Tsunami etc.

Yes, it's a tsunami. Tsunami of liquidity. A fiscal tsunami. Both at the same time. People seem baffled at the strength of the stock market; they keep saying the market is 'divorced from economic reality' and things like that. Others say this is a big bubble waiting to implode. 

I don't mean to argue that the market is always right or anything like that, but the market is reacting to some massive, massive stimulus and liquidity injection. Some of that is bound to leak into the stock market. As I said earlier about  Covid-19, this is forcing governments around the world to try to offset the negative effects of the virus. And as usual, they are going to overdo it. And this, in turn, will lead potentially to a really massive bubble. 

As of now, with S&P 500 forward P/E of 23, or whatever they say, it doesn't really seem all that bubblish. Too, the median P/E ratio of S&P 500 companies on a forward basis is around 18.5x vs. a 15.2x average since 1982, I think. So that is not that crazy looking either, given much lower interest rates now than most of this time period. 

 

People say the S&P 500 forward P/E is as high as it was back in 1999/2000, but don't forget, interest rates were a lot higher back then. Also, the median P/E is much lower than that, which is again, just like 1999/2000. And if you remember 1999/2000, if you didn't own the bubble stocks, you actually did really well throughout the 2000-2002 bear market. It is very possible that this will happen again. Many of the frothy names can have large declines, maybe the S&P 500 index even goes down 50% or more, and people who didn't own the most expensive stocks might actually still do well. So, don't let people scare you out of the market with this talk of market P/E's. If you are happy with what you own and how they are valued, hold on and things should be fine (like it was in 1999/2000). 

This rickety house can symbolize a highly levered equity fund vulnerable to a bear market, but when I saw this picture, the first thing I thought of was all the shorts being steam-rolled by this tsunami (or simultaneous tsunamis). 

Greenblatt and Marks

Anyway, I wouldn't necessarily put this in a category of good news; some would say this is really bad news. But a recent Howard Marks note talked about all the reasons why current market valuations might be reasonable; that the current tech companies leading the market actually has really good, strong business models. Also, Joel Greenblatt was on Bloomberg TV the other day saying we are not in a bubble like 1999/2000 for the same reason; that the recent market leaders have real business models and are really good businesses that might actually deserve high valuations.

 

While not pointing to any individual names, I have been thinking the same thing over the years.

Buffett, Gold and JPM

So, as usual, the financial media is going crazy over the fact that Buffett bought ABX. Most of them didn't even mention that this could be a Ted or Todd pick and not a Buffett pick. Also, he dumped a bunch of JPM, which is actually kind of surprising. Not sure what is going on there. Maybe it's a valuation play as BAC is cheaper. I think Dimon is a much better CEO than Moynihan (who hasn't really been tested yet, whereas Dimon has been through many crises). Maybe BAC has a longer runway as Dimon has health issues. I don't know. Maybe he is a lot more worried about this pandemic than most of us. 

 

Market

Anyway, back to the market. So yes, it's kind of acting contrary to the expectations of many, but not really. If you look at the market leaders, they are really doing well earnings-wise. Sure, this may be a one-time bump for some of these names, but for the most part, Covid-19 is only accelerating what was going to happen anyway (move to cloud, retailers dying off etc...). So there is nothing wrong with being in companies who have been enjoying a tailwind for years and then suddenly gets a big gust from behind. 

As for consumption, as Dimon said, some unemployed, I think he said 60%+, were making even more money from the $600/week assistance than they were making when employed. So that explains the consumption figures. Of course, this is not sustainable forever (new plan hasn't been passed yet as of now). 

I have been spending more time recently looking at things to do due to the extraordinary nature of the what is happening, but I have to say nothing is really jumping out at me. 

I am tempted, of course, to jump into airlines, hotels, real estate, energy, anything travel-related and some other areas hit hard, but nothing is really jumping out at me. If you like any of these businesses and believe in them for the long term and are fairly sure they will survive this crisis without too much dilution, then it's a great idea to buy. 

But the problem is that most of the above businesses are not in areas I would have been interested in pre-crisis. So if I got into any of them now, they would just be 'trades'. I would get in, hold until normalization, and then get out. They would not be situations where I would want to buy and hold forever. So that makes me a little hesitant. 

 

 

Election Stuff

There is a lot of uncertainty about the elections. But as usual, I would say, look back at all the other times we were worried about something. We should never forget 2016 election day. What about the fiscal cliff? All sorts of problems, uncertainties over the years. 

 

So, as usual, I would just say ignore it all. I don't want to talk about politics here as there is plenty of other places to talk about it, and I don't think I have anything to add to what everybody is saying anyway. 

 

But I would say that whatever people worry about, I wouldn't worry too much about it. Whether it's pharmaceutical stocks when Clinton got elected, insurance companies with Obama, financial stocks when Elizabeth Warren was looking good etc. Whenever you have big moves on those worries, as traders, it's actually probably a good idea to trade against it. 

 

Books

I am reading this new book about GE, Lights Out, and it is terrifying. I'm only 1/3 way through it but it sort of confirms what we suspected all along, but at least for me, it's a lot worse than I thought.  

If you always wondered why Buffett always spoke so highly of Immelt and GE but never bought stock (other than emergency financial crisis financing), this would help explain it. I've always wanted to love GE, and it was always on my to-do list to do a detailed analysis of GE and even buy some shares at some point, but it never got to that point because of Immelt. He came across to me as this rah-rah cheerleading type; the kind of manager I would not want to put money with. And his denials and lies throughout the crisis was worrisome too (I didn't realize how much he was lying, though...)

And Immelt apparently still blames Welch, but jeez, the guy ran the place (into the ground) over 16 years; that's enough time to fix things, and many of the big moves / mistakes were his own. It's like a 40 year old man blaming his parents for his behavior.

I am still looking at it and wanting to jump in, but it is quite scary.

Long Book Excerpt

So, during this pandemic, I have been reading a lot as usual, and I started reading an old book that I am embarrassed to say I've never read before. 

Paths to Wealth Through Common Stocks

This is a Philip Fisher book. I think Philip Fisher is sort of underrated compared to Benjamin Graham. Everyone (including me) always talks about Security Analysis and Intelligent Investor, but not everyone talks about Common Stocks and Uncommon Profits or this book. 

That's probably for a good reason. First of all, Graham was the first in setting the ground rules of value investing so comprehensively. But on the other hand, I feel that Fisher has had more of an impact on Buffett (and he admits it) than even many Buffett followers realize. Buffett is still referred to as a 'value' investor, and 'value' is still viewed as things with low P/E ratios and P/B ratios. But Buffett has for decades been saying that he would much rather pay a fair price for a decent business than a good price for a mediocre business (OK, I totally butchered that one, but I'm a little rusty, you see...). 

Anyway, I was reading it and this whole section made me jump out of my seat as I immediately thought of quite a few people I would need to send this book to:

The Economists Go out -- The Psychologists Come In

    I have already commented on the strange tendency of the supposedly forward-looking financial community so often to fail to recognize a changed set of circumstances until the new influence has been in existence for years. I believe this is why the man who attempted to forecast the course of general business was regarded as so important a factor in the making of investment decisions during all of the 1940's and much of the 1950's. Even today, a surprising number of both investors and professional investment men still believe that the heart of a wise investment policy is to obtain the best business forecast you can. If the outlook is one of expanding business, then buy. If the outlook is for a decline, sell.

