Eric Peters: Today"s Opportunities Include Negative Convexity, Complexity, Illiquidity, Leverage, Or All The Above

From the latest Weekend Notes by Eric Peters, CIO of One River Asset Management

Anecdote

“What are the odds we come across an opportunity in the coming 4yrs to earn 20%?” the investor asked his team.

“High,” they answered. “The odds are 100%,” he said, having seen this movie a few times. “So our cost of capital is 5% per year (20% divided by 4yrs), plus the 1% we earn on cash,” he said. His team nodded.

“Under no circumstances should we deploy capital unless it earns well more than 6% per year from here on out.” It made sense.

“What do we see that earns more than this hurdle?” he asked. His team’s list was as short today as it was long in 2016, 2011, 2009, 2003, 1998, 1997, 1994, 1992, 1990, 1987, etc. Today’s few opportunities have much in common with previous peaks: negative convexity, complexity, illiquidity, leverage, and/or all the above.

“Investors confuse a 7.5% average annualized return target with a 7.5% annual return target,” he explained. “They’re entirely different things.”

Targeting average annualized returns allows you to accept what the market gives you, while targeting annual returns forces you to leverage investments near peak valuations to hit your bogey. “Typical pension and endowment boards want incoming investment returns to consistently exceed outgoing flows.”

So most investors attempt to produce the highest return every year, no matter what it takes. “But that’s the wrong objective. Never underestimate the value of cash and patience in achieving the real goal; superior returns over the complete cycle,” he explained.

“Markets tell you what to do if you listen,” he said. “Near the highs, few opportunities exist to earn substantial returns, so you should take little risk. Near the lows, opportunities to earn attractive returns are abundant.” You should take a lot of risk. “This sounds simple because it is. It’s obvious. But obvious is not easy.”

Goldman: The Last Time This Happened Was Just Months Before The Start Of The Great Depression

Ah Goldman, never change.

One week after Goldman"s chief equity strategist David Kostin predicted a three-year bull market of "rational exuberance", lifting his 2018 S&P price target from 2,500 to 2,850 rising to 3,100 in 2020, and stating that should the exuberance turn "irrational", the S&P could rise as high as 5,300 by the end of 2020, another Goldman strategist, Christian Mueller-Glissmann, has decided it may be a good idea to play bad cop and cover all bases.

And so, in a report released on Tuesday "The Balanced Bear - Part 1: Low(er) returns and latent drawdown risk" this now bearish Goldmanite warns that in the medium-term, the two likely scenarios are either i) a "slow pain" deflation scenario of low yields and high valuations "which persist as macro is stable but there are less windfall gains from rising valuations and less carry - as a result, returns are likely to be lower across assets", or ii) a "fast pain" drawdown scenario in which there is "either a material negative growth or inflation/rate shock, or a combination of both, which drives a drawdown in 60/40 portfolios."

For those confused, don"t worry - you read it right. While on one hand Goldman is predicting nothing but blue skies for the "medium-term" of the next three years, predicting no recession and double digit equity upside, at the very same time, the very same Goldman is also forecasting either a "slow" or "fast" pain scenario, which while different, share one thing in common (as the name implies): "pain."

No surprise, Goldman talking out of both sides of its mouth, the only question being while the client-facing "research" is obviously crap and meant to get clients to do the opposite of what Goldman"s prop traders are doing, it remains debatable on what side Goldman"s prop is axed. Is the bank pulling a CDO and shorting everything it sells to its clients, or has the bank assured further S&P upside, even as valuations no "longer make sense" to quote, well, Goldman?

We don"t know the answer, nor do we care. For those who do, here is Mueller-Glissmann summary:

We think a period of low(er) returns (scenario 1) is more likely than a full-fledged bear market in 60/40 portfolios (scenario 2), at least in the near term. But there will likely be a balancing act with slowing growth and rising inflation. And at current low yield levels and with the ‘beginning of the end of QE’, bonds might be less effective hedges for equities and are likely a larger drag on balanced portfolios. And rising inflation could move the central bank put ‘more out of the money’, requiring a larger ‘growth shock’ for central banks to ease policy. Also current easing options are more limited for central banks as rates are still low and QE purchases have only just been reduced.

