INVESTMENT INTELLIGENCER

Siegel Rebuttal, Part 1:

As described in the prior post, Jeremy Siegel made several arguments intended to refute the theory that U.S. corporate profit margins will soon regress to the mean, taking stocks down with them.  One of these arguments was that the percentage of overall U.S. profits captured by corporations vs. private entities is very high, so overall U.S. profitability is not, in fact, extreme.  The following email (from an independent analyst) suggests that this argument, at least, is a hallucination:

It’s hard to know where to begin with Siegel, but I have to start someplace, so I’ll pick his point that looking at corporate profits alone gives an inflated picture of overall profit growth, since capital has shifted to corporate ownership.  Here’s a useful chart from the Federal Reserve Bank of St. Louis (click here and see the second row down: Selected Component Shares of National Income.  Also note the third row, which contains the data everyone else is focused on Corporate Profits as a percent of GDP):

Yes, proprietor’s income has grown more slowly than corporate profits.  But looking at the two together, it’s clear that overall profit (as Siegel defines it) is at or close to a high, at least since 1981.

Warren Buffett: Buy Low-Cost Index Funds

The Oracle delivered some secrets of intelligent investing in a press conference following the Berkshire Hathaway annual investor meeting:

• Buy low-cost index funds, which will outperform the majority of other investors (the vast majority).
• Avoid hedge funds.

Buffett also said he hoped that Berkshire would outperform the S&P by a couple of percentage points (which wouldn't be surprising, given the value effect).  He added that he would be "amazed" if Berkshire did any better than that.

Hussman Bangs The Bearish Drum. No One Listens.

John Hussman of the Hussman Funds keeps banging away on the impending-market-crash drum, this time in a long interview with Kathryn Welling of welling@weeden.  Hussman's points won't come as any surprise to Investment Intelligencer readers, but they are so rare in the larger world of market commentary today that I'll keep repeating them.  (And when the market doubles from here and stays there for a generation, you can throw both of us to the dogs):

• The market is trading at 19-times "peak earnings" (Hussman's equivalent of the cyclically adjusted P/E).  The common bullish arguments that the market's P/E is 15-times (or less) have no basis in theory or historical fact.  Today's valuation is similar to that of many historical peaks, such as 1929.

• Profit margins have always been mean-reverting, and none of the theories floated to suggest that they will forever remain at today's nosebleed level (50% above their historical average) make sense.  These theories, moreover, are only floated by a handful of thoughtful bulls--the rest don't even bother to try to account for today's high profit margins.

• The long-term profit growth trend line in the U.S. is 6% a year.  The reason everyone thinks (and says) profits will grow at least 10% a year forever is because profits have grown that fast for five years (a.k.a., eternity).

• "Fair value" on the S&P is at least 40% below current levels, even if one makes allowances for the (unlikely) possibility that cheap labor in China and India have permanently improved the profitability of U.S. corporations.

• The market might go up another 10% before it has a typical 10% correction.  From now until after this 10% correction, however, the market will have been outperformed by T-bills.

Hussman does not go so far as to make a forecast, but, for him, he comes awfully close. And given these data points, who can blame him?  He also notes that rising interest rates usually suggest that mean-reversion will come sooner rather than later (which it certainly did in 2000).

After having lived through the 1990s, and been on the opposite side of this argument, I can confirm that long-term valuation metrics are worthless at predicting near-term market movements: In the late 1990s, bears like Hussman were not "cautious," they were "wrong," and year-after-year they were carried out on stretchers.  This said, after the market finally collapsed, they looked pretty good.

Flawed Logic: Jason Trennert Barron's Interview

This week's Barron's interview featured Jason Trennert of Strategas Partners.  Jason is bullish about the U.S. market and bearish about emerging markets.  Much of his logic is sound, and his conclusion is fine--the U.S. market goes up about two-thirds of the time, so predicting it will go up this year is rarely a dumb bet.  One of Jason's points is flawed, however:

We expect $93 for S&P 500 operating earnings in '07, and that puts the market at roughly 15 times earnings...The downside risk is low because P/Es are so low.

P/Es are not "so low."  In fact, they're not even "low."  To get to "15-times earnings", Jason is looking at "forward operating earnings" (an estimate).  He's then comparing it to last-twelve-months earnings.  Cliff Asness has written in detail about the folly of this apples-to-oranges comparison.  According to Cliff, the average "forward operating earnings" P/E is about 11-times, not the 15-times that Jason and other contemporary bulls throw around.  This 11-times, moreover, is an average--so half the time the market's P/E has been below this level. 

And then there's the profit-margin problem.  As discussed often in this forum, profit margins are 50% above their long-term average and at 50-year highs.  To compare today's P/E multiples to historical average multiples, you have to believe that today's profit margins will stay where they are.  Anything's possible, but this seems extremely unlikely.  At the very least, the profit-margin question is deserving of 1) acknowledgement, and 2) an explanation.  In Barron's, anyway, Jason didn't have either.

The market may go up, but, if so, it won't be because P/Es are low.

Easterling: Earnings Do Not Grow 6% Every Year In Perpetuity

The seemingly prudent consensus these days is that corporate earnings growth will slow from the torrid double-digit pace of the last few years and settle in at a more normal rate of, say, 6% per annum (the long-term average).  Alas, this consensus is anything but prudent.

