If, as I believe, the small-cap premium is at least partly due to the inherent efficiencies of smaller companies, larger companies have inherent inefficiencies and these inefficiencies will be reflected by the markets. All of which brings me, via circuitous route, to a discussion of Apple. Continue reading
It is axiomatic in the investment world that as an asset class becomes more popular, it suffers from both falling expected returns and rising correlations. In other words, good trades get crowded and their advantages tend to disappear. This crowding happens because success begets copycats as investors chase returns. Mean reversion only tends to make matters worse. In effect, it results in “investing while looking in the rearview mirror” or, as per the title of William Bernstein’s fine new book, Skating Where the Puck Was.
The evidence suggests that this overcrowding is precisely what has been happening with respect to the Yale Model. Continue reading
Regular readers of this site know that I reference and write about what Nassim Taleb calls the narrative fallacy often. It is our tendency to look backward and create a pattern to fit events and to construct a story that explains what happened along with what caused it to happen. We all like to think that our decision-making is a rationally based process — that we examine the evidence and only after careful evaluation come to a reasoned conclusion as to what the evidence suggests or shows.
But we don’t. Continue reading
The Edge Foundation is an organization of science and technology intellectuals. Its main activity is a website, edited John Brockman. The site is an online magazine of sorts exploring scientific and intellectual ideas. The Edge motto is “to arrive at the edge of the world’s knowledge, seek out the most complex and sophisticated minds, put them in a room together, and have them ask each other the questions they are asking themselves.”
In recent years, Edge has posed an annual question to its members. The question and member answers are provided on-line and ultimately collated into a book. As you may have seen, this year’s Edge question is “What *should* we be worried about?” Since most Edge members are scientists, it shouldn’t be surprising that the answers generally focus on science and scientific issues. However, several answers have particular relevance to finance, the markets an investing. Continue reading
Tomorrow evening Duke and North Carolina will renew the best rivalry in sports via a basketball game on the Duke campus (ESPN, 9pm ET). As a freshman, Jay Bilas (now of ESPN) lined up for a foul shot in his first rivalry game next to then All-American and future NBA All-Star Brad Daugherty (and also a current ESPN-er), who looked over at him and said “I’m going to beat you like a rented mule.” That comment was astonishingly mild as these things go.
I first sat in Cameron Indoor Stadium as a student in 1978 and didn’t miss a home basketball game while I was enrolled at Duke. Every game was special – and wild. NBC came to Cameron to do the first national telecast from the arena on January 28, 1979 for a game against Marquette (I was there, of course) and insisted on a time-delay so the crowd could be censored if necessary. But Duke v. Carolina was and is something else entirely. Continue reading
I pay a lot of attention to the investment process. In that regard, every investor — personal or professional — ought to have a clear investment plan based upon appropriate personal considerations, goals and outlooks and every investor ought to stick to that plan unless and until something significant changes. But there is a crucial component of the investment process that gets surprisingly little attention: our investment default settings. We can use them when we aren’t sure what to do, when we’re deciding what to do, when our circumstances have changed but our plan hasn’t (yet), or when we’re just starting out.
The idea here is that we all have default settings — known and unknown, acknowledged and unacknowledged — and that those defaults greatly influence how successful we are and become. Having the right default setting in defined contribution plans make a big difference (more here). I would examine and apply my default settings across and throughout the entire investment process and even suggest that we need to look at our default settings as carefully as we look at anything else.
What follows are my suggested default settings. Your mileage may vary. Continue reading
Sunday may be the biggest unofficial American holiday of the year. The Super Bowl (XLVII) and its surroundings offer some pretty good lessons for investors too. Let’s look at seven (VII) of them. Continue reading
Pretty much since the day I wrote it, my Investors’ 10 Most Common Behavioral Biases has been the most popular post on this blog. It still gets a surprising number of hits all these months later. Due to the pioneering work of Daniel Kahneman and others, nearly everyone in the financial world acknowledges the reality of cognitive and behavioral biases and their impact on people, the markets and life in general. It’s a very popular subject.
Unfortunately, we don’t think that we are susceptible to them personally.
As I have noted before, we all tend to share this foible — the bias blind spot, which is our inability to recognize that we suffer from the same cognitive distortions and behavioral biases that plague other people. As one prominent piece of research puts it:
We cannot attribute [our adversaries'] responses to the nature of the events or issues that elicited them because we deem our own different responses to be the ones dictated by the objective nature of those events or issues. Instead …. we infer that the source of their responses must be something about them.
