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FAQ

Why Don’t We Use Short or Margin?

The title is one of the most frequently asked questions of our portfolios.

The simple answer we usually use is that over 90% of our managed accounts are IRA accounts, and we just can’t short stocks or use margin in IRA accounts.

Following is the actual elaborate answer for more sophisicated clients. Since risk is unlimited using short or margin and they could result in total account loss, it does not match our long term investment goal. Mathematically, as we can see from formula below, since Ls could be infinitely large with short or margin on stocks, over the long term (i.e, f is large) it is unlikely to make money if one keeps using short or margin.

Investment Gain = f * (Wp * Ws – Lp * Ls) where,
f = frequency of trades, e.g., trades/year
Wp/Lp = win/loss percentage
Ws/Ls = average win/loss size, Ls = R (i.e., Risk)

Over a smaller sample size, i.e., in the short term, it is possible to make money using short or margin with a few bets, but this is entirely different from our goal to use the same strategy over and over again for long term growth.

It may be easier to understand using a real life example. Let’s use GSIC to illustrate issue. As the chart below shown, in March, 2011, GSIC chart broke down a decenting triangle, has formed a series of head and shoulder, and was retraced back to $19 resistance level. Its fundamental valulation ratio is expensive (e.g., P/E at 47), earning is on the decline, so it looked like a perfect short setup, and stop loss can be placed at $20, with profit targets at $18, $16, and $14. The reward/risk ratio seems very favorable.

Assume one trader with a $5000 account, decided to take $500 risk to short 500 shares of GSIC at $19 and place a stop loss at $20. The trader also placed braket orders to cover 200 shares at the first profit target $18, and cover 200 shares at next profit target $16, and cover the last 100 shares at $14.

Right after the trader shorted GSIC with the perfect setup and placed all necessary orders to control risk, GSIC gapped up open at $29.41 next day with pending acquisition news, see chart below. So stop loss order was triggerd and 500 shares was covered at $29.41, with total loss more than $5200, resulting in total account loss.

It will probably take a long time to recover from such a trade.

How To Reduce Drawdown In Bear Market?

In the 2008-2009 bear market, all investment asset classes suffered significantly drawdown at the same time. In this global economy, investment bubbles are inflated and deflated at much faster pace and different asset classes become more correlated with each other, making it difficult to spread or reduce risk through allocation or diversification. Is any objective alternative to traditional buy-and-hold asset allocation/diversification scheme for the investors to reduce the pain during the bust cycle while participating the boom cycle when growth returns?

The 2006 paper “A Quantitative Approach to Tactical Asset Allocation” by Mebane T. Faber proposed a simple, price-only, non-optimized, yet elegant solution to above problem, and it proves to work beautifully in out-of-sample 2008-2009 bear market. Readers can use google to find the latest paper which is updated to include more out-of-sample results.

In previous post, it is shown the clear superiority of ^VAY index over any style, sector, country, or asset class. But like all other investment instruments, it suffered 60% drawdown during the 2008-2009 period, which is very difficult for any investor to swallow not to make emotional decision to give up long-term investment goal.

In this post, Faber’s approach is applied to the ^VAY index to see if drawdown can be reduced without hurting performance. Figure 1 shows the exact buy/sell points for ^VAY based on the Faber’s 10-month moving average technique.

Figure 1 shows that one would get out ^VAY at the beginning of August 2008 and re-enter the market at the beginning of May 2009. It clearly avoids the largest drawdown period of the bear market and captures a substantial portion of the initial bull market, just like it did in 2002 bear market.

However, there are numerous false signals creating unwanted whipsaws before both bear markets, making the technique difficult for less experienced investors to follow. Whipsaws from false signals are typical of price and volume-based technical analysis, since human fear and greed from reading news or rumors creates short-term irrational price and volume trading patterns that can’t be explained by mathematical formula (and are frequently taken advantage of by professional traders.) One simple way to avoid the whipsaws is to apply Faber’s technology to fundamental earning data, which is the true representation of the strength of the underlining market. Since there is no publicly available historical ^VAY earning data, Figure 2 shows the result of applying Faber’s 10-month moving average technique to historical SP500 earning (due to availability of data, quarter earning is used in 2000).

Comparing with Figure 1, Figure 2 clearly shows the whipsaws are greatly reduced since earning data shows steady deterioration months before crashes. Although SP500 earning is not necessary a good approximation to ^VAY earning, it serves the purpose of this post to explain the concept. To obtain better buy/sell points, it is possible to calculate the actual composite ^VAY earning from all companies in ^VAY index.

