Wednesday, May 29, 2013

the failure of mutual funds

We spend a lot of time harping on mutual funds. Frankly, they deserve it. Most underperform their benchmarks and charge fees multiple times higher than passive index funds. The result is a giant wealth transfer from investors to fund managers.

But after speaking with a fund manager recently, I realize this story is more complicated than I've made it out to be. Mutual fund investors may only have themselves to blame for awful returns.

Most dismal mutual-fund returns are the result of managers engaging in the classic "buy high, sell low" dance. But those buy and sell decisions don't necessarily reflect the will of the investment manager. Fund investors are constantly adding to and withdrawing from the fund's they invest in -- almost always at the worst time possible.

"You would be surprised how easy it is for a fund's investors to take control of the fund," the manager told me.

Imagine you're a smart fund manager who thinks stocks are overvalued. You don't have any good ideas to invest in. But you come into the office one morning and your secretary says, "Congratulations, your investors just sent you another $1 billion." What do you do? You can:
  • Keep it in cash or bonds.
  • Close down your fund and refuse new investments.
  • Grit your teeth and buy overvalued stocks.
The first choice isn't even an option for some funds, as their charters mandate that they stay almost fully invested. Even if they can, bulking up cash dilutes the investments of existing investors. Fund managers rarely take this option -- equity mutual fund cash levels have fluctuated in a tight band of between 4%-6% over the last decade.

The second option is the noble choice, but rarely occurs because funds earn fees on assets under management. When a fund manager goes to his or her boss and says, "I'd like to turn down $10 million in annual fees," the results are entirely predictable. Greenwich real estate doesn't buy itself, you know.

Option three is usually what happens.

Now imagine it's 2009, and everything is going to hell in a handbasket. Stocks are the cheapest you've seen in your career, and the last thing you want to do is sell them. But you come into the office one morning and your secretary says, "Your investors want to withdraw $5 billion."

You only have one option to meet that demand: sell cheap stocks. Forget about all the buying opportunities -- your traders are working overtime to liquidate the portfolio whether you like it or not.

Sadly, that affects all of a fund's investors. Even if one fund investor has a long-term outlook and no intention of selling, the fund's buy and sell actions can be dictated by maniac deposits and panic withdrawals. Other investors' decisions can hurt you. That's why they call it a mutual fund.

Take Bill Miller of Legg Mason. Miller was one the best investors in the 1990s and early 2000s before suffering huge losses during the financial crisis that sullied his long-term track record.

What happened? In part, he made some bad calls. But Miller's early success and media fame led investors to give him a net $4.4 billion in new cash to invest just as stocks were getting expensive last decade. As his skill came into question, they then yanked nearly $10 billion out just as stocks were the cheapest they had been in years. Miller's wisdom didn't really matter last decade. His investors were calling the shots.

***

[6/5/13 - see also Investor Nirvana by James J. Cramer, Worth, May 1997]

Saturday, May 25, 2013

the market is (still) overvalued

It's that time again.

A growing group of pessimists are asking whether the stock market is back to bubble territory. Some are even comparing it to 1999. They say stocks are being inflated by the Fed. That they're disconnected from the reality of a weak economy. That they're overvalued and bound to fall.

Could they be right? Of course.

They make a forceful case with charts and ratios and historical data.

But they have been making the same argument for four years now, and they have been wrong all the way. Clearly, the world is more complicated than the pessimists assume.

Consider that the S&P 500 has risen as much as 60% since these quotes went to press:
"The S&P 500 is about 40 percent overvalued" -- October, 2009
"US Stocks Surge Back Toward Bubble Territory" -- January, 2010
"On a valuation basis, the S&P 500 remains about 40% above historical norms on the basis of normalized earnings." -- July, 2010
"Is The Stock Market Overvalued? Almost Every Important Measure Says Yes" -- November, 2010
"The market is as overvalued now as it was undervalued [in early 2009]," said David A. Rosenberg, chief economist and strategist for Gluskin Sheff, an investment firm." -- March, 2010
"Andrew Smithers, an excellent economist based in London, is telling us that we're way too optimistic, that fair value for the S&P 500 is actually in the 700-750 range. Smithers, therefore, thinks the stock market is about 50% overvalued." -- June, 2010
Sure, you might say these calls were just early. But let me put forth a truism in finance: When an average business cycle lasts five years, there is no such thing as four years ahead of the game. You are just wrong.

