The natural gravity of stocks

Even in the remotest corner of the world, everyone understands the law of gravity. When you drop something ... it will fall to the ground.

Interestingly most investors don't really understand the natural gravity of stocks. In fact, they find every way possible to confuse matters with too much commentary, charts, and data.

Plain and simple, the gravity of stocks is to move up. Meaning that to move higher is their natural progression UNLESS an opposing force gets in their way.

I'd like to prove this point so you can better understand why stocks will continue higher into year end and into 2015. And to learn the signs of what will eventually lead to an overall market decline.

Growth is the Most Natural Thing in the World

I don't mean to get too philosophical here, but it is important to understand that advancing forward is a prime driver of the human condition. This innate desire to do things better leads to improvements in productivity and our standard of living.

It also creates greater economic activity, which is another way of saying higher profits. And profit growth is the main ingredient we investors seek when selecting stocks.

To boil it down:

Human advancement = higher economic activity = higher profits = higher share prices.

The above equation proves why the natural order of things is for the stock market to move higher. Unfortunately it's not all rainbows and lollipops.

Boom and Bust Cycle

One sad thing about the human condition is that we are also prone to believing that the good times will last forever. This leads to excesses during the boom times that pave the way for the next bust. (And often those excesses are about people, businesses and governments becoming over leveraged).

Here is the equation for a recession:

Lower economic activity = lower profits = *lower share prices

(*average stock market decline during a recession is 34%).

Gladly the average US recession only lasts about 13 months, while the average expansion enjoys a healthy 63-month reign. That means we are able to take five good steps forward for every one backwards.

What Does that Mean for the Future?

It should be clear by now that my premise is this:

Stocks will continue to advance until there are signs of the next recession.

Of course, I don't mean stocks will go up every day, week or month. I mean that the primary long term trend will be bullish until the odds of a future recession increase.

Right now the odds of a looming recession are very low. And so best, to stay in the bullish camp until some more ominous dark clouds emerge.

-- By Steve Reitmeister, September 27, 2014

the 50 State economies

Now that the recovery appears to finally be taking hold, Business Insider decided to see how that recovery was being felt across the country.

We ranked each state on how eight economic measures have grown or shrunk in recent years: the unemployment rate, the number of non-farm payroll jobs, gross domestic product, average wages, the working age (18-64) population, value of international exports, house prices, and auto sales.

50. Alaska

The petroleum sector is a major part of the Alaskan economy, but many of Alaska's oil deposits have been depleted over the years. This depletion has dropped the state's crude oil production to fourth place. Other major employment sectors include the federal government and the fishing and tourism industries.

Alaska was one of the few states that actually lost payroll jobs between June 2013 and June 2014.  Wages decreased by .41% from 2012 to 2013.  And the GDP decreased by 2.5% in 2013, the worst among the states.

33. Nebraska

The agriculture industry is the major economic focal point in Nebraska — including crop and livestock production. Other major Nebraska industries include manufacturing and health and business services.

Nebraska's GDP grew by 3%.
The working age population grew by 0.43%.
Additionally, the unemployment rate fell by 0.5%.

24. Hawaii

Hawaii, with its incredible tropical climate and island scenery, has always relied on tourism, whether or not said tourism is always safe, as a major factor in its economy.

Hawaii saw some of the best improvement in auto sales, with per-dealer sales jumping 11.7% between 2012 and 2013.

Similarly, Hawaii's housing market is booming, with housing prices rising 7.5% from Q1 2013 to Q1 2014.

While not a huge part of the Hawaiian economy, exports dropped 19.5% between 2012 and 2013, the second-largest decline in the country.

23. New York

New York City is the financial capital of the world, but changes in the state's economy have been mixed in the last couple of years. Here's New York's standing in our ranking:

New York had a very respectable 4.8% growth in exports from 2012 to 2013.

Average real wages in New York grew by 0.7% from 2012 to 2013, which, while not a huge increase, is better than in many other states, where wages were completely flat or declined over that time period.

New York's GDP grew by only 0.7% in 2013, the fifth-slowest rate in the nation.

9. Nevada

Nevada was hit extremely hard by the implosion of the 2000's housing bubble, but its economy, including its housing market, is getting back on its feet. Here's where Nevada stands on our variables:

Nevada's home prices have skyrocketed over the past few years, jumping nearly 20% between Q1 2013 and Q2 2014, the largest increase of any state.

Nevada's job market is also dramatically improving. The unemployment rate dropped 2.3% from 10.0% in June 2013 to 7.7% in June 2014, the second-best improvement in the country.

The drop in unemployment was fueled by strong job growth, with Nevada adding 46,200 jobs over the same time period, a 3.9% gain.

7. Washington

The state of Washington is home to many major corporations, with the headquarters of technology companies like Microsoft and Amazon, the home of coffee behemoth Starbucks, and a significant presence of airplane giant Boeing. Here's Washington's score:

Washington saw 6.3% growth in international exports between 2012 and 2013, led by $42.6 billion of exports of aircraft, engines, and parts.

Washington's housing market is improving, with a 5.3% increase in house prices between Q1 2013 and Q1 2014.

Drivers in Washington are buying cars, with per-dealer auto sales increasing 8.7% from 2012 to 2013.

6. Florida

Florida's sunny and hot climate has long made it a natural destination for tourists and retirees, and, largely owing to NASA's presence at Cape Canaveral, the state has a long history of being a center for aerospace industries. Here's how Florida scored:

Florida's housing market shows strong signs of recovery, with prices rising 8.9% from Q1 2013 to Q1 2014.

Florida had a 3.1% jump in payroll jobs between June 2013 and June 2014, adding about 237,500 jobs over that year.

Florida's working age population is expanding, growing at a 0.7% rate, higher than the U.S. rate of 0.4%.

5. Utah

With a state government focused on economic growth, Utah frequently shows up at or near the top of lists of states where it's good to do business. Here's why they're near the top of our list:

Utah has a rapidly growing working-age population, with a 1.5% increase in the number of 18- to 64-year-olds between 2012 and 2013, the second-highest rate in the nation.

Utah also saw robust job growth, adding 45,000 jobs between June 2013 and June 2014, a 3.5% increase.

State GDP rose 3.8% in 2013, tied for sixth in the country.

4. Arizona

With Phoenix at its heart, and despite being hit especially hard by the collapse of the housing bubble, Arizona continues to have a rapidly growing economy. Here's how Arizona scored on our metrics:

Arizona saw an 18.8% jump in per-dealer auto sales from $60.6 million in 2012 to $71.9 million in 2013, the largest jump of that in any state.

Arizona's housing market is making a brisk post-recession recovery, with a 13.4% increase in house prices between Q1 2013 and Q1 2014. Although we count this as a positive, some see the possibility of a new bubble.

Despite this, overall GDP growth in Arizona was a bit weaker than in some of the other high-ranking states, with just 1.1% growth in 2013.

3. Texas

Since the discovery of vast oil reserves around the turn of the 20th century, Texas has been an economic powerhouse. Energy continues to be a huge part of the Texas economy, but many industries have a large presence in the state. Here's how Texas did on our measures:

Texas had a 3.3% increase in nonfarm payroll jobs

The working age population grew by 1.3%

Exports grew by 4.1% to about $279 billion, solidifying Texas' lead in international exports among the states.

2. California

California is the country's largest state by population and sheer economic size. California's economy is enormous in nearly every industrial sector. Here's how the Golden State fared on our metrics:

Housing prices jumped up by 15%, showing strong signs of a booming housing market, though of course this has its costs, especially in the Bay Area.

Real annual wages went up 0.9%, with a 2013 annual wage of $57,121.

Per-dealer auto sales had a 9.5% increase in per-dealer auto sales, indicating that consumers are feeling good.

1. Colorado

Colorado was in the top 10 states on five of our metrics, and in the top 15 on the other three. As with many of the other top economies, Colorado's economy is highly diversified, and it especially boasts a strong aerospace sector and a huge amount of federal investment, such as the NORAD complex. Here are some of the metrics in which Colorado really shined:

Colorado saw 1.2% growth in its working age population from 2012 to 2013.

The state also had 2.8% growth in non-farm payroll jobs, adding 66,300 jobs between June 2013 and June 2014.

Colorado's GDP grew 3.8% year over year in 2013.

All in all, Colorado's economy is broadly growing at a healthy clip, and so it comes in as the overall winner.

