Poetry is nearer to vital truth than history.
~Plato
In our recent discussions about the Couch Potato style of investing, I mentioned that this strategy relies on historical market returns. I pointed out that including a component that reflects valuations might improve the strategy. This is basically the Valuation Informed Indexing approach about which Rob Bennett often writes.
I mentioned in my last post that I like to look at historical data regarding market performance and valuations, but that I didn’t want to rely on it completely. I’ll explain my thinking here and you guys can let me know what you think.
Past Performance Is Not Indicative of Future Results
“History is a vast early warning system.”
~Norman Cousins
One of the things about the financial services industry that always gives me a chuckle is that most advisors and fund managers will try to get you to buy their products by showing you those 100-year charts of the major indices, which of course look like they only ever go up. In the fine print of every prospectus, however, is the standard CYA phrase “Past performance is not indicative of future results.” Translation: “You need to pile into stocks because they’ve risen for 100 years, but we can’t guarantee they won’t go down after you buy. If they do, you’re on your own. (Oh – and by the way, we’ll still get paid.)”
Now I know that neither the Potato investors nor the Valuation Informed Index investors would claim that history will repeat itself exactly. They’re just using it to determine investment probabilities. That’s how I use historical data too. But I also like to incorporate a few other variables, which others may or may not find useful, but have served me well so far:
- Macroeconomic Context: I look at the economy on several levels: 1) What is happening now? 2) What’s happened over the past 10 – 20 years? 3) Where are we in the big, big picture? These are only rough time frames, but the first one might equate to the cyclical economic trend, the second, to the secular trend, and the third to much larger generational factors.
- Technical Factors: I look at technical analysis for various markets. I consider myself a novice, and I’m still refining my skills in this area. Still, when I look at a chart today, I see a lot more information than I did 10 years ago and I’ve learned to trust the charts more than the fundamentals at times. Markets reflect collective psychology and charts are the Rorschach test that maps that psychology. Interpreting them is an art, not a science.
When I look at historical data, I don’t only include market returns or valuations. I will look at charts and macroeconomic factors on multiple time frames as well. This doesn’t mean I catch every market move, get every trade right or accurately predict the future. Far from it. But I’ve managed my risk based on these factors and avoided all of the market carnage of the recent financial crises. I’ve also missed out on some of the gains. I’m OK with that because my portfolio is in the black.
Waiting for Spring
“Each time history repeats itself, the price goes up.“
~Author Unknown
In an article called Get Me Through December, I went through generational cycles based on the Kondratieff seasons. A lot of people think this is bunk, but if you actually read what’s involved in the cycles you might recognize that current economic events look very much like those in a Kondratieff winter. Check out some of the charts and see what you think.
On financial crises: Have you noticed that they’re coming with more frequency and severity? (It’s sort of like labour contractions.) This is actually in line with the idea of a Kondratieff winter and I would expect (hope?) that once “spring” arrives, we will be able to enjoy the birth of a new economic model. This one’s broken.
When I look at the balance sheet problems facing countries worldwide, I can’t help but get much more cautious with my investing approach. That’s one reason I’ve avoided investing very much in the markets for several years now. The bailouts that sparked the 2009-2011 rally did not get at the root causes of the crisis. They only served to transfer the toxic debt from bank balance sheets onto sovereign/taxpayer balance sheets.
Here’s where knowing some macroeconomic history can help our interpretation of real time events. Reinhart and Rogoff looked at “Eight Centuries of Financial Folly” in their book This Time Is Different and found that banking crises are usually followed by sovereign debt crises. I think it’s safe to say we’re there.
While you can’t anticipate every market-moving event, some are pretty obvious well in advance if you take the time to inform yourself. The recent/ongoing crises are perfect examples. It’s a little baffling that those who do the macro research necessary to anticipate these events are often called lucky when they actually come to pass. Those who were looking at a limited set of other factors and missed it feel like they (and their portfolios) were victims of collective misfortune.
