Wanted: More New Highs

Monday, August 20th, 2012

by Bespoke Investment Group

The fact that the S&P 500 is back near multi-year highs is certainly enough to make bulls happy.  That being said, the rally has hardly been broad.  As one example, the Utilities sector, which is comprised of 31 stocks in the S&P 500, was down every day this week.  Earlier in the week, we also noted that in the most recent leg higher, the Russell 2000 has been underperforming the S&P 500.

In terms of new highs, we have also seen a narrowing of the rally.  Back in late March and early April when the S&P 500 made a new bull market high, the number of stocks in the S&P 500 hitting new highs got as high as 78, or 15.6% of the index.  Today, however, the number of new highs was just a little more than half the peak reading we saw in the Spring.  Of the 500 stocks in the S&P 500, there were 42 stocks that hit a new high (8.4% of the index).

The reason for the smaller number of new highs stems from the fact that the rally is being led by megacaps (like AAPL), which stocks with smaller market caps have lagged.  This doesn’t necessarily mean that the rally is doomed.  Rather, the less broad based nature of the rally means that it is imperative for investors to be in the right stocks.  For a lot of us, just summoning up the courage to get into the market is hard enough.  Now, we also have to worry about picking the right stocks!

Copyright © Bespoke Investment Group

Tags: Aapl, Amp, Bespoke Investment Group, Bulls, Courage, Investors, Market Caps, New Highs, Rally, Russell 2000, Stocks
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Rob Arnott: Investment Outlook (June 2012)

Friday, June 1st, 2012

Institutionalizing Courage

June 2012

by Rob Arnott, Research Affiliates (RAFI)

Imagine a boss who is generally supportive of your efforts, but has some odd tendencies around rewarding initiative. Let’s call him Mr. Market.1 Every time you go in for your annual review, Mr. Market gives you a raise which is usually 1% or 2% above inflation, and asks, “Whaddya think?” If you’re “passive” and take whatever Mr. Market offers, you wind up with a steady but modest increase in your income, year after year, assuming the company is still doing well. Mr. Market, however, does not view all projects equally. If you offer to take over some project that he hates, he boosts your raise by an average of 3–6%. With a little initiative, you can triple the average real raise—over and above inflation—that everyone else is getting.

Unfortunately, Mr. Market is also bipolar, with wide mood swings. If you’re willing to take on a project that he really hates, he may give you a 15% raise, just to get it off his desk. On the other hand, if you’re taking a project that he doesn’t much mind doing, he may actually take away some of the normal raise. Because you run this risk every time you propose to take on a new project, it takes a modicum of courage to make these offers to the boss.

With a boss like Mr. Market, what is the right strategy for success? The answer is obvious: You need the courage to stick with the profitable strategy through the good times and the tough times. We’ll come back to Mr. Market shortly. First, we need to understand the true nature of wealth, income, and spending. Sustainable Spending as a Strategy Although people tend to measure wealth in terms of the dollar value of a portfolio, we believe it is better to measure wealth in terms of the real spending that the portfolio can sustain over the entire life of the obligations served by the portfolio. In 2004, we coined the expression “sustainable spending,” to gauge this true value of a portfolio.² Jim Garland used the term “portfolio fecundity,” to describe much the same concept.³

Consider a simple thought experiment. It’s a bull market. Prices double on everything we own, while the dividend yield drops in half. Are we better off? The long-term spending that the portfolio can sustain hasn’t changed a bit. In 1997, Peter Bernstein and I⁴ pointed out that bull markets are actually very bad news for those who are net savers, building a portfolio to fund future needs, because it costs more to buy the same real income stream (a very crude measure of sustainable real spending⁵) after the bull market than before. We’re better off only if we’re spending from the portfolio immediately, not saving more for the future!

Many people felt jubilation at the peak of the tech bubble, because they felt so wealthy. And they were—as long as they were inclined to liquidate their holdings and spend before the market lost its euphoria. If they were still investing (e.g., for some future retirement), those new purchases bought precious little yield! Reciprocally, people felt panic and dismay at the 2009 trough of the financial crisis, because they felt as if their assets had been wiped out. And they were—if they intended to liquidate and spend their assets immediately. But, for the buyand- hold investor, their real income was higher than at the 2007 peak!

None of this is unfamiliar to the serious student of capital markets. So, what lessons can the thoughtful observer learn from “sustainable spending”? In the following discussion, we find bear market drawdowns have little impact on sustainable spending. Indeed, these sell-offs provide opportunities to increase our sustainable spending through disciplined rebalancing between asset classes or within asset classes, especially volatile ones like equities.

This requires courage: “no guts, no glory.”⁶

What is Wealth?

Ben Graham liked to distinguish between a temporary loss of value and a permanent loss of capital. The former is a rebalancing opportunity; the latter is a disaster. In a highly diversified portfolio where all the idiosyncratic risk has been diversified away, the latter is extremely rare. At some time during the 20th century, the stock markets of Argentina, Russia, Germany, Japan, China, and Egypt each went essentially to zero. Suffice it to say those investors had much bigger things to worry about than their stocks! Temporary losses of value are frequent; at times they can become so frightening that they become permanent—for those that sell. Through the lens of sustainable spending, these losses are far less severe. Table 1 illustrates the 10 bear markets larger than 30%, in real total return, in the past century. These aren’t as rare as most people think! The average loss is a horrific 46% real return loss (including dividends, but before taxes). Our nest egg is chopped in half, usually in less than two years. That’s awful… for anyone who wants to spend all of their money at the trough.

