November 2020
What Sharks Can Teach Us About Survivorship Bias
A scathing behavioral interpretation of America’s poor pandemic response, from the one-and-only Annie Duke
Christmas in November?
Cramer: “Bonds are now riskier than stocks”
Markets are the ultimate balancing machine. As demand for safety rises, ceteris paribus, safety becomes more expensive to preserve that balance. For example, those who take long positions in bonds to manage catastrophic risk can capture the catastrophe’s ensuing price appreciation and thereby offset losses among their more risk-seeking positions, this is all standard stuff.
But those who trade actively in bonds have a very different experience! As demand for safety rises and safety becomes more expensive, initiating positions in those expensive bonds becomes more risky. This is where one’s strategy impacts one’s risk. Thinking of risk as “the Likelyhood of a permanent loss of capital”, those who actively trade bonds are significantly more Likely to realize permanent losses than those who hold bonds as part of a long-term strategic asset allocation.
The claim that bonds are “risky assets” employs a questionable definition of risk.
Bonds are fundamentally different products than equities. You know, differences like the certainty in valuation at maturity, principal protection, and negative correlation with equities. Again standard stuff…
…or not! Here’s Jim Cramer rewriting the rules about the risk behind stocks and bonds:
“This year we’re witnessing the passing of the torch: Bonds were the safest assets back in 1982, back when Treasurys yielded double digits. Now they’re risky assets,” the “Mad Money” host said. “The truth is, for many companies that we follow, the equity side is ... a much better repository of wealth for you, the individual, than the credit side. Not all [stocks], but a surprising number.”
“If you’re a young, wet-behind-the-ears broker at Goldman Sachs, I would tell you to forget all of those bond ideas, just tell your clients to buy the stocks of terrific companies with fantastic nation-state-sized balance sheets,” the host said. “You’ll do much better with a heck of a lot less long-term risk and more dividends.”
Ok, this advice is troubling. Sure, 2020 bond returns Likely disappointed investors who expected better bond performance in an economy-paralyzing pandemic. Well, bonds can also lose value if the entire economy shuts down! Bond investors certainly miss the high yields of the good old days, and Cramer is right to question what investors should expect from bonds moving forward. However, the claim that bonds are “risky assets” employs a questionable definition of risk. Bonds are not just “repositories of wealth”; investors typically allocate to bonds because they behave differently than equities through different market conditions. Replacing bond holdings with shares of Facebook, Apple, Microsoft, and Alphabet (FAMA) because they have loads of cash on their “nation-state-sized balance sheets” does not mean their share prices will dampen volatility, preserve capital, “zig when equities zag”, or achieve any number of typical bondholders’ objectives.
I am not saying investors should view bonds the same as they did in 1986. I am saying that tech giants are not Likely to meet the objectives that most investors have for bonds in their portfolios. I get where Cramer is coming from, particularly that the tech companies have such large cash hoards that there is a floor under their intrinsic value that supports their share prices and *should* retain the value of an investor’s principal perhaps like a bond. But Cramer’s headline advice to buy FAMA instead of bonds is clearly oversimplified and ill-advised.
Now flash back to 2015 when Jim Cramer raised a very similar question in his interview with Bill Ackman and Nelson Peltz at the Delivering Alpha Conference:
Jim Cramer: Are there areas that are just off limits for you guys? I never see you coming in on a tech company even though there are tech companies that are loaded with cash [emphasis mine] but seem like the managements aren't that strong. Just not something you want to do?
Bill Ackman: When you put ten, fifteen, twenty percent of your assets in a business you want it to be an incredibly robust, stable, predictable business, and the problem with technology is most technology companies are too dynamic. I mean, you wake up and there's a couple guys in a garage a block from Stanford University, a couple women in a garage, and they're starting a new business that's disruptive, and I think, you know, if you look at the kind of businesses that I think both of us like, we like businesses that can withstand the test of time, technology, commodity. I mean I'm not, I try to stay away from things where an extrinsic factor I can't control whether it’s commodity prices, interest rates, does have a material effect.
Nelson Peltz: Exactly. We like businesses, and I think speaks to Bill as well, that sort of have moats around them, okay, and technology is one that isn’t.
Robust. Stable. Predictable. That's what most investors seek from bonds! Bonds have protective moats in the sense of defined and predictable valuations at maturity. Bond traders aside, cash-flush tech companies are not bond replacements.
Concentration - Watch This Space
Last month I discussed the dense concentration in the S&P 500 index in the context of Wall Street vs. Main Street.
In the 6 months from the previous high on February 19th through the lows and back to new highs on August 18th, fully 62% of S&P 500 stocks remained in the red over that period (The S&P 500’s return to a record doesn’t tell the full story). And further, the 10 largest companies in the S&P 500 index comprised 29% of the entire index as of July 31st, the largest concentration in 40 years (The market's biggest stocks hold the largest share of the S&P 500 in 40 years as mega-cap tech returns swell). This concentration has persisted; as of this writing, the 10 largest companies still comprise just shy of 28% of the index.
…
“As of August 26, 2020, the S&P 500 is up just over 9% YTD and the FAANGM stocks have contributed a 9.4% of that return, meaning that the other 494 stocks in the S&P 500 are aggregate net losers” (Why It’s So Hard To Beat The Market).
