Max Pain – Investing, not the Awful Movie

When I get bored I crunch numbers and build spreadsheets just like everyone else.  This time I wanted to see the maximum amount of money an investor would have lost over the last 40 or so years.

It’s an important number to me for 2 reasons:

1. How far is the deviation from what one would expect given the historical average and standard deviation (i.e. variance around the average)?
2. Investors tend to panic when the losses get really bad.  The results in a sell at the bottom mentality, locking in the already large loss.

Here is what we got:

Let’s breakdown US Stocks (i.e. S&P 500 month-end values, dividends reinvested) because that is what most people care about: 

• From 1970 through April of this year stocks had an annualized return of 10% with a standard deviation of 16%. 
• To elaborate, that means 95% of the time we can expect stocks to fall between -22% and 42% return in a 12-month period. 
• While the max drawdown was 51%, over a full 12 month period that number drops to 41% (not shown).
• During that time frame, the lowest return over a 10 year period for stocks was -29% (also not shown).  This sticks out as there have been 10 year holding periods where investors could lose money by holding equities.  There were 24 times this happened; however, they were all consecutive and took place between 2008 and 2010 corresponding with high equity values (e.g. the start date) prior to the tech bubble.

Risky assets (stocks, REITs, commodities) all have large drawdowns and are relatively correlated (again, not shown) with the exception of maybe commodities.  Thus, diversifying from just US Stocks to other risky assets will most likely not be an adequate hedge in the event of a large drawdown in US Stocks.  The addition of bonds helps; however, from my data is no panacea. 

 Note: Portfolios are rebalanced annually.  For a breakdown of the allocations and the indices used please email me for details.

The above numbers indicate that portfolio diversification can lessen risk (i.e. standard deviation) without sacrificing much, if any, return.  However, the max drawdowns are still large and well outside 2 standard deviations.  So while a diversified portfolio can mitigate maximum drawdown risk, it doesn’t necessarily restrict it.   This leaves the investor with 2 choices:

1. Mentally prepare himself or herself for a large drawdown so that if it does happen he or she doesn’t liquidate at the bottom and lock in a devastating loss.
2. Put risk control measures in place so the max drawdown is limited.  

Past performance is no guarantee of future results.  Diversification does not guarantee a profit or protect against a loss. International investing involves special risks, including, but not limited to, the possibility of substantial volatility due to currency fluctuation and political uncertainties. The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  

Low 10-Year Return Projections <> Underweight Equities

The stock market looks expensive when you take an intermediate term view (3 to 10 years).  That sounds a tad frightening, but don’t let the long view lead to short-sighted decisions in your equity portfolio - at least for the next 12 to 36 months.

A recent MarketWatch article, by Mark Hulbert points to indications of long-term overvaluation and asserts the following:

1. Stock market is not at all-time high in real terms and is 24% below the peak.
2. CAPE (i.e. long-term Price to Earnings, a longer-term valuation metric) suggests weak market returns over the next 10 years (close to zero in real terms).
3. Despite CAPE being rich, it doesn’t mean markets will move in a straight line down and the recent rally (I assume since the 2009 bottom) can continue.

I believe we run similar in-house models to Mr. Hulbert, and while I tend to agree, they do need some context:

1. This suggests the market still has more room to run.
2. Other valuation models we run indicate a similar trend.  But over time market valuations have trended up, suggesting the decline may not be as severe as the average would dictate.
3. The market can stay overvalued for quite some time and the conditions appear to be in place them to do so.  I actually just heard famed investor Joel Greenblatt mention the market is cheap on his free cash flow measure, a shorter-term metric, and this is confirmed amongst sell side research we use.  Also, momentum metrics can help determine when a change in the market is afoot.

So I am on board with the contention the market will revert to the mean as this market cycle ends, leading to a correction, which very well could be larger than anticipated by most.  But I also think there needs to be some perspective around it – don’t miss the upside while you wait for the mean reversion.

The takeaway is to make sure you and your advisor are aware of the longer-term trends and the likelihood of mean reversion, but don’t avoid stocks altogether.  Just have a plan to mitigate the risk when the upside trend starts to reverse. 

Past performance is no guarantee of future results.  The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  

Utilities, Still on Defense?

