Wednesday, February 1, 2017

Bogle Book, Indexing etc.

I have watched and listened to John Bogle for years and always thought he was great, but I never read any of his books. I understand his message and agree with him for the most part. But the other day while I was browsing the library, I came across this book and just grabbed it and decided to read it even though I have a big stack of books that I started and have yet to finish.




There is nothing new in here in terms of message (active managers don't outperform, costs is primary determinant of performance over time; low cost beats high cost in every category, every time period etc...), but it is still amazing to read with all the tables and facts laid out.

Every time non-industry people ask me about stocks and how to learn about them, I go through the usual books that we've all read. I noticed, though, that if they are not in the industry, or not a true market fanatic, people don't ever read the books you recommend.

I understand telling someone to read all of the Berkshire Hathaway letter to shareholders going back to 1977 (available for free, I tell them, at the BRK website) seems like such a tedious thing that no normal, non-financial person would actually do it.

From now on, I think, I will just direct them to this book. It's that good, and it would answer most questions I typically get in the usual 'cocktail party' conversation about markets.

As for stock picking, from now on, I will tell them to just pick stocks based on what you like and believe to be truly good businesses at reasonable valuations.  Even overpriced is OK as long as it is kept small and it's not bubble-like; compensate for the assumption of price risk by keeping dollar exposure low. But keep most of the equity exposure indexed (OK, BRK is fine too, but most people won't know what to do when something happens to Buffett, and may not want to deal with the volatility/uncertainty related to the headlines).

Expensive Stocks
Every once in a while, you just come across businesses that you think are just really, really great, as a customer and as a business analyst. For me, that was Chipotle Mexican Grill (CMG). I bought some a while ago and did very well with it, even selling out at the top once and buying back in at a low and then selling out again (most recently in late 2014).  I know others who have owned Starbucks (SBUX) forever, and I kick myself for not owning that one too. I go there way more often than I'd like to admit, and when you travel, there is never a SBUX anywhere that doesn't have a long line in the morning. And often, it's the only place to get a bagel and coffee.

(By the way, this section has nothing to do with the Bogle book!)

So, on those occasions where you actually see and verify for yourself a great business in action, and the price is reasonable, or even a little on the high side, I say go for it. Own it and hold it for as long as it's good. We value investors are usually afraid of high P/E stocks because we remember 1999/2000 and many high P/E disasters.

Value investors who run value funds might get into trouble owning such growth stocks, but for individuals managing their own money, why not?

I know this goes against the idea of having discipline, but if most of someone's equity exposure is indexed and they 'play' with a small portion of their portfolio on their own picks, it's probably not a bad idea.  Plus, those opportunities don't come up all that often. That's all the more reason to go for it.

Worse is actually going out and trying to find stocks that will go up; buying stuff that you have no idea about etc.  At least with some businesses, you have a strong idea about their competitive position etc. What you absolutely don't want to do is to bend that rule and overpay for things just because everyone says it's the next Chipotle,  Starbucks, Facebook or whatever.  Forget about those "this is the next..." stocks.  Only go for the ones that you really understand.  The "this is the next..." argument is a shortcut; it allows people to pump stocks with minimal bandwidth.  Who's adrenaline doesn't start to flow when you hear about the next CMG, or next Buffett?  (Well, I do some of that here...).

Market Timing
Bogle is also anti-market timing, and that's been a constant theme on this blog too. Market timing is a waste of time unless you are a Druckenmiller-type active trader. But market timing when you are supposed to be allocating assets / investing doesn't make much sense.

I was thinking of this the other day, seeing a lot of market-timers doing horribly in recent years. A lot of people have horrible performance because they were short the market for the past few years.

Gambler's Fallacy
And I realized that this "the market is expensive so it must go down. Therefore, I am short"-type manager is falling for the gambler's fallacy.  OK, well, not exactly.  With the gambler's fallacy, for example, if a coin toss results in heads ten times in a row, people tend to believe the next one must be tails. But the fact that the coin landed on heads ten times in a row doesn't affect the probability of the next coin toss.  Each coin toss is independent. Regardless of how many times you had heads in a row, the odds on the next flip is still 50/50.

In the stock market, this is not true. The higher the market goes, the more expensive it gets, and the lower the prospective returns will be.  So the probability distribution of going forward returns actually shifts lower; the probability of a loss increases as the market gets more expensive.

