vinod1

Markets are fairly efficient and most reasonable people would agree with that. But Fama goes much further. He practically denies there is such a thing as a bubble. Any time there is a factor that is identified that has shown historical outperformance, he turns it into a risk factor. Small stocks have higher returns, well small stocks are more risky, value has higher returns, value must be more risky and so on. According to him, the highest priced stocks (or as her prefers low Book to Price) have low risk. As Taleb like to say, he is a perfect example of an "equation solver" with Physics Envy. Shiller on the other hand, is much much more reasonable and humble guy and fully deserves the prize. Here is an interview with Fama: http://www.minneapolisfed.org/publications_papers/pub_display.cfm?id=1134 Well, economists are arrogant people. And because they can’t explain something, it becomes irrational. The way I look at it, there were two crashes in the last century. One turned out to be too small. The ’29 crash was too small; the market went down subsequently. The ’87 crash turned out to be too big; the market went up afterwards. So you have two cases: One was an underreaction; the other was an overreaction. That’s exactly what you’d expect if the market’s efficient. The word “bubble” drives me nuts. For example, people say “the Internet bubble.” Well, if you go back to that time, most people were saying the Internet was going to revolutionize business, so companies that had a leg up on the Internet were going to become very successful. I did a calculation. Microsoft was an example of a corporation that came from the previous revolution, the computer revolution. It was hugely profitable and successful. How many Microsofts would it have taken to justify the whole set of Internet valuations? I think I estimated it to be something like 1.4. Vinod

Palantir, You got it right. If you look at the dividend discount model, which is the simplest case of the discounted cash flow model, this becomes very obvious. In DDM, value of a share of stock = Dividend next Year/(Cost of Equity - Growth rate of Dividends forever) Growth rate of Dividend = (1 - Payout Ratio) x Return on Equity To account for share buybacks, you would adjust the Payout Ratio and hence the Dividend next year. This automatically adjusts the growth rate down. Just as you noted, growth rate is adjusted down while the dividend for next year is adjusted up. It does not make sense to assume that both dividends go up and growth rate goes up. Big Boss of valuation, Damodaran, has written about this quite a bit so you are on firm ground. Vinod

Isnt the earnings yield on the stock (or stock market) the real earnings yield? Earnings yield on the bonds is nominal. Most of the arguments I see aganist the Fed model is related to this. Both Hussman and Cliff Asness have written extensively on this. Vinod

I think "Value Investing: From Graham to Buffett and beyond" is THE book for you. To me more than any other book, this helped me in how to think about valuation. Vinod

His explanation of the definition of investing is also very interesting: - An “investment operation” is used instead of an issue because it is unsound to think of investment character as inhering in an issue since price is an essential element. So a stock may have investment merit at one price level but not at another. In addition, an investment might be justified in a group of issues, which would not be sufficiently safe if made in any one of them singly. - By “thorough analysis” Graham means, the study of the facts in the light of established standards of safety and value. As an example of analysis, paying 40 times its highest recorded earnings in 1929, merely because of its excellent prospects, would be clearly ruled out as devoid of all quality of thoroughness. - Graham notes that in “promises safety of principal” the “Safety” sought in an investment is not absolute or complete. It means, rather, protection against loss under all normal or reasonably likely conditions or variations. A safe stock is one which holds ever prospect of being worth the price paid except under quite unlikely contingencies. Where study and experience indicate that an appreciable chance of loss must be recognized and allowed for, we have a speculative situation. - “Satisfactory return” covers any rate or amount of return, however low, which the investor is willing to accept, provided he acts with reasonable intelligence. - An investment operation is one that can be justified on both qualitative and quantitative grounds. This is an additional criterion for investment. - A great deal of common stock buying is done with reasonable care and may be called intelligent speculation; a great is done upon inadequate consideration and for unsound reasons and thus must be called unintelligent; in exceptional cases a common stock may be bought on such attractive terms, qualitative and quantitative, as to set the inherent risk at a minimum and justify the title of investment. - It is possible to argue that issues with high degree of speculative risk individually may be made part of an investment operation provided (1) the changes of gain definitely outweigh those of loss and (2) there is ample diversification. Ex. Low priced common stocks meeting certain conditions and even long term calls to buy at prices much above their current levels. This is a marginal area in which distinctions between investment and speculation become blurred. Vinod

