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JakilaTheHun (99.94)

A Change of Seasons, Inflation, and CAPS v. RL

Recs

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July 23, 2009 – Comments (5) | RELATED TICKERS: MU , F , PGR

A Change of Seasons

Up till now, I've been bullish on the market; all the while, bearish on the economy.  One thing I've noticed since joining CAPS and since I started writing for Seeking Alpha, is that most people don't hold very nuanced views.  Just as politics boils down to nothing more than silly labels (e.g. liberal, conservative, libertarian, etc) for most people, the investing world can be remarkably similar.  Unlike politics, however, those with simplistic views will get punished by the market.

The Dow hit 9000 today for the first time in a long while and the S&P has crept above 975.  It's an impossible exercise to "value the market" so I believe that all one can do is guess based on various factors.  Since about November, my guess has been that the market, in terms of the Dow, should be worth about 9000 - 9500.  In other words, I think we're approaching a fair valuation.

I've made some pretty bold calls over the past 9 months.  In early October, I postulated that memory-maker Micron (MU) was getting cheap.   In late November (see my CAPS pitch), it got cheap enough so that it was near the top of my list of buys at $2 - $2.50.  Today, Micron hit the $6.20 mark and while I still believe it's undervalued, it's not undervalued enough so that I would be willing to hold onto the stock.  Thus, I sold off my position in my simulated portfolio.  

It felt kind of strange.  I expected to hold onto MU for 2-3 years before seeing that sort of appreciation, but it's trading above $6 now.  Risk-reward is now neutral in my view for MU and I don't buy or hold unless I believe risk-reward is favorable for the long side.  My views on Ford (F) are similar; it looked very attractive to me at $2 - $3.  I believe it's worth $10 - $12; but it's too risky at $7 and provides too little upside for me to be tempted any more.  

The reason I mention Micron and Ford is because it made me realizing I'm undergoing a change of seasons now.   My strategy was to buy in on some of the most volatile, risky securities before because they had been overly punished in the aggregate.  Now, the price levels of many of those stocks are reaching or close-to-reaching my own "neutral level".  

Inflation versus Deflation

Sometime around late 'Summer or early Fall of last year, a big macroeconomic debate sprung up between "Inflation vs. Deflation."  A lot of people have been investing based on one theory or the other; personally, I've hedged my bets to some extent, but I've been mostly on the inflationary end of the spectrum.  A large part of the wackiness of the market can be explained by the uncertainty regarding this macroeconomic debate.

While it still might be too early to know the answer for certain, June's CPI numbers have to at least led me to believe that inflation is starting to look considerably more likely than deflation.  In June '09, the CPI increased 0.9% before seasonal-adjustment and 0.7% after the adjustment! In the period ranging from Jan - Jun '09, it would appear that CPI is up 2.7% after being down 5.0% in the prior six months.  That would imply a yearly rate of inflation around 5.5% - 6.0%.  

Energy and commodity prices have been two of the main drivers behind the increase, so it's difficult to tell if this signals a trend or merely fluctuations in the market, but a look at a lot of the individual numbers leads me to beleive that inflation is more likely at this point. 

When you consider the fact that from January to June, our economy has probably been in the worst shape since the mid-70s, if not the Great Depression, and we're still seeing inflation, what does that mean when we eventually do have a recovery?  Does it mean double-digit inflation?  

Then, we also have to consider the fact that the US is so dependent on foreign energy that any potential recovery could be stifled by high energy prices, which could then, trigger drops in energy prices.  Or in essence, maybe we're on target for a see-saw economy.  

Investing With the Changing Seasons

Regardless, even while I see the market being fairly valued at around Dow 9000 - 9500, I'd still want to be net long during this time period due to the potential of inflation.   However, as I mentioned before, many of the riskier, volatile securities (mostly focused in energy, commodities, and manufacturing) that I liked over the past six months, I find myself becoming more neutral on now.  There are still great buys out there, but they aren't nearly as numerous as before.

I'm starting to seek out less risky stocks that are undervalued.  I still think a large chunk of the REIT sector is undervalued (volatile or not), so I think companies like DCT Industrial Trust (DCT) are great buys.   But now, I'm also starting to think about companies like Progressive Insurance (PGR) that should stick around throughout the crisis, but also appear to be relatively cheap.

CAPS vs. Real Life

I love CAPS.  This is one of the greatest investment communities on the 'net and I've learned so much about investing since being here.  Yet, I can't help but to notice that the rules of CAPS make me invest a little bit differently than I would in real life.  

We've had numerous conversations about the distortive accuracy component on CAPS before.  Another problem I see with CAPS is that it creates unrealistic returns.  For instance, if I green thumb a stock at $5 and the stock rises to $25 at the end of Year 1 and then stays there for three more years before hitting $30 at the end of Year 5; then I end my pick at the end of Y5, I'm awarded roughly +500 points (minus the S&P's performance).  