 

And once the balanced bear comes, it might be larger and faster. Duration risk in bond markets is much higher this cycle and vol of vol in equities has increased since the mid-80s. While we think investors should lower duration and run higher equity allocations in scenario 1, they should consider hedging at least the risk of smaller equity drawdowns in the near term. We like shorter-dated S&P 500 put spreads. In part 2, we intend to explore different strategies to enhance balanced portfolio returns while managing drawdown risk in case of a bear market.

Ultimately, like every other forecast to come out of Goldman, it"s garbage: want bullish, read Kostin; want bearish - either a little or lot - stick to Glissman. Just remember to use your friendly, Goldman salesperson who will gladly collect the trade commission whatever you do.

That said, there was one useful data point in the 26 page pdf: a chart showing that not only are we nearing the longest 60/40 bull market without a 10% return drawdown, but that the last time we were here was sometime in the late 1920s... and the Great Depression would follow in just a few months.

As Goldman observes: "we are closing in on the longest 60/40 bull market in history - there has been no 10% drawdown in real terms since 2009. A passive long-only balanced portfolio has delivered attractive risk-adjusted returns since the 90s. A favourable ‘Goldilocks’ macro backdrop, supported by the ‘Great Moderation’ and the central bank put, has boosted returns in both equities and bonds. However, after the recent ‘bull market in everything’, valuations across assets are as expensive as they have been this century, which reduces the potential for returns and diversification in balanced portfolios.

Some more statistics:

We are nearing the longest bull market for balanced equity/bond portfolios in over a century - a simple 60/40 portfolio (60% S&P 500, 40% US 10-year bonds) has not had a drawdown of more than 10% since the GFC trough (8.7 years) and has delivered a 143% return (11% p.a.) since then.

And when was the last time a balance portfolio had such a tremendous return? Goldman answers again:

"The longest run has been during  the Roaring 20s, ending with the Great Depression. The second longest run was the post-war ‘Golden age’ in the 50s - the 90s Boom has been in third place but is now fourth, after the current run.

In other words, one would have to go back to some time in early 1929 to be looking at the kind of returns that a balanced "60/40" portfolio is generating today.  In fact, the current period of staggering returns without a 10% total drawdown is now 8.7 years. How long was the comparable period in the 1928s? 9.1 years. Which means that if history is any guide, the second great depression is just around the corner.

"Nightmare On Bond Street": HY Turmoil Leads To Third Largest Junk Outflow In History

Following this month"s drop in junk bond prices and the 40 bps spread widening in high yield last week - the largest since November 2016 - Bank of America has come up with an apt title for its weekly fund flow report: "Nightmare on Bond Street"...

... and with good reason: last week, US junk bond funds and ETFs reported a $4.43bn outflow this past week - the third largest outflow on record and the largest since August 2014. This follows a smaller $0.94Bn outflow the prior week. Non-US HY contributed an additional $2.3bn worth of redemptions, bringing the global junk outflow figure to -$6.7bn, also the 3rd largest ever.

The near record outflows accompanied the second most aggressive round of selling in the US junk bond market in 2017. The weakness in performance only trails a sell-off that occurred in March, when spreads widened by 61 points in less than three weeks according to FT.

“It was very much a flows driven sell-off last week and in the beginning of this week,” said Tim Schwarz, a credit analyst with Investec Asset Management. “We saw a lot of . . . pockets of illiquidity.”

According to EPFR, roughly half of the US HY withdrawals came last Friday, when more than $2bn left the space in one day. Since then, the outflows have been slowly declining each day, from $585mn on Monday to $494mn yesterday. Somewhat surprisingly, large outflows such as the most recent bout are not correlated with subsequently weak performance. In fact, out of the 15 largest-ever daily high yield outflows recorded, next 3 month returns have been positive 10 times, with an average annualized return of 7.2%. According to BofA, this is likely because most of the spread widening occurs just before the flood of withdrawals, providing an opportunity to capture excess returns should the selloff prove to be temporary. Indeed, as BofA"s credit strategist note, given Thurdsday"s strong secondary performance, "we think such is likely to be the case in last week"s episode as investors have once again embraced a buy-the-dip mentality."

In contrast, EPFR also reports that flows for other fixed income asset classes were relatively stable. However, the large outflows from high yield and loans resulted in a net $1.32bn outflow from all bond funds and ETFs, after a $2.27bn inflow in the prior week.