So this is not an accurate analogy. But for me, it still is interesting because when the stock market is expensive, my temptation is to ask, when the market is this expensive, what tends to happen in the following year?  Greenblatt does this and mentions it just about every time he is interviewed. And even in the past few years, using 30 years of data, I think, his prospective returns one year out from the then current valuation has always been positive.

Even many of the bears have long term expected returns that are positive, but just low. Yet they are short. Even more recently with negative long term expected returns, it is usually low negative. So maybe -2%/year or some such.  In that case, it's still better to invest in corporate bonds or other fixed income at something higher than that to earn a positive return than shorting the market.  What if the market went into a bubble like in 1999/2000? The stock market valuation is nowhere near that silliness. If the market did rally like that, it would put a lot of those bearish funds out of business.

Now, what are the odds of some sort of blow-off like that? Versus what are the chances of an imminent collapse/bear market? These are things that you usually don't hear about, and to me, are the more relevant statistics to look at if you insist on timing the market.  And I suspect those are some things that the more successful quant funds are good at evaluating (and therefore don't lose money being net short for multiple consecutive years!).

Hasty Generalization?
The other related and more precise fallacy is the fallacy of hasty generalization or maybe faulty causality. Actually, I'm not sure this is the right one, but let's use it. Initially I was thinking it was fallacy of composition, but my understanding is a little bit different there. I'm referring to the fallacy of assuming that since all bank-robbers had guns, that all gun-owners must be bank robbers.

We all look at these long term valuation charts and go, hey look!,  the market P/E was over 20x before 1929, 1987 and 1999! So, the thinking goes, the market is now over 20x P/E so a crash must be imminent! But then we tend not to look at all the people who own guns that are not bank robbers.

Also, when someone says that the stock market is 90% percentile to the expensive side, there is a tendency to want to believe that there is a 90% chance that the market will go down in the future. Well, if the market is 90% percentile to the expensive side over the past 100 years, then it means that the market will be valued at a lower level 90% of the time in the next 100 years if the same conditions occur.

Anyway, since I was so curious about the year-forward returns and was worried about the declining interest rate bias of Greenblatt's sample (as he uses the past 30 years), I decided to look at this data for myself.

First let's look at Greenblatt's time span. That would be starting around 1985 or 1986.

Just so we can actually see the data, I will use annual figures.  I will look at the P/E ratio (as reported) of the stock market at the beginning of the year and compare it to how the market did during that year (actually, the P/E ratio of the end of the previous year is used).

Using Greenblatt's time period and looking at years when the stock market started with a P/E ratio of over 20x, here are the results:

P/E level of over: 20
Number of up years: 11
Total # years: 15
Percent up years: 73.33%
Average change: 5.5%

DateP/Ereturn
1991.1224.3315.32%
1992.1222.829.85%
1993.1221.290.52%
1997.1224.2325.34%
1998.1231.5621.45%
1999.1229.66-5.70%
2000.1226.62-12.79%
2001.1246.37-20.06%
2002.1232.5922.11%
2003.1222.1712.77%
2004.1220.487.09%
2007.1222.35-38.75%
2008.1258.9829.08%
2009.1221.7813.86%
2014.1220.082.10%
2015.1223.74


The data excludes total return for 2016, but we know it was more than 11%, so the results would be even stronger.  From the above, when the market started the year with a P/E ratio of over 20x, the market was still up more than 70% of the time, for an average gain of 5.5%.  Sure, 5.5% is lower than the 10% or so long term average.

But if you own a fund that is short and is losing money with the market going up, it makes no sense. Actuarially speaking, it makes no sense to short the market just because the P/E ratio is over 20x.  Any middle schooler would know this is a bad bet to make.

Oh, and this only looks at the period since 1985. Interest rates have been declining so there has been a huge tailwind.  So let's look at the same table over a longer time period.

Here is the analysis using data since 1871:

P/E level of over: 20
Number of up years: 14
Total # years: 20
Percent up years: 70.0%
Average change: 5.9%

DateP/Ereturn
1894.1226.884.88%
1896.1220.1016.82%
1921.1225.2127.09%
1933.1222.66-2.61%
1961.1222.49-9.72%
1991.1224.3315.32%
1992.1222.829.85%
1993.1221.290.52%
1997.1224.2325.34%
1998.1231.5621.45%
1999.1229.66-5.70%
2000.1226.62-12.79%
2001.1246.37-20.06%
2002.1232.5922.11%
2003.1222.1712.77%
2004.1220.487.09%
2007.1222.35-38.75%
2008.1258.9829.08%
2009.1221.7813.86%
2014.1220.082.10%
2015.1223.74

And I was sort of surprised that using data that goes all the way back, the results aren't all that different. This includes periods of increasing and decreasing interest rates, so you can't say the data is biased due to a bond bull market tailwind. You can still argue that it is biased by a U.S. bull market tailwind, though.

