May 23, 2011
Scarcity, Usefulness, and Getting an Edge
In a free economy, there are two conditions for achieving profit over the long-term. The first is that one must provide something that is scarce, and the second is that one must provide something that is useful to others. For example, you might open a trendy coffee house, with a great atmosphere and menu. But if you walk out into the street, and see dozens of trendy coffee houses up and down the street that also have a great atmosphere and menu, you should not expect to earn a profit. Even though what you are providing may be desirable and seemingly timely, it is not scarce.
Likewise, you might be the world's only manufacturer of porcupine-needle seat covers. You could even own the patent. But even with the ability to maintain all the scarcity on earth, you should not expect to earn a profit, because that scarcity has not been combined with usefulness to others.
Of course, there are often certain constraints that we might wish to put on otherwise profitable activities, since profits can be obtained by providing things that are scarce and useful to the consumer, but have socially undesirable consequences or are simply illegal from a broader perspective. Likewise, some profits are clearly obtained through fraud or other deception. Still, over the long-term, if an activity (or pattern of activities) does not provide something scarce and useful to others, it will not be profitable over time either.
Investors forget this too often. There is emphatically no basis on which to expect a durable profit in the financial markets unless an investor makes a habit of executing trades that provide some scarce and useful service to others in the market, or to the economy as a whole. Investors who are driven by fundamentals and valuation tend to provide these services when prices are depressed - in the form of liquidity, risk-bearing, scarce capital, and sometimes information from skillful valuation. At these points, the long-term rate of return priced into stocks (which is also the long-term cost of capital for companies issuing new stock in the market) can be very high.
Conversely, when investors are speculating to excess, fundamental investors can sell into this demand, responding to the scarcity of stock and the eagerness of speculators by liquidating shares at elevated prices, and withholding capital from being misallocated into projects having low long-term returns and weak prospects for durable economic benefit. Even if the eager demand of speculators later turns out to be ill-advised, what matters is that the trades provide something desirable to others at the point those trades are made. When value-conscious investors do that repeatedly over the long-term, they provide a stream of scarce and useful services to other market participants and the economy as a whole, and that becomes the basis for expected long-term profit.
The same holds true even for purely technical investment approaches. Those that are successful over time implicitly exercise the habit of accumulating an inventory of securities as early evidence of increased demand emerges, and of liquidating inventory as demand becomes more prevalent and prices become overbought - with particular attention to any evidence that demand has started to wane. This is far more difficult than it sounds, because evidence from price movement typically needs to be confirmed by a variety of other considerations (technical support, breadth, leadership, uniformity across industry groups, trading volume, etc). Even so, the basic rule is simple: you should not expect a profit from trades that contain no expected "edge." In my view, a trade or strategy has an edge when it either immediately provides scarce and useful capital to the economy at a high prospective rate of return (which is what fundamental approaches attempt), or puts you in a position to provide a scarce and useful service to other investors some later time, by accumulating or releasing inventory at a favorable price (which is what good technical approaches attempt).
Surveying the present market environment, it's difficult to see any particular edge that either fundamental or technical investors can expect as a result of buying stocks here. On a fundamental basis, even factoring the most recent data from earnings season, we estimate that the S&P 500 is priced to achieve 10-year total returns in the area of 3.6% annually, contrasting sharply with the nearly 11% prospective returns that were priced into stocks in early 2009. While the prospective returns reflected in March 2009 were far short of those that we've observed at durable lows like 1950, 1974 and 1982 (and in the context of Depression-era credit strains, weren't enough to induce us to accept market risk that would obviously have been rewarding in hindsight), it's clear that the bulk of those prospective gains have now already been achieved.
Put another way, there is little compensation left to be squeezed from the scarce and useful services value-conscious investors might have provided by buying stocks in the panic of late-2008 and 2009. At present valuations, the willingness to accept market risk is neither scarce, nor particularly useful. Advisory bullishness peaked a few weeks ago, along with institutional bullishness, while mutual fund cash levels are easily at the lowest levels in history. We obtain 10-year projected returns in the range of 3-4.5% annually from nearly all of the historically reliable valuation methods we track (i.e. those with numerous decades of strong correlation with subsequent long-term returns, not simply ones that seem reasonable in a sound bite). What possible "edge" would a value-conscious investor obtain from buying stocks at presently elevated valuations, with the S&P 500 near its upper Bollinger band at nearly every resolution?