For those focused on the spending power of the portfolio, most of these monster bear markets were surprisingly boring. The peak to trough decline in real dividend distributions was a scant 3% drop, on average. Even in the Great Depression, real dividend distributions fell by “only” 25%. Of course, the drop was worse in simple nominal terms, because we had deflation. A 25% cut in real spending power on our portfolio, while very unpleasant, was small relative to the 80% real loss of portfolio value… and it was temporary. This 25% drop in our real spending power was the single worst outlier in a century.

On average, real sustainable spending sagged slightly during these 10 worst bear markets, then recovered massively, on average by 35%, off of their lows just five years after the market trough. In almost every case, our real distributions also achieved new highs, relative to our pre-crisis spending, besting the dividends of the previous market peak by an average of 29%! Keep in mind that this is the increase in real dividends, not just nominal payouts.

For those focused on the level of real spending, rather than the level of prices, the worst market downturns in U.S. history were mostly brief bouts of minor disappointment. The results in the recent Global Financial Crisis bear a special mention. While U.S. stocks tumbled by 51%, the real dividends distributed by the S&P 500 Index grew by 4%. To be sure, the real dividends have given up that 4% gain in the subsequent three years. But, from the perspective of spending power, these past 4½ years have been utterly boring and benign! For the buy-and-hold investor, bear markets aren’t nearly as bad as they seem. Massive market corrections disproportionately impact market prices versus spending power. But our proposed shift in our focus—drawing attention away from the value of our portfolio toward the spending power it can sustain— requires real courage: courage to ignore headlines, our brokerage statements, and our natural human instincts to sell.

Return on Courage

Now suppose we have the nerve, not only to focus on our real sustainable spending, but also to seek to increase our real sustainable spending in market downturns! If we rebalance into higher yielding assets after they’ve cratered, presumably funded from assets that have performed much better, we can systematically ratchet our sustainable spending ever higher. This ground is amply explored in asset allocation literature. Indeed, the essence of Tactical Asset Allocation (TAA) is an effort to rebalance into investments when they become most uncomfortable, and are therefore priced with a superior risk premium, to reward those who are courageous enough to invest at such times.

Even a mechanistic rebalancing policy would have compelled a trade from stocks into bonds at the peak in 2000. The trend-chasers who bought stocks at the peak, let alone buyers of high-flying growth or tech stocks, may not live long enough to be wealthier than their contrarian friends who bought ordinary Treasury bonds at that same time. They funded the success of TAA managers and strategies. Conversely, in 2009, a disciplined rebalancing strategy compelled us to buy “Anything but Treasuries.” Treasuries had dipped to the lowest yields seen in three generations. At the same time, almost anything else offered generous future spending, with many markets priced at near-record yields. Still, this was a very frightening trade.

Tags: Bipolar, Boss, Courage, Dollar Value, Expression, Good Times, inflation, Initiative, Investment Outlook, Market 1, Modicum, Mood Swings, Profitable Strategy, Rafi, Research Affiliates, Rob Arnott, Tendencies, Tough Times, True Nature, Wealth Income
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Barton Biggs: Better a Pig, than a Bull or a Bear

Saturday, October 10th, 2009

Barton Biggs visits CNBC to discuss the market – Biggs says its better to be a pig in this market, rather than a bull or a bear. Funny thing is Biggs didn’t get to talk about this with Faber – instead they got down to the subject that there is more left in this rebound than investors imagine. The reference to being a pig comes from Biggs’ letters and a recent Newsweek article:

Biggs’ research looked back at past secular bear markets. Investors in past bear markets experienced an average drop from peak of 57% and a recovery from the trough of 78%. In some cases the recoveries from trough were in the 80 and 90 percent ranges. He pointed out further that this time around the drop from peak was 57%, and so far the recovery rally has provided a recovery of 45% out of the trough, hence his optimism that we may be only about halfway to the top of this market rally.
Click play to watch:

Biggs believes there are strong opportunities left in Big Cap Technology, Pharma, and Oil Services – and he believes that China markets will rally strongly again in the 4th quarter, after a lull that began in Mid-June, and emerging markets in general.

“It takes courage to hold fast and be a pig, as they say on Wall Street—my money is where my mouth is.” - Barton Biggs

Biggs thinks we are only half way through this rally:

The market is only about halfway through what is historically typical of a bear-market recovery—and this time around, the rebound is likely to be even bigger, said Barton Biggs of Traxis Partners.

Traxis analyzed 14 past bear markets—ranging from gold to US stocks—and found that when markets dipped more than 40 percent, the average rally off the lows was about 72 percent, he said.

Since the Dow is up only about 45 percent and the S&P about 52 percent, the market still has a lot of room to the upside, Biggs said.

“We’ve had a tremendous, an unbelievable decline in both the economy and the stock market, and so I just think we’re going to have a bigger than normal bounce,” Biggs said. “I just think we’ve got further to go.”

Tags: 4th Quarter, Barton Biggs, Bear Market, Bear Markets, Bounce, Cap Technology, China, China Markets, Cnbc, Courage, Decline, Dow, Economy, Emerging Markets, Faber, Funny Thing, Gold, Lot, Lows, Lull, Market Rally, Newsweek, Newsweek Article, oil, Oil Services, Optimism, Pig, Rally, Rebound, Stock Market, Stocks, Traxis Partners, Trough, Wall Street
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