Inflows to high grade were little changed at $3.31bn, down from $3.41bn a week earlier. Inflows to short-term fixed income increased (to $0.65bn from $0.27bn) while inflows outside of short-term declined (to $2.66bn from $3.15bn). Inflows were higher for high grade funds (to $1.83bn from $1.52bn), but lower for ETFs (to $1.48bn from $1.89bn). Inflows to global EM bonds weakened to $2.66bn from $3.15bn, mostly driven by local currency funds / ETFs. Inflows to munis instead improved to $0.34bn from $0.28bn. Finally, inflows to money markets were close to flat at $0.02bn, down from a $7.58bn inflow in the prior week.

Speaking to the FT, Robert Cusack, a PM at WhaleRock Point Partners, said that the recent high-yield sell-off could be short lived, likening it to the brief but rapid move higher in credit premiums earlier this year. But Cusack added that he is still looking to reduce exposure to the asset class.

“It’s a topic each week in our investment committee meetings and we have been discussing the risk reward in high yield now,” he said. “Our next move is to reduce our exposure in high yield.”

Meanwhile, there were no problems in equity land: flows to stocks improved to a $3.2 billion inflow, which however once again masked an ongoing divergence, as $9.9bn of this amount went to ETFs. Active, i.e., human managers, saw another outflow, this time for $6.7 billion as the non-ETF financial sector continues to die a slow, painful death.

How To Beat The Market - Buy The F**king Tuesday

Authored by Dmitri Speck via Acting-Man.com,

Recurring Phenomena

Many market participants believe simple phenomena in the stock market are purely random events and cannot recur consistently. Indeed, there is probably no stock market “rule” that will remain valid forever.

However, there continue to be certain statistical phenomena in the stock market – even quite simple ones – that have shown a tendency to persist for very long time periods.

This chart illustrates a “rule that changed” – for eight decades (actually longer, but on this chart we can see the final eight decades during which the rule applied) the dividend yield on the S&P 500 Index would never fall much below 3%. Whenever that level was reached, everybody knew a correction or a bear market was imminent. This changed profoundly in the mid 1990s. The culprit: massive monetary inflation. [PT] – click to enlarge.

 

In today’s report I examine such a phenomenon: namely, the performance of the S&P 500 Index on individual days of the week.

Tuesday is a Particularly Strong Trading Day, Friday a Weak One

The chart below shows the annualized performance of the S&P 500 Index since the turn of the century in black, as well as the cumulative annualized return generated on individual days of the week in blue.

I have measured the price changes from close to close; thus the performance of e.g. Tuesday represents the difference between the closing level on Monday and the closing level on Tuesday.

S&P 500 Index, performance by individual days of the week, 2000 to 2017 – annualized.  Friday is on average a down day.

As you can see, two days are standing out in terms of positive performance: Thursday, and especially Tuesday. The cumulative return of the stock market on Tuesdays alone was actually better than the cumulative return  achieved on all five trading days combined!

By contrast, Friday was on average quite weak. On Mondays and Wednesdays the market by and large tended to move sideways on average.

The difference between these returns, which was measured over no less than 4,436 trading days, is statistically quite significant. This suggests we are unlikely to merely look at a random phenomenon [ed. note: even though it is not possible to actually explain it off the cuff, the statistical significance indicates that an explanation must exist. PT].

What do these data look like in specific market environments though, i.e., during bull and bear market periods?

The Days of the Week Under the Microscope

The next chart shows the performance of the S&P 500 Index since the turn of the century in black, as well as the cumulative return achieved on individual days of the week in other colors – all indexed to 100.

S&P 500 Index, cumulative returns by day of the week, 2000 – 2017, indexed.  Even in 2008 investing exclusively on Tuesdays ended up generating a gain! – click to enlarge.

Take a close look at the performances during the bear market after the year 2000 peak and in the course of the 2008 financial crisis. Even in these otherwise difficult times for the market, Tuesdays (red) and Thursdays (blue) delivered pretty decent results.

In 2008, the cumulative return generated on Tuesdays was actually significantly positive, in the face of an extremely bearish market trend!

In short, these two trading days are indeed rather extraordinary.

Combinations Improve Results

By investing only on Tuesdays, one would have been able to outperform the market over the entire period examined above. However, in rally periods, such as e.g. the rally beginning in 2009, the cumulative return achieved on Tuesdays lagged behind that of the trading week as a whole.

That should actually be expected, as strong gains require longer investment periods, and being invested just 20 percent of the time is simply unlikely to be enough.

