Kevin Armstrong’s Strategy Thoughts
February 2013
Comfortable Company or Anxious Isolation, Which should an investor choose?
Introduction
I have frequently commented that ‘comfort and success rarely go hand in hand in investing’. This does not mean that one should always seek to do the opposite of what everyone else is doing, just to be uncomfortable and different for the sake of being different. Primarily this is because at no time will absolutely everyone else be doing the same thing, they can’t be, in any market for every buyer there always has to be a seller. However, at extremes of either optimism or pessimism it is vital that an investor recognise that extreme and be prepared to adopt a contrary, and by definition uncomfortable, position. By definition that will be uncomfortable, it will require going against whatever the then prevailing conventional wisdom may be and in a rising market will result in missed opportunities to pick up what the majority will be describing as ‘obvious’ and ‘easy’ returns. The reverse will be true as the troughs of bear markets approach and this discomfort will almost certainly endure for an extended period. This extended period will ‘test’ the resolve and intestinal fortitude of the contrarian that by then may be considering abandoning their ‘anxious isolation’ in favour of the alternative of ‘comfortable company’. This temptation to capitulate must be overcome if the investor is going to achieve true success, hence comfort and success often do not go hand in hand in investing.
Over the last dozen years or so there have been several critical turning points for investors to recognise if they were not going to merely endure a repeated whipsawing at the hands of the markets. In the late nineties it took great courage not to believe in the ‘new era’. In 2002 and early 2003 with markets down fifty percent or more anyone doubting the IMF’s outlook for economic ‘stagnation’ seemed crazy, similarly the same organisations extreme optimism throughout 2007 and into 2008 provided comfort to the majority who wanted to extrapolate the prior four years gains further into the future. Most recently anyone forecasting a cyclical bull market in early 2009 was ridiculed given the ‘end of the financial world as we know it’ attitude that prevailed at the time. A similar attitudinal extreme is now building resulting in extreme discomfort for the dwindling number of cautious contrarians.
The last eight months, since the June 2012 lows, during which the US markets have risen about fifteen percent, with the brief exception of the October / November sell off, has been one of those periods when my own extremely ‘anxious’ outlook has become increasingly uncomfortable and it has certainly become an increasingly ‘isolationist’ view. And the almost parabolic rise seen in markets since the beginning of the year has only served to increase that discomfort. However, now is not the time to seek the comfort of the growing bullish consensus, now is the time for a disciplined adherence to core investment beliefs, no matter how uncomfortable they may become.
In this month’s Strategy Thoughts I will illustrate just how extreme the consensus has become, I will also revisit Apple, and what its bear market may be telling investors and finally I will expand on some comments I made a couple of months ago regarding ‘Active share’.
Extremes
Two months ago, in the December 2012 edition of Strategy Thoughts, I quoted the US fund manager John Hussman to illustrate why one should be cautious. Hussman is an investor whose writings I have followed for many years and whilst he looks at markets in a quite different way to me, in that he frequently describes things in a highly complex and academic manner from an economic standpoint, his longer term outlook that aims to identify secular rather than cyclical moves in markets is one that I relate to. He looks to outperform over an entire cycle and so not to be whipsawed by cyclical swings.
In his weekly commentary dated the 28th January he provided a chart that neatly displays why one should be cautious. The chart below shows the US market going back to the 1970s, overlaid upon the chart are blue bars that illustrate periods that Hussman describes as; overvalued, overbought, overbullish and rising yields.
He measures those attributes as follows; Overvalued is when the cyclically adjusted P/E, or Shiller P/E, exceeds 18, overbought is when the market is within 3% of its upper Bollinger band over daily, weekly and monthly resolutions and more than fifty percent above its four year low (this is a measure driven by plotting a band plus or minus two standard deviations from the current price), overbullish is when the two weekly average of advisory bullishness, as measured by Investors Intelligence, is greater than 52% and bearishness is less than 28%, and finally rising yields kick in when the ten year Treasury bond yield is higher than it was six months earlier.
