INVESTMENT INTELLIGENCER

In Search Of: A New Name For "Passive"

One of the many reasons "passive" investing gets dissed is that its name--"passive"--is both misleading and deflating.  Who wants to be "passive"?  The folks who do well in life are active, the ones who have gumption, the ones who get up off the couch and make things happen.  "Passive" investing, moreover, isn't passive--it's active.  Smart passive investors actively determine which types of stocks they want to invest in, actively screen the market to find such stocks, and actively manage their portfolios to make sure they contain only such stocks (and in the proper proportion). 

So smart passive investors, the ones who wouldn't mind earning some respect in addition to superior returns, are forever searching for a new term to describe what they do.  Alas, to date, none has been found.

"Indexing" doesn't work, because "indexing" suggests that the passive investor is simply trying to match the performance of the S&P 500, Russell 2000, or other index.  And now that such strategies are popular, the style suffers from herding, index-reconstitution, and other problems (even thought it still outperforms most active strategies).

"Rules-based investing" doesn't work because...well, because it's boring and vague.

"Factor-based investing" doesn't work because it's mystifying.

"Dimensional investing" doesn't work because...ditto.

"Quantitative" doesn't work because it has already been coopted by "quants."

The latest suggestion, "Equilibrium-based investing", put forth by DFA's Weston Wellington in a recent article, doesn't work because it doesn't mean anything that couldn't just as easily apply to the "active" world.  (Although it is arguably better than "passive").

So the search continues.  One thing is certain, however.  If passive investing continues to be called "passive," those who advocate the strategy will continue to operate at a major marketing disadvantage to their "active" competitors.  In fact, given the inherent connotations of the words "active" and "passive," it is almost certain that the nomenclature was devised by a traditional stockpicker.

Housing Market Still Getting Worse

Henry Blodget submits: According to Asha Bangalore, new home sales declined again in February and are now running at a pace not seen since June 2000 (see March 26 Daily Global Commentary)  The supply of new homes, meanwhile, rose to 8.1 months, a level not seen since 1991.  And the number of completed homes for sale in February set an all-time record. 

Asha's previous commentary, on existing home sales, was slightly less discouraging: the pace of price-declines has moderated.  For three reasons, however, Asha still considers the relatively good news of the past few months in existing home sales to be temporary: tightening mortgage lending standards, less availability of subprime financing, and rising delinquencies.  She also notes that, despite a pick-up in February in the number of houses sold, the total inventory also increased. 

So it seems as though those jubilant shouts about the housing market having stabilized may have been premature.

Kasriel Recession-Warning Indicators Flashing Red

With the exception of Messrs. Roubini and Roach, the vast majority of Wall Street economists are still whistling Dixie.  Another exception, previously noted here, is Northern Trust's Paul Kasriel.  Kasriel hasn't gone so far as to forecast a recession, but he is at least willing to conclude that, when our boat's instruments say we're heading for the rocks, that's probably where we're headed.

In the March 22 eContrarian, Kasriel observes that the LEI is en route to its first quarterly-average year-over-year decline of this expansion.  Barring a miraculous turnaround in March, the quarterly average LEI will produce a "signal" that has preceded every recession since 1960 (and yielded only one "false positive.")  Kasriel notes that Wall Street loves to diss the LEI--but suggests that this is because it outperforms almost every proprietary economic model on the Street.

Kasriel's bearishness, moreover, doesn't stop with LEI.  He also invokes the Kasriel Recession-Warning Indicator: the combination of an inverted yield curve and a year over year contraction in the real money supply.  The KRWI has missed only one recession since 1960 and has given no false signals.  So far in the first quarter, the KRWI is performing about in line with the LEI.

Why So Many Advisors Are Incompetent

Dylan Ross submits:  Most financial advisors are not capable of providing good financial advice.  This is not because they are stupid or unethical; many are quite intelligent and almost all are well intentioned.  They can’t give good advice because they don’t know how.

