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This Puzzling Market



May 31, 2013 – Comments (8)

Board: Macro Economics

Author: ADrumlinDaisy

Is this market puzzling?

Does a moose prowl in the woods?

Of course the market is puzzling – no one knows what to make of it. Personally, I have been gradually selling equity positions and replacing them by selling OTM cash-secured puts, but I keep wondering if I am missing a sea change, a new world where stocks will rise to glorious new heights based on . . . based on . . . gosh, I cannot think of anything such a rise could be based on. QE, possibly?

In times of uncertainty, it is best to consult experts. Below I have summarized recent comments from four mavens, with the following conclusions:

Bill Gross: Gradually reduce risk positions over the rest of 2013 and possibly beyond.
My Mom: Trouble is coming.
John Hussman: We are doomed. Sell or hedge or somehow get market-neutral.
Josh Peters: We cannot predict the market. Stay the course, buy and hold great dividend –paying companies, collect a steady stream of growing dividends, and stop whining. (OK, maybe I editorialized just a bit.)

Here are the details; perhaps they will help us formulate our approaches:

1. Important Thoughts from the Bond King.

A while ago I suggested – really just for fun – that maybe Warren Buffet is not a genius; maybe he is just the lucky person guaranteed by statistics to have a long successful run, like the one man in a thousand who can be expected, on average, to get “Heads” on ten straight coin flips:

Apparently Bill Gross, the Bond King from PIMCO, read that post:

Three straight flips of the coin to “heads” produces a buzz in the crowd for another “heads,” despite the obvious 50/50 probabilities, as do 13 straight years of outperforming the S&P 500 followed by … Well, you get my point.

How many coins do you have to flip before a string of heads begins to suggest that it must be a two-headed coin, loaded with some philosophical/commonsensical bias that places the long-term odds clearly in a firm’s or an individual’s favor? I must tell you, after 40 rather successful years, I still don’t know if I or PIMCO qualifies. I don’t know if anyone, including investing’s most esteemed “oracle” Warren Buffett, does . . . .

April 13 Letter,

Mr. Gross goes on to connect this idea – that investing success may just be a statistical result – to the idea that perhaps markets change greatly over time (indirectly supporting the view that back-testing may be over-rated because the market is not comparable across different times – see Appendix A below (look for the word “BORING” to find it)):

There is not a Bond King or a Stock King or an Investor Sovereign alive that can claim title to a throne. All of us, even the old guys like Buffett, Soros, Fuss, yeah – me too, have cut our teeth during perhaps a most advantageous period of time . . . that an investor could experience. . . . Perhaps, however, it was the epoch that made the man as opposed to the man that made the epoch.

. . . PIMCO’s epoch, Berkshire Hathaway’s epoch, Peter Lynch’s epoch, all occurred . . . within an epoch of credit expansion . . . . What if an epoch changes? What if perpetual credit expansion and its fertilization of asset prices and returns are substantially altered? What if a future epoch . . . encompasses a period of global geopolitical confrontation with a quest for scarce and scarcer resources such as oil, water, or simply food as suggested by Jeremy Grantham? What if the effects of global “climate change or perhaps aging demographics,” substantially alter the rather fertile petri dish of capitalistic expansion and endorsement?


In his May, 2013 letter, Mr. Gross gives the following advice:

PIMCO’s advice is to continue to participate in an obviously central-bank-generated bubble but to gradually reduce risk positions in 2013 and perhaps beyond . . . . So give your own portfolio a trim as the year goes on. In doing so, you will give up some higher returns upfront in order to avoid the swift hand of Sweeney Todd. There will be haircuts. Make sure your head doesn’t go with it.

2. Shocking Warnings from John Hussman: “Geronimo!” (Look Out Below)

John Hussman is no fan of the current market, or of those who expect the rising tide to continue unchecked. So far he has been consistently wrong, but he makes very compelling arguments, and I cannot help but fear that trouble is coming.

As my 89-year-old mother said to me recently:

Me: . . . is there any reason to think that our climb back up this third mountain [on an S&P 500 15-year price chart] is justified, or are we heading right into the teeth of a third bubble and crash?

