Edge and Odds

The enemy of knowledge is not ignorance, it’s the illusion of knowledge (Stephen Hawking)

It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so (Mark Twain)

Edge and Odds

Invest with smart knowledge and objective odds

THE RULE OF 20 STRATEGY

January 23, 2019

I was recently able to get one of our sons (Eng., Math, Computer Sc., MBA/MIT) build a model to assess how a rational, sensible and disciplined use of the Rule of 20 could help investment returns by optimizing the cash/equity mix to systematically manage risk.

The Rule of 20 is not a timing tool but it can help modulate equity exposure (risk on/risk off) given certain equity valuation ranges. Since nobody knows the future, the Rule of 20 provides an objective reading of equity markets valuation only using known data. Since equity markets naturally cycle repeatedly from fear to greed to fear, a disciplined and patient use of the Rule of 20 could be a great risk management tool.

The Rule of 20 P/E (actual P/E + core inflation) nicely fluctuates between 16 and 24 around its “20” median. From a strictly valuation viewpoint, holding equities below 20 should prove less risky and more rewarding than holding equities above 20. Since valuations always return to the steady 20 mean, cycles are predictable, at least in their valuations trends.

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I have asked Danny to calculate investment returns since 1957 based on a set of rules stipulating cash/equity combinations at various Rule of 20 P/E ranges. The guiding principles for the rules are best described with a few quotes from famous investors:

  • The stock market is the story of cycles and of the human behavior that is responsible for overreactions in both directions. (Seth Klarman)
  • Bull-markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria. (Sir John Templeton)
  • Be fearful when others are greedy. Be greedy when others are fearful. (Warren Buffett)
  • You don’t have to trade with Mr. Market when he wants to, but only when you want to. (Benjamin Graham)
  • It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent. (Charlie Munger)
  • We don’t have to be smarter than the rest. We have to be more disciplined than the rest. (Warren Buffett)
  • Confronted with a challenge to distil the secret of sound investment into three words, we venture the motto, Margin of Safety. (Benjamin Graham)
  • You must weigh not only the alluring probabilities of being right, but the dire consequences of being wrong. (Peter Bernstein)
  • Buy not on optimism, but on arithmetic. (Benjamin Graham)
  • Rule No.1: Don’t lose money. Rule No.2: Never forget rule No.1. (Warren Buffett)
  • Cash combined with courage in a time of crisis is priceless. (Warren Buffett)

We don’t know the future and trying to forecast it has been proven futile time and again. But we know there are valuation cycles that can be exploited using simple arithmetic to rationally calculate our margin of safety: at any given point in time, what is the valuation downside risk and how does it measure against the valuation upside potential? Unlike other valuation gauges, the Rule of 20 provides very consistent trends around a stable median.

Using known trailing earnings and inflation data, we can readily see where equities are valued on their 16 to 24 Rule of 20 P/E range, calculate the valuation downside and upside and decide whether we have an adequate margin of safety given our own individual risk tolerance level. At a Rule of 20 P/E of 20, the valuation downside (20 – 16 = 4/20 = 20%) equals the valuation upside (24 – 20 = 4/20 = 20%). “Twenty” is thus the neutral, “fair value” level where valuation upside equals valuation downside. Below 20, the risk/reward equation tilts more favorably and vice versa. Simple “buy low, sell high” strategy.

We don’t have to be smarter than the rest, we have to be more disciplined than the rest.

This is not a backtest exercise where one tries to find a best fit on a set of past data. Rather, I established a set of rules to rationally and sensibly modulate the cash/equity mix taking into account that:

  • it is always best not to lose money;
  • equities tend to rise over time, along with corporate profits;
  • valuations always return to the Rule of 20 mean;
  • it is always best not to lose money.

The rules allow the valuation cycle to fully mean revert before triggering a new series of moves in the cash/equity mix. So after the maximum equity exposure has been reached on the R20 down journey, the exposure remains at this maximum until 20 is crossed again after which it is pared down as valuations keep rising. Similarly, cash is kept at the maximum level reached on the way up until the R20 P/E crosses 20 again on the way down, after which it gets reduced as the R20 P/E declines.