In other words, if we believe something to be true, we quite naturally assume that those who disagree have some sort of problem. Our beliefs are deemed merely to reflect the objective facts because we think they are true. Our thought process goes something like this:
I’ve thought long and hard about it [biases leave no cognitive trace, after all] and I’m convinced I’m not a bigot. Some of my best friends are __________.
Of course, that line of thinking doesn’t convince anybody else. The research again:
We are not particularly comforted when others assure us that they have looked into their own hearts and minds and concluded that they have been fair and objective.
Of course not — they’re biased (but I’m not). It’s the same kind of thinking that allows us to smile knowingly when friends tells us about how smart, talented and attractive their children are while remaining utterly convinced with respect to the objective truth of the amazing attributes of our own kids.
The problem is even more acute when the “answer” is counter-intuitive, and good investing is often wildly counter-intuitive (it’s really hard to sell when we’re euphoric or buy when we’re terrified, for example). So what can we do to try to minimize our own behavioral biases? We can start, of course, by admitting what is obvious based upon the research and the data but so very hard to concede – we are all continually susceptible to cognitive and behavioral biases.
That’s great, so far as it goes. But even though there is a great deal of research into the reality of these biases, there isn’t a lot written about what we might do to deal with them and counteract their impact. That’s partly because there isn’t a lot we can do (as even Kahneman readily admits).
In his 1974 Cal Tech commencement address, the great physicist Richard Feynman talked about the scientific method — a careful and consistent process designed to root out error – as the best means to achieve progress. Even so, notice what he emphasizes: “The first principle is that you must not fool yourself–and you are the easiest person to fool.”
Even so, I am not eager to admit defeat. Therefore, I humbly offer the following ten suggestions to try to deal with our cognitive and behavioral biases. I hasten to emphasize that I offer them tentatively and without any assurance of success. Dealing with bias is extremely hard. Proceed with caution. But also bear in mind this insightful comment from Jeff Bezos of Amazon: people who are right a lot of the time are people who often change their minds. Much of dealing with our biases is simply being willing and able to change our minds when its appropriate. It’s hard, but the reward is huge — being right a lot.
- Focus on the Data. As I have said repeatedly (and I’m not alone in this), focus on the data. As my masthead proclaims, I strive for a data-driven perspective and a data-driven process. That isn’t easy to do, sadly. We relate better to stories and are all too willing to believe and concoct narratives of various sorts to support our latest nonsense, but it’s a worthy aspiration and commitment nonetheless.
- Actively Seek Out Contrary Data and Conclusions. A remarkable universe of discoveries in psychology and neuroscience demonstrate that our preexisting beliefs skew our thoughts and even color what we consider our most dispassionate and reasoned conclusions. This tendency toward so-called “motivated reasoning” helps explain why we find groups so polarized over matters about which the evidence seems so clear. In other words, expecting people (including ourselves) to be convinced by the facts is contrary to, well, the facts. Factor in behavioral biases (such as the ever popular confirmation bias, optimism bias, in-group bias and self-serving bias) and it’s easy to see (at least conceptually) why we can get it so wrong so readily. Our tendency is to look for and consider only those views that correspond to our own – which goes a long way towards explaining the popularity of Fox News and MSNBC, for example, while also explaining why the viewers of each of those networks tend to think that only the other side has it all wrong. If we are going to be able to see things a bit differently, we need to seek out and consider sources that look at things differently.
- Build-In Accountability Mechanisms. We need (relative) objectivity if we are going to succeed in investing and in life unless we are extremely lucky. Having an accountability partner or (better yet) a competent and empowered team is particularly important due to our great ability to spot what’s wrong with everybody else (if not ourselves). It also means taking and dealing with criticism seriously. Even welcoming and encouraging it. It shouldn’t be surprising to see so many people who experience great investment success suffer indifferent performance or even failure subsequently (Bill Miller and John Paulson, for example). The more success and power we achieve, the easier it is to believe the hype. Accountability mechanisms that are maintained and honored can help to undercut that.
- Focus on Process. Accountability is more effective when it’s part of a consistent, careful, clear and clearly defined process. We all recognize that the outcomes in many activities in life combine elements of both skill and luck. Investing is one of these. Especially troublesome is our perfectly human tendency to attribute poor results to bad luck and good results to skill. It’s a lead-pipe-lock that we’re going to err and err often in the investment world. If we are to succeed with any measure of consistency, we need carefully crafted plans with screw-up contingencies built-in together with a commitment to regular re-evaluation and a rescue plan in the event of major catastrophe.
- Test and Re-Test. No matter how good our process is, we need also to assume that we have made errors and set out actively to find them by testing and confirming everything possible. Once we have decided that a given view is correct or committed to a particular course, confirmation bias has a tendency to take over. Planning to be lucky and believing that psychological realities don’t apply to us is a lovely (if arrogant) thought. But it’s not remotely realistic. Keep testing and looking for ways that you’re wrong.