This problem can be addressed by implementing combinations. As already illustrated by the first chart, overall, the S&P 500 Index has gained 2.95% annualized since 2000, while the cumulative gain of all trading sessions on Tuesdays was 3.19%.

Combinations can make a very big difference though. Investing on Tuesdays and Thursdays combined would have generated an annual return of 5.52%. If one had additionally sold the market short on Fridays, the annualized gain would have improved to 8.07% –  definitely an excellent result!

Combining Independent Factors Will Lead to More Stable and Reliable Returns

Alas, there is a drawback to this combination strategy as well: the returns generated on individual days of the week are interdependent. For instance, it may well happen that at some point in the future, in an otherwise slightly uptrending stock market, Tuesdays and Thursdays no longer deliver a strong return over the entire investment period, but turn out to be weak instead.

If that were to happen, it would be highly unlikely that the returns generated on Fridays would remain as weak as they have been to date. In short, all three partial components of the strategy would then exert an unfavorable effect on the overall investment result.

From a statistical perspective, it is therefore as a rule better to combine independent factors, such as those that can be found with the help of the Seasonax app (available on Bloomberg and/or Thomson-Reuters). The probability that what was valid in the past will continue to be valid in the future is higher that way.

PS: For now, you can probably relax on Mondays and enjoy the action on Tuesdays!

The "Big Lie" Of Market Indexes

Authored by Lance Roberts via RealInvestmentAdvice.com,

Last week, I received the following email from a reader which I thought was worth further discussion.

“In a recent article “Signs of Excess – Crowding and Innovation” Lance stated ‘Note the chart above is what has happened to a $100,000 investment in the S&P Index. While the S&P index has soared past previous highs, a $100,000 dollar investment has just recently gotten back to even. This demonstrates the important difference about the impact of losses on a dollar-based portfolio on investments versus a market-cap weighted phantom index.” – M. Fitzpatrick

It’s a great question.

Almost daily there is an article touting the soaring “bull market” which is currently hovering near its highest levels in history. The chart below is based on quarterly data back to 1990 and is nominal (not adjusted for inflation) which is how it is normally presented to investors.

The Big Lie

The “Big Lie” is that you can “beat an index” over an extended period of time.

You can’t, ever.

Let me explain.

While individuals are inundated with a plethora of opinions on why the index is moving up or down from one day to the next, a portfolio of dollars invested in the market is vastly different than the index itself. I have pointed out the problems of benchmarking previously stating:

1. The index contains no cash


2. It has no life expectancy requirements – but you do.


3. It does not have to compensate for distributions to meet living requirements – but you do.


4. It requires you to take on excess risk (potential for loss) in order to obtain equivalent performance – this is fine on the way up, but not on the way down.


5. It has no taxes, costs or other expenses associated with it – but you do.


6. It has the ability to substitute at no penalty – but you don’t.


7. It benefits from share buybacks – but you don’t.

Furthermore, it is also not representative what happens to real dollars invested in the financial markets which are impacted by changes in inflation. The chart below compares the break even times for the nominal index versus an inflation-adjusted index and $100,000 investment into the index.

You will notice in the $100,000 portfolio that investors, once the impact of inflation is added, just got back to even after 16-years of their investment time horizon was lost. The problem with that, as I noted in “The World’s Second Most Deceptive Chart” is the impact of life expectancy on reaching investment goals. To wit:

“For consistency from last week’s article, we will assume the average starting investment age is 35. We will also assume the holding period for stocks is equal to the life expectancy less the starting age. The chart below shows the calculation of total life expectancy (based on the average of males and females) from 1900-present, the average starting age of 35, and the resulting years until death. I have also overlaid the rolling average of the 20-year total, real returns and valuations.”

Here is what you should take away from the two graphs above. Assuming that an individual was 35 at the peak of “Dot.com” bubble, they are now 51 years of age and are no closer to their goals than they were 16 years ago. Assuming they will retire at 65, this leaves precious little time to reach their retirement goals. 

Of course, this is repeatedly proved out in survey after survey which shows a majority of Americans are woefully behind in their savings goals for retirement.

Of course, this is due to one of the most egregious investing “myths” in the financial world today:

“The power of compounding is the most powerful force in investing.” 

Markets Don’t Compound 

There is a massive difference between AVERAGE and ACTUAL returns on invested capital. The impact of losses, in any given year, destroys the annualized “compounding” effect of money.