However, this also isn't very realistic since it encourages me to keep picks longer than I probably should.   Note that in my example, I made a 400% return in Y1 and a paltry total return of about 20% from Y2 - Y5; which is probably about 4% - 4.7% annualized.  Yet, CAPS awarded me an additional +100 points based on the initial buy price, despite the fact that it was a terrible investment those years.

I've found numerous other examples of ways in which CAPS is significantly off-base from real life (RL) investing.  There are two solutions to this particular problem that I can see:

(1) TMF could create a portfolio management application to complement the CAPS game.  This would allow for more complex and realistic investing.

(2) CAPS could alter the scoring system.  One thing that would beneficial is that instead of being scored based on "percentage gain/loss", CAPS simply assumed that for every green thumb pick you make, you bought $1,000 worth of stock.  Then, CAPS could calculate the returns daily so they wouldn't become skewed.  This would solve issues such as dividend treatment and allow for more realistic return metrics.  

I realize Option #2 would probably be difficult to implement given that CAPS has already existed for 3 years.  Regardless, I still loving being here at CAPS and I am very thankful for this community.  Thank you, TMF! 

5 Comments – Post Your Own

#1) On July 23, 2009 at 5:13 PM, dividendhound (< 20) wrote:

I think idea #2 is a great idea - they could simply use it to supplement the existing system.  How would you account for selling at a gain or loss - would you be able to double down on new stocks? Re-up your buys (DCA) from time to time?  Dividend treatment should definitely be taken into account.

 

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#2) On July 23, 2009 at 5:56 PM, TMFJake (44.10) wrote:

How about if we provided YTD returns by position and by Scorecard?  We could also annualize these calculations.

Thanks!

jk

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#3) On July 24, 2009 at 11:46 AM, BigFatBEAR (29.23) wrote:

Jakila,

Great blog! I rec'd you after the first sentence, and then wished I was able to give out even more recs after the first paragraph.

I realized that I too, have been mostly bearish on the economy, but that my market outlook is generally considerably more bullish. BUT - this hasn't been the way I've been approaching the market with my money or my CAPS picks. So thank you for helping to point that out to me.

I also agree that CAPS investing incentives are quite different from real life investing incentives. Because accuracy is SO important up until ~90% accuracy (then it has diminishing returns and overall score becomes much more important), I have an incentive to ONLY close those picks that have at least +5 points on them. Therefore, CAPS can train young investors to "never sell at a loss" which can be extremely harmful for capital preservation.

I'm hoping that CAPS does implement some more features to make returns easier to digest (average pick score is good, but it could go much farther as you point out). It'd also be nice to see whether a player was a stellar green-thumber but a lousy red-thumber (or vice versa) via total accuracy and gains by thumb type.

Anyway, I'll keep my eyes peeled on the REITs. Kaskoosek seems to like them as well, perhaps you could go give some guidance on his recent blog post about them?

-BFB

PS. For what it's worth, I've argued that 1-2% inflation is most likely (in line with the Fed's projections), but have been quite scared of the possibility of Japanese-style deflation. I am also worried about massive debt (and the increasingly large interest we pay on it), and many state government's balance sheets. I think there's at least a small chance that we come out of this crash just fine, only to find that in 10 or 20 years we're unable to cover ours debts and must default, sending the market into another death spiral...

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#4) On July 24, 2009 at 4:37 PM, JakilaTheHun (99.94) wrote:

TMFJake,

That would be a good addition :)

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#5) On July 24, 2009 at 4:55 PM, JakilaTheHun (99.94) wrote:

BFB,

My fears on the national debt load are similar.  The American debt is still somewhat manageable at this point, but it's getting closer to a tipping point.  By historical standards, the process normally seems to take about 50 - 80 years (see 18th Century France).

In one sense, I believe our interest coverage on the Federal debt is fairly low since the Chinese had been massively buying treasuries to help prop up their own economy for years.  This had the effect of reducing yields and driving down interest rates.  At the same time, even if you're paying 3% interest, that doesn't work if you're making a 0% return. And now, the Chinese are scared to buy in, so we're basically at a point if we don't balance the budget ... AND SOON ... we're going to be paying a lot of interest.

 

I always buy based on individual valuation, which is why I think I ended up being more fearless at the bottom than most people.  I read the headlines, too, and was scared to some extent, but the way I saw it, cash wasn't any safer and my best bet was to buy into underpriced hard assets that (a) should be somewhat inflation-protected and (b) were undervalued even in an inflation-neutral environment.  

REITs became particularly intriguing to me around March as I saw people predicting that they would all disappear, which had to be one of the most insane predictions I've ever seen.  What are the odds that people won't need real estate in the future?  Real estate is the ultimate hard asset; there are still risks, but I felt if I could find the ones with reasonable leverage, it could be relatively low risk, even if the market felt it was extremely high risk.  

Of course, deflation would destroy my hypothesis, but I felt that prices were/are so suppressed on some of these securities, that they might even ben undervalued in a deflationary environment.  

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