- Avoid the Noise. Distinguishing signal from noise can be agonizingly difficult. Given the sheer amount of stuff competing for our attention, eliminating distractions unlikely to provide substantive benefit will improve the likelihood of our success. CNBC is fun and all, but how often does it make us smarter or better?
- Take a Tip from Attorneys. I often refer to myself as a recovering attorney, and there is a great deal about the practice of law that is frustrating and silly. But one excellent technique I learned from my time in that profession is to argue the other side’s case. Understanding and even appreciating a contrary point of view is helpful to our own thinking and can provide a good check on the coherence of our own viewpoints. Understanding and seeking support for the opposition’s best arguments is a powerful learning tool. We might even decide that – gasp – mistakes were made (almost surely by someone else, of course).
- Keep Track of Your Mistakes as Carefully as Your Successes. We all tend to trumpet our successes and downplay our failures. I highly suggest that, at least within your circle of influence and with those to whom you are accountable, you carefully track and analyze your failures, readily apparent or not. Sometimes these mistakes will be the result of bad luck. But often you will find correctable errors or even errors in your process. Doing so also helps with #10.
- Take Your Time. The more experienced and successful we are, the easier it is to take short-cuts. Experience is what allows us to apply useful short-cuts, of course, but it’s important to remember that all behavioral biases and ideologies provide mental short-cuts of a sort too. For big decisions, at least, make sure to take the time to connect each and every dot. When I was in law school I often refereed basketball games for extra money. Many situations were repeated time and again with the next action and the right call seemingly foreordained. It was always difficult to avoid anticipating the call — blowing the whistle based upon what was highly likely (perhaps almost surely) to happen rather than waiting to see what actually happened. Surprises happen on the basketball court with remarkable frequency. They happen in investing too.
- Try to Stay Humble (no matter how successful you are). Even though it takes a healthy amount of self-confidence to be an investment success, arrogance and certainty are frequent enemies of continued investment success. Your accountability partners can and should help here, of course. Spouses are especially expert at promoting humility. You will screw up and screw up often. Remind yourself of that reality often as you continue to look for where your most recent failings took place.
It’s really hard to deal with (much less overcome) our cognitive and behavioral biases. These tentative steps are offered to try to do so but I don’t promise anything like success. Yet these steps (or an ongoing commitment to implement the concepts behind them) should put you well ahead of most everyone else.
And that’s a pretty good thing indeed.
As I have noted before (here and here), in economics, leading indicators are measures that typically change before the economy as a whole changes, thus providing some predictive power with respect to what lies ahead. For example, the Conference Board publishes a Leading Economic Index intended to forecast future economic activity.
My intent then was and still is to derive some Leading Investment Indicators. Unlike leading economic indicators, these were not designed as short-term predictors. The strength of these metrics is as a tool to measure potential real long-term returns. Thus they are better used as longer term indicators of value, risk and expected returns. They in no way should be used as any sort of timing mechanism. The stock market can continue higher regardless of what any metric of valuation is showing. These indicators are designed to be a helpful tool to help shape an overall investment thesis and process as well as to separate short-term and long-term concerns, not to dictate trading decisions.
My conclusion then was that the market was not long-term cheap. I think they are worth re-visiting as we begin 2013.
1. PE10. The largest contributing factor to equity returns is the P/E ratio. The expansion or contraction of the broad market P/E ratio creates secular bull and bear markets. The chart below from Crestmont Research breaks down the components of total return for the S&P 500 for ten-year rolling periods.
Yale Professor Robert Shiller’s 10-year Average Inflation-Adjusted PE Ratio, also known as CAPE, Shiller PE or PE10, provides the best longer-term market gauge available. PE10 is the stock index price divided by the average real earnings from the previous 10 years – the time period is designed to smooth out near-term noise in the data. The basis for this approach is the finding that earnings valuation ratios provide predictive power for long-term stock market returns. Campbell & Shiller, “Valuation Ratios and the Long-Run Stock Market Outlook.” Journal of Portfolio Management 24, 2 (Winter 1998), pp. 11–26.
The long-term mean CAPE as calculated by multpl.com using Prof. Robert Shiller’s data is 16.45. In January 1921, PE10 was 5.12, the lowest value of any January in the historical period. Meanwhile, PE10 in January 2000 was 43.77, the highest January level in history. It is 22.19 today, suggesting that stocks remain significantly overvalued. Historical S&P 500 PE10 is charted below.
