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What a lovely frickin day....to be reducing risk!!


bmichaud
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Just to stir the pot a bit, here's why I believe it is a wonderful day to be reducing risk....

 

1. http://www.businesscycle.com/#    (see video on front page)

 

2. http://www.hussman.net/wmc/wmc111017.htm (see paragraph 3 in its entirety as well as list of Euro banks' leverage ratios)

 

3. http://pragcap.com/the-two-biggest-risks-in-europe

 

4. http://pragcap.com/those-darn-italian-bond-yields

 

My guess is that a downgrade of France's RIDICULOUS AAA rating is only a matter of weeks away if not days, which could be the trigger to a nasty domino effect.

 

Not at all saying to go to 100% cash as Hussman currently is - just trying to reiterate the dangers out there very much still lurking that are currently being hidden in plain site by the rallying stock market. There are plenty of individual opportunities out there, which I believe should be taken advantage of...but as Buffett demonstrated back in his BPL days, there is nothing wrong with pairing 50-cent dollar bills with cash and/or market-neutral special situations!

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Completely disagree, as always it seems.

 

Equities have been setting higher lows, since August.

 

It appears you missed the bottom!

 

Ahh Moore, I knew you'd be good for a rebuttal or two on this topic.

 

IMO, the market has not even come close to discounting A) a US recession as the ECRI has predicted, or B) a Eurozone grinding itself into oblivion via forced austerity measures, LET ALONE both at the same exact time (I won't even bother putting a Chinese slowdown as the third simultaneous risk not being discounted).

 

Like I said, there is room for individual 50-cent dollars as well as market hedges in the form of cash, market-neutral special situations, or index shorts.

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Stocks are are oversold and are totally pricing in a recession – SPTSX is 51% priced in for a typical recession, Energy stocks are still 139% priced in for a recession, and Financials are 67% priced in.  Stocks are cheap.

 

 

Recessions 1929-2008* 2008-2009 Credit Crisis** Current Market** % Priced In**

NAME % change peak to trough % change from 2008 peak to 2009 trough % change from 2011 high of a Credit Crisis Typical Recession

S&P 500 INDEX -25% -53% -18% 33% 70%

S&P 500 INFO TECH INDEX -38% -50% -13% 25% 34%

S&P 500 FINANCIALS INDEX -28% -79% -30% 37% 106%

S&P 500 HEALTH CARE IDX -18% -40% -14% 36% 81%

S&P 500 ENERGY INDEX -26% -50% -26% 52% 101%

S&P 500 CONS STAPLES IDX -20% -34% -9% 26% 44%

S&P 500 CONS DISCRET IDX -31% -52% -16% 31% 52%

S&P 500 INDUSTRIALS IDX -27% -62% -25% 40% 92%

S&P 500 UTILITIES INDEX -22% -49% -5% 10% 21%

S&P 500 MATERIALS INDEX -26% -59% -27% 46% 103%

S&P 500 TELECOM SERV IDX -22% -47% -12% 25% 53%

 

S&P/TSX COMPOSITE INDEX -32% -46% -22% 47% 68%

S&P/TSX FINANCIALS INDEX -22% -55% -18% 32% 81%

S&P/TSX ENERGY INDEX -16% -48% -30% 63% 190%

S&P/TSX MATERIALS INDEX -21% -43% -23% 54% 111%

S&P/TSX INDUSTRIALS IDX -31% -46% -21% 46% 69%

S&P/TSX TELECOM SERV IDX -28% -38% -5% 13% 17%

S&P/TSX CONS DISCRET IDX -31% -49% -18% 36% 57%

S&P/TSX CONS STAPLES IDX -12% -16% -7% 44% 58%

S&P/TSX UTILITIES INDEX -5% -34% -5% 15% 106%

S&P/TSX INFO TECH INDEX -54% -59% -44% 75% 81%

S&P/TSX HEALTH CARE IDX -25% -36% -28% 79% 113%

 

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Horizon Kinetics mentions the VIX in their latest letter. (The part about owner-operators is a great read as well!)

