Imagine the stock market as a national park with just three kinds of animals: bulls, bears, and pigs. The saying “bulls make money, bears make money, pigs get slaughtered” conveys the idea that one can be bullish or bearish and be successful depending on the market environment, whereas greedy pigs are almost always set up for catastrophe.

Over the course of secular market cycles, the number of “animals in the park” varies greatly. Near secular market peaks such as those found in the U.S. in 1929, 1965, and 2000– there tends to not only be a lot of animals in the park, but they tend to mostly be bulls, with a healthy pig population, most of whom have falsely conceived of themselves as bulls. The bears are in the park; after all, most of them are converted bulls who have come to believe the ride is over, but they are simply on the sidelines, or in hibernation, waiting patiently for better opportunities. Conversely, near secular market bottoms, such as 1920, 1942, and 1982, not only are there not very many bulls, and practically no pigs, there just aren’t many animals left in the park period. During true secular stock market bottoms, there just aren’t many interested parties around any more. It is not fear or greed which dominates, but total indifference. I guess that’s why nobody hears the bell go off.

Howard Marks off the mark?

I believe Howard Marks is one of the most successful investors around today and I always appreciate his clear-sighted and clearly written memos. I’m sure he would agree however, that his views are not infallible and I believe now is one of those times where he is missing the mark. In a March 13, 2013 memo titled The Outlook for Equities, Mr. Marks revisits his “three stages of bull and bear markets” to assess where the U.S. stock market stands in the behavioral continuum from bull to bear market. This type of analysis is essential as accurately assessing sentiment gives one insight into the relative eagerness of buyers and sellers– and which camp is likely to have a more dominant influence on prices going forward:

“the study of market history only makes us better investors if it teaches us how to assess conditions as they are, rather than in retrospect. (…) a year ago, it was my feeling that equities were in the first stage of a bull market. Experience had been so bad for so long– and the level of dinsinterest was so high– that only a few investors thought equities could ever catch on again. No one should say the likelihood of improvement is entirely unrecognized today, as would have to be the case for this to still be stage one. I think the existence of improvement is generally accepted, but that acceptance is neither extremely widespread nor terribly overdone. Thus I’d say we’re somewhere in the first half of stage two. (…) when attitudes are moderate and allocations are low, like I feel is currently the case with equities, there’s little likelihood of investing being a big mistake.”

Howard Marks is hardly the only one suggesting that skepticism is high, Barry Ritholz discusses in Exuberance? Euphoria? Hardly . . . the idea that “since 2009, this continues to the most hated rally in market history. Until that changes, I suspect it has farther to run.”

The fact is that apart from some data on pension fund allocations, which I’ll discuss below, anecdotes that skepticism is high, expectations and participation are low, cash remains on the sidelines and the like, are only anecdotes. Not only are they anecdotes that market bulls like to share with one another (don’t worry, us bears have our own anecdotes that help get us fired up too) but they can be uniformly refuted with quantifiable evidence about actual positioning of traders and money managers as well as sentiment surveys.

What Howard Marks, Barry Ritholz, and other very smart, experienced, and observant investors are missing is a structural or secular shift in what bull and bear market attitudes look like. When there is not only a cyclical continuum between fear and greed, but a secular continuum between indifference and prevalence, one must look at past long-term cycles both domestically and in foreign countries, to help truly “assess conditions as they are.”

Different, but similar

Of course, the bulls are right that sentiment today is not the same as it was at other market tops over the last 13 years. Day trading is no longer a national past-time, cocktail party conversations rarely center around hot stocks,  and there are not many 27 year old sub-prime mortgage traders driving Lamborghinis. However, that is no argument that we’ll ever get to that kind of sentiment before stocks top out again.  In fact, if we continue on down the line of this long-term bear market, the one thing we can expect is each successive peak coming with less exuberance than the prior one, until there is very little exuberance or interest at all, even when the market does rise.  With that said, the currently quantifiable sentiment measures are certainly lop-sided enough to produce a major top concurrent with what John Hussman calls “over-bullish” conditions.

Mutual fund cash as a % of assets is near the all time low of 3.5% and at similar levels as 2007, 2000, and 1972 which saw subsequent declines of 46%, 43%, and 56%. Conversely, major market lows of 1974, 1982, and 1990 all saw mutual fund cash levels over 10%. The Wall Street Journal reported that number of bond funds which own stocks has climbed to 352 up 25% in the last year and the highest number in 18 years.

The net commercial hedger position in all stock index futures combined (inversely plotted) is now at a record dollar value of $55 billion net short. This means that speculators hold a record net long position valued at $55 billion, about the level of late 2006/2007.

source: www.sentimentrader.com

The total amount of margin debt at NYSE member firms is back to near-record levels, reaching or exceeding peaks last seen in 2000 and  2007.

The correlation of long-short equity “hedge” funds monthly performance has risen to 0.9, meaning they are mostly betting on a market advance.

Additionally, various surveys of manager and advisor positions are showing elevated levels of bullishness. The National Association of Active Investment Managers sentiment survey, which asks investment managers whether they are long or short, hit a levered long position of 104% for the first time ever earlier this year and is just off that mark now.

A similar message is conveyed by the Hulbert Newsletter Writers Stock Sentiment survey

and the and Consensus Inc. % Bulls survey

Last, but not least, is the Barron’s Big Money survey, the cover of which featured a Bull on a pogo stick

Even so, the managers aren’t just bullish on U.S. stocks, but on equities generally. Some call it the TINA trade, for “there is no alternative” to stocks in a slow-growth, ultra-low interest rate world. Eighty-six percent of poll respondents are bullish on stocks for the next 12 months, and a whopping 94% like what they see for the next five years. Real estate has similar approval ratings.

As a reminder of what sort of indicator the cover of Barron’s featuring a bull might be, a picture courtesy of John Hussman is worth a thousand words.

source: www.hussmanfunds.com

In Barry Ritholz’s May 8th piece, Exuberance? Euphoria? Hardly . . . he writes

While I keep hearing some people claim there is an excess of giddiness, please excuse me for failing to see it. My frame of reference is the 1999-2000 top, and I certainly do not see anything remotely resembling that sort of sentiment…Remember the Dow 10,000 hats on CNBC? The insane expense accounts, lavish spending? The forecasts of Dow 36,000?