Some of the bubble arguments haven't changed in the face of a 50% rally. Take the cyclically adjusted price/earnings ratio, or CAPE. In 2010, the S&P 500, which traded near the 1,000 level, had a CAPE valuation of around 22, which many pointed out was about 40% above historic norms. Today, trading above 1,600, the S&P 500 has a CAPE of about ... 23. Even as the market exploded higher, the degree to which the market is supposedly overvalued hasn't changed that much, since companies have been busy investing in their operations and boosting earnings. That's why being four years early means being four years wrong.

Some people predicted the financial crisis in 2008. And good for them. But many of them also predicted a financial crisis in 2007, 2006, 2005, 1997, 1995, 1992, 1985, 1970, and so on. They are perma-bears who get ignored during booms and lionized during busts, even though their arguments rarely change. It's the classic broken-clock-is-right-twice-a-day syndrome.
Author Daniel Gardner wrote earlier this year:
In 2010, [Robert] Prechter said the Dow would crash to 1,000 this year or in the near future. The media loved it. Prechter's call was reported all over the world. Which was nice for Prechter. 
Even better, very few reporters bothered to mention that Prechter has been making pretty much the same prediction since 1987.
It was similar for investor Peter Schiff. There's a great YouTube video -- worthy of some 2.1 million views -- of Schiff predicting a market crash circa 2007. That was an excellent call. But here's another video of Schiff in 2002 predicting all kinds of gloom that never happened. Sadly, that video received only a handful of views. Gardner writes in his book Future Babble:
[Schiff predicted the 2008 crisis,] but it's somewhat less amazing if you bear in mind that Schiff has been making essentially the same prediction for the same reason for many years. And the amazement fades entirely when you learn that the man Schiff credits for his understanding of economics -- his father, Irwin -- has been doing the same at least since 1976.
***

What do I think?  Well, AAPL has a P/E of 10.6.  MSFT has a P/E of 17.7 (forward P/E of 10.8).  Berkshire Hathaway has P/B of 1.4 (higher than low of 1.1 in 2011).  CSCO has a P/E of 13.1.  I would say these stocks aren't overpriced.  The current P/E of VFINX is 14.28.  While not cheap, that still sounds quite reasonable.

The argument is that current earnings are inflated.  I can see that the growth rate will slow, but I still see overall eps increasing from here, if only moderately.

Friday, May 24, 2013

5 things to know about investing

I own one finance textbook, and I occasionally open it to remind myself how little I know about finance. It's packed with formulas on complex option pricing, the Gaussian copula function, and a chapter titled, "Assessment of Confidence Limits of Selected Values of Complex-Valued Models." I have literally no idea what that means.

Should it bother me that there's so much about finance I don't know? I don't think so. As John Reed writes in his book Succeeding:
When you first start to study a field, it seems like you have to memorize a zillion things. You don't. What you need is to identify the core principles -- generally three to twelve of them -- that govern the field. The million things you thought you had to memorize are simply various combinations of the core principles.
Evolution tells you a lot about biology. A handful of cognitive biases explain most of psychology. Likewise, there are a few core principles that explain most of what we need to know about investing.

Here are five that come to mind.

1.  It takes time.
2.  The largest single variable that affect returns is valuations [Peter Lynch might disagree].
3.  Simple is better than smart.
4.  The odds of high volatility is 100%.
5.  The industry is dominated by cranks, charlatans, and salesmen.

Sunday, May 19, 2013

you have it good

Consider human history. For all but a fragment of it, about half of all children died before their fifth birthdays. Of the ones who survived, life was nasty, brutish, and short. According to data compiled by economist Angus Maddison, the total world population grew at an annualized rate indistinguishable from zero over the period from A.D. 1 to A.D. 1820.

Over the millennia, there were pockets of progress, some lasting for centuries. The ones we know of included the Roman Empire in Europe, the Tang and Song dynasties in China, and the Inca, Aztec, and Maya civilizations in the Americas. However, these civilizations, for the most part, did not set growth on a permanently higher trajectory. They usually ended in the sacking of great cities and the burning of books. Humanity didn't convincingly break out of this cycle until a couple of centuries ago.

Even narrowing our scope to the 20th century, our current prosperity looks surprisingly fragile and uneven, the outcome of a series of contingent events that plausibly could have led to far worse outcomes. The future of democratic capitalism was up for grabs during the Great Depression. World War I and World War II devastated Europe twice over and Asia once. The Cold War risked nuclear apocalypse. If we could reroll the 20th century many times, creating slightly different starting conditions each time, some outcomes surely would have led to regress (the probability of such outcomes is unknowable, of course). If you were born to a random family in the first half of the 20th century, chances are you would have experienced privation or total war. Even today, the majority of humanity lives in poverty by the rich world's standards. Bad things happen more often than not.

