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Why Investor Sentiment May Not Be A Contrarian Indicator Anymore

Investor sentiment indices such as the AAII have been extremely bearish since this summer, before the August downturn. Many analysts have pointed to this bearish sentiment as a contrarian, and therefore bullish, indicator. However, the bearish investors this summer were proven right in August, and they may well be proven right again in October. Sentiment surveys may no longer reflect the opinion of as substantial a portion of the market as they used to. Also, the spreading knowledge of technical analysis in recent years may have made average investors — lo and behold — smarter than they were in 2007-2008. Since this summer, well before the August downturn, a variety of measures of investor sentiment have given extremely bearish readings. Headlines appeared in July that investors are the most bearish that they’ve been in 15 years, and similar headlines still appear in September. And it is now typical for the articles about these bearish sentiment measures to point out that historically such sentiment readings have been a contrarian indicator: Extreme bullish sentiment has tended to indicate that a bull market has peaked and is about to decline, while extreme bearish sentiment has tended to indicate that a bear market has bottomed and is about to rally. Strangely, though, this year bearish sentiment exploded before the bull market even entered a correction. Some analysts still point to the sentiment now and use it as an argument that we are only in a correction, not a bear market, and that the bull market will soon resume its march higher. I doubt this very much. Rather, I argue, this year — for once — investor sentiment was and is on the money about the direction of the market. Investors were and are right to be bearish. So why is investor sentiment no longer a contrarian indicator in 2015? This is a very good question, so allow me to offer a couple plausible explanations. First, the individual investors whose sentiment is being measured in the surveys may not represent as substantial a portion of the market as they used to. Large institutional investors make up an even more dominant share of the market than they did 7 years ago or 15 years ago. Trading driven by computer algorithms is certainly a much bigger factor in the market than it ever was before. This summer, individual investors felt the fear before the technical indicators alerted the computer algorithms that something was wrong. Another factor in recent years is the flood of money from overseas that has been seeking out relative safety in the U.S. stock markets. Most of the sentiment indicators probably do not incorporate the opinions of overseas investors as much as those of American investors, so the surveys are likely overlooking relatively more bullish sentiment from overseas investors, who have been happy to buy U.S. stocks rather than Asian, European, or other stocks. Second, the spread of technical analysis itself may be a factor in the sentiment readings since August (most technical indicators turned negative slightly before the market downturn). Individual investors have far more access to the basic principles of technical analysis than they did 15 years ago or even 7 years ago. The technicals were flashing danger signs almost an entire year before the 2008 crash, but most investors were not aware of them or ignored them. Today there is far less ignorance or lack of awareness of such information among investors. Many more people now know how to read a simple chart of the price, the 50-day moving indicator, and the 200-day moving indicator of a stock or index. And even such simple charts give an accurate enough indication to tell individual investors to be bearish before the market has bottomed, rather than waiting until after the market has bottomed to suddenly panic. Moreover, the type of knowledgeable investor who understands technical analysis is precisely the type of investor who is also likely to be a member of the American Association of Individual Investors and reply to their sentiment survey. The investment newsletter advisors whose sentiments are measured in the Investors Intelligence survey are also more likely to follow the technical charts. I strongly suspect that newsletter advisors too have increased their knowledge of basic technical analysis a great deal in the past 7 years. On the other hand, the more passive “buy and hold” investors, and the people who simply put part of their 401k money in an S&P 500 index fund and never make any adjustments to it, are less likely to pay enough attention to turn bearish before the market completely crashes and they panic. Their sentiments are also less likely to be captured in investor sentiment surveys. In summary: The type of active investors whose opinions tend to be measured in sentiment surveys may well have gotten a lot smarter now than they were 7 years ago or 15 years ago! I dare say websites such as Seeking Alpha may have contributed to this increase in investor education. There is still a lot of dumb money out there, but at least there’s hopefully less of it, especially among investors such as those who read Seeking Alpha.