We’ll have to forgive Barry for missing the March 7, 2013 op-ed in Bloomberg, Market Record Shows How to Get to Dow 36,000 where the author of the now infamous 1999 book “Dow 36,000″ reminds us

From its low of 6,547 on March 9, 2009, the Dow has risen 117 percent. Another 117 percent in four years would put it at 31,022, just 16 percentage points shy of the magic number.

You can judge the author’s logic and credentials for yourself, but I can’t resist to mention that he is the Executive Director of the George W. Bush Institute, the standards for analytic rigor being what they are.

Yet despite all this quantifiable evidence that sentiment is well entrenched on the bullish end of the spectrum, something is clearly different. Individuals, the so called “mom and pop” investors just don’t seem to be participating, the “wealth effect” of rising asset prices does not seem to be driving economic growth, and overall interest in the finance market “game” just isn’t there. This is what Howard Marks, Barry Ritholz and others are seeing and if they are waiting for a return to the same prevalence of bullish sentiment, they will be waiting for a very long time.

http://www.zerohedge.com/news/2013-04-24/cnbc-viewership-plunges-eight-year-lows

Secular markets: from prevalence to indifference 

Secular market cycles are driven by many things including demographics and generational attitudes towards risk and investing. Stock market valuations, and thus stock market returns, are driven by the propensity to own equities. The propensity to own stocks is driven by a large share of folks in their peak earnings and savings years AND a favorable view of those folks towards the benefit of owning stocks. In other words, if a large share of the population has sufficient savings to invest and have mainly only experienced bull markets with above average returns, they will continue to invest incremental savings into stocks. Conversely, if a larger share is retiring and spending down their investment assets and/or are no longer enamored with the returns they have been receiving, they will continue to sell their stocks and move out of the market.

This is why there is a well documented relationship between market valuations (P/E ratio), and the ratio of 40 year old (savers and stock buyers) to 60 year olds (spenders and stock sellers), called the M/O ratio.

San Francisco Fed

It is instructive to look at how households and pension funds (in which households hold a significant portion of investment assets) allocate among stocks, bonds, and cash and how that allocation changes over time. I think most would agree that a very high allocation to stocks is a negative indicator of future returns as there are fewer incremental dollars to be allocated toward stocks and that low allocation to stocks represents an opportunity for future investment and returns.

Many investors and commentators point to the decline in stock allocations among US. pensions and households over the last 13 years as evidence that there remains a high degree of skepticism and money on the sidelines that will find its way into the market. One such chart, courtesy of Barry Ritholz, shows the asset allocation survey results from the American Association of Individual Investors which asks what percentage investors are allocating to stocks.

www.ritholz.com

This chart shows the relative weighting to equities from the “historical average”– 1987  to date of 60%. What the chart does not show is that the “average” is always changing and in the case of the last 13 years, it is declining, just as it was rising during the 1990′s.  Thus, today’s roughly 63% allocation for these folks may actually represent an overweight to a new future average which could be quite lower. How much lower? Let’s look at some data from the OECD on household assets and pension fund allocations.

source: OECD; Sitka Pacific Capital Management, LLC

Direct ownership of U.S. equities represents approximately 32% of household assets. When we add mutual and pension funds (likely a blend of stocks and bonds around 50%), we get a total right around 50% of financial assets allocated to equities in one form or another. Compare this to 2000, when, according to the OECD, direct ownership of stocks alone accounted for 50.1% and the net allocation to equities was closer to 65%.

Contrast these levels of stock ownership with a country like Japan where total equity allocations are below 10%. Japan is real-time evidence of the power of a secular indifference to equities that spans a generation with a low propensity to own stocks. This is what a secular low for sentiment looks like.

Note the wide variation of asset allocation inside of pension funds around the globe. For example, according to the OECD, from 2001 to 2011, pension fund allocations to stocks fell in the U.S. from 54.6% to  48.1%, which may be a sign of the first leg of a secular bear market, whereas allocations in Japanese pension funds fell from over 27% to approximately 9%, surely the sign of a more advanced secular bear market driven by demographics and a two decade long response to a credit bubble .

An excellent report from the McKinsey Global Institute “The Emerging Equity Gap” highlights how asset allocation has trended over time in various countries. For example, at previous generational lows and subsequent secular bull markets in the U.S., allocations to stocks stood between 25% and 35%, a full 1/2 to 2/3 lower than the previous bull market peak. Similarly, Japanese household equity allocations have dropped over 2/3 from the peak in 1988, from 31% to under 10% today. So if history is any guide, we can expect a further move away from equities in the U.S., much greater than what we have seen so far.

Data from the Investment Company Institute (ICI) and others supports the view that what we are seeing is not simply a cyclically diminished appetite for equities, but a secular or structural one which will only be healed with passage of time and a restoration of value in the markets, as opposed to a continued rise which is what market bulls seem to be looking for. Ordinarily, and particularly during secular bull markets, there is a positive correlation between market returns and fund flows. That is why Howard Marks, among others, observes “a move upward can be powered by a switch from the fear of losing money to the fear of missing opportunity.” However, since 2009 in a rally that has produced triple digit returns, we have seen a  net cumulative outflow from equity funds.

The idea is supported by attitudes and actions of investors across generations as reported in a variety of recent articles:

• among 401(k) participants in their fifties in 2001, 46% had more than 80 percent of their 401(k) accounts invested in equities As of 2011, only 25% of  401(k) participants in their fifties had more than 80 percent of their accounts invested in equities. (ICI)
• in a survey of nearly 1,000 Gen Y investors with more than $100,000 worth of investible assets, 52% of the respondents agreed with the statement: “I will never feel comfortable investing in the stock market” vs 23% for all age groups, and collectively held a 33% allocation to cash, more than any other age group. (MFS Investment Management)
• in a survey of approximately 600 higher education employees across Generation Y (ages 21-32), Generation X (ages 33-46) and Baby Boomers (ages 47-65), younger employees were found to be using the same asset allocation strategies as their older counterparts, with Gen Y using a similar asset mix (50% stock, 35% bond/annuity and 15% cash) as Gen X and Baby Boomers. (Fidelity)

Finally, in a study titled “Depression Babies: Do Marcroeconomic Experiences Affect Risk Taking,” Ulrike Malmendier and Stefan Nagel found that people who have experienced low stock-market returns throughout their lives are more pessimistic about future returns and subsequently less likely to invest in stocks. Given a shorter frame of reference to draw on, young people are especially prone to making decisions based on recent events. While the memory of past events fade over time and are replaced by new experiences, the researchers use periods lasting 20-50 years to find a correlation between past return experiences, future expectations, and stock market participation.

