We still have some way to go before asset prices normalize for the S&P 500 index, which makes up about 90% of US stock market capitalization. The CAPE and all price-to-fundamental ratios like it (e.g. Tobin’s Q, Buffett’s PE, etc.) are still high and they are all higher than their long-run averages by about the same percentage. That consistency reinforces the notion that it’s the market’s price that is the issue and not that there is something fundamentally different this time with respect to earnings, free cash flow or the replacement cost of business assets.

The CAPE is 24.90 after (last week’s) drop in the S&P 500 to 1970.89. Even if we generously assumed that real S&P earnings for the most recently available month (March 2015’s $100.57) was the proper figure to use in the denominator (as opposed to the lower real $79.13 S&P earnings over the last ten years), the S&P 500 index could still fall another 15% before the CAPE reached its long-term average (16.63). Unfortunately, no one knows when it will regress back to that level. It is impossible to predict it.

In addition, few consider that maybe the current CAPE average is too high. Both the numerator and denominator in the CAPE are adjusted for CPI inflation, so it reduces the ratio to long-run fundamental market and business activity. The CAPE averaged 14.78 from January 1881 through December 1994, which is 11% less than today’s CAPE average since 1881, largely because today’s CAPE average includes the greatest bubble in the market’s history (the dot com bubble). That suggests the S&P could fall 25% from 1970.89 even with the generous earnings figure used for the denominator.

PAR does not care about the market as a whole when it invests client funds in its Separate Account Value Investing (SAVI) strategies, so PAR is not investing as if the market were going to drop another 25%. PAR is still looking from the bottom up for SAVI  clients because that is the way to uncover opportunities that have an MOS, but there should be no surprise that there are far fewer opportunities when the CAPE is 24.9, like today, than when the CAPE is 13.3 as it was in March of 2009.

March 2009  was the last time PAR became fully invested. Most of those new positions in which PAR invested in 4Q08 and 1Q09 to become fully invested were gradually liquidated over the subsequent twelve- to eighteen-months and have largely sat in cash  since. PAR’s SAVI strategies are only a small part of PAR’s clients’ portfolios.

PAR Wealth Management also offers traditional wealth management services as a fee-only fiduciary. PAR Wealth Management is a goals-based financial adviser. Once a client’s goals are quantified and prioritized, PAR Wealth Management allocates that client’s capital to investments with qualities that match those specific goals and how a client feels about risk. Capital for short- and intermediate-term goals are generally allocated to safer, more-liquid investments. For a large percentage of a client’s long-term goal allocation, PAR Wealth Management generally chooses external managers who demonstrate an ability to capture factor premia.

Update 8-24-15: I do not want to leave the impression that the only way for the CAPE to normalize is for the S&P 500 to drop precipitously. The other way is for the denominator–earnings–to rise considerably. But, the denominator will not rise without growth in value-creating economic activity in the private sector, and that takes time. Value-creation has been stagnant since 2008 and there is little on the horizon to suggest that the private sector will turn robust. In any case, the numerator (the level of the S&P 500) would have to rise much slower than the denominator. So, either way, whether it is a numerator that falls or a denominator that rises or some combination, it portends low stock market returns over the next decade. As I have written before, invest accordingly.

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The S&P 500 Index delivered a 13.69% return in 2014 as the market continued to reach new highs after reaching new highs in 2013. This year, for the first time, I have highlighted the years corresponding with the inflation and bursting of the DotCom bubble (grey) in addition to the Great Depression (yellow) and the Housing bubble (blue).

Clearly, there were more extremes and more years of extreme results during the Great Depression than the two most recent crises. In eight of the years from 1928 through 1938, the market either lost or gained more than 30%. In contrast, in each of the DotCom and the Housing bubble periods, the market had just one year of such an extreme.

There were obviously more extremes and more years of extreme outcomes during the Great Depression than the two most recent crises. Over the eight years from 1928 to 1938, generic cialis sales grew by 40% and you can read more about these successes on the main page of our website.

In half of all years since 1825, the market delivered a return between -10% and +10%. So, if we narrow the definition of extreme to losses or gains of more than 10%, the Great Depression experienced nine such years, the DotCom bubble five, and the Housing bubble five.

