ABOUT INVESTING AND… EDGE AND ODDS

• Investing is not black or white, in or out, risky or safe. The key word is calibrate. The amount you have invested, your allocation of capital among the various possibilities, and the riskiness of the things you own all should be calibrated along a continuum that runs from aggressive to defensive.
• It’s not what’s going on; it’s how it’s priced…When we’re getting value cheap, we should be aggressive; when we’re getting value expensive, we should pull back.
• If it’s true, as I believe, that (a) the easy money in this cycle has been made, (b) the world is a risky place, and (c) securities are priced high, then people should probably be taking less risk today than they did three, five or seven years ago. Not out, but less risk and more caution.
• Observations regarding valuation and investor behavior can’t tell you what will happen tomorrow, but they say a lot about where we stand today, and thus about the odds that will govern the intermediate term. They can tell you whether to be more aggressive or more defensive; they just can’t be expected to always be correct, and certainly not correct right away.
• Even though no one can ascertain when we’re at the exact top or bottom, a key to successful investing lies in selling or lightening up closer to the top, and buying or,
  hopefully, loading up when we’re closer to the bottom.

The above is from the September 7, 2017 letter (Yet Again?) of Howard Marks, Oaktree Capital’s CEO. Marks expresses what Edge and Odds is all about.

Equity market cycles are made of 2 components: profit cycles and valuation cycles which may or may not overlap each other.

Profit cycles are essentially tied to the economic cycle as revenues and margins fluctuate with expansion/recession cycles. The science of economic forecasting remains very iffy and much less precise than the science of understanding the present economic situation.

Valuation cycles are even more complex as human psychology mixes with trends in inflation and interest rates to inflate or deflate profit multiples. Valuation cycles are even more significant for investors as their multiplier effect offers enormous money making opportunities… and money losing possibilities.

Relying on forecasts on these 2 different sets of crucial variables is thus highly dangerous to anyone’s financial health. It is best to concentrate on understanding

• where we are today on the economy in order to evaluate the cyclical economic upside/downside probabilities;
• and where we are today on valuation in order to calculate the cyclical upside/downside ratio on equities.

Knowing “where we stand today” on each of these two crucial variables (the Edge) enables us to know “the Odds that will govern the intermediate term” and thus helps us “calibrate” the risk profile of our investments.

Economic and profit cycles can only be evaluated and are thus subject to assessment risk.

Valuation cycles, using the reasonably stable Rule of 20 value band, provide a precise view of the risk/reward equation. History shows that the Rule of 20 P/E fluctuates between 15 and 23 (most of the time) and that it always goes from one extreme to the other, from undervaluation to overvaluation and vice-versa (see below). The calculation of risk vs reward is thus always clear, enabling investors to calibrate their risk exposure using objective data.

Steve Blumenthal (CMG Wealth Management) illustrates the need to cyclically adjust equity exposure

Here is how you read this next chart:

• The top section looks at the S&P 500 from 1900 through August 31, 2017.
• The shaded green areas are the BULL markets.  Also shown are the annualized returns over the period.
• The shaded white areas are the BEAR markets with annualized return numbers.
• The data box (red arrow) shows the GPA, or gain per annum, for secular bull and secular bear periods.  Also shown is the percentage of time in each secular period over the length of the study.
• The middle section looks at yields of long-term U.S. government bonds, while the lower section looks at the commodities market as measured by the NDR Commodity Composite.

When one takes a step back and looks at full market cycles, the need for navigating secular trends becomes apparent.  This is true for all asset classes.

Chart 2: 54% of Time in Bull Markets vs. 46% in Bear Markets Since 1900

Now, visualize the various cycles over time:

• The profit cycles are generally synchronized with the economic cycles, but not always. Profit recessions occur from time to time. Hence the need to really focus on profits.

• Valuation cycles can be violent. Hence the need to focus on valuation.

• Absolute P/E analysis can be hazardous if inflation is not taken into account. The Rule of 20 is the best tool:

Notice how the Rule of 20 P/E is much less volatile than the absolute P/E and fluctuates much more evenly around its central 20 value. This is much more useful when trying to assess “where we stand today”.

BTW, Byron Wien, the Blackstone strategist who hosts lunches every August to tap the collective wisdom of financial experts to see what’s next, recently wrote in Barron’s that

one investor recalled the “Rule of 20” from what now seems like ancient times: the combination of inflation and price earnings ratios should be no more than 20. On that basis, the market is a little more than fully priced but not egregiously overvalued.

Ancient times! Jim Moltz, strategist at C.J. Lawrence (now I am showing how ancient I am) developed the Rule of 20 in the mid-1980’s, really not that ancient. But simple, useful and reliable. The pretty ancient wheel remains simple, useful and reliable…