Nation Currently Experiencing Both Inflation AND Deflation

Here are some words of insight from Jeffrey Saut, who writes the Investment Strategy letter for Raymond James Financial:

In last week’s letter we suggested that the nation currently is experiencing both inflation AND deflation. Consider this, it appears that the country’s top quintile of wage-earners (the folks with the most assets) are experiencing deflation as their house prices have collapsed, their 401(k)s are substantially below where they were in October 2007, their bonuses have been “whacked,” and the list goes on. Meanwhile, the lower income households are experiencing inflation with their healthcare costs rising, food prices escalating, insurance premiums climbing, etc. In such an environment it is logical that Treasury Bonds would rally in the short-run. Longer term, however, we continue think inflation will win out over deflation, which is why we agree 30-year Treasury Bonds are a “bad bet.”

On the dollar, after being bearish from 4Q01 until 4Q07, we turned neutral to moderately bullish on the “buck” in November 2007. At first that “call” was wrong, then it was right, yet all said the Dollar Index is no lower, or higher, now than it was in November 2007. Hereto, over the longer term we think the greenback is likely headed lower. But as the economy recovers, so too should the dollar. Accordingly, in the short term, we remain neutral to slightly positive on the U.S. dollar.

Speaking to the stock market, we have, and continue, to argue that at the March 2009 “lows” stocks were three to four standard deviations below “norms;” and that all we have done is rally back to normalized valuations. Given the severity of the 17-month decline (October 2007 to March 2009), there is no reason why the equity markets can’t rally to one, or two, standard deviations above “norms.” Moreover, stocks don’t necessarily need outsized economic growth to rally. All they need is growth. As our friends at the consummate GaveKal organization, whose service we highly recommend, note:

“The reality is that equity markets do not need high growth to thrive – they just need some growth. In fact, one could argue that a low-growth environment is preferable to one of stellar growth, since low growth is often accompanied by low interest rates and plentiful liquidity. Today, this is the environment which we will likely face for years to come. The latest Beige Book does a good job of summing up this story: the quarterly Fed survey reported that wage and price pressures were non-existent, that retail spending is lackluster in most areas, and that manufacturing activity has moderately improved. This will likely be the story for the foreseeable future. Consumers and banks will remain cautious, but interest rates will stay low, allowing for a gradual recovery in output. This is an ideal environment for corporate profit growth and also helps to explain why equities keep creeping higher.”

And, last week stocks continued to “creep higher” with all of the indices we follow trading higher for the holiday-shortened week. That action left most of those indices at new rally reaction “highs,” putting even more pressure on underinvested money managers. A case in point was an article from a few weeks ago whereby a money manager disclosed that he still has 80% of his $850 million under management in cash. I read the article with both amazement and amusement. Amazement because I was surprised that any portfolio manager would admit he had that huge of a hoard of cash after more than a 50% rally from the March lows. Amusement because he probably allowed himself to be quoted believing that the September 1st Dow Downer, of 185 points, was the beginning of the long anticipated correction.

Mr. Saut’s recommendation:

Our answer to this dilemma, in the current environment, is to scale “buy” into large-cap, dividend-paying, stocks. Manifestly, stock returns are a function of corporate earnings, the price-to-earnings ratio investors are willing to pay for said earnings, and the dividends they receive over time from those stock investments. That’s all you really need to know about the stock market! To reiterate, “If, however, you don’t embrace our near-term caution, we suggest doing what the underinvested money managers are being forced to do – buy lower volatility stocks with dividends.

China Is a Fraud

A must-read by Jeff Clark writing in The Growth Stock Wire:

Is China cooking the books?

It’s a reasonable question. After all, we’ve exported many of our jobs and most of our manufacturing base to the People’s Republic… We might as well send them our accounting standards, too.

Every conspiracy theorist, most rational consumers who buy groceries for their families, and nearly all taxpayers suspect the U.S. government massages its economic statistics to make things look better (or less worse) than they actually are. China appears to be taking our lead, supported by the United Nations Conference on Trade and Development.

In a report released last Tuesday, the U.N. Conference estimated the Chinese economy would grow 7.8% this year, while the global economy is likely to decline. The obvious question here is… How does the world’s leading exporter of manufactured goods grow 8% while the rest of the world stops buying manufactured goods?

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Analysts’ recommendations ‘beat most funds’

From the Financial Times:

Broker stock picks can help investors outperform most mutual funds, research by one of the largest hedge funds has suggested.

While most asset managers have long dismissed analysts’ recommendations as anything but reliable, traders and academics at GLG – the $21.5bn London hedge fund manager – have found otherwise.

Based on a database of the daily recommendations it received from European brokers for the past four years, the hedge fund found that a portfolio following analysts’ tips, and holding them for three months, would outperform 75 per cent of mutual funds.

Such a portfolio delivered annualised returns of between 2.8 per cent and 6.4 per cent above benchmarks and after fees in each of those four years.