I don't write to frighten you but to let you know how good you've had it these past few decades. They were the most peaceful, stable, prosperous period humanity has ever experienced.

[I'll stop here, but the author makes the case that things will regress from here.]

Saturday, May 18, 2013

stocks are headed higher

says David Tepper

Let's get a few things straight:
  • The Federal Reserve is buying $85 billion a month of Treasuries.
  • The budget deficit is shrinking very fast thanks to a combination of a stronger economy, budget cuts, and Fannie Mae and Freddie Mac repaying tens of billions of dollars in bailout funds. 
  • Over the next six months, the budget deficit will likely be less than $100 billion, while the Fed will buy more than $500 billion of Treasuries.
Hedge fund billionaire David Tepper connects these dots and comes to a firm conclusion: Stocks are going higher. The Dow Jones (DJINDICES: ^DJI) surged on his comments.

Here he is on CNBC this morning:
In My Cousin Vinny there's this moment at the end of the movie where he's making a case and he's summing it up, and he sums it up with so many different things that the prosecution says, "case dismissed." Because the evidence is so overwhelming. 
It's kind of like that right now. It's so overwhelming. I mean, the economy is getting better, autos are better, housing is better -- they can't find enough people to work in housing, that's the only thing holding it back right now. 
The Fed ... we actually looked at how the numbers run. The numbers are quite amazing -- just truly amazing. The Fed, as you know, is going to purchase $85 billion of Treasuries and mortgages per month ... so over $500 billion in six months. 
But what's happened, and what's really amazing, is that over the next six months, because of tax increases, because of budget cuts, because of growth in the economy, and also because of Fannie Mae and Freddie Mac paying back money to the government, the deficit over the next six months is shrinking massively. ... It looks like the next six month's deficit is going to be well under $100 [billion], probably closer to $85 [billion]. 
Which means -- and this is an important thing -- ... we have over $500 billion we're going to buy over the next six months, and now we only have a deficit that's less than $100 billion over the next six months. ... That means we've got $400 billion -- $400 billion -- that has to be made up.
A lot of that $400 billion will make its way into stocks, Tepper concludes.

Thursday, May 09, 2013

how rich would you be

if you had bought Apple stock instead of its gadgets?

Ever wonder how much money you would have now had you invested in AAPL stock instead of the first iPod when it came out? (That's $399 in 2001).

You'd have tens of thousands of dollars (see image).

We put 10 of the most popular Apple products of the last two decades together with what their current value would be if they had been stock investments. Our numbers come from Kyle Conroy, a software engineer who compiled all the data on his website.

If you paid for a new MacBook or iPhone in the past 10 years, seeing these figures may cause you to feel some regret. But it's an interesting reflection of just how successful AAPL stock has been.

Saturday, May 04, 2013

the beginning of the end of QE (what happens?)

The Fed met again April 30-May 1 and as expected, kept interest rate policy unchanged. But the recent debate at the Fed has focused less on interest rates and more on when to begin reducing its bond purchases from the current pace of $85 billion per month. A few Fed members have indicated that they would like to taper down purchases later this year. What does that mean for the bond market?

A steeper yield curve is likely. When the Fed signals a slowdown in bond purchases it could trigger higher long-term interest rates and a steepening yield curve, in our view. Since the Fed has concentrated its bond buying in long-term debt, less buying would mean that private sector buyers would need to step in to fill the gap. It's likely they would demand higher interest rates than the Fed. Also, presumably the Fed will begin tapering its purchases when they are confident that the economy is a on a sustainable path to stronger growth and lower unemployment. Those factors are likely to push long-term interest rates higher as well. However, based on the latest projections by the Fed, most members see short-term interest rates to remain near zero until 2016. Consequently, we anticipate that the yield curve will steepen with short-term rates remaining anchored at low levels while long-term interest rates move higher.

Bottom line. The Fed could begin to signal that they are going to reduce the pace of monthly bond purchases later this year. We would expect that long-term interest rates are likely to move higher and the yield curve to steepen, in response to that signal. Although we don't expect a sharp rise in interest rates, we suggest preparing for a steeper yield curve by limiting your exposure to long-term bonds.