2. DY10. The dividend-price ratio or dividend yield (DY) is another predictor of the subsequent 10-year real returns on stocks, although this approach has its problems. Historical S&P 500 DY is charted below and suggests that stocks are significantly overvalued today.
3. Tobin’s Q. The Tobin’s Q is the ratio of price to replacement cost, which is in many ways similar to book value. See Tobin & Brainard, “Asset Markets and the Cost of Capital,” Economic Progress, Private Values and Public Policy (1977). The most current Q ratio can be calculated from September’s release of the Flow of Funds report for Q2 2011. It is calculated by dividing line 35 of table B.102 by line 32. The historical data is also available on the St. Louis FRED website. However, because the Flow of Funds report is released long after the quarter end, getting a relatively current level takes a bit of extrapolation.
When equity as a percentage of GNP is above-average then total real returns for U.S. equities have a high probability of being below average. When equity as a percentage of GNP is below-average then total real returns for U.S. equities have a high probability of being above-average. Another use for Q is to determine the valuation of the whole market in ratio to the aggregate corporate assets. The Q ratio is a statistical measurement of the market’s value; fair value for Q is 0.65, primarily because capital stock is routinely overstated leading to a larger denominator in the Q equation. See Smithers & Wright, Valuing Wall Street : Protecting Wealth in Turbulent Markets and Doug Short’s excellent analysis here).
Per Doug, the average (arithmetic mean) Q Ratio is about 0.70. The all-time Q Ratio high at the peak of the Tech Bubble was 1.78 — which suggests that the market price was 153 percent above the historic average of replacement cost. The all-time lows in 1921, 1932 and 1982 were around 0.30, which is about 57 percent below replacement cost. Based on the latest Flow of Funds data, the Q Ratio at the end of the first quarter was 0.94, down slightly from 1.01 in October, 2011 and 0.96 in August, 2012. Doug’s current estimate puts the ratio about 34 percent above its arithmetic mean and 41 percent above its geometric mean. These numbers are below the levels of overvaluation at the end March, which were 37 percent and 47 percent above the arithmetic and geometric means, respectively. By this measure, then, the market remains overvalued.
4. Market Cap to GDP. Market Capitalization to GDP has been described by Warren Buffet as “probably the best single measure of where valuations stand at any given moment.” It compares the total price of all publicly traded companies to GDP. This metric can also be thought of as an economy wide price to sales ratio. The data here is from the St. Louis FRED. However, because the data is quarterly, data for the other months have been entered using the prior ratio adjusted for the change in stock prices. As charted below, this metric suggests that stocks are significantly overvalued and overvalued as compared to October, 2011 and August, 2012 (.96 and 1.01 to the current 1.03).
Source: Vector Grader
5. Bond Yields. Returns on bonds depend on the initial bond yield and on subsequent yield changes. Low bond yields tend to translate into lower returns because of less income and heightened interest-rate risk. As Warren Buffett has pointed out (although he is not alone in this), “interest rates act as gravity behaves in the physical world. At all times, in all markets, in all parts of the world, the tiniest change in rates changes the value of every financial asset. …If interest rates are, say, 13 percent, the present value of a dollar that you’re going to receive in the future from an investment is not nearly as high as the present value of a dollar if rates are 4 percent.” As charted below, long-term interest rates have been generally declining for more than 30 years and remain near record low levels, suggesting that all assets are at risk going forward.
These measures all confirm that, from a longer-term perspective, the market remains overvalued and, if anything, somewhat more overvalued than it was when I last ran these numbers in August. As I have been saying for a long time (for example, here, here and especially here) – we are (since 2000) in the throes of a secular bear market, subject to strong cyclical swings in either direction. I continue to encourage investors to be skeptical, cautious, and defensive yet opportunistic. I suggest that they look to take advantage of the opportunities that present themselves while carefully managing and mitigating risk, which should remain their top priority.
The New Year traditionally calls for reflection and resolution. We should at least aspire to some thoughtful consideration and hope that we might do better going forward. Accordingly, here are some resolutions for the New Year that we all should be able to agree upon. May we actually fulfill them!
- Demand Simple but Meaningful Honesty. MarketWatch recently ran a piece claiming that “beating the market is easy.” Full Disclosure: I am a MarketWatch contributor. The thrust of the claim focuses upon various sectors and approaches – such as small caps or value – that have beaten the S&P 500 index historically as well as suggesting that investors use leverage and lower fee products. While strictly accurate, the claims are misleadingly so because the comparisons are all of an apples-to-oranges variety. Suggesting that one can readily “beat the market” by taking on more risk via volatility and leverage is hardly a meaningful recommendation for most investors and especially for those – and the target of the article – who are engaged in retirement planning. Moreover, defining “the market” as the S&P 500 and pointing out that various other indexes can and do outperform it historically isn’t very helpful either. For performance measurement to have value, one must use an appropriate measuring stick. Even if (when!) it doesn’t make us look great, let’s offer and demand meaningful honesty.