This is not a strategy aimed at regularly performing above market averages. In fact, the Strategy can never beat a rising market which it can only match if 100% invested. This is a strategy aimed at maximizing absolute returns while managing absolute downside risk smartly and systematically. If well set, the rules should allow to closely match equity returns in a rising market and to significantly protect capital in a declining market, preserving the investment base for the next upturn.

The actual strategy details will remain proprietary but I will share the results of the strategy as if it had been applied since 1957. I will also provide on Edgeandodds.com the current strategy readings and the changes when they get triggered. These should never be seen as investment advice, simply information on what my particular strategy says.

As a token of appreciation to significant donators to Edge and Odds, I will soon add a section to the blog that will detail the Strategy moves and monitor how a real investment in a S&P 500 ETF will behave going forward strictly obeying this Rule of 20 Strategy. Free riders are very welcome on this blog but I must find ways and means by which I can thank readers who voluntarily and generously contribute to the ever rising costs for the research supporting this blog should they find it useful.

Warning: following this Strategy can be very boring and can be hazardous to the relationship with your friendly broker. In the last 62 years, the Strategy has triggered 127 changes in the cash/equity mix, or about 2 per year on average. Some periods were fairly active but there were many intervals with few, if any, movements, requiring investors to develop personal interests other than equity investments. Paul Samuelson once quipped that “investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.” Be warned.

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1957-2018

The Rule of 20 strategy I set out returned 9.7% annually between 1957 and 2018 compared with 6.6% for the S&P 500 Price Index. An investment in January 1957 would be worth 5.7 times more today using the Rule of 20 Strategy than buying and holding the S&P 500 Index during the same period.

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As explained, the Strategy aims at capturing as much as prudently possible from rising equity markets but to protect precious capital during significant corrections and bear markets. The Strategy proved especially protective in 1969-70, 1972-74, 1987, 2000-02 and 2008-09.

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  • 1957-1987

With the same rules, the Strategy returned 9.4% annually between 1957 and 1987, significantly outperforming the 5.5% return of the S&P 500 Price Index.

  • 1988-2018

I only have S&P 500 Total Return data (cum dividends) since 1988. This period is characterized by a 5.5-year span between June 1997 and February 2003 when the rules dictated to remain totally out of equities because of uninterrupted excessive overvaluation. Between June 1997 and March 2000, the Total Return index jumped 76% against a 14.2% increased in the R20 Strategy all cash portfolio. But during the subsequent market rout to February 2003, the Rule of 20 Strategy portfolio appreciated 10.1% while the S&P Total Return Index cratered 43.2%. For the whole trough to trough period, the market returned zero in total while the Rule of 20 Strategy returned 25.7% entirely from its riskless t-bills portfolio.

For the whole 1988-2018 period, in spite of being all cash 31% of the period, the Rule of 20 Strategy returned 10.7% annually, bettering the 9.8% return from the Total Return Index and nicely protecting capital when needed.

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The Strategy offered only a limited absolute protection between September 2007 and March 2009 because equities never reached the overvaluation level that would have triggered the sale of all equities during much of the bear market, unlike in other cycles. The market collapsed mainly because of the Financial Crisis and the subsequent profit debacle.

Nonetheless, the Strategy returned to a fully invested position in late 2008 and remained such through April 2016 even though equity markets more than tripled. The Strategy triggered a 100% cash position in January 2018 and returned to a 100% equity position at the end of December 2018.

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BEWARE DECLINING FAIR VALUES

The Rule of 20 enables us to constantly calculate a “Fair Value” for the S&P 500 Index where FV = [(20 – Inflation) X Trailing EPS]. Fair Value is the Index level at the equilibrium between valuation upside and valuation downside. This FV fluctuates positively with trailing earnings and negatively with inflation and has a 97.5% correlation with the S&P 500 Index since 1957.

A rising Fair Value provides equity markets with an improving fundamental underpinning, mitigating downside stemming from deteriorating sentiment. Conversely, a declining Fair Value accentuates risk until reversed either by an eventual upturn in earnings or a decline in inflation. A declining Fair Value is particularly dangerous for equities.

The Strategy incorporates trends in Fair Value so that initially recommended cash levels are increased if and when Fair Value is in a negative trend phase (cash is capped at 100% to avoid short positions).