 

http://www.hamincny.com/docs/2011Q3_commentary.pdf

 

Also, I loved the article someone (I believe it was you moore?) posted about the vix/vxo:

 

http://news.goldseek.com/Zealllc/1314374831.php

 

 

Not something I would base my market exposure on but it is a nice side-indicator and historically it has a great track record of marking "normal" fear situations. People who claimed there was no fear in August/September, not even in Europe, were dead wrong imo. 2008 was extremely rare and comparing today with the situation back then is bs. There was fear, just not as crazy.

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Stocks are are oversold and are totally pricing in a recession – SPTSX is 51% priced in for a typical recession, Energy stocks are still 139% priced in for a recession, and Financials are 67% priced in.  Stocks are cheap.

 

 

Recessions 1929-2008* 2008-2009 Credit Crisis** Current Market** % Priced In**

NAME % change peak to trough % change from 2008 peak to 2009 trough % change from 2011 high of a Credit Crisis Typical Recession

S&P 500 INDEX -25% -53% -18% 33% 70%

S&P 500 INFO TECH INDEX -38% -50% -13% 25% 34%

S&P 500 FINANCIALS INDEX -28% -79% -30% 37% 106%

S&P 500 HEALTH CARE IDX -18% -40% -14% 36% 81%

S&P 500 ENERGY INDEX -26% -50% -26% 52% 101%

S&P 500 CONS STAPLES IDX -20% -34% -9% 26% 44%

S&P 500 CONS DISCRET IDX -31% -52% -16% 31% 52%

S&P 500 INDUSTRIALS IDX -27% -62% -25% 40% 92%

S&P 500 UTILITIES INDEX -22% -49% -5% 10% 21%

S&P 500 MATERIALS INDEX -26% -59% -27% 46% 103%

S&P 500 TELECOM SERV IDX -22% -47% -12% 25% 53%

 

S&P/TSX COMPOSITE INDEX -32% -46% -22% 47% 68%

S&P/TSX FINANCIALS INDEX -22% -55% -18% 32% 81%

S&P/TSX ENERGY INDEX -16% -48% -30% 63% 190%

S&P/TSX MATERIALS INDEX -21% -43% -23% 54% 111%

S&P/TSX INDUSTRIALS IDX -31% -46% -21% 46% 69%

S&P/TSX TELECOM SERV IDX -28% -38% -5% 13% 17%

S&P/TSX CONS DISCRET IDX -31% -49% -18% 36% 57%

S&P/TSX CONS STAPLES IDX -12% -16% -7% 44% 58%

S&P/TSX UTILITIES INDEX -5% -34% -5% 15% 106%

S&P/TSX INFO TECH INDEX -54% -59% -44% 75% 81%

S&P/TSX HEALTH CARE IDX -25% -36% -28% 79% 113%

 

Perhaps I am too rigid in my valuation techniques, but when you look at a range of normalized valuation metrics, the market as a whole is overvalued here. To simplify things and lend credibility to my claim that the general market is overvalued, I lean on Grantham to provide an exact FV for the S&P 500, which he recently said is no more than 950 (see here: http://www.investmentpostcards.com/2011/08/16/jeremy-grantham-sp-worth-no-more-than-950/).

 

So under the assumption that at fair value said asset is priced to deliver its cost of capital, we can back out the implied growth rate of the S&P 500 at 950 assuming a 9% cost of equity (the long-run nominal return for the market - see attached) and a $25.18 per share dividend for the index. At 950, the dividend yield would be 2.65% (25.18/950) and the implied GR would be 6.35% (or a little lower b/c technically the forward dividend should be used).

 

Currently with the market at 1231, the expected 10-year CATR (compounded annual total return) is 5.84%: 2.05% yield + 6.35% GR + -2.56% annual decline to fair value [(950/1231)^(1/10)-1].