Figure 3 below compares the performance of ^VAY (blue line), with Figure 1’s price-based timing technique (red line), and with Figure 2’s earning-based timing technique (violet). After a sell signal and before a buy signal, the performance is calculated using cash without any interest. As expected, the performance of price-based timing technique suffers due to whipsaw during normal bull market, but is compensated during severe bear market. Earning-based timing technique outperforms the ^VAY by closely following the performance of ^VAY during bull market while avoiding most of drawdown during bear market.

Figure 4 compares the drawdown of ^VAY (blue line), with Figure 1’s price-based timing technique (red line), and with Figure 2’s earning-based timing technique (violet). Both timing techniques maintain the same drawdown size during bull market, but significantly reduces the drawdown during bear market.

In summary, the key to long-term investing success is to have an objective and unemotional strategy to reduce drawdown during bear market while participating the growth in bull market. The goal can be achieved by applying Faber’s technique to earning data of the underlining market to reduce bear market drawdown significantly without giving up the performance of bull market. Of course, stock market is very dynamic and dangerous, there is no guarantee that the experience learned from previous bear markets can be successfully applied into future.

The Best Long Term Investing Strategy For Last Decade

As we enter into a new decade, it is worthwhile to look at the past decade to review which strategy worked best during the worst investment environment.

Value Line (www.valueline.com) is one of the most respected investment research firms, and its “Value Line Investment Survey” is the most trusted and used US stock market database, which is available from most of public libraries. Since June 30, 1961, Value Line created an “Value Line Composite Index” to cover around 1700 companies (out of 8000+ companies traded in US exchanges.) On February 1, 1988, Value Line began publishing the “Value Line Arithmetic Average” of the Composite Index, which can be found using symbol ^VAY on Yahoo finance page.

Unlike all the other static indices, Value Line Arithmetic index is interesting because from its web site, we know (1) it requires stocks in the index to have “Annual Net Income: at least $5-10 million preferably, but not necessarily growing.”; (2) “Vacancies constantly occur within our approximately 1,700 stock universe. Sometimes a company’s earnings will deteriorate to such a degree that we believe investors have lost interest. If that happens, we will discontinue coverage.”; (3) it re-balances very frequently since it is an arithmetic index.

Using Yahoo chart, let’s compare ^VAY with other popular US indices over the last 10 years.

^VAY is clearly on the top, with almost average annual 8% return without any leverage, followed by MDY (midcap 400 stocks), ^RUT (Russell smallcap 2000 stocks), ^DJI (Dow Jones large cap 30 stocks), ^GSPC (large cap SP 500 stocks), with ^IXIC (Nasdaq, around 2500+ stocks) last.

In the chart below, let’s compare ^VAY with some popular sectors and asset classes with long enough 10-year historical data. Once again, ^VAY is the top leader, followed by oil, real estate, retail, pharmaceutical, biotech, internet, with semiconductor last. Yahoo does not have long enough data on commodities index, but based on last 10-year GSCI futures data,  commodities performance is about the same as oil. In addition, based on inverse Dollar Index futures data, past 10-year return of buying foreign currencies is around 25% , which is not a bad investment since it does not lose money over the decade.

How does ^VAY compare with major emerging countries BRIC? The chart below shows only Brazil beats ^VAY for the past decade, with almost average 15% annual return, China ties with ^VAY for the 2nd place, followed by India, with Russia last. As one can see from the chart, BRIC countries are wildly volatile, it would be very difficult for any investor to invest in them without emotion.

Let’s also compare the most famous investors of the past decade in the following chart. ^VAY again is the clear leader, Warren Buffett’s BRK-A is the second, followed by Bill Nygren’s Oakmark Select Fund (OAKLX, 10-year 5-star fund), David Herro’s Oakmark International (OAKIX, 10-year 5-star fund, fund manager of the decade), Bill Gross’ Pimco Total Return (PTTRX, 10-year 5-star fund, fund manager of the decade), then last is William Danoff’s Fidelity Contrafund (FCNTX, 10-year 5-star fund).

The performance comparison may be a little bit surprised, but it makes absolute sense. Since companies traded in US exchanges pretty much cover any sector/country/asset, and ^VAY is designed to include only companies from all sector/country/asset making money at current market condition, it is natural for ^VAY to outperform the static indices and funds that does not sell losers.