The book quantitative value would be perfect for you if you have not already read it. It goes into quite some detail on many of the issues you are talking about. Also fool.com has a very good mechanical investing board. I think the Quant "bug" is like the Value Investing "bug", you either take to it immediately or you can never get yourself to fully believe in it. Vinod

The fact that wealth has not been destroyed recently should result in higher cash flows. Factories, infrastructure, etc. that are not destroyed should be increasing productivity and generating additional cash flows. So I do not see why the multiple that you pay for a given cash flow should increase - except to the extent that the world is much safer than in the past and people are willing to accept lower returns as a result. But this has nothing to do with mean reversion. Mean reversion argument rests on two inter-related factors 1. Capitalism - If a company starts making very high returns, it attracts competitors reducing its rates of return to more normal levels. Likewise if a company keeps losing lots of money, it would be acquired, goes bankrupt, etc until the rest of the companies earn at least acceptable rates of return. 2. Democracy - In a democratic society if companies as whole start making too much money as compared to wage income, people would vote for politicians/policies to redress this balance. The mean around which profits would revert could change but the above two factors would ensure mean reversion in a capitalist/democratic society. Vinod

We could have said the same about the housing market in late 2007. Yet, the severity was still a shock to the system. The problem with the Japanese situation is that we just do not how the problems would manifest themselves or even if there would be any severe problems. Very good point. This is the mistake I think many like Hussman, Rob Rodriguez, etc made. They fully expected the 2008 crisis to turn into a depression as they did not expect Fed/Treasury to do as much as they did. They did not invest aggressively at the bottom due to this and are now bitter. I would not go as far as say dont fight the Fed, but you do have to consider Fed's reaction. Bernanke has pretty much laid out his thinking in "Essays on the Great Depression" and still people kept getting surprised that he did what he said he would do in a situation like 2008. Vinod

The way I see it is that it not a prediction as much as being aware of the environment you are in. We know there are times when it is more dangerous to drive a car, like when there is severe freezing snow. We do not know for certain we would get into an accident, but we know that the chances of getting into an accident is much higher when driving in freezing snow than when driving on a bright sunny day with low traffic. We would drive much more carefully and more slowly (20 MPH instead of 60 MPH). Being aware of the various valuation measures is just similar. We know we are in a much more dangerous territory and we approach investments much more cautiously. Each of us have different tolerances for risk and choose to hedge/reduce allocation, etc at different levels of the valuation measures. I have chosen to position my portfolio very defensively when S&P 500 is around 1600. I have no strong particular view of how the market would behave going forward, just that we have entered a territory where the medieval cartographers used to mark as "Here be dragons". Vinod

I pretty much used the same argument on another board in a different era. The argument I used is that if one has extremely low costs and under performing the market then by efficient market implication it must be because they must be taking lower risk than the market. Not that I believe in this but was pointing out the logical implications of a belief in efficient markets. Vinod

This market is making me uncomfortable. Reminds me of the song: "I'm only happy when it rains You know I love it when the news is bad Why it feels so good to feel so sad " Vinod

As James Montier has pointed out, Europe is certainly cheap but only if you assume low probability of a bad Euro scenario. Basically his point is that there is more fundamental risk in Europe and stocks are pricing in a low probability of a major crisis (Euro breakup, etc). They are not cheap if you assume a Euro breakup or long period of Japanese style stagnation. Vinod

Tommm50, Thank you! I really liked your presentation. Very informative and something I have not seen other industry executives talk about. Only Buffett had mentioned in the past that the cycle of hard and soft markets might not repeat as regularly as it had in the past but the rest of the industry seems to be always seeing a hard market just around the corner. Vinod