Bill Gross leaves Pimco

NEW YORK (Reuters) - Bill Gross, one of the bond market's most renowned investors, is leaving Pimco, the investment firm he founded and with which his name has been effectively synonymous, for rival asset management firm Janus Capital Group, Janus said on Friday.

The surprise announcement, which rattled the U.S. Treasury market, comes just days after news broke that U.S. securities regulators were investigating Pimco and Gross in connection with an exchange-traded fund he managed at Pimco.

A source familiar with the matter told Reuters that Gross had been clashing with the firm's executive committee and had threatened to quit multiple times.

Dubbed the "Bond King" and long-time manager of the Pimco Total Return Fund, the world's largest bond fund, Gross will manage the Janus Global Unconstrained Bond Fund, Janus said in a statement. He begins work at Janus on Sept. 29, Janus said.

German insurer Allianz SE, the parent of Newport Beach, California-based Pimco, was not immediately available for comment.

Pimco said in a statement that it had a succession plan in place and that its management board would confirm a new chief investment officer shortly.

Allianz shares sank more than 5 percent in Germany following the news, while Janus surged more than 30 percent in premarket trading in New York.

Bonds also took a hit. The 10-year U.S. Treasury yield, which moves in the opposite direction of its price, rose 4 basis points to 2.54 percent.

"Pimco and Bill Gross are synonymous," said Todd Rosenbluth, director of mutual fund research at S&P Capital IQ. "It will be extremely hard to think of Pimco and Bill Gross as separate, and it will take time for investors to realize that he no longer is going to play a role at one of the world’s largest fixed income managers."

Gross, 70, who built Pimco into one of the world's largest asset managers with nearly $2 trillion, had come under renewed scrutiny as the U.S. Securities and Exchange Commission investigates whether a popular ETF he runs, which was launched to mimic the strategy of the much larger Pimco Total Return Fund, had artificially inflated returns. The probe was first reported by the Wall Street Journal.

Gross had already been under intense scrutiny after a public falling-out with former heir-apparent Mohamed El-Erian, who left Pimco earlier this year.

The management turmoil at Pimco was one catalyst behind persistent investor redemptions from the flagship Total Return Fund. In August the fund suffered its 16th straight month of outflows, and its performance lagged 73 percent of its peers.

Buffett on macro forecasts

We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen. Thirty years ago, no one could have foreseen the huge expansion of the Vietnam War, wage and price controls, two oil shocks, the resignation of a president, the dissolution of the Soviet Union, a one-day drop in the Dow of 508 points, or treasury bill yields fluctuating between 2.8% and 17.4%.

But, surprise - none of these blockbuster events made the slightest dent in Ben Graham's investment principles. Nor did they render unsound the negotiated purchases of fine businesses at sensible prices. Imagine the cost to us, then, if we had let a fear of unknowns cause us to defer or alter the deployment of capital. Indeed, we have usually made our best purchases when apprehensions about some macro event were at a peak. Fear is the foe of the faddist, but the friend of the fundamentalist.

A different set of major shocks is sure to occur in the next 30 years. We will neither try to predict these nor to profit from them. If we can identify businesses similar to those we have purchased in the past, external surprises will have little effect on our long-term results.

From the 1994 Berkshire Hathaway shareholder letter

3 Mistakes Investors Keep Making

Markets are unpredictable, and people are emotional. The combination keeps breeding misbehavior and regret, over and over again.

Forget derivatives, inverse exchange-traded funds or 50-day moving averages. Investing shouldn't be difficult.

Spend less than you earn. Put the difference in a low-cost broad-based index fund. Leave it alone and let it grow over time.

Yet markets are unpredictable, and people are emotional. Mixing the two breeds misbehavior and regret, as the temptation to buy stocks when they're high and sell when they're low overwhelms common sense.

Depending on how it's calculated, buying high and selling low has cost the average investor anywhere between one percentage point and four percentage points a year in lost return over the long run.

The cost of this misbehavior can be devastating: Over a 20-year period, $10,000 grows to more than $38,000 at a 7 percent annual return, but just $22,000 at a 4 percent return.

Successful investing is mostly a battle with your own brain. With stocks more than doubling in value over the past five years, now is the time to prepare yourself for the emotional roller coaster that will come during the inevitable correction.

Here are three common pitfalls investors fall for.


Mistake No. 1: Incorrectly predicting your future emotions

Too many investors are confident they will be greedy when others are fearful. None assume they will be the fearful ones, even though somebody has to be, by definition.

Christopher Gardner, president of FMF&E Wealth Management in East Syracuse, New York, recalls a pair of clients who were comfortable with the idea of big price swings during the boom last decade and said they were prepared to handle them when they came.

Both threw in the towel as soon as the 2008 crash hit.

"They closed their accounts and transferred the money to a bank account," Gardner says. "There was absolutely nothing I could do to talk them out of it."

The problem: "The vast majority of people overestimate their willingness to take risk. Fear is a strong emotion and often plays a much greater role in decision making than logic."

Past behavior may be the best way to judge risk tolerance. If you panicked and sold stocks in 2008, you probably have a low risk tolerance, regardless of what you think today. If you went headfirst into technology stocks in 1999, you are probably susceptible to future bubbles, regardless of how contrarian you think you are now.

Coming to terms with this reality is vital to avoiding future regret.

Gardner's clients who dumped their stocks in 2008 now use a more conservative investment strategy than before. "They are now much more in tune with their willingness to take risk," he says.


Mistake No. 2: Failing to realize how common volatility is

Napoleon was said to define a military genius as a man who can do the average thing when all those around him are going crazy.

The same holds true for investors. You needn't have been a genius to have done well in stocks over the past decade. You just had to not have panicked in 2008, when everyone around you was going crazy.

One key to keeping a cool head during market drops is realizing how common they are. If you don't understand how normal big market moves really are, you are more likely to think a pullback is something unusual that requires attention and action. It often doesn't.

From 1900 to 2013, a broad index of U.S. stocks returned an annualized 6.5 percent, after accounting for inflation and dividends, according to data from Yale University economist Robert Shiller. Yet chaos in any given year is normal: The spread between an average year's highest and lowest close was 23 percentage points.

Investors regularly want explanations for why the market is dropping. The honest answer -- that this is just what stocks do sometimes, like why some days are colder than others -- feels inadequate to some, which can cause untold amounts of overanalysis, anxiety and misbehavior.


Mistake No. 3: Trying to forecast what stocks will do next

The inability to forecast hasn't prevented the desire to keep forecasting. No matter how bad forecasts are, investors come back for more.

"We really can't forecast all that well, and yet we pretend that we can. But we really can't," former Federal Reserve chairman Alan Greenspan said last year.

In 2005, investment bank Dresdner Kleinwort published a study of aggregate professional forecasts such as stock prices, interest rates and gross domestic product growth.

As a group, the forecasts were terrible. But the researchers found a fascinating trend: an almost perfect lag between forecasts and actual results.

Analysts would wait until stock prices rose and then forecast that stock prices were about to rise. After interest rates fell, analysts would forecast that interest rates were due to fall.

"Analysts are terribly good at telling us what has just happened but of little use in telling us what is going to happen in the future," the researchers wrote. Yet the appetite for such predictions is still insatiable.

A world without forecasts doesn't have to be scary. It just requires making room for error. The great investor Benjamin Graham once wrote that the purpose of having a margin of safety -- an emergency fund, job flexibility, avoiding expensive stocks -- was "rendering unnecessary an accurate estimate of the future."

I don't know if we'll have a recession this coming year. Nor does anyone else. But if you have a margin of safety, you don't need to know. Humility can be more valuable than prescience in investing, because it's sustainable and far easier.

You have no control over what the market will do next. You have complete control over how you react to whatever it does.

***

Worst Mistakes Investors Make [updated link]

a fun fact

Nine months ago it seemed a prediction that was bold and unimaginative all at once: That the Standard & Poor’s 500 index would claim for itself the theatrical moment of reaching the 2,014 level in the year 2014. Now this unyielding bull market, after a few nervous stutter steps, has made it happen.

The S&P 500 touched this level Friday morning. It got there on the day the instant megacap Alibaba Group (BABA) debuted in a culmination of the easy-money, China-emergence and e-commerce market themes, and in the week when investors were, yet again, reassured for the moment that the Federal Reserve remains inclined to move slow in sunsetting its easy-money policies.