    Many years ago there was probably considerably more merit to such a policy than there could possibly be today. The banking structure was weaker. There was no assurance it would be shored up by the government in times of real trouble -- a process bound to produce a massive dose of inflation. There was no tax system of a type that can hardly fail to produce strong inflationary spending whenever business (and therefore federal tax revenues) are at abnormally low levels. No public opinion had crystallized to assure that whenever business levels dipped sharply, the government would take strong countermeasures to stem the tide. Finally, the industrial base was much more narrow. The large number of industries in today's complex economy that bear little relationship to each other in their basic characteristics probably assures that even without the actions of government, modern business recession would be somewhat less severe than its former counterpart. Some industries would be enjoying unusual background conditions enabling them to expand, while the majority might be in a declining phase. This tends somewhat to stabilize the economy as a whole.

    All this means that a depression is of less significance to the investor than it was many years ago. It does not mean knowing what business is going to do would not be quite useful information to have. But having such information is not vital for obtaining magnificent results from common stock investments. Simple arithmetic should show this. When a stock market decline coincides with a fairly sizable economic slump as happened in 1937 to 1938 or 1957 to 1958, most stocks sell off from 35 to 50 percent. The better ones then recover when the slump ends and usually go on to new high levels. Even in the greatest slump of all time, only a small percentage of all companies failed, that is, went down 100 per cent. Most of these companies were companies which had had fantastic amounts of debt and senior securities placed ahead of their common. After one of the wildest speculative booms ever known, much of it financed by borrowed money, the average stock slumped 80 or 90 per cent. In contrast, when stocks rise over a period of years, even the most casual study of stock market history shows many figures of a very much greater order of magnitude. Compared to the temporary declines, usually of 35 to 50 per cent, that frequently accompany depressions, the outstanding stocks (those of the unusually well-run companies that have maneuvered themselves into growth fields) go up several hundred per cent, stay at these levels, and then go still higher. Many can be found for which a decade's progress can be measured in multiples of 1000 per cent rather than 100 per cent. 

...

    From the standpoint of obtaining results, I have noticed that investors who place heavy emphasis on economic forecasts in the making of investment decisions usually fall into one of two main groups. Those who are inclined to be cautious by nature can nearly always find an impressive sounding forecast that for quite plausible and persuasive reasons makes it appear that important economic difficulties lie ahead for the business community. Therefore, they seldom take advantage of opportunities when they present themselves and, on balance, these missed opportunities mean the economic forecasts have done them considerable harm. The other group are the perpetual optimists who can always find a favorable forecast to satisfy them. Since they always decide to go ahead with whatever action they are considering, it is hard to see how all the time they spend on business forecasting does much good. 

    More and more investors are coming to recognize the wisdom of making their decisions about common stocks largely on the basis of such outright business factors as appraisal of the quality of the management and the growth potential of the individual company's product line. These things both can be measured with a fair degree of preciseness and have a far greater influence on how good a long-range investment will be... 

This book was published in 1960, and it is amazing as it still applies to this day; there are still people who think that predicting the economy accurately will lead to superior investment results. 

So...
Anyway, this is a fascinating time to be living in. This pandemic is really terrible and I hope we at least find some sort of treatment to take death off the table. I feel this is the key to normalization rather than vaccines. Of course, a vaccine would be great, but it is probably unrealistic to expect one to come within a year. If we can figure out how to treat the worst cases, and this treatment becomes widely available, this would sort of turn Covid-19 into something like the flu.

But who knows, really. 

As for stocks, there is certainly a lot of trading opportunities, but for us long term investors, I would stick to things that have secular growth potential. I don't really feel that excited about buying the dip on something in a long term downtrend. Not to say those can't be great trades. I would rather buy the dip on things in long term uptrends. If things are in secular downtrends but got a bump up due to this, then that's probably a great time to sell.

As for the market, it may seem like it's crazy, but keep in mind the amount of stimulus and liquidity injected into the system. It's not just lower interest rates. Also, people keep talking about overoptimism about the virus, but if you look at hotels, airlines etc., the market is clearly not all that optimistic about anything returning to normal any time soon.

Also, keep in mind that a lot of the big winners this year are making a lot of money; revenues are growing at incredible rates, profits etc. Other than the cloud players, look at COST, WMT, TGT etc. What is happening is that the smaller operators are suffering. Fast food is taking share away from the independent restaurants. As those are closed, if you want to eat out, you have fewer choices so you end up at CMG or QSR (Popeye's). A lot of the eating out money is moving to eating at home (groceries, again, COST, WMT, TGT etc...). 

 

If airline and hotel stocks were making new highs, then I would think the market is nuts. But that's not what's happening. You have to sort of look under the hood to see what's going on, but of course, that's too much work for most! I get it. 

Also, a lot of the revenues / profits that were not listed (small, mom-and-pop restaurants / stores) are moving to listed companies; as independents go under, the only ones left standing are the big ones, and often those are listed companies.

So there is a lot about this market that does make sense. This is not to say the market is always right, or that the valuations of each of these businesses at this point is correct. I am just pointing out that it may not be as crazy as some suggest. Airlines and hotels, REITS are down, and they are down big. Cloud players, stay-at-home beneficiaries are up big. What is so crazy about that? I don't know. 

Also, I think there has been a lot of tech adoption from the never-adopters. I see all these posts about kids teaching their grandparents how to use a tablet, how to get on a Zoom call with family, how to chat on FB, Line, or how to use email. People (many of them seniors) who only used land-line phones and didn't know how to turn on their TV (well, I have trouble with that too with so many remotes and buttons...) are chatting with their kids / grandkids on Skype on their tablets. They are learning how to order things online. 

A lot of this will be permanent. When things clear, many of these newbies will keep using their new devices and will continue to shop in their new ways. Not all of them, of course, and maybe not as often as right now. But this has caused an increase in this market for sure.

 

As for all the talk about how things will never go back to the way it was, that people will never go to conventions ever again, and that client visits will never happen again as Zoom calls work just as well, and offices will decline as people get used to working from home, I think, is rubbish. People always extrapolate what they see. Sure, it may take some time to get back to normal, but things will get back to normal, eventually. 

 

Surely there will be some permanent changes for the better, utilizing things we have learned during this time, and that's great. But I wouldn't expect a lot of this stuff to be permanent by any means. 

 

China Crash -> U.S. Crash?! and Great Book

A lot of people are talking about how bad China is.  It's worse than the U.S. 2007, it's worse than Greece, it's worse than this or that.  It seems like the big China bubble is blowing up.  But so what, right?  Who cares what happens over there.  Yes, the prices got crazy, but as long as you don't own that stuff, it really shouldn't matter.

Or should it?  China owns a lot of U.S. treasuries, and if things get really bad over there, it can cause problems around the world.  Well, we've been seeing the impact of China on the commodities markets over the past few years.  That's certainly a big deal.

So I've been thinking about that, and this is a movie I've seen before.  The same exact thing seems to be happening as when the Japanese market topped out in December 1989.  Now, that was a bubble.  I'm not saying China isn't or wasn't a bubble.  It sure seems like some stocks got pretty expensive over there.  But it is a little confusing because the Hong Kong listed H-shares are trading at below 9x P/E or something like that.

But anyway, yeah, Japan was quite a bubble.  That one goes into the history books along with 1929, 1999, South Sea Bubble etc...   And the Chinese one may too.

Back then, people were worried about Japan taking over the world.  They were buying up trophy properties in the U.S.  By the way, did any of those investments work out?   And do the Japanese still own those properties?  Did they actually make money on them?  Or was it just a big transfer of wealth (from the Japanese buyers to the American sellers)?