Following The Smart Money For Asian Stocks Beyond 13Fs

Summary Filing form 13F, the reporting of holdings for institutional investment managers with investment discretion over $100 million or more in stocks, is unique to the U.S. It is possible to utilize a piggybacking strategy for idea generation in Asia, if you know who and how to follow. I utilize a 360-degree idea generation process via screens, insider trades, 13Fs, fund manager letters, analyst reports, blogs, forums among others. Following The Smart Money In Asia In the U.S., institutional investment managers with investment discretion over $100 million or more in stocks have to file 13Fs declaring their holdings (long only) with the U.S. Securities and Exchange Commission within 45 days of every quarter. This has indirectly made the investment strategy of cloning the portfolios of well-known and successful fund managers a reality. Even for investors who do not believe in replicating the positions of their favorite investors in full, they might still generate potential investment ideas by taking a peek at the investors’ holdings. Since I invest in both Asian and U.S. stocks, I have always thought about the possibility of applying certain aspects of this piggybacking strategy in the Asian context and this is precisely the focus of this article. In the sections below, I will provide a few examples of generating Asian stock ideas by following the smart money. That being said, it is intriguing that while I generated most of my stock ideas via quantitative screens, my investments and calls were validated to a large extent by similar positions that other fund managers and investors held. I will share some of these past and current stock ideas below. Following U.S. Investors Vested In Asian Stocks An increasing number of U.S. funds are investing in Asia-listed stocks. While they do not have to file 13Fs for these non-U.S. holdings, it is possible to uncover these hidden gems by reviewing mutual funds’ shareholder reports and hedge funds’ investor letters (assuming that they are accessible). Let me illustrate this with some examples. Oriental Watch Holdings Ltd ( OTC:ORWHF ) (0398.HK) was the first Asia-listed stock which I wrote about here on Seeking Alpha. Oriental Watch simply just appeared on my net-net screens one day, and it appeared to be attractive given its long-term profitability and dividend track record and the value of its self-owned properties. I was not alone in my views on Oriental Watch. Tweedy Browne, Benjamin Graham’s former broker which subsequently made its foray into fund management as a classic Graham value manager (read “The Little Book Of Value Investing” by Christopher Browne if you are interested about understanding the firm’s investment philosophy), first disclosed its stake in the stock in its Q3 2013 commentary , and referred to it as “a luxury retailer and a classic Ben Graham net current asset microcap stock, which at purchase was trading at two-thirds of its net cash and inventories.” As of June 30, 2015, Tweedy, Browne Global Value Fund and Tweedy, Browne Global Value Fund II held 7,364,000 and 3,348,000 shares of Oriental Watch, respectively. Other Hong Kong-listed stocks currently held by Tweedy Browne include Great Eagle Holdings Ltd ( OTCPK:GEAHF ) (41 HK), Hengdeli Holdings Ltd ( OTCPK:HENGY ) (3389 HK), Miramar Hotel & Investment ( OTC:MMHTF ) (71 HK) and Tai Cheung Holdings Ltd ( OTC:TAICY ) (88 HK). Tweedy Browne also holds shares in a Japanese net-net, Shinko Shoji ( OTCPK:SKSJF ) (8141 JP), which I briefly wrote about here . Besides reading investor letters and shareholder reports of U.S. funds investing globally, one can also follow individual fund managers on their social media platforms such as blogs. Travis Wiedower, Managing Director of Wiedower Capital, a small value-oriented investment firm, writes a blog (called Egregiously Cheap) and he recently wrote an article titled “Oriental Watch: Deep Value at its Finest”. In the article, Travis refers to Oriental Watch as a “company selling for ~35% of liquidation value that has a clear route back to profitability.” This is the first Asia-listed stock that Travis has written about, and I hope he can share more such ideas in the future! Following Asian Fund Managers Directly Asian mutual funds will disclose their holdings periodically in quarterly or semi-annual shareholder reports, which are typically available on their respective websites. For Asian hedge funds, I will be on the lookout for any interviews that the fund managers have done or investor letters that they have made available. Ronald Chan will probably be a familiar name to my readers. Ronald Chan is the author of the book “The Value Investors: The Lessons From The World’s Top Fund Managers, which I have quoted a couple of times in my previous articles. Ronald is also the author of another book “Behind the Berkshire Hathaway Curtain: Lessons from Warren Buffett’s Top Business Leaders,” where he interviewed the top managers of Berkshire Hathaway’s subsidiaries. It is obvious from these two books that Ronald is a value investor; he is currently the Chief Investment Officer of Chartwell Capital based in Hong Kong, which he started in 2007. In a Barron’s interview published in November 2014, Ronald spoke about some of his holdings, including Oriental Watch (I am using the same stock as an example to illustrate that implementing a piggybacking strategy in Asia is more difficult compared with the U.S., but not impossible if one knows