Although Value Line database has been available for a long time, and for the past decade, the simple, boring, and labor intensive strategy has been outperforming any sector, country, or asset class, it is too easy for investors to get lost in all the news, hype, fear, and greed to adopt this strategy.

Of course, we are in a secular bear for the last decade, so how does ^VAY fare during the last secular bull market? Yahoo only has long enough historical data for a few indices, and following is the comparison since the inception for ^VAY. Clearly, during secular bull market from 1988 to 2000, earning does not matter that much. Just buy any stock that moves quickly will make money. Nasdaq is the top, with average 20% annual return, followed by Dow Jones 30 stocks, SP 500 stocks, with ^VAY comes in last, with annual return only 12%. However, the consistent advantage of ^VAY becomes clear once the secular bull market ends.

On February 1, 1988, Value Line began publishing the Value Line (Arithmetic) Average

Understand Secular US Stock Market Cycles

As most people are aware, about every 5 years US stock market goes through one cyclic bear market, and we just exited one of the worst cyclic bear markets in history.

US stock market also has a longer secular cycles of average around 17 years, shown in the chart below, and we are still in the secular bear market. The cyclic bear market in a secular bear market tends to be much severe than the cyclic bear market in secular bull market.

100-year cycle

The chart above starts with the Great Depression/World War II secular bear from 1929 to 1942, due to the burst of the largest asset bubbles from heavy leverage of banks and investors.

One of the strongest secular bull market started at 1942, two years before the end of WWII, at a time of great pessimisms and extremely high tax rate. Dow Jones index went up 10 times during the 22-year period, which again created asset bubbles from greedy investors.

After that, with Vietnam War, assassination of JFK, Watergate, oil embargo, etc., Dow Jones Index stayed sideway in the 17-year secular bear market period from 1965 to 1982.

The next secular bull market started in 1982 when tax, inflation, interest rate were at extremely high level. Dow Jones index went up 10 times during the 18-year period, created various asset bubbles globally again, and that was also the time the terms “buy-and-hold”, “buy-the-dip”, and “dollar-cost averaging” became popular again, and they were proved again to be fatal in the subsequent secular bear market.

If stock market history repeats itself again like the past 100 years, we probably will experience another 5-year cyclic bull and bear market before we enter into the next 17-year secular bull market, and we should expect tax rate to be much higher over the next several years, just like the previous transition from secular bear market to secular bull market.

Like other auction markets (real estates, commodities, bonds, tulips, antique collectibles, etc.), stock market tends to play against human emotion of greed and fear by inflating and deflating asset bubbles, so the secular market cycles probably will repeat itself as well. The proven investment strategy in a secular bear market can be learned from the greatest stock investors (Sir John Templeton and Warren Buffett) of previous secular bear markets: buy-low-sell-high value stocks. Sir John Templeton made his first fortune from buying depressed stocks during the 1939 secular bear market cycle, and Warren Buffett has been very successful in both previous and current secular bear markets.

When the current secular bear market ends, money will be shifted towards buying and holding speculative growth stocks. Peter Lynch, made his fortune from the 1980 to 1990 secular bull market, describes the growth strategy in his books. In a secular bull market, expensive stocks will get even more expensive due to speculative expectation, hence this growth strategy is usually called “buy-high-sell-higher”.

Value Investing Books

The global bear market from 2008 to 2009 were one of the worst in history, traditional asset allocation approach were proven to be deadly wrong for retirement accounts since simultaneously all assets went down heavily and none of the asset classes can recover quickly back to previous high when the crisis was over. The only thing continues to weather the storm well and can quickly recover from bear market draw down and make equity high is value investing approach – buy quality investments at low price and sell when they become expensive.

One of the best value investing books written for 8 year old kids to 80 year old retirees is “The Little Book That Beats The Market” by Joel Greenblatt, who uses a simple story to explain an easy yet powerful magic formula. Here are some quotes from Chapter 11 of the book: “Choosing individual stocks without any idea of what you’re looking for is like running through a dynamite factory with a burning match. You may live, but you’re still an idiot.” “Most people have no business investing in individual stocks on their own.”

Another book offering timeless quantitative value investing strategies is from James O’Shaughnessy: “What Works on Wall Street” The price-to-sales ratio strategy revealed in his 1997 book proves again to be a run-away winner in 2009 recovery.