Thursday, September 15, 2011

The Perils of Trying to Time the Market

There has been a lot of bearish talk lately (or in the past few years) about how hopeless things are.  Someone posted a link to a very well done analysis by Comstock Partners.  The conclusion was that there is too much debt around the world, soveriegn debt is a big problem, consumers have too much debt, politicians are downright irresponsible if not stupid etc...

In other words, the stock market will go down.

It is often said that bearish arguments always sound better than bullish arguments and this is very true.  The bears typically put together a bunch of data, graphs and things of that sort that scares any sane person out of their wits.

But does that sort of analysis add much value in the investing world?  Of course, there are the very small world of macro traders who do make money with this sort of thing (George Soros being one of the well-known ones).  But most others won't be able to capitalize on this sort of thing.

Here is a probably not too atypical example of those who try. 

Take a look at  Comstock's long term performance.  If you can't see the chart, it basically shows that investors in their fund has lost tons of money (going from over $12/share in 1994 to less than $2/share today.  And the amazing thing is that Comstock has been bearish since the late 1980s and many of their predictions have come true.

Let's look at the world since 1994

In 1994, there was a mortgage and carry trade blowup (when Michael Steinhardt and other prominent hedge fund investors lost a ton of money on their leveraged European bond positions). 
In 1997 there was the Asian contagion/collapse. 
In 1998 there was the Russian default and Long Term Capital blowup that almost took down the global financial system.
In 2000 the internet stock bubble popped, leading to a bear market that took the market down 50%, and the NASDAQ index down 80%.  That is a bear market of historical proportions.
In 2001 there was 9/11, leading to two wars and higher oil prices, recession etc...
In 2008-2009 we had a huge financial crisis with some of the largest financial institutions blowing up, threatening another great depression.  The damage done was biblical.
Since 2000 to 2011, gold prices went from $250 per ounce to over $1800/ounce.

I am just typing this stuff off the top of my head so I am surely missing a whole bunch of other things.  (Oh yeah, Japan had a 20 year bear market taking the Nikkei down from over 39,000 to under 10,000 today).

So no matter how you look at it, it does look like Comstock was correct in many of their predictions.  Gold prices did go up a lot.  A lot of financial institutions did go bust.  The stock market did have a bear market (two big ones just in the past decade!).

And yet they were unable to make any money!

Another prominent bear that got a lot of face time on CNBC during the crisis is Peter Schiff.  He seemed to be on CNBC every day, screaming and yelling to viewers that we are on the road to ruin; that Bernanke and Geithner are devaluing the dollar so much that we will have hyper-inflation.  He told viewers to get out of U.S. dollar denominated assets.

His views weren't entirely out of line.  There was a lot of truth to what he was saying.  But was his opinion worth anything?  Well, when his prediction came true and the financial markets melted down, his fund lost 70%!  That's insane.  How can you be right and lose so much money?!

Buffett, on the other hand, calmly bought preferred shares (with warrants) in Goldman Sachs, General Electric, bought Burlington Northern, Lubrizol, more Wells Fargo stock and many others.  He was aware of the world's problems, but didn't let that distract him from the opportunities that the panic presented.  And Berkshire Hathaway has done very well through the crisis, thank you very much.

So what is the value in all that macro, doom and gloom analysis if they can't make money off of it?

Here is another guy that had a great idea
This fund, the Prudent Bear Fund had a great idea.  This guy thought stocks were overvalued back in the1990s so decided to put together a bearish fund that short stocks to capitalize on the inevitable decline in stock prices.

The presentations at the website are fantastic.  They are very well written and convincing.  But again, the value of that analysis is proven to be nil.  Here is a chart of their long term performance.

The idea, I think, was that they would stay short when the market had a dividend yield less than a certain amount, and then they would go long stocks when the dividend yield went above a certain amount.  I forget what levels they said, but it was based on the long term range of dividend yields.

As you can see, the results are horrible.

Again, Prudent Bear's analysis was correct in many cases.  Yes, the dollar has gone down.  Yes, the housing bubble popped and there was a financial crisis.  Large financial institutions failed.  The fed pumped the money machine and caused gold and commodity prices to go up.

But what good did predicting that correctly do for the fund?  Not much judging from this chart.

Then what should we care about?
My favorite investors are people like Warren Buffett, Seth Klarman, Joel Greenblatt, David Einhorn and many others.

