RANDOM MUSSINGS (iii)

It seems to me that today everyone is a trend follower.  In 2009, everyone was macro economist. And both without apparent reason. It is clear today that the latter was wrong. At least, so far. I think that majority of the first will be trapped, too. Buffett is talking his book and eternal perspective and obviously he is right, so those who can afford to follow his advise, should definitely do that.  The rest at least has to be hedged.

I liked (let's call it) the battle of John Hussman and the Brooklyn Investor on the profit margins (a few additional dimensions on the subject - link). Frankly, after reading the Brooklyn Investor post I became hesitant, which means it is a must read. John seems like a strong statistician to me but as someone said owls are not what they seem.. Eternal perspective assumes that it is unclear what people will think when profit margins shrink, which is inevitable. In other words, multiple is uncertain. I still tend to lean towards a bias against high margins, which is now happening at the same time with a high multiple.

Graham with 50% in cash (link) is thinking in the same direction but instead of cash my hedge is a more aggressive bet (short of indexes).

A brief and eclectic stock update: INFU looks interesting below $1.40 (for a brief moment). Gazprom below $8.00, too. Gas reserves cannot cost 80x cheaper than at CHK for a long. However, Russian element brings some shiver in me. Umom Rasiju neponiatj (link - loose translation: you can't fathom Russia with mind). I do not have positions in both, yet. Of my holdings, LOJN looks cheap, trading almost at cash.

FOR BEGINNERS (PART VI)

II. c) Psychological Misjudgments

Human brain was designed to work in a wild world. Not that the present world is not wild but what was useful then may ruin you in the present day. You cannot rewire the brain, which seeks to help itself and regularly make shortcuts or automatic decisions without thinking (judgmental heuristics). That is what really useful for savvy sellers and very important to be aware of for investors.

Charlie Munger recommends knowing them by heart because the list is not long and this way the study would become applicable in practice (help to avoid problems).

I prepared a list of the most common and recurring misjudgments. The list really works for me - I memorized it and reread regularly. I know that I have similar points but with different framing – I thought that certain situations are easier to memorize as compared to dry theory.

In order to facilitate memorizing, I divided the list into 4 manageable sub-lists and I recommend devoting 15 minutes per day for each and in a week you will see the difference.

Before we go into the details, I would highly recommend the following links and books on the subject.

Charlie Munger’s Article on Psychology of Human Misjudgment - Link

Online Behavioral Finance Resource (very technical) - Link

Influence by Robert Cialdini - Link

Why Smart People Make Big Money Mistakes by Gary Belsky and Thomas Gilovich - Link

The Little Book of Behavioral Investing by James Montier - Link

List I

1. Mental Accounting. The key principle to remember: all money is equal. People tend to spent some money differently, e.g. inheritance, credit card or lottery winnings. If you play roulette and start with $1, then reach $100,000 and then lose it all. How much did you lose – most people will say that they lost a dollar.

2. Integrate Losses. Would you drive 4 blocks to get a lamp for $75 while at a store you are in it goes for $100? What if prices are $1,500 and $1,525? When you have a loss you prefer to hide it from yourself inside a bigger loss.

3. Asymmetry in Loss & Gain Treatment. A lost dollar is twice as painful as a gained dollar. That is how you avoid to get rid of your portfolio losers because until you sold it, it feels less painful. You start gambling with losers but are ultra conservative with winners. Scientifically, it is a part of a prospect theory and is called loss aversion and sunk cost fallacy.

4. Status Quo Bias. A variation of loss aversion. It may paralyze you, especially in the most important perceptively moment (decision paralysis).  You are simply avoiding a feeling of regret. This also explains why loss aversion can lead us to avoid or delay action. Addition of second good deal makes people less likely to take advantage of either opportunity. Remember March of 2009, when all had to invest while terrified and opportunities were plentiful (Link). How many dared to catch a falling knife?

5. Endowment Effect. People tend to overvalue what belongs to them - another manifestation of loss aversion and that is how trial periods and money back guarantees work. This explains why most people would demand at least twice as much to sell than they would to buy it.

6. Weber’s Law. The impact of change in the intensity of a stimulus is proportional to the absolute level of the original stimulus. When dealing about gain, difference between 0 and 500 is greater than between 500 and 1,000. When dealing about loss, difference between losing 500 and nothing is greater psychologically than that between losing 500 and losing 1,000.

FOR BEGINNERS (PART V)

II. b) Market Valuation and Long-term Trend

Understanding of the current market level is essential for successful investing. It should provide guidance for your investment stance: is it advisable to be active or passive, hedged or fully long.

Alice Schroeder started her brilliant The Snowball, the best book about life of Warren Buffett, with a memorable lecture the value investing grandmaster gave to the wealthiest and successful businessmen back in 1999, a few months before an important market top.

In the long run economy grows because of fundamentals: population size and productivity change. Stock prices depend on profit size (% of GDP gives a good perspective, too) and multiple of earnings, which is dictated by prevailing interest rates and inflation expectations – gravity force of the market. Share price can go up via growing profits and expanding multiple. Dividend payback is also a very important part of the total investment return. That is a brief summary of how the markets work in the long term.

