My Photo
Note: Jeff does not accept guest blog posts on A Dash of Insight.

For inquiries regarding advertising and republication, contact main@newarc.com

Follow Jeff on Twitter!

Enter your email address:

Delivered by FeedBurner

Certifications

  • Seeking Alpha
    Seeking Alpha Certified
  • AllTopSites
    Alltop, all the top stories
  • iStockAnalyst
Talk Markets
Forexpros Contributor
Disclaimer
Copyright 2005-2014
All Rights Reserved

« What You Really Need to Know about Employment Data | Main | The Importance of Economic Perceptions »

March 27, 2011

Comments

Jason

Watch the commodity markets.

Risk-conscious Investor

Bill Miller gets a lot of publicity. He knows that everything he says can be summoned up and quoted. Over a long time period you can find something to criticize in the record of anyone who takes a public position.

This is true. That said, there are mistakes and then there are ***MISTAKES***. I would argue that EVERYONE makes mistakes, but that some MISTAKES reveal that that individual is operating from a completely incorrect theoretical model on how the economic/financial world operates (Greenspan basically admitted this is in front of Congress that his model was flawed). Bill Miller once said that "he knew he was wrong on a stock when he couldn't get a quote anymore". That philosophy underscores an intellectual arrogance and total disdain for any sort of risk control and it shows up in his long-term track record as he is behind the S&P 500 long-term. His arrogance destroyed many years of good returns. This is an unforgiving business/endeavor and as Buffett says the downcycle will reveal those who are swimming naked during the upcycle.

I have seized that advantage by looking beyond questions of valuation to embrace a weekly monitoring of risk. This approach was actually stimulated by a discussion with your good friend Mike C. Regardless of what the market valuation was in 2008, it was not relevant in the face of extreme financial stress, reflected in the St. Louis Fed Stress Index.

This point is highly problematic because I think the market valuation was highly relevant to the *magnitude* of the decline. If we cannot agree that valuations were excessive in 2007/2008 prior to a 60% market decline, then essentially we should just disregard the entire concept of valuation as an analytical tool.

Assume hypothetically that sometime in 2013, 2014, 2015 we have another market decline comparable to 2000-2002 or 2007-2009 starting from a high Shiller P/E. Let's assume the trigger event is some exogenous factor like a sovereign debt crisis. Then we are right back at point A with one person saying the magnitude of the decline was due to high valuations while the other persons says it was due to event A happening and if A didn't happen valuations were just fine. It is sort of arguing how many angels are dancing on the head of a pin. Pretty much all 40-50% or greater market declines occurred from high Shiller P/E starting points (1929, 1937, 1972, 2000, 2007). Does it really matter what specific event triggered the 50%+ decline? There was always some reason, some trigger event. In 29 the crash, 37 pulling in stimulus too soon, 72 oil and geopolitical issues, etc. The point is when stocks are demonstrably cheap, it doesn't matter what event happens because bad conditions are already priced in. In 1990-1991, and 2002-2003 the stock market basically yawned at the beginning of wars (Iraq 1 and 2) because the stock market was already cheap at that point.

Now the interesting thing about the Shiller P/E which some recent studies have highlighted is that it is ABSOLUTELY WORTHLESS as a model for the subsequent 1 or 2 year returns. The market could just as easily go up 30% as down 30% so it is absolutely correct to note it has no utility over a 1-year time horizon.

It is ONLY when stocks are expensive, that trigger events can lead to massive declines. If the S&P had been at 800-900 when Lehman occurred, I highly doubt it would have dropped 60% to 300. It would have been a normal bear market of 20 t0 25%. I really think this point is critical. The notion that stock market risk levels are very low now in terms of potential magnitude of decline is to make the exact same mistake as 2007. That is the mistake in Miller's process. To compare earnings now to 2009 is to completely ignore that earnings are cyclical and 2009 was a trough in earnings. It is comparing apples to oranges. Are we at or near the peak? I have no idea. Maybe we do $150 in 2012. But there will be a peak someday eventually that will lead to cyclical downturn and I can pretty much guarantee that stocks will look cheap at the peak relative to other assets.

I notice that you did not comment on Miller's process, which was the point of my old article on him. What part of it don't you like? What metrics do you think he is missing now, making him "right for the wrong reasons?"