- Address Issues Head-On. As I have noted repeatedly in this space, our nation faces a serious retirement crisis. Few of us have planned well enough and few of us are saving enough to expect to live a comfortable retirement. These undeniable facts demand that we face some serious personal and policy challenges. The defined contribution landscape – never intended as a stand-alone retirement solution – isn’t working nearly well enough. Some more fundamental and far-reaching choices deserve careful consideration. These include mandatory retirement saving, portable pensions, and comprehensive Social Security and Medicare reforms. What we are doing at present isn’t working. Accordingly, some difficult policy choices we might not otherwise prefer or endorse need to be considered.
- Acknowledge Reality. Our behavioral biases are alarming in their scope and impact. They can be astonishingly difficult to perceive and overcome. Yet because of what’s called the “bias blind spot,” even when we recognize these biases, we tend to think that they apply to others but not to ourselves. For 2013 and beyond, let’s all resolve consciously to try to acknowledge and deal with our biases on a consistent and comprehensive basis.
- Embrace Personal Accountability. Because of our behavioral biases, it’s also easy for us to take credit for our successes while blaming our failures and failings on bad luck. Let’s instead resolve to be accountable for our choices and our actions, even (especially!) when they do not work out well. In one way or another, we would all like to privatize our gains and socialize our losses, take credit for success and blame failure on somebody else. Stop! We all know a lot less than we think.
- Insist on Effectiveness. Too many of our planning and investment choices are based upon ideological commitments of various sorts. Whatever our market “schools,” economic and political preferences and party persuasions, we all tend to act first and ask questions later. Let’s demand instead that the choices we make actually be predicated upon good data and evidence such that what we want to achieve has a reasonable likelihood of actually happening. As the saying goes, we are all entitled to our own opinions, but we are not entitled to our own facts.
- Focus. We are all prone to being distracted by the new, new thing. Being new isn’t necessarily bad, obviously, but it isn’t necessarily good either. A well-researched and supported new idea or approach can be of value – even tremendous value. But at least as often the new thing is a chimera that makes promises it can’t keep. If that object of desire makes bold assurances like easy, huge, safe or revolutionary, be especially wary.
- Develop a Comprehensive Plan (and put it in writing). In the same way having to teach a class on a given subject demands that we understand it really well (and, in my case, always engenders a lot of new research even on subjects I already know), developing a comprehensive plan is a great way to find and establish goals, ideas and priorities. Going through this process goes a long way toward ensuring that the final result will be well thought-out. Moreover, only a clear plan allows for an evaluation of how things are going and thus if any changes are called for. Recent research from Advisor Impact Inc. goes one step further and shows that those who create their plan in written form and include a recitation of how they plan to react when trouble comes are a good bit more likely to deal better with the trouble that inevitably comes. Too many of us let our investment and retirement planning strategies develop haphazardly, virtually guaranteeing that they are not thorough and making the likelihood of inconsistency in goals, purpose and execution astonishingly high. An otherwise great investment plan can readily become a disaster is it doesn’t line up with our understanding, goals, objectives and risk tolerances.
- Set Appropriate Defaults. On a related note, our planning default settings need to be carefully considered and implemented. These can relate to asset allocation, investment type and time horizon. Some good examples follow. When in doubt, lower fees win, passive beats active, manage risk first, simple beats complex, save more, spend less, and this time probably isn’t different.
- Evaluate and Re-evaluate. Every plan, no matter how good, should be subject to regular scrutiny and evaluation. Adjustment based upon new or better evidence is always in order. This process also demands clear goals and targets, both interim and longer-term. Most of us are aware of the Lewis Carroll saying: If you don’t know where you are going, any road will take you there. It’s a great warning. We also need to know where we are at all times for planning to be truly effective.
- Be Willing to Ask for Help. My late father reminded me often of the Abraham Lincoln saying, Better to remain silent and thought a fool than to speak up and remove all doubt. We would all be wise to think more, study more and reflect more while saying and doing less. Similarly, most of us resist asking for help. We all like to think we’re the smartest person in the room even though we would all benefit from asking for help often. None of us knows nearly enough to do it all and to do it all alone. Resolve not to try.
My thanks go out to all of you for reading and for a wonderful year here at Above the Market. I am blessed by your interest and support. May your 2013 be a joyful and prosperous one for each of you.