The 2,014 level was a cutesy year-end 2014 target set in December by a couple of Wall Street strategists, representing a respectable 9% gain after last year’s 30% surge. Yet, mostly by coincidence, the 2,014 level also sits at a threshold of some consequence, representing exactly a 50% gain from the point in late 2012 when the stock market embarked upon its “liftoff phase.”

While we’re talking index-and-year number quirks, Doug Ramsey points out that the last time a major index climbed across a level that was also the year number was when the Dow Jones Industrial Average crossed 1987 in January of 1987. It would, of course, crash through the level that October.

This is just a fun fact and not meant as a foreboding prediction that an ’87-like collapse is ahead.

Richard Band is bullish (or not)

Another leg up is all the more likely now, because
we’re heading into what history tells us is an
extraordinarily strong period for stocks. Take a glance
at the chart on this page.

As you can see, the S&P 500 during the fourth
quarter of midterm election years has produced
double the average gain of all fourth quarters since
1950, and quadruple the gain of all quarters (first,
second, third and fourth). What’s more, 88% of all
fourth quarters in midterm election years since 1950
have ended in the green. Do you really want to pitch
against a batter with an average like that?

Interestingly enough, the only two midterm fourth
quarters to post a loss since 1950, according to the
folks at LPL Financial who compiled the numbers,
were 1978 and 1994. In both years, the Fed was
aggressively jacking up interest rates. Is the Hobbit
Lady doing that now?

Hardly. Dr. Yellen and her comrades are taking
pains (promising zero rates for a “considerable time”)
to exclude any such possibility. So, despite the already
elevated valuations of many big-name stocks, the path
of least resistance is still up. If anything, the magnitude
of the rally may even catch most of Wall Street’s bulls
by surprise. A blowoff approaching 2200 on the S&P
isn’t out of the question.

You might expect me to be whooping it up over
this prospect. However, my enthusiasm is actually
quite restrained. Today’s market is rife with not
only overvaluation but also excessive speculation,
as evidenced by record margin debt and frenzied
mergers-and-acquisitions activity. Polls reveal a high
degree of complacency among most market players.
Such conditions can fuel a breathtaking, parabolic,
“I can’t afford to be left out” rally. Alas, though:
Blowoff rallies tend to burn out quickly and to
collapse suddenly, as in 1929 and 1987.

-- Profitable Investing, October 2014

BABA IPO

Alibaba, the biggest IPO to ever hit Wall Street, made a huge splash in its debut on Friday.

Shares of the Chinese e-commerce giant opened at $92.70. That marks a 36% pop from the $68 price of its record-shattering initial public offering. The first day of trading can be very volatile. Alibaba continued to climb and nearly hit $100 before sinking back down to around $93.

The early bounce signals optimism among investors about Alibaba's (BABA) ability to continue its rapid growth trajectory as China's middle class grows and buys more and the company possibly expands to other parts of the world.

Unlike the disastrous 2012 Facebook (FB, Tech30) IPO on Nasdaq, Alibaba's first few minutes as a public company went smoothly. That's good news for the New York Stock Exchange, where Alibaba chose to list its high-profile IPO under the ticker symbol "BABA."

Alibaba raised $21.8 billion late Thursday by pricing its IPO at $68 per share. That's the largest ever IPO for a company listed on an American exchange.

*** [9/23/14]

BEIJING — China's richest man celebrated his 50th birthday last week in the United States and expects his company will last twice as long, plus two years.

Revealing his ambition — and a love of numbers common in China — Jack Ma says Alibaba will last 102 years so the Internet empire he founded in 1999 can span three centuries.

Under Ma's maverick leadership, the 15-year-old firm has already bridged a period of extraordinary change in global trade and the Chinese economy. In a nation with little e-commerce but plenty of Communist Party bureaucrats, he raised a still-growing giant whose U.S. initial public offering, which will start trading under the BABA ticker Friday, is the largest in history.

REJECTED BY KFC

His rags-to-riches journey is just as spectacular. A scrawny Ma, just over 5 feet tall, was rejected by KFC and other employers in his hometown of Hangzhou in east China. He believed in the Internet's business potential when few other Chinese did. Outlandish ideas earned him the nickname "Crazy Jack Ma." No one thinks he's mad now, even when dressing in wild wigs and lipstick for his annual meeting where he serenades a stadium full of Alibaba employees.

Ma's readiness to make fun of himself, and speak his mind, stands in contrast to China's often conservative corporate barons. Charismatic and energetic, this former teacher has become an inspiration to millions across China. He flunked at math but loved English, and countless books and DVDs sell his business lessons in every airport lounge.

Ma — whose net worth is $21.9 billion,according to the Bloomberg Billionaires Index — now stars in the coming-out party for China's private sector onto the world stage. He praises and uses Western management techniques but also quotes regularly from Chairman Mao Zedong. He is a fan of China's kung fu novels and made those legends part of his company's culture. He travels the world with a tai chi trainer.

nobody knew Ben Graham

We had 36 hours to analyze a company and present it in front of the whole committee. Oh, and we did not get to choose the company. So I locked myself in my room and started grinding through the annual reports of Intel Corp. (INTC). I actually managed to do a pretty good job in such a short time frame. Once in front of the committee, I started to recite everything I could remember from what I had read about the company. Everyone seemed to follow until I mentioned a word (or a name, I must say) that seemed to leave everyone puzzled. I tried repeating the name for a second time to make sure everyone understood. Now my audience was not just puzzled anymore, they were completely lost.

-Ben Graham used a formula in Security Analysis...
-Wait, who?
-Benjamin Graham, nobody has heard about him?
-Yeah, isn't that guy a teacher in Harvard or something?

That's when I realized that I was not in the same world as these people in front of me. Even though they could recite every corporate finance textbook, nobody knew who was Benjamin Graham.

-- charlesmatte

Day-Trading

[9/16/05] According to managers of day-trading firms cited in a Washington Post Magazine article, about 90 percent of day traders "are washed up within three months." A principal of a day-trading firm even admitted, "95 percent will fail in the first two years." Former Securities and Exchange Commission Chairman Arthur Levitt recommended that people only day-trade with "money they can afford to lose."

[9/14/14]  excerpts from this investorhome article

There have been many studies that have concluded that most day traders lose money, but there have also been studies that documented successful trading by day traders. The data currently available seems to imply the following results.

• The majority of new day traders probably do lose money.
• At some firms a very high percentage of day traders lose money.
• However, there is some evidence that a majority of (surviving) day traders at some firms are profitable and many traders generate tremendous returns on their money.
• Industry commentators also suggested in the past that day-traders using software at home are much less successful than those trading at professional day trading firms.

... there have been a number of studies and investigations with less encouraging results. The most frequently cited is a study by Ronald L. Johnson for the NASAA. Johnson concluded in An Analysis of Public Day Trading at a Retail Day Trading Firm - Report of the Day Trading Project Group Findings and Recommendations (8/9/99) that the majority of traders studied lost money and the vast majority of traders ran the risk of losing their entire stakes.

In an administrative complaint filed against a now-defunct day-trading firm, Massachusetts securities regulators alleged that only one of the branch's 68 accounts made money. According to an article in the NYTimes (Day Trading's Underbelly (8/1/99)) day trading has exceptionally high "washout rates" and "regulators who have examined the books of day-trading firms say that more than 9 out of 10 traders wind up losing money. Because most of these people disappear quietly when their cash runs out, few who replace them in the trading rooms know about them or their failures."

In "Day trading is a quick road to financial ruin" (5/5/99), Humberto Cruz of the Sun Sentinel cites Laura Walsh, a certified financial planner who said she prepared 40 tax returns the prior year for investors doing online trading, and not one made a profit. According to Walsh none of the traders had any idea about the concept of the spread.

In The Profitability of Day Traders (Nov/Dec 2003) in the Financial Analysts Journal, Douglas J. Jordan and J. David Diltz found that about twice as many day traders lose money as make money. Approximately 20 percent of sample day traders were more than marginally profitable.

We also have some international evidence thanks to Brad M. Barber, Yi-Tsung Lee, Yu-Jane Liu, and Terrance Odean. In there paper Do Individual Day Traders Make Money? Evidence from Taiwan they found that day trading by individual investors is prevalent in Taiwan – accounting for over 20 percent of total volume from 1995 through 1999 (individual investors account for over 97 percent of all day trading activity). They found that heavy day traders earn gross profits, but their profits are not sufficient to cover transaction costs and that in the typical six month period, more than eight out of ten day traders lose money. Yet they still found evidence of persistent ability for a relatively small group of day traders to cover transaction costs.