Over the last forty three years all these conditions have occurred simultaneously on only five prior occasions; 1972, 1987, 2000, 2007 and 2011. Subsequently the market fell 50% in 1972, suffered the worst crash since the 1920s in 1987, fell in half in both 2000 and 2007 and suffered an almost 20% decline in 2011. As can be seen on the chart all those conditions are once more in place.
A change in attitudes amongst individual investors, no doubt driven by the seemingly relentless rise in the markets, has been picked up by the mainstream media. On Sunday the 25th January the New York Times ran the following headline;
"As Worries Ebb, Small Investors Propel Markets."
The article began;
Americans seem to be falling in love with stocks again. Millions of people all but abandoned the market after the 2008 financial crisis, but now individual investors are pouring more money than they have in years into stock mutual funds. The flood, prompted by fading economic threats and better news on housing and jobs, has helped propel the broad market to within striking distance of its highest nominal level ever.
This change in attitude that the New York Times was describing is part of the ‘overbullish’ feature that Hussman was highlighting and it is not just the Times that has noticed this shift. Forbes reported on the latest survey results from the American Association of Individual Investors (AAII);
AAII Sentiment: Bullish Sentiment Reaches Two-Year High
The article went on to describe how in the latest weekly survey of individual investors bullish sentiment rose 8.4% on the week to 52.3% bulls, the highest reading since early 2011, and the number of bears ‘plunged’ 5.3% to 23.4%, the lowest reading in almost a year.
None of this means that markets should reverse immediately but it does highlight that attitudes are shifting and the comfortably bullish consensus is growing and this trend is not only being seen in the US.
Bullish Expectations Internationally
Ahead of the recent World Economic Forum, in Davos Switzerland, Bloomberg ran the following headline on 23rd January;
Investors Are Most Optimistic on Stocks in 3 1/2 Years
The story went on to describe an international trend very similar to that reported by Forbes in the US and highlighted by John Hussman;
International investors are the most bullish on stocks in at least 3 1/2 years, with close to two- thirds planning to raise their holdings of equities during the next six months, according to a Bloomberg survey.
The article went on to point out that the global economy was in “its best shape since May 2011.”
What the authors failed to point out was that the last time the global economy was apparently this good, or better, was immediately prior to an almost thirty percent bear market in just five months in the Global Dow Index. It must be remembered that markets always peak when everything seems great, because at such a time expectations have understandably been raised and the scope for disappointment is huge. With optimism, at least on some measure, as high as it has been since the bull market began, investors must realise that the risk of disappointment and so a decline in markets, has increased dramatically. It certainly has not decreased.
It is also valuable to take a slightly longer term perspective, and to also look at some sentiment readings that have in the past been a little more prescient. Last November I described how the Conference Board’s survey of CEO’s confidence had shown some anticipation of prior market peaks, whereas consumer confidence surveys tended to be quite lagging indicators for the market. The latest quarterly release from the Conference Board continues to show a reading below 50%, indicating more negative than positive responses, well down from the levels seen in the first couple of years of the bull market in 2010 and 2011. Interestingly the same is true of the global Dow, as shown below.
At the same time as the media was focussing upon Davos PWC reported the results of their latest annual global survey of CEO confidence and this should not be seen as encouraging to the growing number of rampant bulls. Again this survey seems to be closer to a leading indicator than any of the more widely followed consumer confidence surveys. The survey is conducted in the last few months each year and reported in January of the following year, so there is some lag in the results coming out, nonetheless they have been fairly indicative of the cyclical position of markets.
The 2003 survey, conducted late in 2002, showed a very depressed outlook with a reading of just 26% of respondents very confident about the prospects of revenue growth over the next twelve months. That was the trough reading as by late 2003 the number had risen to 31% and continued to rise, with markets, right through to late 2006 when the measure peaked at 52% (reported as the 2007 number in early 2007). By late 2007, when markets had only just started what was at the time dismissed as a correction, even that oxymoron a ‘healthy correction’ the survey had rolled over. It then plunged through 2008 to a new low of just 21%. However, by the time of the next survey in late 2009 the survey reading was once again rising, and continued to rise for another year with the peak result, to date, for the last cyclical bull market having been reported in early 2011 at 48%, just below the peak of the prior cyclical bull market. Since then the readings have declined to the most recent result of 36%.