Mom: Son, if you can’t smell a storm coming by now, you never will. But I have seen the varmint, and he is heading our way again. (subscription required)

Here are a few key excerpts from Dr. Hussman’s May 13, 2013 musings:

. . . investors are not simply choosing between a 3.2% prospective 10-year return in stocks versus a zero return on cash. They are also choosing between an exposure to 30-50% interim losses in stocks versus an exposure to zero loss in cash. They aren’t focused on the “risk” aspect of the tradeoff, either because they assume that downside risk has been eliminated, or because they believe that they will somehow be able to exit stocks before the tens of millions of other investors who hold an identical expectation that they can do so.

. . . the discipline to “sit by quietly while the mob has its day” can be nearly excruciating in the excitement of late-stage bull markets, as the market registers multi-year highs amid rich valuations and heavily optimistic sentiment.

Moderate losses are frustrating, but deep, major losses from rich valuations are the ones that matter, because it is difficult to recover from them in a durable way. The recent advance is a gift in that regard. Consider that carefully now, not later.

QE has not increased the value of equities. It has only increased the price, but that increase in price has no significant fundamental underpinning. . . . [it] is driven by the willingness of investors to abandon their demand for a risk premium that will actually compensate them for the risk they are taking.

. . . all of this will end badly.

He sounds like my mother! And she is the smartest person I know (plus she once hugged the great Honus Wagner, which pretty much seals the deal as far as I am concerned).

Although it is not entirely germane to the topics at hand, let me also reproduce one memorable excerpt from Dr. Hussman’s May 20, 2013 essay:

Knowing where you are doesn't mean that you're leaving, but you should still know where you are. We’re not in Kansas anymore.

Uh, OK . . . .

Let’s face it – some people should just not try to come up with pithy, common-man quotes and stories.

In fact, it occurs to me that this curious mixture of Buckaroo Banzai (“wherever you go, there you are”) and The Wizard of Oz (“Toto, I've a feeling we're not in Kansas any more”) is the kind of thing one gets when he or she tries to insert a humor algorithm into an AI program. Which leads me to wonder, could John Hussman be . . . an economics bot on a supercomputer?

Food for thought . . . .

In support of which, I offer yet another clunker from Dr. Hussman’s May 27 letter:

The Fed is stepping on a gas pedal in the hope of making the wheels go faster, and instead the gasoline is spurting out of the tank and feeding speculative flames, because a reliable transmission mechanism does not exist.

OK, this is actually kind of fun; let me try one:

“The Fed is digging a deep hole of debt with one of those long-handled thing-a-ma-jigs that has a sharp blade on the end, but it has accidentally struck a buried deflationary gas line, and the odorless gas is seeping out and drifting over toward the charcoal-fueled outdoor grill on the neighbor’s recessionary lawn, where it threatened to explode, destroying the exquisite sea-salt-rubbed Moldavian pheasants of economic recovery that the neighbor is grilling.”

No, that is not quite right; I will have to keep working . . . .

3. Thoughts from Josh Peters, Chief Honcho, Morningstar Dividend Investor

In his June newsletter, Josh Peters explains why he plans to continue to do business as usual despite the uncertainties surrounding the market. Basically, he admits that he has no idea where the market is headed, and simply adheres to his “fully invested in companies with moats and strong, secure, growing dividends” philosophy. FWIW, I find Josh’s investing philosophy, and his implementation of it, to be compelling, and recommend his newsletter.

Here is Josh:

If this is a new secular bull market . . . we may have some adjusting to do.

Is it time to sell? . . . . What do we do with the money?

There’s no way to know . . . if a new secular bull market is under way. However, I’m not sure it’s necessary to know. Through the dark days of 2008 and 2009, I deployed a concept I called the courage to do nothing. . . . I stayed fully invested. I let the bear market drag the market values of our accounts lower without abandoning our strategy, which turned out to be a very profitable view to hold. Now that stock prices are setting new records and still rising, I think the same courage is equally valuable.

I measure our progress primarily on the basis of the income we’re collecting and the growth of that income through dividend increases. . . Even if the stock starts to look somewhat overvalued, I only act if and when there is a clearly better use of my capital in sight.

The best course of action is to stick with our tightly-focused approach . . . . I am willing to risk short-term underperformance—and, yes, even temporary declines in market value—in exchange for the large and growing dividends we’re collecting. It may take some courage to do nothing, but it’s a kind of courage I’m happy to supply.