In 1999, W. Buffett made his first prediction in 30 years that market would grow by 6% annually for the next 17 years (he highlighted a period between 1964 and 1981 when Dow Jones Industrial moved from 874 to 875 while economy grew fivefold).

Dow Jones in July 30, 1999 - 10,655

Dow Jones in July 31, 2011 – 12,143

17.27% up in 12 years or 1.1% annual cumulative returns. Presently, it seems that W. Buffett was an optimist and based on his frequent and recent media appearances he still is. We have 5 years to go, so who knows… And you have to remember that he speaks his book.

From 1900 to 2011 S&P 500 generated 5% cumulative return (dividends provided another 4%+). Coincidentally, 4.8% is a historical S&P 500 profit growth rate and 6.2% is historical nominal GDP growth rate (Ed Esterling’s Crestmont Research website). Long term simple average inflation is 2.9%, population growth rate is 1.3%, therefore, the rest (or 2.0%) is productivity driven growth. Noteworthy, GDP growth is slowing down during the last 30 years because accumulated leveraged started to weight economy down.

Multiples awarded by Mr. Market or a fellow with fast swinging mood are probably the most unpredictable. Jeremy Grantham of GMO nicely put it in Risk Management and Investing Part II (Q1 2006):

“Exhibit 1, the “Exhibit of the Quarter,” shows the incredibly low volatility of the U.S. GDP, which two-thirds of the time has a volatility that is a mere ±1% around its long-term trend of about +3.5% a year real. This trend is stable because the economy is mean reverting, and bad times (like the 1930s) that produce spare capacity in both labor and capital are followed by strong times as the economy works to use up its excess resources. This ultra stable GDP engine can be thought of as the engine driving corporate profits and dividends. They in turn, although far less stable at a yearly level, follow the GDP in its mean reverting tendency towards a ‘normal’ level. Because of this, if you were clairvoyant in 1882 about the entire actual stream of corporate earnings and dividends until today, and used your clairvoyance to calculate a fair value, and then did the same for 1883 and so on for every year, it would produce a very stable trend of stock market fair value, as first revealed by Robert Shiller 18 or so years ago. Perhaps, not surprisingly, the volatility of this fair market value also stays within ±1% of its long-term trend two-thirds of the time. But what a contrast these two series are to the actual stock market, which manages to spend two-thirds of its time within only ±19% of fair value. This means that the market is 19 times as volatile as the underlying fundamentals would seem to justify! Understanding this 19 to 1 discrepancy would put us a long way along the road to understanding risk.”

A few highly respectable investors estimate that now fair market value of S&P is 900-1,000 (2012), which probably means that it is better to be cautious.

Media pays most of attention to short term forecasts, which are mainly based on estimated next year’s operating earnings. It may really look reasonable to apply 10-15 earnings multiple to a basket of equities, however, one has to remember that currently profits command unprecedentedly high share of the economy, which - history tells - should mean revert. Problem is that nobody knows when.

Stock market as % of GDP - Link

Inflation adjusted S&P 500 compared to the trend - Link

4 different methods (Tobin's Q Ratio including) compared to the trend - Link

Dollar value against stock returns - Link

Make your own conclusions but I am fully hedged. 

READING RECOMMENDATIONS (ii)

I wanted to document a few good reads.

First, I reread a few times a few weeks old John Mauldin’s Outside the Box with Dr. Lacy Hunt of Hoisington Investment Management. If you are going to read a single piece on macro this year this one qualifies quite well. It is a very powerful reminder on where we currently stand – protracted deleveraging; and on the trend direction of treasury rates – down. Consumers are spending their savings and are taking more debt – this does not spell well on growth prospects. There are plenty of graphs and non-noise insights.

Second, I recommend always reading Jeremy Grantham’s quarterly missives. His latest one resonates well with my thinking about individual investor’s edge – it is simply absent, at least in terms of thinking of a professional investment manager.

A few interesting thoughts from the letter: 

“You don’t have to be a PhD mathematician to work out that if the average Chinese and Indian were to catch up with (the theoretically moving target of) the average American, then our planet’s goose is cooked, along with most other things.” 

“…: there have been several recent decades in which the BTU equivalent price of natural gas did, at least for a second, reach parity with oil. But now it is at just 14% of BTU equivalency, the lowest in 50 years. Everyone who has a brain should be thinking of how to make money on this in the longer term.” 

Jeremy Grantham made an interesting twist on S&P fair market value. He is saying that top quality quarter of S&P is fairly priced (5.5% real annual returns for next 7 years), while the poor quality 75% is moderately overpriced and will deliver negative returns over the next 7 years. At current price GMO projects 1% real annual return for S&P 500 for the next 7 years.

I believe that he still thinks that FMV of S&P should be close to 950 – 1,000. Therefore, S&P at 1,370 clearly warrants a fully hedged position. I think that IWO (Russell 2000 Growth) could be the most convenient hedge – it is volatile and @ 93 has only 0.65% yield (if you have no time to identify the most mispriced poor quality stocks).

Interestingly, J. Grantham and L. Hunt views differ on long duration treasury rates. The first believes that long duration bonds is almost the most risky investment at the moment. The second projects that 30Y Bond will go down to 2% (now ~3.1%). Maybe they do not contradict each other because interest rates may go down first before jumping up.