When the bubble popped, there was a tremendous amount of fear.  The Japanese were buying U.S. treasuries in such huge amounts that the fear was that U.S. interest rates will spike once Japanese buying evaporates.

As you see, this is sort of very similar to the situation currently with China.  Whenever people say that if Japan (and now China) stops buying U.S. paper, we are in big trouble, I scratch my head because they will only stop buying U.S. paper when we stop shipping all our money over there (we import stuff from them, they take the dollars, come back and buy treasuries).  I always thought that the day they stop buying our treasuries will be when they don't have the dollars flowing in.  And in that case, the dollars will come from somewhere else.  In the 80's, Japan funded the U.S. deficits.  In the 00's and 10's, China did.   Maybe we will start funding them internally (excess bank liquidity etc.).   Who knows.

Anyway, I remember how resilient the U.S. (and the rest of the world) was to the Japanese bubble collapse.  Check this out.  Here is the chart of the Nikkei 225 index (blue) and the S&P 500 (red) index, both indexed to 0% at the end of 1989.

Nikkei Index versus S&P 500 Index 

(December 1989 - October 1995: change in index, excl dividends)

The Nikkei started to collapse immediately in 1990, but the U.S. market was fine.  For the record, the S&P 500 index was trading at 15.2x P/E (ttm) and the 10-year treasury rate was 7.8% at the end of 1989.  That's an earnings yield of 6.6% versus the 7.8% interest rate.

As you can see, the S&P 500 was fine despite the total collapse in the Nikkei.  The little bear market in the second half of 1990, as you recall, was when oil prices hit $40/barrel due to Sadam Hussein's invasion of Kuwait.  We all remember that, and the Baker press conference which began with "Regrettably..." or some such thing that began the war; the comment, "the skies of Baghdad have been illuminated" etc. (those events came way after the low).

This is the event, by the way, that lead to every trading room on Wall Street being equipped with televisions. During this first Iraq war, traders called their wives, told them to turn on CNN, put the phone by the TV and just leave it there.  Traders then took that 'feed' and piped it into the squawk box for all to hear (this was before you could watch TV on your computer.  Don't forget, this was the era of glowing, green screen Quotrons).

Anyway, other than that, the U.S. stock market did fine as Japan disintegrated.

We usually look at long term returns going backwards, like the five, ten, twenty year figures going backwards.

Let's look at this going forwards from December 1989 for the S&P 500 index (total return):

From December 1989:
5 years   (to 1994-end):   +8.7%/year
10 years (to 1999-end):   +18.2%/year
20 years (to 2009-end):   +8.2%/year
25 years (to 2014-end):   +9.6%/year

And just for fun, if you looked at the period from December 1989 through December 2008, which was the year-end low point of the financial crisis, the 19-year annualized return would have been +7.3%/year.

The ten year return from 1989 might be meaningless as that was the great bubble.  But if you look at the 19, 20 and 25 year returns, the U.S. stock market did fine despite the Japan crash.

I really don't know what will happen going forward, but I thought I'd take a look at this as it seems really analogous to what's going on now in China.  Of course there are a lot of things different than 1989, but it's one thing to think about when thinking about China.

Of course, this is not to say the we won't have a correction or a bear market.  I'm just looking at things, sometimes one at a time, like when I looked at interest rates versus the stock market.  There are many other factors that will impact the stock market.  And this is not to say that there won't be impact in certain places.  I think luxury goods makers took a hit when Japan collapsed.  There will be certain areas that will get hit if China falls apart (more than just the stock market).

But judging from this, it need not take down the whole world.


Great Book

And by the way, I recently finished this book by Lawrence Cunningham and really enjoyed it.  The only thought was that I wished it was a longer book.   This is the first time I read stuff that dug deeply into the histories of the operating companies.  Some of the stuff, we've read over the years from other sources, but there is a lot here that is new to me.

For those planning on holding Berkshire Hathaway post-Buffett, this book is a must read.

Check it out!

In Search of a Stock Market Bubble

So, (the sentence starts with "so" because this is a sort of ongoing discussion that's been going on here for years) I've been thinking about the overall market again.  Despite my telling people to ignore this and ignore that, I can't help it; sometimes I think about this stuff.  Well, it's OK to think about it as long as it doesn't lead to irrational decisions.

Anyway, as usual, there is a lot of talk of the market being insanely overvalued, median P/E's at post war records and all the usual.

I look at the charts and some are scary, but I still don't get the sense of a bubble.  I've seen the Japan bubble in 1989, the 2000 internet bubble and some others.  I see the Chinese bubble going on right now.  But I still don't really get the sense that the U.S. stock market is in a bubble.  Yes, there is a pocket of bubbliness, like in some parts of the tech sector (social networks, biotech etc.), but overall I just really don't see it.

Like Black Monday?
Also, there were comments to the effect that 2015 feels just like 1987 before Black Monday because interest rates spiked up right before the stock market crash.  Well, back then the stock market was at 20x P/E and bond yields spiked up to 10%.  So that was a Fed model yield gap of a whopping 5% (earnings yield of 5% versus bond yield of 10%).

Today, we are talking about interest rates spiking up to 2.5% with the P/E ratio under 20.  So in that sense, there is no stretched rubber band ready to snap based on interest rates.  And I showed in recent posts that the market is fine with interest rates spiking up to 6% (of course there will volatility based on that, though).

Nifty Fifty 1972
I made a post just like this one two or threes years ago when people were saying the market is overvalued.  I looked up the P/E ratios of the Nifty Fifty stocks in 1972 to see what a real bubble looks like.

Here is what you were dealing with if you were investing in blue chip stocks back in 1972:

What is really interesting to me here is that the S&P 500 index P/E ratio at the time was 19.2x.  But look at the nifty fifty P/E ratios.  To me, this is what a bubble looks like.  These 'ordinary' companies were trading at higher P/E's than high growth social network stocks or fast casual restaurant chain today!

So, while everyone focuses on the big scary charts of market P/E ratios and whatnot, let's just look under the hood and see what's actually going on.

To be totally neutral, I just picked the Dow 30 stocks.  They are large caps, representative of major U.S. companies.  Despite the horrible structure of the index (price-weighted), it does correlate pretty closely with the S&P 500 index.  I plan on looking at the S&P 500 index in the same way in the near future.

Dow Jones Industrial Average Component Valuations

I just scraped this data off of Yahoo Finance.   I ranked it from cheapest up based on forward P/Es.

It's sometimes a good idea, when trying to figure something out, to invert.  To get comfortable being long something, let's see what it would feel like to be short it instead (just because it's not a good short doesn't automatically make it a good long, though).

People say that the market is tremendously overvalued.  Is the market so overvalued that I would be comfortable with a massive short position?  I just imagine myself with a big short position to see how I would feel.  What do I need to make money?  What can go wrong?  Is there really a big margin of safety in terms of valuation; are things so overvalued that it's a no brainer to be short?  At this point, I would not be comfortable short at all.  Sure, earnings for everyone might be bloated due to QE-infinity and budget deficits.  There are other reasons to be bearish, but I just don't see it from a valuation point of view.  The market is certainly not cheap.  But it's not so expensive that it's a no-brainer short either.

It's true that many of the Nifty Fifty were the growth stocks of the day.  So shorting those back then may not have been any easier than shorting Facebook or Amazon today.  In that sense, this is not really apples to apples.  I'm comparing the Nifty Fifty of 1972 to the Dow 30 stocks now; not fair.