These CEO surveys seem fairly consistent in at least reflecting the current position of markets and at times heralding a reversal. They are also consistent with the idea that confidence levels generally peak at lower levels with each subsequent cyclical peak as a secular bear market progresses.
Whilst an increasing number of indices have recorded minor new highs the peak in the Global Dow, back in early 2011 when CEO confidence also peaked, may well ultimately be seen as the actual peak of the last cyclical bull market and that all that has happened since are merely bear market rallies that have finally delivered the optimism amongst the majority typically seen at a peak.
Getting back to Davos and the World economic forum, the headline that investors are as confident as they have been in three and a half years should be compared to the message coming out of Davos four years ago. Then the Bloomberg headline was;
Grimmest Davos ever brings anger, finger pointing at bankers
Quotes within that article included; ‘Everyone I spoke to says it’s the grimmest Davos they’ve ever been to’ ‘we’re in a multiyear problem, the mood is very depressed. It’s a low burn depression.’
Quite a contrast. Late January 2009 will be looked back upon as a time when everyone should have been jumping into risk assets aggressively. They weren’t, they were petrified, the VIX index of volatility was at incredibly high levels in the mid 40’s, markets had been collapsing for a year and a half and everyone knew what was wrong with the world. Now, the VIX is at 12.5, a low level not seen since 2007, markets have been rallying and there is a growing belief that central banks have fixed the world’s problems and this is reflected in the complacent bullishness that has emerged.
Hedge fund manager Doug Kass publishes a list of potential surprises each year and this year, based upon the generally upbeat consensus view held by strategists, he sees the potential for far more disappointments than positive surprises. In assessing what the consensus view for 2013 was he wrote;
‘As we enter 2013, investors and strategists are again grouped in a narrow consensus on economic growth (+2% real GDP), bond yields (higher) and year-end 2013 closing stock market price targets (on average at about 1575, a gain of 10%). U.S. monetary policy is now effectively shooting blanks, and fiscal policy will now turn to be a drag on growth. Moreover, the likely reluctance and inertia by our leaders in addressing our budget will continue to turn off the individual investor class to stocks this year. Finally, my ursine tone is also a reflection that, by most measures, the U.S. stock market is not meaningfully undervalued and that given the dynamic of the headwinds of slowing economic growth, a poor profit outlook and the developing weakness of policy are unlikely to be revalued upward in 2013 (as many strategists suggest).’
I certainly share his concern regarding what the complacent consensus is and where the greatest risk of surprise lies.
‘Wall of Worry’, revisited
I continue to believe that the peak of the ‘Wall of Worry’, or the summit of the last cyclical bull market, for the average market in the world was seen in the first half of 2011. That was the peak in the index of the Global Dow, as shown in the chart on the previous page. What has been since then has been the start of the next cyclical bear market and a substantial bear market rally. Nonetheless, for a number of important markets in the world, notably the US, the recent strength has seen new recovery highs in the major indices and so I must concede that their bull markets did not end almost two years ago. However, some longer term perspective as to what has been delivered since early 2011 is probably of value given the hype and excitement that the very recent strength has garnered and the marked attitudinal shift that has resulted.
The UK market recorded its 2011 peak in February of that year since when the FTSE index has risen just 3% on balance over the intervening twenty three months. In Germany the peak came in May of 2011 and over the last twenty months since then the DAX has also risen just 3%. The CAC in France peaked at the same time as the FTSE, February 2011, since when it has fallen 10%. In Korea the picture is very similar to France, the KOSPI is down 13% since the index peaked in April of 2011. In Hong Kong the Hang Seng index is down 5% since its November 2010 peak and the Singapore market peaked at the same time and is still fractionally below that peak. In Japan the Nikkei peaked earlier still, in April of 2010, and despite its recent rally is still 4% below that bull market peak. The Australian market remains 3% below its April 2011 high and finally the Chinese index remains 30% below the high it recorded all the way back in the second half of 2009.