Likewise, from a technical perspective, it might have been desirable to accumulate an inventory of stock near the beginning of QE2, in hopes of distributing it at higher prices. But those prices have now been realized, and QE2 is closer to its end than investors may recognize. Last year, in early November when QE2 commenced, the monetary base was at $1.985 trillion, and the Fed's SOMA portfolio was at about $2 trillion. As of May 15, the monetary base had expanded to $2.586 trillion (already up by just over $600 billion) and the SOMA portfolio, which has an explicit QE2 target of $2.6 trillion, stood at $2.532 trillion. At the prevailing rate of purchases - approximately $19 billion per week net of MBS reinvestments - the Fed should complete its purchases under QE2 on or about Friday, June 10. Unless one anticipates a burst of demand for stock by speculators during the final days of the Fed's program, one would think that we may have passed the point of ideal inventory liquidation. Little wonder we're observing a clear slowing of price momentum, deteriorating internals in speculative indices such as the Nasdaq and Russell 2000, and price-volume behavior characteristic of persistent distribution.
That's not to rule out the possibility that we could observe yet another burst of speculative demand from some source. Given the recent increase in new claims for unemployment and rollover in a variety of short- and long-leading economic measures, that possibility might even include weak suggestions of further quantitative easing. While I doubt that further Fed purchases would do much for the economy other than set up an even more troublesome adjustment down the road, and while the current batch of Fed governors is more hawkish than what Bernanke had available last fall, we've learned painfully enough not to rule out the possibility of reckless policy decisions. Still, it seems dangerous to base one's "edge" here on the expectation that the Fed will embark on further easing, hoping that fresh demand will follow - even at present valuations - and that further demand will follow upon that which will allow the inventory to be sold at a profit. For our part, we prefer an evidence-based approach that doesn't require our hopes about future scenarios to run overtime.
This is a good time to recall that markets rarely form "V-shaped" peaks or troughs. While the initial blast lower from an overvalued, overbought peak can be very steep, aging bull markets also have a tendency to exhaust a sequence of attempts at "buying the dip" - resulting in a broader, range-bound distribution process that can last for several months. Even here, we're open to the possibility of modest, periodic exposure to market risk depending on the specific set of conditions we observe, but at this point, any exposure we accept is likely to be coupled with a continued "line" of defense using index put options to cover the risk of any abrupt market losses. That said, the overall tone of market internals is deteriorating rather than improving, and with valuations elevated, it's best to view any range-bound rallies with a memory of how things worked out following the apparently "resilient" markets of 2000 and 2007.
While my sense is that many investors and institutions are holding a greater market exposure than is appropriate given present return/risk prospects, I should mention that there isn't a great deal of evidence that bears and short-sellers have a particular "edge" here either. Our own investment stance is defensive but also fairly neutral, and with a preference toward moderate, if transitory, positive exposure. At the point we see a greater deterioration of market internals, particularly if it is coupled with economic deterioration and widening credit spreads, the market environment will probably turn hostile in a more sustained way. For now, I want to be clear that we don't see how accepting market exposure here provides much in the way of scarce or useful services to other investors or the economy - but we also that we don't yet see the internal deterioration that would allow a trader to anticipate aggressive selling with a high probability.
Prospective returns as a measure of prospective risk
"In bull markets - usually when things have been going well for a while - people tend to say 'Risk is my friend. The more risk I take, the greater my return will be. I'd like more risk, please.' The truth is, risk tolerance is antithetical to successful investing. When people aren't afraid of risk, they'll accept risk without being compensated for doing so... and risk compensation will disappear. But only when investors are sufficiently risk-averse will markets offer adequate risk premiums. When worry is in short supply, risky borrowers and questionable schemes will have easy access to capital, and the financial system will become precarious. Too much money will chase the risky and the new, driving up asset prices and driving down prospective returns and safety."
