So far 2012 has lived up to the volatility we anticipated back in January. We’ve had a massive market rally followed by a rather significant correction. Central bank and government intervention caused quite a spike in risk assets at the beginning of the year, but renewed debt worries coupled with a significant global growth slowdown (particularly in Europe) have caused a market U-turn this spring.

Now seems likes as good a time as any to stop and assess our position. To put the moves we’ve seen into perspective, I’ve prepared a chart to show how the magnitude of the recent (and ongoing) correction varies across several global stock indices and a couple of key commodities.

Global Indices: You Are Here

Notice that U.S. and Japanese markets were the last to top out while Canada’s TSX was among the first. I’m not sure what to make of that except that Canada’s commodity-heavy market may have been anticipating a global growth slowdown. While the Nikkei was late to turn lower, its descent seems to have been a little steeper so far.

Looking at these results by region, it’s not at all surprising to see the PIGS (Portugal, Italy, Greece and Spain) under performing so dramatically given their precarious debt loads. It is worth noting, however, that France is clearly not in the same sort of safe-haven category as Germany. This bears watching as most of the focus seems to be on the PIGS at the moment.

The fact that some indices are still positive on the year in spite of sizeable corrections is a testament to the magnitude of the first quarter rally. Strength in the Shanghai Composite seems to be at odds with repeated warnings about China’s slowing economy and real estate bubble. While the index is down this spring, the correction hasn’t been as deep as it has for other indices and it’s still hanging onto decent gains on the year. This is one to watch for sure.

Those are some of the patterns I noticed in these numbers.

What did you see?

(Photo Credit: Shutterstock)

Related posts:

1. 5 Year Market Outlook: Felix Zulauf
2. Is SecondMarket a Better Market?
3. What Would Make Me Invest in the Stock Market?

If I were one of these crazy hedge fund guys, with the slick haircuts and fancy shoes and racing stripe shirts, the trade I’d put on is 10-times-leveraged natural gas long versus 10-times short Apple.

~ Jeffrey Gundlach, April 26, 2012

The quote above is from the latest presentation given by DoubleLine’s Jeffrey Gundlach. For those who aren’t familiar with him, Mr. Gundlach has been anointed by many as “the new bond king”, taking over for PIMCO’s Bill Gross. When he talks, people listen. Josh Brown was in attendance at the event and was kind enough to share his Notes from the DoubleLine Lunch.

At the time Mr. Gundlach made his short Apple/long natural gas pair trade recommendation just a week ago, Apple had just reported killer results and resumed its upward trajectory after a short but steep correction. Natural gas was bouncing a little from its latest tumble in a multi-year shellacking. It’s only been a week, but Apple has continued to slide and natgas, to rally. For now, Mr. Gundlach’s trade is working. I wonder whether that has anything  to do with fund managers taking his advice?

On Stocks, Debt, Austerity, and Fed Futility

So what else did Jeff Gundlach have to say? I’ll hit a few of the highlights that stood out to me below. (Again, this is courtesy of the Reformed Broker. You can read the full article for a lot more detail.)

• The Shanghai market is a great leading indicator for stocks.
• The wealthy don’t pay enough taxes in the US.
• Like the Roman Empire, the US spends a ton of money on the military, although health care and Medicare are also huge budget-busters.
• QE has boosted stock prices, but hasn’t accomplished much more than that. (Check out his Bernanke Wheel of Fortune slide.)
• The middle class is facing biflation.
• Developed countries are sitting on unsustainable piles of debt.
• The possibility of civil unrest is rising in Europe given extremely high rates of unemployed youth, especially in Spain and Greece where youth unemployment recently passed 50% (not a typo).
• Apple’s chart looks just like Google’s did just as it topped out in 2007.
• “Austerity is guaranteed to lead to a weaker economy no matter where it takes place and the alternative, a continuation of debt-financed solutions – is even worse.”

If more debt-financed stimulus is not the answer, and austerity only leads to economic depression, what does Mr. Gundlach think the Fed should do? According to Josh:

Jeffrey says that the right thing to do is the hardest – let the debt clear and have a depression.  You could hear a salad fork drop when he says this.

But of course, we’ll never do this, he says.  So in the absence of letting the everything reboot, at the very least the Fed should “stop with the manipulation of markets.”

I found a lot of these insights very interesting, but of course, the Apple/natgas trade was the one that grabbed the most headlines. I’ve been tempted to dip into some natural gas from time to time, but have not pulled the trigger yet, as it just keeps falling. Let’s see how it acts on the next pullback after the current bounce. If it can hold the previous low, I think we’ll consider a small position. Mr. Gundlach did emphasize that these were longer-term trades, and I would concur.

How about shorting Apple? Mr. Gundlach may be proven right on that trade too, but I can’t bring myself to put any money on the table for that one. I enjoy the products too much to bet against them!

What about you? Any thoughts on the Apple/natural gas trade or any of the other ideas advanced by Jeff Gundlach?

Related posts:

1. Passive Investing and the Ostrich Effect
2. The Real January Effect

There was a poll taken the other day showing that Colorado voters prefer having Eli Manning as the quarterback of the Denver Broncos over Tim Tebow. The poll states: “Democrats prefer Manning by 46 points, 60/14, while Republicans do by just a 7 point spread at 44/37. Every group of the electorate prefers Manning over Tebow except for ‘very conservative’ voters, who go for Tebow 53/28.”