where to look). Ronald has this to say about Oriental Watch: Oriental Watch is a classic Benjamin Graham example where its assets are trading much higher than its market cap. Its market cap is about HKD900 million. Its retail properties are worth HKD650 million. The watch inventory, which is 70% Rolex, has a value of HKD1.8 billion. Add cash, minus debt, I think it’s worth HKD2.4 billion. I can sleep at night because I know that it has good inventory and the retail locations that are worth a fortune. This is a classic asset-driven, asset-backed idea which no one looks at! In his interview with Barron’s, Ronald also highlighted the following Asian stocks: Hyundai ( OTC:HYMPY ) (005380.KS), Kia ( OTC:KIMTF )(000270.KS), Central China Real Estate (832 HK) and Dynam Japan Holdings Co. Ltd. ( OTC:DJPHF ) (6889 HK), a Magic Formula stock which I wrote about here . Cederberg Capital is another Asian fund that I follow. On its website , Cederberg Capital outlines its investment approach as follows: “Cederberg Capital utilizes a disciplined value-oriented approach in order to protect capital during periods of market declines and to maximize returns in the long run.” In Cederberg Greater China Equity Fund’s Q2 2015 letter, Managing Director Dawid Krige also commented on the firm’s investment philosophy: We are value investors at heart. However, we aren’t looking for Ben Graham’s “net-nets” or the “cigar butts” of the early-Buffett years. In our experience “cheap” often stays cheap in China, hence we are better off buying undervalued quality, i.e. good businesses managed by trustworthy people. We love growth, if through our research we can gain confidence about the likelihood it will be realised. However, we are careful not to overpay for growth, hence we always insist on a significant margin of safety, regardless of a company’s growth potential. Past and present investments that Cederberg Capital has profiled or commented on in its letters include Kweichow Moutai (600519 CH), which owns the top Maotai liquor brand in China, and Clear Media ( OTC:CRMLY ) (100 HK). Clear Media was a past investment of mine which I successfully exited with a 80% return in 14 months in August 2014, inclusive of a special dividend. Clear Media was an outdoor media company with dominant bus-shelter advertising network; it boasted an unique mix of deep value and wide moat characteristics. At the point of my purchase, Clear Media traded at 3x EV/EBITDA, with net cash accounting for close to half of market capitalization. Its business and attractive returns on capital were protected by high barriers to entry due to local regulatory approvals required for construction and maintenance of bus shelters. However, it is unfortunate (for investors like us) that Cederberg Capital has decided to “limit discussions of existing holdings to protect our intellectual property and to mitigate any behavioral biases, though we will continue to discuss investments we’ve exited in future letters.” Nevertheless, I look forward to reading Cederberg Capital’s future letters to learn about the firm’s past “case studies.” Replicating Guru Investors’ Potential Buys In Asia Via Quantitative Screening Walter Schloss is one of the deep value investors that I admire and seek to emulate, particularly considering that he has the longest and most consistent investment track records among his peers. However, it is regrettable that Walter Schloss stopped managing money in 2001 (partly due to the fact that cheap U.S. stocks became hard to find), and he never invested in Japan or Asian stocks given concerns over differences in politics, language and regulations. Nevertheless, I thought hard about what Walter Schloss could have potentially bought in Asia if he applied his stock selection criteria for U.S. In an article titled “Walter Schloss’ Japan Shopping List For Deep-Value Stocks” published here , I did a screen based on Schloss’ 16-point “investment checklist” and found 20 Japanese stocks and 299 Asian stocks that will meet his stock selection criteria of trading near historical share price lows, being valued at a discount to net asset value and having debt-to-equity ratios below 1. Looking ahead, I plan to try to replicate other investors’ investment strategies in Asia using screens and sharing the results with my readers and subscribers. Concluding Thoughts Personally, I don’t subscribe to the view of cloning any investor’s portfolio lock, stock and barrel, even for U.S. stocks. The reason is that there are various complications involved with piggybacking such as time lag, average purchase cost and portfolio sizing. In the Asian context, a complete cloning approach is even more risky, considering that it is more difficult to track any individual fund manager’s exact holdings and buy/sell history with reasonable accuracy. Instead, I advocate that investors use fund managers’ holdings as either an idea generation tool or an alternative form of validation of one’s original investment thesis. Note: I utilize a 360-degree process to generate investment ideas, including screens, insider trades, 13Fs, fund manager letters, analyst reports, blogs, forums among others. Subscribers to my Asia/U.S. Deep-Value Wide-Moat Stocks exclusive research service get full access to the list of deep-value & wide moat investment candidates and value traps, including “Magic Formula” stocks, wide moat compounders, hidden champions, high quality businesses, net-nets, net cash stocks, low P/B stocks and sum-of-the-parts discounts.

