Market turbulence: Our 8 timeless principles as a guide for stock selection

Note: the information in this post is general in nature only and does not in any way constitute advice.

Individual circumstances differ, so always seek licensed advice before making investment decisions.

Turbulence ahead

We’re living through turbulent times and we have no doubts that the global economy is in for a rough period ahead.

We expect that many companies will not survive. 

We think we’re heading towards a somewhat different world ahead, and this also needs to be considered when looking at investment opportunities.

What looked like a winner 12 or 24 months ago may be so no longer.

Many fund managers have been caught with their pants down, moving to be close to fully invested for fear of ‘missing out’ on gains late in the market cycle.

It may become the best advert you ever get for managing your own money (remember the 3 Cs: cost, choice, and control).

Remember Rule #1: don’t lose money.

Today’s let’s look at how we can use our investment philosophy and the 8 timeless principles as a guide for stock selection. 

Let’s do our usual top down approach.

Opportunities are coming

Much of the world is probably shocked at the ferocious impact of the coronavirus.

And many younger investors will be taken aback by the violent stock market crashes as they unfold all around the world.

We’re not surprised by the crash, because as we said some months ago, valuations were far too high.

But on the positive side we do remain confident that at some stage (we don’t know exactly when) the world will pull together, and eventually we’ll see the coronavirus out the back door. 

Globally stocks have fallen everywhere and there’s a bit of a temptation to become the proverbial kid in a candy store.

When everything looks cheaper it’s important to remember that you need to look at the future…not the past.

What appears to cheap today may still not be a great performer in the future.

For example, we hold some reservations about banks and the finance industry more generally (we’re happy to hear the other side on this point, as always) as we think greater regulation will likely eventuate in order to avoid these hugely volatile swings in asset prices.

Stocks have become somewhat cheaper globally; or at least cheaper than they were. 

As we have seen a few cycles, as ever we recommend sticking to your investment philosophy and process.

Let’s start by looking at the regional level.

Global approach

We know the US market was expensive, and even though the CAPE has fallen from 33 to 22 we expect earnings to fall in tandem, and thus US stocks overall do not look cheap.

This doesn’t mean there are no opportunities; but as always we need to bear in mind the overall valuation of the market.

There will, however, be sectors, countries, and companies that are worthy of further consideration, both inside and outside the US.

Looking at regions we see that some of the emerging markets have become cheap, so there are some suggestions there as well.

Having already taken a knock through the Brexit disruption, UK stocks are now looking relatively good value, and dividend yields much more attractive than they once were.

Locally there will be some opportunities too.

Given the large decline in the Australian dollar to some other currencies (meaning it may not be as beneficial to buy overseas stocks) we may begin looking towards the ASX for some individual stocks, and also some ETFs which we can use to invest in overseas countries etc. (currency hedged may be desirable at this stage). 

To re-cap on the individual principles you can follow the links below:

The 4 thought principles 

(i) Systematic investing – this is the time to take a measured and considered approach.

When markets fall there’s a temptation to buy anything and everything (and yes you can do that with an ETF), but you should remain a disciple to your written investment strategy or plan.

(ii) Personality and decision making – the only folks who aren’t emotional at this stage of the cycle are investing automatons, and probably Warren Buffett…and we’re not even sure about Buffett.

Check back to your Enneagram assessment and your investment map.

Make sure you’re not being too greedy or thinking that every investment must be a ‘no-brainer’.

Because there will be losers you need to be prepared and understand that some companies and investments made today may go pear-shaped.

If you stick to the 8 principles, this will minimise your probabilities of a loss.

(iii) Market cycles and mean reversion – well, yes, we have moved a little closer to the bottom of the global market cycle, but also think about where in the cycle a company may sit.

Market valuations have become somewhat cheaper, but we’re only four weeks from the peak of the market, and there’s going to be lots of fallout ahead.

(iv) Risk hierarchy – in periods of uncertainty, ETFs can often be a safer investment than  a single company.

Yes, you can buy companies, but if you buy low enough then indexes can also deliver very solid returns over the following decade. 

The 4 action principles

(v) Asset allocation – generally speaking we’d probably recommend being conservative at first (for example, you might start with a 20-25% position in stocks).

This way you have a small portfolio already formed and you can simply choose to add to it as the outlook improves.

No, you won’t miss the significant gains by starting with a small position.

There’s a lot of misleading stuff being written by vested interests about the potential for face-ripping rallies, and making sure you don’t miss out on this great opportunity (it was also apparently a great time to invest before the crunch, which immediately negates their point).

Think first and foremost about risk, about what it would be like to lose capital.

There will be ample opportunities to deploy your cash ahead…don’t worry about that.

(vi) Buy low, sell high – this point is inherently pretty obvious.

Simply use our 8 timeless principles and their criteria, and make sure you stick to them.

Don’t try and squeeze in a ‘favourite’ or something that you just ‘know’ (feel) will be a winner.

Stick to your systematic approach as always.

(vii) Diversification – there will be opportunities in markets all around the world since the coronavirus is a global problem.

But remember to use the CAPE ratio as your guide.

We suspect there will be plenty of cheap markets in the period ahead, and therefore it might be a good idea to limit your selections to one company per market if you’re picking individual stocks, and to stick to the larger, proven, profitable, systemic companies.  

Remember adding too many companies in one basket raises your risk levels and probability of losses.

Especially in these volatile times. 

(viii) Rebalancing – given the current state of events, you’re more likely to be rebalancing by adding additional cash into the stock markets, rather than taking profits off the table.

If you aim to buy when markets are very depressed then that should help you to avoid large drops. 

Remember, just one good correction in a global recession combined with some judicious investments can help you to establish a wonderful platform for future wealth generation. 

To find out more about our coaching programs, see here.

Applying the 8 timeless principles in a bear market

A time for cool heads

It seems that many folks are increasingly hanging their hopes on daily market gyrations, which of course is utter madness writ large!

Let’s take a chill pill, and instead look to place and address current events according to our 8 timeless principles of investing.

Today we aim to show you how valuable they can be as core principles of any investment plan – especially during times of market turmoil to allow you to keep a cool head when others are apparently losing their’s.

