Asymmetric Investment Returns - Insights into portfolio management beliefs, strategies, and tactics that aim to create a positive imbalance between risk and reward

Is the world in a bear market?

Read: World Bear Market.pdf

Individual investors should consider taking a close look at the chart below of the stock index since 1996. You don't know what it is going to do next, but you can probably see what kind of strategy is more likely to provide you with asymmetry of returns. For more information about long term market cycles, read: Seasons and Cycles of the Stock Market.

Source: Standard & Poor’s, First Call, Compustat, FactSet, J.P. Morgan Asset Management.

Dividend yield is calculated as the annualized dividend rate divided by price, as provided by Compustat. Forward Price to Earnings Ratio is a bottom-up calculation based on the most recent S&P 500 Index price, divided by consensus estimates for earnings in the next twelve months (NTM), and is provided by FactSet Market Aggregates. Returns are cumulative and based on S&P 500 Index price movement only, and do not include the reinvestment of dividends. Past performance is not indicative of future results.

Data are as of 3/31/12.

Based on a few comments and questions we received about "Stock market risk becomes elevated with breadth indicators reaching bearish level", I thought I would add a few more pictures for reference. First, I will point out that we are simply using a visual representation here, not our more sophisticated statistical study to quantify the probability and expectation of these indicators. I am well aware of their probability and we don't share that publicly. I show these indicators only because they are at elevated levels and that may be telling us something about the state of stock market. 

Below we show the NYSE Bullish Percent Index with an overlay of the S&P 500 stock index. I colored the high Bullish Percent levels in red to point out what happened in the recent past when it got to these high levels. 

Source: http://stockcharts.com/h-sc/ui

Someone mentioned the CBOE Volatility Index (VIX). Volatility is at a very low level, which is good if you own stocks, but may not be so good when it gets to an extreme low. The VIX is known as the "fear gauge". When the VIX is at a extreme high, it suggests investor fear is very high. They fear losing money. When the VIX is at an extreme low like it is now, it suggests stock investors are complacent. They fear missing out. When measures like the VIX, NYSE Bullish Percent, and Investors Sentiment all line up to suggest complacency, we won't be surprised to see stocks turn down at some point. Below, we overlay the S&P 500 stock index with the VIX and mark the recent past extreme lows in red. When the VIX gets this low, suggesting complacency, you can see what can happen next. As you can see, it isn't perfect, but it doesn't need to be. It does what it does.

Source: http://stockcharts.com/h-sc/ui

Crowd sentiment has become very optimistic according to the AAII Investor Sentiment Survey. The poll shows the investors who are "Bullish" thinking the stock market will rise has exceeded its long term average. Bullish sentiment tends to follow, and at times precede, price trend changes as investors eventually overreact. After prices have trended up, investors as a crowd tend to become more and more optimistic that prices will continue to rise. As prices go down, investors tend to extrapolate that action into the future. Prices, therefore, drift in one direction or another based on under-reaction this way. But then, at some point prices sometimes get to a point of overreaction as demand to buy more has peaked. After everyone has already entered, who is left to bid up prices? Of course, a strong trend can continue far longer than you expect, but these polls are useful to understand so that we aren't caught off guard when a trend change does begin. Strong upward trends decline after people become overconfident and complacent. 

Source: http://www.aaii.com/sentimentsurvey

Chart of the day included a chart of the cost of single family homes priced in ounces of gold instead of dollars.

They said:

Severely depressed real estate prices continue to be a concern for investors. For some perspective on the magnitude of the decline in home prices, today's chart presents the median single-family home price divided by the price of one ounce of gold. This results in the home / gold ratio or the cost of the median single-family home in ounces of gold. For example, it currently takes a relatively low 105 ounces of gold to buy the median single-family home. This is dramatically less than the 601 ounces it took back in 2001. When priced in gold, the median single-family home is down over 80% from its 2001 peak, remains well within the confines of a six-year accelerated downtrend and remains very near its 1980 trough.

I believe, based on empirical quantitative evidence, that marny market prices tend to trend asymmetrically: they decline faster than they rise. It's probably because investors respond to negative news and losses differently than they do good news and gains. As we see in the chart, home prices fell asymmetrically, they increased for 20 years and only took 10 years to erase those gains.

During the secular bear market of the 1960's and 70's, home prices decline along with stock prices. Gold increased in price. You may recall that gold was a popular investment in the early 1990's. Of course, that was 'after' gold had already gone up. You may notice the cost of a single family home priced in gold is near the low in 1980. Some people may look at the chart and conclude that it's at the 'low', but that assumption would be based only on one data point. Statistical significance requires many more to draw inference about the future. Though, this is such a long term trend unfolding that, for all we know, it very well could be one indication that the secular bear market may be closer to its end. Since you don't know, nor does anyone else, you can probably see why it's important that our investment management programs that pursue an asymmetric risk/reward profile be adaptive to changing directional trends. 