Preparing For A Market Collapse, Part III

Summary U.S. equities are down but not cheap. They could fall further. It is time to prepare…. … In fact, it is always a good time to be prepared. This is the third in a series. You can read Part I and Part II for background. Since the series began, the S&P 500 (NYSEARCA: SPY ) is down over 10%; it could have much further to fall. What current shorts have the most asymmetric exposure? How can average investors see the need to short? Here are three specific short ideas followed by three ways for investors, including retail investors, to weigh when to short. China In terms of country exposure, China is among my favorite shorts. Artificial central bank stimulus drove the Chinese equity mania in early 2015. New equity buyers flooded into the market. These new investors purchased stocks using a record amount of margin debt. They had weak hands once the market direction turned around. The supply of new capital was finite. Eager new investors pushed up prices, but quickly pulled out of the market once prices declined. How do you short China? One way is to short Direxion Daily China Bull 3X Shares (NYSEARCA: YINN ). It is down over 70% since I first disclosed this idea, but it could drop much further over time. That being said, not all Chinese equities are expensive. While China is a big short idea overall, there are some small long ideas worth considering, such as Taomee (NYSE: TAOM ). Biotech Turning to sector exposure, biotech is another favorite short opportunity. This has been a hot sector, but one with market prices that are high, unstable, and precarious . It is down over 20% but remains overpriced. In the long term, it will probably decline substantially further. While biotech is a major short opportunity, one can find bargains in the wreckage. Depomed (NASDAQ: DEPO ) is one worth considering. Due to its drug prices, it is far less sensitive to political pressure than Horizon (NASDAQ: HZNP ) or Valeant (NYSE: VRX ). High Yield In the current credit environment, “high yield” is a bit of a misnomer. In fact, it borders on false advertising. This is one of my favorite types of securities to short because high yield is expensive enough that it does not cost too much if it maintains these rarified prices, and investors long this exposure will probably not hang in there if it begins to decline substantially. Retail investors (including not just a few on Seeking Alpha) who seek yield at any price have driven securities with the appearance of stable yield to zany prices. One security to consider is PIMCO High Income Fund (NYSE: PHK ). As of today, it trades at a 13% premium to its NAV. Down over 25%, it is still overpriced. Its price should continue to converge upon its value in the years ahead. If credit spreads widen from here, it could decline substantially. Should you own any broad-based bond exposure? At today’s prices, no. “HPHs [high priced helpers] frequently think of risk as a function of asset class along the lines of “cash is safe, stock is risky, and bonds are in the middle”. In reality, risk is never a function of asset class; it is a function of price. Thinking proxies such as asset class-based risk models are designed only to excuse HPHs from doing any fundamental analysis to determine value. They can’t make you safe because they can’t even define, let alone quantify, risk. If you are a 65-year-old retiree, a smart-sounding HPH might say that you should be 65% in bonds, with others arguing importantly that the right number is 70% or 60%. The right number is 0%. Alternatively, come up with an explanation of how the credit market is currently undervalued. I could, of course, be completely wrong, but the current credit market looks like an epic bubble. It is conventional to own a lot of bonds, but when the bubble bursts, you will conventionally lose a lot of money.” – Where Can I Find Safe Income For Retirement? Shiller P/E When to short? At the level of individual securities, the fundamental analysis and event analysis takes more time than most investors have to short stocks. In terms of shorting country markets, sectors, or parts of the capital structure, there are some readily-available resources that might be helpful in knowing when to short. For a quick heuristic on the market’s price, you might consider the Shiller P/E. This ratio is more indicative of value across business cycles because it is less impacted by fluctuating profit margins. The U.S. equity market’s Shiller P/E is currently over 43% above its historical mean of about 17. Market prices have rarely maintained such high multiples for long. For further reading on topics, including the Shiller P/E, you might like Rock Breaks Scissors: A Practical Guide to Outguessing and Outwitting Almost Everybody . U.S. equities are the fourth most expensive in the world according to this