June 2021
What is value, anyway?
Sorry, not even Congress can stop technology.
Inflation Inflation Inflation
Markets are the ultimate balancing machine. For every action there is an equal and opposite reaction, although the complexity and diffuse nature of those reactions make it impossible to understand precisely how they interrelate.
It is not surprising that many analysts’ economic chains of events end with inflation, that invisible, corrosive cancer that eats away at real returns. Hot inflation may have become scorching in May and is expected to hit a 28-year high, I mean come on, that headline really does its job(!).
Plenty of market commentary this month pronounced the arrival of inflation, suggested how to “protect” one’s portfolio from looming inflationary pressures, and debated whether inflation is transitory or structural.
Prudent investment management requires maintaining a functional mental model for processing noise-laden economic data. Inflation is but one link in a noisy chain of economic events. That said, most links in the chain are not in the Federal Reserve’s dual mandate of price stability and maximum employment, so here we are.
There are a few big ideas to keep in mind with inflation:
Economic chains of events do not “end” with inflation. Like any other link in the chain, inflation is both a reaction to a prior cause and a cause to a future reaction.
Not all inflation is created equal. Inflation originating from a pandemic-induced economic reopening differs from inflation originating from structural long-term economic changes.
Inflation is a normal and in some ways beneficial byproduct of a growing economy, particularly when companies are able to pass along their increased costs to consumers through price increases. Inflation becomes a real concern when the consumer cannot tolerate those increases.
In other news, the flaws inherent to traditional stock picking are not Likely to work any more effectively in defending against inflation than any other investment objective. But you know how it is, that won’t stop the stock pickers: Leon Cooperman plans to stock pick his way to success, not expecting much more from overall market.
Conflicting Advice
When I ask people what turns them off from managing their own investments, their responses tend to have two general themes:
“There are too many products, I don’t know which to choose.”
“There is too much conflicting advice, I don’t know who to listen to.”
On the first theme, decision fatigue and choice overload are real. I truly despise Walmart’s shampoo aisle - seriously how many different types of shampoo are needed?!! There’s a reason why Costco’s business model of limited choices for each product type works so well.
On the second theme, a relative inability to grapple well with uncertainty leads advisors to give conflicting advice. Take this piece by Randy Frederick from Schwab’s Summer 2021 issue of OnInvesting titled Breaking Bad Trade Behaviors:
"Research has shown that losing money is roughly twice as painful, emotionally speaking, as gaining it is pleasurable--a psychological effect known as loss aversion.
The fix: A common trading maxim applies here--cut your losses short and let your winners run."
Later in the same article, in addressing the overconfidence, self-attribution, and herd mentality biases especially as when markets are soaring, Frederick writes:
"The fix: Above all, remember that gains aren't gains until you've sold the position at a profit, so don't let a trade stay open too long."
The conflicting guidance of “let your winners run” and “lock in your profits” is virtually impossible to resolve without the advantage of hindsight.
I prefer a different approach.
As Frederick notes, the reason behind “cut your losses short and let your winners run” is loss aversion. Loss averse investors disproportionately fear losses because they are just too painful relative to equally sized gains. Graphically, loss aversion can be represented this way:
© Likely Capital Management
But how might we reduce the harmful effects of loss aversion? For that answer, let me first ask: Would you buy insurance on a vacuum? You know, those highly profitable service agreements that often are more profitable for companies than the products themselves…
If the cost of buying a new vacuum outright would impact your lifestyle, then the smaller insurance premiums are Likely worth the larger costs in the long run. But if you can afford to pay cash for a new vacuum when your old one breaks, then why insure your vacuum at all? If you think the vacuum is Likely to break soon enough such that the insurance policy would pay for itself, then, well, you should probably buy a better vacuum instead.
Insurance has greater value for loss averse clients, which ultimately means those clients are paying for their loss aversion in the form of lost premiums and subsequent underperformance.
Anyway, the decision comes down to cash reserves. With the cushion of a sufficient cash reserve, the pain of paying cash for a new vacuum is low. But if replacing your vacuum means eating spam sandwiches for a month, well, those insurance premiums look pretty good.
Likewise with a loss in an investment position, one’s dependency on invested dollars directly corresponds to the pain they feel were they to lose those dollars. If an investor has sufficient wealth such that even a sizeable loss would not change the investor’s lifestyle, portfolio management, or have other negative impacts, then why insure the position?
Insurance has greater value for loss averse clients, which ultimately means those clients are paying for their loss aversion in the form of lost premiums and subsequent underperformance. Psychologically, then, there is money to be gained, in the form of avoided insurance premiums, by making one’s tolerance for losses more symmetric about the origin with their enjoyment from gains:
© Likely Capital Management
A symmetric loss aversion graph is the Likely way.
When “good performance” still underperforms
Did you see this article with its somewhat misleading title, Hedge fund assets soar to record high amid boom in trading profits?