The chart below shows the impact of losses on a portfolio as compared to the commonly perceived myth that investors “average 8%” annually in the stock market.

As you can see, while investors did finally get back to even by just “buying and holding” their investments, they are far short of the goals they needed to achieve financial security. The problem is due to the fact we “anchor” to our original “peak investment valuation” rather than our ultimate goal.

However, let’s take this one step further and look at a $1000 investment for each peak and trough valuation period with the assumption of a real, total return holding period until death based on life expectancy tables. No withdrawals were ever made. (Note: the periods from 1983 forward are still running as the investable life expectancy span is 40-plus years.)

The gold sloping line is the “promise” of 6% annualized compound returns. The blue line is what actually happened with invested capital from 35 years of age until death, with the bar chart at the bottom of each period showing the surplus or shortfall of the goal of 6% annualized returns.

Again, in every single case, at the point of death, the invested capital is short of the promised goal.

The difference between “close” to goal, and not, was the starting valuation level when investments were made.

This is why, as I discussed in “The Fatal Flaws In Your Retirement Plan,” that you must compensate for both starting period valuations and variability in returns when making future return assumptions. If you calculate your retirement plan using a 6% compounded growth rates (much less 8% or 10%) you WILL fall short of your goals. 

Hang On…That’s Not The End Of Story

There is one more calculation that needs to be accounted for that is too often left out of the “just buy an index because you can’t beat the index” meme.

Let me just state again, as noted above, NO ONE can beat an arbitrary, hypothetical, index. PERIOD.

Why?

Because of inflation, taxes, and expenses.

The chart below once again returns us to our $100,000 invested into the nominal index versus a $100,000 portfolio adjusted for “reality.”

$100,000 invested in 1998 has had a compounded annual growth rate of 6.72% on a nominal basis as compared to just a 4.39% rate when adjusted for reality. The numbers are far worse if you started in 2000 or 2008.

Furthermore, both numbers also fall far short of the promised 8% annualized rates of return often promised by the mainstream analysts promising riches if you just buy their investment product or service and hang on long enough.

The reality is, as proven repeatedly over time, such an outcome will likely prove to be extremely disappointing.

In order to win the long-term investing game, your portfolio should be built around the things that matter most to you.

– Capital preservation

– A rate of return sufficient to keep pace with the rate of inflation.

– Expectations based on realistic objectives.  (The market does not compound at 8%, 6% or 4%)

– Higher rates of return require an exponential increase in the underlying risk profile.  This tends to not work out well.

– You can replace lost capital – but you can’t replace lost time.  Time is a precious commodity that you cannot afford to waste.

– Portfolios are time-frame specific.  If you have a 5-years to retirement but build a portfolio with a 20-year time horizon (taking on more risk) the results will likely be disastrous.

As I wrote previously:

“The index is a mythical creature, like the Unicorn, and chasing it takes your focus off of what is most important – your money and your specific goals. Investing is not a competition and, as history shows, there are horrid consequences for treating it as such.”

So, do yourself a favor and forget about what the benchmark index does from one day to the next. Focus instead on matching your portfolio to your own personal goals, objectives, and time frames. In the long run, you may not beat the index but you are likely to achieve your own personal goals.

But isn’t that why you invested in the first place?

The Market Rig of the Last Two Weeks is Now Ending

The $USD/Yen prop is now actively being pulled.

For two weeks straight “somebody” was pinning stocks by ramping the $USD/ Yen pair. You can see the tight correlation between the two in the chart below.

This resulted in a one in 125 years event: a 10-day period in which stocks didn’t move more than 0.2%. And we’ve even had confirmation now that the last 15 days have seen the LEAST movement in stocks in history.

However, now that we’re on to their game, the rampers are giving up. The $USD/Yen pair is now breaking down in a big way.  

The downside target for this move will be 2,200 on the S&P 500.

And if the rampers REALLY let go, we’re looking at a much larger drop than that.

Are you ready?

We offer a FREE investment report outlining when the bubble will burst as well as what investments will pay out massive returns to investors when this happens. It"s called The Biggest Bubble of All Time (and three investment strategies to profit from it).

We made 1,000 copies to the general public.

Only 29 are left.

To pick up your FREE copy...

CLICK HERE!