Given all the above it is perhaps surprising that bullishness has rushed back quite as dramatically as it has, nonetheless it has and this should raise a cautionary flag for all investors.
Finally, for those markets that have recorded new bull market highs, and so are still climbing the ‘Wall of Worry’ it is important to remember just how the analogy works. It is not that at a market peak there is nothing to worry about, although the New York Times article quoted earlier appears to imply that there is now far less to worry about, what happens at a market peak is the majority of investors choose not to worry about anything and only see the positive in any news that comes out.
Perhaps the most intriguing aspect of the recent strength in markets is that it has all been achieved without the help of the bull markets most sensational stock, Apple.
Apple
From September last year through to January this year Apple’s share price fell from $705 down to below $450. This 36% decline, while the market rose slightly, has been the first period of marked underperformance by the stock in more than five years. What is remarkable is that the general attitude towards the stock by investors continues to be very positive. According to Yahoo there has only been one downgrade of the company by an industry analyst throughout the period of its fall, and that was on January 28th when it had already fallen 36% and the average rating continues to be somewhere between a strong buy and an outperform. One reaction that alarmed (and amused) me the most came from the analyst who in late April last year published the highest price target yet for the company; $1111, this was an increase from his prior highest target of $1001, at the time the stock price was $615. In the wake of the fall that has now been suffered the same analyst has lowered his target to $888, a large cut but still looking for the stock to almost double, this is actually even more aggressive than his prior target was as that was only looking for the stock to rise another 80%. This was all more amusing than alarming, what I found most alarming was that he described the price action since September as having been a ‘pullback’. This has to be one of the greatest understatements ever about such a widely followed stock. By comparison, over a similar length of time, from August 1987 to December 1987, the US market fell an almost identical 36%. No one was talking about the ‘pullback’ that the market had suffered then, no, previously bullish attitudes had been decimated and expectations were through the floor which is why the market was able to rise in a remarkable bull market over more than the next decade. Expectations, and hype, about Apple probably have further to fall.
I first wrote about the phenomenon that was Apple ten months ago, partially prompted by the sensational targets that the stocks already remarkable performance was spawning, partially because it had become the biggest company in the world and partially because it had announced its first dividend for many years. I wrote in the April 2012 Strategy Thoughts;
Apple is not only the largest company in the world but it has now become the most closely followed. This obviously has some positive implications in that the more people follow a stock the more potential buyers there are, and there have undoubtedly been an enormous number of those given the spectacular run up the stock has enjoyed. However, there are draw backs as well as the article below from the associated press highlights;
Apple’s market clout likely to draw more scrutiny
Apple’s power, ambitions to dominate ‘post-PC’ era may attract more antitrust attention
By Michael Liedtke, AP Technology Writer | Associated Press 12th March 2012
In everything it does, from product design to business deals, Apple strives for as much control as possible. But as the world’s most valuable company sets out to define and dominate the rapidly evolving markets it created with the iPhone and the iPad, Apple is likely to face antitrust regulators who want to curb its power. Apple’s clout is coming under scrutiny as the U.S. Justice Department considers filing a lawsuit against the company and five U.S. publishers on allegations they orchestrated a price-fixing scheme on electronic books. The involved parties are trying to avoid a high-profile court battle by negotiating a settlement, according to The Wall Street Journal. The newspaper broke the news last week about the government’s plans to allege that Apple Inc. and the publishers tried to thwart e-book discounts offered by Amazon.com Inc. and drive up prices since the 2010 release of the iPad. "I think this might be a bit of a wake-up call for Apple," says Ted
Other companies that have achieved the stature of being the ‘biggest in the world’, notably Microsoft, have faced similar scrutiny. As I discussed in a Thoughts and Observations article, “Revisiting ‘How the Mighty Fall! Or, the curse of being biggest’” on the 13th February, being the biggest can gave its drawbacks. More importantly secular bear markets have not been kind to any company that achieves the ‘Biggest’ title.