 

As you can see in the Schiller Data attached, over the last 10, 20, 30, 40, 50 and 60 years, Actual EPS grew 8.6, 7.6, 5.9, 7.1, 6.9 and 5.9%, respectively, while Actual Dividends grew 4.8, 3.7, 4.6, 5.4, 5.2 and 4.8%, respectively. Reported earnings have been very robust over the past ten years, yet cash actually making its way into shareholders' pockets (i.e. dividends) has grown anemically in comparison. I would posit that the level of EPS growth relative to per share dividend growth was primarily due to elevated profit margins as a result of A) cheap leverage, B) elevated financial sector leverage, thus elevated financial sector EPS contribution, and C) record high O&G profits not reflecting actual cash making its way into O&G investors' pockets due to D&A vastly understating the true cost of maintaining an O&G business (i.e. it costs XOM FAR more to maintain its production than its $15.8B LTM D&A, which includes its R&M/Chemical segments).

 

All that to say....dividends have grown around 5% over the last 10 years, yet Grantham's 950 FV is assuming growth of a little more than 6% - we just came off of a 10-year period of tremendous leverage, and are most likely going to go through a 10-year period (about three years in now - 2009, 2010, 2011 - so 7 left) of tremendous DE-leveraging, thus I believe it is logical to conclude growth is going to most likely be below-average on a go-forward basis. So assuming below-average growth, IMO the market should be trading at a level that implies below-average growth, versus where it is trading at now, which, by definition, is implying ABOVE-average growth going forward. If the market was in fact fairly valued at 1231, then the implied growth would be around 6.9% [9% cost of equity minus (25.18/1231)]. I just don't buy that dividends are going to grow 6.9% per annum over the next 10 years.

 

So I'm not sure how that fits in with what the market is implying based on how far it has fallen relative to past bear markets, but that is how I am looking at general market risk at the moment.

7YrForecasts_911.pdf

Schiller_Data.xls

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Just to stir the pot a bit, here's why I believe it is a wonderful day to be reducing risk....

 

I don't know your style well enough, what's the average turnover on your portfolios?  (Not looking for a precise answer)

 

About 3/4 of the portfolio does not change much, as its made up of long-term (if not permanent) holdings and special situations that will be held for more than a year. The remaining 25% has higher turnover consisting of opportunistic short-term trading opportunities (not intentionally short-term, but rather securities that would not lend themselves to a permanent status in the portfolio that will be sold if they move up 25% or more), workouts, and cash. The short side of the portfolio has high turnover as it is done opportunistically (as in today) after larger moves in the market and/or individual securities I utilize to hedge. I use a very rudimentary formula for managing general market exposure - so right now my calculated expected 10-year CAGR for the market is 5.84% and my general exposure is around 55%. If for example the market moved up to where it was priced to return 3% per annum, I'd bring the exposure down to around 30%.

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Yeah, 950 is not far from the last "fair value" estimates that I made last spring.  FWIW, here's a nice piece that shows a half dozen different ways of looking at "fair value," all of which indicate that we're probably still 20-40% overvalued today:

 

http://advisorperspectives.com/dshort/updates/Market-Valuation-Overview.php

 

 

With the broad market likely being overvalued, it's imperative to be selective about individual securities!

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perma bears will always be perma. they will keep you from looking for Values and making a fortune. You wanna know what these perma bears would have been saying "at the bottom" in 1974? Reduce Risk. Hussman would be 100% in cash and "gloomy". Meanwhile the Grahamites would be getting rich.

 

My primary goal is to not lose the nest egg that I plan on carrying me through retirement (Warren's rule #1 and rule #2 guide a lot of my thinking).  If being risk averse is seen the same as being a perma bear, I'll take the label.  If others want to get "rich",  or make a "fortune" more power to them. 

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Guest misterstockwell

I am with you bmichaud. The market has no idea a recession is coming(here), nor does it price in risk from Eurotrash, and it hasn't even given a thought to any issues in China. "Cheap" is a relative term based on prospects that are unrealistic. I haven't had a higher level of cash since I started in this business in 1995.