Another interesting question that follows along the same lines is whether it is possible to train individuals to become successful traders. The question was asked several times by Jack Schwager in his interviews with successful traders in the best seller Market Wizards. While hardly scientific, the following observations from the book are certainly interesting.

Richard Dennis described an experiment where 40 of 1000 applicants where chosen and 23 were eventually trained. According to Dennis "It’s frightening how well it worked." 3 dropped out, but the successful 20 (known by many as the "turtles") averaged 100% profits per year.

However, others interviewed in the book were apparently less successful in training others and less optimistic about probabilities of success.

Bruce Kovner discussed trying to train perhaps thirty people, and only four or five turned out to be good traders. The other 25 left the business and according to Dennis "it had nothing to do with intelligence."

According to Brian Gelber five or less out of every 100 people who go to the floor to become traders make at least a million dollars within five years and at least half will end up losing everything they came in with.

Tom Baldwin responded that less than 20 percent of those who come to trade on the floor are still around after five years and one percent are successful to the point of making and keeping at least a couple of million.

market timing

[9/14/14] Extensive data over multiple years shows that market timing as an investment strategy does not work.

The base case for the market over a long period of time is to move upward. Historically, the stock market advances at an annual rate of around 6% above the risk-free rate. With the risk-free rate around zero, this indicates that a 6% annualized rate of return for the market is reasonable at current levels. It is important to note that this rate of return materializes through all sorts of political and economic catastrophes. Look what the U.S. equity market has faced since 1973:

Issues that Menaced the Market

1973: ENERGY CRISIS
1974: NIXON RESIGNS
1975: FALL OF VIETNAM
1976: ECONOMIC RECOVERY SLOWS
1977: MARKET SLUMPS
1978: RISE IN INTEREST RATES
1979: OIL PRICES SURGE TO NEW HEIGHTS
1980: INTEREST RATES AT ALL-TIME HIGHS
1981: BEGINNING OF A SHARPLY RISING RECESSION
1982: UNEMPLOYMENT REACHES THE DOUBLE DIGITS
1983: RECORD BUDGET DEFICIT
1984: TECHNOLOGY BUBBLE BURSTS
1985: EPA INITIATES BAN ON LEADED GASOLINE
1986: DOW AT 1800 - "TOO HIGH"
1987: STOCK MARKET CRASH
1988: WORST DROUGHT IN 50 YEARS
1989: SAVINGS & LOAN SCANDAL
1990: IRAQ INVADES KUWAIT
1991: RECESSION
1992: RECORD BUDGET DEFICIT
1993: CONGRESS PASSED LARGEST TAX INCREASE IN HISTORY
1994: INTEREST RATES ON THE RISE
1995: DOLLAR AT HISTORIC LOWS
1996: GREENSPAN'S "IRRATIONAL EXUBERANCE" SPEECH
1997: COLLAPSE OF THE ASIAN MARKETS
1998: LONG TERM CAPITAL COLLAPSES
1999: Y2K PROBLEM
2000: DOT-COM STOCKS PLUMMET
2001: TERRORISTS ATTACK ON U.S. SOIL
2002: CORPORATE SCANDALS: ENRON
2003: U.S. INVASION OF IRAQ
2004: INFLATED OIL PRICES
2005: TRADE DEFICIT
2006: LEBANON CONFLICT
2007: CREDIT CRUNCH
2008: MASSIVE BANKING  FAILURES, HOME PRICES DOWN
2009: STATES HOVER NEAR BANKRUPTCY
2010: SOVEREIGN DEBT CRISIS
2011: EUROPEAN DEBT CRISIS
2012: FISCAL CLIFF
2013: SYRIAN CRISIS/DEBT CEILING DEBATES

Now imagine that you could have predicted the yearly problems detailed above. Say for argument's sake that you were capable of not only predicting the above events, but also knew exactly when the events were going to occur down to the exact month. What was the correct course of action to take?

In almost every case, the best strategy was to wait for the market to sell-off in response to the event and then buy more equities. When you take the perspective of a true long-term investor, the market movements around the above events are simply small fluctuations.

Of course, there are years and even a decade or two when the market will be full of sound and fury and not advance. In these periods, returns are limited to dividend payments from the stocks owned as prices do absolutely nothing. Also, along the way there are market crashes and corrections.

There has been true fear in the market, and I can guarantee you that at some point in time fear will return. Nevertheless, the key for an investor is to shun both the fear and the greed, and instead try to stay invested over a long period of time.

Look back at the list above. It is very clear that for long-term investors the best action historically has been mostly to:

Ignore the News and Stay Invested.

Make sure the allocation across various investment strategies is consistent with your risk level. This enables you to remain invested even in the face of higher than normal degrees of volatility.

We know that if we go out twenty years, even given current valuation levels, stocks will likely outperform most other asset classes. The basis for that knowledge is that it has been that way historically.

[Mitch Zacks, ZIM Weekly Update]

[11/19/08] Assume, for example, that it is December 31, 1925, and we are consulting a market timer who has made forecasts of 1926 security returns for Treasury Bills, long-term government bonds, long-term corporate bonds, common stocks, and small stocks. He correctly predicts that of these five investment alternatives, common stocks will produce the best total return for 1926. We invest $1.00, which by the end of 1926 grows to be worth $1.12. Impressed with our market timer's predictive abilities, we again meet with him on December 31, 1926 for his advice as to where to position our money for the following year. Year after year our market timer, with perfect predictive accuracy, advises us concerning which investment alternative is appropriate for our market-timed portfolio.

Through compounding our wealth in this manner, our initial $1.00 investment would grow to be worth more than $85 million by the end of 2005. This result is impressive when compared to the best-performing investement alternative, small company stocks, with its ending value of $13,706, and with the more modest ending value of approximately $18 for Treasury Bills!

To contextualize this phenomenal result, consider the outcome had we initially invested $1 million with our market timer at the end of 1925. By the end of 2005, our portfolio would be worth more than $85 trillion. We would own more than 90 percent of the world's total investable capital of $93.4 trillion.

Clearly, such market timing ability does not exist.

... According to a research study by William F. Sharpe, "a manager who attempts to time the market must be right roughly three times out of four, merely to match the overall performance of those competitors who don't. If he is right less often, his relative performance will be inferior. There are two reasons for this. First such a manager will often have his funds in cash equivalents in good market years, sacrificing the higher returns stocks provide in such years. Second, he will incur transaction costs in making switches, many of which will prove to be unprofitable.

[from Asset Allocation by Roger C. Gibson, which was excerpted in What Do I Do with My Money Now? by Clint Willis]

[11/15/08 via chucks_angels] "The long, sad history of market timing is clear: Virtually nobody gets it right even half the time. And the cost of getting it wrong wipes out the occasional gain of getting it right. So the average investor's experience with market timing is costly. Remember, every time you decide to get out of the market (or get in), the investors you buy from and sell to are the best of the big professionals. (Of course, they're not always right, but how confident are you that you will be 'more right' more often than they will be?) What's more, you will incur trading costs or mutual fund sales charges with each move-and, unless you are managing a tax-sheltered retirement account, you will have to pay taxes every time you take a profit." - Charles Ellis, Winning the Loser's Game

[1/27/07] Between 80% and 90% of the returns realized on stocks occurs between 2% and 7% of the time. So, if you're out of the market when stocks make their move, your portfolio is doomed to underperformance.

Between 1986 and 2005, the S&P 500 compounded at an annual rate of return of 11.9% -- even while facing market booms and busts, war, 9/11, constitutional crises, and more. Over that 20-year period, $10,000 invested in the index would have grown to $94,555. Yet a recent report by Dalbar shows that the average investor's return during that time was only 3.9% (so that $10,000 grew to just $21,422). The reason was simple: market timing.

[5/15/06] There are two kinds of technical traders. Some look for signals on individual stocks, jumping from one stock to another, plotting to get in or out ahead of the crowd. Others are like Jim Rohrbach, founder and editor of the investment Web site Investment Models, who employs technical indicators to go in and out of the stock market overall.

"The experts say that the stock market can't be timed," says Rohrbach. "They are wrong."

Buy-and-hold investors, who pay attention to fundamental data ranging from earnings growth and price-earning ratios to book value, always say market timing is a fool's game, doomed to failure. But Stock Trader has profiled other traders such as Tony Carrión, and Frank Minssieux and Serge Dacic, the creators of the Timing Cube system, all of whom excel at and rely on technical analysis.