You can also follow the links for more considered thoughts on each key principle when others (with the wrong model) have their emotions screaming at them to do something.

First, let’s look at the 4 thought principles:

1. Systematic investing

A swathe of folks have contacted us asking if it’s time to pile back in with abandon since markets have plunged.

The truth is you need consider your own situation and plan.

But for our own portfolios the answer is a resounding…no!

Why?

Because even after a 30% fall, the market is still expensive.

The US CAPE ratio is approximately 24 (and has been fast moving downwards from a high of above 33), and so while a 30% decline in Australia may feel like a lot if you’re fully invested, you need to put in context and realise that the market probably has further to fall.

Stick to your system, because this is how you beat the averages.

Don’t be tempted to break out of your written plan because these will be emotional decisions not using cool, calm logic, and patience.

And, furthermore, they will simply increase your probability of losing.

2. Personality

This is a tough one because your emotional brain will be pressing hard against your logical brain to do something. Anything!

‘Buy, sell, whatever…just DO something!’ is a common thought process.

Remember your own personality can prove to be your worst enemy here, and it’s all the more reason for you to stick to your investment plan.

Our Investment Maps for your specific personality type are designed exactly for these periods where your feelings rather than your logic are trying to seize control.

You can always email us for a free Enneagram Assessment and investment map for your personality type.

3. Market cycles/mean reversion

Needless to say, we’ve been in the late part of the market cycle for a while hence why markets have been so expensive, and they have now been trending quickly downwards.

Again, if you ignore market cycles you will lose, or at best receive average returns over the full market cycle.

Yes, you might feel like you are missing out at various points in time, but history is an excellent teacher (and also a brutal punisher if you ignore her lessons).  

3. Risk hierarchy

Risks have been very elevated for some time and it’s why we’ve had very little exposure to global markets, even though some markets such as Russia, Turkey, and Poland are relatively cheap (while the UK is now heading in that direction).

The number one rule ‘don’t lose money’ is so often forgotten when market sentiment is bullish.

Prudent and experienced investors know that risks are always higher after a strong 10-year period.

That’s why most decades show that a good 10 years is followed by a not-so-good 10 years if you don’t exhibit patience, sell at the highs, and feed back in at the lows.

With the 4 thought principles now covered off, let’s look at the 4 action principles:

5. Asset allocation

This is the time to have low exposure to stocks given the overall valuations levels.

We’re heavily in cash and in no rush to deploy it when markets are still expensive.

Might we miss out?

Sure, maybe we ‘miss out’ on the odd bear market rally.

But remember years of apparently great returns in Aussie stocks have already been wiped out in only 4 weeks, with the index falling all the way back to October 2009 levels in seemingly no time.

The bear market could yet run for months (or even much longer).

In fact we now, like Buffett, are sitting on piles of cash to deploy when and how we choose.

We can tell you it feels much better than simply hoping for markets to stop falling.

6. Buy low, sell high

A sudden 30% plus drop may feel like it must surely be a good time to buy.

In all likelihood, buying now may be early given that the CAPE ratio is still high.

Now if you look at individual stocks there may well be some that are cheap, such as in the oil sector.

But remember what Howard Marks said: buying a cheap stock in an expensive market may be a little hubristic, and although you may not realise it your initial price can fall a lot more.

7. Diversification

We always stress that diversification is useful, but it’s ineffective unless there are uncorrelated assets in the portfolio.

As as we also show, when all hell breaks loose stocks can ‘correlate to one’ and diversification within markets will not save you.

Markets have never been more correlated than they are today, and so losses will be widespread, even where and when they don’t appear to be justified.

Remember, cheap stocks and cheap markets can always get cheaper.

8. The magic of rebalancing

The timeless magic of rebalancing is what has repeatedly saved us from large losses.

Rebalancing means taking profits off the table at the highs and building cash piles for later use – to feed back in at the lows – not simply leaving funds fully invested to be swept away by large market declines.

We never really know exactly when we will deploy the cash, but we know for certain that there will always come another great time to buy as history and market cycles do repeat.

Holding cash can sometimes be painful, but it’s not nearly as bad as watching your portfolio in meltdown (leaving you with little cash to deploy when prices are at rock bottom and everything is on sale, just when markets are set to recover).

Take money off at the highs, and feed it back in at the lows.

Bringing it all together

So there you have it.

This post explains why our 8 timeless principles of of investing are an excellent and proven way of delivering solid investment returns throughout the whole market cycle, and not just when everything is doing well.

Stick with considered ‘System 2’ type thinking, and through the cycle you will comfortably outperform the averages, including market speculators, unthinking investors, and emotional investors.

To find out more about our coaching programs see here.

Requiem for a bull market

Stages of a market decline

Unless you’ve been hiding under a rock you’re probably aware that the stock markets around the world are falling.

This is what we’ve been expecting for some time.

What we didn’t predict was the reason.

Why?

Because we’re no better than anyone else at predicting the future.

What we did know for certain, however, is that expensive stock markets don’t stay expensive forever.

This is the reason why we use market cycles and mean reversion as part of our 8 timeless principles for investing.

The final grain of sand

The reason why markets fall could almost be irrelevant because we know from history that expensive markets deliver lower returns over various time horizons.

But the fundamental laws remain: low valuations lead to higher returns and vice versa.

This is the reason why we believe that an investor seeking strong returns needs to actively manage their portfolio and we want to place these returns in a historical context.

We aim to show you why buy and hold is not a performing strategy for all markets at all times (it also delivers lower returns than is often advertised).

The below statistics are for the US market and as we tell folks, the US is the big one, and when their markets decline the rest tend to follow.

Even as recently as 2018 when the US declined so did other markets (and in 2019 its bounce back was replicated across other markets too).

Long-term returns

Here’s how buy and hold can damage your portfolio if you don’t incorporate macro valuations and market cycles into your investment strategy.

Note that we’re not ‘market timers’.

But if you look at recent earnings yields instead of the potential capital growth then you will understand that markets have been too expensive for a while.

Invest accordingly.

