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Don’t Be This Guy

Take a look at this picture, which I took a few years ago, on a Friday afternoon, on a New York/New Jersey ferry. After a long and stressful work week (it was 2008), the gentleman in the photo was more than a little inebriated (i.e., could barely stand up), probably the victim of an early happy hour. Now, you should also know that these ferries are fast, and the winds on the river are strong – the wind is often strong enough to blow glasses off your face. This poor soul had urgent business that was unable to wait for the trip across the river, so he walked to the front of the ferry, unzipped, and relieved himself over the bow-directly into what was probably a 35-knot headwind. Though this happened a while ago, the lesson and the aftermath made a lasting impression (probably more so on the people who did not see it coming and did not step out of the spray). Though few of us might commit the Technicolor version of this error, financial commentators do it all the time, in other ways. I spent some time this weekend doing a lot of reading – everything from social media, “big” media, gurus and pundits, and paid research. It was interesting to see the commonalities across the group (a less kind assessment might be “groupthink”), but I saw one error repeatedly: Attempts to catch or call a trend turn with no justification. This error can be hazardous to your financial health, so let me share a few thoughts. Why we are always looking for the turn I think there are good reasons why traders are always looking for the end of the trend. Many of us who do this are competitive and contrary in the extreme. I joke with people that I could have a conversation like this: Me: “Look at the pretty blue sky.” You: “Yes, that really is a pretty color of blue.” Me (now concerned because I agree with someone else): “Well… is it really blue? Isn’t it more blue green? And we know it’s essentially an optical illusion anyway…” This tendency is natural and pretty common among traders. On one hand, it’s a very good thing – you will do your own work, be naturally distrustful of outside opinions and cynical about information, and will work to think critically about everything. But it’s also a weakness because it makes us naturally inclined to see any market movement and think that the crowd is wrong. The crowd is not always wrong; often, they are right and they are right for a very long time. I think this is a simple reason why so many of us are always looking for the turn – many traders (not all) are simply wired to be contrary and to think in a contrary way. We are different, and we want to stand apart from the crowd. For many of us, this is a part of our personality and we must learn to manage it, and to understand that it is the lens that can distort everything we see. Trading lessons and psychology Beyond this element of personality, there are also some trading and market related reasons why we are always looking for a turn. There’s a misguided idea that we have to catch the turn to make money. Decades of trend following returns (for example, the Turtles) have proven that you don’t have to catch the turn; it’s enough to take a chunk out of the middle. There’s also a natural inclination to be angry and distrustful of a move we missed – if we see a long, extended, multi-month trend in which we are not participating, it’s natural to be scornful of those who did participate and to look for reasons the trend might be ending. Many classical chart patterns are taught and used out of context. Any trend will always show multiple “head and shoulders” patterns, and inexperienced chartists will not hesitate to point these out. The problem with poorly defined chart patterns (out of context) is that you can see anything you wish to see in a chart – it’s always possible to justify being long, short, or flat a market, so it’s always possible to find evidence to support whatever you want to do, at least in the absence of clearly defined trading rules and objectives. Another problem is that many traders use tools that are supposed to somehow measure extremes. Overbought/oversold indicators, sentiment indicators, ratios, bands – the problem is that these all measure the same thing, in a different way. If I get an oversold signal from sentiment, RSI, and some Fibonacci extension, I do not have three signals – I only have one because the tools are so tightly correlated. This is important to understand – if we don’t understand this (the correlation of inputs into a trading decision), then we will have false confidence in our calls, and performance will suffer. Better to know you don’t know than to think you know more than you do. Commentators and asymmetrical payoffs If a trader places a trade, she makes money if the trade is profitable and loses money if it is not. This is simple, logical, and just. However, for a commentator (blog writer, research provider, TV personality, guru, etc.), the payoffs are very different – the public remembers the times we are right, and very quickly forgets the times we are wrong. The fact there even are permabears (people who have been bearish stocks for decades) who are called to be on TV and in the paper when the market goes down is proof of this fact. It’s possible to run a newsletter or blog business for years making outrageous claims that never come true such as “end of the financial world,” “the coming crash,” “how to protect your assets from the coming seizures,” etc. The crazier and more outlandish the forecast, the better: If someone says the S&P is going down 500 points tomorrow and he’s wrong, no one will long remember because it was a dumb call. If, however the S&P should, for some reason, go down 500 points, that person is, instantly and forever, the expert who “called the crash.” In fact, if that forecast doesn’t come true but there’s some mild decline in the next few months, creative PR can still tie the forecast in. Why does this matter? You can read blogs and listen to commentators, but read with skepticism. Realize that the person writing has a reason for calling ends of trends and turns. Your trading account, however, has a different standard: If you lose more on your losing trades than you make on the sum of your winners, that’s going to be a problem, in the long run. Finding ends of trends I’ve written about this before, so I will just point you to the relevant posts. One way I have found to avoid the situation where I’m going against the trend is to require some clear signal from the market that the trend might have ended. There are specific patterns that can help: (exhaustion, climax, three pushes, failure tests, price rejection), and then seeing the change of character (new momentum in the other direction) to set up a pullback in the possibly new trend is key. (Start reading here for ideas on evaluating and catching a possible turn.) In the absence of that sequence: 1) something to break the trend and 2) new counter-trend momentum and change of character, the best bet is to not try to fade the trend and to wait for clear signals. Let me leave you with a few charts of current markets, with only one question: What direction is the trend in each of these markets? Most of the time, that’s all the commentary we need. And that guy back at the top of this post? Yeah, don’t be that guy.