Stop and imagine for a minute what it is like to be a 35 year old saver. You became of aware of the market just as it was peaking (you may have even bought JDSU for $330/share from your dorm room in 2000 as I did) and have seen the ugly side of two bubbles, but fortunately have had very little savings to put into the markets. You have watched the value of your parents retirement portfolio stagnate and their U.S. stocks lose real purchasing power over the last 13 years as they push off the prospect of retirement. You have seen evidence of significant fraud and malfeasance as well as general greediness and ineptitude that accompanies every period of market excess. Add to that general mistrust, a lack of confidence in Wall Street bankers and those in Washington charged with overseeing them, a debt and deficit profile that reduces the prospect of receiving material support from social security, coupled with rapidly expanding income inequality benefiting the top 1%. Now that you’ve finally paid off that college debt, bought your first house, and have an expanding pool of savings, what are you going to do with it? Day trade the market and compete with high frequency traders? Hand it off to a financial services industry, that has hardly been the beacon of fiduciary duty, to compete for meager or non-existent returns after fees and taxes?

In summary, what we are seeing today is a “lower high” in the downward trending interest in stock market investing. Interest and sentiment likely peaked with bubble in 2000 and has experienced several cyclical lows and peaks over the last 13 years and will continue to make lower lows and lower highs until the secular bottom is finally in.

Bringing it all home: what a true market bottom looks like

At Sitka Pacific Capital Management we are often asked why we do not think the March 2009 low will prove to be the beginning of a new secular bull market in stocks lasting a decade or more. While the low around 666 on the S&P 500 could very well mark the nominal low in prices, we believe the stock market valuations will continue to decline as the challenges presented by demographics, deficit spending, and debt lead to higher inflation and much lower participation in the markets. Lower valuations, measured in a variety of ways, have accompanied every secular stock market bottom that we have studied both in the U.S. and abroad over the last 200 years and we expect this time to be no different.

A few signposts of a durable secular market bottom include generational disdain for stocks among tomorrow’s savers with a corresponding low allocation, a total lack of interest in the market, and valuations that reflect little hope for future value creation. These valuations have historically been below 10x normalized or cyclically adjusted P/Es, whether reported inflation and interest rates are high (as in early 1980s) or low (as in early 1940s) with stocks trading around book value, and cheap relative to real assets like gold and commodities. Some stock markets, like that of Japan, are much closer to this point, while others, like the U.S. are very far off indeed.

The new Buffetts, ex-ante

I recently came across a Fortune Magazine article from 1989 titled “Are These The New Warren Buffetts”? The article attempted to identify which of the then-current cadre of young money managers might “go on to investing fame and their clients to fortunes.” Of the 12 managers highlighted in the article, 10 were in their 30s, and most only had independent track records of one to five years. Despite this, though, the article attempts to identify what makes a great money manager capable of delivering superior returns. The article provides an ex-ante assessment of what most investors only analyze ex-post.

Now that we have 22 years of history from which to judge these managers, we can evaluate the effort.

The Fortune article cites Warren Buffet, who prioritizes “high-grade ethics. The investment manager must put the client first in everything he does.” He said he wants to know that a manager handles his mother’s money as well as his clients’. Intelligence is important, but the proper temperament is essential: “Rationality is essential when others are making decisions based on short-term greed or fear,” Buffett said. “That is when the money is made.” While the article follows managers who invest across a variety of asset classes — both long and short — and utilize a variety of strategies, the common thread is a value discipline in the spirit of Buffett’s mentor Benjamin Graham. They all use fundamental analysis, among other things, to find mispriced securities that offer a margin of safety. Importantly, the all seek to minimize the true risk of investing—a permanent loss of capital.

The list of 12 managers is astounding, in that it presciently identifies many of the most prominent and successful managers of the last two decades: Michael Price, Jim Chanos, Karen and Jim Cramer, Glenn Greenberg and John Shapiro, Eddie Lampert, Richard Perry and Seth Klarman. The others on the list, including Randy Updyke and Thomas Sweeney, seem to have chosen a quieter path or retired early. The fact that so many of these managers have, in fact, “gone on to investing fame and their clients to fortunes” speaks volumes about the ability of investors to identify great managers.

Finding managers with the requisite ethics, aligned incentives, proper temperament and a disciplined value-oriented approach will go a long way toward ensuring long-term performance success.

Size Matters (but not how you think it does)

In addition to the qualitative characteristics above, what other things should investors look for in choosing money managers? In Modern Portfolio Theory IS Harming Your Portfolio, I proposed the idea that smaller firms may be in a better position to manage assets.

When one is trying to be dynamic and active in their approach, flexibility is hugely important. Whether it’s the inherent inflexibility of an investment committee, the curse of success (overconfidence), ingrained cultural constraints, or simply the challenge of moving around and effectively deploying a large chunk of assets, large, well established firms often lack flexibility.

The cultural constrains I was referring to were highlighted in Comfort is Rarely Rewarded; Maverick Risk and False Benchmarks where I argued that too many in our industry have become asset gatherers instead of asset managers, favoring the business of investing at the expense of the profession of investing. When firms become successful and large, it becomes increasingly difficult for them to focus on investment results for their clients.

In a January 2009 paper entitled, “Does Size Matter in the Hedge Fund Industry?”, Melvyn Teo concludes there is a negative, convex relationship between hedge fund size and future risk-adjusted returns.

He examined hedge fund returns from January 1994 through June 2008, Using monthly net-of-fee returns for 3,177 live and 4,240 shuttered (to avoid survivorship bias) hedge funds allocated to four styles over the period. He found that a portfolio comprised of the smallest 40% of hedge funds outperforms a portfolio of the largest 40% hedge funds (both rebalanced annually) by a risk-adjusted 3.65% per year. Similarly, a recent Wall St. Journal article, When to Trust a Hedge-Fund Rookie, found that

in the three years ending in March, newer managers—those with two years or less of experience—delivered annualized net returns of 9.3%, compared with 4.5% for established managers, according to fund tracker HFR Inc. From 1995 to March 2011, emerging managers had annualized returns of 16.5%, compared with 10.7% for established managers.