Why History Only Rhymes
Mark Twain said “History doesn’t repeat itself, but it does rhyme.” So we can indeed use historical patterns as an early warning signal, but we need to remember that history cannot repeat itself exactly. Why? Because each new historical development affects the next. There are market forces that exist today that did not exist during the historical period that the data cover.
I’ll give you just a few examples of the ones I think will have the most effect on the markets in the near to medium term:
- Derivatives: If I had to choose the single biggest game-changer for how markets play out, this might be the one. Credit default swaps and other derivative products did not exist for most historically documented market periods. Many are aware that if a number of CDS were triggered, there isn’t enough cash in the system to back them. This ticking time bomb is the reason the EU officials were so intent on making sure the “partial default” by Greece was not considered a credit event. That would have triggered the CDS and a cascade of counter party risk that could bring the financial system down – again.
- The European Union: Here’s what I wrote on the topic back in May of 2010: “The European Union wasn’t established until 1993. The mechanics of 27 distinct countries operating under a single monetary policy are complicated. What if one member has run up huge debts and can’t pay them back? Should the healthier nations be obliged to rescue them?” This is one of the factors contributing to the most recent market meltdown.
- Computerized Trading: Many large financial institutions use sophisticated computer models to trade using technical analysis. This can cause a lot of extreme “risk on” and “risk off” moves in the market as similar computer models execute trades at the same time.
Diversify Your Context
While I love to use history as a guide, I’m careful not to ignore the information coming from other sources. We can’t understand every variable affecting markets at any given moment. Nor can we know the future. It’s human nature to use prior experiences as a context for future decisions and there’s nothing wrong with that. But, to borrow from an article I highlighted in 20 Cents from July, You Are Not an Equation. I’ll reproduce the money quote for you:
“In finance, people built models that use mathematics to describe markets and to describe people and the participants in the markets. And it becomes tempting for them to believe that the mathematics is a theory and forget that it’s actually an analogy [i.e. model] that only has limited extension.”
We can look at data and study history and calculate returns as much as we like, but in the end we need to try to take in as much of the whole picture as we can. Reliance on studies, statistics, and mathematics can only take you so far when you’re dealing with matters of psychology. Markets are collective psychology. That’s why trying to interpret them can often feel more like art than science and why science alone probably won’t make you a better investor. Mixing in some new contexts and a dash of common sense can help. 
To what extent do you rely on historical data to make your investment decisions? Do you consider the economic context of your portfolio?
Some interesting points to consider again
One thing I try to be careful with in looking at potential performance is not to get too far from the core of what makes a profitable business. Governments are struggling, but that’s not what we invest in (apart from certain bonds, and investors fleeing those markets would drive up prices in others). I believe there are studies showing GDP growth is not correlated with stock market performance, and we all saw in the last couple of years that the stock market did great but that didn’t give people their jobs back. Corporations have strong profits and stockpiles of cash now, so regardless of what governments can and can’t do they have a lot more options than in 2007.
We also can’t make the mistake of associating a hot industry with profitable business. As Warren Buffet points out, industries such as airlines and technology have had huge growth and delivered a lot of benefits but on the whole they lose investors’ money. We don’t invest in an economy or an entire industry, just selected businesses that have found a way to create a profit.
I know this personally since I’m in a somewhat technology-related business where the common perception would dictate that what I’m getting is impossible. I just found an advantage and used it, which is what the best businesses will do regardless of the macro environment. Many great businesses were founded in times of change when they had an opportunity to do something different. And as Thomas Stanley’s books illustrate to no end, appearances can be deceiving, since on a personal level doctors and lawyers have a lower chances of being wealthy than people like junkyard owners.
You make some excellent points. Unfortunately, I think the macro backdrop will trump – and probably hurt – corporate fundamentals this time around. I’m in the camp that thinks this is a balance sheet recession and not a normal business cycle correction. The problems we have are systemic and not related to corporate performance. (We saw in 2008 the effects of systemic problems.) I think there’s a possibility things could be worse this time as the governments who bailed out the banking system last time have now run into balance sheet problems themselves.