Here, by the way, is the list of Dow 30 stocks as of 1976 from the Dow Jones website (they didn't have 1972, but I assume it hasn't changed much):

But anyway, if you look slowly through the current Dow stocks, which ones are really overvalued?  I mean overvalued in a bubblistic sense?  I don't want to comment on each one, but most look pretty reasonable to me.  Most of the high P/E stocks (NKE, DIS, V, KO etc.) seem to be stocks that always had high P/Es, so don't feel like bloated P/Es based on a bubble.  Many others are just totally reasonable and some are really cheap (AXP, for example.  It has a close to 30% ROE, 12-15% long term EPS growth target, and it's trading at less than 14x P/E and less than 10x pretax earnings per share!).

Let's say you think the market should go down 50%.  I remember reading a comment by a hedge fund manager who said that he likes to buy stocks where if you doubled the price it would still be cheap and short stocks that if you cut the price in half, it would still be expensive.  That's quite a margin of safety built in!

If you look at the Dow stocks above, do I really think that the fair value of each of those is half the current P/E ratio?  I would say no to most of them.  OK, margins are bloated.  But just finger through the list slowly from the top to bottom.  Which ones are over-earning with bloated, bubbled up margins?  Honestly, I don't know.  Nothing jumps out at me as a candidate.  Readers here know that I am not a big long term fan of Apple as an investment, so I would argue that AAPL would be an example of possibly bloated, long-term unsustainable margins (and I know, I know, a lot of people don't agree with me on that and that's OK!).

But otherwise, it seems like a lot of them are actually under-earning.

Berkshire Stocks
As another 'sample', let's just look at BRK's portfolio, which in aggregate is down on the year so far.

Berkshire Hathaway Large Stockholdings Valuations

Here too, I come to a similar conclusion as the above (well, there are overlaps).  Nothing jumps out at me as needing a 'crash' or big bear market to correct.  I don't really see a stretched rubber band here either.  Most seem to be under-earning and I don't really see any unsustainably high margins.

Buffett Dogs Strategy?
So, looking at this, it's interesting to see that there are three stocks down a lot this year.  WMT, PG, and AXP are down -16%, -14% and -15% year-to-date respectively.  And as I said above, AXP has incredible margins and ROE and is trading under 14x P/E.  I know there are worries about competition; alternative payment systems (Munger said there is more competition now than before, but it's still a great business).  And the loss of Costco is certainly weighing on the stock.  This will cause earnings to be flat, but AXP expects EPS to start growing 12-15% again in 2017.

Conclusion
I've been saying this sort of thing since 2011 when I first started this blog; that the market is fine.  But sooner or later the bull market will end.  The market will tank and people will go back and read these posts and have a good laugh.  I know that will happen for sure.  But that's OK.

I'm not trying to predict anything, nor am I saying that we won't have another bear market again.  The market will go down for sure, 50% or more.  There is no doubt about that at all.  But I don't know when that will happen.

I am just looking at a bunch of facts to see what's actually going on.  Sometimes, it's hard to see what is happening just looking at big, macro charts; they can be misleading, like flying over a disaster zone in an airplane.  Sometimes you have to get on the ground and walk around to see for yourself.

Market Valuation (Scatter Plot)

So, Buffett's response (at the 2015 annual meeting) to questions regarding the valuation of the stock market was interesting.  He used to just say it's in a "zone of reasonableness", but this time said that if interest rates stay at current low levels, the stock market is cheap, and if interest rates normalize, it is expensive. Well, he has been saying for a while that stocks are better than bonds.

We know there is a relationship between interest rates and stock market valuation.  Some criticized the old Fed model (10-year bond yields compared to the earnings yield of the S&P 500 index) saying that there was a correlation between the two for only a short period in history but there hasn't been a correlation between them for most of history.  This is true, but it is also true that there is a logical connection between them so we can't deny a relationship just because we can't get some charts to look convincing.

Anyway, just for fun, I decided to play around with some figures.  My goal was actually just to see what the stock market should be valued at if interest rates normalize.  I did that before, but this time I wanted to do it empirically.

One thing I don't advocate or call for is for the stock market to catch up to the bond market.  If it did, then the P/E ratio of the market would get to 50x, and that's too expensive.  At that level, even I would pound the table to get out of the market.

So first of all, we've already seen the many charts comparing bond yields to earnings yields and how they have tracked each other closely (and diverged)  in recent years.  So I decided to look at it a different way; by X-Y plotting it.  This is nothing new; strategists do this sort of thing all the time (as I used to too back in the old days).

This is the data from 1871 through the end of 2014.  The earnings yield is on the Y-axis and the 10-year bond rate is on the X-axis. (all data is based on the S&P 500 index (and predecessors for older data), ttm earnings from Shiller's website).

Earnings Yield Vs Bond Yield 1871 - 2014

        (x=bond yield, y = earnings yield)

Wow.  Looks like a raptor claw.  So the Fed model critics are right.  The R² is basically zero. But we knew that.

The two vertical clusters are from the era when interest rates were low.  The cluster to the left is when rates were around 2% and the stock market got cheap in the late 1940's and early 50's.  The second vertical cluster (or claw) was when the market swung around in 1915-1920.    Excluding those two periods, there seems to be sort of a linear relationship.

So let's see what happened since 1955:

Earnings Yield Vs Bond Yield 1955 - 2014

        (x=bond yield, y = earnings yield)

Now we see a little bit more of a clear slope, verified by the higher R² of around 0.4.

Not that different, but here it is from 1970:

Earnings Yield Vs Bond Yield 1970 - 2014

        (x=bond yield, y = earnings yield)

We can see that the stock market didn't continue down the slope as rates declined.  The dots all the way at the bottom when interest rates were between 2% to 4% and earnings yield dipped below 2% was just from the financial crisis; the E declined dramatically.

Eye-balling this chart, even if rates got back up to 6%, the stock market valuation would still be reasonable; no need for a valuation adjustment.

Just for fun, I took out the data after 2007.  Let's look at this from 1980-2007:

Earnings Yield Vs Bond Yield 1980 - 2007

        (x=bond yield, y = earnings yield)

Obviously, the  R² increases and the slope gets closer to 1 (0.8367).

So we see that stock prices are cheap at current interest rates, but the thought is that they may become expensive if interest rates "normalize".

But what does it mean for interest rates to normalize?  From the above charts, it looks like the stock market can be in the fair value range even with rates going back up to 6% or more.

What is "Normal"?
People have been calling for higher rates for years now, so I won't quote anyone's guess on where they think rates will go.  Here's a chart I used in a post a while back about valuing the stock market using interest rates.  Since noone can predict interest rates, as a proxy, I used the nominal GDP growth rate as a level where long term interest rates should eventually settle.

Here's the chart that only goes to 2012, but since it's a long data series, it doesn't matter too much:



Of course, the problem with this is that yes, nobody can predict interest rates but to use this model we need to predict GDP growth and inflation.  Economist track records there aren't much better.

But we can at least see where rates would be without the "distortion" of central banks given reasonable assumptions.

For example, I have no problem with "normal" long term real GDP growth of 2.0%, and inflation in the 2.0%-3.0% range.  That gives us a range for nominal GDP growth of 4-5%.  So interest rates too, should be around there.  I have no problem thinking of 4-5% as the level of long term interest rates in a normalized environment with no central bank manipulation of long term rates (well, there will always be some sort of activity going on, but I just mean the massive QE-type thing).

Let's go back to the above X-Y plot charts.   I am going to go back to the chart from 1955 to include more data.  Data before 1955 may not be too meaningful, plus 59 years is enough data for this.