There’s an important message for stock investors in these words.  Five important messages, actually.

1) People Are Nuts

It’s one thing to acknowledge that there are legitimate differences of opinion about whether Tim Tebow can be a winning quarterback in the NFL. It’s something else to note that people form their assessments re this question based on their political leanings. Democrats prefer Manning by 46 points while very conservative voters go for Tebow 53/28? Huh?

People are nuts.

This is an important investing insight. I often point out that stocks were priced at three times fair value in January 2000. This means that those who directed $9,000 to the purchase of stocks in that year obtained $3,000 worth of return-producing stock goodness and $6,000 worth of cotton-candy nothingness fated to be blown away in the wind sometime over the course of the next 10 years.

Many of my readers question whether it is reasonable to conclude that investors for a time got the stock price so wildly wrong. But look at that Tebow result. People are not logic-processing machines. Our emotions influence us. A lot.

2) People Sound Smart

We are nuts. But our craziness usually evidences itself in intelligent sorts of ways. This makes it hard to detect the nutty part.

If you asked the people who were polled why they favor Tebow or Manning, they would give plausible-sounding answers. The Manning supporters would note that even Tebow acknowledges that Manning has the far better passing mechanics. And that would seem to settle the matter. But, if you asked one of the Tebow supporters for his reasoning, he would point out that Manning missed an entire season due to injury and that Tebow is young enough to be capable of making huge progress in a single year. Listening to that side of the story would lead you to believe that the pro-Tebow case is equally credible or perhaps even more so.

But wait. We know these are not the real reasons why people are saying what they say. The poll shows that the explanations people give for liking Tebow or Manning are rationalizations. People decide for emotional reasons who to support and then turn on the brainpower to concoct explanations for those emotional beliefs that sound sensible.

When stocks are priced at three times fair value, there will be dozens of reasons put forward for why the price being set by the market is the proper one. Don’t believe any of it. It is always possible to come up with both plausible-sounding reasons for high prices and plausible-sounding reasons for low prices. Most investing analyses (including this one, to be sure) are so much hot air.

3) People Fool Themselves

When I point out how experts in this field mislead us as to the value of stocks at times of overvaluation, people often jump to the conclusion that I am accusing people of dishonesty. No! The conservatives really believe in their hearts that Tebow is the better quarterback. The liberals really believe in their hearts that the case for Manning is so strong as to be beyond dispute. People see what they want to see and they generally do not see too much beyond that.

Many people faulted the Madoff investors for falling for a Get Rich Quick scheme. I think we would be better to take a “there but for the grace of God” line re the matter. We all fall for all sorts of things all the time. And more often than not the people pulling us in fell for the same things before they tried to get us taken in too. We all think with our emotions. It’s just the way we are constructed.

4) People Are Biased

What do you think will happen if Manning has five great games to start out the next season and Tebow has five terrible ones (or the other way around)? Will that settle matters? You know it won’t. People who like Manning for emotional reasons will continue to like Manning for emotional reasons and people who like Tebow for emotional reasons will continue to like Tebow for emotional reasons. People will just concoct new rationalizations for believing what they want to believe. Facts rarely have much influence on human decision-making.

I believe that investors should change their stock allocations in response to big valuation swings. But I think it would be a good idea if every article I wrote had a message attached saying “Rob has been going with a zero stock allocation since 1996.” You know why? Someone with a zero stock allocation cannot possibly write without bias on any investing question. I’ve got an emotional stake in convincing people of one side of the story. That influences every word I write.

The same is true with those who speak from the other side of the table, of course. Most of the people we think of as “experts” in this field have connections to Wall Street. That means that they make money by selling stocks. That means that they are not capable of shooting entirely straight re any investing question.

They can try. But no one can fully overcome his biases. Why? No one can ever even fully see his own biases. We see other peoples’ biases, but  not our own.

5) People Are Fickle

I bet that poll would have showed very different results had it been taken during the time when Tebow was winning seven games straight in late-game comebacks. People can believe something very strongly one month and then believe something very different a few months later.

That’s why there are stocks crashes.

I noted above that people don’t change their minds when presented with facts. That’s because our decisions are generally rooted in emotion, not logic. But, while we can ignore fact after fact after fact for years, we can also make dramatic about-faces when we finally come to experience emotional desires to believe something different.

Stock prices usually head upward (with relatively insignificant dips mixed in) for 20 years and then head downward (with relatively insignificant upward moves mixed in) for 20 years. If investors were rational, it couldn’t happen like that.

That’s the pattern you would expect to see in a world in which most investors were motivated primarily by emotion. It takes a long time to change emotions, but, when they change, they change hard and remain changed for a long time.

Rob Bennett created The Investment Strategy Tester. His bio is here.

Related posts:

1. Stock Investing Is a Political Act
2. Is the Stock Market Rigged?
3. Stop Making Paper and Start Making Things: Bill Gross

I haven’t written a Bulls vs. Bears post in a while. Given the tremendous stock market run from the end of last year through the end of the first quarter of this year, it seems like a good time to assess the current position of the markets. I recently read two articles which, on the surface, appear to make inverse arguments.

One article says that stocks are the place to be even if the global economy slows. The other makes the case for historically low stock market returns over the next decade – whether the economy recovers or not. I think there may be more common ground here than a first glance would indicate. Let’s take a look at each argument and see if we can draw any conclusions.

The Bull Case

A weakening economy is never fun, but you shouldn’t necessarily run to the safety of fixed income. That could be more risky than stocks.