Many advisor trainees hired at Wall Street firms have no more expertise about investing or personal finance than the clients they will be expected to serve.  Many have less.  To ready these green advisors, most firms provide some type of in-house training program.  The training usually focuses on the the firm’s products and how to sell them.  For example, recruits are not taught about the negative impact fees have on returns, they are taught how to justify their fees.  The usual line goes something like this: “Lower fee products don’t come with advice.” Never mind that the “advice” usually amounts to “buy this more expensive product.”

a

(New hires also study for the Series 7 Exam, which teaches them about different types of securities, how markets operate, and the regulations they must follow—but not how to give intelligent advice.)

a

Brokerage firms make more money selling expensive, actively managed strategies, so their training programs rarely give new advisors an opportunity to objectively compare the merits of passive strategies (indexing).  Advisors are instead armed with talking points to overcome a prospective client’s inquiries about index funds.  Some of the more popular rebuttals include:

a

• When you buy an index you are buying all of the market risk that comes with it (falsely implying there is less risk in active management).
• Yes, most mutual funds don’t beat the index, but I don’t use most mutual funds (implies that the advisor can select funds that will beat the index). 

• Indexing guarantees mediocrity (simply incorrect).

The sad part is that the advisor is not trying to pull one over on you; he or she probably believes this.  Advisors also believe that their firm’s rigorous manager screening process is the result of something other than sales agreements and revenue sharing. Advisors mistake sales tactics for universal truths from the start of their careers--and tend to hold tight to these learned biases.

a 

As they continue to build their practices, the advisors become more invested in those same ideas and their bias grows stronger. Unfortunately, the global effect of having so many pseudo-experts in agreement only perpetuates their misconceptions about fees, market-beating strategies, and other bad advice.

a

On the bright side, there are some competent advisors.  The challenge is finding one.  Referrals and references can be misleading because people don’t usually know about their advisor’s shortcomings until it’s too late.  Asking probing questions about an advisors training and experience beyond the basic, “how long have you been at this?” may help uncover what he or she really knows.

a

Dylan Ross is a CFP at Swan Financial Planning, LLC.  The opinions expressed in this post are his.

Hester: Why High Profit Margins Are Bad News For Stocks

Bullish market seers often point to today's big profits when arguing that there are great things to come.  Because today's big profits are due to today's record-high profit margins, however, they should be arguing exactly the opposite. 

As William Hester of the Hussman Funds shows in this excellent analysis, high current profit margins usually mean bad news for both future earnings growth and future stock performance.  Why?  Because, as GMO's Jeremy Grantham likes to say, profit margins are one "one of the most dependably mean-reverting series in finance."  When some companies are making fat profits, other companies rush to compete with them, and the new competition reduces the profits--and vice versa.  To believe that profit margins won't revert to the mean, Grantham says, you have to believe that capitalism is broken.

Hester's report shows that the 50-year profit margin range for the S&P 500 has generally been 5.5% to 7.5% of sales.  Only four times in 50 years have margins climbed above 7.5%, and the first three times, they quickly dropped down below the mean.  Now, the fourth time, profit margins have continued upwards, to a 50-year record of 8.5%.  Is it possible that outsourcing, globalization, and other structural forces have permanently changed corporate America's profitability?  It's possible.  It's also very unlikely.  (Your competitors are benefiting from the same trends you are, so why should you all be able to maintain pricing power?)

Hester attributes today's fat profit margins to three primary factors: slow wage growth, reduced corporate investment rates, and increased profitability in the financial sector.  He makes compelling arguments why none of these factors will bode well indefinitely.

Hester also includes a handy chart that shows how fast corporate profits will grow for the next five years under different profit margin assumptions.  Assuming standard sales growth of 6% per year (the long term average), if profit margins somehow remain at today's levels, earnings will grow about 6% per year--a fine rate, but a significant deceleration from the past few years.  If margins revert to their 50-year mean, meanwhile, earnings will grow only 0.3% per year.

Hester also explains the other reason why fat profit margins are bad for stocks: Because investors always extrapolate today's conditions into the hereafter.  Hester divides the 50 years of margin performance into quintiles and shows that, when profit margins are highest, investors are so happy and optimistic that they pay an average P/E of 25-times earnings, and when they are lowest, investors are so depressed and pessimistic that they only pay 13-times.  (Exactly the opposite of what they should do).   Not only do high profit margins presage slower earnings growth, in other words--they also presage severe multiple compression.

The bottom line: According to Hester, the 3-year anualized return for the S&P 500 after profit margins have hit the highest quintile has been -1% per year.  The 3-year annualized return when margins have dipped into the lowest quintile, meanwhile, has been 15%. 

But don't worry.  It's different this time.

Hussman: Sorry, Market Still Overvalued

In his weekly market letter, John Hussman of the Hussman Funds notes that the current market environment feels a lot like that of the late 1990s and then invokes a sobering statistic to back this up.  Hussman's conclusion is the same as that of Jeremy Grantham, Andrew Smithers, Robert Shiller, and others: the U.S. equity market is still overvalued by at least 30%. 