I drew vertical lines between 4% and 6%.  My question is, what is the average earnings yield (and standard deviation) of the stock market when interest rates were in this range?  Keep in mind that this interest range is far higher than where interest rates are now.

Earnings Yield Vs Bond Yield 1955 - 2014

        (x=bond yield, y = earnings yield)

When interest rates were between 4% and 6% since 1955, the stock market traded at an average P/E of 20.4x.  If you put standard deviation bands around the cluster, the range would be 16.6x - 26.6x for one standard deviation and 14x - 37.9x for two standard deviations.

If you expand the range to 4-7% or 4-8%, then the average P/E comes down to 14x, so in that case the market would look overvalued.  But I think a lot of the vertical dot cluster in the 7-8% range is from the 1970's.  Of course, we can't assume that won't happen again.

Just for fun, let's see these figures from 1980-2014.  Some will argue that this is no good since the market has been overvalued for most of the past three decades.  But again, let's just see for fun:

             Interest rate range            average P/E
                   4 - 6%                            23.3x
                   4 - 7%                            22.7x
                   4 - 8%                            21.6x

If you do it by constant range (instead of expanding it) you get:

               Interest rate range           average P/E
                   4 - 6%                             23.3x
                   6 - 8%                             19.6x

Using data since 1980, even if rates went up to the range of 6-8%, the market would be fairly valued at 19.6x P/E.

I actually don't agree with this; I would still value the market at closer to the inverse of the bond yield; a 6-8% interest rate range would suggest P/E ratios of 13-17x.

Shorting an Overvalued Market?
So people keep saying the market is overvalued.  If you are short the market because you think it's overvalued, then you would have to think hard about it.  The above suggests that the market is not overvalued even with interest rates going up to 6%  (well, I would view it as a little overvalued with rates at 6%).  If you think the market is overvalued, then you have to think that bond yields have to go higher than 6%.  But then if that is the case, it's probably a better trade to just short the bond market.

When you say the market is overvalued, you are basically saying that interest rates are too low.  In that case, the bond market is even more overvalued than the stock market; the stock market has a big valuation cushion before rising rates start to hurt it whereas bond prices will get hit immediately.   In fact, if you believe in mean regression, then you would have to actually buy stocks and short bonds against it.

Of course, there are other reasons to be short the market, but I am just isolating this one component, valuation.

If you look at long term charts of market valuation, it looks really high and scary, but the above shows that in this environment, things are pretty normal.

If you do assume that a 1970's event is coming soon (and this view is not so uncommon), then shorting stocks and bonds might be a great idea.  But even then, you have to keep in mind that if you do short expecting a 1970's-type event, you are betting on an event that occurs very infrequently. How many interest rates spikes and inflationary events have we had in the past 100 years?

As Buffett likes to say, it's not smart to bet on low probability events.   (It's just as dumb to assume that low probability events are zero probability events!)


Conclusion
I don't know why, but I suddenly just wanted to do this.   I guess Buffett's comment made me think about market valuation again and made me wonder what "normal" interest rates are and where the market should trade in that case. Sometimes it's fun to plot some data to see what things look like.

I am more comfortable comparing bond yields and earnings yields directly as Buffett does in his discussion about market valuation (which I excerpted in length here:  Buffett on Market Valuation) without going through all of this.

From this, though, we can conclude that even if long term interest rates pop up into the 4-6% range, the stock market is still in the fair value range; the market is trading now at just about exactly the average level the market has traded at when interest rates were between 4% and 6% since 1955.

Yes, moving that range up to 7% or 8% moves the average down to a 14x P/E, but most of that vertical cluster is from the 1970's (note the lack of that cluster since 1980).  The same figures for data since 1980 shows much higher valuation levels (but maybe biased on the high side).

If we are constrained in growth as economies around the world mature, then normal interest rates may not go too far above the 4-6% range. If that's the case, the stock market looks fine.

Market Timers vs. Macro Hedge Funds

OK, so this is another post that follows a discussion in the comments section (of previous posts).  I think it's pretty important so I thought I'd expand on a comment I made and turn it into a post.

Halo Effect
No, not the book.  But the same idea.  I think some of these top-down, market-timing mutual funds in the past have benefited from a sort of halo effect.  For example, people read about how Soros made billions betting against the Bank of England.  They read about how some hedge fund wizard made a killing shorting Japanese stocks.  They read about a trader that had a massive position in index puts on the day of the crash.  They read about how someone piled into subprime default swaps and made a killing during the crisis.

So they see all these people making tons of money while other, "normal" mom and pops lose their shirts in a nasty bear market.

And then they see these funds that promise to watch out for these macro factors and structure the portfolio accordingly, promising them that they won't get crushed in the next bear market (never mind that there is a cost to that; a cost/risk that is not at first evident).

Most individual investors don't have access to hedge funds, so these market-timing funds sort of fill that need to have an 'alternative' to the usual equity funds.

The more volatile the markets, the higher returns that the big hedge funds show, the better relative performance these market-timing funds put up in the short term, the more popular these funds get.

Market Timing Funds Have to Be Right All the Time
But there is a big difference between the big hedge funds and the market timing mutual funds.  The market timing mutual funds, for the most part, have to be right just about all the time for them to do well.  If they miss one bear market, their performance is in the tank.  If they miss one rally, that can also destroy their performance.  Once you do that, it gets exponentially harder to try to make it back.

For example, you can take some of the great traders from the past.  Say, George Soros or Stanley Druckenmiller.  I can't prove this or know for sure, but I am pretty certain that if they had a mandate to hold an equity portfolio and then hedge it according to their market views over the past 30 years or so, they would not have gotten anywhere near keeping pace with the S&P 500 index.  No way.  Druckenmiller himself has said that he has predicted 15 of the last 3 bear markets (or something like that; I don't remember the numbers but you get the point!).

Difference Between Market Timing Funds and Macro Hedge Funds
Contrary to popular belief, most of the high returns generated by macro hedge funds are not from timing the stock market.   Yes, some have made tons of money shorting stocks on Black Monday (Soros was actually on the wrong side of that, famously having sold the low tick on Tuesday), shorting the Nikkei crash in 1990-1992 etc.

But most of the money, I would guess, in macro hedge funds were made in fixed income and currencies.  Back in the 1980's and 1990's, there were a lot of strong and persistent trends, macro imbalances with sudden corrections and other things that allowed hedge funds to make tons of money.  And these funds put these trades on with massive leverage; leverage that can't be replicated in the usual equity mutual fund format.

So they can be wrong about the stock market for years and still make tons of money (also, if they are bearish and short, they don't stay short for very long when the market goes against them).

However, market timing funds don't have alternative sources of income.  They live and die, basically, by being right about the U.S. stock market.  And they have to be right year in and year out.  It's just impossible to do that.  Not even Soros can do that.

A lot of macro hedge funds take massive bets, but they do so in many markets around the world.  If they have no opinion about the U.S. stock market, they can still go long something else somewhere in the world.  Like Buffett looks for the easy questions to answer, macro hedge fund traders do the same thing; they look for the easier questions to answer.  They don't have to know where the stock market will go.

One of the big macro funds today has a bunch of non-correlated trades on.  So they can be wrong about the stock market or interest rates, or even both and still make money because they have different trades on with uncorrelated factors.

If you are a market timing fund, you have to be right about the stock market.  If you are right, that's great.  If you are wrong, that's it.  It's hard to make it back.

This is not to say, of course, that all macro hedge funds are good.  It is very hard to make money in global macro hedge funds and there are plenty of failures there too.