So yes, my gambler's fallacy analogy is not accurate, but check it out. If someone says that the coin landed heads ten times in a row so the next flip must be tails, you'd think he is an idiot. But if you are short the market because the market is overvalued at 20+x P/E ratio, you are even more of an idiot because at least the coin flipper and real fallacious gambler has a 50% chance of being right whereas if you are short a 20x P/E market, you only have a 30% chance of being right!

That's kind of surprising.

What happens if we do the above with a 25x P/E threshold?

Since 1871:

P/E level of over: 25
Number of up years: 5
Total # years: 8
Percent up years: 62.5%
Average change: 8.3%

Since 1985:

P/E level of over: 25
Number of up years: 3
Total # years: 6
Percent up years: 50.0%
Average change: 5.7%

The average change is still up. Since 1985, the market was up only 50% of the time in years the market started at a 25x or higher P/E ratio. But these figures are questionable as there isn't enough data points to be significant.

Even the earlier figures are questionable with only 15 or 20 years in the sample size.

All Months, not just year-end
Just to be thorough, I reran all of the above using all months, not just year-end.  I looked at all months where the P/E ratio was over 20x or 25x and what the total return was 12 months later.

PE >= 20

Since 1871:
P/E level of over: 20
Number of up years: 139
Total # years: 223
Percent up years: 62.3%
Average change: 3.5%


Since 1985:
P/E level of over: 20
Number of up years: 111
Total # years: 162
Percent up years: 68.5%
Average change: 4.8%


PE >= 25

Since 1871:
P/E level of over: 25
Number of up years: 58
Total # years: 96
Percent up years: 60.4%
Average change: 5.1%

Since 1985:
P/E level of over: 25
Number of up years: 54
Total # years: 90
Percent up years: 60.0%
Average change: 5.2%

Using all months, you still get positive expected return with P/E's over 20x and 25x over the next 12 months, with the market rising 60%-70% of the time. I think markets are usually up 70% of the time, 12 months after any given month.

This sort of shows you why it doesn't make too much sense to point to an 'overvalued' stock market, go short and stay short. There are people who have been net short for years and it's amazing to think anyone would do so given the above statistics.

It also explains why Buffett and others can keep buying stocks even as many 'experts' claim the market is way overvalued and due for a correction. Buffett is a numbers and odds guy so I'm sure all of the above figures, at least intuitively, are in his head.

Anyway, the next time someone tells you that they are short because the market is expensive, run away! If they have your money, get it back.

But as usual, this is not to say that the market won't correct at some point. It will correct, as it always does.

Indexing
So, why am I advocating indexing here on a value investing, stock-pickers blog? I don't know. That's a good question. I do believe that most funds over time will not outperform the market so I do believe that indexing is probably right for most people. But do I believe that the market is totally efficient? Well, no. I am a big fan of Buffett, Greenblatt and many others who have outperformed over time.

The stats in Bogle's book are amazing. He shows how top performing funds almost always revert to the mean, even in the long term.

I was going to post more about this here, but this is already getting long and I would like to get this out, so my next post will be about funds, indexing and things like that. Just my random thoughts on the subject.

I was thinking about the above analysis and was playing around with Python and ended up writing a script to calculate all of that. I loved how Greenblatt always said the market is valued at so-and-so percentile and the going forward expected return from these levels is x%.  And he uses 30 years as his history and it always sort of nagged at me that the entire sample period was during a huge decline in interest rates. The above work sort of comforts me.

Trump
Oh yeah, and on Trump. Hmm.  What can I say. We live in interesting times. I binged House of Cards last year and loved it, but nowadays, it seems like truth is stranger than fiction (fiction has to make sense!).

Am I worried? Well, I am worried about all sorts of things, but although I may be wrong, I am not that worried about economic issues. I am not expecting some huge infrastructure binge or anything like that. All that was needed is just a leaning in the other direction from over-regulation. Just the lifting of some of that pressure, and not even a lot of deregulation, I think, is enough to lift business sentiment.

I am comforted by the fact that Trump is surrounding himself with people I respect (business world people, not the alt-right), and I hope they will be listened to.