Sort of addressed this already above, but one more thing here. I've been reading the Great Reflation by Tony Boeckh who I'm sure you know is a big name in this business with decades of experience at BCA. He has a model for market analysis rank ordered by importance. Factor 1 is Monetary Policy, Liquidity, and Credit. Factor 2 is Valuation. He goes out of his way to stress that 1 is more important then 2. Again, that isn't my position...that is his position with decades of market experience. I'm trying to learn from his book on how to build a better mental model for market analysis. But clearly, looking at that last several months and the initiation of QE2 and overlaying Boeckh's model, it should be clear it is Factor 1 driving this move, not Factor 2. Is it sheer coincidence this monster move started exactly with QE2 in late August (and that QE1 put in the bottom in March 2009 and reversed the downtrend). David Tepper basically said exactly this on CNBC in his call to buy stocks. That is what I mean by being "right for the wrong reasons". It is correct to be bullish but probably incorrect to attribute it to attractive valuations instead of Fed policy. The real lesson here is one you have emphasized before which is "Do not Fight the Fed".

Anyways, we are all trying to accomplish the same objective which is to try and ascertain when it makes sense to have stock market exposure or have it at maximum targets, and when it is time to dial back stock market exposure and play defense and/or hedge. The simple fact of the matter is that the decline from Oct 2007 through March 2009 and the subsequent rebound from March 2009-present indicate that many people were operating from flawed models. In the case of those who missed the last 2-years, I think it is almost obvious to state they did not properly account for government fiscal and central bank monetary policy in their market analysis as the Boeck factor #1 would stress.

oldprof

Risk-conscious Investor --- Bill Miller gets a lot of publicity. He knows that everything he says can be summoned up and quoted. Over a long time period you can find something to criticize in the record of anyone who takes a public position. That is the reason that I combined the CNBC piece with the Bespoke Investment Group chart on his record. There are few who can match it. I also don't think it has anything to do with metrics or inflection points.

Those of us who manage individual accounts have an advantage over managers of a fund. When you buy a fund, most people are doing their own asset allocation. They expect the manager to be invested.

I have seized that advantage by looking beyond questions of valuation to embrace a weekly monitoring of risk. This approach was actually stimulated by a discussion with your good friend Mike C. Regardless of what the market valuation was in 2008, it was not relevant in the face of extreme financial stress, reflected in the St. Louis Fed Stress Index.

Everyone should measure position size in terms of acceptable risk. When objective measures of risk (and I don't mean the typical list of headwinds you read everywhere) get larger, your positions should get smaller.

I notice that you did not comment on Miller's process, which was the point of my old article on him. What part of it don't you like? What metrics do you think he is missing now, making him "right for the wrong reasons?"

That comment could more aptly be applied to many of those who "called the crash" starting in 2005 and are still calling it today!

Even though I disagree with your take, it is a fair question, and one worthy of discussion.

Jeff

oldprof

DE -- Thanks for taking the time to look so closely through my work. I hope you found some helpful nuggets.

You are correct in noting that, unlike most others who write about investments, I publish a specific weekly market viewpoint and it changes with the circumstances.

You are also correct that a valuation approach is not particularly helpful in forecasting a market crash related to the breakdown of financial institutions. My valuation methods have been quite bearish in past times, but that was when my investment writings went only to clients, predating my blog.

The question of how the long-term investor can protect himself is of major interest. I have been offering a paper I wrote on controlling risk, where I discuss this in some detail.

For now, let me just say that the very first thing I do with a prospective client is to determine what risk is appropriate, using the client's needs and attitudes. Too many people "had it made" before 2008 and should not have been taking any risk at all.

In preparing a program, I combine the long-term horizon with other approaches. The biggest cost of 2008 for most people is that they are now constantly afraid, causing them to miss out. I am going to elaborate a bit more in my reply to risk-conscious investor, so please check there as well.

Thanks for a very good question. I am probably overdue for a couple of articles about how I and others have altered some methods since 2008.

Jeff

Risk-conscious Investor

http://oldprof.typepad.com/a_dash_of_insight/2007/10/new-market-high.html

http://oldprof.typepad.com/a_dash_of_insight/2007/10/process-versus-.html

At the start of this year, Miller gave his opinion about the markets:  The stock market is still cheap.

At this point, how much credibility does Bill Miller have? Go back to his spring 2006 letter where he was adamant about Citigroup over commodities on a multi-year basis. How's that one working out?

DE, most people count on the fact that few will go back and check who said what when, and if a particular line of reasoning led to the wrong conclusion before, should it be utilized now?

We are in a bull trend no doubt, but many are RIGHT now for the wrong reasons. They will miss the inflection point when the trend turns bearish because they are looking at the wrong metrics.

DE

Jeff, I am fairly new to the site and have been working through past articles. I am trying to determine if you were ever bearish during the 07-early 09 span from a long term timing perspective. I do not find any evidence of this, which is not surprising given your focus on relative valuation. However, have you written an article about where you may have been wrong in your thinking in hindsight? Or was there no way to miss some of the downside given your long term approach? Note that I understand you have short term trading strategies that were likely defensively position during this period, I am referencing the longer term outlook of your articles during this time period.

The comments to this entry are closed.