(Subscription required)

You know, Josh Peters is not famous, and he constantly needs a shave, but he always seems to make sense.


A Drumlin Daisy


THEORETICAL APPENDIX Q: A Few Thoughts on Back-Testing, Complete With Citations and Links

A lot of people rely on back-testing methods to try to make predictions about the future behaviors of the economy and the stock market (which are not necessarily closely linked, at least over the short term). For example, John Hussman, whom my daughter calls the “most huggable of the perma-bears,” relies heavily on such methods.

Many of these back-testers are current or former professors with beards, pipes, and corduroy patches on their elbows, so obviously I am hesitant to disagree with them; all I have is a porkpie hat:

that I think makes me look intelligent but my daughter claims makes me look like Huckleberry Hound. . Still, I must respectfully dissent. While I accept that these methods add useful information to the overall analytical mix, I suspect that they should be viewed with great caution in these contexts.


The value of the back-testing depends heavily on (i) the existence of an adequate supply of data from which to extract reliable statistics, and (ii) the assumption that the data being analyzed is drawn from the same system – e.g., that the market in 1930 is essentially the same beast as the market today. And I fear that both of these assumptions are not valid in the context of the economy and the stock market.

If one back-tests the behavior of a billiard ball on a pool table over hundreds of thousands of repetitions, he or she will extract useful and predictive rules describing the behavior of the billiard ball, most likely closely fitting the kinematic equations of Newtonian mechanics. Here back-testing works because the system is very simple – meaning that the data base is sufficient to capture its full range of behavior – and it is unchanging over time – the billiard table today is essentially the same system that it was while the data is compiled.

Unfortunately, the economy and the market are qualitatively very different systems from our billiard ball example. They are both in essence descriptions of the cumulative behavior of vast populations of people, which is, I suspect, at least somewhat of a chaotic system, and also a system that changes very significantly over time. After all, can we really be comfortable thinking that the rules of behavior of even vast populations will be the same when (i) we add the Internet and computer revolutions, (ii) we subtract the Cold War and the threat of imminent global destruction, (iii) we add distance from the two Great Wars, (iv) we add incredible innovations such as Pop Tarts and catsup in upside-down jars, (v) we add women to the workforce in mass numbers and equalize to some extent the rights of minorities, in the workplace and elsewhere, (vi) we add computerized trading, (vii) we move the Baby Boomers up through the age curve, etc., etc.?

I submit that our data base is far too small to describe these incredibly complex, possibly chaotic systems adequately, and also that in fact these systems change so much, and so rapidly, that the data set is highly unreliable. Thus, for example, when we see a black swan event, it often is not really a black swan event; instead it is just the behavior of a system that has evolved so much it can fairly be described as being a new system, with different rules.

And possibly this is one reason why John Hussman has been so consistently wrong while also being so consistently intelligent and careful. Possibly his fundamental premise – his methodology – is flawed.

Allow me to enter a counter-argument to my own argument, however. As pointed out by a poster named Aleax on the paid boards, the eminent Jeremy Siegel has concluded, after careful research, that yearly total real market returns after appropriate adjustments “have not deviated much from 6.6% over a couple centuries,” suggesting fairly strongly that it does make sense to compare market behaviors at different times.

The evidence is before you. Now you, the jury, must decide . . . . 

8 Comments – Post Your Own

#1) On May 31, 2013 at 8:59 PM, awallejr (35.47) wrote:

There will be haircuts

I suffered them in 2008-2009.  Then, however, is not now.  I guess I am in your Josh Peters camp.  I came close to capitulating  but just knew if I pulled out I wouldn't get my money back.  So I hung tough and finally feel comfortable with my portfolio.  It is doing what I wanted it to do as I said in my very first blog here.

All of us could probably look back on their lives and recall "pivotal" decisions that had dramatic effects on one's life.  One of them for me was in March 2008 where I was about to tie up my money in a 1 year CD but decided to put it into the market instead. What a difference a year would have made.

Another pivotal decision was my deciding to hang tough. And so with my dwindled portfolio I retooled it, still made a couple errors, but am fine with it now.