As 2011 is in the past and the new year is here, there is always a lot of talk about the prior year as well as predictions about the year ahead. If you believe you know the outcome in advance of a time that doesn't yet exist, go ahead and make your prediction and your bets. Even talking about a calendar year in the past isn't of much use unless you were trading your way to a new car, home, or yacht and December 31, 2011 was your deadline. I believe the best time frame is a full market cycle that includes up and down periods. Those who don't understand investment results are created over complete cycles probably find themselves earning big gains that are later wiped out by large losses, over and over again. The pursuit of an asymmetric return profile necessarily requires the capture of some of the upside and then the avoidance of some of the downside. It's the capture of more of one than the other. With that said, we view the past stock market performance history using the Russell broad market indices. Nevertheless, below is a table of the typical format of presenting a performance profile. In the table we show the calendar year but also include longer periods to include the more important full market cycle (5 years or longer). The definitions for the indices are at the bottom of this post. 

Source: Rusell Return and value data utilized in this calculation tool comes from sources believed to be reliable but is neither guaranteed nor warranted and is subject to revision without notice

A picture speaks a thousand words. Below is the price chart of some of the broad stock market indices that represent the performance of stocks of companies of different sizes: small, mid, and large company stocks. Stocks broadly started 2011 in a rising price trend. The year was filled with negative headlines and fear. The stocks indices declined around -20% very quickly late summer and then recovered those losses to close the year at about the price they started. One useful thing about viewing price charts this way is we can see the visual representation of the path along the way, not just the ending point. The calendar year range for these broad indices was -9% to 1.5%. Stocks were "flat" if we look at the average, but that doesn't present the experience during the year. In the chart, we can note the highest high, the lowest low, and the distance between the high and low (the draw-down) along the way. You can probably see how stock investors probably oscillated between the fear of missing out and the fear of losing money in such a volatile period. 

Source: http://stockcharts.com/freecharts/perf.html?$RUT,$rui,$rua,$rmc, 

Looking at these stock market indices over a full market cycle (a period typically 5-6 years that includes both rising and declining price trends) we see the performance profile of stocks that include both gains and losses. Performance tables do not present "investment returns" appropriately because they only illustrate the end result for a period, but not the path or the worse draw-down along the way. In the price chart below, we get a visual representation for the most recent market cycles. Since April 2005, these stock indices gained a total 10 - 25%, or and average of only 1-4% annually.  From that starting point, they were up over 40% at one point (October 2007) and then declined over -50% by March 2009. The smallest stocks recovered their declines is the 100% gain it takes to recover from a -50% loss. The majority of the stock market, mid and large companies, are still far from their previous highs with the broadest index, the Russell 3000 (green line) gaining only about 10% over the entire period. While these price charts don't include dividends, they also don't include any costs. As we have illustrated both the risk and reward over the most recent full market cycle, you may agree that the stock market by itself has not presented the kind of asymmetric investment returns that meets most investors' objectives. In fact, applying a conventional asset allocation with annual reblancing to a broad mix of stocks and bonds doesn't create the kind of asymmetric profile many investors want. It's important to understand long term (secular) trends and Seasons and Cycles of the Stock Market.

Index Definitions (Source: Russell Investments)

The Russell 3000 Index measures the performance of the largest 3000 U.S. companies representing approximately 98% of the investable U.S. equity market.  The Russell 3000 Index is constructed to provide a comprehensive, unbiased, and stable barometer of the broad market and is completely reconstituted annually to ensure new and growing equities are reflected.

The Russell 1000 Index measures the performance of the large-cap segment of the U.S. equity universe. It is a subset of the Russell 3000® Index and includes approximately 1000 of the largest securities based on a combination of their market cap and current index membership. The Russell 1000 represents approximately 92% of the U.S. market. The Russell 1000 Index is constructed to provide a comprehensive and unbiased barometer for the large-cap segment and is completely reconstituted annually to ensure new and growing equities are reflected

The Russell Midcap Index measures the performance of the mid-cap segment of the U.S. equity universe. The Russell Midcap is a subset of the Russell 1000® Index. It includes approximately 800 of the smallest securities based on a combination of their market cap and current index membership. The Russell Midcap represents approximately 31% of the total market capitalization of the Russell 1000 companies. The Russell Midcap Index is constructed to provide a comprehensive and unbiased barometer for the mid-cap segment. The Index is completely reconstituted annually to ensure larger stocks do not distort the performance and characteristics of the true mid-cap opportunity set.

The Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 is a subset of the Russell 3000® Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2000 of the smallest securities based on a combination of their market cap and current index membership. The Russell 2000 Index is constructed to provide a comprehensive and unbiased small-cap barometer and is completely reconstituted annually to ensure larger stocks do not distort the performance and characteristics of the true small-cap opportunity set.

The Russell Microcap Index measures the performance of the microcap segment of the U.S. equity market. Microcap stocks make up less than 3% of the U.S. equity market (by market cap) and consist of the smallest 1,000 securities in the small-cap Russell 2000® Index, plus the next smallest eligible securities by market cap. The Russell Microcap Index is constructed to provide a comprehensive and unbiased barometer for the microcap segment trading on national exchanges, while excluding lesser-regulated OTC bulletin board securities and pink-sheet stocks due to their failure to meet national exchange listing requirements. The Russell Microcap is completely reconstituted annually to ensure larger stocks do not distort performance and characteristics of the true microcap opportunity set.

PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS.

Several weeks ago I said “I wonder what the market is telling us about world banks? And included a price trend chart showing some of the largest investment banks like UBS, Bank of America (Merrill Lynch), Wells Fargo, Goldman Sachs, Credit Suisse, and Citigroup. (You can click the title to see the chart) From 2007 to more recently, the prices of these investment banks have declined around -30% to -99%. While most of their prices recovered some of the losses from the 2008-2009 cascade decline, we observe they have trended back down and as evidenced by the visual of the price trend chart; their direction has been down again. Banking and investment brokerage is a major part of the world economy and the financial system. When this part of the financial sector is weak, it's the market tell us something. For example, these financials were the first sign of weakness prior to the 2008 – 2009 cascades. The Financial sector was very weak in its directional price trends prior to weakness in other sectors and markets. I’m not saying the recent action is necessarily a precursor to another cascade that spreads to other sectors and markets, but when major banks like these trend as they have the past several years it’s not a sign of strength.

I’m not a news reader, but I do glance the headlines of sources like the Wall Street Journal, Market Watch, Barron’s, Investor’s Business Daily, and the New York Times for sentiment. It’s hard to miss today’s headline about MF Global:

The Wall Street Journal MF Global Files for Bankruptcy

Market Watch: MF Global from bad to worse

The Washington Post with Bloomberg Business: MF Global files for bankruptcy protection after big loss

It's apparently a big "deal" since the WSJ says: 

The $41 billion in assets listed in the bankruptcy filing would make MF Global the eighth-largest corporate bankruptcy filing in the U.S. at least since 1980, according to research firm BankruptcyData.com.

apparently some things went wrong when Jon Corzine, a former chairman of Goldman Sachs Group Inc. set out to change MF Global from a midsize derivatives broker to a full-fledged investment bank that took risks with its own capital. I bold that last part because just a few days after I wrote that I wonder what those negative price trends were telling us about global banks, the headline news was UBS: Rogue Trader Hit Firm: Swiss Bank Says It Lost $2 Billion on London Employee's Unauthorized Bets. 

You can probably see how the direction of the market price has been telling us something. I wonder what more it's tell us. We'll see as it all plays out.

That leads me to the topic of "systemic risk".

Systemic Risk is the risk of collapse of an entire financial system or entire market, as opposed to risk associated with any one individual entity, group or component of a system. 

In the financial sector, such as banking and investment brokerage, the government looks to manage systemic risk of the financial sector by creating limits on credit and borrowing such as margin requirements. Basically, they supposedly monitor the financial condition of financial institutions. They consider it a systemic risk to the sector, and possibly the entire economy, if banks and brokers have too much liabilities relative to their assets and income. You can probably see how this is related to today's headlines about MF Global. 

I wonder, though, what "we the people" are doing to do about a much larger systemic risk. The one that our own government itself is creating. I don't make my trading decisions based on such wonders, but I thought I would point on this logical contradiction. 

By the way, good active risk management in regard to investment portfolio management doesn't require that anyone predict in advance what's going to happen next. Instead, it's a matter of executing robust tactics for dealing with what does happen. If those tactics are robust, it will be evidenced in your performance history, not just your back-tests and simulations. And, you may notice I said "executing" such systems, not just a matter of "having" them. From what I see, most people don't have any such thing. Many of those who do have risk management tactics learn they aren't very good. Others may even have some that are robust (likely to work) but are unable to execute. You can probably see why there is so much written that "active management" doesn't work for most people. It's certainly not something many have a good history of doing well. 