From The Studs Up: Building (And Rebuilding) A Portfolio With MPT

An optimal investment portfolio contains assets intended to show well in the light and in the dark. That means it’s built to suit for your risk tolerance and target time frame, for moments of market clarity and uncertainty. We’re talking about modern portfolio theory (MPT), which aims to optimize potential returns for nearly any given risk. Modern portfolio theory has a fresh-sounding resonance, but it’s a 63-year-old investing model structured on three elements: asset allocation, diversification, and periodic rebalancing . At its roots, MPT is a basic investing model – and by now a fundamental one – that embraces diversification and equilibrium while sticking to a measured regime of the classic buy low/sell high. “The idea is that by sticking to that kind of discipline, you can ride out the down markets by staying diversified, and not making rash moves when the market is going up significantly or pulling back,” says John Bell, director of guidance platforms and tools at TD Ameritrade. For example, asset classes whose prices go sharply higher tend to become overweighted and could warp the balance. “If you’re consistently rebalancing back to a target, in general you will be selling the assets that are most highly valued and overpriced, and buying those things that are undervalued and underpriced,” Bell adds. “Buy low/sell high is what rebalancing allows you to do without attempting to introduce biases into your analysis. The beauty of calendar-based rebalancing is there’s nothing more magical about it other than enforcing some discipline,” he says. Mix of Materials Modern portfolio theory was first penned in 1952 by economist and Nobel Prize laureate Harry Markowitz, who used mathematics to support his theory that you can minimize risk and maximize returns by holding a combination of asset classes that aren’t correlated to each other and that align with your personal appetite for risk as well as your age . In other words, with MPT, you spread the risk among assets that don’t typically behave in the same way. It all boils down to these three components: Asset allocation. Investment products span asset classes that might include stocks, bonds, cash, real estate, international holdings, and emerging markets. Ideally (although this isn’t always the case), each asset class performs differently over time and has different levels of risk. For instance, equities typically have higher risk than fixed-income products, but the return is generally greater over time. Diversification. MPT disciples choose assets that don’t correlate to each other, like oil and food, or technology and apparel, domestic versus foreign, large cap versus small cap, and so on. Rebalancing. Consider regular realignment of a portfolio to the target asset allocation already in place. Certain stocks in your portfolio, for example, might soar and upend your targets. Rebalancing allows you to get back on task and, MPT proponents argue, tends to lower the portfolio’s risk. Check Emotions at the Door Why such lasting power for MPT? Because self-control practiced through rebalancing manages two emotions that typically prompt investors to make bad decisions: greed and fear. “Human behavior sometimes trumps logic and sound thinking,” Bell says. “People tend to buy at the absolute worst time and sell at the absolute worst time. Discipline takes the human emotion part out.” But MPT is not bullet-proof. It’s aimed at helping you dodge what’s called “undiversifiable” risk, or what happens when you have all your investment eggs in one asset-class basket and that class stumbles. If all your money was tied up in stocks in 2008, you likely lost a big chunk of change. Wealth Accumulation MPT also follows a basic school of thought about accumulating and keeping wealth. In your 20s, when you have decades of investing before you, conventional wisdom urges taking more risks, perhaps investing more heavily in equities than fixed income in your portfolio weightings. The assumption is that you have time to recover from a harrowing market event that could wipe out 50% of your portfolio. Remember 2008? But if you’re in your 60s, when time has snuck up on you, MPT says it’s best to protect your wealth by taking a more conservative approach without swaying too far from your goals. Those who ran for the hills and converted equities to cash in 2008 probably missed the bull market that followed. MPT cannot – and does not claim to – eliminate “systematic” risk, or what happens when the entire market takes a tumble. But it can soften the blow. Rather than suffering a 50% loss along with the stock-market crash of 2008, a well-balanced portfolio may have set you back only 25% or sometimes less. “You’ll very rarely ever be at the top or the bottom of a broad group of asset classes, but most likely in the middle. That makes sense, because you have a mix of all the asset classes,” Bell says. Disclaimer: TD Ameritrade, Inc., member FINRA/SIPC. TD Ameritrade is a trademark jointly owned by TD Ameritrade IP Company, Inc. and The Toronto-Dominion Bank. Commentary provided for educational purposes only. Past performance is no guarantee of future results or investment success. Options involve risks and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before investing.