GLG said the research was some of the first to be conducted into the value of equity analysts’ calls since the scandals and subsequent reforms that rocked brokerages after the telecoms and tech bubble.

“When you look at the returns the average active manager tries to beat benchmarks by, we think the outperformance of recommendations is reasonably good,” said Sandy Rattray, an asset manager at the fund.

GLG’s findings were based on all the recommendations from salespeople at a range of European brokerages it had received since 2005, based on a single daily “pick” given to the fund from each.

Read the full story here

Montier: Seven Sins of Fund Management

Via SSRN. This is an interesting paper from James Montier that outlines what he considers to be the seven sins of fund management.

From the summary:

How can behavioural finance inform the investment process? We have taken a hypothetical ‘typical’ large fund management house and analysed their process. This collection of notes tries to explore some of the areas in which understanding psychology could radically alter the way they structure their businesses. The results may challenge some of your most deeply held beliefs.

► This collection of notes aims to explore some of the more obvious behavioural weaknesses inherent in the ‘average’ investment process.

► Seven sins (common mistakes) were identified. The first was placing forecasting at the very heart of the investment process. An enormous amount of evidence suggests that investors are generally hopeless at forecasting. So using forecasts as an integral part of the investment process is like tying one hand behind your back before you start.

► Secondly, investors seem to be obsessed with information. Instead of focusing on a few important factors (such as valuations and earnings quality), many investors spend countless hours trying to become experts about almost everything. The evidence suggests that in general more information just makes us increasingly over-confident rather than better at making decisions.

► Thirdly, the insistence of spending hours meeting company managements strikes us as bizarre from a psychological standpoint. We aren’t good at looking for information that will prove us to be wrong. So most of the time, these meetings are likely to be mutual love ins. Our ability to spot deception is also very poor, so we won’t even spot who is lying.

► Fourthly, many investors spend their time trying to ‘beat the gun’ as Keynes put it. Effectively, everyone thinks they can get in at the bottom and out at the top. However, this seems to be remarkably hubristic.

► Fifthly, many investors seem to end up trying to perform on very short time horizons and overtrade as a consequence. The average holding period for a stock on the NYSE is 11 months! This has nothing to do with investment, it is speculation, pure and simple.

► Penultimately, we all appear to be hardwired to accept stories. However, stories can be very misleading. Investors would be better served by looking at the facts, rather than getting sucked into a great (but often hollow) tale.

► And finally, many of the decisions taken by investors are the result of group interaction. Unfortunately groups are far more a behavioural panacea. In general, they amplify rather than alleviate the problems of decision making.

► Each of these sins seems to be a largely self imposed handicap when it comes to trying to outperform. Identifying the psychological flaws in the ‘average’ investment process is an important first step in trying to design a superior version that might just be more robust to behavioural biases.

You can read the paper here.

Ritholtz: Beware of Naive Contrarianism

Barry Ritholtz has a great post on being contrarian:

One thing you should consider when betting against the crowd: They tend to be right most of the time. There are a several things I disagree with in Surowiecki’s The Wisdom of Crowds, but the basic idea that crowds can determine outcomes is undeniable.

Indeed, markets are essentially the net result of the behavior of crowds. When asked why stocks were going down, the old trading desk joke is “More sellers than buyers.” That is as good a definition of a crowd as I’ve seen.

To better explain contrary thinking, I like to describe Wall Street and Markets as a sports stadium filled with fans. The better the team does, the louder the crowd cheers. The louder they cheer, the better the team does. Hence, markets have a large degree of self-fulfilling prophecy in the way they respond to crowd behavior.

Call it what you like — sentiment, reflexivity, feedback loop — for most of the time, the crowd not only determines market direction, IT IS market direction.

The secret to being a true contrarian is identifying when this excited (but orderly) crowd of cheering fans becomes a an unruly mob; Determining the point at which the fanatics become hooligans. Not throwing paper cups on the court, but overturning cars; When the Wisdom of Crowds becomes the Madness of Crowds.

That is when you short a raging bull market, buy into a crash. You hold your nose and make the purchase.

You can read the full post here.

Is The Market Rational?

This article ran in Fortune in 2002. If you never read it before, you should. If you have read it, it’s worth your time to read it again. It’s written by Justin Fox. He went to the University of Chicago to talk to Efficient Markets guru Eugene Fama and behavioral economist Richard Thaler. You can read the exchange below. Also, from this article, Justin wrote a recently published book that you should read. It’s called The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street

Is The Market Rational? No, say the experts. But neither are you–so don’t go thinking you can outsmart it.
By Justin Fox
December 9, 2002

Buy and hold. Diversify. Put your money in index funds. Pay attention to the one thing you can control–costs–and keep them as low as possible. Today that is pretty standard, if often unheeded, investment advice. Forty years ago it was revolutionary. The revolution started on college campuses, in particular at the University of Chicago, and it went by the unrevolutionary-sounding name “efficient markets.”