Have a safe and Happy Halloween!

By guest contributor Ed Easterling

Although the weather can seem fairly random from day to day, the weekly and monthly patterns are driven by the overriding impact of the seasons. Likewise, the stock market has long-term “secular” cycles driven by the fundamentals of finance and short-term “cyclical” cycles within these secular cycles.

Because the market movements often appear random, conventional wisdom assumes a random walk for the market.

Yet conventional wisdom too often includes shortcuts that create blinders to insight. Whether you invest or trade, an understanding of the cycles and their implications can be invaluable toward financial success.

Secular Cycles

Secular stock market cycles are extended periods of above-average returns (secular bull markets) and below-average returns (secular bear markets). Just like seasons of the weather, these secular cycles are not coincidental patterns or long-term phenomena; rather, these periods are caused by fundamental drivers of returns.

Why does this matter to a trader or investor? An understanding of the patterns and drivers can greatly enhance success in the market. The market is not a random pattern of results or a simple game of chance, such as flipping a coin or spinning the roulette wheel.

In games of chance, the odds are known and are unaffected by previous events or current conditions.

The market more closely relates to a game of skill, where past events and current conditions actually affect future results. This article should help you to “count the cards” in the market to know when it is winter or summer and to know when to fade a winter warm spell or lean into the emerging spring.

Fundamental Drivers

If returns in the market were occurring randomly over time, then 10-year periods in the stock market would presumably show relatively random results. However, Figure 1 presents quite a different pattern.

It undulates from below-average to above-average. The chart reflects all 10-year periods since 1900: the first is 1900 to 1909, then 1901 to 1910 and so on. Each bar is the average compounded return including dividends during every 10-year period since 1900. The pattern clearly is not random, and it is driven primarily by the significant factor of market valuation.

Figure 1. S&P 500 Index Total Returns By Decades

Key Components

To understand a multifaceted situation, it is sometimes helpful to break it into the component parts. Stock market returns consist of three parts: earnings growth, dividend yield and the change in the price-to-earnings ratio (P/E).

The growth of earnings represents the core driver of stock market appreciation. As the earnings of companies increase over time, the value of companies tends to increase. If P/E (the valuation multiple of the market) stays the same, then the stock price (or overall market) will increase consistently with earnings growth.

But the stock market often increases by more than earnings growth or, at times, declines despite earnings growth. In these instances, respectively, earnings growth is multiplied by an increase in P/E or offset by a decrease in P/E.

The Big Picture

The price/earnings ratio for the overall market is developed by dividing a price index by the aggregate earnings of companies in the index. P/E is a valuation multiple because it essentially reflects the number of years worth of earnings that investors will pay today for a future stream of income from stocks.

When inflation and interest rates are high, investors want higher returns, so they pay a lower price upfront for stocks. When deflation occurs, future income and dividends reflect a declining deflationary trend, so investors pay lower prices here, too.

Only in conditions when inflation is low and stable do investors pay higher P/Es for stocks. Therefore, trends in inflation or deflation drive P/Es through a cycle of higher and lower levels.

Because P/E is a multiplier of earnings growth, a rising trend in P/E can often double or triple the level of return from earnings growth. A declining trend in P/E, however, can offset some or all of the benefit from earnings growth.

Beyond the return that is driven by earnings growth and the change in P/E, an investor also receives dividends from a portfolio of stocks. So dividends add a final component to the total return from the stock market.

What’s the Cycle?

The key point, as detailed in the book Unexpected Returns: Understanding Secular Stock Market Cycles, is to recognize that the cycle in P/E drives the secular stock market cycles. As earnings tend to grow over time, a rising P/E will multiply earnings growth and drive above-average returns. A decline in P/E will offset earnings growth and deliver below-average returns.

The impact of the price/earnings ratio on the stock market is reflected in Figure 2. The red and green bars represent the year-end level of the market; the colors of the bars represent secular bear and secular bull cycles, respectively. The blue line on the bottom of the graph is P/E. As it rises, we experience green-bar, secular bull market periods. As P/E falls, we experience red-bar, secular bear market periods.

Figure 2. Secular Stock Market Cycles Explained

Most noteworthy, the pattern of P/E is not random…and the red-bar and green-bar periods are not random.

The price pattern for secular bull markets is a generally rising stock market driven by an increase in earnings and an increase in P/Es. The price pattern for secular bear markets is a generally choppy stock market driven by an increase in earnings and a decrease in P/Es.