The celebrations from last year’s 25% return have vanished in just a few weeks, with the ASX down 31% in 17 trading sessions (so far).

So much for buy and hold in all markets.

‘But there’s no alternative’ we hear the critics cry.

Well, yes, bonds may be awful, and certainly, interest rates are low.

But it’s prudent to hold cash when there’s very little to buy at a reasonable price and most stocks are expensive.

Being fully invested exposes you to a large probability of losing a lot versus a very small probability of making returns of a few per cent.

That’s what you face when the CAPE and other macro valuations are extremely high.

And that’s what history shows us.

The following excerpt is from an excellent book called Bull! by Maggie Mahar (a book we highly recommend you read):

So, your chances of holding on to extremely good returns over a long period are low – especially if you do not utilise market cycles.

Real returns from stock prices growth are lower than people think, and the geometric average return is materially lower.

Australian share prices have increased by a geometric average of around 6% per year over the past 100 years, or by around 2% after accounting for inflation.

The geometric average return is lower the frequently advertised returns because the downturns erase so much of the preceding gains, while inflation takes care of much of the rest.

This is strong evidence for buying equities when they’re cheap, and selling them when they’re not.

Requiem for a bull market

Now on to more recent events.

One could be shocked at the recent extreme volatility in markets, but we can tell you that this is fairly standard when markets are very overpriced.

This time the initial panic set in after a decade-long bull market in US stocks which generated more than 400% of gains.

It’s just plain silly to think these kind of returns will be sustained when the 10-year average returns are far below this level.

Don’t now make the mistake of watching daily moves and trying to time the market to the last cent.

In highly volatile markets it’s difficult to pick the short-term trend, but we know that because the market is expensive it will fall as high volatility happens in declining markets.

Realize that the CAPE remains high and that there’s a probability is of further significant falls once companies announce their earnings or delay their earnings guidance.

Steady, systematic investing while screening out the noise will stand you in good stead over the longer term.

What will certainly fail is jumping at every shadow or move by a market that will be very volatile. 

We’ll show why in the next few posts why our 8 timeless principles are, as ever, relevant to current events, and how they can be used to avoid large investment losses.

To find out more about our coaching programs see here.

The two phases of the bear market (Madame Guillotine strikes)

Guillotine strikes

If you’ve been following our 8 timeless principles of investing carefully then you’ve successfully avoided the initial market crunch we’ve been warning about throughout the duration of this blog.

This has been the fastest moving bear market in history for the US.

The Aussie market also recorded a 32% decline in stock valuations across 3 weeks, before snapping back sharply from its alarming losing streak during Friday’s trade.

Although this brutal guillotine strike acted as an initial shock to sentiment market valuations are still far too high.

Investors must now remain extremely wary of the key risk during the next phase of the cycle: being sandpapered to death.

Two phases of bear markets

Although history doesn’t repeat, through the cycles investor sentiment does tend to rhyme.

Here are the two phases of the bear market:

Phase one, the guillotine, has already been initiated over the past three weeks.

There then tends to follow a flicker of optimism that perhaps things mightn’t be too bad, or that hopefully markets might immediately return to normal in an orderly fashion.

But the spell has been broken, and in time phase two will follow: the sandpaper.

Whipsaw rallies

On Friday, as we anticipated and discussed here, on Friday came the first dramatic rally of the bear market.

This is normal and to be expected, and it’s what we always see in bear markets.

The sheer size of the intraday swing in Australia was unprecedented.

That shouldn’t be a surprise, since markets can reflect a certain symmetry, with short sellers covering, fund managers desperately looking for opportunities to buy in after a 32% drop, algorithms being triggered, and so on.

The fastest moving bear market we’ve experienced may well contain some of the most dramatic daily rebounds.

However, be warned, because the downtrend in investor sentiment remains firmly intact.

Bull trap sprung

Friday’s rally inevitably leads on to permabulls and optimists calling for a possible market bottom and discussing the potential for great buying opportunities.

Realistically it’s normally the same people that were also recommending buying before the crunch, so it’s not a meaningful guide from a market timing perspective.

Unfortunately, on the balance of probabilities, they’re likely to be wrong.

As we previously discussed here, volatility is a key characteristic of bear markets, with 5% daily gains featuring regularly during the tech wreck and the global financial crisis.

To elaborate further on this point, a higher level of market volatility has historically had a proven link with lower expected returns:

The current level of volatility is unprecedented in modern times, with stocks moving between 4% and 10% on every day of the past week for the first time since the Great Depression.

The market was also trading limit down one day and limit up the next, for the first time ever (the SPX will probably hit limit down early in Monday’s trade too).

These are wild and unrivalled moves, and unfortunately they do not signal a market at its bottom.

Earnings decline

Moreover, the cumulative and deleterious effects of the coronavirus have not yet even begun to be felt on the economy, let alone reflected in company earnings.

Cases have increased from 100,000 to 150,000 over the past 8 days, suggesting that countries across Europe such as France, Spain, and possibly Germany will first go into lockdown, with others to follow.

We have no reason or desire to be alarmist but should the spread of cases seen in other countries be seen in Australia, then schools and universities will be closed for a time, international travel banned, and non-essential businesses may be impacted.

The initial effects will be felt most keenly over the coming few weeks by airlines, cruise ship operators, travel agencies, hotels, and tourism resorts, among others.

But eventually the erosion of revenue and earnings will likely spread into retail and wholesale trade, construction and the trades, banks, insurance groups, other financials, and other business services.

Oil prices touching two-decade lows will also cripple the value of LNG exports, global capital investment in the energy sector, and on and on it goes.

Critically, US stocks are still trading at very frothy valuations, even after the initial guillotine phase, and this chart is before company earnings are punched lower.

The US CAPE ratio has fallen from above 33 to about 26, but in a now-likely recession scenario there’s no reason it can’t fall towards 15 (or even towards 10).

In summary the initial guillotine phase has now been initiated on stock market sentiment.

Be wary of being sandpapered to death.

Bear market volatility

Wild swings

The last couple of years have been very challenging for investors seeking value, and it has required no little patience to sit on a high allocation to cash.