~ Fabrice Taylor

A Globe and Mail article by Fabrice Taylor explains Why Stocks Are Your Best Bet … Even If the Recovery Fizzles. Mr. Taylor says your investment approach will likely be determined by your view on interest rates. He thinks low rates will be with us for some time. His view is that recent improvements in economic data are a bit of a mirage, offering the following points as evidence:

• The U.S. unemployment rate has fallen, but much of that is due to a drop in the labour force participation rate.
• Any improvement  in the U.S. housing market is a result of strength in multi-family units and an increasing number of people renting due to a poor employment backdrop and stagnant income levels.
• The ECRI (Economic Cycle Research Institute) has a great track record and is sticking to its recession call.
• The European debt issue may be on the back burner, but it’s still simmering. That’s why the OECD is recommending a $1.3 trillion firewall.
• Demographics are working against most developed countries.

Given these economic headwinds, Mr. Taylor sees low interest rates sticking around. That means more paltry returns from fixed income and a continued migration to riskier assets like stocks. But he’s not recommending broad market indices. Rather, he suggests 3 alternatives:

1. Smaller dividend stocks
2. Broken stocks on the mend
3. Growth: try the wireless technology space.

As the opening quote for this section indicates, Mr. Taylor isn’t particularly sanguine about the global economic backdrop, but doesn’t see the fixed income markets as a great defensive play.

The Bear Case

Capitalism and free markets work, and America remains the most creative and innovative nation on the planet, but until policy makers and regulators wake up, it will be impossible to escape the long-term consequences of distorted markets, reckless bubble-seeking Fed Chairmen, repressively low interest rates that penalize saving and lower the bar for productive investment, a self-serving financial system, and bailouts that remove all consequences for misallocating capital that could otherwise create jobs and raise living standards.

~John Hussman

The bear case comes to us from John Hussman’s Weekly Market Comment: A False Sense of Security. This article is much longer, but well worth your time. I won’t be able to do it justice here, so I’ll just hit a few main points.

Like Mr. Taylor, Hussman is doubtful about an economic recovery, citing the recent “superficially positive data.” The article seeks to debunk two recent analyst memes:

1. Stocks are in a secular bull market.
2. The equity risk premium on stocks has never been higher.

The commentary kicks off with a thorough discussion of the difference between secular and cyclical trends. I write a lot about the idea that we’re currently in a secular bear market and I highly recommend reading this portion of the article if you’re interested in learning more. Hussman’s model, which has been remarkably accurate, projects 4% annual returns for the S&P 500 over the next 10 years. Have a look at the chart he includes:

(Click on chart for a closer look!)

The equity risk premium is the percent return stocks are priced to deliver over the “risk-free interest rate”, typically the 10-year U.S. Treasury rate. With equities priced to return about 4% annually over the next decade and the 10-Year Treasury yielding about 2%, the equity risk premium sits around 2%. Here are Mr. Hussman’s views on that:

When has the equity risk premium been as low as it is today? Prior to the late-1990′s bubble period, the estimated equity risk premium has been below 2% only during the two-year period leading up to the 1929 peak, between 1968-1972 (when the equity risk premium finally normalized as a result of the 1973-1974 market plunge), and briefly in 1987, before the market crash of that year. We know how each of these periods ended. The only real variation is in how long the preceding overvaluation was sustained.

Mr. Hussman also sees today’s historically high corporate profit margins as a direct result of policy interventions. Consequently, he thinks they’re vulnerable to a significant mean reversion. He also offers another informative chart comparing the ratio of corporate profits to GDP with the subsequent 5 year growth in profits. Suffice it to say that Hussman doesn’t see these inflated profit margins as a new normal.

A third chart attempts to explain why economic worries persist on Main Street while Wall Street is nearly giddy with optimism. It shows the ratio of wages to GDP in a virtual free fall over the past 40 years. Enough said.

Hussman sees unimpressive stock returns whether the economic data improves or not.

Conclusions?

While these two authors seem to be at odds on the surface, I was struck by the idea that their arguments are almost two sides of the same coin rather than two completely different positions. Both acknowledge that further economic weakness is a possibility, but by no means a foregone conclusion. Both note the effects of ultra-low interest rates. Both are cautious on broad indices like the S&P 500. Both advocate controlling risk using strategic asset allocation.

While Mr. Taylor offers a few ideas for equities that lie off the beaten path, Mr. Hussman tells us that his funds are currently hedged to reflect his cautious stance:

“Our primary risk estimates are now in the worst 0.5% of what we observe in historical data. We have increasingly used the word “warning” in our weekly comments for that reason.”

Each of us will, as always, approach the current environment differently according to our personal financial situation and strategic approach. Those who are already “all in” on equities will choose differently than those with very little exposure. Traders will react differently than long-term holders, although the latter may choose to rebalance soon if Mr. Hussman’s assessment of the current market as “overvalued, overbought, overbullish” eventually proves correct.

On the other hand, rebalancing doesn’t necessarily mean running for the hills, as Mr. Taylor points out. Depending on your time horizon, you don’t necessarily need to make huge changes to shift the risk profile of your portfolio. To each his or her own.

What are your thoughts on these two market views?

Related posts:

1. Bulls vs. Bears: Who’s Right?
2. Bulls vs. Bears: Q4 2011 Edition
3. Why the Economy Most Certainly Is Relevant to Investing

Recently, correlations across virtually all assets have increased. This means that diversification benefits are far sparser than they were in previous years.

