw valuation out the window because it can go on for a long time. There’s nothing that says the market couldn’t get more expensive for five more years, and just put all the bears out of business and the market just keeps chugging along. That is fully within the realm of possibility. And it’s done that before, I mean, the ’90s it got to a valuation, a CAPE ratio 45. It’s only, like, 27 now.
Jeff: This reminds me of…
Meb: There’s a long way to go.
Jeff: Reminds me of the article we wrote comparing it to 21, where you can keep hitting on a 19, potentially you’re, you know, 18, 17, get you 21, but statistically…
Meb: So people…
Jeff: …you’re most likely to win.
Meb: People draw so much…so many conclusions from a short amount of time frame and data in the way they feel now, you know, and then when times are bad, do that exact same thing with the opposite conclusion. And so when you look at a lot of these countries which by the way have been ripping for the last year, and they have low CAPE ratios in the year prior to that, and the world looked like it was gonna end, and Brazil is gonna fall into the ocean, and everything else would go through the Great Depression, you know, that’s the way that it always feels and looks, and you feel like things are never gonna get better. And lo and behold these markets go up 50%, 100%, 200%, triple, quadruple, whatever it may be.
Jeff: It’s recency bias.
Meb: Yeah it’s a recency bias. And so, I mean, look, you know, we…there’s a post we did I think four years ago that just said keeping it simple, and we have a fund that does this, and we said, “Look, let’s have your long [inaudible 00:39:18] stock exposure.” You want the tailwind of stock, so we’ll have that stock exposure with the factored tilt. And then were gonna put the market in four different boxes. It’s based on valuation and trends, so is the market in an uptrend or downtrend? Is the market cheap or expensive? Couldn’t be more simple, right? And historically, that has worked out great and it’s the exact way you think it would, where if you’re in an uptrend which happened, uptrend in the market is cheap, that happens a third of the time, and that’s the best performing quadrant. Historically that’s done 14% per year. But the next best quadrant is an uptrend in an expensive market which is where we are now, that happens 30% of the time.
So right there an uptrend, which we know in most markets around the world, occurs around two thirds, 70% of time, most time markets spend going up. So about half the time it’s cheap and half the time it’s expensive. Well that makes sense obviously because that’s the definition of it. But the second best place to be in isn’t [SP] uptrend expensive, the problem comes…is when that uptrend becomes a downtrend, so that uptrend expensive is still 12% a year. Uptrend, when it flips to downtrend and expensive, it’s minus 6% a year. So it’s a terrible time to be investing. And so, you know, you need to be a little more careful. So in cheap and in a downtrend is still positive, it’s over 6% a year. You know, you can be a little more cavalier when markets are cheap because it doesn’t matter as much uptrend or downtrend, but when markets are expensive and rollover, that’s when you really want to start to batten down the hatches. But it doesn’t have to be 2017, could be 2019.
Jeff: Have there ever been any studies about sort of the velocity of the drawdown based upon this, you know, “expensive market” versus a cheap market? You know, is it a much faster, more violent drawdown at the very top or is there any sort of rhyme or reason?
Meb: Yeah, we wrote one, we wrote two, but one was called “Where the Black Swans Hide”, and it looked at returns in a bunch of different markets when in an uptrend and in a downtrend. And in a downtrend, the volatility’s much higher and returns are much lower. And there’s a lotta behavioral reasons we think that works, but in general you wanna avoid those periods if you can, thus that’s why trend following works, is you avoid the higher volatility. So you move to a low vol instrument like cash or bonds and you end up avoiding that. And so along the same line of thinking is that if you look at valuation, you know, a lotta people have done this, Montier has done some charts, so has Star Capital, we’ve done some, and you look at valuation and then future drawdowns, we just posted a chart from Hussman on this a couple weeks ago where the more you pay initially for valuation, the higher your future chances of a big, fat drawdown. And it makes sense, the less you pay, the lower it is.
Jeff: But yeah, no, I got that, I was just curious about, say for instance from a CAPE range, [inaudible 00:42:27] call it 30 down to 20 if the velocity of drawdowns during that time somehow could be measured as more violent or [inaudible 00:42:36] are falling farther quicker rather than say a CAPE then from 18 down to 10 you might have the same size of the drawdown, but it would take two or three times as long.
Meb: Yeah. Well as far as time, you know, we looked at magnitude of bubbles in, I think, our “Global Value” book and kinda demonstrated that the size of the valuation over valuation bubble correlated nicely to how long it took to wear off. So Japan, biggest bubble we’ve ever seen took 20 years to wear off. The U.S., for the 2000 bubble only took eight. You know, it got really cheap in March of ’09 a lotta people don’t remember that or don’t wanna admit that because no one was buying, but on a CAPE basis, it was signaling very cheap, I think it was low teens. You know, where we are now again, it’s not terrific, but it’s not good.
Jeff: Well, speaking of CAPE, another question here. I was wondering if you guys have done research on earnings growth rates compared with CAPE to get a more accurate indicator of expected [SP] returns. For example, while CAPE for many countries in Europe is low, their growth rates are also considerably lower than the U.S. which could justify the lower CAPE as compared with the U.S. Any thoughts?
