Asset-Class Value Traps and Catalysts to Avoid Them

Asset-Class Value Traps and Catalysts to Avoid Them

Executive Summary In the last of our asset-class valuation series, I discuss costly value traps that can derail even the best-reasoned asset-class value themes. A lot can go wrong when you bet on value. In particular, an asset class that appears to be an excellent value can stay that way for years.  All investors face this problem and most professional investors who manage billions of dollars have only one option, which is to leg into these investments over time. Asset class traders have the benefit of being small enough to wait for a catalyst before trading a compelling value opportunity. In this blog post, I review various catalysts I use to get the timing right and avoid the value traps. Introduction Most traders and investors know to be aware of value traps when investing in cheap assets. Value investors comment that risk of permanent loss is the true risk associated with investing, and a worst-case scenario is losing 100% of capital. Although asset classes rarely lose 100% of...

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Compelling Value

Compelling Value

Executive Summary Asset classes trading significantly below intrinsic value occur infrequently, perhaps once every 10-20 years per asset class. We need to accept that asset pricing (for long hold periods) is rational and correct most the time, and that cheap asset classes are usually cheap for a reason. I discuss methods I use to determine when an asset class is irrationally mispriced well below long-term intrinsic value. I’m trying to distinguish a once-a-decade compelling valuation versus run-of-the-mill everyday value opportunities. Compelling values set up lucrative multi-year trades to the long side. While there’s no formula for identifying these opportunities, I present three steps I take in the search. First, I find prices that appear to be an extreme outlier with respect to history, logic and other asset class valuations. Second, I identify the behavioral effect causing the asset class to be mispriced compared to long-term intrinsic value. Finally, I ask myself a few...

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Shiller CAPE – A Deceptively Dangerous Tool

Shiller CAPE – A Deceptively Dangerous Tool

Executive Summary In this post, I examine the popular stock market valuation tool, the Shiller CAPE. The Shiller CAPE valuation approach, based on 150 years of data, appears to have an uncanny ability to predict future S&P 500 returns. Unfortunately, the benefits of using this tool for actual investment decisions appear to be limited. The Shiller CAPE, along with all asset class valuation measures, has the following significant weaknesses and issues. Selection bias has likely overstated the reliability of predicting future expected returns. Using CAPE to shift between equities and T-bills doesn’t enhance risk-adjusted returns. Using historical valuation data is susceptible to unpredictable long-term regime shifts that can devastate the effectiveness of such a tool. When the Shiller CAPE is low, risks are high, and many competing asset classes are also priced cheaply. When the CAPE is high, competing assets also have low expected returns. It appears the S&P 500 is efficiently...

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Value Investing for Asset Class Traders

Value Investing for Asset Class Traders

Executive Summary This is the first of a multi-part series examining the use of valuation approaches to identify future outperforming asset classes. I discuss why value investing is an essential and useful tool for asset class traders. I briefly discuss the Warren Buffett approach as the purest form of discretionary value investing. I clarify the distinction between fair value (a concept I’ve used to discuss short-term trading edges) and intrinsic value used by value investors. I briefly review the vast academic literature on mechanically value-tilted portfolios. These portfolios are typically heavily weighted towards cheap and risky assets. These cheap securities are most often fairly priced to deliver long-term returns that are superior to a market cap weighted basket of similar securities. Finally, I introduce Asset Class Value Investing as: identifying moments in time when an asset class appears to be irrationally mispriced based on an assessment of long-term intrinsic value....

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Navigating Asset Bubbles for Profits

Navigating Asset Bubbles for Profits

Large price runups, such as a gain of 100% over two years, are rare.1 In a previous blog post, I presented 10 attributes to distinguish asset class bubbles from large price runups that are justified by improving fundamentals. Those bubble attributes are: Heavy retail investor involvement New-era thinking Irrational valuations Five or more years of swiftly rising prices Parabolic rise in price Shorting is unattractive or impossible Social mania Product providers exploit excessive demand Leverage fuels more buying Bubbles are late-cycle phenomena As asset class traders, we are especially interested in bubbles as a potential huge source of alpha when they collapse. As it turns out, bubbles are a lot tougher to exploit than it might seem. In this blog post, we’ll delve into bubble characteristics in more detail, and then investigate the best ways to trade asset classes that are experiencing a bubble. We’ll examine bubble characteristics over the short term (plus and minus three years...

