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Efficient Market Hypothesis - A Tough Opponent

I stumbled across this article on Yahoo the other day (yes, I take all my financial cues from Yahoo :) and although it’s message is basic (KISS, stupid) it got me thinking about where I would be if I would have read this at the beginning of my investing career and taken it’s advice blindly to heart.

As detailed in these pages, I have invested in everything from Index Funds to gold to Treasury-shorting ETFs to private investments, with an element of market timing along the way. I have come up with what can only be described as genius! moves and some others that I am truly trying to block out.

So I put together a fairly basic analysis of what I actually did versus the Yahoo! advice and went back to 2003, which was admittedly not the start of my investing career but was close enough.

I assumed that I would have invest the same money at the same time (end of each quarter) but would pick only VFINX (Vanguard 500 Index) or VBMFX (Vanguard Bond Index) depending on which gets the ratio closer to the optimum, simple ratio. I assumed I would have chosen the typical “subtract your age from 100” routine. We’ll call it 65/35 stocks to bonds. Drumroll please …

Christ.

The difference between the lines is 3.8% which is the same as .4% per year. A very small win which is a rounding error as far as I'm concerned. What is more interesting is looking at what happens when the market is up versus down. In 2008, the blue line is crushing (!!) the pink line. “Risk on!” Then the market teaches me and everyone else about humility. My portfolio gives up all it’s gains plus a bunch more as equities implode. I even timed the turn almost exactly right putting all my chips in the middle in March of 2009 but the damage was more than done. The message here is that we’re not all searching for return; we’re searching for risk-adjusted return. There is a difference.

This whole exercise reminds me of what my buddy told me about sports betting once. (To be clear, I do not bet on sports!) He told me that the reason sports betting is so tempting is that the worst sports better is right 45% of the time. And that’s just about everyone. You’re picking one team or the other and the “market” is pretty darn efficient. The bookie takes his cut (which is why you’re not a coin flip) and it leaves everyone thinking that the wins were genius and there were strange reasons for the losses. And with just a couple more wins, you’d be really good at this!

Hmm. Sounds familiar.

2011 Thoughts

A pension consultant that I respect published their thoughts on 2010 (review) and thoughts about 2011 and beyond (forecasts) back in January. I took some notes but sometimes like to see how things start out to see how their thoughts are starting to bear out.

2010
Very good year for the S&P on it’s face: a 15% return but a 20% rise happened after August and QE2 was announced and subsequently implemented. Bond yields still rose 1% after this happened.

General thoughts on valuations and the economy

• Equities have once again reached frothy levels



• Normalized P/E ratio on the S&P500 23; 25% above the median level since 1956.



• Correlates with a 0% real annual return (range of –3% to 6%) over the next decade.



• Forecasts a 3.5% real return.



• Reverting to the mean could cause a 16% drop in real terms.



• A traditional 60/40 portfolio is priced to return a modest 3% real return; same as in 2000.



• Profit margins are high, matching levels only seen twice since 1950.



• A recession in late 2011 or 2012 cannot be ruled out.
  
  
  

Small Caps have reached ridiculous levels relative to large-caps and an 30% divergence to get back to historical means should be expected. They are expensive any way you look at them. Aggressive investors could short the Russell 2000 futures against a long position in the S&P500 futures or a basket of large-cap quality growth stocks.

Japan looks incredibly cheap and is trading at 1.2X book and 6X cash flow. Valuations remain similar to 2009 lows. 40% discount to US Equities. Overall, their cheapest levels since 1996.

Conclusions

• Remain cautious, but not “out”


• Short Russell in Schwab while long S&P in Vanguard?


• 5% in EWJ?
  
  

Q-Ratio

The Q Ratio is a method of estimating the fair value of the stock market developed by Nobel Laureate James Tobin. It's a fairly simple concept, but rough to calculate. It's basically the total price of the market divided by the replacement cost of all its companies. It's history looks something like this:

Calulations: Doug Short

The idea here is that if it’s cheaper to build a factory instead of buying a competitor, the factory will eventually get built by someone. If not, the competitor gets bought. These two rational actions take the ratio back to the average over time.

So, what can you do with this? As I’m writing this, I haven’t looked at any DJIA quotes yet. So here’s a theory: buy when the ratio < .4 and sell when it’s >1. Let’s see what that gets us. I’m eyeballing this and am rounding to the beginning of the next year, thinking ratio is probably not available in real time.
Buy 1/1/1919, Sell 1/1/1930 (DJIA: 83 – 244)
Buy 1933, Sell 1936 (60 - 144)
Buy 1947, Sell 1969 (176 – 948)
Buy 1974, Sell 1994 (855 – 3820)
Buy when ??? (would have been out of the market for 17 years and counting ...)

The math, going back to the first buy in 1919:
$1 turns into $170 using the Q-ratio to time the market.
$1 turns into $46 if you just let the $1 ride from 1919 to 1994.
$1 turns into $144 if you let it ride from 1919 until today (Dow 12,000)

$170 is better but not radically different than $144 but there has been lots of down time over that period (36 years), during which (in our little experiment) you would be holding nothing. That doesn’t really seem fair to the test. It seems like the two most logical replacements for stocks are bonds and gold. Considering the last 17 years, if you let me buy a bond index in 1994 with my $170, the final result changes to $483. Gold changes $170 to $531. If you let me buy gold every time I sell the DJIA for the entire period, my $1 turns into $1,360 and there are no periods in aggregate that I lose money.