Best Regards

Graham Summers

Chief Market Strategist

Phoenix Capital Research

"What Has Kept The Rally Going": Some Thoughts From Deutsche Bank

The relentless, steady, monotonous levitation to all time highs keeps chugging along: while last week saw the S&P experience its first 1% intraday move in nearly two months, there has yet to be a comparable move on the downside. As Deutsche Bank notes, pull backs of 3-5% in the S&P 500 are typical every 2 to 3 months historically. The last such pull back occurred just prior to the US presidential election. The 4 month uninterrupted rally since is now well above average and if it continues for another 2 weeks will put it in the top 10% of rallies by duration. At 14%, the size of the rally is also somewhat larger than the historical average between such pullbacks (+10%).

Incidentally, sell-offs of 5% or more occurred on average every 5 to 6 months. With the last one occurring after the Brexit vote, the 8 months since is also well above the historical average. If the rally continues past mid-April it will be in the top 10% by duration. In size, the 19% rally since then is also well above the 14% historical average

So while it is clear that the recent move is an outlier, the next question is what factors have kept the rally going. Here, Deutsche Bank offers several possible answers:

Strong equity inflows following large outflows and massive under-allocation. After stalling at the beginning of the year, US equity fund flows have resumed over the last 5 weeks. US equities have got $80bn of inflows since the election but from a slightly longer term perspective, under-allocation remains massive. Over the last two years cumulative outflows from US equities still stand at a large -$230bn compared to inflows of +$250bn to other developed market equities and +$310bn into bond funds. The direction and pace of equity inflows remains tightly tied to macro data surprises.

US equity fund positioning moved from under- to over-weight though has been pared since. From slightly underweight positioning at the start of the year, positioning rose steadily through January, then leveled off and over the last two weeks has been trimmed even as data surprises which tend to drive positioning have moved up, suggesting funds may already be anticipating a modest slowdown in data surprises

Buybacks remain solid but seasonal slowdown during the earnings blackout period is approaching. After a slowing in Q2 and Q3 last year, buybacks ramped up again in Q4 and the 2016 annual total ($460bn net) was in line with our forecast (Buybacks: Myths, Realities and the Outlook, Jan 2016). We see net buybacks rising in line with earnings growth and forecast $500bn in 2017. Our demand-supply model for equities points to buybacks continuing to provide steady support and by themselves imply 10% upside for the S&P 500 in 2017. However, the buyback blackout periods starting in two weeks should see the pace slow temporarily again.

DB then points out that from a fundamental perspective, the rally has kept going as data surprises skipped typical negative phase. With equity inflows and positioning both tending to follow data surprises, the fundamental reason for the long duration of the equity rally has been the unusually long period without sustained negative surprises. Data surprises generally alternate between positive and negative phases. This time around, however, they skipped a negative phase. After falling to neutral by the end of last year, DB"s index of US data surprises, the MAPI, hovered around neutral for the first 6 weeks of the year, then rose sharply again and moved back up to near a 4 year high. The MAPI has consequently been neutral or positive for the last 3.5 months.

Finally, while rates futures positioning remains very short an upside risk is that bond outflows
resume on strong data and rising rates. Leveraged fund shorts in
bond futures remain very large albeit off extremes while real money bond
funds are already neutral their benchmark. Bond funds have received
steady inflows this year but the historical relationship with rising
data surprises and rates suggests outflows to come.

* * *

That said, as Deutsche Bank pointed out recently, the global "economic surprise" rally is finally poised to roll over after hitting near record highs...

... primarily as a result of a loss in Chinese momentum and the slowdown, or in some cases outright drop, in commodity prices:

Deutsche also added the following warning:

We believe global macro momentum is likely to roll over from current elevated levels:

• Global macro surprises have only been higher 5% of the time since 2003 (when the data series starts), typically roll over from these elevated levels and have shown first signs of softening over the past week;


• Global PMIs are already consistent with global GDP growth 50bps above our economists’ 2017 growth forecasts of 3%, despite the fact that the latter incorporate aggressive assumptions for fiscal stimulus in the US;


• Chinese PMIs are already close to a six-year high, having rebounded by 7 points over the past 15 months. They point to quarterly annualized GDP growth of 8%+ (above the government’s target of 6.5%) and the credit impulse (a key driver of SoE fixed asset investment) is set to turn negative. This suggests the risk to Chinese growth momentum is now to the downside;


• Our model of global PMIs suggests global growth momentum has rebounded because of the easing in financial conditions due to tighter HY spreads and a reduced drag from USD strength as well as lower global uncertainty. However, it also implies that the rebound in growth momentum should start to fade, as the lagged benefit from falling commodity prices is wearing off.