* * *

[4/20/06] Mike Kavanagh, CFP® asserts that market timing does not work.

"My experience and the following studies show there is no reliable way to time asset classes in the market. This would require a set of crystal balls and tea leaves that simply has never existed and will never exist in my view."

-- from chuck_angels

waiting for the fat pitch

Ted Williams was famous for “waiting for the fat pitch.” He would only look to swing at pitches in the part of the strike zone where he knew he had a higher probability of getting a hit. There were parts of his strike zone where he batted .230 and there were other parts of the strike zone where he batted .400. He knew that if he waited for a pitch over the heart of the plate and didn’t swing at pitches in the .230 part of the strike zone – even though they were strikes – he would improve his odds of getting a hit and increase his overall batting average.

Similarly, Buffett waits for the .400 pitches. And as he’s pointed out, the beautiful thing about the stock market is there are no called strikes. You can never get behind in the count while passing on the .230 pitches and waiting for the .400 pitches.

The concept of “waiting for the fat pitch” is one that is often talked about in investing. Despite the well-known baseball metaphor, it’s still one of the most valuable concepts in investing. “There are no called strikes on Wall Street” is something that is often stated but rarely practiced. Investment managers are paranoid about falling behind in the count. Part of this behavior is what leads to the various inefficiencies that occur in the market.

Here’s a clip that Farnam Street referenced from a 2011 interview with Buffett talking about this topic:

Warren: If you look at the typical stock on the New York Stock Exchange, its high will be, perhaps, for the last 12 months will be 150 percent of its low so they’re bobbing all over the place. All you have to do is sit there and wait until something is really attractive that you understand.

And you can forget about everything else. That is a wonderful game to play in. There’s almost nothing where the game is stacked in your favor like the stock market.

What happens is people start listening to everybody talk on television or whatever it may be or read the paper, and they take what is a fundamental advantage and turn it into a disadvantage. There’s no easier game than stocks. You have to be sure you don’t play it too often.

Half of Americans own stock

The widening gap between the wealthy and the rest of America during the recovery can largely be explained in one word: stocks.

According to recent data from the Federal Reserve, America has the lowest level of stock ownership in 18 years. Yet stock ownership for the wealthy is at a new high -- and that has accounted for most of their good fortune compared to the rest of America.

The Federal Reserve Survey of Consumer Finance found that only 48.8 percent of Americans held stock either directly or indirectly in 2012, the latest period measured.

Percentage of Americans with indirect or directly held stocks

Year	Own stocks
1989	32%
1992	37%
1995	41%
1998	49%
2001	53%
2004	50%
2007	53%
2010	50%
2013	49%

--Source: Federal Reserve

That's the lowest level since 1995, when 40.5 percent of Americans held some form of stock. (Indirect ownership of stock includes stocks held in mutual funds, 401k plans and other investment vehicles.)  [But still well up from 1989, 1992, 1995.  And still the same as in 1998 when the market was riding high.  What's odd is that ownership increased in 2001 after the bubble burst.]

The survey said only 14 percent of Americans own stocks directly -- down from 21 percent in 2001.

But even more than most assets in America, their ownership is highly skewed toward the wealthy. Fully 93 percent of the wealthiest 10 percent of Americans own stocks. That's nearly twice the level for the middle 50 percent and far more than the 26 percent stock-ownership rate for the bottom 40 percent.  [What?  Stock ownership is higher for the rich than the poor?]

The flip side of the data is that those who have stayed in stocks -- whatever their wealth level -- have generally done the best in the recovery. The mean value of stock holdings for those who held them hit $269,000 in 2013, up 18 percent from $228,000 in 2010 and up from $137,000 in 1995.

Among the top 10 percent, the mean value of stock holdings soared to $975,600 in 2013, up from $834,800 in 2010. For those whose net worth puts them in the bottom 20 percent to 40 percent of Americans, the mean value of their holdings rose to $51,000 from $44,000 in 2010.

Stocks have helped the rich get richer in this recovery. But they have also helped the less-rich get richer.

CNBC ratings

There was a time in the late 1990s –- and again briefly during the financial crisis of in the late 2000s –- when CNBC was the 800-pound gorilla of financial news. Professionals in the financial services industry and amateurs who were active traders were tuned in constantly, and even those with just a cursory interest in the markets were regular viewers.

Those viewers -- especially the retail investors like you and me -- were the lifeblood of the network, driving the ratings of its personality-driven programming. And as much as Comcast's (CMCSA) CNBC needed us, its well-crafted propaganda tried to convince us that we, too, needed CNBC to get the best, up-to-the-minute financial information.

It's questionable as to how much the average retail investor ever really needed CNBC in the past, but what is blatantly clear is that we no longer need it today -- and we know it.

According to the latest Nielsen ratings, CNBC's total audience viewership during the second quarter of 2014 for business day programming has dropped to its lowest levels since 1997 [make that since 1993]. The news is even worse for its marquee show, "Mad Money," hosted by the controversial financial pundit Jim Cramer.

Cramer's show recently had its second-lowest ratings ever among total viewers, and its lowest-rated show among the key 25-54 year old demographic, bringing in only 2,000 such viewers on a Friday afternoon. As Cramer might say, "Un-booyah!"

*** [9/5/14]

Comparing the fate of CNBC to Bloomberg, considered the more hard hitting business news source, is to note a study in contrast. Since spring of 2008, Bloomberg’s revenue has jumped to more than $9 billion, from $5.4 billion while subscriptions to Bloomberg’s pricey financial news terminals have grown to 321,000, from 273,000, despite a shrinking financial sector, a recent New York Times article noted. Bloomberg’s television ratings are not public but they are said to be lower than CNBC, however.

*** [10/11/13]

Fox Business Network had better ratings than CNBC among the advertising demo of people aged 25–54 for every hour between 2pm and 6pm on Wednesday October 9, according to Nielsen Media Research. Lou Dobbs also bested his rival, CNBC host Larry Kudlow, in both total viewers and the advertising demo. This news is another blow against the network, which just had its worst quarter in twenty years.

Maria Bartiromo and Bill Griffith’s Closing Bell was the worst performer, with 58 percent fewer viewers in the demo than FBN’s After the Bell from 4pm to 5pm, and 38 percent fewer than Countdown to Closing Bell from 3pm to 4pm. Fast Money had half as many viewers in the demo as Money with Melissa Francis, and Street Signs had 38 percent fewer viewers than FBN’s Markets Now. FBN has been outperforming CNBC for a while now, but this is the first time they managed to completely sweep the afternoon shows in the demo.

John Hussman

In 2009, John Hussman (Trades, Portfolio)’s flagship Strategic Growth Fund was looking good: while the fund had declined 4.3% in the year to June 30, 2009, that had handily outperformed the S&P 500, which had fallen by more than 25% over the same 12-month period; in the nearly nine years since the fund’s inception, Mr. Hussman had racked up compounded annual returns of 8.9% – trouncing the 3.3% annual decline for the S&P 500 over that period. A year later, the fund would report net assets in excess of $6 billion – roughly 4X the amount under management five years earlier.

Fast forward to the present: in the years from 2009 to 2014, Mr. Hussman ceded the entire advantage he built in the first nine years of the fund’s operation back to the S&P 500; at June 30, 2014, he had reported annual returns since inception of 3.7%, against 4.1% for the S&P 500.

When most people are only interested in what you’ve done for them lately, Mr. Hussman finds himself in a painful position: his flagship fund has reported a 6.5% annual loss over the past three years, compared to a 16.5% annualized gain for the S&P 500. That decline alone was enough to deplete the fund’s AUM by nearly 20% from 2011.

Unfortunately, underperformance doesn’t come in a vacuum: investors have run for the doors as well, as Mr. Hussman’s bets have failed to pay off or been wrong (time will tell). From $5.64 billion in June 2011, the fund reported net assets of $1.14 billion at the end of June 2014 – a decline of 80% in just three years. The AUM for his flagship fund was lower in June 2014 than it was a decade earlier– a period where the index has more than doubled (including dividends).

Jean-Marie Eveillard (Trades, Portfolio) famously said, “I’d rather lose half of my clients than lose half of my clients’ money.” That’s a noble statement, and maybe John Hussman (Trades, Portfolio) agrees; with that said, the interim can be difficult – with returns and AUM both suffering. Most money managers are terrified of underperforming by a wide margin (as Hussman has done) or losing half their clients (which Eveillard did in the late 1990’s), even if it might mean being proven right and looking good at some point in the future. There are managers who were willing to make that trade-off in the late 1990’s rather than participate at the height of the tech bubble – only to lose their jobs before the bust finally came; potential job loss is a strong deterrent from leaving the herd.

