Risk Management Isn’t Market Timing

“By repeatedly repressing financial-market volatility over the last few years, central-bank policies have inadvertently encouraged excessive risk-taking, which has pushed many financial-asset prices higher than economic fundamentals warrant. To the extent that continued currency-market volatility spills over into other markets – and it will – the imperative for stronger economic fundamentals to validate asset prices will intensify.” By Mohamed El-Erian Project Syndicate, Nov. 13, 2014

Translation: The Federal Reserve and other central banks around the world have artificially propped up capital markets by providing extraordinary amounts of cheap liquidity to speculators. The markets are in trouble if fundamentals don’t improve enough to justify artificially elevated prices. Forecast: There is only a small probability of economic fundamentals improving sufficiently to justify an S&P 500 price almost twice fair value.  There is a much higher probability that the market will trade lower at some point as the normal process of unfettered price discovery resumes and the market seeks fair value.

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I was discussing future returns for stocks with a community foundation director and mentioned that the S&P 500 would likely return less than 2% per annum over the next 10-years. She visibly recoiled and immediately labeled me a bear, never mind whether I had a logical reason for the forecast. Likewise, I was chatting with a financial advisor about the investment year a few weeks ago and made the observation that it was currently a high risk environment.  He dropped his chin to his chest, smirking as he shook his head from side to side, managing to convey both amusement and disagreement at the same time. Again, no interest in asking why. Rather, he slowly raised his head until he made eye contact, paused for effect, and then intoned, as if talking to a halfwit, that no one knew where the market was going.

And of course I agree! Academic research manifestly supports the notion that daily, weekly, and even monthly market movements are impossible to predict with any degree of consistency and accuracy. But that wasn’t what I had said. The advisor was opining on market timing and failing to understand that risk management isn’t market timing.

You don’t need to know if the market is going to rise or fall tomorrow to practice risk management. You need only be able to perform basic business valuation, which is the essence of actual investing – as opposed to speculating.  Do basic business valuation with 500 different stocks, add the values together, and you arrive at a fair value for the basket of 500 stocks as a whole.  I believe the concept of business valuation is sufficiently accepted by CPAs, CFAs, the IRS, and academia to dispense with a defense of our ability to value a business (the community fund director’s protests and the so-called financial advisor’s smirk aside).

Speculating on stock price movements is what most mutual funds do. (As opposed to investing in a company for an entire business cycle, or even longer, in order to benefit from rising shareholder cashflow).  In fact, short-term investing (speculating) is so ubiquitous today that it seems the majority of investors, both professional and otherwise, are no longer able to distinguish between speculating and investing. For instance, the average actively managed mutual fund has a turnover of approximately 100% per annum, according to Kiplinger’s and numerous other sources, which means that the average holding period for a typical stock in a typical mutual fund is approximately 12 months.  How ironic that the industry which touts the benefits of long-term investing doesn’t actually practice what it preaches.  And that means that even investors who maintain long-term exposure to a specific mutual fund are actually speculating as well, since they aren’t maintaining long-term exposure to specific stocks either. Mutual funds are merely conduits for stock (and bond) ownership. It is the underlying portfolio that determines exposures. The mutual fund manager speculates, as evidenced by rapid portfolio turnover. The mutual fund investor speculates by proxy.

Market timing is an attempt to profit by increasing or decreasing exposure to an asset class based on an expected return path for that asset, typically over a time period ranging anywhere from a few minutes to several months (but well short of a complete business cycle). Speculating in a stock is an attempt to profit by increasing or decreasing exposure to a stock based on an expected return path for that stock, also over a short period of time (on average one-year based on the trading patterns coming out of the mutual fund complex). Speculating with individual stocks is just as pointless an undertaking as market timing.  After all, it is the same game, just on a different scale.  But if the logic of sums doesn’t sway you then there is also the overwhelming evidence accumulated by academics over the past five decades or so…market timing doesn’t work, and neither does stock timing.