So whether it is any of the above factors, or simply the influx of retail investors as JPM showed last weekend, coupled with an aggressive selloff by institutions and hedge funds, or an even simpler explanation - a relentless short squeeze - it is clear that while everyone has a theory to "explain" what is going on, nobody really knows, even though everyone can admit the duration of this latest market surge is anything but normal.

As such perhaps the best indicator of what to expect in terms of future returns may be the good, old Shiller CAPE. At 30x, the market has been at these valuations only 2% of the time in history, with future returns without fail being negative in the medium to long-run.

Of course, it is the short-run that everyone obsesses about these days, and as such, those betting on further upside may be wiser to just put their money in "Millennial momentum favorites" like Snapchat. At least there nobody pretends to even bother with such anachronistic concepts like "valuation."

Valuations Matter – Even For Millennial Investors

Submitted by Lance Roberts via RealInvestmentAdvice.com,

A friend reached out to me today and asked me a simple question:

“If the average person gets a $3000 tax refund every year and then invests the refund into the S&P 500, what would their end result look like?” 

No problem. All we need to do is make a few quick assumptions.

1. Historically, going back to 1900, using Robert Shiller’s historical data, the market has averaged, more or less, 10% annually on a total return basis. Of that 10%, roughly 6% came from capital appreciation and 4% from dividends. (This is important and we will return to this later.)


2. Given the lack of ability, and or desire, to save in younger years most people begin to get serious about saving money around 35 years of age on average.


3. We will assume a retirement age of 65 which puts our saving and investing time frame at 30-years.

As I stated, this is a relatively easy calculation which you can find regularly espoused throughout the majority of the financial media, blogosphere, and Wall Street as the promise of “passive indexing” persists.

Not bad. The $3000 per year savings plan grows to a nice lump sum of $500,000.

This clearly supports the long-held belief that if you have 30-years to retirement, just dollar-cost average into some index funds and you will be fine. 

You can stop reading now.

---

But What If The Entire Premise Is Flawed? 

If, as a millennial investor, you really want to save and invest for retirement you need to understand how markets really work.

Markets are highly volatile over the long-term investment period. During any time horizon the biggest detractors from the achievement of financial goals come from five factors:

• Lack of capital to invest.


• Psychological and behavioral factors. (i.e. buy high/sell low)


• Variable rates of return.


• Time horizons, and;


• Beginning valuation levels 

I have addressed the first two at length in Dalbar 2016, Why You Still Suck At Investing but the important points are these:

Despite your best intentions to “buy and hold” over the long-term, the reality is that you will unlikely achieve those promised returns.

While the inability to participate in the financial markets is certainly a major issue, the biggest reason for underperformance by investors who do participate in the financial markets over time is psychology.

Behavioral biases that lead to poor investment decision-making is the single largest contributor to underperformance over time. Dalbar defined nine of the irrational investment behavior biases specifically:

• Loss Aversion – The fear of loss leads to a withdrawal of capital at the worst possible time.  Also known as “panic selling.”


• Narrow Framing – Making decisions about on part of the portfolio without considering the effects on the total.


• Anchoring – The process of remaining focused on what happened previously and not adapting to a changing market.


• Mental Accounting – Separating performance of investments mentally to justify success and failure.


• Lack of Diversification – Believing a portfolio is diversified when in fact it is a highly correlated pool of assets.


• Herding– Following what everyone else is doing. Leads to “buy high/sell low.”


• Regret – Not performing a necessary action due to the regret of a previous failure.


• Media Response – The media has a bias to optimism to sell products from advertisers and attract view/readership.


• Optimism – Overly optimistic assumptions tend to lead to rather dramatic reversions when met with reality.

The biggest of these problems for individuals is the “herding effect” and “loss aversion.”

These two behaviors tend to function together compounding the issues of investor mistakes over time. As markets are rising, individuals are lead to believe that the current price trend will continue to last for an indefinite period. The longer the rising trend last, the more ingrained the belief becomes until the last of “holdouts” finally “buys in” as the financial markets evolve into a “euphoric state.”

As the markets decline, there is a slow realization that “this decline” is something more than a “buy the dip” opportunity.  As losses mount, the anxiety of loss begins to mount until individuals seek to “avert further loss” by selling.