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Bubbles

Bubbles

If you’re in the investment biz long enough, you’ll inevitably find yourselves searching for profitable ideas when an asset class is experiencing a bubble. The term “bubble” is a heavily overused term in the financial media and among professional investors. Any large price increase over a short time period, such as a 50% gain over a year, prompts a few writers, analysts or professional investors to describe the runup as a bubble. These bearish folks are typically using the term loosely without a nuanced evaluation to determine if prices have simply reflected new highly positive information. Additionally, how many times have we heard “bubble” used for assets that have experienced long-term, secular bull markets, such as U.S. or Japanese government bonds, when current prices are not experiencing anything like the bubble phenomenon? Then other folks use the term in a variety of ways to describe investor group think, such as “hedge funds are the next investment bubble,” or “there’s...

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Long-Term Relative Strength Line Trend Changes

Long-Term Relative Strength Line Trend Changes

Often in trading we become totally engrossed in searching for short-term opportunities with a hyper-focus on news flow and daily price movements. Occasionally it’s good to drastically alter time frames, especially if your creativity has dried up on short-term ideas. One way to search for new trades is to scan asset classes that have performed the worst over the previous decade. This is especially interesting when there’s been a large divergence of performance in asset class returns over the previous 5 to 10 years. Table 1 shows a ranking of the worst-performing ETFs by 10-year annualized returns as of October 31, 2017. When tabulating this ranking, I excluded the ProShares daily leveraging funds and commodity exchange traded notes. For comparison, the S&P 500 returned 7.51% per year during this time frame. This list contains many ETFs in the energy space, with a few niche asset classes (clean energy, gold miners, steel and nuclear), country funds (Russia, Italy and Brazil) and...

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Does Experience Provide an Asset Class Trading Edge?

Does Experience Provide an Asset Class Trading Edge?

Does experience trading the markets provide an actual trading edge? Surely an investor who’s seen many bull and bear markets has an advantage compared to a novice just starting out in the field. The beginner is an alpha source for seasoned traders as the former pays their “tuition” associated with learning how to trade. The counterargument, using efficient markets logic, suggests that if a great number of portfolio managers (PMs) have significant experience, then the performance benefits of experience become arbitraged away as prices quickly incorporate the collective wisdom of the pros and experts. Fund marketers ignore the efficient markets logic and advertise portfolio manager experience because it’s very convincing to most customers. I’ve traded asset classes for about 20 years. I’ve experienced two major and several minor bear markets, and seen a variety of bull markets. When I assess my current trading edges, I admit I’ve started putting “experience” as an edge – although at...

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Market Tells – Part 2

Market Tells – Part 2

In the Market Tells – Part 1 blog, I introduced the concept of market tells as an enduring trading edge that can be used to enhance returns over the long term. Developing the ability to identify market tells and act on these signals takes practice. It’s important to keep track of trading results to get better and gain confidence to jump on these opportunities in size when they occur. In this blog, I first clarify thoughts on a few instances when the market tell guidelines are not met. The most important guideline for identifying a market tell is the 80% rule, which states that to consider market action as unusual (and thus providing a market tell), the usual behavior must occur at least 80% of the time. Otherwise, it’s just too difficult to associate the unusual behavior with a market tell rather than normal market gyrations. Next, I’ll review three more market tell techniques that can be used to trade asset classes. I’ll close with some thoughts on crowded trades and implementation...

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Market Tells – Part 1

Market Tells – Part 1

In any competitive field, the awareness of tells can provide a significant and enduring edge. Most people think of poker when they hear about tells.1 Is a player acting strong to encourage other players to fold? Does a player seem nervous when they throw their chips in the pot? Can any useful information about an opponent’s poker hand be gleaned from these actions? Tells occur in many aspects of life and competition. For most sporting events, searching for tendencies in an opponent’s play is an integral part of game preparation. In the home arena, parents look for facial clues when interrogating a fidgety teenager as the youngster explains what she’s doing on a Saturday night. Tells are an important source of feedback when trading the financial markets. I call these “market tells” to distinguish between the variety of tells that occur in other forms of competitive environments (more on this distinction later). A market tell is a powerful approach to sensing moments in time when...

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