Fortunately, risk management has zero to do with market timing.  Investing is buying future shareholder cash flow at a price that will earn the investor an acceptable rate of return. Historically, investors in the S&P 500 have required an approximately 6.5% real rate of return to accept the risk of owning the S&P 500. Ergo the price that will earn an investor a 6.5% real rate of return going forward is the fair value (assuming investor requirements haven’t changed – a safe assumption since human behavior hasn’t changed in millennium).

Buy at a price above fair value and expect to earn a below market rate. Buy below fair value and expect to earn an above market rate. Buy at fair value and, by definition, earn the long-term real return rate of 6.5%.  Fortunately there are half a dozen very good long-term measures of value that can be substituted for the tedious and time-consuming task of doing basic business valuation 500 times.  Warren Buffet’s favorite is Market Capitalization to Gross Domestic Product (mkt cap/GDP). Price to replacement cost, price to trailing 10-year average earnings adjusted for inflation, price-to-book, and price-to-sales work just as well however – all highly predictive of subsequent returns.

Risk management is not market timing. Risk management is a basic component of successful investing. When valuation risk is present, common sense dictates reducing risk in your portfolio to account for the higher-than-normal risk environment (Conversely, adding risk to your portfolio when valuations are compelling – as they clearly were with the SP 500 trading below 800 in early 2009 – is also simple common sense). Next time your financial advisor tells you not to worry about valuation risk (because no one knows how to determine fair value for the market) fire him!

The Doubting Economist

“In Spite Of Market Rally, S&P 500 At Lowest Valuation Since 1980”  blared a recent headline from Bloomberg News. “Thus hath the candle singd the moath,” I immediately thought, as I harkened back to my high school Shakespeare (not really).  Of course the word moth was used in the 17th century to mean someone who was apt to be tempted by something that would lead to their downfall, according to The Phrase Finder.  How apropos! Diving into the current market rally is likely to singe more than a few unwary investors. A cheap market?

The chart above goes back to 1900 and uses four measures of stock market “cheapness” or, more precisely, valuation. The zero percent horizontal line is the average value of the S&P 500 based on the four measures. Three of the four measures are academic and/or mathematically sound (cyclical P/E 10, Q ratio, and regression) whereas the fourth measure (Crestmont) is a proprietary index that just came along for the ride. Please note that, in over 100 years, the squiggly lines have always come back to and then through zero, eventually falling to the minus 0.50% range (zero currently equals approximately 1000 on the S&P 500 while the lower level equals… about 500). 

Could it really be that the market had somehow gone and gotten cheap, even after a 135% move off the March 2009 bottom, even with multiple long-term valuation metrics arguing the opposite?  Could my shocked disbelief  be misplaced? Should I feel relief instead that all was good and right within the world of stocks?  In other words, could the S&P 500 really be cheaper than at any other time since 1980, a mere two years before the start of, arguably, the greatest secular bull market in American history? Nah, not likely. Count me as a doubting Thomas.

Nevertheless, like a moth to a flame…

“Even after U.S. stocks more than doubled in the four-year bull market, companies in the Standard & Poor’s 500 Index are cheaper than at any record high since 1980 as individual investors shun equities,” the Bloomberg article began. (boldface is mine)

Well okay… the author has already altered his claim, in the very first sentence of the article, by qualifying his bold headline (but he’s also probably made you wonder if  YOU are an idiot for under-weighting  equities in your portfolio, since the S&P 500 is apparently so dang cheap!)  

So before running off and loading your plate with cheap stocks, please make sure you fully appreciate the import of the author’s not insignificant caveat.  No longer is the S&P 500 at its lowest valuation level since 1980 but, rather at its lowest valuation “at any record high” since 1980. And that’s a horse of a different color.  It is a favorite trick of people looking to grab headlines, or make a name for themselves with some bold prediction or other, to carefully choose their data set. Our author has conveniently chosen to go back only to 1980, just prior to the aforementioned start of the greatest secular bull market in  American history.  And of course the market is cheaper now (based on his chosen metric of 12-month trailing reported earnings), as it approaches a record high, than in the 80s, 90s, and first 12 years of the 2000s, when hitting all time highs.