To their credit, it looks like many corporations have stockpiled cash in anticipation of this type of systemic problem. Many of them raised cash once the 2008 crisis settled down. I think it was only a week or two ago that many large Canadian banks successfully tapped the markets for more capital.
The type of economy you describe where innovators and those who fill market needs are rewarded is wonderful. That’s capitalism. Unfortunately, that’s not how our current system works. Capitalism means failed banks/businesses fail. Creditors take haircuts and equity holders are wiped out. That’s not how we’ve operated and that’s why BAC and several European banks are on the brink of failure again in spite of massive taxpayer bailouts just a couple of years ago.
I could go on, but I’ve already been waytoo long-winded. Thanks so much for your observations Value Indexer.
It makes me happy when I find myself in agreement with my Buy-and-Hold friends!
I of course find no fault in you doing things the way you do them, Two Cents. One of the keys to investing success is having confidence in your decisions (so that you can stick with them for the long run), And you can never have confidence in choices that you follow only because someone else recommends them and that do not really ring true in your own mind.
I believe that the Buy-and-Holders will say that there are just too many factors to consider and that, if you try to take them all into consideration, you will end up confused. That idea sounds right to me. For example, there were people who shorted stocks in 1996 because valuations were so high. They got their heads handed to them. Some of them probably concluded that for some reason or other it was going to be different this time and went back into stocks. So now they have had their heads handed to them a second time. My personal belief is that markets are perversely unpredictable in the short term so it is just not worth the effort even trying to make sense of short-term price changes.
I look at only the historical data (including the data on valuations — this is where I differ with the Buy-and-Holders). My take is that that provides me with an objective means of figuring out where things stands and thereby protects me from all the “on one hand this and on the other hand that” analysis that stock advisors are famous for. One of the things I love about Buy-and-Holders is that their focus on data and research provided us a means of escaping all that subjectivity.
I even take it a step further. Instead of using news events to determine where stocks are headed, I use stock valuation levels to figure out where the news is headed. In the aftermath of times when valuations are high, we always go to valuation levels of one-half fair value. That’s a 65 percent drop from where we are today. That tells me that we are going to see economic turmoil and political turmoil in coming years. The Buy-and-Holders will say that it is the economic and political turmoil causing the stock crashes. My view is that they have the causation backwards. There’s always political and economic turmoil when stock prices are crashing. People get upset when they lose all that Pretend Money!
The article is a fine (and balanced!) piece of work, Two Cents. It might be that I am wrong about everything, I will read your article over a few times in hopes that it will break through the block of wood that is my brain (in all seriousness, this is true for all of us — we all cling to our current beliefs for fear of accepting that we are even more vulnerable to mistakes than we realize we are). I am confident that you will get others thinking things over a bit too and that is of course a wonderful thing.
Rob
I can sympathize with everyone who thinks market moves are hard to predict. I run on the “anything can happen” principle in the short term and I’ve been confused on many occasions. Prudent risk management principles can help. The thing is, when I’ve been really baffled, I’ve stepped aside.
If I understand the buy & hold crowd, they don’t believe anyone can successfully trade actively because the market is too unpredictable. At the same time, they are willing to keep pouring money into it on the assumption that it will be higher when they need their money back again. That kind of cognitive dissonance doesn’t compute for me.
Maybe that goes to your point about not being able to stick to a strategy you really don’t believe in. I have believed for nearly 10 years now that we were on a path to significant market volatility and perhaps serial crashes due to the global debt bubble, the exponential multiplier imposed by derivatives, and the recent political tendency to throw the capitalist principle of failure under the bus. Market rallies (at times huge) have not changed my mind because the measures taken didn’t solve the problems. (A look at BJ archives should confirm that.)