Many argue that the Federal Reserve is getting better at managing crises, and the above data would seem to agree. The Great Depression was the first crisis that the Fed experienced and many recent policy makers, including Ben Bernanke, went to school on Great Depression policy. On the other hand, others argue that the mere awareness of a Federal Reserve “put” is creating crises that future Fed policy will be unable to fix. I guess we will know who is right soon enough.

The return mode is still 0% to 10%. In a large majority (71%) of years, the market is positive. And, the market experiences declines of 10% (20%) or more in a mere 13.7% (4.9%) of years. So, an outsider’s perspective indicates that investing in the broad market is clearly in your favor, in part because of natural inflationary increases, and in part because of real increases in productivity and earnings due to technological and human capital advances.

The insider’s perspective is a different story. As of January 19, 2015, Shiller’s CAPE sits at 26.7, which is 61% above the average CAPE of 16.6 since January, 1881. The only periods in which the CAPE was higher than today were 1929 – 1930, immediately before the Great Depression; late 1996 – 2002, immediately before and after the DotCom bubble burst; and from late 2004 – late 2007, immediately before the bursting of the housing bubble. So, the CAPE is not a great short-term timing mechanism because recent extremes were able to persist for long periods, but it is an excellent indicator that the piper has to be paid eventually.

Other market indicators including Tobin’s Q and Buffett’s PE confirm the implications of Shiller’s CAPE. Investors who were cautious in periods like this had dry powder to exploit market declines. Investors who chased returns in periods like this rode the market without a brake (a hedge) and often only got off the ride by jumping off at market lows.

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“Over the past 100 years the returns from smaller companies have exceeded those of larger companies. It is also true that stocks with low valuations (i.e. lower prices relative to earnings and book values) have generated better returns than those with high valuations. What is less certain is whether these tendencies will continue in the future…”

–Burton G. Malkiel, criticizing investors like Buffett who have captured factor premia for decades

To be fair, Malkiel goes on to list other reasons to be skeptical of smart beta, but number one is that it might not work in the future. Malkiel’s comment is almost akin to a health policy expert telling us, “Sure, Jonas Salk’s polio vaccine has worked for 62 years, but let’s give it a little more time before we declare victory.” I guess we will never know whether the polio vaccine will become ineffective, but that doesn’t mean we shouldn’t exploit its use today. But, Malkiel would condemn investors into accepting market risk in order to receive reduced fee invoices. What if you didn’t want market risk? Or, what if you wanted more risk than the market provided (as PAR did in 1Q09 when it used some leverage to become fully invested)?

Factor premia have existed for more than 100 years. The premia exist either because of sub-optimal investor behavior (mostly my view) or because factor investors are being compensated for risk (mostly the view of EMH proponents). Either way, factor premia are not likely to disappear for the long-term investor, so we might as well exploit factor premia for the long-term portion of our portfolios.

https://blog.wealthfront.com/smart-beta/

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At this month’s CFA Institute Annual Conference in Seattle, Sharpe said that Smart Beta made him sick because it implied that index investors had to be “dumb beta.” Sharpe believes the so-called dumb beta investors would eventually gravitate to Smart Beta strategies because no one is that dumb for long, and then the advantages of Smart Beta would simply melt away into average beta.

As regular readers know, Fama and French (F&F), and later Lakonishok et al. (LSV)  (See F&F and LSV tab above) demonstrated as early as 1992 that two factors consistently resulted in outperformance in the long run: Value and Small Cap. It is largely these two factors that put the “smart” in “Smart Beta.” F&F and LSV were not the first academics to publish papers on the value and small-cap factors, but they certainly popularized the factors in academia. Before these academics came along, we had research from practitioners Ben Graham from the 1930s through the 1970s; Warren Buffett from the 1950s to today; and Seth Klarman from the 1980s to today; that demonstrated that value strategies consistently outperform the market in the long run.

Since F&F and LSV published their research in the 1990s, there has been an overwhelming amount of academic research that demonstrates that value strategies outperform. Most of that research proves that value outperforms for reasons that are not related to risk, therefore value has consistently delivered alpha in the long run.

Most Smart Beta strategies are nothing more than systematic ways for managers to capture some of the factors that are known to deliver this alpha in the long run. The adoption of this approach in a more systematic and passive way somewhat proves Sharpe’s theory that no one stays that dumb for long. However, value and small-cap strategies outperform over long periods not necessarily because value and small-cap investors are smarter than everyone else, but because behavioral flaws and institutional constraints do not permit EVERYONE to FULLY capture the alpha in value and small cap. I remind you that it did take over 150 years for Smart Beta to be born.