Michael Pettis commentary on the recent Euro developments. If you have not heard of him before, his commentary is by far the best I have come across on China's growth and its potential problems. http://www.mpettis.com/2013/03/21/when-do-we-call-it-a-solvency-crisis/ But is peripheral Europe really suffering primarily from a liquidity crisis? It would help me feel a lot better if I could find even one case in history of a sovereign solvency crisis in which the authorities didn’t assure us for years that we were facing not a solvency crisis, but merely a short-term problem with liquidity. A sovereign solvency crisis always begins with many years of assurances from policymakers in both the creditor and the debtor nations that the problem can be resolved with time, confidence, and a just few more debt rollovers. ... Most bankers knew by 1985-86 that the region was actually suffering from a generalized solvency problem, and among the big banks JP Morgan had been taking substantial provisions all along. No one could formally acknowledge the possibility of insolvency, however, because to have done so would have required that all of banks take much greater provisions than they already had. In May 1987 Citibank, after many years of replenishing its capital, was able to announce suddenly and to the great surprise of the entire market that it had decided to take a huge amount of provisions against dodgy sovereign loans. By 1989-90 the rest of the big American banks were also able to accept the write-offs without becoming technically insolvent. That is when everybody formally “discovered” that in fact the LDC debt crisis was a lot more than just a liquidity crisis. This is the key point. The American bankers weren’t stupid. They just could not formally acknowledge reality until they had built up sufficient capital through many years of high earnings – thanks in no small part to the help provided by the Fed in the form of distorted yield curves – to recognize the losses without becoming insolvent. And this matters to Europe. There is simply no way European banks, especially in Germany, can acknowledge the possibility of sovereign insolvency until they, too, have built up enough capital to absorb the losses. Vinod

Yes. I was trying to model their returns so I had noted down this % way back in 2011 and here it goes: Equities/Shareholders Equity Year 40% 2002 47% 2003 59% 2004 76% 2005 77% 2006 62% 2007 77% 2008 64% 2009 47% 2010 Vinod

No one would be more happy to have the stock market fall 50% than me. My daily prayer goes something like this: "Lord, I do not ask for a bull market. I do not even ask for a bear market. All I ask is for some volatility, is that so freakin too much to ask?" I do not think anyone knows or can know where profit margins are going. It is just too complex. In cases like this, I would always ask myself what would cause me to change my mind? I had written to myself in my investment diary way back in 2004/2005 or so, that if profit margins are going to remain high in another 5 years I should reconsider my assumption of historical profit margins. I used to be fairly confident that profit margins would go down rather quickly below 6% but I was wrong so I am now more agnostic about this. Maybe I am the perfect contrary indicator when a true hard core believer in mean reversion and 6% profit margins, throws in the towel on the 6% margins. Vinod

I went from 65% cash to over 80% cash last week. Wanted to cash in my gains given the overall market level. My nominal portfolio exposure is about 60% due to leveraged exposure via LEAPS. I remain very defensively positioned. Wide eyed optimist I am not :) I am more looking at profit margins as a percent of sales (though they are pretty tightly related to profits/GDP as well). My main point is that 6% profit margins are not like the Planck constant or the value of PI, I would expect it to change over time due to structural changes in the economy. To me it seems more likely that it might be higher in the future for various reasons - primary ones being weaker labor power due to emergence of Chinese and Indian work forces into global economy and associated offshoring of low margin production to these countries. I do not want to bet on it but I would not be surprised either if margins are at a slightly higher level in future compared to past. I just disagree with the absolute confidence that Hussman seems to have that they have to revert to 6%. Shiller does not show the anywhere near the same level of confidence in this. In 20 years, we might again go back to 6% margins, that again would not surprise me. The Montier equation showing how deficits are related to high profit margins is technically correct but is very limited use as it most certainly does not show causation. It is an accounting identify, which is true by definition. Sort of like the monetary equation MV = PQ which says as velocity increases prices increases holding others constant. It is true but it tells us zilch. Montier derivation seems to be about the same. Where I am going with all this is that, we need to be much less confident in basing our valuations on the 6% margin number. I can imagine Hussman if he is writing in the 1950s. "We remain 100% hedged because the dividend yield on the stock market is less than the dividend yield on the bonds. The only few times this has been true in the last 75 years, it resulted in losses of 40% to 85%. Suffice to say, we do not speculate and intend to fully protect our shareholders from such unacceptable losses.". He would have waited for 55 years or so until he got the opportunity in 2009. Vinod