~ Abraham Bailin

It’s almost Easter and many of us have thoughts of eggs and baskets running through our heads. Everyone’s looking forward to enjoying a little chocolate and some quality time with family and friends. In terms of finance, however, we often speak of eggs and baskets in the context of diversification.

Diversification means spreading your investments among asset classes that are less correlated with one another. You can put some of your money in stocks, some in bonds, commodities or real estate. The idea, of course, is that if one asset class is hit with a large decline the others will either rise or stay the same, cushioning the blow to your overall portfolio.

The Correlation Crunch

I wrote an article called No Respite in Diversification about 18 months ago. In it, I made the case that it’s becoming increasingly difficult to diversify your portfolio because correlations across almost all asset classes are rising. Recently, Morningstar came out with some data to support this idea in an article entitled A Market Lacking Diversification. (I found it via The Reformed Broker.)

In the article, Abraham Bailin notes that it’s difficult to empirically pin down an exact reason why more and more asset classes seem to trade in tandem with the S&P 500, but he offers a couple of reasonable possibilities. Real estate investment trusts (REITs) and commodities have traditionally been seen as great diversifiers, since they were not all that correlated to the stock market. In recent years, that has changed. Mr. Bailin posits that access to these markets due to the proliferation of ETFs that track them may be one reason.

Another possible reason for increased correlations may have something to do with the increasing herd mentality of fund managers, many of whom are using similar quantitative models to drive their investing behaviour. The risk-on/risk-off hokey pokey to which we’ve been witness over the past decade has money managers bailing on just about all asset classes when systemic risk rears its head and then piling back in again when some kind of tentative all clear signal is trumpeted across financial markets.

By the Numbers

Morningstar offers an informative table that examines the change in the correlation of various asset classes to the S&P 500 over the past 10 years:

You can see that correlations to the S&P 500 have increased across all asset types over the past 10 years with two notable exceptions:  treasury bonds and gold. The bond indices studied here, with the exception of the high yield index, are more negatively correlated with the S&P than they were 10 years ago, meaning their prices will tend to move in the opposite direction to the broader equity index.

Still, it’s worth noting that the height of the financial crisis saw extreme risk-off conditions that drove all asset classes – including bonds – lower. That effect, however, was very short-lived and bonds subsequently resumed their safe haven function. Having said that, I remain cautious on bonds in our own portfolio due to the fact that the bond bull market is very long in the tooth and I think other asset classes (like GICs or CDs) offer more safety for comparable returns.

The Moral of the Story

The data presented by Morningstar doesn’t mean you shouldn’t make every effort to diversify your holdings. It just means it’s getting harder to do so, and you have to be careful about using canned advice that’s well past its due date. You can no longer expect REITs or commodities or foreign equity indices to smooth out your portfolio’s performance.

Mathematically, bonds and gold are still pretty good at providing that function, although I’m sure some of us could make a case for why we may not want to hold very much of either of those asset classes. I mentioned briefly why I’m not keen on devoting a significant allocation to bonds, and the vehement, and often vitriolic debate surrounding gold will likely continue for many years to come.

The moral of the story: Be careful where you put your eggs.

Here’s hoping you find some time this weekend to forget about the kind of eggs I wrote about today and devote some serious effort to enjoying some of the things that make life worthwhile – like family, friends, and chocolate!

Your comments are always welcome.

Related posts:

1. No Respite in Diversification
2. In Praise of Imbalance
3. Financial Literacy Is Like Green Eggs and Ham

The following is a guest post by Rob Bennett. 

I knew the cause of the economic crisis before it happened.

So did Robert Shiller. And Andrew Smithers. And John Walter Russell. And Rob Arnott. And all other Valuation-Informed Indexers. If you understand that stock valuations affect long-term returns, you understand that bull markets of the size we saw in the late 1990s always cause an economic collapse a few years later.

But most do not share my perspective. Most of us are Buy-and-Holders. The Buy-and-Holders were shocked to see the events of September 2008 play out. When people are in shock, they feel a need to come up with explanations of the shocking thing that has happened to them. The 90 percent of us who don’t follow Valuation-Informed Indexing strategies began offering explanations within days of the beginning of the collapse.

The explanations fall into two categories. Liberals argued that it was the weakening of the regulation of Wall Street that caused the trouble. Conservatives pointed to recent policies that encouraged the issuance of mortgages to low-income people who in earlier days would not have qualified for such mortgages.

Neither explanation hits the nail on the head, in my assessment. Neither contains zero truth. I am a conservative. But it is my belief that in this case it is the liberals who have the better of the argument. The liberals came closer than the conservatives to getting this one right.

It is my hope that enough time has passed that we may be able to begin to make some real sense of what is going on without our fears blinding us to the realities and causing us to hold tight to our ideological security blankets.

The good thing about conservatives is that they favor fiscal integrity. So their first reaction when they heard about the crisis was to look for irresponsible spending. They found it in the new policies regarding subprime mortgages. Puzzle solved!

The problem here is that, while subprime mortgages may well have been a bad idea, it is more than a little hard to accept that the new policies on subprime mortgages would be enough to bring on a worldwide economic collapse. You might be able to make a case that it served as the straw that broke the camel’s bank. But, if that’s the case, the true cause of the crisis was the thing that added the first 10,000 straws to the camel’s back, not the last one. There is more than a bad policy regarding subprime mortgages at the root of this.