As with all analyses based on mean reversion, Hussman's assumes that past is prologue.  As a result, if something is "different this time" (which it sometimes is), the concern may be unfounded.  The bad news is that, if something isn't different this time, if past is prologue, the outlook is very grim indeed.  The "mean" in a mean-reversion analysis is in the middle: half of the observations are above and half are below.  A drop of 30% in the market, in other words, would not necessarily take us to the bottom.  It would just take us to the mean.

Hussman:

Ever watch those old Road Runner cartoons where the Wile E. Coyote goes over the edge of a cliff holding an anvil and just hovers there for a moment, while it sinks in that he's in trouble? That's about what this market feels like. In particular, the current environment in housing, financials, and the stock market feels a lot like what we observed in the dot-com bubble in the late 90's. It was the clear (or should have been) that speculation had gone too far, and that the excessive bullishness of investors would probably end badly. But even after individual stocks began to collapse, many investors maintained hope until it was far too late..

...[S]tocks remain very richly valued. The bait taken by investors here is the belief that the market's “price-to-forward operating earnings” ratio is reasonable. Unfortunately, this morsel of bait carries a very sharp hook. “Forward operating earnings” did not even exist prior to the 1980's, and if one proxies it historically as Cliff Asness has done (based on how it relates to other fundamentals with longer records), you find that the historical norm of “price-to-forward operating earnings” is about 30% below current levels. Adjusting for the present elevation of profit margins, the normalized level is probably even lower.

Fama and French Dish, Diss, and Disagree

In this Journal of Indexes (JOI) interview (download below), two of the world's smartest investors weigh in on the strategies that have made Dimensional Fund Advisors one of the most successful fund firms in the world.  Better known as finance professors, Eugene Fama and Ken French helped design DFA's stock-selection and fund-management techniques.  In this interview, Fama and French revisit their original conclusions, poke fun at the arrivistes who have since claimed to have discovered their ideas, and, once again, show why traditional stock-picking is almost always for the birds.

Notable points:

• Fama and French now disagree about the cause of the "value effect"--the phenomenon in which value stocks have outperformed growth stocks over the long term (for more on the value effect, see this post).  French no longer believes that this outperformance represents "distress risk" and, instead, thinks there is some "mispricing" involved (investors underestimating the prospects for value stocks and overestimating them for growth stocks).  Fama, ever the efficient market man, begs to differ.

• Both men are shocked that commentators believe that today's hot product--"fundamental indexing"--is actually something new.  The academic literature, they point out (and DFA), has described the strategy for 15 years.  The advantage of "fundamental indexing" is merely that it captures the value effect.  As French puts it: "It's not even another way [of doing this.]  It's the same way.  I have a friend who calls [fundamental indexing] value investing for clients who don't understand ratios."

• On the "dividend-weighting" strategy used by Jeremy Siegel and WisdomTree: This, too, is nothing new.  Dividends are just another way of sorting stocks to capture the value premium.  Unfortunately, using dividends as the value screening metric is inferior to using book-to-market ratios.  How do Fama and French know this?  Because they've tested all the value metrics.

• Fama still thinks the market is efficient, but French now concedes that some people can probably beat it.  Returns are so random, however, that he just doesn't have enough information to figure out who they are (implication: neither do the rest of us.)

• On whether the value/growth mean-reversions can be timed (Specifically, as I asked in this post:  Can investors use the ratio between value and growth to predict the performance of each asset class?)  According to French, there's no evidence that this works.

• On ETFs: Great tools, as long as they're cheap and passive.

• On behavioral finance: Investors make the mistake of assuming that, now that they know some of the mistakes investors make, they won't make those mistakes.  Unfortunately, they'll probably just make others.

Download fama_french_journal_of_indexes_3_07.pdf

Finally...Someone Thinks Inverted Yield Curve Might Mean "Recession"

Ever since the yield curve inverted, back in the summer of 2006, almost every economist and strategist who has commented on the subject (including Ben Bernanke) has calmed fears about this ominous indicator by carefully explaining why this inversion does NOT mean that we're headed into a recession.  In other words, the forecasters have carefully explained why "it's different this time."  Well, finally, one economist--Northern Trust's Paul Kasriel--has had the guts to suggest that the inverted curve might actually means what it usually means.