Implications for Trading

For long-term investors, a multi-year and multi-decade perspective is often sufficient, especially when the environment is a green-bar, secular bull market. But for traders and curious investors, a look inside a typical secular bear market can be revealing.

For example, although the Himalaya Mountains may appear to be little hills from an airplane flying over them, the terrain is quite different for someone taking each step on the ground.

The red-bar, secular bear market of the 1960s and 1970s in Figure 2 appears muted across a century of time. Yet the daily, trail-worn path “feels” quite different.

Another View

Figure 3 reflects the dramatic short-term cyclical bull and bear cycles that occur throughout the longer secular bear market period. The magnitude of the swings, presented as percentages between peaks and troughs, is much more significant than most people expect.

Figure 3. Living Through The Last Secular Bear Market

Additionally, the relatively short periods for the cyclical bulls and bears further multiplies the drama.

The investment approach employed not only by investors, but also particularly by traders, should adjust to the different conditions of secular bulls and secular bears.

Whether your strategy is long- or short-biased, each of the secular market animals presents a unique environment of challenges and opportunities. Secular bear markets, with their repeatedly changing and erratic short-term cycles, pose especially challenging conditions. However, one trader’s challenge is another’s opportunity.

Outlook for the Next Few Years

In chapter five of Reminiscences of a Stock Operator by Edwin Lefèvre, the stalwart sage Mr. Partridge has a jousting exchange with investment newbie Elmer Harwood.

Harwood was focused only on the current stock trade; Partridge’s many years of experience taught him not to ignore the overall trend. Harwood would ultimately learn, while Partridge would profit.

The underlying conditions of the market were as relevant a century ago as they are today. But today, unlike the secular bull market of the 1920s, we are in the middle of a secular bear market that started in 2000.

For the remainder of this secular bear—which can be expected to last many more years—we can expect a couple or several years of surges punctuated by a year or two of decline.

While inflation remains relatively low and P/Es are commensurately high, the fundamentals are not in place to enable P/Es to double or triple to generate the next secular bull market.

The pattern will be frustrating for those who are not aware of it, yet rewarding for those who see the opportunities.

The secular bear roller coaster reflected in Figure 3 emphasizes the need to stay aware of the current normalized P/E. After the first quarter of 2010, P/E is in the lower end of the typical valuation range for relatively low inflation environments.

Crestmont Research updates quarterly, or more often as warranted, a complimentary assessment of the current state of P/E in the Stock Market section of its website. For now, the short-term cyclical bull has momentum; within quarters or years, another short-term bear will likely add another punctuation point to the current longer-term secular bear market.

The Seasons

For thousands of years, early man observed a pattern of seasons—from winter to spring, then on to summer, and concluding with fall. For many millenniums, seasons were a constant, though unexplained, pattern. At times, a warm day in the middle of winter would be confused with the beginning of spring. Farmers would run out and plant crops, only to be nipped by the continuation of winter.

Then about 500 years ago, astronomers determined that the tilt of the Earth caused the seasons. Suddenly they knew that summer cannot start in the middle of winter, no matter how long the warm spell persists. As a matter of fact, as the winter warm spell extends beyond a few days, the likelihood of a return to cold increases.

During winter, there are significant implications for farming. A few warm days are now known to be temporary, so savvy farmers know not to plant the summer crop too early. Most of all, success in these periods requires a more active, greenhouse approach or the planting of unique winter crops.

Be Nimble

During winter-like secular bear markets, investors and traders will not have the extended multi-year secular bull runs to rely upon. Market conditions will deliver intermittent, short-term cyclical bulls and bears, requiring a more nimble, hedged and actively managed approach to investing and trading.

A note from Mike Shell: You can probably see why we pursue asymmetric investment returns through global tactical rotation. If you still aren't convinced that market cycles exist, I encourage you to read Ed’s books.

We hear people talking a lot about stock indices like the S&P 500 stock index, referring to the index more than just a proxy for stocks, but also an investment. What you see below is a monthly chart of the past 10 years for the S&P 500 stock index. It is an index that many investment managers benchmark. I look at this chart, and I wonder; Who wants this?

Ten Year Chart of the S&P 500 Stock Index

^{Chart courtesy of eSignal}

In August 2000 the S&P 500 index was as high as 1,525. On Friday, it closed at 1,064. This index is down -43% from were it was ten years ago. (1065 - 1525) / 1064 = -43%. We could say the same about its more recent high point in October 2007.

At Shell Capital, we don't benchmark indexes. Our objective is to earn as much profit as we can with a specific amount of absolute risk. We call this "absolute return" rather than "relative return". We do not have benchmark-itis and we avoid relativity.