metric, behind only Japan, Ireland, and Denmark. Market Cap/GDP Market capitalization / GDP in the U.S. is another key metric. When it is high, it is a particularly important time to focus on short opportunities. Today, the U.S. market cap is about 112% of the U.S. GDP. Historically, from such lofty levels, subsequent total returns are typically less than 2% per year. The U.S. equity market is pricey on both metrics. Real returns are probably negative or too low to justify the risk. Incidentally, on both metrics, Russia is a bargain. Its Shiller P/E is about 5 and its market cap/GDP is about 18%, close to its historical minimum of 17% over the past 15 years. The inverse, leveraged Russian ETF (NYSEARCA: RUSS ) is down over 25% since our previous article on that opportunity. However, despite the move in price, it remains an attractive short. 7-Year Real Return Forecast GMO publishes a monthly chart comparing the estimated prospective annual real return over the subsequent seven years of various asset classes from current market prices. The comparison between the 6.5% long-term historical U.S. equity return and the returns from today’s levels is not favorable for today’s equity investors. Average returns will probably be around zero, with somewhat negative returns overall and only marginally positive returns for equities that GMO considers to be high quality. At least we have plenty of timber in Maine, so we have that one covered. Conclusion Part I covered the virtues of maintaining both sizing discipline and a cash balance. “Ordinary opportunity sets should lead to only ordinary position sizing, leaving extraordinarily large positions for only the rarest of opportunities. At a one percent position, one could conceivably find subsequent risk:reward opportunities to double down three times and still have a statistically diversified portfolio. Hyper-diversification accomplishes very little, but having a dozen truly uncorrelated positions accomplishes much of what correlation can offer. However, if one starts with a 5% position and doubles it three times on apparently better subsequent entry points, one is left with an over-concentrated or overleveraged portfolio.” “When everything is going horribly wrong, the comparative advantage of being more liquid than your marginal counterparty becomes extreme. So, while I do not know what the right amount of cash is, I am certain that it is better to have more. You should have more than whomever you are trading against when nothing is working in the markets. How much is that? I currently have 25% of my assets in easily accessible cash and am glad that I do. My percentage might be too low but I am virtually certain that it is not too high. Whatever opportunity cost that I pay in terms of diminished return can be quickly recouped during the next market collapse.” Part II covered some of my favorite company-specific short ideas. The ten disclosed short ideas declined from 2 to 35% since publication; none have yet to fully converge upon their intrinsic values. The average decline of 16% is over three times the S&P 500 ( SPY ) decline over the same period. The larger point is that a flexible mandate that allows one to go long or short creates an optimal environment for analytical rigor. “When someone is able to buy or short investment opportunities, he can first be analytical – gathering relevant facts, measuring value, and examining events that are likely to unlock or reveal that value. One need not be a fan, only an analyst. Regardless of whether or not you like what you are looking at, there is something to do either way. One can buy, one can short, one can ignore. One does not need to prejudge before reaching a conclusion informed by the relevant premises.” You can protect your capital by shorting expensive (and therefore risky) securities with exposures to China, biotech, and high yield credit as described above in Part III. Additionally, you can monitor the Shiller P/E ratio, the market cap/GDP, and the 7-year return forecast for a quick look at the market’s price. These tools are valuable additions to the toolkit of the prepared investor. Regardless of the specifics on how you choose to prepare for the possibility of a market crash, it is unlikely that the next half-century will look anything like the past. It is (barely) conceivable that it continues at the current pace and the S&P 500 races through 48,000. But even if it is possible, it is not a safe bet. When it comes to investing, I do not hope for or expect any single outcome. I do not hope or expect that my home will burn down either, but I still have fire extinguishers and plenty of insurance. None of this is a call to panic; it is a modest call to prepare. I would be perfectly happy to be wrong in my view that such preparation is both wise and timely. 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.