Here’s an update from Pierre Debru at WisdomTree (Analysis S&P 500 or S&P 5? Is the current concentration sustainable long term?):
“Year to date [through November 5th], the S&P 500 is up 9.45% but the contributions of Apple, Microsoft, Amazon, Facebook and Alphabet to that performance sum up to an incredible 8.35%. This means that the “other 495 stocks” in the index only contributed 1.1%.”
Debru did not include Netflix though, call it FAMAA, so let’s do some math. With Netflix’s YTD move from 329.81 to 487.22 and approximate 0.69% weight in the S&P 500 Index, Netflix contributes an additional 0.32% for a FAMAAN performance sum of 8.67%. But heyo! The other 494 stocks are now aggregate net contributors of 0.78%.
In other news, I love acronyms.
Here’s Debru again:
“The S&P 500 is more concentrated and more geared toward technology than at the height of the 'dot-com' bubble”.
The most dangerous saying in all of investing is “well, this time is different”. But maybe COVID-19 is different from the dot-com bubble! There certainly seem to be fundamentally different underlying causes. The dot-com bubble was essentially blindly buying anything with .com in the name. Today’s tech concentration has at least some basis in fundamental strength due to the pandemic-induced changes in work from home, distance learning in schools, and Likely longer-term shifts in flexible work arrangements given the COVID-induced proof-of-concept.
More killer stats from Debru:
“Apple, Microsoft, Amazon, Facebook, and Alphabet contributed to almost 90% of the year to date performance of the S&P 500”
“The five biggest stocks had never represented more than 18.2%, last seen at the height of the 'dot-com' bubble in March 2000. Currently Apple, Microsoft, Amazon, Facebook and Alphabet represent 21% of the index, almost double the long-term average of 12.5%.”
This one’s for Cramer: “Companies have historically struggled to maintain their grip on a top 5 spot in the index being forced out by new entrants, new trends. This is interestingly enough true also for sectors with Technology dominating the 90s, then Energy in the 00s, then Tech again and so on…”
We have a vaccine
20 years from now, when we think back to 2020, we will probably remember social distancing and working from home, maybe the presidential election, and any family, friends, and colleagues who were ailed with COVID-19. We will probably forget most of our daily frustrations and sense of helplessness while we waited for a vaccine to be developed. I doubt we will remember and appreciate just how remarkable it was for such effective vaccines to be developed in such a short period of time.
One nominee for my “Headline Of The Year Award” is: Moderna says its coronavirus vaccine is more than 94% effective. Good news for markets! Sell the news, take some profits, onto the next opportunity, that’s what you’re supposed to do…
…or not, says Jim Cramer, Cramer says he's never seen such resilient stock buyers — 'They don't seem to want to sell:
“There’s a new young crop of buyers who do not sell on the news,” Cramer said on “Squawk Box.” “They’re very different from the older buyers. They don’t seem to want to sell. They see good news and then they buy, and then no one comes forward to sell. It’s rather remarkable. We haven’t seen this pattern ever.”
Fiscal stimulus, monetary easing, and vaccines… Who would have thought that COVID-19 would make it easier for investors to stay true to their long-term objectives?
All polls are wrong, but some are useful
Think back to Wednesday, November 9th, 2016. Students were asking me “What happened?” Yes, the polls were “wrong”, but how is that possible? My answer was “that’s just statistics”. Sampling methods, sampling error, margin of error, nonresponse bias, all the basic stuff.
Folks place such high confidence, almost certainty, in anything numeric - and investing has a lot of numbers.
Reputable pollsters quantify the amount of sampling error inherent in their methodologies. When surveys report a ±3% margin of error at a 95% confidence level, they are saying that if their survey methodology were repeated many many many times, the true population value will be within 95% of those ±3% wide intervals. Which means… 5% of the confidence intervals will not capture the true population value. Necessarily, there is sampling error anytime one surveys roughly 1,000 people then extrapolates to 100,000,000 people. That’s just statistics.
The math we teach in schools is sanitized and certain; the math of the real world is, well, not. As a math teacher I was saddened in 2016 and again this month when Lindsey Graham (and others) said “To all the pollsters out there, you have no idea what you're doing.” Real world data is messy. Predicting voter turnout - or anything involving humans for that matter - is more difficult than most folks realize. As they did in 2016, this year’s pollsters will again gorge in the 2020 election data, test explanatory hypotheses, update and upgrade their models, and be ready to do it all over again in the next election.
Which brings us to investing! Forecasting the future, quantifying uncertainty, making sense of data - investment math is not all that different from election math. The accuracy of investing models during this pandemic is perhaps universally in-question due to the unique nature of both the COVID-19 pandemic as well as the government’s unprecedented response. Ray Dalio, continuing to endure historic losses in Bridgewater’s flagship Pure Alpha II fund, finally ceded his usual steadfast confidence in his models when they stopped working and spent 70 hours per week along with his staff to revise their models. It’s what modelers do.
The well-known statistician George Box said “All models are wrong, but some are useful.” Well, all polls are wrong, but some are useful too. The first step to understanding is a pinch of mathematical literacy.
Source: https://www.azquotes.com/author/22390-George_E_P_Box
ONE MORE THING…
What sharks can teach us about survivorship bias: A late addition to September’s Likelyhoods. Don’t overlook those whose failures are less public. What Sharks Can Teach Us About Survivorship Bias.
A scathing behavioral interpretation of America’s poor pandemic response: From the one-and-only Annie Duke. Opinion: Hoping for a lucky break in the pandemic could cost the US economy dearly
Christmas in November? Huge November gains may make the usual year-end 'Santa Claus rally' less likely
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