As for the tweeting and big pronouncements, I do think a lot of that is posturing. He is a negotiator so it's to his advantage to start at the extreme and then work his way down.

At least that's my hope. That' what I hope he's doing. But we can't be sure.

We shall see.

19 comments:

  1. Truth is stranger than fiction. Well said.

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  2. When can I find historic PE ratios by month?

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    1. Hi, I use data from Shiller.
      http://www.econ.yale.edu/~shiller/data.htm

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  3. Really enjoyed your analysis. I would love to see the results if you run the analysis on the basis of Shiller-PE or another "better" indicator for overvaluation. Because what do high PEs in 2002.12 or 2008.12 really mean?

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    1. Good question. I tried to run it now but for some reason, the script is not reading in the correct csv; I will work on this later. I suspect, though, that the results may be similar. Why? Because the market has been 'overvalued' for a very long time and has done pretty well.

      Anyway, once I get it to run, I will probably put all of this on a single page in the 'scrapbook' section at brklninvestor.com. I will let you know when I put it up... I will try to do it within the next few days...

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    2. This is the same, annual version using CAPE10:
      P/E level of over: 20
      Number of up years: 23
      Total # years: 33
      Percent up years: 69.7%
      Average change: 5.2%

      ...and using 25x CAPE10 since 1871:
      P/E level of over: 25
      Number of up years: 9
      Total # years: 14
      Percent up years: 64.29%
      Average change: 4.5%

      so actually not that different. If you take it up to 30x CAPE10, then only late 1990's/2000 comes out, so becomes more or less a single data point...

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    3. OK, I did all the runs with CAPE10 and put it up at the website. Check it out here:
      http://brklninvestor.com/scrapbook/pe_fwd_returns.html

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    4. Wow, I did not expect this outcome. Thanks a lot!

      But I am not fully convinced:
      - I think average change might be a bit too much simplification, because it underweights the effect of big loss months/years
      - maybe it would be interesting to calculate the return on a 100$ investment if only invested in the <20 CAPE10 month. That means leave the market if overvalued and put everything back in if overvaluation has past
      - Compare the return to the buy and hold strategy
      - I would do this on a monthly basis, to have the better approximation to being invested

      Also, and I think this is important, one should maybe look at this from a 2009 point of view. Of course returns look a lot better when they are calculated at all time highs. But I would want to be right wenn there is a major depression.

      This might become an interesting series where you could test some other overvaluation indicators, like Buffets MarketCap/GDP indicator.

      I might have to change my current strategy if you are correct. Currently that is hedging my stockpicks by shorting the market while the market is "overvalued" from my point of view.

      But as I said, I am not convinced yet ;-) Even though this is really suprising to me.

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    5. Hi,
      This is only one simple look at it, but it does show sufficiently to me that it is not so smart to short the market just because the P/E is high. There is no doubt about that. There may be other reasons to short the market, though.

      As for a simulation to see if you can improve on a buy-and-hold based on P/E ratio, Damodaran did that and showed pretty definitively that getting out and holding cash when P/E is high and getting back in is a losing strategy. You can google it and find it somewhere, maybe on his blog. But the results were pretty clear and unambiguous.

      My analysis above was deliberately simple; I didn't play with various P/E levels, time periods and did not isolate specific events/periods, because doing so would risk back-fitting / over-fitting. I didn't want to tweak the data.

      As for large losses/depressions, again, since we can't know when it will happen (if at all), we can't really exclude, and the above results include ALL events; great depression, great recession etc.

      But since those events and large losses in general are so rare, looking at them alone would result in insufficient sample size to make any determination about anything; this is where many economists went wrong. They tried to model the great recession on the great depression and expected the same or similar outcomes. But the problem with that is that they were comparing a single event to another single event for a statistically meaningless comparison, not to mention a sort of Heisenberg-like (well, again, that's a little off in terms of analogy, lol) situation where the central banks used the depression as a model, specifically, to prevent a recurrence thus throwing off the forecasts of the doom-predictors.

      But anyway, go look for the Damodaran simulation. It's pretty interesting.

      There is a reason why Buffett has done so well over the past half century and I have been digging into trying to figure out why on this blog since it started, and the above post, I think, gets to one of the main factors of his success. He knew it from the beginning. The rest of us are still too worried and afraid that we take self-destructive measures to shoot ourselves in the foot!

