February 25, 2019
First, an apology is due for my tardiness as I was on vacation in Florida. We had a ton of family down there for my Grams’ 80th birthday. Fun was had by all.
Meanwhile, the stock market has continued to run higher and higher, seemingly without a breather of any kind. We are witnessing one of the sharpest v-shaped recoveries that markets have ever seen – and as we know from experience – things that can’t go on forever, won’t. And the kicker is that since falling nearly 20% to end 2018, not only have the markets still not made a new all-time high, they still haven’t even made a higher high.
On the bright side, we did finally see prices close solidly above the 200-day moving average (for the S&P 500), signaling a possible resumption of the long-term up-trend.
An important point follows:
If you start with $100 and lose 20% and then immediately gain 20%, how much money do you have? Most people would assume $100. Most people would be wrong. You would have only $96. You would still be down 4% from where you started. This is why cutting losses quickly is so important to long-term success in investing. We have all heard that the best offense is a good defense. A clearer illustration may not be found anywhere. It is even more illustrative at larger percentage moves.
Consider a drop of 50% and a gain of 50% - your $100 is now $75 and you are down 25%.
And a drop of 80% and a recovery of 80% leaves you with $36 – down 64% from where you started.
It cannot be said with enough emphasis that that preventing large losses is the #1 goal of all serious investors (followed closely by “paying less taxes”).
Defense wins championships.
So, as of Friday, the S&P 500 Index (SPX) is up 10.7% for the calendar year setting a pace that is virtually impossible to sustain. Humans are famous extrapolators – to our detriment. If the market kept this pace for the year the SPX would finish up around 75%, this year. The biggest 1-year move in history was +45% in 1933 coming out of the great depression. Still, investors (from the professional to the novice) are all subject to the same human behavioral biases and humans tend to extrapolate – when the market has gone up, they are bullish and when the market has gone down, they are bearish.
I study this behavior intensely, and one of our favorite ways to watch is through the “smart-money and dumb-money indicator” from Sentimentrader.com. Using a number of statistics from the market like certain put/call ratios, commitment of traders reports, and fund flows they are able to get an idea of the sentiment of retail investors, vs institutional investors and then they create this amazing chart.
Here is how it looks today:
We want to invest alongside the smart money and opposite the dumb money – at extremes. When the differences (or spreads) are small, we don’t put a lot of weight into this indicator, but when they are extreme (like today) we pay attention. Right now, this indicator is saying that the odds are not in our favor for new capital investments. More likely, is that we see a meaningful pull-back sooner than later – and if that pull-back doesn’t fall below the low achieved on 12/24 – I think that will signal the “all clear” for a proper resumption of the bull market.
But we aren’t quite there yet. And chasing this market higher is likely to lead to disappointment in the short-term.
Markets have reacted favorably to positive news on the trade war between the US and China, but economic data has continued to come in light – even if earnings have largely met their lowered expectations. I continue to see a risk that even if the trade war comes to an end (words chosen carefully because we all know that nobody can win a trade war…) too much global demand may have been pulled forward back in 2018 when corporate CFOs had to make inventory decisions for 2019 under the threat of massive tariffs increasing the cost of waiting to order.
Meanwhile, given recent news that Mr. Trump is considering new auto tariffs on the European Union, we could just be moving from one set of problems to another, albeit smaller, set of problems.
Either way, we take our queues from price action in the markets as it relates to buy and sell signals. Markets can stay irrational for a lot longer than investors can stay solvent or patient.
If markets remain above their 200-day moving averages and continue higher we will continue to invest cash in our best ideas. Our buy signals are designed to get us in when the odds are in our favor and to keep us on the sidelines when they are not. Right now, we are in-between and waiting for direction. Yes, this means we have missed the 10.7% rally over the past 9 weeks – but we are confident that our rules will get us in when the danger has passed – which as of today, it has not.
We could have gotten lucky investing all of your hard-earned cash on Christmas Eve, or somewhere between then and now – but we couldn’t have done so without a violating our time-tested rules and putting you in harms way.
To be fair, we have bought several securities along the way, and added to others – all of which are up substantially. One I specifically mentioned in my blog on January 22nd was Ubiquiti Networks (UBNT) which subsequently released strong earning and has soared 38.19% since we bought it on January 8th (vs. the S&P 500 return of +8.48%). There other examples like this one which are far outperforming the market – and there will be many more if the market powers higher from here. Like the largest alligator in the swamp, we grow the largest portfolio by waiting for our prey to come to us – and then we strike.
We have chosen to employ a rigorously back-tested (over long periods of time covering varying market regimes) and researched strategy that has been used for years by some of the world’s brightest but unknown investors.
Another important point follows:
There is no secret to what we are doing. The “recipe” has been widely published in many forms over the years. Much like if I were to cook Martha Stewart’s recipe for anything – mine is probably not going to taste like hers… at first. But over time, I may perfect the execution, and I may even find ways to improve upon the recipe given the changing tastes of the clientele.
The strategy we use has been absolutely proven to improve upon the results achieved by other of the world’s greatest well-known investors like Warren Buffett, Carl Icahn and David Einhorn.
Here is a sample of some results from one study:
And before you conclude that “1% (in the case of Warren Buffet) isn’t much” – consider the 2018 Berkshire Hathaway Annual Shareholder Letter posted on Friday, February 22nd where Warren himself said:
“Let me add one additional calculation that I believe will shock you: If that hypothetical institution had paid only 1% of assets annually to various “helpers,” such as investment managers and consultants, its gain would have been cut in half, to $2.65 billion. That’s what happens over 77 years when the 11.8% annual return actually achieved by the S&P 500 is recalculated at a 10.8% rate.”
So, by the same arithmetic, a 1% increase in annual performance would nearly double (from 2.65B back to 5.3B in his example) your compounded return over the 77-year (nonsensical) period. That his numbers in the chart above and the numbers he provided in his letter on Friday are so similar, is a total coincidence.
I do think the point that Warren makes is important. If your goal isn’t to earn a better risk-adjusted return than the market has to offer, then the evidence is clear – just buy the SPY exchange-traded-fund and fire your “helper” ASAP. It’s costing you a fortune to keep them.
However, before you totally go-it-alone, consider the following chart – which is also very real. People are irrational and behave in ways that Warren (evidently) can’t imagine… and why is this so hard to imagine given how irrationally (even extremely intelligent) people behave when it comes to things as important as life and death?
Consider your own irrational behaviors – past or present. (sorry! 😉)
Have you always worn your seat belt?
The above, illustrates what we (at Elevate) refer to as the “Behavior Penalty”, which is paid by most investors at the time of maximum pain. This behavior is what actually creates market tops and perhaps more importantly – market bottoms.
If you can control your personal behavioral biases to sell when you should buy, and vice versa; in other words, if you are confident you can avoid the behavior penalty and thus volatility of returns is no issue – then by all means - go buy the SPY fund and check-in on it in about 77 years.
If you are this impervious to volatility and behavioral bias however, we might suggest the EEM fund, instead. Or at least the 3x leveraged SPY (UPRO) fund… but that is a whole other blog…
If you just want the market return, we can build you a portfolio of index funds that has better risk characteristics than the market overall, and we can do it lower cost than anyone else in the world.
And we can manage your urge to sell when your strategy calls for holding.
If you want to do better than the above options (over time) we can invest your capital using the same rules that have been proven to improve upon the returns generated by the best investors in the world.
It’s ultimately your money and you make the decisions. My commitment is to tell you what I would want to know if our roles were reversed… and with respect for that - I like option 3 best!
Until next time,
Chief Investment Officer
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