Tuesday, January 11, 2011

I feel their pain

It is a truism in investment management that often in our investment careers, our investment styles will be out of favor. I therefore winced when end of year client letters started filtering out and it was evident that the Value style was out of favor.

I have the greatest of respect for investors like Jeremy Grantham, John Hussman and David Rosenberg. However, when I read the following missive from John Hussman, it was evident that investment styles that focus on cash flows, earnings and valuation (i.e. Value), which tends to tilt towards higher quality stocks, was out of favor and Momentum and Speculation was dominant [my emphasis]
Through mid-September of 2010, the stock market was essentially a roller-coaster with no net gains for the year, but the final months saw a speculative burst that was heavily skewed toward cyclicals, small-caps, commodities, and shares characterized by low stability of earnings and high sensitivity to market risk. The Strategic Growth Fund finished the year with a slight loss of 3.62%. The loss resulted from our defense against an overvalued, overbought, overbullish, rising-yields condition coupled with a runup in risk assets that was still uncorrected as the year came to a close. While the decline was minor from a long-term perspective, it felt excruciating in the final weeks of 2010, as stocks characterized by low-quality, low yield and high risk persistently outperformed those ranked higher in quality, yield and stability.
Since I have a Value bias in my own genetic makeup, I had to wince when I read the above paragraph. Moreover, since Jeremy Grantham and his firm GMO has gone on record as favoring high quality US stocks, the same effect would have hurt their performance as well.

I feel their pain.

Evaluating your manager
Some investors have asked me what to do about their managers during periods of underperformance. My preferred method of manager evaluation has to do with how the manager communicates during these painful periods.

Does the manager stick to his guns? If so, did you hire that manager to fill that "style" slot in your portfolio? Hussman does an admirable job defending his style by pointing to his long-term record:
Our investment objective remains to outperform our benchmarks over complete market cycles (peak-to-peak, trough-to-trough, bull market plus bear market), with smaller periodic losses than a buy-and-hold strategy. In the Strategic Growth Fund, we've achieved that since inception, and over the complete market cycles we've observed since then - from the 2000 peak to the 2007 peak, from the 2002 trough to the 2009 trough, and from the 2007 peak to the recent highs. The challenge will be the cycle from the 2009 low to the next bear market low, whenever it arrives, but we'll rise to that challenge day to day.

Or does the manager change his stripes (which is a firing offense in many books)? Hussman manages to navigate the changes in his investment process well by describing them as "tweaks" (my words, not his):
To that end, we've introduced some new methods that broaden the range of Market Climates we define, and will allow us to accept moderate (possibly transitory) exposures to market fluctuations more frequently. The main focus of this research been on robust methods to integrate the information from multiple data sets and multiple time frames. We've extensively tested this approach to uncertainty, and expect that it will contribute to future performance.

The basic approach falls into the class of what are called "ensemble methods." Our investment positions continue to be driven by our most reliable measures of valuation, market action, sentiment, yield pressures and other variables, but rather than applying a single model over the full span of history, we can proliferate multiple models and evaluate them over numerous samples of history. In that way, we can measure not only risk (the spread between individual returns and the average outcome), but also uncertainty (the possibility that any particular model or view about the world is incorrect). Suppose we look at present market conditions. The more uniform the conclusions are about expected returns, regardless of how we slice the data, the more confidence we can have about investment exposure. In contrast, the wider the dispersion of conclusions about expected returns, the greater uncertainty there is, and the smaller the proportional exposure. In an environment where we remain skeptical that the underlying economic difficulties have vanished, I believe that this is our best response.
I am right and the market is wrong!
A greater concern is a manager who starts to write "I am right and the market is wrong" comments. Consider this account of how David Rosenberg "lost his cool" by picking through the data to show how his double-dip call was on the mark by telling his critics to "put that in your pipe and smoke it."
Were it anyone except for the statuture of someone like Rosenberg, I would be really concerned. These kinds of outbursts are either signs of cognitive dissonance, or a sign of capitulation for that investing style. Take your pick.
Sensible approaches, but beware the pain
I have written before that for buy-and-hold investors who want to adopt a portfolio style in this current volatile and low return environment, a focus on either high quality stocks or Rosenberg's SIRP (Safety and Income at a Reasonable Price) are sensible approaches. However, they will have to suffer through periods of underperformance as well as bear markets.
This is just one of those times.


I Will Never Accept The Terms of Service said...

Come on. At least by 200BC it was already received wisdom in the Mediterranean that "to everything there is a season".

That means when there is money to be made, the competent investor makes that money.

I want my fund manager to outperform the market at all times. Anyone dogmatic enough to sit in a losing position, and let it continue losing, while all around others are making money, shouldn't see his career in fund management last longer than 1 year.

If Hussman wants to continue sitting on his losing positions because he feels the market is wrong, fine. But he should lose his clients, or lose his job. The market has disproved his doom & gloom scenario all year. A hard and fast rule of investing is, if the market is disproving your theory, then the market is right and your theory is wrong.

Another hard and fast rule of investing is that you don't take a position until you've gotten a signal that it's time. Anyone who can't time their entry into the market shouldn't even be allowed to buy an index fund for their personal investment, much less manage other people's money.

It's fine to have a theory. It's fantastic to plan out that theory. But it's most important to wait until the market agrees with your little theory, and to keep your eyes open for signs that your little theory has taken hold. Until then, you're supposed to be making money.

If the market is saying "I really like this QE and QE2, I'm completely blind to the consequences, I'm going to inflate like crazy and blow a huge commodity bubble", then you're supposed to jump on and ride that pony til the ride is done.

Positioning oneself for a market crash 2 years before it happens isn't the sign of a genius, it's the sign of a dogmatic, arrogant fool who considers himself wiser than the market. Hussman looks clever every few years for a couple months when the market crashes. The rest of the time he's just a fool.

etindell said...

Hello Mr Terms,

Repeat after me:

"Hussman has outperformed the market"
"Hussman has outperformed the market"
"Hussman has outperformed the market"

WimpyInvestor said...

Can't believe your blog didn't make the Top 20 List -- Social Finance: The New Influentials.


Personally, I find many of the top 20 not very actionable / practical for every day investment decision making ... there are great for those interested in engaging in smart philosophical discussions on politics, economy, and investing.

The simple Inflation-Deflation Model (and well synthesized arguments to support the model indicator) beat the long theoretical discussions found in many of those popular blogs.

Please keep up with great work!