Warren Buffett has a long history of strong performance and he often says to anyone who will listen that he will never NOT buy something just because he is worried about what the economy is going to do in the near future.  If he sees a good business at a good price, he will buy it.  If it's not a good price, he won't buy it.  If the business is no good, he won't buy.

This is what matters.  Is it a good business?  Is it priced attractively? If yes to both, then buy.  If not, don't buy.  He doesn't look at an opportunity and say, wow, it looks good, but since economists think that the U.S. will default, or that the GDP will go down next year, maybe I'll skip it.

But people lost tons of money in 2008/2009 by ignoring warnings!
Yes, many people lost money in that bear market.  I still think people lost money for two reasons.  One is that their analysis of individual companies was flawed.  People who owned AIG, LEH, BSC and others really didn't understand the flimsiness of those balance sheets.  People who owned solid companies are doing fine.  Prices went down during the panic, but when things quieted down, many prices came right back.  Many are even higher than they were before the crisis (like Apple).

And the second reason is that people panicked and sold out.  If you sold out of fear during the bear market, it is likely you lost a lot of money.   Stocks should only be sold if there is a permanent impairment in the business, not because we think the recession may go deeper than we thought or because we are afraid prices will go even lower.

If we do our analysis correctly, then solid businesses should be fine even in tough economic times.  Notice that J.P. Morgan didn't have a single money-losing quarter throughout the crisis despite it being one of the larest money center banks with hefty exposure in all the areas that got hit hard: mortgages, derivatives, investment banking, retail banking/credit cards etc...  (skeptics will say that JPM didn't market their books correctly, but I doubt that.  I have a lot of faith in Jamie Dimon.  That's another post for another day).

They basically had the same sort of business profile as Citigroup.  Compare the two stock prices.  This is a problem of stock selection, not macro economic forecasting.

If you held on tight to good, solid businesses, you would have been fine. 

Another error may be that some people owned a bit too much stock.  For this, I refer you back to my other post, Are stocks still good investments?    There is a link to an article Joel Greenblatt wrote for his website.  He is absolutely correct about how much stock to own.

How much stock should you own?
All this talk in the financial press about figuring out how much stock to own as a percentage of your net worth is utter nonsense.  I always thought so.  It all depends on many factors.  Greenblatt's view is a very good one.  You should own as much as you can, but only as much as you can stand to see go down by 40-50%, because stocks will go down 40-50% or more from time to time.

If that doesn't work for you, then maybe you shouldn't own any stocks (Buffett said that too; if it is going to disturb you to see a stock you buy go down 50%, then don't buy stocks!).

If you can't stand to see a paper loss of $5,000, then obviously, you shouldn't own even $10,000 of stock. 

On the other hand, if you are wealthy and have $10 million cash in the bank and another $1 billion in a stock portfolio, and you think the $10 million is more than enough to pay the bills, then having just about your entire net worth in stocks can make sense.

But then of course, you will have to stomach occasionaly $500 million marks against you.  If you can stomach that, then that's the way to go.

So how much stock you might want to own really shouldn't depend on what you think the market is going to do.  Or what the economy is going to do.  Or whether the U.S. will default or not.  Or whether inflation will be high or low.

The amount of stock you own should be a function of how much you can afford to own, how much you can tolerate to see in volatility, and of course the prices/opportunities you see in the market.

Unless you are a professional macro trader like a George Soros, it really makes no sense in trying to time the markets.  There really is no proof that most people can do this successfully consistently enough for it to be profitable.

There will always be guys in your local bar telling you how they sold all their stocks in August 1987, or August 2007 or some such, and some may even tell you that they bought back every penny of it in March 2009.

I bet you that for everyone who says they sold out at the tippy top in August 1987 never really got back in at a good price.  People in the financial industry are always looking for those geniuses that sold stocks in 1969, bought them back in 1974, sold them in 1977, then bought back in in 1982, then sold in mid 1987, then bought back in late 1987, then sold them in 1989 and then bought back during the mini-crash, and then sold in mid 1990 and then bought back in in October 1990, etc...

But these people don't exist.  Many try to be that person.  But for the most part, that is not how wealth is made, and in fact studies show that this is primarily how most retail investors actually LOSE money... (again, I do know that there are  some pretty big funds out there doing primarily macro trading/investing).

1 comment:

  1. Perfect post. Especially the part on stock allocation. Thx