The idea that larger managers have a harder time outperforming is found in a variety of research on mutual funds as well. Several recent studies have taken an even deeper look at what distinguishes investment managers and how those differences impact performance. An analysis done by consulting company Kasina and highlighted in their article, How Advisors Select Investments, found that manager tenure has consistently ranked in the top five factors driving manager selection decisions. Yet  when Kasina examined 3,000 mutual funds

for the three year period ending January 1st, 2011, there was a correlation of just 0.06 between a fund’s “Manager Tenure” and its excess return (three year return in excess/deficient of its stated benchmark). Advisors basing investment decisions upon “Manager Tenure” would have anticipated a strong, positive correlation, implying that a more tenured manager could produce more favorable results. That hypothesis lacks an empirical foundation.

So while size matters, perhaps in ways we do not expect, work experience and manager tenure may not.

Another 2009 paper, “Investing in Talents: Manager Characteristics and Hedge Fund Performances” Li, Zhang, and Zhao took a comprehensive look at both fund characteristics such as fees, structure, and size as well as manager characteristics including age, work experience, tenure with the fund, and educational background. While they also found that fund size was negatively correlated to performance, their findings regarding work experience were most notable.

Less experienced managers had superior performance.

We also document a strong negative relation between raw excess returns and WORK (work experience),where the coefficient is -0.027 and highly significant…a manager with 5 years less working experience can expect to earn an additional 0.54% raw excess return more per year.

Their empirical research supports the hypothesis that “the impact of career concern dominates that of working experience,” and that less experienced managers have stronger incentives and more willingness to take risks, often leading to superior performance.

Most people would find this concept somewhat shocking.

Consider how many firms espouse the experience of their managers as a key selling trait. The idea that experience might actually be detrimental to returns is not one that the investment management industry is willing to promote. However, an intellectually honest assessment of the role of experience in driving investment decision-making and results is in the best interest of advisors, managers and clients alike.

It is not difficult to understand the power of incentives and their effect on work ethic and career concern, particularly in the lucratively compensated hedge fund world. However, there may be other reasons why experience is not necessarily positively correlated with investment returns.

Young Brains: Experience vs. Exposure

[amazon_enhanced asin="0140143459" container="" container_class="" price="All" background_color="FFFFFF" link_color="000000" text_color="0000FF" /] I recently attended a panel discussion on tail risk hedging featuring three money managers devoted to that complex and increasingly popular strategy. Aside from the moderator on the panel, the elder statesmen of the group was in his late 30s. None of these young bucks had even been in the business during the tail risk event that gave tail risk events their name– the stock market crash of 1987. Struck by the youth of the panel, I was reminded of Michael Lewis’ observation in Liar’s Poker describing the protagonists of the then-newly-developing mortgage bond market. “A young brain leaped at the chance to know something his superiors did not,” Lewis wrote. ” The older people were too busy clearing their desktops to stay at the frontiers of innovation.”

In his 2001 shareholder letter, Warren Buffett distinguished between experience and exposure and argued that most investors mistakenly focus on experience when they should focus on exposure. This came from a man who has heaps of both. Relying heavily on experience tends to mean looking to the past and considering the probability of future outcomes based on how things played out historically. Exposure, on the other hand, considers the likelihood — and potential risk — of an event that recent history may not reveal.

Perhaps even more importantly, relying on experience often means relying on a cloudy, biased recollection where our “memory is not as much a factual recording of events as it is a perception of the physical and emotional experience,” as behavioral finance professor John Nofsinger teaches us. Focusing on exposure, on the other hand, frees us to think beyond what our experience allows for. Perhaps ironically, forsaking experience for exposure may allow for a greater respect for the rhythm of history with a more objective and long-term analysis.

The fruits of this labor were driven home in This Time Is Different: Eight Centuries of Financial Folly, by Carmen Reinhart and Ken Rogoff, who documented consistent historical patterns in financial crises and subsequent recessions over a long time frame and across many countries. [amazon_enhanced asin="0691142165" container="" container_class="" price="All" background_color="FFFFFF" link_color="000000" text_color="0000FF" /]

In practical terms, most investors today are impaired by their experiences in the 1980s and 1990s. They lack a historical understanding of secular market cycles and valuation, the closest thing we have to a law of gravity in finance. Similarly, most economists, with their data-heavy analysis, lean almost exclusively on the post-war period when modeling how the economy should behave. Most economists, strategists, analysts and investors have not experienced debt-induced financial crises, de-leveraging global economies or the demographic headwinds we face today. Nor does anybody’s experience include the ways in which today’s world is unique from any other point in history and the ways in which tomorrow’s history is completely unwritten.

To avoid the risk of being accused of ageism, I want to be clear that the disposition to rely on what we think we already know is a universally human trait. The challenge is just that older people already know so much more than their younger, less experienced counterparts. As Charlie Munger quipped

The human mind is a lot like the human egg, and the human egg has a shut-off device. When one sperm gets in, it shuts down so the next one can’t get in.

This makes the experienced mind predisposed to missing regime changes and paradigm shifts that define the world in which we live and invest. These paradigm shifts can include anything from changes in the direction of long-term valuations and thus long-term returns to changes in the value of the currency in which we measure everything to changes in the theories that inform our decisions, such as Modern Portfolio Theory and many other shifts which I have not written about.

Perhaps we are witnessing the end of the belief that stimulative government policies will always succeed at growing the economy coined the “Keynesian Endpoint” by PIMCO’s Tony Crescenzi. As technology increases the pace of regime changes and paradigm shifts, the need to identify managers with the right exposure, rather than experience, is critical.

A recent Farnam Street Blog post asks How to orchestrate a paradigm shift?, and looks to science and The Structure of Scientific Revolutions by Thomas Kuhn for some insight.