The bad thing about conservatives is that they are hyper-vigilant of mistakes made by government and hyper-tolerant of mistakes made by private companies. I once contacted a conservative blogger offering to write a guest blog entry arguing that it was the reckless promotion of Buy-and-Hold investing strategies that served as the primary cause of the crisis. He said “no.” Not because he didn’t buy the argument. He seemed generally sympathetic to it. He told me that he was saying “no” because Buy-and-Hold was not promoted by the government and thus there was no news value in identifying Buy-and-Hold as the primary cause of the crisis. Oh, my!

The good thing about liberals is that they are sensitive to the injustices that follow from excessively unequal distributions of wealth. Liberals are well aware that the financial sector has been capturing a larger share of the nation’s wealth production in recent years. That settle’s it! It’s those bad guys and gals on Wall Street who did the dirty deed!

The comedian John Stewart had a funny line re this aspect of the story. There was a debate in the early days that executives of firms in the financial sector should be denied bonuses because they would be out of work but for the bailouts they received from the U.S. taxpayers. One executive complained that, without bonuses, “we won’t be able to hold onto out best people!” Stewart observed (I’m paraphrasing) that: “You don’t seem to get it. That’s just the problem. You don’t have any best people! That’s why we’re in this mess!”

That hits close to the truth but not precisely in the way that Stewart meant the words. It’s true that Wall Street doesn’t have any “best people” today. It has plenty of smart and hardworking people, however. The problem is that smart, hardworking people learn what is in the textbooks very, very well, and we happen to be living in a time when most of what is written in the financial textbooks is outdated gibberish (Modern Portfolio Theory was discredited years ago but is still used in the analysis of financial transactions because there are so many powerful people who have made careers promoting it and who don’t want to acknowledge having made such fundamental and widely destructive mistakes).

The bad thing about liberals is that they too easily give in to the temptation to see things in us vs. them terms. Did Wall Street mess up? Big time! But Wall Street messed up by playing up to our human weakness for Get Rich Quick schemes (Buy-and-Hold is a Get Rich Quick scheme because it encourages investors to treat bull market gains as real).

The people who push Buy-and-Hold are in positions of added responsibility. So they are more to blame than the average investor. But the average investor shares in the blame. Wall Street would have stopped pushing Buy-and-Hold if we had reacted poorly to their marketing efforts. We ate it up! Liberals want to blame only the rich and that limits their ability to offer a 100 percent clear and accurate explanation for the crisis.

This shouldn’t be a liberal or conservative issue. It is in the best interests of all of us for us to see a recovery before we find ourselves in the Second Great Depression. We need to encourage liberals to be clearer and more forthright and more complete and more detailed n their assertions that Wall Street is to blame. And we need to encourage conservative to stop the government bashing long enough to demand that private firms practice the financial integrity that conservative are always happy to demand of government.

Rob Bennett often writes about investment research and the tricky tricks used to trick you. His bio is here.

Related posts:

1. Why We Are Afraid to Acknowledge the True Cause of the Economic Crisis
2. How the Leadership Void Feeds the Financial Crisis
3. 5 Economic Trends Affecting Your Money

The following is a guest post by Rob Bennett.  I’m pleased to announce that Rob will be sharing his thoughts with us here in a monthly column. Thanks Rob!

Gene Mauch was the manager of the Phillies baseball team when I was a boy growing up in Philadelphia. He once said something in an interview that has stuck with me ever since.

Mauch said that, when his team was on a winning streak, his job was to pop holes in the inflated egos of his players. When players are winning, they start thinking that they are so awesome that they can never be beat. They get sloppy. They stop doing sit-ups. They stop backing up throws. They’ve got it. They’re hot. Mauch would yell at the Phillies at such times. It was his job to bring them back to earth.

His job changed when the team was on a losing streak. The same guys who were so full of themselves a week before would now be down on themselves, certain that they would never again find the groove. They so lacked confidence that they were afraid to swing the bat with authority, afraid to take chances on the basepaths, afraid to take control of a game. At these times, Mauch would not yell, no matter how many strikeouts or errors he saw. At these times, it was his job to remind his players how great they had to have been to have made the team in the first place.

I believe in the Gene Mauch rule. It’s easy to yell at people when they mess up. Easy and dumb. People are never as incompetent as they appear to be when they are making mistakes.

And its easy to cheer people on when they are turning up aces. That’s dumb too. No one needs to be reminded of how great he is when the entire world is busy telling him how great he is. People are never so awesome as they appear to be when they are hitting all line drives.

I am a critic of Buy-and-Hold. I advocate Valuation-Informed Indexing instead. Why? Valuation-Informed Indexing is rooted in a belief in the Gene Mauch rule.

Bull markets are the stock market’s equivalent to baseball winning streaks. During bull markets, the temptation is to get overly excited about stocks, to count the phony and temporary bull market gains as permanent. Gene Mauch would not approve.

Gene Mauch would be yelling at investors who took the numbers on their portfolio statements seriously in the late 1990s. Stocks were priced at three times fair value in the late 1990s. That means that stock investors should have been expecting to see a loss of two-thirds of their accumulated wealth of a lifetime as stock prices worked their way back down to fair value in the coming years. But how many investors knew that? How many of the “experts” in this field reminded them?