As fund-of-funds' manager, analyst, and SMU adjunct professor Ed Easterling writes, earnings just don't behave that way.  Yes, they average about 6% a year (6.6% in Ed's 80-year model).  But they achieve this average by shooting up for 3-5 years, collapsing for 1-2 years, shooting up for another 3-5 years, and so on.  In other words, for all of recorded history, earnings have followed a 3-steps-forward, 2-steps-back pattern, not safe, smooth trend-line growth.

So, what's the problem?  Well, as previously discussed, profit margins--"one of the most mean-reverting series in finance" (Jeremy Grantham)--just hit a 50-year high of 14% of GDP, as compared to the 9% average.  As Ed Easterling points out, profits have also now grown strongly for 5 years in a row.  According to Ed's data, there has been only one business cycle since 1950 in which profits grew for more than 5 years in a row (in the late 70s).  In the sixth year of that expansion, moreover, growth was miniscule, and in the following two years, it collapsed--taking the stock market to a 16 year low. 

As of this writing, meanwhile, "prudent" forecasters are expecting profits to continue to grow for not only 2007 but 2008--what would be the 7th year in a row.  Is this possible?  Anything's possible.  Is it likely?  A review of the business cycles of the past half-century suggests the answer is an emphatic "no."

If, instead of setting a record for consecutive years of impressive growth, earnings behave the way they normally do--collapse for a year or two--what is the stock market likely to do?  Happily deliver another two years of low-volatility, near-double digit growth?  We could do that math, but then we might be accused of always being the bearer of bad news. 

 

 

Mauboussin: Why the Market is Smarter Than You Are

Most people who write about the wisdom of crowds offer colorful anecdotes about crowd intelligence but don't explain why groups are smarter than individuals.  In a recent piece, Explaining the Wisdom of Crowds, Legg Mason strategist Michael Mauboussin solves this mystery.

Drawing on a book by Scott Page (The Difference) and some of his own experiments at Columbia Business School, Mauboussin first observes that, in order for crowd wisdom to prevail, several conditions must be met:

• The group must be cognitively diverse (the individuals in the group must have different approaches to analyzing and solving problems).
• There must be a way to aggregate each individual's opinion into a collective view (such as a stock market).
• There must be incentives: rewards for being right, punishment for being wrong.

In most cases, the stock market easily satisfies all three conditions.  (Mauboussin has argued in the past that part of what happens during bubbles is that there is reduced cognitive diversity, as most investors begin to think and invest alike). 

Mauboussin then describes three distinct types of situations in which groups are wiser than individuals. In the first, the "needle-in-the-haystack," a subset of the group knows the correct answer, but the majority does not (Mauboussin uses the example of the audience on Who Wants to Be a Millionaire).  Here, the crowd's "best guess" is superior because the subset of people who know the answer ensure that the correct answer is the most popular choice (everyone else's guess is random).

In the second and third cases, which are closer to the situation in the stock market, no one in the crowd knows the correct answer, so it must be estimated.  (In the stock market, no one knows what stocks are worth because the valuation process is subjective and because the key variable--future cash flows--is unknown).  In these cases, Mauboussin attributes the crowd's wisdom to Page's "diversity prediction theorem," which states the following:

Collective error (the difference between the correct answer and the group's average estimate) = average individual error minus prediction diversity (the dispersion of the individual estimates).

Mauboussin invokes his Columbia experiments--"guess the number of jelly beans in the jar" and "predict the Oscar winners"--to show how this theorem works.  He also summarizes the theory's implications, all of which apply to investing:

1. A diverse crowd will always predict better than the average individual.  Not sometimes.  Always. 
2. Collective predictive ability is driven by average individual accuracy and diversity.  In other words, a crowd composed of simpletons who think the same way will be less intelligent than one composed of independent-minded geniuses or experts.
3. The group is often smarter than not only the average individual, but the smartest individual.

The last point is critical for investors.  Because of our innate overconfidence, we quickly dismiss the fact that a diverse crowd is always smarter than the average individual.  (Most of us think we're above average).  What is far harder to dismiss is the fact that the crowd is often smarter than all individuals. 

In instances in which the crowd is not smarter than all individuals, moreover, the individuals who beat the crowd usually change with each successive prediction (which gives the investment media a parade of new gurus and "fallen stars" to write about).  Just because you are occasionally right when the market is wrong, in other words, doesn't mean you usually will be. 

Costs Matter: Vanguard Wins Again

Low-cost fund leader Vanguard had another strong year in 2006, with 78% of its funds beating their peer-group averages.  Over longer periods--three, five, and ten years--the percentage is even higher: more than 80%.

This performance, of course, has nothing to do with superior stock-picking and market timing--and everything to do with costs.  The industry-wide average mutual fund expense ratio was 1.27% of assets in 2006.  The average Vanguard fund expense ratio was 0.21%.  Since 1975, moreover, Vanguard's average expense ratio has dropped to one-quarter of its original level--while the industry-wide average has risen.

Given Vanguard's consistently strong performance, it is no wonder that it now manages more than $1 trillion of assets and is the second largest fund firm in the world.  What is a wonder is why more fund companies haven't copied Vanguard's "secret formula."

Actually, it's not a wonder.  Most other fund companies are for-profit corporations, many of them publicly held.  For-profit corporations, especially publicly-owned ones, have impatient shareholders to please.  And for impatient shareholders, even a three-to-five year time horizon is eternity.

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.

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.”

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(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.)

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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:

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• 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.

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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.

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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.

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

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