[amazon_enhanced asin="0226458083" container="" container_class="" price="All" background_color="FFFFFF" link_color="000000" text_color="0000FF" /] Kuhn argues that scientific progress is marked by anomalies that fall outside of the conventional wisdom or accepted scientific principles of the day. These anomalies are studied in a wide variety of ways until they become blurred. Eventually, Kuhn notes, practitioners cannot agree on what the paradigm is and “formally standard solutions of solved problems are called into question.”

“A reconstruction of the field from new fundamentals, a reconstruction that changes some of the field’s most elementary theoretical generalizations as well as many of its paradigm methods and applications” ensues, Kuhn writes. Almost always, those who manage to identify the shifting paradigms are either young or inexperienced, making them more likely to see that old rules no longer apply and a new set has replaced them.”

It is precisely because they lack experience and the baggage of old paradigms that the relatively young or inexperienced are able to see the fundamental shifts underway and change course as necessary. The Farnam Street Blog quotes Max Planck

A new scientific truth does not triumph by convincing its opponents and making them see the light, but rather because its opponents eventually die, and a new generation grows up that is familiar with it.

Some truths — like the long-term trends of valuation expansion and contraction or the power of fear and greed to impact asset prices — live and die again with each cycle. Other “truths,” like the efficient market hypothesis and modern portfolio theory, will perhaps go the way of the buggy whip. If Planck’s observation is right, we should be able to pinpoint the approximate date of death to 2050, when the last 25-year old who entered the business in 2000, trained on the “truths” learned in the decades prior, finally decides to retire.

He lived a long, happy life

Or perhaps we will not have to wait that long. The highly social and reflexive nature of markets and economies distinguishes investing from the hard sciences. Copernicus proved mathematically that our system was heliocentric — the Earth and other planets revolve around a stationary sun — as opposed to geocentric, a model that places Earth at the center. His models were at odds with not only conventional wisdom but also the then-prevailing understanding of the Bible and teachings of the Church. It took more than 60 years, well after Copernicus and his critics had died, before the observations of Galileo, supported by Copernicus’ early work, were enough to change the views of contemporary astrologists, the Church and the people.

If we are convinced of the idea that success in the markets requires us to evolve, to hold old ideas lightly, to seek anomalies and disconfirming evidence, to dedicate ourselves to lifelong learning and to identify and align ourselves with the many paradigm shifts constantly underway, then there are things we can do to make that process easier. While T. Boone Pickens probably has good genes to thankfor having the brain function and physical health of a man half his 83 years, a healthy, active lifestyle and a preference to surround himself with “sharp young minds” rather “than play golf and gin rummy all day” certainly helps Despite being in his 80s, T. Boone is Michael Lewis’ “young brain,” eager to learn something others do not know.

Playing on the back nine of his career, has not prevented Jeremy Grantham from continuing to shepherd his clients’ asset through a variety of paradigm shifts either.  Lastly, Jim Ware and his Focus Consulting Group have identified that investment managers who meditate, among other things, are more likely to remain curious and open where the “very best thinking– creative and insightful” takes place.

Bringing it All Home: What We Know and What We Don’t

The fact that the “New Warren Buffetts” article from 1989 correctly identified  so many successful managers based essentially  on their qualities alone is only anecdotal evidence for the philosophical belief that investors can and should seek outstanding managers to shepherd their capital. The fact that smaller managers tend to outperform is supported by empirical evidence alongside the logical argument for why incentives and cultural and organizational factors might make it so. The idea that more experience does not lead to better results also has empirical support, but the logical and philosophical argument is not widely addressed or accepted. This is probably because admitting to a limit of the benefit of experience on investment results is akin to admitting our weaknesses and our vulnerabilities. As Tom Brakke of the Research Puzzle notes

the investment professional is caught between two realities:  Clients want answers and markets are unpredictable…Zweig reminded me what Peter Bernstein said was the major lesson that he had learned during his long career.  Simply, it was that “we don’t know what the future holds.” We forget that first principle all too frequently on our own, and by its nature the investment business encourages that amnesia.

Truly successful managers, advisors, and investors will embrace the unknown. They will leave behind the large and traditional for the small and maverick. They will forsake their experience and what they’ve learned in the past in order to gain greater exposure and a better chance of identifying what will be important to know in the future.

“Men are anxious to improve their circumstances, but are unwilling to improve themselves; they therefore remain bound.” -James Allen, As a Man Thinketh

One of the most consistent messages I’ve heard throughout my career is that the market is inexpensive or at least “fairly valued” based on next years earnings. We hear it at heights of euphoria and the depths of despair. I don’t recall ever hearing the consensus or even a vocal minority calling the market overvalued based on forward earnings estimates. In fact, we rarely even hear perma-bears cite high P/Es based on forward estimates as the primary cause for concern. Over a decade with low and often significantly negative returns, how can that be?

A Flawed Exercise

What makes market calls based on forward P/Es so dangerous is that the concept makes such good intuitive sense. We know the market’s primary function is to look forward and discount the future back to the present. We know that valuation, as James Montier puts it, is “the closest thing we have to a law of gravity” in finance. We know that earnings, while flawed in many ways (another discussion for another day), are essentially what investors want to pay for. To confuse matters worse, when analyzing an individual company’s stock, skilled investors absolutely would want to forecast forward earnings, make pro-forma adjustments from GAAP and then estimate a fair value based on a P/E multiple of that estimate.

Valuing the market on forward earnings estimates is a flawed exercise which often leads to incorrect assumptions about future market returns. It just doesn’t work very well.

1. The earnings estimates are usually inflated by improper adjustments and blind optimism

In another post criticizing a typical Wall Street approach to valuing the market, I challenged the conventional wisdom that operating earnings represented a clearer picture:

I’m no accounting expert, but I know one thing: pro-forma operating EPS is what company management uses to make their results look as good as possible without being accused of wrongdoing. Stock option expense? It’s not real money. Business restructuring? One-time event. Overpaying for an acquisition? Just a non-cash write down.