Gene Mauch would have reminded them. He understood that believing in your own press releases when things are going good leads to laziness and arrogance and that laziness and arrogance lead to losses, both in baseball and in investing. We didn’t need to hear financial planners telling us how smart we were to invest in stocks in the late 1990s. We needed them to bust our bubble. If Gene Mauch had been around, he would have given a few of us a kick in the bottom.

He wouldn’t be doing that today, however.

We don’t need to be brought down a few pegs today. We need to be reassured that we are not the losers that we are coming to believe we are. Mauch would be pointing out to the investors of today that, while prices remain too high today for us to realistically expect good long-term returns just yet, things are certainly moving in the right direction. Afer the next stock crash, prices will be where they need to be for stocks to represent a strong long-term value proposition. Today’s investor should be getting prepared, not depressed.

Buy-and-Holders are like the baseball managers who are thrilled with their teams as long as they are winning and are punching lockers when they experience a losing streak. Buy-and-Holders are the Billy Martins of the investing world, getting excited over the phony profits of bull markets and looking for a place to place the blame when the phoniness inevitably takes things to a bad place. Have you noticed that the same Buy-and-Holders who praised their own genius during the bull years do not accept personal blame for the losses they have seen over the past 12 years? Wins are their doing. Losses are the fault of a bad economy.

Mauch understood that winning streaks and losing streaks are rooted in the same thing — human emotion. When things are going well, we feel confident and our performance goes up a notch. When things are going poorly, we are afraid to show our faces in public and our fears cause us to underperform. You don’t want players becoming too full of themselves during winning streaks. Those that get caught up in a phenomenon that is rooted in luck will feel all the worse when lucks turns the other way. You want your players to achieve emotional balance, to know that they are good enough to win but not good enough to win without working it hard.

So it is with investing. Valuation-Informed Indexers don’t count the phony gains of bull markets as real. When stocks are priced at three times fair value, we divide the number reported on our portfolio statement by three so that we know the real and lasting value of our portfolios. We don’t want to experience panic when things turn bad. The way to avoid panic when things turn bad is not to buy into the nonsense being told when things are going good.

Gene Mauch understood that managing a baseball team is not primarily about mastering the mechanics of hitting or pitching or fielding or running. Baseball teams are comprised of human players with human emotions. The first job of a manager is to help those humans avoid the emotional ups and downs that plague teams lacking managers as smart as Mauch.

Strategies come and go in the stock field. There’s always a new craze. Today it is Buy-and-Hold, tomorrow it will be for something else.

Emotionally balanced investing is not a craze. Valuation-Informed Indexing is the only strategy I know of that never once would have let you down over the 140 years for which we have records of stock performance. Gene Mauch was a genius.

Rob Bennett argues that IBonds are cash, new and improved! His bio is here.

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Youth is when you’re allowed to stay up late on New Year’s Eve. Middle age is when you’re forced to.

~Bill Vaughn

2011 has now passed into the annals of history. How did the financial world fare? What did we learn in the process?

2011 By the Numbers

Let’s start with a short report card on the 2011 performance of a few key indices: (You can click on each index to see the chart.)

TSX: -11.1%

S&P 500: No Change

CRB Commodity Index: -8.3%

Gold: +13.9%

Oil: +6.4%

Canadian Financials (XFN): -4.4%

U.S. Financials (XLF): -17.1%

Bonds (XBB): +9.3%

Canadian Dollar: -2.1%

Shanghai Composite: -22.6%

You can see that, although commodities in general were down for the year, gold and oil still rose. Copper was down over 20%, commensurate with the “global growth is slowing” thesis.

In general, the markets painted a picture of the quintessential secular bear market in 2011. Specifically, the S&P 500 chart maps the volatile road to nowhere that characterizes secular bears. “While the $SPX finished where it started (1257), it swung about 3238 points over the course of the year to do it.” (via @TBPInvictus)

How Did 2011 Predictions Do?

In my overview of 2011 What Ifs, I noted that sentiment was largely bullish to start the year. We had experienced quite the stock market rally off the March 2009 lows and many were anticipating a strong economic recovery and continued support from central banks and governments.

Whether you were a bull or a bear to start 2011, you could probably claim some kind of victory, for the overwhelming trend of the year seemed to be increased volatility. We regularly saw multiple percentage point moves intraday in just about every global index. Precipitous downdrafts seemed to be followed by rocket rides higher with almost alarming frequency as most traders and investors developed a chronic case of headline whiplash.

Bifurcation

I picked bifurcation as my dominant theme for 2011. Based on the underlying biflation thesis I’ve carried for the past few years, I thought we would continue to see a rising cost of living coupled with slow economic and employment growth. I also thought the U.S. housing market would remain stagnant and that we would see a growing divide between the prosperity of high and low income households.

Commodities had risen a lot since the 2008 lows and we had not yet seen the full effects of those increases at the grocery store yet. If you bought groceries in 2011, you no doubt noticed that just about everything has gone up in price by a significant margin. Energy prices remained elevated as well, adding to the strain on the average to low income consumer. Many predict that these high food prices are here for an extended stay.

I also mentioned the bifurcation we’ve witnessed between wealthier and highly indebted sovereign nations. This dichotomy came to a full boil in 2011 as the European debt crisis seemed to be in the financial headlines daily and was regularly mentioned as the one issue that could send markets tumbling or soaring depending on the headline du jour.