The JP Morgan Guide to the Markets is out for Q2 and is always a good place to find some fun charts and a recap of the prior quarter.  I usually peruse through it when it arrives in my inbox.  This quarter, something in particular caught my eye – in Q12013 Utilities are up more than the S&P 500 (SPX). 

The sector was up 13% and the index was up 10.6%.  This is odd as Utilities are typically defensive so when SPX rallies hard like it did in Q1 you would expect Utilities to lag.  Over the last 10 years the beta (how Utilities move relative to a move in SPX) is .52, which means since SPX was up 10.6% Utilities should have been up roughly 5.50% based on the last 10 years of historical moves.  So why did this happen?  I have two thoughts:

• Search for yield.  The 10-Year Treasury floats around 1.75% with SPX around 2.00%.  Utilities yield about 4.00%.  This feeds into…
• Capital Protection.  Investors are still nervous from 2008 and 2009.  Given the low yields, investors feel more compelled to reach for yield and return in less volatile equities.  This is evidenced by large moves in other low beta, defensive sectors – Health Care, Staples, Telecom – in Q12013.

This presents two questions.  The first is will these conditions persist?  I think yes given QE (Fed won’t let rates rise) and investor psychology being extremely sticky.

The second is what happens if the market reverses?  Utilities are roughly 30% overvalued to their historical norms.  Thus, the risk is that if the market starts trending negatively, the downside protection Utilities provided in the past may not hold this time around.  Though if the market moves higher and Utilities lag this could correct itself before an overall market correction. 

Thus, the conclusion I draw is that while the conditions driving Utilities higher are still in place, I am concerned their upside potential does not compensate for the downside risk.  This kind of market disconnect can have great bearing if there is a sudden increase in downside market volatility as the investor could be subject to more risk than initially thought.

If decent yield with a defensive posture is a prime goal, an investor may be better served looking at alternatives to this sector or, at the very least, understand the risk.

Past performance is no guarantee of future results. An investment concentrated in sectors and industries may involve greater risk and volatility than a more diversified investment.  The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  

Looks Good, but not Without Reservation

Bloomberg posted an article last week claiming “Stocks Cheaper Than Any U.S. Peak in 23 Years”.  The first sentence sums up what I believe most investors are thinking:

Corporate profits that doubled since 2009 have left the Standard & Poor’s 500 Index cheaper than at all 34 peaks since 1989, even as options traders push the cost of protecting against losses to the highest in four years.

Let’s break this down, first I will address part I of that sentence.

• Corporate profits are strong.
• Valuations are not moving higher with the rise in profits.

In a vacuum, this is good news.  Profits are up; valuations are not correspondingly rising, so it must be a good time to buy stocks.  Not so fast though, you can’t ignore part II of the sentence (insurance costs are high):

• There are still a lot of risks out there; the article alludes to a few:  Eurozone credit crisis, rising oil prices, China hard landing, possible softening US economy (not noted is the removal of stimulus from the system), abnormally high profit margins.
• Given the above, multiples remain low and insurance costs remain high.
• Further, I should note valuations are subjective and not all valuations models tell the same story.

So now what?  If we can avoid the risks mentioned above, given the improving US data, strong profits, and lower valuation level, stocks should have a good year.  That said, the risks mentioned are voluminous and highly impactful. 

Thus, the current state of the markets seems reasonable and supports my overall opinion of the state of the markets this year.

Depends on Your Definition of “Long Run”

The graph below, which I created in Excel from Bob Shiller’s Real S&P 500 data, does a good job illustrating secular market cycles:

I like to use the S&P 500 Index adjusted for inflation (i.e. in today’s dollars) to more easily demonstrate market cycles. The red lines indicate the start of secular bear markets and the green lines indicate the start of secular bull markets. Both of those were subjective determinations on my part.

The point of this graph is simply to illustrate that markets don't move up forever; in fact there are long periods of time (20+ years at times) when equity prices can trend flat or downward. That being said, markets can deviate from their secular trend (e.g. a cyclical bull market in a secular bear market) as all secular bull and bear markets have periods of reversal from the longer-term trend.

Since 2000 we appear to be in a secular downward trend.  While it is possible that we are starting (from March 2009) a new secular bull market, it appears secular trends tend to last roughly 16 years.  Thus, based on the history of market cycles alone we appear to be in a cyclical bull market within a secular bear market.