Hmmm. I never thought about the idea that high valuations cause market downturns, which in turn cause political unrest. I suppose it gets to be a chicken/egg thing. Either way, I would agree that there’s significant downside to this market – based on your idea of valuations and the macro backdrop. I also think that we’ll see some huge cyclical rallies. That’s what you can expect from a secular bear market.
I’m sure some of the people reading this will say (or at least think) that I’ve got a block of wood for a brain too. Frankly, that doesn’t concern me. I’d be more than happy to change my mind if I heard a good argument. So far I haven’t, so I will invest accordingly and wish everyone well with their own investing strategies – which may or may not be better than mine.
Thanks as always for your comments Rob. I always learn something new.
Since I have a top-down perspective, I believe in using historical data to value an investment and also to determine when to buy an under-valued investment. Isn’t that what we do when we evaluate retail sales events? I choose to see the micro trends in the context of the macro trends. It is the macro trends which help us determine the probable boundaries and limits of the smaller trends. This is how they generate weather forecasts. One fund manager on TV, this morning, said we have flipped from a bull to a bear market. He could only believe that in failing to see that the last couple of years have really been a bear market rally of unusual proportions when seen in the context of micro events, but not all that unusual for previous financial (as opposed to economic) crises. To me, the real question has not been if we would suffer another major correction, but when.
Your comments here over the past year or so speak for themselves. Your call for “another major correction” looks pretty good today (unfortunately). I take a similar approach, looking at shorter term trends, but always keeping the big picture in mind. I was happy to sit out the rally over the past couple of years, although I can understand and commend those who profited from it. (If I’m not mistaken, you are in that camp.) As I always say, there’s more than one way to make money by investing and you can do anything as long as you have a risk management strategy in place.
Thanks for your contributions here Ian.
I must say that I admire my buy and hold investor friends (especially today)! I admire their discipline clinging to their strategy over the long term. They have a plan and stick to it through thick and thin and are NOT stressed (believe it or not) like many of the rest of us!
Their plan has an endgame in which risk management is built into their strategy that unfolds as a dynamic target asset diversification scheme that changes as one gets older slowly reducing the equity assets to less volatile fixed income securities. Of course, this strategy is based on historical data which largely supports this philosophy. It believes the ‘market’ though ever evolving, fluctuating, and becoming exceedingly complicated will always be smarter than any individual and will always follow probability theory and normalize over time as it has based on historical data. And that is the dictum that must be swallowed to be such a buy and hold investor! And this is fair enough and takes a certain faith.
I’ve realized that I am not an investor but instead a saver. When I examine Benjamin Graham’s book ‘Security Analysis’ and read what he wrote concerning one’s investment portfolio: “An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative”, I naturally focus on the “promises safety of principal” and my saver personality immediately majors on that aspect. I can never allow myself to lose my principal and therefore preservation of capital is the theme of my own portfolio management.
Of course, this means that I almost never beat the market. I have set myself a annual goal of four percent return (which is my own definition of Graham’s “adequate return”) on my portfolio which has been easy to obtain over the years by buying large strips etc. in the late eighties when interest rates were high. Recently, I have been happy to purchase bonds that pay 4% and have bought dividend paying stocks paying likewise. When I have bought equities (including dividend payers) I have not hesitated to profit take when my capital gain has exceeded 4%. I know that my buy and hold friends have done better and I’m fine with that. This 4% rule has allowed me to accumulate a comfortable retirement portfolio and if my health should wane I can quit working and be okay. Everyone needs a portfolio strategy plan which they need to develop when they are young which likewise has a predictable endgame they can live with.
Sounds like you have a very clear strategy that you trust to deliver the kind of return you’re looking for. I think it’s great that you identified your strengths and weaknesses and invested accordingly. I’m assuming that, like many, if you followed the buy and hold dictum, you would be nervous today. Although it sounds like you have some equity exposure, it also sounds like you’ve managed your position size to match your risk tolerance.
Thanks for sharing your ideas here Jon!