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  4. Looks like someone created a Twitter account that is "reserved" for you. Financial Twitter was all excited for a moment, thinking you were joining.. In the bio of the account it says where you can email to claim the account if you decide to join Twitter.

    https://twitter.com/BrooklynInvest

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  5. How much down are the down years when the market starts the year as overvalued? After all if say 70% up years have an average 10% gain but the 30% ones have a 50% loss, then your expected gain is still negative and it still makes sense to short

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    Replies
    1. The average return is the average of both up and down years, so the 'expected' return is still positive in all above cases.

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  6. So I basically tell non-accredited/non qualified investors the same thing you write about. The argument I have against indexing is that: 1.It assumes people will stay rational during huge down drafts. 2. It does not account for "risk adjusted" returns.
    I've been fortunate to outperform the SPXTR for 8 years of audited returns with a 0/20% carry. Longer on an unaudited basis. I'm primarily managing my own capital with a few LP's. BUT, I always come to the conclusion that I would keep doing it for myself even if I underperformed. Why? The same two reasons:1. There have been many periods when I have had huge allocations to cash because nothing was cheap and things were frothy. 2. I personally need to be able to retest my thesis in a decline and I can't do that on 500 names. If you are 25 years old and going to be putting small sums away each year while you earn your living doing something else, then sure...You can set it and forget it. If you are 55 and investing your life savings without ever wanting to return to the grind....Not so much me thinks.

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    1. If you'er 55 and investing your life savings, why would the SP500 be a relevant benchmark? The name of the game becomes asset allocation well before one is 55 but you should still set it and forget it. If you have a 60/40 or 30/70 allocation, whatever, the point is in fact to stick with it under the assumption the AA is right for you from a return, income, and psychological standpoint.

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  7. Thanks as always for posting!

    I agree completely with the thought that
    "the next time someone tells you that they are short because the market is expensive, run away! If they have your money, get it back."

    Some years ago (maybe around 2005-2006) I compiled a bunch of data into excel and tried to see if I could predict negative returns on the S&P 500.

    My predictive factors were
    1) Market PE
    2) Interest rate levels and trends
    3) Price trends
    4) Yield curve

    So what I did was essentially just a more in-depth and curve-fitted version of the studies you cite above.

    And I couldn't forecast negative returns! It was pretty darn easy to predict whether the expected returns (on over 100 years of historical data) were high, medium, or low.

    But only with *extreme* curve fitting on specific factors could I predict about a 2% expected annual decline.

    And when I super-optimized the predictive model on a big chunk of the data and then applied it to the rest of the data as "out-of-sample" data, I found it impossible to predict actual market declines on the out-of-sample time periods.

    The lowest returns I could predict on out-of-sample data was +2% a year, and even that almost certainly benefited from the 'out-of-sample' still being a time period that I was familiar with even though I wasn't explicitly curve-fitting the model to it.

    And since it's proven that value investing gets most of its outperformance during weak markets, then a little stock selection could probably boost the +2% a year (or whatever the low expected returns were).

    All this is just me using a lot of words to say that it's clearly foolish to short the entire market.
    And yet some prominent investors like to do it!

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  8. Great Post and love the blog.

    Quick question: There's seems to be a difference depending on if the "P" was out of whack as opposed to when the "E" was depressed, as in the aftermath of the tech bubble and financial crisis. Did anyone pick up on that?

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    1. Good point. I did notice that, but once you start tweaking things, like taking out certain data points for certain reasons, it gets tricky and you start overfitting. If you go back to that time, you would have heard the same argument that the P/E is too high even on depressed earnings because there was a real belief that earnings can't come back due to the 'it's all over' mentality. Fed has run out of bullets, federal debt is too high so can't spend our way out etc.

      So if you eliminate those datapoints because we now know in hindsight that earnings and the economy did come back, that's sort of a problem too, right?

      P/E is now 25+, but some of that is due to the depressed earnings in the oil/energy/commodities/industrials area. So do we now exclude today too from the high P/E condition?

      So anyway, good point, but kind of tricky. That's why I left it at that with minimal tweaking and fitting...

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    2. I've seen 25-year historic data show fairly random next 12-month returns from various starting P/E ratios but if you take the returns out to a longer time period such as 60-months, a high P/E at the start tends to result in lower 60-month returns and vice versa (not always but usually, based on data from the past 25 years for what that's worth).

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    3. Even over the next 12 months, a higher P/E definitely leads to lower forward returns; no question about that. Long term average is 10%/year and the above results show returns below that; 5%, 8% etc... So that is true even for shorter time periods.

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