The pandemic era has been great for hedge funds, which have seen their assets boom to a record amid high hopes for the economy and huge government spending.
Total assets for the industry swelled to $4.07 trillion as of the end of March, according to the most recent data from BarclayHedge. Assets under management first topped the $4 trillion mark in February.
That growth has come thanks both to solid performance and heightened interest from investors who continue to plow cash into the space. Over the past 12 months, hedge funds have made more than half a trillion dollars – $552.1 billion – in trading profits alone.
In that time, assets under management have swelled more than 42%.
Seems hedge funds are the place to be! You couldn’t ask for a more positive opening to such an article. But here’s one paragraph later:
Hedge funds continue to trail the S&P 500 in returns, but still have made handsome profits amid a solid backdrop for risk assets. The Barclay Hedge Fund Index gained 7.06% year to date through April, against the 11.84% return from the S&P 500 Total Return Index, which includes dividends.
So play this back… AUM topped $4 trillion in February, but for ease let’s extend that back to January. That $4 trillion invested according to the Barclay Hedge Fund Index at 7.06% YTD through April gives $282.4 billion in returns, whereas that same $4 trillion invested according to the S&P 500 Total Return Index at 11.84% YTD through April gives $473.6 billion in returns. I guess writing an article that hedge funds underperformed a low cost S&P 500 Index fund by $191 billion in just 4 months doesn’t help the industry.
To be fair and clear, industry apologists often argue that hedge funds do not even seek to outperform the S&P 500 Index, but rather seek so-called “risk-adjusted returns”. To which I say:
If a hedge fund did outperform the S&P 500 Index, you bet they would tout that outperformance.
Articles like these usually do not cite risk-adjusted returns (more accurately called “volatility-adjusted” returns) as important metrics. The emphasis on performance is clear.
There is indeed evidence that hedge funds outperform the S&P 500 Index during sufficiently large sell offs. This is not surprising because on-net, hedging strategies exchange downside protection for upside potential. Accordingly, outperforming during these narrow and infrequent time periods looks good from a risk (volatility) management perspective.
Much is lost with volatility-focused strategies that exchange outperformance during narrow and less-frequent time periods for underperformance during longer and more frequent time periods.
The problem is that, well, these time periods are narrow and infrequent(!).
Consider the S&P 500 Index, for example. In the roughly 75 years from World War II through 2019 there have been 26 market corrections with an average decline of 13.7% and an average recovery time of 4 months. Quite narrow and infrequent.
There are other ways to quantify this same concept of course. 63.5% of months had positive returns with an average monthly return of 3.32%, whereas 36.5% of months had negative returns with an average monthly return of -3.51%. Positive months outnumber negative months by roughly 2-to-1, yet the average for the negative months is just 0.19% worse than the positive months.
Regardless of the quantification, the concept still holds: much is lost with volatility-focused strategies that exchange outperformance during narrow and less-frequent time periods for underperformance during longer and more frequent time periods.
But wait, there’s more. Missing just a few of the largest up days can negate all of the positive returns, and the largest up days are more Likely to occur shortly after the largest down days - which is precisely when loss-averse investors are most inclined to sell and “wait out the volatility”.
Here is Less Wright back in 2019: Stock Market Timing: Why the odds are strongly against it (and why investors should fear missing the upside, not avoiding the downside), in which he leans on a fabulous paper from Wim Antoons in 2016 titled Market Timing: Opportunities and Risks:
To make things even harder for trying to avoid downturns, and this is where market timing becomes incredibly difficult — the paper found that some of the best positive gains are clustered near some of the largest downturns. Yet, after a downturn is when most people move to cash and then wait until the coast is clear and the market has risen.
Here’s the problem of missing some of the best days, or what the paper terms ‘compression’. Namely, that a large percentage of the market's gains over the long run are ‘compressed’ into a small amount of large upside days.
Consider the time-frame of 1961–2015, or 55 years. The buy and hold annual return was 9.87%.
Yet, if you missed the 81 most positive days during this 55 year period …your return plummets to a meager .03% annualized (!).
In other words, missing only .59%, less than 1% of the total time, could take a healthy annualized return and turn it into no better than T-bill returns. Add the cost of transactions on top (commission, spreads) and the picture gets even bleaker.
But what about the ‘experts’? Certainly they are able to time the market?
A study by CXO advisory group collected timing predictions for the market from 2005–2012. A total of 6,582 forecasts for the S&P 500 from 68 different experts. After reviewing the results and including transactions costs, the Brandes Institute in their paper concludes — “no single market timer was able to make money.” (!)
Strong evidence for my case that “traditional active management is not performing”.
ONE MORE THING…
What is value, anyway? Lance Roberts: "For instance, the two top holdings of IWN, the iShares Russell 2000 Value ETF, are GameStop (GME) and AMC Entertainment which are about as far from value as one can imagine." Market hits all-time highs as money flows peak
Sorry, not even Congress can stop technology: Fed explores ‘once in a century’ bid to remake the U.S. dollar
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