- Howard Marks, Oaktree Capital Management, The Most Important Thing
One of the interesting points that both Warren Buffett and Howard Marks have stressed over the years is that risk - viewed as the risk of losing significant amounts of money - moves in the same direction as valuations. So as valuations become rich, risk increases, and as valuations become depressed, risk declines. At the same time, rich valuations imply weak long-term prospective returns, while depressed valuations imply strong long-term prospective returns. As a result, both Marks and Buffett suggest that risk is lowest precisely when prospective returns are the highest, and risk is highest precisely when prospective returns are the worst.
Of course, most of finance theory is based on a positive relationship between risk and return. That is, higher risk is assumed to be required in order to achieve higher expected return. But the hidden assumption in finance theory is that the securities are "efficiently" priced. See, efficiency says that there is no way to adjust your portfolio in a way that produces greater expected return per unit of risk. It therefore follows that the only way to increase expected return, once your portfolio is efficient, is to take more risk. Still, even finance theory has no problem with the idea that you can reduce risk and increase expected return at the same time if you are starting with a poorly diversified portfolio or inefficiently priced securities. So neither Buffett nor Marks are proposing some "new" sort of finance theory. They're simply saying that they don't believe that stocks are always efficiently priced.
On the subject of expected returns, I noted last week that Jeremy Grantham views "fair value" to be about 920 on the S&P 500. That implies a price-to-revenue multiple of just under 1.0, which is about right historically. Since 1940, the average price-to-revenue multiple for the S&P 500 has been about 0.9. Given that revenues are still somewhat depressed here, it makes sense to bump up the current number ($962.71) somewhat, or to use a multiple closer to 0.95, which is consistent with what Grantham is getting, albeit with much different methods. As I noted above, on the basis of virtually every normalized fundamental we choose to examine (normalized net earnings, forward operating earnings, dividends, book values, Tobin's Q, or revenues), we estimate that prospective 10-year returns on the S&P 500 are only about 3.6%, which translates into a market that appears overvalued by roughly 45%.
Below, I've presented a somewhat simplified revenue-based methodology, which correlates strongly with subsequent 10-year S&P 500 total returns, despite its simplicity. Again, we obtain nearly identical expected returns from a whole range of methods that we've detailed over the years.
[Geek's Note: The algebra for the projections above is simply (1.06)(0.9/PR)^0.10 - 1 + DY(PR/.9 + 1)/2 where PR is the prevailing price/revenue multiple of the S&P 500, and DY is the dividend yield in decimal form (e.g. 0.02 is 2%). As usual, the first term estimates the expected annual capital gain and the second term approximates the expected yield, which is an average of the present yield and the implied yield a decade from today.]
The ability of valuations to provide long-term projections for S&P 500 returns gives us a nice laboratory in which to test Marks' and Buffett's views about projected return and risk. Specifically, if we view risk as the potential for deep losses, we would expect that the depth of periodic losses would tend to be greater following points where the projected 10-year total return for the S&P 500 was particularly low, while the worst losses would tend to be shallower when stocks were priced to achieve very strong 10-year total returns. In fact, that's exactly what we observe.
Notice that at rare points where stocks have been priced to achieve 10-year annual total returns in the neighborhood of 20% or higher (as they were, for example, in 1950 and 1982), the worst subsequent losses from those points have been limited to little more than 10%. So investors accepting market risk at those points were inviting years and years of 20% compound returns, yet with a total downside that - even if it emerged - amounted to little more than 6-8 months of lost expected return.
When stocks have been priced to achieve a prospective return of 10%, potential losses were greater, but except in rare cases were typically confined to about 20% downside over the following 3-year period. That's not negligible of course, but more often than not, even fairly passive investors could expect to be well compensated for that risk over an extended holding period.
