Tag Archives: management

Not Owning Stocks Today Is Risking Dollars To Make Pennies

A recent article posited that owning stocks today is “risking dollars to make pennies.” A review of historical data suggests this is alarmist and statistically unlikely; it also implies an overly narrow definition of risk. Stocks in general are expensive, but they still offer better return potential than bonds over the next decade, and there are plenty of individual stocks that offer low-risk returns. A recent article proclaimed owning stocks today is risking dollars to make pennies . For investors with a sufficiently long time horizon, I believe the truth is the opposite: NOT owning stocks today is risking dollars to make pennies. I’m not advocating being all-in on the S&P 500 or anything like that – I have plenty of cash reserves – but in line with Seeking Alpha’s “read, decide, invest” motto, I think it’s important for investors to understand both sides of the issue. I would recommend you read the linked article (written by Jesse Felder) prior to going any further. Let’s start from a high level: What does “risking dollars to make pennies” mean? Well, according to Jesse, it means stocks are so wildly overvalued that your potential return over the next ten years is miniscule, and your potential downside is massive. I posit this is: A) alarmist and statistically inaccurate; B) overly narrow in its definition of risk; and C) treats “stocks” as some monolithic entity (which devalues the excellent investment ideas posted every month here on Seeking Alpha). Starting with point A: What is the actual likelihood of stocks resulting in a significantly negative 10-year return? Here’s a link to a nice document providing this data from 1926 through 2013 in both tabular and graphical format. Summarily, there were only a very few rolling 10-year periods when investing in the S&P 500 would have resulted in losses in nominal terms. Specifically, you would have had to invest right before the Great Depression or in the late 1990s – two of the larger bubbles of all time. Even on an inflation-adjusted basis, there were not many periods when stocks had negative returns. Most of the time, stocks have had substantially positive 10-year returns, averaging 201.15% across all rolling ten-year periods during those 87 years. The two supporting arguments for the author’s assertion that the 10-year return on stocks will be less than the risk-free rate are: a graph of GDP versus market cap over time, and a graph of household equity ownership. The former is merely one data point that ignores substantial changes in the makeup of the economy. Relative to the past, today it is much more service- and knowledge-oriented – thus, there are higher returns on capital. This statistic also ignores changes in effective tax rates over time, which have benefited reported profitability (and consequently, valuation). As for the latter point of equity ownership, let’s discuss that. Point B: Paraphrasing the original article title, I believe NOT owning stocks today is risking dollars to make pennies. Paltry yields on fixed income mean traditional “your age in bonds” portfolios may no longer achieve the returns they used to, and this is likely one factor driving more investors into equities. The 10-year yield barely exceeds the Fed’s targeted inflation; while there are reasons to believe inflation may be on hold for now, the point remains that you will make no more than pennies by investing in bonds. Moreover, there is more than one definition of “risking dollars” – assuming you have a ten-year or greater time horizon and need to invest to fund long-term liabilities (kids’ college funds, retirement, etc.), then earning near-zero returns by investing exclusively in bonds is just as much of a risk as potential volatility from investing in stocks. Risk, in this context, means you won’t meet your financial goals – and if you don’t invest in any stocks, it’s very hard to see how you will generate sufficient returns with yields on fixed income where they are. Please note that I am not arguing stocks are cheap – in fact, I think most indexes are on the expensive side – I’m just saying that if I had to put all of my money in either stocks or bonds for the next ten years, it would be stocks without a question. Finally, point C: I think it’s unfair to treat “stocks” as a monolithic entity – as if you either own the S&P 500 (NYSEARCA: SPY ) or you do not, and there’s no other alternative. Even if you believe the market as a whole is overvalued, like I do, that doesn’t mean every single component of the market is overvalued. To the contrary, there are plenty of low-risk, high-quality companies with good management teams, conservative balance sheets, and solid future prospects that trade at reasonable multiples of cash flow or earnings. One such company which meets these criteria is Prosperity Bancshares (NYSE: PB ), which I’ve written about here . That is far from your only option, of course – but as long as you stick to those basic criteria, you will certainly be able to identify companies that will outperform 10-year Treasuries or corporate bonds. If you can’t find a single stock which meets these criteria, then you’re not spending enough time on Seeking Alpha! To conclude, there is a charming (if crude) saying about what part of your body opinions are like – the punchline is “they all stink” – and this aphorism applies especially to macro predictions, which almost always end up being wrong. Economists have predicted 12 of the last 2 recessions, etc. The future is obviously unpredictable, so we have to make logical decisions based on the information we have available. Despite the high valuation of most indices, stocks (whether individually or via ETFs or mutual funds) still seem to offer much better prospective returns over the next ten years than fixed income. As such, while it’s obviously the responsibility of every investor to determine their own risk tolerance and investment goals, it seems not owning any stocks is risking (future) dollars to make pennies.