Only small investors with contrarian streaks (see my future post on Investor DNA) can fully exploit these factors. Even Smart Beta strategies will fail to fully exploit these factors because of the amount of capital that Smart Beta will need to invest. Much of that capital will have to be allocated to large cap firms, but most of the alpha in these factors is found in relatively unknown and un-followed small-cap firms.

So, my answer to Sharpe’s queasiness is this: Smart Beta is just a label. Would he have taken less umbrage if that label were “Behavioral Beta” or “Factor-Focused Beta?”

http://advisorperspectives.com/newsletters14/Bill_Sharpe-Smart_beta_makes_me_sick.php

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1. He’s super-smart;

Yet, as Buffett himself has said, if you have more than 130 IQ points you should sell the excess because you won’t need it to be a great investor. In fact, that extra IQ may be detrimental if it leads to behavioral flaws such as overconfidence or lack of discipline.

2. He’s guided by an overarching philosophy;

That philosophy is value investing, which can be executed in several forms.

3. He’s mentally flexible;

It may seem as if Buffett had a change in philosophy when he transitioned from Ben Graham’s “Net Net” and “Cigar Butt” approaches to investing to Charlie Munger’s “wide-moat” approach. However, all three approaches are guided by the value-investing tenet that requires a Margin of Safety.

Graham’s margin of safety was found in businesses trading at less than the net value of their assets. Munger’s approach of investing in under-appreciated companies with wide moats found a margin of safety in well-run business with pricing power and even growth. The key is in the qualifier “under-appreciated.”  Value investors love growth, but tend to be more skeptical of growth projections than glamour investors, and are usually better at maintaining discipline when pricing growth, and rightly so.

Hence, value investors usually buy fast-growing, wide-moat companies only when the market does not fully appreciate their wide moats as much as it should. One example: Buffett paid $1.02 billion for shares of Coca Cola by the end of 1989 after the 1987 crash had damaged Coke’s shares. By 1999, that investment was worth $11.6 billion according to Hagstrom.

4. He’s unemotional;

Marks: “Many of the obstacles to investment success relate to human emotion…perhaps worst of all, (most investors) have a tendency to judge how they’re doing based on how others are doing, and to let envy of others’ success force them to take additional risk… (Warren) doesn’t care whether others think he’s right or whether his investment decisions promptly (my emphasis) make him look right.”

My Take: Warren is disciplined, which can make a person appear unemotional. I would be willing to bet that on more than one occasion in his career he lost sleep over a decision, but that his discipline allowed logic to triumph.

5. He’s contrarian and iconoclastic;

As Charlie Munger likes to say, I have nothing more to add.

6. He’s counter-cyclical;

Marks: “Many of the best investors accept that they can’t predict what the macro future holds in terms of economic developments, interest rates and market fluctuations…the greatest bargains are accessed by buying when the economy and companies are suffering…how many acted as boldly (as Buffett) when fear of financial collapse was rampant (in 2009)?”

7. He has a long-term focus and is unconcerned with volatility;

One should only invest in the equity or long-term debt of businesses to cover long term liabilities such as college tuition that is due in twenty years, retirement liabilities, and bequests, so volatility is the friend of the long-term value investor. Volatility gives the long-term value investor the chance to buy low and eventually sell high, in contrast to what most investors do; that is, buying when rising prices make them feel good and selling when plummeting prices are too painful to bear.

This is where a good wealth advisor comes in for an individual investor or family office. He or she will help such investors identify their goals and estimate when the invoices for those goals need to be paid. Then, a good advisor will allocate assets to broad asset categories that “immunize” those liabilities and help make the euphoria of rising prices and pain of plummeting ones easier to ignore and bear because short-term goals are covered in cash or high-quality short-term debt, and opportunities to cover long-term goals will arise over a multi-decade run.

This is known in High Net-Worth Investor (HNWI) Wealth Management circles as Goals-Based Investing (GBI).  The underlying assumption is that all investors would be happy to simply meet their goals and avoid their nightmares so that they can focus on their careers and the things that make them happy.

In GBI, capital for near-term goals is held mostly in cash and short-term bills, and capital for long-term goals is invested in less liquid or more volatile (in the short run) investments such as equities, long-term debt, real estate, and alternatives in order to exploit the return premiums that are available there.