US stocks are down about 20% in less than three weeks, which has afforded a few buying opportunities – including in oil stocks – for those sitting on plenty of cash.

The challenge for my personality type is to avoid getting greedy, and to keep referring back to my investment plan before acting on impulse.

The US S&P 500 had fallen from about 3,400 last month to 2,734 at today’s lows, but still the CAPE ratio was only down from 33.3 to 26.1, indicating that the market is still historically expensive.

Source: Shiller

Yes, despite all the crash headlines, markets remain expensive at this stage.

For my plan, this still demands carefully managing exposure and a heavy allocation to cash (refer back to the 8 timeless principles, including market cycles, asset allocation, and buying low).

While the wider market remains expensive, one sector which gradually looks set to offer at least some value is energy.

Crude is now pricing for a US recession, while an oil price war has seen some energy prices have moved towards the point where it might be time to put out the bucket rather than a thimble.

Elsewhere, the market remains expensive and caution is warranted.

High voltage

I’ve noticed a few younger investors questioning whether such high intraday volatility is normal.

The below chart shows the times when US stocks have experienced a gain of 5% or more in a day.

Which is to say, during the tech wreck and the global financial crisis.

During stock market meltdowns, it’s common to see the market ‘pop’ higher at various points, leading ‘permabulls’ and market optimists to declare that the worst must surely be over.

Source: Oddstats

We can also experience numerous face-burning rallies (a little like what we saw in the last hour of trade last week!).

Despite what we were taught in business and accounting school, volatility isn’t the same thing as risk.

If you have an effective asset allocation policy between stocks and cash, then volatility can be your friend, not a foe, allowing better opportunities to deploy capital.

To find out more about our coaching programs see here.

A bird in the hand

New paradigm!

‘Another old paradigm that has come back to prominence is the peak oil hypothesis. This is a theory that the world is running out of oil. Each time the oil price cycle swings up, this one reappears.

Another new paradigm concerns end of the world scenarios based on global warming.

Maybe readers will remember when the internet was going to change the world. Old industrial companies would fade away. Imagine believing that rubbish.

Lots of people who lost large chunks of capital in the 1990s did believe it.

Before that it was canals, railways, electricity, the telephone, the motor car, radio, air travel, computers and television. Why would the internet be any different?’.

Colin Nicholson, late 2006.

When Nicholson wrote this he noted that the market had entered the rampant speculation phase of the cycle, where new participants weren’t interested in boring old investing ideas, instead speculating solely on prices, increasingly with the use of leverage (due to having missed out on the strong gains earlier in the cycle).

Stock market bubbles invariably seem to involve some form of ‘new’ tech.

And since humans don’t much learn from history, we’re doomed to repeat it.

The value of a business (a bird in the hand)

Around 600 B.C. the many-fabled Aesop noted that a ‘bird in the hand is worth two in the bush’, and this ancient adage lies at the very heart of the mathematics of investment.

As Buffett said, the intrinsic value of a company is the ‘present value of the stream of cash that’s going to be generated between now and doomsday’.

Due to the future’s inherent uncertainty and opportunity cost, cash generated today is considered more valuable than promised possible profits far into the future.

At this stage of the cycle, however, new market entrant speculators are often ignorant of earnings and cashflows (heck, even revenues!), preferring to gamble purely on stock prices in the hope of making a fast buck.

It will end in the same way it always does: painfully.

The ‘death’ of fossil fuels

In recent years, to diversify my portfolio, I’ve been acquiring as many of acres of cropland as I can afford – in the UK, where it’s inheritance tax free – because it’s a tax-effective asset, which I’m confident will still be producing crops for consumption or biofuel hundreds of years from now (or at least until it’s zoned for housing).

It’s been a quiet couple of years for stock market investments from a value perspective, because the US market has been so terribly overpriced.

It can take no small amount of patience to sit in cash, when bragging rights appear to be going to those speculating in the latest tech unicorn.

In the short run, remember, and during the rampant speculation phase, money flows into whatever is popular, such as cryptocurrencies or the latest ‘new tech’ story.

For some time now the market has been a voting machine or popularity contest, with little regard paid to free cashflow or earnings.

But at some point, a switch is flicked, and a level of rationality begins to return to markets.

And when the speculative gains dry up, investors all of a sudden begin to wake up and look at what businesses are actually worth.

At this point, the market becomes a weighing machine.

Crude crash

One sector which is gradually beginning to show at least some value is energy, having been a relative underperformer for 5 of the past 6 years (and, indeed, for 15 years).

The price of Brent crude is now pricing for a US recession, with oil prices collapsing 50% since January.

Looking back through history, it’s likely that oil prices can fall even further as demand has dropped off a cliff due to the coronavirus and the widespread measures being taken to prevent its spread.

Saudi Arabia is not keen on co-operating with Russia on supply, leading to chronic downward pressure on oil prices.

In the sector CapEx and then dividends may be cut.

The ‘ESG tsunami’ has also seen institutional investors panicking and fleeing fossil fuel companies towards so-termed ‘ethical investments’ or perceived greener companies.

Yet oil and gas will still be used hundreds of years from now, and even if the world transitions towards renewable energies, by 2050 oil and natural gas will continue to dominate energy sources (with much of these fuels being provided by the US).

Statistics over stories

Having begun this year at 80% in cash and only 20% in stocks in accordance with my allocation policy, it’ll be good to see a small handful of opportunities finally emerging to deploy some capital.

A bird in the hand, remember, is worth at least two in the bush.

The dividend yields of oil supermajors such as BP and Shell are now very high (although in the short term dividends could be cut), while Suncor is another energy giant coming onto the radar of value investors.

In 2019, Occidental Petroleum – a huge corporation founded 100 years earlier, and already with annual revenues of US$18 billion and net income of US$4 billion – acquired Anadarko Petroleum for US$38 billion in a controversial transaction.

The acquisition secured Occidental’s domination of the Permian Basin, a field half the size of California which produces more than 4 million barrels of oil equivalent per day.

The deal was in part debt-financed which led to downgrades, and a swathe of cuts to CapEx.