In the March 16th issue of the eContrarian, Kasriel notes that every recession since the one in 1970 has been preceded by an inverted yield curve and that only once, in the fall of 1998, has the curve inverted without an ensuing recession (and in that case, you may remember, the Fed reacted to the decelerating economy and tanking stock market by slashing the Fed Funds rate 75 basis points--which Kasriel suggests may have forestalled a recession).

Kasriel explains the theory behind the "signalling" effect of the inverted yield curve (a slackening of demand for credit drives down long-term rates) and then shows that demand for credit is indeed slackening.  He notes that economic growth is indeed decelerating.  And then he quietly floats the Occam's Razor hypothesis that most of his economist brethren continue to reject: It might not be different this time.

Will the "Value Effect" and "Size Effect" Persist? Do They Even Exist?

In my "dumbest column of the year" post, I suggested that DFA and other smart investors have capitalized on the "value effect" to design better passive funds.  Astute readers pointed out that the value effect is a theory, not a fact, and that it might soon disappear--leaving those who bought "value tilted" or "fundmental-weighted" funds holding an underperforming bag.

This is a complex topic, one that still produces violent arguments in the halls of academia and elsewhere.  Fama, French, DFA, and others attribute some of the superior long-term performance of value and small stocks over large growth stocks to higher risks: stocks get cheap because the companies are in distress (or riskier), and rational investors demand a higher return.  If this view is correct, the effects should persist over the long term, even if they disappear for decades at a time.

One contrary view, held by John Bogle and others, is that the value effect is merely a short-term trend that, like other such trends, will eventually become over-bought.  Having "discovered" that value stocks outperform growth stocks, this theory goes, investors will bid up the prices of value stocks, and this will reduce or eliminate future higher returns (or, more pertinently, result in lower returns relative to growth stocks). 

Common sense and analyses of past data suggest that the latter view--temporary phenomenon--is certainly valid over periods that most investors consider long-term: 1-5 years.  Other analyses, however, show that the value effect has, on average, been persistent over many decades and in many markets, validating the former theory, too.  The same can be said for the size effect.

In the coming weeks, I will assemble some of the most important work on this topic (and please feel free to weigh in with studies, thoughts, and comments, either in the comments section or via email).  For today, I will simply highlight some excellent charts produced by Index Funds Advisors.  These show the frequency with which small and value stocks have outperformed large and growth stocks (scroll down to the bar charts, Figs 9-9 through 9-16), as well as the relative performance of small vs. large over selected time periods (Fig 9-17).  The charts show that:

• Small value outperformed large growth in 58% of 1-year periods from 1927 to 2006.
• Small value outperformed large growth in 97% of 20-year periods over the same 80 years.
• Large value outperformed large growth in 58% of 1-year periods and 92% of 20-year periods.
• The "size effect" showed perfect decile by decile performance correlation over 80 years (smallest 10% outperform second-smallest 10%, etc.)  Over shorter--but still long--periods, however, this performance has completely reversed.
• From 1965-1968, 1975-1983, 1992-1993, and 2002-2006, the smallest 10% of stocks wildly outperformed the largest 10%.
• In all the interim periods, small stocks got absolutely crushed.

These charts illustrate why both camps in the "persistent" versus "temporary" camp have an important point.  Over the truly long-term (80 years), the value and small effects appear to be undeniable.  Over interim periods long enough to feel like eternity, however, small and value stocks get overextended and experienced painful reversion to (and beyond) the mean.

Should investors try to take advantage of either pattern? Both?  Should investors "tilt" portfolios toward value/small, but also try to time the mean-reversion by changing ideal portfolio weights depending on relative valuation?  The latter would depend on whether the mean-reversion can be meaningfully predicted...

Are We Already in A Recession?

Recessions are not only hard to predict, they're also sometimes hard to identify until after-the-fact.  For example, as Dan Gross describes in this NYT piece, back 2000, very few economists saw any trouble on the economic horizon.  Many economists, in fact, kept pooh-poohing the idea of a recession until the government figured out (through data revisions) that we were already in one. 

These days, few economists are expecting a recession.  The sub-prime woes, the bull theory goes, are limited to a tiny segment of the mortgage market, the housing recession won't spill over into the rest of the economy, the ever-optimistic consumer is charging right along...etc.  The stock market, of course, is telling a different story.  The market doesn't always get it right, but it probably gets it right more often than economists (which isn't a knock against economists: If predicting the future were easy, everyone would do it).

In any case, given what happened last time (optimistic economists and investors + tanking market + deteriorating fundamentals), perhaps we should stop asking whether we are going to have a recession and start wondering whether we are already in one.