This raises the question of; what could possibly go wrong for Apple? At first blush this seems to be a rather dumb question, everyone knows about the incredible innovation, the slew of new products, the amazing sales, the spectacular stock market performance, the fact that Steve Jobs’ passing seems to have been absorbed with barely a blip and now the dividend. The story is undoubtedly phenomenal and that is why the average rating by the 46 analysts that cover the stock, and are monitored by Thomson / First Call, is 1.7, where 1 is a buy and 5 is a sell. The average rating is somewhere between an outperform and a buy. Not only is Apple a great story, everyone agrees that it is a great story. As an investor one has to ask; how can it get any better, where is the next positive surprise going to come from. Perhaps there are more rabbits that they can pull out of the hat to attract an even wider audience of investors, but it must be getting harder.
Up until late September of last year it didn’t seem that anything could go wrong with Apple, the news was all good as the following headline from ABC News on the 18th September last year illustrates;
IPhone 5 Soaring Pre-Sales Lift Apple (AAPL)
The article started; ‘Just how high can Apple go?’
It seems that amid the excitement that was then Apple there were plenty who wanted to answer that question. The next day Yahoo ran a banner story under the headline;
Apple Shares to Hit $1,650 by Late 2015: Eric Jackson
Others saw 20% or 30% upside and there was a general scramble for analysts to get their targets ahead of the stock price. And despite the gains the most used adjective for the stock was; ‘inexpensive’.
Ever since then the stock has ‘pulledback’ in a spectacular and worrying fashion. Whether such a poor performance from what was undoubtedly the market’s darling and bellwether is telling investors anything only time will tell. However, it is of some concern to look back at earlier ‘biggest companies in the world’ and market bellwethers. In the second half of the 1960’s General Motors was the market bellwether. The stock hit its all time high in late 1965 and then collapsed by about 75% over the next nine years, dramatically underperforming the market. This heralded an end to the markets post war secular bull market and ushered in a secular bear market characterised by a series of cyclical bull and bear markets that resulted in a broad trading range.
Ultimately the market broke out to new recovery highs in 1982. It would be another twelve years before GM got back to its mid sixties high.
Activeshare revisited
In the December 2012 edition of Strategy Thoughts I included a section that explored the concept of ‘active share’. I concluded that section with the following;
‘an investor should not be paying active fees for a manager or adviser who opts to ‘hug’ the index in the pursuit of comfort. As the current secular bear market continues to unfold, and long term returns continue to disappoint, it is highly likely that ‘active share’ will become increasingly examined and discussed. In an environment of low returns active fees for comfort seeking passive management will not prove sustainable.’
At that time I had only just been introduced to the concept of ‘active share’ in a small article in Barron’s. Two months later my forecast that ‘active share’ would become increasingly examined and discussed seemed to be proved correct. Rather than the small story hidden on the inside of Barron’s magazine last December the subject had become the cover story in the January 14th 2013 edition.
The concept of ‘active share’ was originally devised by two academics, Antti Petajisto and Martijn Cremers, who were intrigued by the accusations being made that large fund managers were closet indexers. The original article described ‘active share’ as follows;
Active share is a measure of the portion of a mutual fund’s holdings that differs from its benchmark index. In other words, it’s a measure of how actively managed your actively managed fund is. Stated as a percentage of the fund’s holdings, it takes into account both security selection and any overweighting or underweighting of the stocks in a fund versus the index. "One of the most important considerations when buying an actively managed fund is that you expect the fund to be substantially different from the index," Cremers says. "Active share tells you what percentage of the portfolio is different."