Once prospective returns have dropped below about 7.5% (which we saw regularly in the late 1960's and early 1970's), and particularly when they have fallen below 5% (which we saw in the 1998-2000 period and again in 2007 and today), the potential downside risk has exploded higher. Not in every case, of course, as the cluster of points in the 0-10% range attests. Still, the sweep of points down and to the left represent excruciating and often rapid losses. The market's historical collapses have been born of periods where stocks were already priced to achieve predictably weak returns. Worse, investors in those periods were bargaining for a small expected return while taking on downside risk that would often easily wipe out several years of those returns. Investors who took on this risk on clearly provided no useful service to others, but often did immense damage to themselves.
Again, it is essential to stress that this risk did not materialize immediately or in every case. Still, low prospective returns have produced deep losses with enough regularity that historically, once prospective returns have dropped below about 7.5%, investors could have adopted what I've called a "Rip van Winkle" strategy: just going to sleep until stocks dropped by at least 30% or moved back to prospective returns above 10% - a strategy that would have historically outperformed the S&P 500 with about half the overall risk. Now, there are certainly better and more practical strategies that have less tracking risk, but the point is essential: once stocks have been priced to achieve disappointingly low prospective returns, whatever additional returns are achieved by the market are ultimately surrendered.
Gains that emerge from an already overvalued market are almost always temporary. The only reason for continuing to accept risk is the belief that some speculative edge can be exploited to allow a better exit. There are certainly a variety of strategies that can be pursued to that end, but as I noted earlier, they ultimately have to deliver - immediately or over time - some scarce and useful service to other investors. In recent months, it has evidently been enough to carry an inventory of stock on the belief that not every seat on the bandwagon was full. Once bullish sentiment hit the same extremes seen in 2007 a few weeks ago, the case for unsatisfied demand became weaker, but there was still a schedule of QE2 purchases and a reasonable earnings season ahead. If market internals recover somewhat, or if oversold conditions or less bullish sentiment provide some hope of accumulating inventory and distributing it to others at higher levels, there may be some room for a moderate, if transitory, exposure to market fluctuations. Here and now, we can't see what exploitable edge there is in buying an overvalued, overbought market.
We certainly believe we can always find individual stocks that are worthy of investment - as long as we can periodically hedge their exposure to overall market fluctuations. But as for the market as a whole, we can't see what scarce, useful service our exposure to risk would provide to other investors or to the economy today, nor the likelihood that inventory we might accumulate at current levels will predictably be in such great demand in the future that we should act now to position ourselves to provide that service.
As of last week, the Market Climate was characterized by strenuous overvaluation, mixed market internals, overbought intermediate-term conditions, overbullish sentiment, and some early but modest indications of economic weakness (e.g. unemployment claims, Philly Fed). On last week's mid-week selloff, we actually got a brief opportunity to jolt our put strikes from what became in-the-money levels to lower out-of-the-money strikes. Given that we covered about 30% of the short-call side of our hedge several weeks ago, the shift gave us a modestly positive overall exposure to market fluctuations about mid-week, while remaining well-covered against further downside. By Friday, our ensemble of methods was back to a negative expected return/risk profile, and we moved back to a defensive stance. Overall, the brief shift helped to nicely offset a pullback in a few individual stocks we own, as our own holdings weren't quite able to escape the general deterioration in market internals last week. Presently, both Strategic Growth and Strategic International Equity are well-hedged.
In bonds, longer-term yields are dabbling right at the lower end of a trading range that has defined their movement for several months. While budget issues and the oncoming drop in Fed purchases of U.S. Treasuries threaten some potential upside pressure on yields, emerging economic weakness - though early - has kept yields at the low end of their range. The overall set of prospective return and risk is positive, but modestly so, and keeps the Strategic Total Return Fund at a roughly 3-year duration overall. At the same time, the combination of somewhat less yield pressure, early economic weakness, and a selloff in precious metals shares has contributed to a moderate improvement in the expected return/risk profile in that market. Accordingly, we increased our exposure to precious metals shares to about 8% of assets in Strategic Total Return, which is not aggressive by any means, but certainly more constructive than we've been in recent weeks. The Fund also holds about 2% of assets in utility shares at present.
The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse.
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