I am only trying to illustrate the difference between market timing mutual funds and the global macro hedge funds.  Some market timing mutual funds talk about going into various asset classes and flexibility to go anywhere, but it seems like they are still mostly driven by being right or wrong about U.S. stocks.

Analogy
OK, so here goes one of my analogies that might just confuse the issue.  But anyway, it goes back to Rumsfeld's known knowns, known unknowns and unknown unknowns.   By the way, I am not a fan (or unfan) of Rumsfeld; it's just a convenient expression.

Buffett is known as a great stock picker.  He has done well for more than 50 years.   But if you look at Wall Street analysts, they do no better than random.  Why is this?  The usual interpretation is that Wall Street analysts are just incompetent.  But I beg to differ.  Many Wall Street analysts are very smart.  Yes, I've met some really, truly dumb ones.  But most of them are normal, highly intelligent, hard working people.

So why are they so wrong all the time?  Well, they're not wrong all the time.  They are just no better than random.

But again, just like asking Soros to hedge and unhedge a portfolio over the years, if you ask Buffett to look at a list of the S&P 500 stocks and pick the ones that will outperform over the next year or even five years and then pick the ones that will underperform, I bet he will do no better than random.

Why?

Because for most stocks, his opinion would be "I don't know".  Most stocks would go into his "too hard pile".  If we force him to choose, buy, sell or hold, he will choose.  But he will have no conviction.   And he will probably do no better than random.

The key here is that in order for him to do well, he doesn't have to have an opinion on most stocks!  He only has to have conviction on the ones he understands well and has a strong opinion about.  He can ignore the rest.

Wall Street can't do that.  Analysts, in aggregate, can't say, "no opinion".  They have to say, buy, sell, or hold.   Not to mention that they have to guess the next quarter's EPS etc.  I don't know if Buffett would be any better at guessing EPS on a quarter to quarter basis than Wall Street analysts.

Again, it doesn't matter because he doesn't have to do that to do well!  But Wall Street does.  This is why Buffett is not often wrong while Wall Street is very often wrong.    In fact, Buffett has been wrong about all sorts of things but it hasn't hurt his performance because he knows what he doesn't know (he predicted a housing recovery that never came, higher interest rates that hasn't come yet etc.)

Back to Market Timing Mutual Funds
Similarly, market timing mutual funds, like Wall Street analysts, have to have an opinion all the time. They have to be long, flat or short.   They can't really say, "I don't know" and just stay flat, as that is their only source of profits.  Yes, some funds have flexibility to go elsewhere, but for all practical purposes, other assets will usually only be a small part of an equity mutual fund.

Macro hedge funds can afford to say I don't know about the U.S. market and choose to do something elsewhere.  They can put on massive, leveraged bets on things they have conviction about and don't have to have a view on the U.S. stock market at all.  They can just go out and find something they do have conviction about.

Fallacy of Overvalued Markets
When you look at these long term charts, it's really easy to fall into the trap of saying, "gee, look how expensive the market was in 1929, 1962, 1972, 1987, 1997, 1999 etc...  We should have shorted the market at these levels!".

Yes, expensive markets are often followed by corrections.  Sometimes corrections are meaningful, like in 1929, 1999 and 2008.  Sometimes they are not, like 1987.

But this is sort of like the guns and bank robbers fallacy.  All bank robbers have guns, but not all gun owners are bank robbers.  Many large corrections and bear markets are preceded by overvalued markets, but not all overvalued markets are followed by bear markets or corrections.

Here, check this out:

CAPE 10 (inverse): 1909 - 1992

Again, Excel couldn't handle the length of data so I chopped it off at 1909.  If you go back further, the chart is even more convincing as CAPE10 (inverse) was under 5 in 1901.

If you saw this in December 1992 when the CAPE10 yield fell under 5% for the first time since the late 1960's, it would have been perfectly reasonable to assume that the market is very overvalued, even more so than right before Black Monday.  I didn't do it, but you can put an average on here and then standard deviation bands around the 100-year average, and it would have told you that the market was really, really outlier expensive in late 1992.  Look what happened to the market in that past after it got below 5% CAPE yield; 1929, 1937, mid 1960's etc.

It is a visually compelling argument.  It's hard to argue that the market is not overvalued at this point.  I just picked a 5% yield because it corresponds to a 20x P/E ratio that usually makes people think the market is expensive.

But check this out.

Where was the Dow and S&P 500 index back then?

                        December 1992                   Now          Chg       per year
DJIA                3301                                    17613         5.3x       +7.9%
S&P 500            436                                      2023         4,6x       +7.2%

And this 7-8%/year return since then, when the market was just about as overvalued as ever is excluding dividends.  That's just the change in the index level.  Throw in dividends and it's probably close to 10%/year.  From an expensive market!

And then check this out:

CAPE 10 (inverse):  1992 - 2014

If 5% earnings yield was silly expensive and you held to that 'standard' which has proven itself over 100+ years in the stock market, you would have basically been out of the market (or even short) for just about the whole period since 1992.  You may have gotten in during the financial crisis, but then you would have gotten out again pretty soon after that.

It's crazy, isn't it?   Now you see why a lot of people have been saying that the market is overvalued for more than 20 years!

This is why it's so dangerous to make investment decisions based on this stuff.  And again, this is why Buffett is such a great investor; he ignores it.  Well, I'm sure he sees the graphs and charts and goes, whoa...  But he doesn't let this stuff distract him from doing what he knows what to do.  And he isn't tricked by these charts into thinking that he can guess where the market will go in the future.

As great as any argument sounds, you still really can't know what is going to happen to the stock market going forward.

You can look at these charts and go, wow, returns are going to be lower going forward.  I've seen those tables that show stock market return based on the P/E ratio of the market on the initiation date.  Yes, higher P/E's mean lower prospective returns.

But what I haven't yet seen is a table that shows, for example, that when a P/E is 25x, that, say, there is a 30% probability of a 30% correction within the next three years such that if we get long at the bottom of such bear market, our total return from this timing strategy will be Y%.  This could be a table.  Maybe there is a 50% chance of a correction of 30% or more within the next five years after such a valuation, and if this happened, and we were able to go 100% long at the bottom of that bear market, our prospective return would Y% etc...

All of these possible scenarios have to be calculated, including the probability that there won't be any correction greater than 20% within the next five years.  And if the sum of all the expected returns in all those scenarios is higher than the prospective, buy-and-hold expected return, then you can say maybe it's a good idea to try to time the market.  But then again, we all know how these complicated calculations with layers and layers of assumptions go.

But anyone who has traded (and/or studied) equity derivatives knows, there is a cost to such opportunism and it can be calculated.  For example, in the old days, there used to be interesting-sounding options like "down-and-in" options, or "lookback" options, and other trigger or barrier type options.  These options were designed for buy-the-dippers.  For example, you can create  a call option that becomes effective when the market goes down 10%, and the strike price becomes the stock market level 10% lower than when you put on the trade.  Of course, you would have to pay a call option premium to the seller for them to take that risk, and for them to effectively 'trade' for you.  If the market didn't go down 10% within the time period of the call option, it expires worthless and you lose your premium.

The theoretical value of these options can be calculated, incorporating the probability of the movements in the market, trading costs etc.  And this theoretical cost would effectively be the opportunity cost of waiting for the market to come to your level.  This has to be compared to the buy-and-hold, fully invested return.   If, say, interest rates were 8% and the expected return in the stock market is (unlikely in this scenario) 1%, and the knock-in option is worth 3%, then maybe it's a good idea to sit it out; you are getting paid 8% to wait, and out of that you pay 3% for an opportunity to get in lower, so you are earning 5% already; much better than the 1% you would get by investing fully now.   Again, unlikely scenario, but I just did that to illustrate the thought process that would go into something like this.