Interestingly, the crisis in Europe is rooted in problems caused by economic bifurcation in the Eurozone. Nations with lower debt loads are trying to figure out how to get debt-laden countries to strengthen their balance sheets without taking down the European (and global) economy or asking their own taxpayers to foot the bill in the process – no small dilemma.

Occupy & Steve Jobs

The bifurcation theme is fittingly captured by the juxtaposition of two of the major financial headline-grabbers of 2011: the Occupy movement and the passing of Apple CEO Steve Jobs. The Occupy Wall Street movement grew out of a frustration with the burgeoning divide between the ultra-rich and the not-so-rich. People seemed to have had it with watching financial scandals affect their livelihood and then witnessing the instigators of these crises walk away with multimillion dollar parting gifts rather than orange jump suits and handcuffs.

Very shortly, however, an anti-Occupy meme seemed to erupt wherein the message of the movement was misinterpreted as a wealth-hating, anti-capitalist, anti-success, and (gasp!) anti-American sentiment enounced by jealous whiners. Jamie Dimon’s “stop picking on billionaires” statements were alternately met with applause and derision depending on which side of the Occupy debate you reside. For the record, I’m with The Reformed Broker.

Compare this divisive backdrop with the unanimous grief with which the passing of Steve Jobs was met. Steve Jobs was pretty rich. And yet his loss was sincerely mourned by those who profited from Apple’s zooming stock price as well as those who could barely afford their latest devices – but wanted to buy them anyway.

Although I’ve read a few less-than-flattering articles on Mr. Jobs’ aggressive pursuit of his goals, I can’t help but think that the company he founded may be one of the last bastions of true capitalism. You see, Apple actually makes stuff – really cool gadgets that people find extremely useful in their everyday lives – at home and at work. Nobody seems to mind paying a little more for them and nobody that I know ever said Steve Jobs didn’t deserve to be very wealthy.

Contrast that with the manner in which some members of the financial elite came upon their wealth. Many have derived tremendous income from the creation of derivatives like the CDOs that sunk the subprime market or the CDS that will either protect or implode the financial system, depending on whom you ask. When these things do blow up, the financial elites escape accountability and happily leave others (taxpayers) to clean up the mess. While the financial sector is a vital component of our economy, it has become too large and too powerful. It contributes too little to the real economy and siphons too much capital for itself.

Let’s hope that the capitalist vision of a company that exists for the purpose of, and derives profits from useful contributions to society did not die along with Steve Jobs. Let’s hope that the bifurcation of 2011 someday gives way to the kind of unity engendered by the accomplishments of Mr. Jobs. Real capitalism is alive and well. We just need to cultivate it a little more and get serious about pulling those weeds. These are some of the lessons I’m taking away from 2011.

What did you learn in 2011 that you’re taking with you in 2012?

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You don’t get harmony when everybody sings the same note.

~Doug Floyd

Every so often I like to write about what the bulls are saying versus what the bears are saying. Usually, both make a pretty good case. That doesn’t make it any easier for investors to make decisions, but it does offer them some balanced information which they can then use in any way they like. Today’s bull vs. bear debate zeroes in on a few specific factors rather than presenting a comprehensive overview.

I recently  came across two differing takes on the market heading into the end of the year. The fourth quarter is often pivotal for portfolio managers as it’s their last chance to meet or beat their benchmark. Like it or not, that’s the nature of the game and it can affect markets as investors jump on trends in an attempt to cross the December 31st finish line ahead of the competition.

The Bull

Barry Ritholtz is hardly a permabull, but he began to put more cash to work around the third week in October. He explains several reasons for his Tactical Shift in Portfolios:

1. Seasonality: November and December are typically the months of the year when the stock market performs best. They kick off the seasonally best 6 months of the year, which usually run from November to April.
2. Sentiment: Excessive bearish sentiment exhibited in extremely high short interest had many hedge fund managers poorly positioned for a snap-back rally. Short-covering can ignite and propel a rally even in the absence of strong fundamental underpinnings.
3. Market History: The type of “buying panic” by investors at the beginning of October has few historical precedents. In just 5 trading days the S&P 500 shot up 11.4%. On the relatively few occasions this has happened in the past, markets experienced healthy gains in the following weeks more often than not.

But . . . Ritholtz is careful to point out that he is still a subscriber to the secular bear market thesis. He thinks “a recession is more likely than most economists expect” and that markets will eventually head lower. For the next few quarters, however, factors like seasonality and sentiment may trump economic fundamentals.

The Bear

I recently came across an interesting article that offered a compelling technical analogy between the current market environment and the one that preceded the 2008 crash. According to Short Takes, Stocks Dropped 54% After a Similar Point in 2008. If you’re into charts, this post has a few that may help to remind us that seasonality, sentiment, and history work some of the time, but that they all go by the wayside when markets truly break.

On the other hand, the fact that the charts are setting up in a similar way to those of 2008 does not make another crash a foregone conclusion. It’s just another data point to put in your arsenal for consideration. The reality is that markets can and will move in either direction over any given period of time and the only way to navigate that kind of capriciousness is to have a rigorous risk management discipline in place.

And the Winner Is . . .

Just kidding, of course. You know there’s no winner. 2011 has been a poster child for the type of volatility we would expect to see in a secular bear market. Both bulls and bears can get repeatedly whipsawed and many investors are left with a serious case of motion sickness. Neither bulls nor bears can claim a clear victory.

In this type of market, those with a solid plan and a thorough understanding of their personal risk tolerance will thrive. They will not cling to either bullish or bearish expectations, but having a pretty good understanding of the kind of ride they’re stepping onto, take appropriate precautionary measures.