At the end of the day, it is really boils down to what profit margins you believe are normal. Shiller PE is implicitly incorporating some of the higher profit margins of the past decade (mitigated somewhat by the presence of two deep recessions, which might be more than can be expected over a 10 year period). Hussman seems to be 100% certain that profit margins would absolutely without any doubt revert to and probably below the 6% historical margins. I think it is more likely that profit margins are going to be somewhat higher in the future than in the past to say 7 or 8% for maybe another decade or so if not more. If we assume normalized S&P 500 per share sales are about $1000 (compared to $910 at the recession bottom in 2009 and $1075 TTM) and apply 7.5% margins it gives about $75 per share earnings. Put in a 16 multiple, the fair value is about 1200. If we assume interest rates are likely to remain low for a long time and deficits would continue for a long time, then I can see an 18 or even 20 multiple which puts the current value as rich but not outrageously expensive. I do not think it would make sense to both believe that deficits would continue for a long time and also argue that profit margins would revert to historical levels in the near future when as Hussman and GMO articles specify that the deficits are really behind the surge in profit margins. Vinod

My library account includes access to M* research. All you have to do is put your library card # when you login to M* website from your home pc and you get all the access. Vinod

Investment Survey. Vinod

I periodically go through value line. I get a 3 month subscription about once a year. I note down companies that seem to have good operating results over long periods and cyclicals that probably would be available purchase at deep discounts during the inevitable downturns. One thing I found helpful is to actually write out a short investment thesis for every businesses you are interested in, even though it might not be worth buying at this time. Set a price target 3 years out (one each for pessimistic case, baseline case, and optimistic case) and lay out your expectations for the 2-3 core drivers. I think three years out is a reasonable time for the market to recognize a company's value and this would give you good feedback on your investment process. Also an Investment diary that captures your thought process behind each trade - not just a particular businesses but the days that you actually bought and what you are thinking in real time as you make the trade. Vinod

Good interview with Shiller. Recommends financials using sector index fund as they are the cheapest sector trading at a CAPE of 14 which below average. Others sectors that are attractive Health Care, Energy, and Industrials. http://blip.tv/wealthtrack-AppleTV/robert-shiller-6560861 Vinod

Here is how I think about this. I would classify every investment opportunity into one of three categories 1. Businesses which increase IV at about 8% or more annually. Need not be smooth but they should be able to meet this hurdle over the long term as a normal course of business. Think BRK, JNJ, WMT, FFH, MKL, etc. 2. Businesses which about maintain their IV steady or increase at a sub par rate. Unlikely to go out of businesses but managers would need to do something out of normal course of business to increase IV. Think Dell, SD, FTP, LUK (in the past), etc. 3. Businesses which have a tough time maintaining their IV. Perpetually money losing companies, most net nets, etc fall under this. This classification basically simplifies a lot of things like position sizing, buy/sell criteria including what to do in case of large price changes, holding period, etc. Averaging in/out works well with investments of the #1 category but it is not a good idea for #3. Averaging in/out would probably be fine with #2 but within strict position limits. Vinod

Did not get around to reading about Carnegie. Thanks for the recommendation, I would add it to my reading list. Vinod

I would recommend House of Morgan by Ron Chernow. Along with Titan by the same author and The First Tycoon, these would make a very nice trinity that provides insight from three different perspectives on the same time period. Check out the videos on You Tube, there are hour to two hour segments on many of them as well. Vinod