Within asset categories a good advisor will help clients find investment managers who understand each asset’s risks and who can manage those risks well. He will also find managers who can exploit specific premiums in those asset classes such as the value premium in equity investments.

8. He’s unafraid to bet big on his best ideas;

So many active investors have capital spread thinly, and almost all of it is allocated to S&P 500 companies. They have low “active share,” so they are essentially closet indexers who charge higher fees than indexers.

9. He’s willing to be inactive;

According to a speech that Seth Klarman delivered at a Grant’s conference in the fall of 2013, Baupost Group has about 50% in cash. Klarman is fearful of returning cash to his investors because he believes that they may go out and invest it with a hot-hand manager and will suffer during an inevitable shakeout.

PAR views cash as an investment in an option on every asset, an option that has no expiration date. That option is worth quite a lot right now.

10. Finally, he’s not worried about losing his job;

Professional portfolio managers who work for large firms lose their jobs if they underperform. That is why many make the rational decision to become closet indexers in order to hug their benchmark and avoid underperformance.

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“Individual investors who avoid ‘doing things you know too little about’ still stand a decent chance of outperforming professional investors.”

How true.
http://online.wsj.com/article/SB10001424127887324731304578193323337104806.html

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In Hedgehogging, among other topics, Biggs writes of the trials and tribulations of starting a fund, the difficulties of shorting (the hedge in hedge fund) and he reminisces about how he appeared as a dunce to the young, upstart managers (and some of his fund’s investors) because he warned repeatedly in the late 1990s that the internet bubble was going to end badly and so he refused to participate in it.

To many young guns he was past his prime, out of touch, should be put out to pasture, he did not understand that “it was different this time.” And, of course, the knowledge that he accumulated over the years–wisdom–turned out to be absolutely correct in the end. Unfortunately for many fund managers, value managers in particular, the bubble inflated for too long and it put them out of business as their investors redeemed to put their money in the latest, hottest fund.

One of the most insightful parts of the book for me was his discussion of the value of gold and other jewelry. As a value investor, I find it hard to appreciate precious metals and stones because I find it hard to place a value on them. Their value is almost completely subjective. Biggs drove home the point that they are literally lifesavers in the most distressed of periods–e.g. the get-out-of-Nazi-Germany kind of periods when the only assets that you can keep are the jewelry you can carry and hide on your person.

Unfortunately, I strongly disagreed with Biggs in the last chapter, so it stayed with me and allowed me forget the value of the previous chapters. Biggs defended Keynesianism with the kind of vigor reserved for zealots, as in this sentence (emphasis mine), “To be truly taken as the economic savior of civilization, Keynes needed to present a conventional face to the world” which discussed his marriage to Lydia. Biggs attributes the end of the Great Depression to Keynesian economics.

I suspect that when the current debt crises that are cascading in practically every western economy are finally resolved, objective minds will have an entirely different view of Keynesian economics. It was Keynesianism that justified large government spending after all, and a sheep-like political class was only too happy to use Keynesianism in their re-election bids. There is no easier way to get re-elected than to spend taxpayer dollars (not your own) on your constituents. Keynesianism will have had a century-plus run, but century-plus runs are not uncommon for many failed ideologies. The latest century-survivor to fail is communism, which was considered by many in its day as more economically efficient than western capitalism and therefore unstoppable. It was considered efficient in the west in part because of Keynes.

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Good Stuff.

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I have found the story of Allan Mecham to be fairly typical. You have probably never heard of Mecham because his fund is structured as a hedge fund, and so SEC rules prevent him from advertising and state that he must limit the number of his investors to a few hundred who must be wealthy.

The companies he buys trade at a discount to their intrinsic value because the “smart money” will not buy them, usually (but not always) because the company is too small to attract the attention of large investors. If the smart money does buy them, they usually do not stay with the investment for very long; the typical non-index mutual fund turnover rate is over 100%. In many ways the story of investment in these companies parallels the predicament of Mecham’s fund. The smart money that will not invest in the companies that Mecham buys shares a philosophy with the smart money that will not invest in small, concentrated, contrarian funds.