As the ESG tsunami takes hold (‘fossil fuels are dead!’) contrarian investors can buy the combined net proved oil and gas reserves of both Occidental and Anardarko a market cap of about US$10 billion.

Once the acquisition costs and integration have washed through, as the the largest producer in the Permian Basin Occidental will be pumping out 1.4 million barrels of oil equivalent per day.

Occidental has made 182 consecutive dividend payments, although markets will likely be questioning whether such a dividend can be defended while oil prices remain low and Occidental looks to repair its balance sheet.

When oil prices revert higher, this investment will ultimately represent prodigious free cashflow and a strong dividend – a very profitable bird in the hand.

What it’s not is some claim of supposed untold riches from digital media monopolies, ride-sharing, flexible workspace, plant-based burgers, lunar exploration, or other future technologies.

As predominantly an income play, I won’t even need to look at the stock prices of oil supermajors for the next 10-20 years, except in passing to note any future buying opportunities.

But contrarian investing always just sounds so boring during the rampant speculation phase of the cycle…

Choose your own strategy

These are not stock pick recommendations, of course, merely examples of my present line of thinking.

Circumstances differ, and you mightn’t be keen on a resources investment for ethical reasons, or even interested in a company paying strong dividend streams between now and doomsday.

But these will be good long-term investments for me, and because I know that stock markets mean revert, I’ll still be keeping a lot of cash ready on the sidelines for when the tech bubble bursts (again).

Although stocks have fallen sharply for a few weeks during February and early March, the US market is still historically expensive, which for my personal investment plan still demands a high allocation to cash.

This image has an empty alt attribute; its file name is cape-1.jpg

Exposure policy

If the CAPE ratio falls to around 20, then I can gradually move more out of cash and towards 50% invested in stocks.

Only when the CAPE is below 20 would I personally look to be up to 60% invested in stocks, moving closer to 80% invested in stocks if the CAPE ratio sinks to 15 or below.

To find out more about our coaching programs, see here.

Groupthink or groupstink? (Devil take the hindmost)

The madness of men

‘I can calculate the movement of stars, but not the madness of men’.

Isaac Newton (apparently said after he lost his fortune).

The importance of this is not the quote itself.

The importance is that Newton learned the lesson the hard way – that is, after he lost his fortune.

As they say, the stock market is an expensive place to learn about yourself.

And we learn these lessons, unfortunately, when we ignore our critical faculties and simply follow the crowd.

Can the crowd be right?

In 2005, James Surowiecki wrote a book entitled The Wisdom Of Crowds, where he put forward the argument that collective knowledge from a large crowd can be superior to the knowledge of any one individual.

This can indeed be the case!

For example, he showed that when it came to guessing the weight of a cow, the average of everyone’s individual estimations was closer to the real weight than any one individual.

What Surowiecki was explaining is called the normal distribution, better known as the bell curve.

This ‘wisdom’ worked when:

• There was a diversity of opinion;
• People’s opinions are not influenced by the opinion of those around them; and
• People have access to the same knowledge

Now it’s important to ask ourselves whether these criteria apply to markets and whether we can leverage this to make solid investment returns.

Long term vs. short term

Ben Graham famously said that in the short term the stock market was a voting machine (meaning a popularity contest where everyone chases the more popular stocks), while in the long term it’s a weighing machine (meaning everyone becomes rational and sees the real value of each stock).

In other words, things go according to the popular vote until we each come to our senses and rationality returns to the market.

While it’s fair to say there is a certain level of wisdom in crowds, this is applicable only over the long term.

There are plenty of studies showing that in the short term the stock market has momentum (the voting bit) and in the long term it has mean reversion (the weighing bit).

Yes, markets may drift for a while, but generally they’re either in momentum mode or mean reversion mode.

And given the level of valuations presently, and the results from the recent few years, we think it’s pretty accurate to say we’ve been in momentum mode!

You only need to glance at the stock prices for companies such as Tesla and other unicorns to see that the market is voting, not weighing.

This momentum stems from many folks thinking the same thing.

There’s definitely a lack of the 3 criteria mentioned above for drawing any wisdom from the market at the moment!

Social physics (safety in numbers)

How can we derive some wisdom from collective behaviour where, like in the stock market, everyone seems to be on the same side of the boat?

Social physics attempts to explain collective behaviour using just a few simple rules governing individual behaviour.

Even though we all, as individuals, have free will, we’re generally constrained by both social and physical mores.

In nature these are called Murmurations – where you see a flock of birds or a school of fish all acting in concert with one another, even though any one of them could choose a different path.

Safety in numbers.

In the stock market many fund managers and individual investors will simply align themselves with the crowd.

It’s a lot safer than going it alone and risking shame and a loss of client funds by being a contrarian.

And for fund managers there is a real career risk of missing a rally and having to face angry bosses and clients about the lack of performance when the market is rising.

It’s safer and much easier for them to align with the crowd.

That way, you get to enjoy the rise, and if the market goes pear-shaped, then you’re not to blame since everyone else lost too.

This is exactly what happened in the global financial crisis (GFC).

A contrarian advisor or fund manager may look silly for what can be an extended period when they’re sitting in cash and the market is steadily climbing.

As an individual you have a tremendous advantage – you don’t have to benchmark yourself against 12-month returns, but simply look for wonderful opportunities to make money (and, importantly, not lose money).

The Great Humiliator

It can be difficult to sit by and watch everyone else boast about their returns in an industry that’s unforgiving in its ability to humiliate you.

Ken Fisher, a billionaire fund manager in the US calls the stock market The Great Humiliator.

Just when you think you have it sussed, the market delivers a crushing blow to your ego and your portfolio.

There’s an old saying in markets: there are old traders and there are bold traders, but there are no old, bold traders.

This is because experience can teach those who have not witnessed a significant market decline a painful lesson.

Remember many market bulls and commentators have their own interests at heart when they assure you that a high stock market and valuation isn’t a problem.

In addition to this, remember many of today’s hotshot managers have not lived through a recession or a serious sustained market decline.