It’s not that on a company-by-company basis there aren’t legitimate adjustments that should be made, however most sell-side analysts simply take management guidance and run it through management blessed models making their forward EPS estimates questionable. Aggregating those estimates gets you to an even worse place when analyzing the market as a whole. Ed Easterling of Crestmont quantifies these adjustments for us

“As Reported” earnings reflects the past and projected (by S&P analysts) net income from the five hundred large companies in the S&P 500 Index.  This measure is based upon Generally Accepted Accounting  Principles (GAAP) and is the  measure that historical averages are based upon.  “Operating” earnings reflects a subjective  measure of earnings (by other S&P analysts) that adds back certain costs and charges.  It attempts to reduce the impact of the business cycle and one-time charges, yet it is generally considered to be an optimistic view of earnings.  This measure of earnings per share (EPS) is NOT comparable to the long-term average P/E, since operating earnings excludes a variety of costs and charges that reduce the funds available for dividends.  On average, ‘Operating EPS’ is almost 20% more than ‘As Reported EPS’.

In a recent update from Crestmont, this number was established at roughly 16% over the past 20+ years. This is clearly NOT a function of extreme events or unusual occurrences that should be omitted from our analysis, but is instead a systematic overestimation of earnings. Of course, “as reported” earnings also have their limitations like undue influence from large losses in a small number of companies. As chronicled by Denis Ouellet at his excellent blog, AIG alone shaved over $7  from S&P 500 reported earnings in the 4th quarter of 2008, even though the stock at the time had little effect on the index’s price. And both operating and reported earnings on the index level are subject to issues of non comparability when the folks at S&P simply remove failing companies (stocks) and replace them with successful ones.  Yet another reason why a normalized earnings measure like Shiller’s, Ben Graham’s, or Ed Easterling’s is so useful.

2. The resulting P/E multiple is usually improperly compared to historical averages or notions of fair value

The typical analysis goes something like this: at 13x next year’s earnings, the S&P 500 is attractively valued compared to it’s long-term historical average of 15x.

That is comparing Apples to Oranges.

14x is the long-term average P/E based on reported earnings since 1900.  Many cite the arithmetic mean of 15x which gets a bit of an unfair lift from the bubble years without a comparable low-end offset according to Ed Easterling. 14x is consistent with both the median and trimmed-mean and serves as a better guide for “average” in this case.

So what is the long-term average P/E based on forward operating earnings? What is the number that we can compare the oft-cited valuation measure to? While there is no good really long-term data on forward estimates, we can get a pretty good idea by going through this exercise:

Hypothetical $100 reported EPS

Operating EPS is about 16% more than reported EPS= $116 operating EPS

Forward EPS is about 6% more than current EPS historically=  $123 forward operating EPS

An average P/E of 14x on $100 is only 11.4x the SAME level of earnings, using forward operating earnings

 

This is the approximate historical average that we should be comparing to the market P/E based on consensus estimates. While the above exercise may lack scientific rigor, the eminently quotable John Maynard Keynes would certainly approve as he too “would rather be vaguely right, than precisely wrong.“

A glance at this chart from Goldman Sachs (I added the bars at 10x and 15x) shows the more recent past of the P/E based on “Next 12 months Operating Earnings Estimates.” The P/E spent much of the first 15 years below 10x and was only pushed above 15x in 1997 before falling once again below 15x for much of the last 4 years.

source: Goldman Sachs, Compustat

Average Valuation ≠ Fair Valuation

However, our analysis on market valuation should not stop there. While the average P/E on forward earnings is approximately 11.4x, it would be unwise to assume that every instance of  above average P/Es means overvaluation and every instance of below average P/Es mean undervaluation. There are many drivers of intrinsic value or fair value that have significant impact on measure such as P/E multiples. The obvious wild card is inflation. During periods of higher inflation investors rightly demand higher nominal returns to compensate them for the loss of purchasing power. This pushes P/E multiples down as investors pay less for future earnings which also tend to be of lower quality. Note, this is NOT an endorsement of the so called Fed Model. Please see Cliff Asness’ classic work Fight the Fed Model: The Relationship Between Stock Market Yields, Bond Market Yields, and Future Returns. If you are too busy to read the paper that disproves one of the most widely used asset allocation forecast tools, I’ll sum it up for you– forget bond yields when forecasting future stock market returns– the only thing that matters is starting and ending valuation.

Theoretical Concept of the Fed Model Leads to False Conclusions About The Market's Fair Value

In fact the theoretical construct of the Fed Model which says that at low nominal interest rates, P/E multiples should be higher combined with the elevated nature of future earnings allowed for some erroneous justification of wildly expensive markets in 1998-2002 and again from 2004-2007. One can conduct a good smell test by looking at the Goldman chart above and see that on forward earnings the market appeared to be “equally cheap” in 2007 as it was in 2009 (about 15x) when intuitively we know (and the 10 year normalized measures confirm) that the market was much cheaper in 2009 than it was in 2007.

A Better Way?

Obviously I think there is a better way to try to ascertain the market’s value. Valuation ratios based on Normalized Earnings is one place to start the analysis. How we determine “fair value” based on these earnings is another matter. I covered a few versions used by GMO, Hussman, and others. I recently discovered Denis Oulette’s valuation approach– “The Rule of 20″ in the Valuation section at the excellent www.news-to-use.com. I intend to spend more time applying some of his framework to a normalized earnings measure and will report back in a future post.

In the meantime, the next time you hear a pundit tell you the market is “cheap” or below the historical average based on next year’s earnings, be sure to run, not walk away to find a more suitable comparison of value.

Thoughtful minds are reading Scott Vincent’s recent paper, “Is Portfolio Theory Harming Your Portfolio” (HT: @jasonbremer)

In the paper Vincent argues that the flawed foundation of Modern Portfolio Theory (MPT) that risk=volatility has allowed MPT advocates to control the language of the debate and set the stage for the obvious conclusion that passive index-based investing is inherently superior. And don’t think for a second that this debate is simply theoretical, academic, or unimportant– the basic tenets of MPT shape the decisions of nearly every institutional money manager, wealth management firm, investment counselor/consultant, and financial planner in profound and often disturbing ways. YOUR money is almost certainly being managed with these ideas at the core. The traditional approach to asset allocation is built on false axioms.

While Vincent’s direct assault seems to be focused on highlighting the mistreatment of active, concentrated equity or fixed income asset managers vs. holding a passive equity or fixed income index, his arguments hold sway over the much larger and dangerous consequences of MPT on asset allocation. My assertion is that most damage to investors portfolios from the traditional approach to investing comes from the foundation of static, backward looking assumptions informing broad asset allocation decisions.