GOING FORWARD

I have always been wary of “models” showing their prowess using back data. I trust this Rule of 20 Strategy is rational and sound enough to deliver its promises in the future but nothing beats the real life testing. I have thus set up an investment in a tax free account in which I have invested in a low cost ETF of the S&P 500 Index with a Dividend Reinvestment Plan. I will trade this ETF exactly as the Strategy dictates, starting with the initial investment at the close on Dec. 24, 2018 when the Strategy triggered a 100% equity component. I will be dutifully following the Strategy and track the results.

Data sources:

  • S&P 500 price and total return data: Capital IQ, Yahoo Finance.
  • Inflation data: bls.gov
  • Earnings data: Capital IQ, Refinitiv/IBES.

THE DAILY EDGE: 23 JANUARY 2019

Home Sales Sank 6.4% in December

(…) December capped the weakest year for home sales in three years. Existing-home sales fell 6.4% in December from the previous month to a seasonally adjusted annual rate of 4.99 million, the National Association of Realtors said Tuesday. Compared with a year earlier, sales in December declined 10.3%. (…)

The decline in December sales was broad, with Seattle, Portland, much of California, Denver, Maryland, Delaware and the Philadelphia area experiencing double-digit declines, according to an analysis of local multiple-listing service data by Lawler Economic and Housing Consulting. (…)

The median sale price for an existing home in December grew 2.9% from a year earlier—the smallest increase since March 2012, when the market was still depressed from the housing crash. (…)

The Commerce Department isn’t expected to release December’s data due to the government shutdown, but an analysis by Redfin found that new-home sales dropped 10.3% in the South in December, 13.4% in the West and more than 16% in the Northeast. (…)

Mortgage rates have also come down in recent weeks, easing concerns that a long era of cheap housing credit was about to end. Rates nearly hit 5% about two months ago, but average rates for a 30-year, fixed-rate mortgage dropped to 4.45% last week, according to Freddie Mac. Purchase mortgage applications grew 9% for the week ending Jan. 11 from a week earlier to the highest level since April 2010, according to a Mortgage Bankers Association index. (…)

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Here’s a scary chart (@MikaelSarwe)

This will help some:

Los Angeles Teachers, School District Announce Deal to End Weeklong Strike Union members vote to approve agreement that includes 6% raise, additional staffing

(…) LAUSD Superintendent Austin Beutner said the agreement included a 6% raise, additional staffing at schools, and a reduction to class sizes, covering the union’s major demands. He said the nation’s second-largest school district agreed “to invest every nickel we have in our classrooms while maintaining the fiscal solvency of Los Angeles Unified.”

The deal includes $403 million to be spent through 2022 to add nurses, counselors and librarians at schools and to reduce class size. It doesn’t address health-care and other retiree benefits, which the district has cited as a major strain on its finances. (…)

“So far it seems like we got everything we wanted, most importantly that we are taken seriously,” teacher Julia Guzman said. (…)

In the last year, teachers in states including North Carolina, Arizona and West Virginia have gone on strike to demand higher pay and other changes, winning average pay increases of between 5% and 20%.

The trend could continue as teachers unions in Denver and Oakland, Calif. are currently locked in disputes with their districts and threatening to strike within the next month.

Truckers See Momentum Slowing Heading Into 2019

(…) “We see more evidence pointing to a potential freight recession in 2019 similar to 2015/16,” Morgan Stanley analysts Ravi Shanker and Diane Huang wrote in a Jan. 16 research note. “With net inventory levels reaching another all-time high and ordering levels falling, the risk of a destocking event in 2019 is high.” (…)

An index of U.S. domestic freight volumes slipped 0.8% last month compared with December 2017, the first annual decline in two years, according to Cass Information Systems Inc., which processes freight bills.

Trucking rates on the spot market, where shippers book last-minute transportation, also fell in December for the first time in several years, according to online freight marketplace DAT Solutions LLC. The average price to hire the most common type of big rig dipped to $2.07 per mile, a penny lower than the prior month and 5 cents below the level in December 2017.

The first quarter is typically a slower period for freight, although factory production ticked up at the end of last year, suggesting consumer demand could make up for a pullback in exports.

But analysts say trucking companies could face an even steeper drop-off in shipping demand this year because some manufacturers and retailers pulled imports forward in 2018 to avoid tariffs expected to take effect around March.