There will always be naysayers.  That is good since they force us to always examine our decisions.  But the market is not overpriced.  It could use a breather.  Companies' balance sheets are solid.  You have a very accommodating FED. Housing is coming back.  We have tons of available energy.

My biggest concern is Washington. 

As for QE and Bernanke, people always love to make chilling predictions.  Without his action this country would be mired in a deep depression.  Absent some stellar future numbers, he isn't raising interest rates.  Tapering, perhaps late this year but even then I doubt it.  If he is not seeking another term he won't make any policy changes.  He will pass that off to his successor which I predict will be Janet Yellin.  And she might be even more dovish than Uncle Ben.

People always cry "how can the FED unwind it's balance sheet without wrecking havoc."  Except they are buying SELF-AMORTIZING paper.  They don't NEED to do anything absent runaway inflation.

I do agree with you about the value of "back testing." My biggest argument with technical predictions is it often compares apples to oranges, although I do think limited technical charts have some value (like overbought/oversold conditions).

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#2) On May 31, 2013 at 11:07 PM, awallejr (35.47) wrote:

K watching Cramer now, please ignore "Tuesday Dallas FED speech." Listen to Yellin.

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#3) On June 01, 2013 at 1:04 AM, jiltin (46.10) wrote:

Awallejr, well said "Without his action this country would be mired in a deep depression".

 There may be many dislike this kind of statement, but I believe he made it so far.



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#4) On June 01, 2013 at 11:29 AM, aleax (53.69) wrote:

Hi ADD, great post as usual (and tx for quoting me re Siegel's 6.6% "constant"!-).  However, Buffett amply addressed the `coin-flipping context` hypotheses almost 20 years ago -- surely you've read (if not, rush to do so -- if you have, re-read it, it's one of those classics that need to be re-read every few years to gain more new insights every time).

The continuing great results of these value-focused investors across 20 years of bulls and bears only strengthen Warren's arguments.

Sure, past performance is no guarantee of future results -- the sun might fail to rise tomorrow even though it always previously did -- but, would you bet on that, really...?

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#5) On June 01, 2013 at 6:03 PM, ikkyu2 (98.09) wrote:

There will be haircuts  Always true.

I have seen the varmint, and he is heading our way again  Always true.

We are doomed  Backtest this statement.  It hasn't been true since the Italian Renaissance.

Now.  What good are always-true statements?  They are no good unless they are investable.  With my apologies to your mother, let me give you an example:

"The varmint is headed our way again."  Not investible.

"The varmint is headed our way again, and he will strike on Sep 13, 2013, upon which day, the market will fall 20%."  Investible.

People - smart people - have observed that equity stocks in companies that produce valuable goods and services, over time, tend to outperform other investments.  From my perspective I am giving this an 'always true.'

But under what circumstance is that statement always true?  It's always true if you stay invested in stocks .  Pretty much it's not expected to be true if you pop in and out of stocks, incurring frictional costs, staying in for declines, popping out and missing rallies.  If you goof around with trying to time the market in equity stocks, you are out on a limb, out on your own; and you do not have the statistics about staying invested in equity stocks on your side.

That is why it's so important, when evaluating statements like "the varmint is coming," to evaluate them on the basis of whether or not they make an investible statement.  Here are some questions to help with that evaluation:  

1)  Can I take an action based upon this statement that would make me money if the statement is true?

2)  If so, is that action that I could take consistent with my own investment principles?  (For instance, if the answer to #1 is based on market timing, do I embrace market timing as one of my investment principles?)

I have spent a lot of time thinking about these issues, as the original poster has, so I hope my comment is helpful to others. 

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#6) On June 01, 2013 at 6:16 PM, constructive (99.97) wrote:

My granny's perspective was when life hands you varmints, make varmint stew.

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#7) On June 03, 2013 at 1:36 AM, Option1307 (30.68) wrote:

Excellent thoughts!

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#8) On June 04, 2013 at 3:25 PM, Zack907 (< 20) wrote:

I started a comment, but it got so long I decided to turn it into a blog.

The main point was that instead of a billards comparison for using back testing, you should use blackjack. The market and blackjack are both changing, but the overarching rules on how to make money remain the same. A stock is still a business and requires earning to make a profit. The price/ the profits it will make is what counts.  

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