***

Morningstar rates HSGFX one star.  Looking at the last ten years, it outperformed the S&P 500 in 2008 (-9.02% to -37.00%) and 2005 (5.71%  to 4.91%), but underperformed in the other eight years.  It has returned -6.89%, -5.50%, -1.26% compared to the S&P 500's 24.58%, 17.24%, 8.27% for 1, 5, 10 years.  A $10,000 investment 10 years ago would have shrunk to $8812 which the S&P 500 would have given you $22,134.  The fund holds 104 stocks with 141% turnover.  So it isn't for lack of trying.  Among the holdings are MSFT, MMM, WFC, INTC, AMGN,  Gurufocus has ABX and NEM as his top holdings, so maybe they were buying in the most recent quarter.

So maybe time to buy when he's looking bad?

Hussman holds a PhD in economics from Stanford University and was a professor of economics and international finance at the University of Michigan.

He was graded a little above average in 2009.  Don't see him rated at the current website.

bull (or bear)?

[9/3/14 Dr. Paul Price]  Despite decidedly negative world events and lackluster economic data, the broad U.S. indices all posted solid, though unspectacular, numbers through August.

The SPY and Nasdaq Composite are both on track for solidly double-digit total returns while the DJIA and Barron’s 400 still have a fighting chance at 10% or better if an end-of-the-year rally materializes.

Has 2014’s rise sent the averages into crazy-high territory? Not really. Improved EPS and increased dividends show only minor changes in the P/E ratios and yields versus 52-weeks ago. The DJIA’s multiple, at 15.2x, is just 1.9% above its year ago level. The SPY’s P/E has expanded by 6.6% but remains far off a nosebleed valuation.

Many bears think the duration of the 2001 day current bull market, as of Sep. 1, 2014, means it has to end soon. They must be forgetting that three of the previous four best runups lasted from 2,931 to 4,554 days.

The cumulative percentage gain from March 9, 2009, is impressive but it’s not even close to the 250% – 497% gains posted in the four other previous ‘best’ positive stretches.

Psychology favors further gains. August’s early selloff showed the opposite of euphoria as mutual fund investors yanked out $18.5 billion just in the week ended Aug. 6. That doesn’t happen when greed is running rampant.

Economic "doom and gloomers" who are still waiiting for good news have been unable to buy stocks since 2008. They’ve suffered mightily while jealously watching their "stupid" friends make huge gains.

Precious metal advocates felt fine when gold broke through $1,900 about three years ago. Since then gold is down over 32%, producing no income, while the market has surged relentlessly higher.

Portfolio managers that were short have been anhililated. Market timers have badly lagged buy-and-hold (remember those?) dinosaurs. Cash-rich underperforming funds are praying for a huge decline and the chance to catch up with managers that were brave/smart enough to stay invested.

Many under-invested funds would need a 30% - 50% drop just to get back to where they should have been putting cash to work.

We live in a world where central banks have ruled that “cash is trash.” You will be better off to stop fighting that fact while arguing about what should be happening.

We must all deal with the world as it is. Money printing will continue until the world as we know it collapses. Until then, you’re better off in stocks than any other liquid asset.

Enjoy the ride.

Shiller P/E (does it matter?)

Coffina: One metric that I've been looking at a lot recently is the Shiller price-to-earnings ratio, and this metric uses 10-year average of real GAAP earnings in the denominator. The advantage is that it's been much more predictive historically of future total returns than one-year price-to-earnings ratios, which really hold little to no predictive value. A one-year price-to-earnings ratio will tell you, for example, that the valuation looked in line with historical norms right up to the financial crisis, and then it actually peaked in late 2009, after the recovery was already well under way.

In contrast, the Shiller price-to-earnings ratio was at relatively high levels, about the 80th percentile relative to the last 25 years, or in other words, it had been lower 80% of the time in the lead-up to the financial crisis. And then in the depths of the financial crisis in late 2008 and early 2009, the Shiller price-to-earnings ratio was seeing levels that it hadn't seen in 20-plus years.

So, the Shiller P/E tends to be a lot more predictive of future total returns, and that measure right now is at about 26, which is about the 68th percentile relative to the last 25 years. So, in other words, the market has in general been cheaper, based on this measure, 68% of the time since the late 1980s. That's certainly a cause for concern based on recent history.

So, what we've seen historically is that any time the Shiller P/E is above, say, 25.5, which is about the 60th percentile relative to the past 25 years, subsequent total returns for investors have been very poor, on average in the low-single digits, with some very severe drawdowns

Glaser: So should investors then be preparing for a big sell-off, or a repeat of 2008?

Coffina: It's very, very hard to say. It's one thing to say that the market is richly valued relative to historical standards. It's a completely different thing to say that this means stocks are going to decline over the next one year, three years, or even five years. As I mentioned, in 1996 and in 2002, the S&P 500 was valued at similar levels and went on to have a great run over the next five years until it ended in a crash. So even over a time period as long as five years, saying that the market is relatively richly valued relative to history doesn't tell you much about what stocks are actually going to do in the near term.

Glaser: Over the next 10 years, then, from these valuation levels, what kind of total return should investors be thinking about?

Coffina: Well, that's a great question, and I wish I had a better answer for you. It's going to largely depend on what happens to price-to-earnings ratios. I mentioned before that over the last 25 years, the Shiller P/E ratio took a big step up versus the prior 100 years. The measure used to be around 14-15. Over the last 25 years the norm has been more like 23-24. So anyone who is looking at a measure like this in, say, the early '90s would have decided that, say, 1992 was a great time to sell stocks, and they would have missed out on the '90s bull market, and even through the 2002 crash, they would have missed out on total returns in the high-single digits.

There's definitely a caveat to this whole kind of analysis; market conditions can change, and past is not necessarily a good indicator of what's going to happen in the future. In particular, in the environment that we're in right now, if interest rates stay as low as they are currently, that can certainly justify sustained higher valuation levels going forward. I'm not saying that's going to happen, but it's certainly possible.

[8/24/14 Mitch Zacks chimes in]

Currently the CAPE ratio is flashing some warning signs as it hits levels that have previously been seen only before some of the major market sell-offs of the past century. Interestingly enough, however, valuation multiples based on trailing twelve-month earnings and future earnings estimates are showing a market which is expensive but not unusually extended given current interest rate levels.

The question for investors is, of course, whether the high reading of the CAPE ratio should prompt a reduction in equity exposure.

Now, I am a little biased as Zacks created the quarterly consensus earnings estimate which effectively enables valuation multiples to be calculated based on forward looking earnings data. P/E multiples based on analysts' earnings estimates show a market that is more expensive than historical, but not at the eye-popping levels shown by the CAPE ratio. Despite this bias, at the end of the day, I do not think long-term equity allocation should be adjusted based on the current high reading of the CAPE ratio.

First and foremost, I have learned over many years it never makes sense to time the market. It does not work. It does not work if you react to newsletters, earnings trends, IPO activity levels, discounted cash flow models, P/E multiples, gurus, magazine articles, tea leaves or sunspots.

In fact, one of the few metrics that does seem to have some value in terms of predicting future market performance is interestingly enough, tracking what Wall Street investment strategists—the analysts who set equity and fixed-income exposure of brokerage firm model portfolios—are recommending to investors and promptly do the opposite. The reason this methodology may work is that by the time multiple strategists are calling for the market to go in a certain direction, the information they're responding to is already reflected in stock prices. As a result, the market surprises by reacting to new information and moves in the opposite direction. This rule of thumb would currently indicate increasing equity exposure as many of the strategists are recommending a reduction in equity exposure.

Additionally, there are a few problems with the CAPE ratio. All the methodologies of calculating P/E multiples are designed to compare current prices to future expected earnings. There is agreement amongst investors that the key metric in stock market valuation is future earnings.

No one buys a stock such as Apple ( AAPL ) based on what the company earned over the past twelve months. Investors instead focus primarily on what AAPL will earn in the future and whether those earnings are greater than expectations currently built into the stock's price. As a shareholder of AAPL, you are valuing the company based on the future theoretical dividends AAPL can potentially pay as opposed to the historical dividends it has paid. The past earnings data, however, is often used as benchmark for predicting what the future will bring. Want to know what Apple will earn next year? Look at what they earned last year and then estimate how many more iPhones they will sell.