The following are the typical characteristics of the philosophy and processes used by small, value investors such as Mecham. They:

• Make investment decisions alone because groupthink generally leads to poor investing results. As Mohnish Pabrai once said, it is doubtful that Warren Buffett would have made one of the most successful investments of his career–taking a stake in American Express that amounted to 40% of his fund’s assets–if he had to answer to an investment committee or justify the investment to a pension fund consultant;
• Are usually somewhat quirky and do not have the pedigree or use processes that Wall Street understands, at least not before they have $1 billion in assets under management (AUM). After a billion dollars in AUM, Wall Street understands even gibberish. To Wall Street, Buffett was just some quirky guy in Omaha before he had a few billion in AUM. And, by Wall Street, I mean every potential investor in Meacham’s fund–seeders, incubators, funds of funds, pension funds, family offices, and other high net worth investors. At a recent family office (FO) conference that I attended, every speaker said that FOs–once the mainstay investor in small, quirky, value-investing startups–have gone the way of big institutions seeking to invest only in large, well known managers who have the infrastructure to gather assets;
• Because of the “institutionalization” since 2000 of the processes used by FOs and other high net worth investors, it is nearly impossible to find funds like Arlington that launched after 2000. We now know of the huge success stories such as Arlington, Klarman’s Baupost; Einhorn’s Greenlight; Pabrai’s Pabrai Funds; and Tilson’s T2 partners. These once-tiny value funds all launched before 2000–almost all with less than $1 million AUM–and grew through word of mouth. Can you name one that launched after 2000? Those that launched after 2000 have had little chance to raise capital in the new institutional environment;
• Are contrarian–buying when others sell, and selling when others buy
• Are structured as hedge funds because 1. SEC rules severely restrict the way mutual fund managers operate (e.g. SEC rules force diversification–”di-Worsification” as Peter Lynch liked to say–limit the ability to manage risk by hedging and selling short; and limit the ability to use leverage to exploit extraordinary contrarian opportunities and special situations); 2. mutual funds must be able to meet redemptions every day and so are not conducive to long-term thinking; and 3. mutual funds have higher startup costs;
• Do not try to predict where the market is heading but hedge market risks when the costs of hedges are cheap such as when everyone thinks the market can only go higher. In fact, they usually do not make explicit predictions for the companies in which they invest because they know that those predictions are rarely accurate (See the evidence for this in any of about one hundred sources such as Dreman’s Contrarian Strategies (Just added the latest edition to the bookstore above))
• Do not take in a lot of money because they know that true value opportunities are few and that sitting on a lot of unused cash would only hurt their investors’ returns. Even if the smart money suddenly realized that funds like Mecham’s were safe investments that delivered excellent long-term results, Mecham would not likely take in much more than he is managing now;
• Know that senior managers rise to the top of their organizations because of their inordinate salesmanship abilities and so meetings with companies are likely to lead to biased analyses. Meetings with management should therefore be avoided, or kept short and limited to extracting a vital piece of information that could not be obtained any other way;

I have a personal story. I write this blog anonymously because I do not want to run afoul of SEC rules regarding solicitation. A high net worth investor–a doctor from North Carolina–managed to track me down because he liked what he read here and wanted more information in order to invest in my fund. My law firm said he had to fill out a questionnaire before I sent him any information.

The doctor filled out the paperwork, but I could only send him the PPM after I received his information and determined that the fund was a suitable investment for him. The PPM is boilerplate but I told him that I could not take any investment from him until he had taken a little over a month to digest it. He still has not seen the results that the fund delivered, but he did ask general questions about the fund, which I launched in 2010. The information I gave him demonstrated that my fund started with ten times the assets and ten times the number of partners as Mecham’s fund, and from what I gathered in the article, twice the number of fund employees as Mecham.

Doctors like the one who contacted me were once the angels of startup funds like mine and they reaped the rewards; yet, it has been almost three months since I heard from him. As of today, I have nine investors in my fund made up of one family member, one former fund employee, six former colleagues from prior firms in which I worked, and one former client from a firm in which I last worked in 1997; no one that I have known for fewer than fifteen years.

The traditional investors who invested in funds like mine no longer invest in funds like mine. It is sad, and not just for entrepreneurial fund managers. Maybe it is the Madoff effect or severe risk-avoidance after two bubbles burst last decade, but it is especially sad for anyone who needs to fund a future liability–i.e. everyone. The story about Mecham opens with him in a conference room in New York City surrounded by potential investors who are peppering him with questions, trying to gauge his ”sophistication.” It would be funny, if it weren’t so sad.

http://www.smartmoney.com/invest/strategies/the-400-man-1328818316857/#tabs

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