Fundamental Items Rarely Affect Valuation

By Rupert Hargreaves Almost all fundamental investors based their research, analysis and investment decisions on the assumption that some positive relationships exist over time between equity valuation and key financial metrics. However, while a large amount of investment activity is based on the assumed relationships between the aforementioned factors, research conducted by S&P Capital IQ, shows that for the past decade it has been impossible to prove a strong statistical relationship between commonly referenced fundamental financial statistics and the direction of the equity market, momentum, and valuation: “Whether we are looking at various measures of profit margin, reported revenue and earnings growth, or even estimated future sales and earnings growth, the past decade’s correlations between price-to-earnings (P/E) valuations and a variety of commonly referenced fundamental financial statistics randomly range between strongly positive and negative readings.” – S&P Capital IQ Global Markets Intelligence Valuation versus fundamental data items Any investor that’s been watching the market for more than a year or two will know that the relationship between the valuation assigned to equities by stock market investors and underlying fundamental characteristics, over time, is extremely complex. There are many internal (stock specific) and external factors that can affect valuations. According to S&P Capital IQ ‘s research on the matter, the only net positive correlation relationship with P/E multiples since 2005 is related to selling, general, and administrative expense margins or the ratio of non-price of goods sold expenses to revenues. The best way to explain this relationship is with a table. (click to enlarge) P/E Valuation vs. Fundamental Data Items Based on a decade’s worth of data, S&P Capital’s research shows that a change in a company’s selling, general, and administrative expense margin is the only factor that will consistently impact earnings multiples across sectors. There is a clear reason for this correlation. Higher expenses will compress profit margins, weigh on profit and ultimately investors will abandon the company, driving the P/E lower. However, it’s unclear why a similar relationship doesn’t exist across other fundamental metrics. Prime example The tech sector is a prime example of an industry where the average P/E does not reflect the underlying and improving fundamentals. After the tech stock market bubble burst in 2000, the S&P 500 technology sector entered the economic recovery cycle in the first quarter of 2002 with a forward 12-month P/E valuation ratio of 54x. Between 2002 and 2010, tech sector valuations continued to be consistently marked down, although, the sector’s earnings growth averaged 23% per quarter throughout the period. The sector’s forward P/E reached a low watermark of 10.7 during Q3 2011 and has only recently started to readjust higher – as shown below. (click to enlarge) Interesting trends Aside from the obvious disconnect between P/E multiples and underlying fundamentals, S&P Capital IQ’s data highlights some other interesting trends. For example, the energy sector is currently trading at a forward P/E multiple of 33, exceeding the levels recorded while exiting the 2001 recession. The energy sector exited the 2001 recession with an elevated forward P/E of 24 that steadily declined to 8.6 by Q4 2005, well into the economic recovery and actually half way through the Fed’s tightening cycle, which took place between June 2004 and June 2006. The sector’s P/E bottomed in 2005, steadily increasing as the price of crude oil continued to rise from $50-$60 per barrel in the final quarter of 2005 to as high as $145 in July 2008. The sector P/E reached a peak of 15.3 in Q4 2008. These historic trends show that the current extreme forward energy sector P/E ratio reflects severely depressed anticipated future earnings per share relative to existing share prices, not unlike the excessive valuations seen at the tail-end of the tech stock market bubble in 2000. The excessive valuation now needs to be worked off as revenue and profit growth slowly becomes aligned with market pricing. The consumer discretionary sector illustrates more contemporary equity market valuation-related issues. Specifically, between mid-year 2004 and mid-year 2006, as the Fed continued to raise short-term interest rates at every Federal Open Market Committee meeting, investors became more cautious toward the consumer discretionary sector, pushing the sector’s P/E multiple down to 18.4 in the second quarter of 2006, from 19.4. Over the same period, sector earnings grew at an average of 8.8%: “Moving ahead to current valuations, the consumer discretionary sector’s forward P/E ratio has averaged 19.1x in the past two years while sector earnings per share growth has averaged 10.5%. Interestingly enough, this figure is close to the average P/E of 19.4x recorded by the sector during the prior period of Fed tightening when earnings grew by 8.8%. From this perspective, investors appear to be comfortable with a prospective Fed tightening cycle, as they were during most of the prior tightening cycle, as long as consumer discretionary sector earnings continue to grow at a healthy pace.” – S&P Capital IQ Global Markets Intelligence