The CAPE ratio makes the assumption that historical ten-year inflation adjusted earnings are a good predictor for corporate earnings over the next ten years. As a result, the CAPE multiple is showing an extremely high level because current stock prices are being compared to trailing ten-year historical earnings.

Essentially, ten-year historical corporate earnings numbers may not be a good predictor of the future as they include the years 2008 through 2010 when corporate earnings were incredibly depressed due to the financial crisis. Therefore, an investor's faith in the CAPE ratio as a predictive tool of future market performance comes down to whether or not corporate earnings will revert to historically depressed levels.

This depends to some extent on whether the financial crisis is seen as a recurring event or a once in a seventy-five year outlier. I am certain the financial crisis is an outlier as opposed to a recurring event, and as a result, the CAPE ratio is likely not as meaningful as it has been at other times.

Corporate Earnings, Inflation and Interest Rates

Unfortunately, another argument why corporate earnings will mean-revert is because corporate profit margins, which are at all-time highs, will move back to historical lower levels. This argument has a stronger leg to stand on because if wage inflation starts to pick up, corporate profit margins should come under some pressure.

As I have written numerous times before, the market's P/E multiple is higher than its historical average primarily because interest rates are substantially lower than what they have been. If interest rates remain below historical levels then the market's valuation is reasonable. It all comes down to whether wage inflation materializes. If it does, the market will be in for some rough sledding with decreasing corporate profit margins while the P/E multiples come under pressure due to rising interest rates.

Despite my anticipation of inflation as a result of quantitative easing, no inflation has actually materialized for more than two years. The trillions of dollars sloshing around the fixed income market buying and selling U.S. government bonds is telling us that interest rates are expected to remain low for quite some time. The yield on the 10-year would be below 3% only if inflation was expected to remain incredibly low for a very long time. 

Though I am convinced that once the yield on ten-year U.S. government bonds starts to revert to its historical levels, stock market valuation multiples, regardless of how they are calculated, will come under pressure. Ultimately, the future direction of the market is going to be dependent on whether interest rates remain low or inflation returns to the system.

So Where Is the Market Headed Now?

While I do not think the market is at a dangerous level of valuation, I do feel that future returns in the market will be lower than they have been over the past five years. Rates are going to have to go higher and valuations are going to have to come down.

[That's safe to say.  The past five years have returned 16.58% mainly because it doesn't include 2008 which returned -37.00%.  The returns have been (starting in 2009): 26%, 15%, 2%, 16%, 32% (for an average of 18%, 16.58% for the five years from today).  AAPL returned 147%, 53%, 26%, 33%, 8% (for an average of 53%!, 34% for the five years from today).  AAPL dropped 57% in 2008.]

200 years of the stock market (actually only 189)

I'm a glutton for historical numbers, especially pertaining to stocks. Awhile back I came across a post that had a histogram of the overall stock market returns since 1825. More on the numbers shortly...

Prior to reading that post, I was already aware that, from the end of 1814 to the end of 1925, the U.S. stock market experienced compound annual growth of about 5.8% per year. This is based on data put together by Robert Shiller, and this measure used a price-weighted index, which has many flaws but is the way that most of the indices are measured today.

To use a different time period and a different yardstick, Buffett once mentioned that the Dow went from 66 to 11,219 during the 100-year period during the 20th century, which is a 5.3% CAGR. Adding dividends to that figure, and shareholders might have realized 7-8% annually or so.

To use a third historical time period, I noticed in Buffett's annual shareholder letter that the S&P 500 has averaged 9.8% annually over the last 49 years (since he took over at Berkshire).

I think the last 200 years provides pretty good evidence that over the very long term, I feel comfortable expecting the market to average somewhere between 6% and 9% annually including dividends (if I had to guess, I'd be closer to 6 than 9).

Take a look at the last 189 years of general stock prices:

Some anecdotes I find it interesting to observe the results of 189 years between 1825 and 2013:

• The market had 134 positive years and 55 negative years (the market was up 71% of the time)
• 44% of the time the market finished the year between 0% and +20%
• 60% of the time the market finished the year between -10% and +20%
• Only 14% of the time (26 out of 189 years) did the market finish worse than -10%
• Only a mere 4.8% of the time (fewer than 1 in 20 years) did the market finish worse than -20%

So to put it another way (using the 189 years between 1825 and 2013 as our sample space), there is an 86% chance that the market finishes the year better than -10%. There is a 95% chance the market ends higher than -20%. And as I mentioned above, there is a 71% chance that the market ends any given year in positive territory.

One last observation: the market was 5 times more likely to be up 20% or more in a year (50 out of 189) than down 20% or more in a year (9 out of 189)!

Now, lest my readers suspect me of predicting further gains... let me make it clear that I'm not trying to make a case that I think the market won't or can't go down, or even go down a lot. On the contrary, after 5 years in a row of not just positive years, but exceedingly above average gains, we are certainly "due" for a down year. After all, the market finished the year down 29% of the time over the past 189 years, or about once every 3 or 4 years.

I just think that it's difficult to predict when the down year--and certainly when the next big crash will come. Make no mistake, the market will crash from time to time. The economy will suffer another credit crisis. It's just difficult to know when. The stock market certainly will go through another 10% correction in the near future. It will likely go through a 20% correction in the near future. There have been 12 of those corrections since the mid-'50s when the S&P 500 index was instituted, or about one every 5 years. We haven't had one since early 2009 so we're due for one of those as well.

Although certain to happen again, crashes are rare. The 2008 type scenarios are extremely rare. Only 3 times since 1825 did the market finish a calendar year down 30% or worse. That's about once every 63 years. People tend to overestimate the probability of a market crash when one recently occurred. The storm clouds of 2008 are in the rearview mirror, but they are still visible and the effects of the storm still evident.

They key thing to remember is that when you own a stock, you own a piece of a business. Graham's logic is as simple as it is timeless. It really helps to remember that you don't own numbers that bounce around on a screen, you own a business that has assets, cash flows, employees, products, customers, etc. Just like the owner of a stable, cash-producing duplex located in a quality part of town isn't frantically checking economic numbers or general stock index prices on a daily or weekly basis, nor should the owner of a durable business that produces predictable cash flow – purchased at an attractive price – be concerned about the day-to-day fluctuations in the quoted price of his share of the company.

As Munger said, sometimes the tide will be with us and sometimes the tide will be against us, but the best thing to do is to just continue to swim as competently as we can. Although ocean tides are much easier to predict than the direction of the stock market, I still think it's best to focus on swimming as opposed to anticipating the changes in the tides.

-- John Huber, Base Hit Investing

understanding the business

Many investors equate understanding the business to understanding the product or service of the business. I certainly wasn’t too far from that line of thinking in my earlier investment journey. I was ignorant enough to think that Coca-Cola, MasterCard and Wal-Mart were without doubt within my circle of competence. I don’t drink Coke, but I certainly know what Coke is. Heck, better yet, I even know Cherry Coke and Diet Coke. I have two credit cards that have MasterCard sign on them and I use them very often. I also go to Wal-mart occasionally. How could I not understand these businesses? They are part of our daily lives.

It all changed when I heard the following message from Mr. Buffett in his talk to UGA students:

“I have an old-fashioned belief that I can only make money in things that I can understand. And when I say ‘understand,’ I don’t mean understand what the product does or anything like that. I mean understand what the economics of the business are likely to look like 10 years from now or 20 years from now. I know in general what the economics of, say, Wrigley chewing gum will look like in 10 years. ”

It was truly a "eureka" moment for me because I have taken it for granted that "understand" means understand what the product does. We all know how to use a credit card. But that doesn’t mean we understand MasterCard. For readers who think you understand MasterCard, I challenge you to answer the following questions about MasterCard. What is the business model of MasterCard? What is MasterCard’s gross and net margin and why? Why would banks issue credit cards with MasterCard, and why do merchants accept them?

... I hope by now, you can see the differences between understanding the product of a business and understanding the economics of the business and why it matters enormously to us. It is the difference between knowing the name of something and knowing something, which are two levels of understanding. Very often we understand both the product of a business and the economics of the business as our research moves along, but great danger remains when we mix up those two concepts, especially when it comes to the brands that are ubiquitous in our daily lives.