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Bmichaud you waste so much time coming up with rationalizations for why the market is going to get worst, which is in my experience truly a fools errand.

 

The only reason you are even able to garner a response is because we are truly in a a shitty market with unusual uncertainties, abnormally high volatility, and several black swan events that have occurred almost in sequence.

 

My advice to you is that instead of wasting all this precious time trying to pin point exactly when we are fully pricing in a recession, or what the ultimate fair value of the S&P is, to spend an equivalent amount of time seeking value.

 

Small Cap stocks are basically at their March 2009 levels. To think this market isn't cheap, and is not pricing a recession is madness.

 

Also, Some of you act as though the projections for 1-2% growth are set in stone.

 

Let me remind you, that in the year 2000 economists and the treasury projected that by 2012, the US would have paid off all its debt... Even crazier they then discussed the ramifications of not having a treasury market.

 

http://www.npr.org/blogs/money/2011/10/20/141510617/what-if-we-paid-off-the-debt-the-secret-government-report

 

What this tells me is that when it comes to the fiat money economies coupled with fractional reserve banking, growth can come back quickly, and rapidly. Now what happens if we start growing say 2.7% in 2012? or 3.8% in 2013, well in that case the market goes back to discounting a growing pie, in which case stocks are insanely cheap.

 

I think that all your wildest dreams about what could go wrong have come to fruition, and the market is still here, we still need to buy toothpaste and drive our cars to work, what more everytime we get a few days of silence from the European Circus US equities seem to go in one direction... up.

 

Predicting the things you are predicting is a total waste of time in my humble opinion.

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How is me going thru this exercise any different than you and ur firm conducting "research" on whether or not the market is pricing in a recession?

 

You utilize your fantasy macro monetary view to guide your investment decisions just as much as I integrate my macro view into my general market analysis. Zero difference.

 

I never once claimed there are not screaming buys right now. Just because the general market isn't pricing in a recession doesn't mean small caps aren't attractive - so it doesn't make sense to say that it's a fantasy for me to believe the market isn't pricing in a recession. You happen to utilize current earnings of the market to justify ur belief the market is cheap - I think that's asinine given the record high NPMs right now.

 

So if you would like to put 100pc of ur portfolio into small caps that are as low as 2009 as we enter a recession here in the US and Europe grinds itself into depression, more power to you. We'll see who comes out the other side with superior performance. I will be the first one to admit defeat and that I need to change my approach once this all plays out...

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Did you see the ECRI video I posted?

 

Since when does a week of stock market performance indicate economic direction?

 

Stocks went up 30pc in response to QE2, yet the economy got worse - pure speculation. Now we're bemoaning the QE2 air coming out of the QE2 balloon. If the QE2 rally never happened, we'd still be having this conversation - but since the market has declined from those levels, psychology is such that this is a temporary dip and we'll be right back up there.

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Buffett doesn't believe we will go into a recession. I'm humble enough to think that a guy who is much smarter than I'll ever be and has more access to resources than I'll ever have probably knows more about the how the economic winds blow.

 

He even said "it's very, very unlikely we'll go back into a recession... We're coming out of a recession."

 

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That is my biggest concern with taking the ECRI side - it's a tremendous matchup Buffett versus ECRI, but I give the nod to ECRI (perhaps at my peril) given Buffett missed the last recession and the housing crash.

 

Buffett didn't dream about holding treasurys over the last two years, yet Prem loaded up on them.

 

Lots of different opinions and time horizons. Sure, if you buy the market or something cheap and don't look at it for ten years you'll probably do fine. I'd rather hedge and prepare for events to play out in order to take advantage of the time when nobody wants to own stocks.

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What about the CPI running at 3.9% annualized for the economists out here?

 

http://www.bloomberg.com/news/2011-10-19/u-s-september-consumer-price-index-report-text-.html

 

Of course, if you back out food and energy it still looks better at 0.1% for September, but it is still 1.2% annualized. The 12 month figure ex food and energy is at 2.0%.