In fact, while the GFC may feel like a distant memory – even to those of us who actually experienced it – it’s simply impossible to explain to a young investor the power of a lesson dispensed by The Great Humiliator.

Devil take the hindmost

Groupthink is a powerful, predominantly silent influence in our thinking, and more importantly our decision making.

That’s because we seldom act alone without any influence from others.

Ignoring others is hard since we are social animals, designed to live in packs.

So naturally we tend to check to see what others are doing.

There are several excellent reads available to give you a history of economic madness and the severe lack of wisdom of crowds.

Charles Mackay wrote Extraordinary Popular Delusions and the Madness of Crowds detailing some of the bubbles and what they looked like.

Edward Chancellor’s Devil Take The Hindmost is also an excellent source, as is Charles Kindleberger’s Manias, Panics, and Crashes.

All of these books will give you a splendid view of history and force you to understand that markets cycle, and that there’s little to be gained from simply following the crowd.

Superior investors such as Warren Buffett, Howard Marks, and George Soros have seen it all before, and their out-performance comes from their experience and ability to ignore the crowd and await the inevitable crunch.

And then they put their previous build-up of cash to more profitable use.

Work out your own strategy and look after your own interests first.

Don’t succumb to the general madness or apparent wisdom of the crowd by overstaying your welcome.

What are your expected returns? (earnings vs. capital gains)

Expected returns

How do how do you think your portfolio will perform over the next few years?

Do you have a figure in mind?

10% per annum?

15%?

5%?

Most people don’t have an expected return, and if they do, it’s not always based on any solid understanding of markets, but derived from averages, what their advisor thinks, or what’s being bandied about in the mainstream media.

And when economists are asked what the expected return might be, they seldom talk about the changes in the earnings yield, but give a figure based on, say, the level of the ASX 200 index.

So if the index is currently at 7,100, they’ll take a stab in the dark at a new figure, say 7,800, for a rise of 10% next year.

It tells you nothing useful, really.

For one thing, the guesses can miss by as much as 50%, even over a short time horizon, as we saw in 2008.

More pertinently, they say nothing about the expected returns over the coming decade, which is close to zero in real terms from such a high level.

You might feel a little differently if they said ‘we think the dividend yield will shrink, and you’ll pay more for it by December’.

To understand the composition of stock market returns you need to look at both the expected return and the capital gain.

Much the same way folks do with an investment property.

It’s the vital interplay between price, which is what you pay, and value, which is what you get (yes, we did steal that from Warren Buffett).

Price versus value

Let’s look at how we can see the difference between price and value (really, it’s about expected returns).

Look at the diagram below.

There’s a benefit to waiting for an opportunity to invest at a higher expected return, even if you waited for years, and even if the expected return is only a few per cent higher.

And the higher expected return (the value bit) relates directly to the price you pay.

So the less you pay the more value you get.

If you start out investing when the expected return is relatively high then you will make plenty more money over the investment’s lifetime.

That means staying focused on what the expected return on offer is.

And that is, in turn, tied to the price you pay for the investment.

The good news is that, while it’s never an exact science, there are valuation tools and measures you can use to calculate an approximate expected return (in 2020 expected returns are low in Australia and the US, but higher in some other markets).

The good news is that markets are mean reverting, and good opportunities always come around (and about every dozen years or so, on average, we tend to see amazing opportunities).

Numerical example

A simple example should suffice – if you pay $1 to receive a 10 cent dividend then your return is a healthy 10%.

But paying $2 for the same 10 cent dividend means you are only generating 5%.

Heaven forbid, if you pay $6 for the same stock then the yield is awful (hello US stocks).

The finance industry may still say you should expect an ‘average’ return of 8%, but this is a fallacy at such extreme prices, and perhaps even intellectually dishonest.

But, this is what happens.

In the stock market as the price rises, you are getting less in the way of dividends, and therefore the higher the market rises the lower your expected return should be.

Why?

Because you’re paying more to get the dividend.

If you’re like most people, you probably had a pretty good year in investing in 2019, with the local Aussie markets rising by about 20-25%.

So most folks in the finance field are now feeling pretty chirpy.

Markets up, so everyone’s happy.

But what does that great increase mean?

Remember what we just said – higher prices means lower returns.

Ah yes, you say, but I get the capital gains as well.

Well, yes…if prices go up, which itself is questionable, and if you sell.

If you don’t sell and you’re a buy and hold investor (as you may be in your superannuation fund account), then the capital gain is largely irrelevant since you’re a long term holder – so the capital gain looks nice on paper, but what you really want is to generate a great return on your initial investment.

Thus, lower prices are better, not higher prices.

In fact, it makes complete sense to want lower starting prices because you get a greater expected return.

When markets are bullish and heading north, many forget the shrinking expected return and get too excited about the capital gain, and so the cycle turns.

Mean reversion applies

We know that markets mean revert and so at some stage the market will decline (in capital value).

But somewhat paradoxically you should rejoice because this means you’re being offered a cheaper price for the value that you will get (usually expressed via the dividend).

In order to do that, some investors will be better off selling some of their stocks at the current high prices, placing the capital gain in the cash tin for a while, and awaiting the next opportunity when Mr. Market offers you a better expected return.

‘Market timing doesn’t work’ you may say?

Well, sort of – it’s not about picking exact months for markets to peak or decline.

It means simply seeking opportunities to make every dollar work as hard for you as possible at higher rates of return.

You can think of your hard-earned dollars as employees going out to work for you.

It’s fine if you only want them to earn 0-4% each year, but it’s much more lucrative if they’re expecting to earn 12-20%.

After all, this is what the world’s best investors do – Warren Buffett, George Soros, and others – buy the cheap, and sell the expensive.

The diagram above shows that even compounding at a slightly higher rate delivers excellent returns over a shorter period because you’re getting a good deal of value via paying a cheaper price.

So when it comes to markets don’t just check what the capital gain is, because that’s only useful if you sell and collect the gain.

If you’re planning to be in the markets for a long time, it’s wise to focus on both the price and the value you are receiving.