Assessing The Utility Of Wall Street’s Annual Forecasts

It’s that time of year when everyone starts preparing for the New Year and Wall Street makes its 2016 predictions. I’ll get right to the point here – these annual predictions are largely useless. But it’s still helpful to put these predictions in perspective, because it highlights a good deal of behavioral bias and some of the mistakes investors make when analyzing their portfolios. The 2016 annual stock market predictions are reliably bullish. Of the analysts that Barrons surveyed, they found no bears and an expected average return of 10%. This is pretty much what we should expect. After all, predicting a negative return is a fool’s errand given that the S&P 500 is positive about 80% of the time on an annual basis. And the S&P 500 has averaged about a 12.74% return in the post-war era. So, that 10% expected return isn’t far off from what a smart analyst might guess, if they’re at all familiar with probabilities. There is a chorus of boos (and some cheers) every year when this is done. No analyst will get the exact figure right, and there will tend to be many pundits who ridicule these predictions despite the fact that expecting a positive return of about 10% is the smart probabilistic prediction. In fact, if most investors actually listened to these analysts and their permabullish views, they’d have been far better off buying and holding stocks based on these predictions than most investors who constantly flip their portfolios in and out of stocks and bonds. But that’s the reason why these predictions exist in the first place. Because every year, investors perform their annual check-ups and evaluate the last 12 months’ performance before deciding to make changes. And of course, Wall Street encourages you to do exactly that, because turning over your portfolio means increasing the fees paid to the people who promote these annual predictions. But when we put this analysis in the right perspective, it becomes clear that this mentality is misleading at best and highly destructive at worst. Stocks and bonds are relatively long-term instruments. The average lifespan of a public company in the USA is about 15 years.¹ And the average effective maturity of the aggregate bond index is about 8 years.² This means an investor who holds a portfolio of balanced stocks and bonds holds instruments with a lifespan of about 11.5 years. When viewed through this lens, it becomes clear that evaluating a portfolio of long-term instruments on a 12-month basis makes very little sense. What we do on an annual basis with these portfolios is a lot like owning a 12-month CD that pays a one-time 1% coupon at maturity and getting mad that the CD hasn’t generated a return every month. But this annual perspective makes even less sense from a probabilistic perspective. As I’ve described previously , great investors think in terms of probabilities. When we look at the returns of the S&P 500, we know that returns tend to become more predictable as we extend time frames. And the probability of being able to predict the market’s returns increases as you increase the duration of the holding period. While the probability of positive returns becomes increasingly skewed as you extend the time frame, there is still far too much randomness inside of a 1-year return for us to place any faith in these predictions. The number of negative data points is only a bit lower than the number of positive data points, even though the average return is positively skewed: (click to enlarge) So, at what point do returns become reliably positive? If we look at the historical data, we don’t have reliably positive returns from the stock market until we look about 5 years into the future, when the average 5-year returns become positively skewed. A 50/50 stock/bond portfolio has a purely positive skew, with an average rolling return of 3 years. Interestingly, this stock market data is just as random even though it’s positively skewed. So, trying to pinpoint what the 5-year average returns will be is probably a fool’s errand (even though stocks will be reliably positive, on average, over a 5-year period). (click to enlarge) All of this provides us with some good insights into the relevancy of making forecasts about future returns. When it comes to stocks and bonds, we really shouldn’t bother listening to or analyzing predictions made inside of a 12-month period. The data is simply too random. As we extend our time horizons, the data becomes increasingly reliable with a positive skew. But it still remains a very imprecise science. The bottom line – If you’re going to hold stocks and bonds, it’s almost certainly best to plan on having at least a 3-5 year+ time horizon. Any analysis and prediction inside of this time horizon is likely to resemble gambling. As Blaise Pascal once said, “All of human unhappiness comes from a single thing: not knowing how to remain at rest in a room”. The urge to be excessively “active” in the financial markets is strong; however, the investor who can take a reasonable temporal perspective will very likely increase their odds of making smarter decisions, leading to higher odds of a happy ending. Sources: ¹ – Can a company live forever? ² – Vanguard Total Bond Market ETF, Morningstar