I highlighted the previous article because closet indexing and the desire to be not too different from the next fund manager or asset allocator are characteristics that have long troubled me about the asset management business. It is not that there is anything wrong with hugging an index, so long as you don’t charge active fees for it as there are now a myriad of products that can give an investor index performance at minimal cost. High fees for index hugging was one of the primary focuses of the recent cover story. ‘Active share’ has become mainstream and is now employed by major fund consultancies such as Morning star and Lipper. A few quotes from the article illustrate the importance and value of the concept;
“If nothing else, active share pulls back the kimono on managers who charge high fees for piggybacking the index. "It gives you a very quick and dirty indication of how active a fund is, relative to the index," says Michael Herbst, director of active-funds research at Morningstar.”
“Active share is no crystal ball, but that doesn’t take away from its significance, says Terry Dennison, U.S. director of consulting for Mercer Investments. Dog-eared, marked-up, and splattered with coffee stains, the Yale paper has a permanent spot on his desk, where it’s "within arm’s reach all the time," says Dennison, who has incorporated active share into the firm’s analysis of individual fund managers, as well as of entire portfolios. "High active share is no guarantee that a fund will outperform, but it is likely a necessary condition," he says. "You can’t beat the index if you look exactly like it."”
“"If you are a closet indexer charging high fees, you are doomed to fail. It’s almost impossible to win," Swedroe concedes, adding that "it doesn’t take a genius" to come to that conclusion. "But that doesn’t mean the odds are good of winning just because you have high active share."”
‘Active share’ is not a simple solution that will ensure consistently healthy and index beating returns, however, it is an important indication as to what fees an asset allocator or fund manager should be charging. Hopefully, as it becomes employed more widely, it will also encourage the industry to become less concerned about looking at what each other is doing and more focussed upon doing what they believe to be the absolutely best thing for their clients. Unfortunately it will likely take more of the frustrating trading range markets that have been suffered for the last thirteen years to bring such a change about.
Conclusions
Despite, and to a large extent because of, the rallies that have been seen since the beginning of the year my level of concern has only grown. Now is not the time to seek the comfort of what is now a swelling and increasingly complacent crowd that are jumping into equity markets. Now, as John Hussman highlights, is the time for caution. Equities are over bought, they are overvalued, investors, as hopefully I have illustrated, are over bullish and Treasury yields have certainly risen. The US thirty year Treasury yield is now almost 30% higher than it was in late July, 3.17% now compared to less than 2.5% then. I wrote in the October 2012 edition of Strategy Thoughts that ‘the chances of the low, seen in late July in ten year treasury yields, being an important long term secular low as very high.’ That continues to be my view and I still believe that capital preservation should be investors’ primary consideration through 2013, not chasing returns.
Kevin Armstrong
30th January 2013
Afterthought
I had planned to write a little this month about a book I just bought, however, space is limited and my comments on ‘The Signal and the Noise, The Art and Science of Prediction’ by statistician Nate Silver will have to wait a month. Silver gained his reputation by correctly forecasting 49 of the 50 states presidential votes in 2008 and in 2012 he was correct in all 50 plus the District of Columbia. The book was named Amazon’s nonfiction book of the year in 2012 and was on The New York Times best seller list. I have thoroughly enjoyed his refreshing take on predicting, especially his perspectives on the shortcomings of economic forecasts (particularly when compared to weather forecasters who he is quite complimentary about), and would highly recommend it. I aim to include some perspectives from the book next month
Disclaimer
The information presented in Kevin Armstrong’s Strategy Thoughts is provided for informational purposes only and is not to be considered as an offer or a solicitation to buy or sell particular securities. Information should not be interpreted as investment or personal investment advice or as an endorsement of individual securities. Always consult a financial adviser before making any investment decisions. The research herein does not have regard to specific investment objectives, financial situation and the particular needs of any specific individual who may read Kevin Armstrong’s Strategy Thoughts. The information is believed to be-but not guaranteed-to be accurate. Past performance is never a guarantee of future performance. Kevin Armstrong’s Strategy Thoughts nor its author accepts no responsibility for any losses or damages resulting from decisions made from or because of information within this publication. Investing and trading securities is always risky so you should do your own research before buying or selling securities.