Check the expected return (e.g. what the earnings yield or dividend return is) and use the CAPE ratio to figure out how markets might fare over the next 10-20 years.

If the return is shrinking then smart investors think about rebalancing some of their portfolio into cash to await the next offer that comes around with higher expected returns.

It takes a bit of patience, but history says they’ll be rewarded.

Winning systematically with Fortune’s formula

When timing is everything

When Ed Thorp, the famous billionaire money manager, wanted to test his gambling theory of how to beat the dealer, he started out by card counting at the casinos.

In those days casinos only used a 52-card deck, and when the deck was exhausted the house shuffled and started again.

This allowed Thorp and his partner Claude Shannon to understand that if they knew which cards were already ‘dead’ then the odds on the current hand they were dealt would change.

If all four Aces were already out of the pack, for example, then there was no point calculating the odds of a win based on the appearance of another Ace.

Thus the probability of success was slightly altered. 

Playing the probabilities

A simple example: let’s say you’re playing Blackjack, and you’re dealt a King, and so to get 21 or Blackjack, you need an Ace.

Now imagine it’s the first hand of a fresh deck and so there are 51 cards left (52 minus your King) and so there are 4 Aces in 51 cards.

The probability of drawing an Ace is low.

Now imagine the same hand but it comes nearer the end of the deck, and you know that there are still 4 Aces among the 10 remaining cards.

This increases the probability of drawing an Ace and thus winning the hand.

Thorp understood that in these cases where the probability was higher, it was profitable to bet a larger amount.

How much to bet, though?

The Kelly Criterion

Thorp went on to help create and modify what is now often known as the Kelly Criterion.

Put simply, when you know as an investor the odds are heavily in your favour (a bit like card counting) then you should bet more accordingly (but not so aggressively that you damage your account!).

It doesn’t mean you will win every time, but Kelly and Thorp developed a mathematical formula which demonstrated that if you bet according to the your odds (or probability of winning) then your wealth would end up far in front…and by a greater and greater amount over time.

Source: Poundstone

Why is this important?

Because if you think of your capital as a series of bets, and bet only when the odds in your favour – with appropriate position sizing – your wealth in real terms will accelerate much faster than if you blindly bet the same amount regardless of the odds.

Aiming for each and every dollar invested to work harder is a key reason Buffett has generated such enormous wealth over the decades.

Buffett famously invested 40% of his partnership’s capital in American Express in 1963 after its stock had halved during the ‘Salad Oil’ scandal.

Buffett doesn’t remain fully invested at all times, and he doesn’t bet the same amount each time he invests, which is one of the ‘secrets’ to his enormous wealth.

Unfair advantage

In many gambling situations, such as over a long series of Blackjack hands and only betting when the odds were in your favour (generally better than 50/50), you would, on average, succeed in winning more than losing.

Once the casinos wised up to what Shannon and Thorp were up to they created larger decks to make card counting harder. 

Why were the casinos forced to respond?

Because card counting worked by tilting the odds in the gambler’s favour.

Not just once, but systematically. 

Card counting is banned because it gives the gambler an ‘unfair’ advantage. 

It worked because you could use updated knowledge (the ‘new’ number of cards left in the deck to calculate a new probability of success after every hand) to connect the present to the past.

As with card counting, what has happened in the past affects your current and future prospects in stock markets.

Know your history!

Fortune’s formula

After making some money, Thorp sought other fields of gambling where he could test out his theories.

He developed a mathematical formula and a way to wager using knowledge and probabilities to determine a rate of success.

Thorp developed what is now often known as the Kelly Criterion or ‘Fortune’s formula’.

After a few years of winning and developing the formula further, he came to the stock market, and was tremendously successful as a hedge fund investor, obliterating the index return.

Thorp was able to compound his wealth dramatically faster than the index, by using the Kelly Criterion.

Back to card counting

Gamblers counted cards because they realised that the outcome of previous hands influences your probability of success in the current hand.

Imagine being dealt a hand with a high probability of success. 

If you don’t know what cards are already out of the deck through previous hands you can’t really calculate the odds of drawing a card you want.

However if you’ve been card counting and realise the odds are in your favour then you should place a larger bet.

Why bet a larger amount on this particular hand? 

Because you know when there are 10s, Jacks, Queens, and Kings left in the remaining cards and when the probability of a win is higher.

But that’s looking at the odds in isolation…

Thinking in 10-year timeframes

Investing doesn’t quite present the same dynamic.

You must account carefully for what has happened previously, a bit like listening to the echoes from the Big Bang.

Benoît Mandelbrot showed that stocks have a long memory, and in turn that markets are not always efficient (see Long Term Dependence, and the Hurst exponent).

If you’re an investor seeking favourable bets then you need to look at the expected returns given what has gone on in the past.

10 years of history is a somewhat subjective figure, but it does have an accord with the business cycle, and so Ben Graham and later Robert Shiller invented the CAPE ratio to account for the previous ‘echo’, and the influence it has on future returns.

So investing now is not quite the same as playing the current hand and ignoring the cards that are no dead and no longer available.

What’s happened in the past significantly influences the present – like echoes of the Big Bang it fades, of course, the longer it goes on, but still it pays a key influence.

3 key rules

If investors in US stocks have made a wonderful 400% of gains since 2009, how long will it be before they start living like they have made 400% and cash in their gains, driving prices lower?

You’d be surprised at how alike we are in our behaviour.

As Robert Shiller stated: ‘the folks who are responsible for the bull market don’t realise they are the same folks that cause the bear market’. 

There are 3 important takeaways here:

  1. Be patient – you can’t and won’t win every hand. But there will be opportunities when the odds are heavily in your favour. As Buffett is fond of saying – you don’t have to swing at every pitch;
  2. Bet accordingly – Following rule #1 above means that when the odds do come in your favour then you should bet accordingly. This is why we like using the CAPE ratio, because it tells us when the odds have swung in our favour; and
  3. It does mean that there will be hands where we miss out on a ‘win’ – but still we always think in probabilities.

Probability in investing

There are two fields in probability. 

Some forms of gambling are games where the probability and the odds can be calculated – like cards, horse racing, and lotto, for example.