Even simple hedges have their costs.  You can buy put options to hedge against stock market risk, but those premiums can add up over time.  And especially in this lower return environment, it's going to be hard to make money with low return stocks when you dish out a bunch of money on put premiums.

But again, if you can precisely calculate the odds, maybe some sort of hedging structure makes sense.

But  you never really hear anything like that.  Usually, it's something much simpler, like, "the market is overvalued because the P/E ratio is as high as it's been in 100 years, therefore the market must go down soon so we will buy puts, short futures and buy gold", or something like that.

Conclusion
So anyway, market timing mutual funds and macro hedge funds are very, very different animals. They are not even close in terms of what they do and how they make money.  Even the best traders of all time, I don't think, could time in and out of the markets if his sole mandate was to hold a U.S. equity portfolio and then hedge / unhedge according to his market views.  No way.  In fact, many of the great macro hedge fund traders have lost tons of money trying to short the U.S. market.  But they make it up elsewhere in other massive, leveraged trades so it's not an issue for them.  Each trade is like a single poker hand; one bad hand or bad beat is not going to ruin their year; and macro hedge fund traders typically make many, many trades a year (as opposed to market timing funds that make very few decisions; if they are bearish due to market valuations, they will stay bearish etc.)

If a market timing mutual fund gets the timing wrong, it's just going to be a total disaster.

Just as there is no way that even Warren Buffett can predict which stocks will go up and down in the future (out of, say, a list of the 2000 Russell stocks), even the best macro hedge fund traders couldn't time in and out of the markets consistently.

And the key is that neither Buffett nor macro hedge funds have to do that.  Just like Buffett has to only find the questions he knows he can answer (just buy the stocks that he thinks will go up and then ignore the rest), macro hedge funds can take massive bets when they see an opportunity and can throw the direction of the U.S. stock market in the "don't know" bucket and leave it there for years if need be.

But just like analysts have to have an opinion on every single stock they cover (even if they personally may be indifferent and have no strong opinion either way most of the time), market timing funds have to always have an opinion on the market, and if they are wrong, they are dead.

It is impossible for market timers to get it right consistently all the time just as it is impossible for analysts to be right on every opinion they have on every single stock they cover.

But unfortunately, those people are in a game they can't win.  Buffett and macro hedge fund traders have the luxury to only pick their shots when they have conviction.

Having said that, not all macro hedge funds are good.  Most are probably no good.  And having said what I said about analysts, they do have a role to play in the financial markets.  It's not always critical for them to be right or wrong on stocks; they do act as a conduit between companies and investors.  And they have sort of a high level 'reporter' role in keeping a professional eye on companies and report on various developments.   Many analysts are valued not necessarily for being right or wrong, but for their deep knowledge about companies and industries that can be helpful to investors.

And no, I am not arguing that the markets will stay expensive forever.  I am just trying to point out that it is not so easy as saying "the market is expensive, let's get short!".

What to Do in this Market: Gotham Funds Update

So my posts about the perils of market timing and market valuation have led to some interesting discussions in the comments section.

Anyway, I wrote about the Gotham funds last year and since a little more time has passed, I thought I'd look at their performance to see what's going on.

But first, let me just say that if you *must* invest in some sort of hedged vehicle (in mutual funds), or something that mitigates stock market volatility, as I said in my original post (What To Do In This Market II), I would recommend one of the Gotham funds.

As I always say, I am not usually a big fan of long/short (unless they are run by people who have real track records like Loeb, Einhorn etc...).  I would definitely stay away from the long/short stuff that are put out by the mutual fund giants.

Why Gotham?  Well, we all know what a great manager Joel Greenblatt is.  He does have a long track record of outperformance.  OK, so it wasn't a long/short fund.  But he knows stocks and markets very well, and he has often spoken against the idea of long/short.  But he is doing it now.  What does this suggest?  It means that they have really dug in and figured out how to manage the risk inherent in a short book.  Otherwise he wouldn't do it.  He knows why long/short funds usually don't work out.

Plus, the funds will be operated according to the simple ideas laid out in his books, and I feel I do understand those well, and do have faith that they will continue to work over time.

He said on CNBC once (when the first Magic Formula book came out) that if he shorted the most expensive Magic Formula names against the long portfolio, the portfolio volatility would have been far greater than the long only portfolio, and I think he even said that the portfolio lost 90% or something like that at one point.  I'm not sure he said that, but I do remember him mentioning a huge drawdown with the long/short.

So I am sure he will not have a huge drawdown on the long/shorts like that as we know he is aware that is possible if you just bought the cheapest and shortest the dearest names.

Macro Based Mutual Funds
But first, let me get back to the macro, top-down mutual funds that I would caution people away from.  As I said in the comments section, my caution against market-timing funds is simply that there isn't any fund that I am aware of that has done it well over time and through cycles, never seen a newsletter or investment strategist that called things consistently over a long period of time (there are always stars, though, that have called the most recent correction, rally or both.  Maybe we can make a list of them).

As I said, for value investors, there is a Graham and Doddsville and the resident superinvestors.  Where is the Graham and Doddsville of market timers?

One thing you can do is subscribe to Hulbert's Financial Digest for a while and check out the long term performance of timers.  It is dreadful.  And many of them use the same things everyone else uses; P/E ratios etc...

So why do these funds come and go all the time?  And how can a fund like this, below, even exist?  Well, it barely does.  I think AUM is now $34 million.



To understand this, check out the performance figures below.  This is from the fact sheet for the fund from their website,  The above chart only starts at 1994.

So this fund started in 1985.  It is interesting to note that the arguments made back then are very similar to the arguments made today.  Especially going into 1987 and then after that throughout the early 1990's, the argument was about high stock prices, too much leverage (junk bond driven LBO mania), twin tower of deficits (budget and trade deficits), and there were no shortage of calls for another great depression to come.

In that environment, this fund came out and then nailed it in 1987.  Look at that.  They did OK in 1985 and 1986, and then absolutely hit it out of the park in 1987, no doubt due to their cautious stance.  That stance cost them in 1988, but it looked like things will be OK in 1989 (I don't know if that gain is due to the UAL crash, or from longs, but...).

And then from 1990 on, things start to go wrong, and then from 1994 on you can just look at the chart and things go horribly wrong forever after.

If you go to their website, there is a video of Charles Minter making some persuasively bearish statements in 2003.

The funny thing is, as is often the case, I totally agree with so many things the bears talk about.  They are right but I just tend to disagree on what to do about it (Buffett too often says things that are in agreement with the bears but acts totally differently so it's not that he is stupid and he doesn't see it, or that he is complacent.  He just has a time horizon long enough (and holdings solid enough to survive that long) for it not to matter.

These funds get very popular after a bear market because there are usually some people who absolutely nailed it.  Maybe they get the bear right and even get the turn correctly and rides up a rally.  Maybe they can even get the next bear etc.

But it is very hard to keep doing that and at some point, inevitably, your luck runs out and you can't keep calling the turns anymore.  This is true with newsletters and investment strategists too.

Cursed by Early Success
And their early success is the reason why they can't evolve or change.  When their best relative performance (and rise to fame) occurred during bear markets, it's only natural that these managers will almost always lean towards the bearish side.  Looking at the above table of Comstock's early success (1987), you can suspect that the management there has spent the next 27 years trying to replicate that success; kind of like Jay Gatsby trying to relive a summer of his youth.