Secular bull markets tend to increase valuations substantially and the 1982-2000 super bull was certainly no exception.  Would it, perhaps, be more appropriate to measure how the current valuation looks relative to prior secular bear market all-time highs, which occurred in 1972 and 1980, rather than the secular bull market all-time highs in 1983. 85, 86, 87, 89, 90, 91, 92, 93, 95, 96, 97, 98, 99, AND 2000?  As it happens, the author does mention that the 1980 valuation, based on reported trailing 12-month earnings, was 9.1 versus the current 15.4.  Applying a 9.1 multiple to actual 2012 earnings of approximately $102.50 (according to Barron’s) would give you an S&P 500 of 933, or 630 points below the current index level. A decline of 40%, just to get to the equivalent valuation of the last “all time high”-during-a-secular-bear-market, should give one something to ponder…

There are many other misleading statements in the Bloomberg article, including the author’s careful selection of the 2009 – 13 period to highlight a big increase in corporate earnings (again leaving the poor reader with the distinct impression that the cyclical bull market is all about fundamentals).   Specifically, he points out that corporate earnings have almost doubled from $61.84 to an estimated $109.50 in 2013.  Had he expanded his window to include 2006, when earnings peaked at $87.72, and limited himself to 2012 reported earnings of $102.47,  he would have a much less impressive number to report – 16.8%.  The fact is that corporate earnings have only grown 16.8% cumulative over the six-year period from 2006 to 2012 – an annualized growth rate of only 2.8% per annum.

It gets worse however. Corporate net profit margins are currently some 70% above the long-term historic average, according to Dr. John Hussman, and others who track such things.  Furthermore, corporate profit margins are strongly mean reverting (a strong tendency to return to average).  Normalizing earnings by using average net profit margins is a scary, yet quite reasonable, exercise. Last year’s reported earnings of $102.47, if normalized for average profit margins, would shrink to somewhere in the $65 dollar range.  Go ahead and multiply $65 dollars of S&P 500 profit by a very average 16 P/E ratio and you get… 1040 for a typically valued S&P 500 based on more normal net profit margins (1040 is 33% below the current level). Use a secular bear market single digit number – let’s say 9x earnings – and you get 585 for the S&P 500… not too far from where the log-normal chart at the top of this article would put the S&P 500 during a major secular bear market low…

Not to worry you are telling yourself. Net profit margins may normalize eventually, but not any time soon.  Heck, it’s okay to jump in the pool and do a few laps before the lifeguard blows the whistle to get the heck back out.  After all, the Wall Street Journal just reported that the consensus forecast is for 2.4% GDP growth in 2013 and estimates for corporate earnings growth for this year are at almost 7%!.  Sure, actual corporate earnings growth has been slowing down since last summer, turning negative in Q3 2012, and earnings are forecast to be a negative number in Q1 2013 (-0.7%),  but surely the economists know what they are talking about and certainly earnings growth will accelerate once again before year end. (Never mind that embedded in the dual forecast of 2.4% GDP growth and 7% earnings growth is an assumption of even wider net profit margins, a small cautionary voice, quickly dismissed, whispers somewhere in the back of your mind). 

Let’s have a Rod Serling Twilight Zone moment… Submitted for your consideration and approval – consensus economic forecasts predicted exactly two of the sixty recessions that occured around the world in the 1990s, according to Nate Silver in his book “The Signal and the Noise – Why So Many Predictions Fail –  But Some Don’t”  That is a 3.3% success rate in predicting recessions.  Now, let’s put the situation into terms we humans can grasp more easily.  You are standing at the edge of a pool. It’s dark. You can’t see if you are at the deep end of the pool or the shallow end. Heck you don’t even know if there is a deep end – might be a wading pool rather than a swimming pool. But if it is a swimming pool it might be shallow at both ends or only one. And the thing is –  you can’t see!

Would you really choose to dive headfirst into that black water, knowing that you could easily break your neck?