Does This Look Familiar? source: turtletrader.com

Vincent’s Case

In the piece, the author does a fantastic job of summarizing the history of Modern Portfolio Theory and it’s building block components:

• Harry Markowitz’s work on “Portfolio Selection” (which informs the chart above) proved mathematically that diversification could reduce volatility which he equated with risk
• William Sharpe’s Capital Asset Pricing Model (CAPM) which mathematically defines an asset’s return into two parts:
  • systemic risk or “beta” which describes how an asset has historically behaved relative to “the market” or a broad index
  • idiosyncratic (stock specific) risk  which can and should be diversified away
• Eugene Fama’s Efficient Market Hypothesis (EMH) which asserts that the market is ultimately efficient at pricing all available information

Vincent notes that most advocates for passive investing and MPT start with a compelling statement:

Active managers in general have been shown to underperform passive funds, especially when taking into account their higher management fees, taxes, sales charges, and trading costs. If you can make more money in index funds then why bother with the hassle of trying to find a good manager?

On the surface, that’s hard to argue with. I’ve seen studies that indicate after taxes, 80% of active long-only equity managers underperform their benchmarks over long time periods.  Here’s the problem: Most “active” managers aren’t active at all. They are closet indexers:

While diversification has always been a selling point for actively managed mutual funds, the average number of holdings in a fund have increased dramatically since MPT made the scene. The average number of stocks held in actively managed funds is up roughly one hundred percent since 1980… the average fund holdings had risen to approximately 140 positions by 2000. The actual number of holdings in a given year could easily surpass 200 because portfolio turnover exceeds 100 percent per year on average…Investors in actively managed funds suffer – they receive quasi-active management at full active management prices.

MPT and the quantification of investing has further (mis)informed the debate by seeking a easy way to label and quantify “risk.” In 1952, Harry Markowitz chose variance or volatility of prices or returns to define risk. He did so because it was mathematically elegant and computationally simple. However, this idea has serious limitations (most of which Markowitz has since acknowledged).

On the individual stock level, Vincent notes

Risk is often in the eye of the beholder. While “quants” (who rely heavily on MPT) might view a stock that has fallen in value by 50 percent over a short period of time as quite risky (i.e. it has a high beta), others might view the investment as extremely safe, offering an almost guaranteed return. Perhaps the stock trades well below the cash on its books and the company is likely to generate cash going forward. This latter group of investors might even view volatility as a positive; not something that they need to be paid more to accept. On the other hand, a stock that has climbed slowly and steadily for years and accordingly has a relatively low beta might sell at an astronomical multiple to revenue or earnings. A risk-averse, beta-focused investor is happy to add the stock to his diversified portfolio, while demanding relatively small expected upside, because of the stock’s consistent track record and low volatility. But a fundamentally-inclined investor might consider the stock a high risk investment, even in a diversified portfolio, due to its valuation. There’s a tradeoff between risk and return, but volatility and return shouldn’t necessarily have this same relationship.

I would add to this sentiment, particularly for equities as an asset class; there is actually more risk (chance of loss) when volatility is low, and less likelihood of loss when volatility is high.

Additionally, not all volatility or standard deviation is created equal. Most investors, for example, do not think that the prospect of achieving returns that are 2 standard deviations ABOVE average is risky, where the opposite is clearly so. So MPT’s cornerstone– its definition of risk– is incomplete at best and at worst, completely misleading.

Vincent continues

Regardless of MPT’s shortcomings on both a theoretical and empirical level, its dominating influence will not easily be dislodged. MPT is deeply woven into the fabric of our financial system, its mathematical grounding and precise answers inspire confidence. Further, its application is crucial in bringing increased scale and profitability to the financial services industry. Few want to see change. As such, common sense and judgment will continue to diminish in importance as top-down, quantitative strategies and blind diversification gain investment dollars.

And this is the part the ticks me off the most. The ideas behind MPT are so self-serving for our industry that despite their shortcomings, we can’t seem to move past them. Of course fear of embracing Maverick Risk (see my recent post) help keep the status quo alive and well

There’s a feeling of safety that accompanies index investing; neither the advisor nor the investor risks losing face or losing a job over putting money to work in a broad index. We enjoy the mathematical certainty of MPT, it’s reassuring that we can fix a value to assets, and that we can quantify risk in a non-subjective manner – free from human error…When defending an entrenched system that furthers the economic interests of powerful entities, the rationale doesn’t need to be sound, it just has to be somewhat convincing.

Vincent’s Prescription

The author contends that smart investors should welcome the dumb money move to highly diversified, passive strategies, while acknowledging if you ARE the dumb money or are forced on some level into limited choices (like 401(k) plan participants or beneficiaries of trusts with bank trustees– at least don’t pay active management fees for closet indexers.

An informed investor should welcome this shift. As highly-diversified strategies gain assets, inefficiencies become more prevalent because share prices are increasingly driven by factors other than fundamentals… there is compelling empirical research that shows active managers who are truly “active,” do persistently outperform indexes. The astute individual investor can seize the opportunity that blind, passive index investing provides in the form of increased market inefficiencies by hiring active managers who have shown the ability to exploit and profit from these inefficiencies.

Take advantage of the fact that your neighbors are leaving for passive funds, as their passive investments could provide the inefficiency your manager seeks to exploit.  But, by all means, avoid investing in highly diversified active funds whose returns closely match an index.  If index returns are what you seek, then pull your money and invest in efficient passive index funds or ETFs (emphasis mine).

This is where many investors stop thinking about their portfolio. They say, Yes! index returns is what I seek. After all, if you buy and hold the market you can earn the long-term returns right? Unfortunately, the answer to that is no. The long-term “average” returns are rarely available. In fact, depending on where you are standing, the returns are either much higher, or much lower. Consider this chart from Crestmont Research which shows that even for periods as long as 10 years, average rarely occurs:

MPT & Asset Allocation

Scott Vincent seems to be focused on encouraging investors to choose the correct managers (truly active, relatively concentrated, fundamentally-focused) WITHIN asset classes like stocks or bonds. And he is certainly compelling. However, as I alluded to earlier, his argument holds sway over the much larger and dangerous consequences of asset allocation.

Consider this chart which you’ve probably seen in one form or another. It shows expected risk and return of various mixes of asset classes and the typical approach to asset allocation which Modern Portfolio Theory has spawned:

So what’s wrong with this picture? Lots of things.