 

So yes, you can seek refuge in cash during these uncertain times, but please understand that you are losing your purchasing power weather there is a recession or not. I also wonder how long the bond vigilantes will stay calm with their yields below the CPI or at par with the ex food and energy?

 

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Guest misterstockwell

Also, Some of you act as though the projections for 1-2% growth are set in stone.

 

That would be a positive. I am thinking you left out the "-" sign.

 

 

Let me remind you, that in the year 2000 economists and the treasury projected that by 2012, the US would have paid off all its debt... Even crazier they then discussed the ramifications of not having a treasury market.

 

...and now the treasury makes all its predictions based on no recessions and 3% GDP growth. Equally nutty but it gets no press.

 

 

What this tells me is that when it comes to the fiat money economies coupled with fractional reserve banking, growth can come back quickly, and rapidly. Now what happens if we start growing say 2.7% in 2012? or 3.8% in 2013, well in that case the market goes back to discounting a growing pie, in which case stocks are insanely cheap.

 

Let's see, how high would inflation be in your scenario? Incredibly overworked printing presses and high growth? Never a good combo.

 

I think that all your wildest dreams about what could go wrong have come to fruition, and the market is still here, we still need to buy toothpaste and drive our cars to work, what more everytime we get a few days of silence from the European Circus US equities seem to go in one direction... up.

 

I can't speak for bmichaud, but my wildest dreams about what could go wrong are not even close to fruition. There's a bankrupt continent across the pond, and nobody will admit it. The banks there are toast. Our US money market funds have ~30% of their holdings in European bank paper. I think it insane to ignore things like that. The "E" in p/e can evaporate faster than one can imagine.

 

Predicting the things you are predicting is a total waste of time in my humble opinion.

 

I think he is being prudent. You can't ignore Europe's bankruptcy, the japanese dilemna, China's real estate bubble, Australia's real estate bubble, US stubbornly high unemployment, falling house prices, falling wages, excess housing inventory,  etc. It all comes back to affect US companies, including those cheap small caps. I have been through the Asian currency crisis, Long Term Capital, the bursting NASDAQ bubble, recessions, Great Recessions, and everything in between, all with the demeanor of a value investor. I did well--more than well. I dove in when others were fearful. The current environment is frightening, and one I don't feel comfortable investing in. Most troubling, I am most fearful while others are diving in.

 

 

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That is my biggest concern with taking the ECRI side - it's a tremendous matchup Buffett versus ECRI, but I give the nod to ECRI (perhaps at my peril) given Buffett missed the last recession and the housing crash.

 

Buffett didn't dream about holding treasurys over the last two years, yet Prem loaded up on them.

 

Lots of different opinions and time horizons. Sure, if you buy the market or something cheap and don't look at it for ten years you'll probably do fine. I'd rather hedge and prepare for events to play out in order to take advantage of the time when nobody wants to own stocks.

 

I get tired of repeating myself, but here goes.  Buffett's insurance business is not going to stop if his total investment portfolio (bonds and equity) drops 25-30%, whereas Prem's insurance business could stop if his total portfolio (bonds and equity) drop 25-30%.  And that doesn't matter what the macro-environment looks like.  If either of their portfolio drops considerably, one is far more likely to stop writing insurance than the other.  Buffett doesn't have to worry as much about macro. 

 

And if you thought Buffett missed the recession or what was happening, remember that he was running off Gen Re's derivatives book 8 years ago, well before anyone thought about counterparty liability and a credit crisis.  Prem's two-three moves ahead of everyone else, and Buffett is two-three moves ahead of Prem. 

 

By the way, if you look at the title of this message board, and the dinner I hold for Fairfax Shareholders, you'll realize that I'm one of Prem's biggest cheerleaders...but Buffett is just in a different league than anyone else.  There's just never been anyone better, and probably never will...especially when it comes to translating his intellect, so that all of us dummies can grasp it!  Cheers! 

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