-- Grahamites

the nature of long-term investing

I think it's in the nature of long term shareholding of the normal vicissitudes, in worldly outcomes, and in markets that the long-term holder has his quoted value of his stocks go down by say 50%. In fact, you can argue that if you're not willing to react with equanimity to a market price decline of 50% two or three times a century you're not fit to be a common shareholder, and you deserve the mediocre result you're going to get compared to the people who do have the temperament, who can be more philosophical about these market fluctuations.

-- Charlie Munger, BBC interview

Lazy Investing

here are 10 “think-like-an-amateur” secrets from our “Lazy Person’s Guide to Investing.” (review) Ten simple ways to get into peace-of-mind investing.

3. Peace of mind from knowing advisers have no special skills either

Actually it’s worse. Nobel economist Daniel Kahneman also used the casino metaphor in “Thinking, Fast and Slow,” neuroscience. Based on “50 years of research” he found that the “stock-picking skills” of managers and advisers is “more like rolling dice than like playing poker.” Their picks are no more “accurate than blind guesses.” In fact, “this is true for nearly all stock pickers ... whether they know it or not ... and most do not.”

5. Peace of mind: realizing markets are irrational, unpredictable, dangerous

Wharton School of Finance economist Jeremy Siegel, author of “Stocks for the Long Run: The Definitive Guide to Financial Market Returns and Long-Term Investment Strategies,” researched 120 of the biggest up and biggest down days in the stock market, the last two centuries. In only 30 of those big-move days did Siegel find a reason for market movement. In other words, 75% of the market’s biggest twists and turns in history were irrational and unpredictable black swans. Bottom line: 100% of the time Wall Street’s just guessing.

6. Peace of mind is deciding never to actively trade in the stock market

Active trading feeds anxieties and stress and kills peace of mind. Behavioral-finance professors Terry Odean and Brad Barber of University of California studied 66,400 portfolios at a major Wall Street firm for seven years. Three key factors reduced their returns: their stock-picking skills, transaction costs and taxes. Active traders averaged 258% portfolio turnover annually. But turnover was a mere 2% for buy-and-hold investors. Yet they earned seven percentage points more than the active traders.

8. Peace of mind means never trading on hot tips and emotions

Yes, the stock-picking and trading skills based on “gut feel” is invariably a loser decision. A Morningstar study says most investors get in and out of the market at the wrong time. Irrational exuberance fuels a buying frenzy at the top. Investors jump in, buy high, lose. Then when the market drops, they panic, sell, lose. You want peace of mind? Build your Lazy Portfolio.

9. Peace of mind vs. overconfidence: Your brain may be your worst enemy

A behavioral-finance study reported in Money magazine concluded that 88% of all investors have what psychologists like Kahneman call “optimism bias,” overconfidence. We take big risks, handicapping ourselves, lose. Then we make excuses. Over half the overconfident investors who think they are beating the market often underperform by 5% to 15%. But they can’t admit failure, so never learn. Bottom line: Our brains are often our worst enemies.

10. Peace of mind: Most day-traders don’t make a living, eventually get out

In the end, you wake up to the fact that trading is not the get-rich promises that overly optimistic newsletter gurus want you believe. Yes, you can trade online for a few bucks a pop. But you can still make lousy picks. Lose fast and furious. Another Odean-Barber study revealed that as many as 75% of traders lose money. And even the rare successful traders rarely make more than $100,000 a year. As David Dreman put it in his New Contrarian Investment Strategy, “Market timers, if they don’t die broke, rarely beat the market.”

[by Paul Farrell via roy]

see also Six Rules for Lazy Investors

follow the billionaires

Investors looking for a one-stop “buy and forget” guru-following strategy now have a couple of exchange-traded funds to choose from.

In June, I compared the Global X Top Guru Holdings Index ETF (GURU) to its chief competitor, the AlphaClone Alternative Alpha ETF (ALFA). Today, I’m going to throw a new index competitor into the mix: the iBillionaire Index. An iBillionaire Index ETF is in the works as well, though the sponsor did not have a specific launch date.

Let’s take a quick peek at each of these guru-following strategies and highlight their differences. At first glance, you might think the strategies are interchangeable and that there is no value in adding another “me too” ETF. But the strategies each have unique features that can make each better than the others under the right set of market conditions.

ALFA was the first guru ETF to come to market, beating GURU by about a month. It also happens to be the most complex of the three. The AlphaClone index ranks hedge fund managers by a proprietary system and equally weights their top holdings. There is an allowance for overweighting if a stock has multiple guru owners. For example, a stock held by twice the number of managers would have twice the weighting in the index.

ALFA has one other noteworthy feature: It has a “dynamic hedging” mechanism that allows it to be up to 50% short during a prolonged market downturn. In ALFA’s case, the ETF will shift half of the portfolio into an inverse S&P 500 fund when the S&P ends a month below its 200-day moving average.

GURU, which is based on the Solactive Top Guru Holdings Index, runs a simpler strategy. GURU’s portfolio is simply an equally weighted mix of the “high conviction” picks of the hedge fund managers that Global X follows. Only managers that run concentrated portfolios are considered, but beyond that, there really is no other criteria.

The iBillionaire Index takes a slightly different approach. To start, it limited its pool of gurus to “financial billionaires,” or money managers who have amassed personal fortunes of over a billion dollars.
But secondly — and most importantly — its holdings are limited to constituents of the S&P 500. Per iBillionaire,

“It is composed of the top 30 large-cap equities listed on the S&P 500 in which financial billionaires have allocated the most funds, providing ample trading liquidity, a well-known benchmark, and better results to equity indexation than capitalization-weighted indices. Devised from 13F filings, the iBillionaire Index provides investors an efficient and effective way to follow the smart money. In essence, the index works as though one gathered a group of billionaires and asked them to come to a consensus as to which S&P 500 stocks are the best bets.”

With that said, which guru-following ETF strategy is best?

It’s really going to depend on the kind of market you’re in and what you’re using as a benchmark. ALFA’s ability to go short is a tremendous asset in a sustained bear market and will almost certainly cause it to outperform GURU and iBillionaire’s index. But in a sideways market or a volatile zig-zagging market (not exactly technical terms, but bear with me), it’s going to get whipsawed. It’s the curse of all trend-following models — they only work in a trending market. And in a long bull market, it won’t have any effect at all.

ALFA also has a small market-cap bias; Morningstar classifies it as a “mid-cap growth fund.”  GURU is considered a “large-cap” growth fund by Morningstar. iBillionaire — when its ETF is released — will likely have an even greater large-cap bias, as its mandate limits it to companies within the S&P 500.

I’ll summarize like this: If you think we might see a prolonged bear market, ALFA is the ETF for you; if not, GURU or an ETF based on the iBillionaire Index would likely be your better option.

***

article links

Brains vs. Brains: Which ‘Guru’ ETF Is Right for You? (6/13/13)

Your Newest Guru Investing Option: The iBillionaire Index (11/13/13)

iBillionaire To Launch New Billionaire-Tracking Guru ETF (2/21/04)

Investing Like A Billionaire With The iBillionaire ETF (8/2/14)

Want to invest like Buffett and Soros? Try this (8/3/14)

Buffett on the market valuation

As stated in the GuruFocus' "Where are We With Market Valuations?" article, "as pointed by Warren Buffett, the percentage of total market cap (TMC) relative to the US GNP is “probably the best single measure of where valuations stand at any given moment.”

What were his comments in a December 2001 Fortune article about the market in 2000?
Memorably he stated that "the ratio rose to an unprecedented level. That should have been a very strong warning signal."

[It reached 148.50 on 3/30/00]

What was the percent return of the S&P 500 after the Market Cap/GDP reached that "unprecedented level?"

[it dropped 43.1% in three years]

Has there ever been another time when Buffett touted a “very low-cost index?”
As stated on Reuters.com in the Buffett: Index funds better for most investors article by Jonathan Stempel dated May 6, 2007, “Buffett said at a press conference,” “A very low-cost index is going to beat a majority of the amateur-managed money or professionally-managed money.”

What was the Market Cap to GDP at that time?

[110.70 on 6/30/07]

What was the percent return of a “low cost” ETF that tracks the S&P 500 from May 6, 2007 to March 2009?

[it lost 53.6%]

What is the Market cap to GDP today?

122.3%

Considering the "best indicator where valuations stand," is currently near previous highs, might Warren actually be estimating that by the time his trustee is needed, the Market Cap to GDP will be at much lower levels?

If the valuation ratio reverts to those historical lows of 40%, and we are currently at 122%, does that mean a near 67% drop is possible?