“In an efficient market,” wrote Chicago professor Eugene Fama in a landmark paper he delivered at the 1969 annual meeting of the American Finance Association, “prices ‘fully reflect’ available information.” That is, in an efficient market you can’t beat the market unless you have inside information. So why bother trying?

That logic led, among other things, to the creation of index funds that aim to mimic, not beat, the likes of the S&P 500 and the Wilshire 5000. Today such funds account for about 10% of total U.S. stock market capitalization, as well as 60% of what little money has flowed into equity mutual funds so far this year. But millions of small investors have continued to ignore the advice derived from efficient-markets theory, preferring instead to trade stocks and pile in and out of mutual funds in search of elusive market-beating returns (blowing much of their money on fees and commissions in the process).

Meanwhile, back on campus, a new generation of finance professors has been ripping Fama’s teachings to shreds. The organizing principle for this new breed of scholars is not efficient markets but something called behavioral finance. Behavioral finance teaches that stock market investors are irrational, that future stock price movements are at least partly predictable from past behavior, and that careful analysis of past trends and financial reports can pay off. Which happens to be the way most investors see the market already.

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Why Is September Bad for Stocks?

From Morningstar Advisor:

The answer to this question lies in Nassim Taleb’s bestseller Fooled by Randomness. If you haven’t read it (you should), let me sum up the book in one sentence: We humans have this amazing ability to see a pattern where there is none.

The three worst stock market crashes all happened in October. Do you see a pattern here? If you do, you are fooled by randomness. A sample size of three signifies nothing statistically. That does not prevent us from associating October with market crashes.

Now that this “pattern” is public knowledge, thanks to the financial media, guess what investors do in September? They sell. That’s why September is the worst month for stocks on average, even worse than the supposedly crash-prone October.

The Four Dirtiest Words in Trading

Brian Hunt, writing in the Growth Stock Wire, gives some very important advice: use stop losses!

I heard the four dirty words of trading last week…

My friend had recently purchased stock in a small oil company for around $20 per share. Things weren’t going well for the company, so its share value was down to $8 – a 60% loss for my friend.

Here’s what he said: “It will come back.”

I shuddered at his analysis of the situation. I shuddered at those four dirty words.

This is the mantra of stock market losers. If you catch yourself making this statement, immediately sell all your stocks and stick the cash in the bank.

You’ll be much better off financially if you do. You’ll also have a lot less stress in your life.

“It will come back” is a common reaction investors and traders have after seeing a stock fall 30%… 50%… or 70%. Most folks just can’t stand to admit they’re wrong. Saying “it will come back” allows them to convince themselves they aren’t wrong… just “early.”

It allows them to keep hope alive… and to ignore the elephant in the room: They need an absolutely huge, highly improbable gain just to break even.

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Arthur Zeikel “On Thinking”

These are two great quotes from Arthur Zeikel. Read these and truly think about them.

“Thinking, good thinking that is, is a lonely sport.  This may explain why so many of us do it so poorly.  Good thinking is also an inefficient process.  It takes a lot of thinking to come up with those few good, new ideas that are clearly worth thinking about – ideas that can be exploited in the marketplace.  Particularly, as Seldon so accurately noted in 1912, ‘Most coming events cast their shadow before, and it is on that intelligent speculation must be based.’

At the heart of the thinking process is the need to anticipate change correctly, and on a timely basis.  Investment thinkers must develop for themselves a model, or systematic perception, as to how markets really work.  Those believing strongly in the efficient market hypothesis are, of course, relieved of such undertakings.  However, as is becoming increasingly clear, portfolio theory does not fully explain security price movements, either here or abroad, or tell us too much about how to achieve better-than-average performance.  Most practitioners of active money management need to improve their thinking procedures.”

“The consensus view is usually wrong because it’s based on a more-or-less simple extrapolation of past trends and events and does not effectively incorporate change into expectations.  Theory tells us that value-changing events occur in a random fashion and cannot be predicted with any accuracy or consistency.  This is not so.  There is a flow to the news because there is a flow to the events that make the news.  Stock prices begin reflecting new developments before it is generally recognized that these developments have taken place.”

The Single Best Way to Beat the Market

This is a great article on investing by Dr. Scott Brown of Investment U.

For decades, economists and academics have tried to define exactly how the stock market works – and the best way to profit from its moves.

In the 1950s, one argument stated that short-term market activity results in the law of one price – i.e., that buying and selling mispriced shares of the same stock forces a single price to dominate.

Then came the “modern portfolio theory,” which claimed that investors simply couldn’t beat the market averages. This so-called “market efficiency theory” was the impetus behind the formation of the Vanguard 500 Index Fund (NYSE: VFINX) – the world’s largest mutual fund.

Score one for the stuffy “efficiency theorists.”

But while they congratulated each other over brandy and cigars, a little-known professor spoiled the party in the 1980s with a straightforward study that is still the driving force behind one of the most lucrative wealth-building approaches today…

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