The V20 Portfolio Week #10: Almost There

Summary The search for a hedge continues. Dex Media’s new deadline is Monday, but it could be extended again. With all major events now behind us, it should be smooth sailing ahead. The V20 portfolio is an actively managed portfolio that seeks to achieve annualized return of 20% over the long term. If you are a long-term investor, then this portfolio may be for you. You can read more about how the portfolio works and the associated risks here . Always do your own research before making an investment. Read last week’s update here ! The bears are back just before we wrap up the year. The V20 Portfolio claimed another victory over the S&P 500 this week, staying virtually flat (-0.4%) versus the index’s decline of 4% this week. With oil hitting historic lows recently, having broken the $40/bbl mark and now testing $35/bbl, there seems to be no end to this commodity slump. Update On Hedging Those of you that follow my weekly updates probably remembered that I was looking for an energy stock to offset the position in Spirit Airlines (NASDAQ: SAVE ). I still have not found any energy stock that would be worthwhile to include in the V20 portfolio, and it looks that I got lucky with this delay. I want to stress the word “luck” because I had every intention to find a good energy company, it’s just that I have been successful thus far. Had I taken a position then, it sure wouldn’t have been pretty. Given the current outlook for oil, has my objective changed? The answer is no. I remain committed to find an offsetting position for Spirit Airlines. Keep in mind that this is not limited to a long on energy stocks, it could also be a short on a less impressive airline, or even futures for a more direct hedge for fuel prices. The reason why I am more inclined to find a long position is simply the result of better risk/reward of a long position on an undervalued energy company. Ideally, the company would earn money during the current downturn, and will hence perform even better when oil rises. So in other words, I don’t want the value of this hedging position to completely offset any gains or losses that I make on Spirit Airlines. Outlook With Conn’s (NASDAQ: CONN ) earnings now behind us, we’ve officially wrapped up Q3 earnings. Going forward, Conn’s will continue to report monthly sales data. Through Q3 earnings, we already know that November sales were up 8% on a same store basis, so growth continues to be strong. Previously there were worries that tightening credit policies would impact sales, this is clear evidence that points to the contrary. There is also the curious case of Dex Media (NASDAQ: DXM ). As always, the stock fluctuated wildly during the week, and I expect this trend to continue going forward. However, because the stock is such a minute portion of the V20 Portfolio, any downside volatility will not significantly impact overall results at all. Even if equity holders lose everything post-restructuring, the V20 Portfolio will only decline by 0.7%. On the contrary, if the restructuring outcome is favorable to equity holders, then its value will skyrocket. As of right now, all stakeholders are still negotiating. Having extended the forbearance period once already, I wouldn’t be surprised if it is extended once again after the deadline passes on Monday. With major events now behind us, the V20 Portfolio is looking to have a strong finish in 2015. Editor’s Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.