Those measures may include reducing equity exposure, setting prudent stop loss levels, or buying when valuations become attractive. Investors may choose to implement any or all of the above to manage risk. In this kind of secular bear market, it’s more important to understand the investment context and perhaps more importantly, yourself than it is to track every news headline that crosses the wire.

How are you handling the volatility of 2011? Are you more optimistic heading into year end?

(Photo Credit: Shutterstock)

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Illusions commend themselves to us because they save us pain and allow us to enjoy pleasure instead. We must therefore accept it without complaint when they sometimes collide with a bit of reality against which they are dashed to pieces.

~ Sigmund Freud

November started out much the same as October. Global markets plunged. By October 4th, however, most indices had bottomed and proceeded to embark on a historic month-long rally in anticipation of some kind of tangible action to quell the Eurozone debt crisis. As of October 30th, Toronto’s TSX was up about 7.7% on the month while the S&P 500 was up a whopping 13.5%. Those gains moderated somewhat to 5.5% and just shy of 11% respectively because of the Halloween dip.

So what caused the October bounce and subsequent fall from grace? Perhaps there were just enough rumours of a Eurozone debt solution throughout October to float some hope and squeeze some shorts. Perhaps it was the improved U.S. GDP stats and hopeful earnings reports by some large U.S. corporations. Perhaps it was the prospect of China coming to the rescue with their big bag of reserves. Perhaps it was all of the above and more.

What then, caused the rather sudden Halloween reversal? The European debt framework was announced very early Thursday morning and kicked off a “face-ripping” rally across the globe. That enthusiasm had already subsided by Friday and headed decidedly in the opposite direction on Monday and Tuesday.

Why the Rally Fizzled Fast

• Voluntary Haircuts: The European debt deal supposedly included voluntary debt reductions of 50% for institutional holders of Greek bonds. Many have begun to realize that this does not mean that public bondholders like governments will offer the same haircut. Some will stick with the original 21% offer and others won’t take any haircut at all. Details are sketchy, to say the least.
• Capital-Raising Reality Check: As part of the agreement, European banks would be expected to raise capital to shore up their balance sheets. With many of their share prices having already experienced haircuts of their own, this may be easier said than done. Confidence in European banks isn’t exactly flowing freely among potential investors.
• Defining Default: If you offered to pay the bank $100,000 of your $200,000 mortgage and call it a day, would they consider your loan to be in default? You bet. It’s still unclear whether the ISDA is going to call a 50% haircut on Greek debt a default. The semantic sticking point is the word “voluntary.” I guess if banks volunteer to take the hit it’s somehow not a default?
• Credit Default Swaps: It seems like every discussion of the debt crisis comes back to those pesky, opaque, unregulated CDS. The ISDA (International Swaps and Derivatives Association) treatment of the Greek haircut reminds us of the reality that the financial system is still being held hostage by these WMDs. If the ISDA deems Greece to be in default, the CDS on those bonds will be triggered, creating a chain reaction that no one seems to truly comprehend. If they decide that Greece is not in default, then we have to ask what CDS are really good for anyway.
• Where’s My Haircut? Suppose your neighbour got away with the $100,000 discount on her mortgage. Would you maybe like to get the same deal? That’s what many are hoping Spain, Italy, Portugal, Ireland and others won’t do. It’s clear that neither the troika, the taxpayers nor the financial system can support haircuts and bailouts for all.
• China to the Rescue: Much of the market euphoria had to do with hopes that China might come to the table with a lot of money to help stem the crisis. Some think China has enough problems of its own to deal with at the moment. China itself has said that they are willing to help, but that the real responsibility for cleaning up the mess rests in Europe. The fact that China reported weaker than expected PMI data didn’t help either.
• Greek Referendum: On Monday, rumours began circulating that Greece would hold a referendum on whether or not to accept the terms of the proposed bailout. Markets didn’t like this.
• MF’s Monumental Failure: MF Global, a large brokerage and primary dealer filed for bankruptcy protection on Monday, exacerbating market fears about European contagion. With reports circulating that MF Global failed to segregate client collateral and the small matter of a missing $700 million, this news did little to help investor confidence. Don’t worry about CEO Jon Corzine though. The former Goldman Sachs CEO and New Jersey governor will reportedly receive $12 million for his stellar performance over the 19 months he headed MF Global. (And we wonder what those Occupy kids are so upset about.)

 Freudian Markets

It is often said that the bond market is a lot smarter than the stock market. Last week, when stock markets were giddy about the prospects for any kind of Euro debt fix, credit markets were still expressing skepticism. Perhaps they are once again playing superego to the stock market’s id.

The secular bear market that began in 2000 has seen its share of extreme moves both to the upside and to the downside. There have been scary declines that suddenly turn to short-killing rallies. There have also been hope-induced rocket-rides that terminate in disappointing reversals. Heck, we’ve seen all of that just in the past month.

So if we’re in the middle of a quick move lower, what could lead to the next whipsaw higher? For one thing, rumours that Greece is backtracking on the much-hated referendum idea are hitting the wires as I write this and markets, though still negative, have rallied back a little on the news. For another, the Fed could whisper QE3 again – possibly soon.

More Fed action could clobber some newly-minted short positions and light a fire under the gold price. It would be a triumph of the financial id. Hmmm … I wonder what the superego will have to say?

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