The impact “will likely be seen most in February after the impacts of an earlier Chinese new year leave the market somewhat naked to difficult  [year-over-year] comparisons,” Cowen & Co. transportation analyst Jason Seidl wrote in a Jan. 14 research note. Factor in falling spot rates, and “the data would suggest that much of the spot pricing gains from mid-2018 that strongly benefited carriers could be erased in 1H19, with the advantage in contract negotiations reverting back toward the shippers.”

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China Risks Real Hard Landing This Time Beijing’s crackdown on shadow banking has gone overboard. Some backtracking looks necessary.

(…) Chinese credit growth has continued to decelerate, despite nine months of significant central bank easing. If it doesn’t turn back up soon, producer-price inflation could turn negative—causing big problems in the heavily indebted industrial sector.

The mushrooming of Chinese shadow banking was an unfortunate, but necessary, byproduct of a banking system that has grown more state dominated since 2010. Private companies account for about two-thirds of the economy but receive only about a third of net new lending. It’s little wonder they have turned increasingly to unofficial channels to get loans. (…)

Despite several big reserve ratio cuts and sharply lower benchmark interbank rates, growth in net nonfinancial fundraising had declined to 9.8% in December, its lowest in more than a decade.

In other words, in the past year, banking-system liquidity has risen by about a fifth, but net credit growth has fallen by about a third. The reason is clear. Shadow finance outstanding fell by a full 10% in 2018—by far the sharpest contraction on record. (…)

  • Shadow banking was cut sharply last year, with shadow loans outstanding down by almost 11% YoY as of December, in contrast to a rise of 15% through December of 2017. Total credit rose by about 10% last year, but the composition of the new flow changed: traditional bank loans accounted for 81% of new credit, up from a 51% share in 2013 as shadow banking was curbed. There was a similar clampdown on peer-to-peer lending. While these changes are good for the long-term health of the financial system, they created short-term pain for many private firms, who were among the largest recipients of shadow credit. (Andy Rothman)

  • The SMI report from World Economics shows further softening in China’s economic activity in January. (The Daily Shot)

EARNINGS WATCH

We have 61 reports in with an aggregate 20.0% earnings growth rate, a 79% earnings beat rate with a low +1.7% surprise factor (+0.7% for Financials). The revenue beat rate is 57% (42% for Financials).

The blended growth rate for Q4 is 14.1% (12.2% ex-Energy), down from 15.8% on Jan. 1. Q1’19 estimates now show earnings rising 2.7%, down sharply from 5.3% on Jan. 1. with only 3 sectors expected to report good growth: Financials (+5.3%), Health Care (+8.7%) and Industrials (+8.2%). The remaining 8 sectors’ earnings are seen down 0.5% on average in Q1’19.

Trailing EPS are now $162.05. The Rule of 20 P/E is at 18.4.

ODD ODDS

There are many ways to skin a cat, and so many ways to forecast a recession. There’s this old saying that markets have forecasted 9 of the last 5 recessions and economists none of them. David Rosenberg plays the odds in his own many ways:

You don’t need to have the S&P 500 decline 20% to have a recession – we had an official downturn in 1990-91 without that happening (…). And we have had periods in the past when the stock market corrected more than 22% (1961, 1966, 1987) and there was no recession. But (…) declines in the S&P 500 of 20% or more typically does foreshadow recessions around 80% of the time. Nothing is truly infallible, but I’ll take those odds.

We don’t need a 20% beating and we have had bears greater than 22% without recessions but 20% or more typically does foreshadow recessions 80% of the time. Only President Trump can make some sense out of these numbers. Recessions without bear markets, bear markets without recessions but bear markets which, typically, do foreshadow recessions 80% of the time. I never thought I could use “typically” with “does” and 80% odds.

And about those 80% odds: there have been only 11 official recessions since WWII. Pretty small sample to derive solid statistics, especially if you also had recessions without a bear and bears without recessions. But there is a key to this:

The real key is whether the September high in the S&P 500 of 2,930 was indeed the peak of the cycle. This has nothing to do with the severity of the decline. Just a simple fact, which is that every post-WWII peak in the stock market was followed by a peak in the real economy. This is not 9 out of 5; it is 9 out of 9.

The real, real key in all this is what is actually a peak in the stock market? Obviously, if one waits long enough, there will be a peak close enough to a recession…Look at these charts from Ed Yardeni and try to make solid odds out of them. Confused smile

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