Woah.

The boxed figures are the invested periods.

So, this seems pretty simple but would have worked amazingly well for the last hundred years. This overall conclusion seems especially dramatic when considering we would have sat out the bull market of the 1990s and still had spectacular results. Why doesn’t this get more publicity? This is a serious question, why is this basically the first time I’m hearing about this?

I think what is the most scary about the current position of the chart is that in all other cases, when the ratio crossed the average in the past, it’s momentum ultimately took things much further. The “bounce” off the average in 2008 is pretty unusual at this point. Did government intervention stop the fall? That seems possible. Is the final outcome yet to come? That seems possible.

With a Q-Ratio of 1.17, is the market a clear sell at this point? If not, what could the reasons for it not to be? In other words, why would we think things are different this time?

Reviewing my Genius Prognostications

Here’s a recap of some of the things I said in 2010:

I cited upcoming demographic changes and deleveraging and sold quite a bit in April of last year when the Dow was around 11,000. The timing looked really good on that for a while as the Dow dropped 1,000 points, but is now up to 12,000. I still think 12,000 is ridiculous; it’s coming down. But at this point, this has cost me some money.

I had four other ideas, some that I acted on and some that I didn’t.

Sell Emerging Markets (push)
Rebalance toward Domestic (win)
Tilt toward small caps (would have been a win, I didn’t do it)
Japan (would have been a loss, I didn’t do it)

I also have been thinking a lot about “buying what you like” which by that I mean buy the stocks of those companies who you like in real life. I think my rule there is when a company has competitors but you don’t even investigate them before buying, then it’s time to buy the stock. My list is:

Apple
Netflix
Bank of America
Southwest
Panera

4 of these 5 would have been big hits going back to when I personally started liking each of these, with the exception of Bank of America, depending on the timing. So having said this, I don’t have any specific ideas at this point but I’m going to keep my eyes open.

2010 Wrapup

What’s up bitches, knucklehead here. Thought we could review where we stand after 2010.

A couple notes on the overall market: Wilshire 5000 is now up 100% of its low. S&P recorded a 12% gain for the year. All in all pretty good, and not the meltdown I somewhat suspected.

My YTD performance was 6.25% vs. S&P’s 12%. The underperformance is largely a function of the cash sitting around and also an investment of a quarter of my portfolio in a private investment which at this point I’m marking as “even” for the year. I wanted to be conservative, I was, and my returns are muted. That was the plan I guess so it’s hard to feel too bad about it. My stock picking did cause me to lose a little ground, here’s the breakdown:

Return on Equities: 11.01% (hello, EMH)
Return on Equities and Bonds: 9.64%
Return on the above plus company stock and cash: 8.17%
Return on the above plus private investments: 6.25%

Here’s a rundown of the actual investment choices I made vs. the S&P:

Gold (GLD): 9.1% (i.e. outperformed the S&P)
Singapore (EWS): 8.4%
Large Growth (VIGRX): 3.6%
Emerging Markets (VEIEX): 0.7%
Int’l Growth (VWIGX): -0.6% (i.e. underperformed the S&P)
Bond Index (VBMFX): -3.8%
Energy (VGENX): -5.6%
Agriculture (MOO): -10.3%
Pot (POT): -15.47%

I no longer own Gold, Energy, Bonds, MOO, POT. For anyone that follows POT, you are probably wondering how I lost money on this one. Here’s the chart. Guess which day I sold.


Get a load of this:


I mean, seriously? This shit ain't easy, man.

So, I’ve got some winners and some losers. I’m really starting to conclude this stock picking stuff is for the birds and am starting to wonder why I’m doing it.

So, back to the macro level. Overall, I’m still pretty pessimistic. So I plan to stay pretty conservative but I also have a large tax credit from a previous sale that I would love to “soak up” in 2011 with some gains. So I’m a little conflicted there. I’m also conflicted due to the fact that it’s hard to fight the government, and by that I mean QE2, QEs 3-10(!), etc. and next year being the third year of Obama’s first term. Third years are usually pretty darn good.

So my strategy is going to start simplifying things but keep a toe in the water. I recently sold some stuff as mentioned above and have the cash lying around, I think it’s time to lob most of that at my mortgage. I just can’t get excited about a single thing. Equities are look overvalued, Bonds are arguably a bubble, and gold is ridiculous. I’m currently looking into crystal meth futures, I will let you know how that pans out.

Here’s where we're leaving things:


Later kids.

The Plan

I've sold what I'm going to sell for the year and am 31% invested at this point. I bought a car, have a bond fund for the first time and am going to ride out the rest of the year as is. I could actually use a break from thinking about this for a while.

Here's where I stand:



So ... I was all set to make a big mortgage payment and starting thinking ... what if the market goes down 2,000 points and I can't buy any of it? (I'm a sucker for a bargain, you know.) So I've resolved to do the following:

I've got $30k that is just sitting around in cash; this was going to be my first big mortgage payment. Instead of paying now, I'm waiting until the end of the year. That will cost me $540 in tax-deductable mortgage interest. That seems small. If the Dow goes down to 9100, that's going back in the market instead of toward the mortgage. So I'm effectively paying $540 for a put that could be worth several thousand. That seems reasonable.

If the Dow goes down to 8,100 I'm selling the bonds and putting that back in the market. There's about $50k of that.

The real question is whether I want any of that to happen or not.