But investing is a little different.

It’s more to do with uncertainty – you don’t know with any degree of certainty what the payoff will be if you outlay a bet today. 

Bayesian probability

When investing you must update your knowledge and calculate the ‘new’ odds given what has happened previously.

The CAPE ratio gives us a good reading on what to expect because it uses a smoothed 10-year timeframe (you can use others if you wish, but the 10-year has a good correlation with actual investment returns).

But what else you can do to improve your chances of a positive return, such as when card counting?

Look at the situation you are currently faced with and see what has happened in the past.

In investing we know that history won’t repeat, but it does rhyme.

We argue that investing in stock markets is far more favourable given that you can’t easily lose your entire stake on one hand as you can in a card game.

Cards are more independent in the sense that each hand has only a small influence on the odds for the next hand.

We know stock markets around the world rise and fall, however, and so we can look at history (our informational advantage) and determine that they don’t all go to zero (losing every hand).

Therefore you can simply adjust your allocation to ensure that you survive to play the strong Aces hand each time it comes up.

And we know from history that the bigger opportunities will come up, thanks to the patterns of stock market behaviour (market cycles and mean reversion).

At the time of writing we believe the odds are not very favourable in many developed markets.

Buffett, for example, is holding US$128 billion in cash at the moment – a huge percentage share of his capital – and that tells you he’s waiting patiently for the fat pitch.

He wants to make his money work harder.

It’s Fortune’s formula.

To find out more about our coaching programs see here.

Value investing for income (NOT speculating)

Investing for income

Many global stock markets have moved into the rampant speculation phase of the cycle, whereby nearly all of the focus and talk is about speculating for capital growth.

It will end nastily, as it always does.

But how does one invest for income in the meantime, while patiently waiting for sanity to return to global prices?

Today, a brief look at some of the recent investments we’ve made in line with our 8 timeless investment principles.

Of course, these are not recommendations or advice, because individual circumstances differ; they’re merely examples to demonstrate a few of our thought processes.

Contrarian investing

At the time of writing the dividend yield on the S&P 500 is close to a record low at an appalling 1.7%, which means that investing for income in the US is very difficult.

Speculation is rife.

To get better results than average, you have to do something different from the herd, so let’s take a look at how that might be done.

Start with our timeless principles of market cycles and mean reversion, and buying low.

A starting point, for example, might be to look at the sectors that have been out of favour.

For those with no ethical filter or boundaries, you might start with the hated tobacco stocks such as Imperial Brands or British American Tobacco…however, these are off limits for many of us!

Energy has also been amongst the worst performing US sectors for 3 years in a row (and for 5 years out of the past 6), while tech has been soaring.

This is not without reason, as the ESG juggernaut (and associated virtue-signalling) gathers momentum, and fundies scramble towards perceived ‘ethical’ investments.

After a relatively barren run since 2010, energy may be a place to begin looking for value (even still, none of the S&P 500 sectors is actually cheap at the present time).

Within the energy sector, oil and petroleum stocks have been unloved, including mature ‘supermajors’, giving rise to potentially strong dividend yields.

Managing the risk hierarchy

Now, remember the risk hierarchy.

If you’re concerned about company-specific risk, it may be safer for you to consider a diversified ETF, instead of individual stocks.

If you are going to accept company-specific risk then ideally we like to look for companies that:

-are well established

-have reasonably low and manageable debt

-have a long track record of strong revenues, earnings, and dividends

-are large, systemic type companies

Oil plays

Following a botched acquisition (and admittedly some swollen debt-related challenges), Occidental Petroleum was one hated stock which is coming on to our radar (another such an energy giant is Suncor).

Occidental has been around for 99 years, and with a dividend yield of about 9% looks to be a decent 10-20 year investment, as well as a medium-term bet on oil price upside.

FTSE-listed oil supermajor BP has seen its stock price fall back to 1996 levels, which Shell has faced a similar predicament.

Nobody knows where the price goes in the short term given the ESG tsunami and stalling Chinese and global economies, but with strong annual income such investments can now go into the bottom draw for the next 10-20 years (or until a great opportunity to sell comes around).

Income!

The US market is still very expensive in general, however, hence we’ve looked further afield…

Russian monopoly

Now if you can combine out of favour sectors with out of favour countries, then you can really get supercharged results.

As noted previously, Russia’s stock market was annihilated in 2014 in the face of international sanctions and a currency crisis, and this threw up wonderful value opportunities as investors exited the markets in droves.

Looking at the globally out of favour sectors within Russia ultimately brought us to repeatedly buying into Gazprom with a yield of about 7-8% and a PE ratio of about 2-3.

Just a little background.

Gazprom is the world’s largest producer of natural gas, with enormous reserves.

Russia has the world’s largest gas reserves, and Gazprom accounts about 83% of Russian production.

The behemoth Gazprom is majority owned by the Russian government, supplies gas right across Europe to 25 countries, and employs about 500,000 people.

In other words, it ain’t going anywhere.

Despite having one of the lowest payout ratios in the sector, having had a PE ratio running below 3, the income is now fairly gushing to patient investors.

And although it took a couple of years to take off, the stock price has also comfortably more than doubled (although it’s still relatively cheap, even now).

Cycles repeat

To recap, these are not recommendations, but brief insights into workable ways to invest safely for income, at a stage in the cycle when most people are nervously speculating on a bit of further price growth.

If you’re not comfortable taking on company-specific risk then you don’t need to; you can easily invest in country or sector ETFs instead, for example.

To get better than average results and generate wealth-producing rates of return, you need to jettison the idea of benchmarking yourself against the 12-month returns from any given index.

Such calendar-driven results are meaningless, unless you only have a 1-year timeframe for generating wealth (which you don’t).

See the big picture and remember Rule #1: don’t lose money.

That’s how you become wealthy: by not losing money on expensive investments.

Remember, in cheap markets, you can hoist the mainsail and let the tailwind carry you along.

When markets are historically expensive, you need to protect your capital, and when there’s a headwind this means you’ll need to work a bit harder to generate steady returns.

To find out more about our coaching programs see here.