This is the basis of the “Buy High / Sell Low” syndrome that plagues investors over the long-term.

However, without understanding what drives market returns over the long term, you can’t understand the impact the market has on psychology and investor behavior.

Over any 30-year period the beginning valuation levels, the price your pay for your investments has a spectacular impact on future returns. I have highlighted return levels at 7-12x earnings and 18-22x earnings. We will use the average of 10x and 20x earnings for our savings analysis.

As you will notice, 30-year forward returns are significantly higher on average when investing at 10x earnings as opposed to 20x earnings or where we are currently near 25x.

For the purpose of this exercise, I went back through history and pulled the 4-periods where valuations were either above 20x earnings or below 10x earnings. I then ran a $1000 investment going forward for 30-years on a total-return, inflation adjusted, basis.

At 10x earnings, the worst performing period started in 1918 and only saw $1000 grow to a bit more than $6000. The best performing period was not the screaming bull market that started in 1980 because the last 10-years of that particular cycle caught the “dot.com” crash. It was the post-WWII bull market than ran from 1942 through 1972 that was the winner. Of course, the crash of 1974, just two years later, extracted a good bit of those returns.

Conversely, at 20x earnings, the best performing period started in 1900 which caught the rise of the market to its peak in 1929. Unfortunately, the next 4-years wiped out roughly 85% of those gains. However, outside of that one period, all of the other periods fared worse than investing at lower valuations. (Note: 1993 is still currently running as its 30-year period will end in 2023.)

The point to be made here is simple and was precisely summed up by Warren Buffett:

“Price is what you pay. Value is what you get.” 

This is shown in the chart below. I have averaged each of the 4-periods above into a single total return, inflation adjusted, index, Clearly, investing at 10x earnings yields substantially better results.

So, with this understanding let me return once again to the young, Millennial saver, who is going to endeavor at saving their annual tax refund of $3000. The chart below shows $3000 invested annually into the S&P 500 inflation-adjusted, total return index at 10% compounded annually and both 10x and 20x valuation starting levels. I have also shown $3000 saved annually in a mattress.

The red line is 10% compounded annually. You won’t get that but it is there so you can compare it to the real returns received over the 30-year investment horizon starting at 10x and 20x valuation levels. The short fall between the promised 10% annual rates of return and actual returns are shown by in two shaded areas. In other words, if our young saver was banking on some advisors promise of 10% annual returns for retirement, he isn’t going to make it.

I want you to take note of the point made that when investing your money when markets are above 20x earnings, it was 22-years before it grew more than money stuffed in a mattress. Why 22 years? 

Take a look at the chart below.

Historically, it has generally taken roughly 22-years to resolve a period of over-valuation. Given the last major over-valuation period started in 1999, history suggests another major market downturn will mean revert valuations by 2021.

The point here is obvious, but difficult to grasp from a mainstream media that is continually enticing young Millennial investors to mistakenly invest their savings into an overvalued market. Saving your money, and waiting for a valuation based opportunity to invest those savings in the market, is the best, safest way, to invest for your financial future. 

Of course, Wall Street won’t like this much because they can’t charge you a fee if you are sitting on a mountain of cash awaiting the opportunity to “buy” their next misfortune.

But isn’t that what Baron Rothschild meant when quipped:

“The time to buy is when there’s blood in the streets.”

7-Steps To Long-Term Investment Success

With the market currently trading at the third-highest valuation level in history, only surpassed currently by the peaks in 1929 and 1999, you can only surmise what the outcome for our young saver will likely be.

The analysis reveals the important points young investors should consider given current valuation levels and the reality of investing over the long-term:

• Expectations for future returns should be downwardly adjusted.


• The potential for front-loaded returns going forward is unlikely.


• Control investment behaviors and emotions that detract from portfolio returns is critical.


• Future inflation expectations must be carefully considered.


• Understand risk and control drawdowns in portfolios during market declines.


• Save money regularly, invest when reward outweighs the risk. 


• Expectations for compounded annual rates of returns should be dismissed 

Robo-advisors, passive indexing, etc. do not address these issues and will impair the ability of young investors to achieve their long-term goals.

Investing is not a competition. There are no awards for beating the market, but there are severe and lasting consequences for chasing markets where others fear to tread.

You are fine as long as there is a “greater fool” to eventually sell to. Just make sure that “fool” is not you.