Meb: Yeah, so earnings growth is certainly a component of total returns, we’ve written some articles on what we call the Bogle formula which is distilling future stock returns into the various components of dividends, and earning, or… and by the way, AQR, we just sent this to The Idea Farm, AQR has a good paper on capital market assumptions that looks at this. But just doing it down in the dividends, earning growth, and of course valuation change, the problem is that listener that emailed that in, is backward looking. So earnings growth, yes, it’s obvious that it was lower looking back, but do you expect that to continue going forward? You’re making a very active bet. And historically and ironically, if you look at a lot of these factors that work for broad stock markets, you wanna invest where the numbers are worse. So you wanna invest in the place with the worst trailing five year GDP. You wanna be investing where the worst currency returns were the last five years. You wanna be investing where… So all these things you would think would help. So yeah, if you could just magically forecast that somewhere’s gonna grow earnings 10% a year for the next 10 years let me know. Wonderful, awesome, we’ll plug it into the equation, you’re gonna have great returns.
But the problem is I think the ability to forecast earnings growth is a pretty tall order.
Jeff: Well that means you’re always battling the question of, is this time different, the behavioral bias, you know, everybody wonders about, and we talk about sort of investing in certain countries, no one wants to go where…no one wants to go to Greece, no one wants to go to Brazil.
Meb: I wanna go to Greece. I really wanna go to Greece, sounds amazing. I’ve never been to Brazil. And the only place I’ve been in Greece doesn’t count because it was with my brother when I was in high school and it was one of those islands on, like, the west coast. It was, like, Corfu or something. So…I mean, it’s like a spring break destination.
Jeff: All right, let’s…think were sitting around 45 minutes. Let’s do one more and wrap it up so we don’t go too long today. I am…
Meb: We can do an hour, Jeff. Why you always wanna cut it short?
Jeff: Doing it for you, you’re running outta steam, you’re losing your edge here. I’m 22 with a moderate to high risk tolerance and I’m looking to increase the risk return profile of a global asset allocation portfolio. I realize this will likely reduce Sharpe ratio, but do you know if adding global equities at the expense of global bonds would completely destroy the risk return profile of a globally diversified portfolio?
Meb: It’s sort of interesting that he says, I wanna increase the risk-adjusted returns and I know this is gonna reduce them, so should I do this? He’s like [inaudible 00:46:40], I wonder if he, like, already knows the answer to the question. I mean, there’s a couple schools of thought here. One is that if you truly have a really long-term time horizon and you don’t care about drawdowns, you know, the volatility numbers, etc., compress over a longer time horizon. So if you look at equities in the best and worst case scenario and the volatility on rolling 20 year periods, totally different than 1 year periods. And you start to see the ability for equities to become more bond-like the longer your time horizon is. The problem is the order of events. And so most young people or people in general, don’t think in terms of 20 years. I mean, how many people do you know put their money in a bank account, close their eyes and say, “You know what? Let me see what this is worth in 20 years,” right? It goes down 30%, they say, “Oh my God, I gotta sell this because I gotta buy a car next year,” or “I just had three kid…my third kid, and how in the world I have half the money I used to have in my bank account, but oh, we got a 20 year time horizon.”
You know, most people…it’s a great theoretical exercise, and so maybe this is a business idea. Maybe we come up with a investment company that locks away your money and says, “You know what? Tough. You can’t access this for 10 years. Not only can you not access it, we’re not gonna tell you what the balance is. Only in extreme circumstances, or maybe we’re not gonna charge you a management fee until you withdraw. And if you withdraw…” And sorta it’s…you know, we…
Jeff: Interesting. I mean…
Meb: There’s gotta be some behavioral nudges that would work there to where it would help people. It’s almost like a lock box scenario. It says, “Really? You think you really have a 20 year time horizon? Fine, give us your money and we’ll lock it up for 20 years and you can have it in 20 years.”
Jeff: That would fund your Greece trip.
Meb: No, but it’s I think the way…you’d have to be a little more creative about management fees too, because you’d say…you’re, like, penalizing bad behavior. So many of these brokerages and money management shops, you know, they tout doing the right thing, but all of the incentives are built in the wrong way. You know, the ability to see your account value every day, the ability to trade lightning fast, the ability to use margin, all these crazy things. I wonder if you couldn’t come up with a better model for investor success than what’s currently out there. Anyway, think of some ideas, readers, email me. Listeners. God, I can’t stop.
Jeff: See, that’s why we’re stopping right now at 45 minutes.
Meb: No more, is that it?
Jeff: Yeah, let’s call it a day. Why don’t you take us out?
Meb: Okay. And by the way, I didn’t even answer the question at all. The question was, as far as the global portfolio, one is you’re making an active bet against bonds by the way, and if you look at the global portfolio, it’s roughly 55, 45 stocks bonds, but a good chunk of that, and I think it’s a third of the world market portfolio is corporate bonds. And so corporate bonds are about half stocks and bonds. So, you know, putting more in equities, I’m totally cool with, and I think a great way to do it would be a global value approach, you know, using CAPE ratio or any valuation approach that’ll get you away from putting half in the world’s largest market cap. But anyway, long-term time horizon, yeah, go buy some of our global value fund and then put it away for 20 years, I think it’s great idea.
All right, we got some great guests coming up, you guys, keep sending the questions in. We may start doing these more often or maybe on Mondays. We’ll see what feels right for the Q&A episodes. But thanks taking the time to listen. For the mail bags, send all the questions and tequila to email@example.com. As a reminder, you can always find the show notes and other episodes at mebfaber.com/podcast. Subscribe to the show on iTunes, and if you’re enjoying the podcast, leave us a review. Thanks for listening, friends, and good investing.
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