The first is the inputs– namely expected returns and volatilities of various asset classes– most investment programs are built on logic like this:

• Bonds will return 5% on average over the long-term but be between 0-10% in any given year
• Stocks will return 10% on average over the long-term but be between -10% and +20% in any given year
• Some might include other nuance regarding different types of bonds like High Yield or different types of stocks like Emerging Markets
• Some might include different types of assets like real estate, commodities, or “alternatives”

The problem of course is this is an incomplete description of investment returns:

• The math contends that returns are randomly and unpredictably distributed around the average
• This “normal distribution” of returns contends that larger market movements outside of the ranges above will be relatively rare
• “Average” returns ignore the role of valuation and the importance of when you start investing (buy) and when you finish (sell) even over multi-decade time horizons

The traditional approach to asset allocation is built on false axioms. The phenomenal secular bull market in stocks and bonds from 1982-1999 created the perfect conditions for the  nearly religious acceptance of MPT. In a recent post, Expensive Markets Mean Low (or Negative) Prospective Returns, I made the case that valuation matters greatly and currently portend disappointing returns for both stocks and bonds. Traditional asset allocation has no way of dealing with this in a way that successfully protects portfolios from experiencing meaningful and unnecessary drawdowns.

The Normal Distribution Does Not Apply to Long Term Stock Returns. Source: stockcharts.com

As colleague Brian McAuley penned in Sitka Pacific’s March 2010 client letter

Whether or not these themes are presented directly, they underpin the advice that most investment advisors give their clients. At its core, the message is usually something similar to this: “The markets are random and unpredictable, so the best way to invest is to properly diversify and wait for the averages to play out.”

However, what most investors seem to be unaware of is  that this whole theory of random movement of  market prices was proven false over 50 years ago by one of the most influential mathematicians of the 20th century, Benoit Mandelbrot. The random motion of market prices was a very nice theory, but it just doesn’t match what actually happens in the real world.

In a completely random world, a large movement in prices would be a relatively rare event. But we know from market history that large movements in prices happen far more frequently than they should if prices moved completely randomly. In fact, if we look at annual  market returns, there are 50% more extreme events than there should be… It’s clear that there are other forces influencing the markets that aren’t taken into account by the statistics of purely random movements—and they have to do with human behavior.

Since the movement of market prices is not random, most investment advice given today that is based on Modern Portfolio Theory is simply wrong. Particularly, the assumption that market risk can be reduced by diversification has led to frequent catastrophic results throughout market history—most recently in 2008.

Although the theory of random market movements was proven false more than 50 years ago for those fluent in mathematics, with multiple bubbles and busts in the last decade it has become painfully obvious to everyone that there is more to market movements besides a Brownian-like random motion. Markets are subject to the rational and irrational decisions made by millions of people, and as such they are prone to cycles of extremes in sentiment and valuation—booms and busts.

Even those who bill themselves as “active” asset allocators typically only move within a small range of acceptable allocations such as 40-60%. Consider even this progressive asset allocation policy:

source: University of California

My Prescriptions

Obviously, I think investors can do better. Just as Scott Vincent highlights the cadre of truly active, relatively concentrated investment managers who have “beaten the market” consistently– there are asset allocation strategies which aim to improve upon the traditional approach. At Sitka Pacific, we’ve taken an “Absolute Return” approach to the markets. From our 2006 Annual Review

We have the flexibility to take more meaningful actions to preserve capital, manage risk and volatility, and invest where the best opportunities are. Our goals are simple: to preserve capital first and generate an absolute positive returns second. In order to achieve those goals we look at the market as a means to generate a return, not something that should be blindly followed. We use the market when it can be useful to us, and can look elsewhere (even to cash) when there is more risk than potential reward in the market. The flexibility to manage risk may prove critical over the next several years.

Lots of managers aim to do the same thing. I’d recommend finding one who not only has demonstrated a successful approach in various market environments, but also whose process seems repeatable and makes sense to you. Take Mebane Faber at Cambria and his GTAA ETF. It’s a pretty straightforward process that using long-term momentum indicators to decide when and when not to be invested in various markets. It’s an improvement on a static approach, but might leave a little something to be desired for folks who wish to have a fundamental approach to their portfolio. John Hussman’s approach at the Hussman Funds is worth a look as well. For Do-it-Yourselfers, I’d recommend this post by David Merkel: The Impossible Dream Project for a good look at how to build your own process. For our approach to be successful, we need 3 Key Traits:

When one is trying to be dynamic and active in their approach, flexibility is hugely important. Whether it’s the inherent inflexibility of an investment committee, the curse of success (overconfidence), ingrained cultural constraints, or simply the challenge of moving around and effectively deploying a large chunk of assets, large, well established firms often lack flexibility.

Folks in this position, MPT devotees, and folks who don’t want to rock the boat too much would be wise to consider several emerging theoretical frameworks which aim to improve upon the status quo.

• Post-Modern Portfolio Theory (PMPT) is compellingly described in this FPA Journal article by Pete Swisher and Gregory Kasten.
• Allocating based on Downside Risk (versus Mean Variance) seems like a no-brainer and should be evaluated by anybody trying to “optimize” portfolio allocations. Here is a good primer.
• Fundamental Indexing: Research Affiliates is a good source.
• Risk Parity, which Bridgewater, PanAgora, and AQR  are all pursuing in various forms, takes a different view of targeting acceptable levels of risk as opposed to returns

source: Unified Trust

These approaches all have their own limitations and should be evaluated critically (like anything involving your or your client’s money). Ironically, one can make the argument that “Absolute Return” or GTAA or Fundamental Indexing can be considered as distinct asset classes, with their own projected risk and return characteristics and lower correlations to traditional benchmarks. In this case, MPT would suggest that “efficient” portfolios should have an allocation to them, just as many traditional investors have embraced alternatives to varying degrees.

Regardless of how you are currently invested, the shortcomings of MPT and its pervasiveness in portfolios is becoming increasingly clear. The last two years have given MPT-based investors a reprieve from the secular bear market underway since 2000. The next two years may not be so friendly. Investors should take the leap into truly active investing and asset allocation, even if it just means “trying it” with one or more managers or funds.