I suspect other similar funds will do the same thing and if they fail, it will be because of the irresponsibility of the Fed.  In other words, it's won't be their fault.

Speaking of which, I remember in the 1980's and 1990's, the hedge funds and macro guys loved the central banks and governments because they were so inept.  It was very easy to trade against them and make tons of money.  So it's kind of ironic that many of them are now complaining that their bond market / interest rate manipulation is interfering with their ability to make money.  But that's another story for a different post.

And by the way, sometimes in the trading world, we say that making a killing on the very first trade can be the worst thing that can happen to you.  The thinking is that the trader will spend the rest of his career losing what he made and then some trying to replicate it.  (Imagine how much money has been wasted on S&P 500 index puts in the years following Black Monday?)

Value Funds
Of course, this inevitably leads to the argument, "gee, but value funds don't outperform the index either!".  Well, that's why Buffett says index investing (the S&P 500 index) is the right way to go for most people.

But I'll add that even if a value fund underperforms (hopefully they outperform over time, though) usually they end up making money.  You can still do pretty well.  I know someone who has become pretty wealthy just owning the Magellan fund for many years (I mean, many, many years!).

Why Do I Waste Time on This Topic?
Well, as I said in a response in the comments section, when people realize I am involved with the stock market, the discussion almost always ends up not being about stocks, but about what to do because the stock market is dangerous, dishonest and rigged, too expensive and bubbled up etc.

Also, I am not at all against the idea of market timing.  I don't write this stuff because I have something against them and I don't feel like I am trying to prove anything idealogically or anything like that at all.  In fact, I am very curious about these things and have always been.  True, I don't spend a whole lot of time on it, but I am curious about what others have to say about it and about attempts to do it.

If I find someone who can do it consistently and has a track record (or a group of such people), I would be very interested in what they do.

But the fact is that I just haven't found any yet.

In fact, early on in my career, I was very into this stuff and what lead me to value investing is that there was no Graham and Doddsville of market timers.  It turns out most market timers make the bulk of their money selling books / newsletters etc.  Every time I read a book about it, I couldn't verify the author's performance.  If they were newsletter writers, their letters performed horribly.

Back to Gotham Funds
OK, so back to Gotham.  Why am I OK with Gotham versus the others?  Because Gotham does not try to forecast the economy and structure a portfolio around it!  They don't get bearish and put on a hedge, and then get bullish and take off their hedge.  They simply buy the cheapest stocks and short the dearest stocks.

Here are the funds that they offer from their website (gothamfunds.com):

And here is how they've done:

These funds are still too young to really evaluate them, but so far it looks pretty good.

Check out how they have done versus the S&P 500 (Morningstar charts via Gotham's website):

Gotham Absolute Return

Gotham Absolute 500

Gotham Enhanced Return

Gotham Neutral

If I had to choose one to hold for the long haul (or recommend to, say, your sister or some non-market person), I would say Gotham Absolute Return.  Gotham Neutral is interesting, but that seems too cautious.  Also, the Enhanced Return looks exciting, but seems to have more leverage than I might be comfortable with to recommend someone who doesn't follow the markets. The Absolute Return long/short allocation is similar to how the typical long/short hedge fund operates.

Anyway, again, I would be very skeptical of the long/short funds coming out of the big fund families.  Think about how their funds tend to underperform most of the time anyway.  And add the risk of short-selling to that underperforming long portfolio.  Short-selling tends to be very tough, and in my experience, long-only managers suddenly being allowed to short have often lead to dreadful results.  It's just a lot harder to do.

If a stock is cheap you can buy it and if it goes down, you can just buy more.  But if you short a stock and it goes up, you can't just sell more.  If you try, you can really get killed.  And shorting wrong stocks can easily offset gains on longs.

Oh, and not to mention that the best short-sellers/stockpickers tend to go into hedge funds where the fees are higher (and therefore their own salaries/bonuses).

This Time it's Different
Over the years, when I get into this sort of discussion about the markets (and talking people out of market timing), they argue that the bulls are saying "this time it's different".

But it's never different.  Some things do differ, though.

For example, what's not different?

• Value still matters.  Cheap stocks will do better over time, and expensive stocks will do worse.  Gotham funds can exploit that.
• Asset values have always been valued against the U.S. treasury market.  Sure, there might not have been a close correlation in some periods in the past.  For long duration assets, U.S. long bond yields have always been the "risk-free" benchmark.  And against that, the U.S. stock market is not at all overvalued.  
• Even if the stock market is not overvalued versus bonds, it is expensive on an absolute basis which implies lower returns going forward.  This is a mathematical certainty that can't be denied.  But it doesn't necessarily follow that someone can earn a higher return than this projected low return by getting in and out of the market on a timely basis.  All evidence I have seen to date seems to suggest otherwise (most would have been better off in August 1987 to just hold on and ignore the headlines). 
• But having said all of that, even I wouldn't be comfortable if stocks got up to 50x or 100x P/E (to catch up to the bond market).  I think the stock market is acting prudently by not going there! 
• And, in general, people who try to time the market will get one, two or maybe even three turns right and will look good (and get a lot of face time on TV).  But the odds of that success continuing is very low.  This is not a judgement of anyone in particular.  Even Buffett has said that in his fifty+ years of life in the markets, he hasn't seen anyone do it. 

So most things don't change.  I think the world will go on as it always has in the above sense.

But what is different?

I was going to make a list, but I think the biggest difference is monetary policy.  In the old days, the Fed can just lower rates and things were hunky dory.  Now, all sorts of stimuli are having a much lower impact than in the past.  I think that's due to the amount of leverage already built into the system.  There is something going on that most of us don't understand; why are rates so low for so long?  I tend to believe it is not just about the Fed.  Why are rates still lower despite the end of QE?  We may be in a long term Japan scenario where deflationary pressures (and not Fed bond buying/manipulation) keep rates low.   This is sort of uncharted territory so old models may not work as they have in the past.

Conclusion
So maybe I sound like some idealogical extremist in terms of this stuff (anti-market-timing, pro-value investing) but there is a reason.  I have no horse in this race, really.  I don't sell a newsletter or book, don't own a value investing shop or anything like that.  And I have no relationship with Gotham, Greenblatt or anyone associated with either of them.

But I've been in the business a long time (well, maybe not as long as some of you!) and feel like I've seen it all.  I didn't experience Black Monday or any of the big bear markets before then, but I've been through all of the other crises, and they are all the same.

Heroes inevitably emerge from each of them (sometimes multiple heroes).  Some of them are wire-house investment strategist (that go out afterward to start a fund after making a great call), newsletter writers, economists etc.  And most of those guys that make their name in bear markets don't go on to make great long term track records.

Again, I exclude some of the really good trading oriented hedge funds (think traders in the Market Wizards book).  A lot of those guys are very good and have long, consistent records of profit.  But they are very different from the macro-based mutual funds (maybe that would be a topic of a future post).

So in a sense, no, this time is not different.

If you must invest in some hedged vehicle (again, I am only talking about mutual funds), then go with the Gotham funds.  They don't try to do the impossible (guess where the markets go) and they stick to fundamentals / valuation in stock selection.  It is a fund run by a successful manager with a great track record, great books with a method of picking stocks that have worked over time etc.

Of course, it may not work out at all.  Who really knows with these things.  But I can tell you that if you are going to do something in the long/short world, or 'hedged' world (to temper volatility), I can't think of anything (in the mutual fund world) I would feel more comfortable with.