Investing tips from socialist Soros

Even though George Soros is a devout socialist, he knows something about investing. He writes about a typical cycle in the stock market in his book The Crisis of Global Capitalism. He calls his theory “reflexivity,” but the general idea is that the stock market usually tracks profits closely until near the end of the cycle.

As the reader can see from the chart below, the variance in profits isn’t as great as that in stock prices. The two begin to diverge about halfway through the expansion. All that means is that the PE ratio begins to inflate because credit expansion by the Fed is pumping new dollars into the economy. 

If stock prices remained tethered to earnings, stock prices would level off. To prevent that, the media send in the clowns. In a rodeo, clowns distract the bulls to prevent them from stomping the cowboy into the arena dirt, but in the market the clowns distract the investor. The clowns pull from their shirt sleeves old tricks to make the fundamentals look better. They use performance measures that rely on creative accounting, alternative profit measures, pro forma statements, and complicated valuation techniques. The clowns break the connection to earnings so that prices continue their ascent unrestrained by fundamentals. If the market was an actual rodeo, the clowns would be lynched for letting the bulls pulverize the cowboys.

Morgan Stanley says ride the raging bull

Morgan Stanley’s analysts suggest running with the bulls this week. They recently announced that they expect the S&P 500 to rise 15% in the next twelve months and possibly to reach 3,000, a gain of 27.4%. They wrote, 

Although optimism is a late cycle phenomenon, history tells us the best returns often come at the end."

Essentially, they are shouting “the end is near!” but “party while you can!” They credited President Trump for their optimism:

While acknowledging that the pro-business agenda of President Trump has awakened "animal spirits" in the economy, the Morgan Stanley strategists feel that Trump has simply "turbocharged" a global business recovery that already has been underway since the first quarter of 2016. They note that one of the worst economic contractions in 30 years, as measured by U.S. GDP, bottomed out a year ago. Since then, their favorite economic indicators have been accelerating, including those capturing business conditions, business outlook and global trade.

Investors to get slapped by the invisible hand

The great American economist Benjamin Anderson wrote Economics and the Public Welfare: A Financial and Economic History of the United State, 1914 – 1946. Most mainstream economists get the history of that period, especially the Great Depression, wrong. If you want to know what really happened and why, read Anderson's book. In a chapter on the stock market crash of 1929, Anderson related the following story:

One able Jewish investment banker said in the summer of 1928 that he did not understand what was going on. He said, “When I do no understand I do nothing.” He had withdrawn from the market. He had turned his holdings into cash, and he was waiting until he understood.

Earnings stumble

Despite what mainstream finance and economics teach, the stock market is rational. Two things drive it - profits and risk tolerance, or as they say in finance, the discount rate. Both have advanced the stock market from its lows at the bottom of the latest recession to recent record highs as profit rates and risk tolerance soared so that investors have been willing to pay more for the same profits.

As of the writing of this post, the S&P 500 is down about 3% from its record set on March 2. Some of the selling could have come from profit taking or covering shorts, but much of it is due to concerns about future earnings. Last week I showed that profit rates are at record highs and reasonable investors would assume such rates are unsustainable based on the history. And that seems to be the case as Seeking Alpha's Brian Gilmartin wrote:

Looking at the first half of 2015, analysts are now projecting year-over-year declines in both earnings and revenues for both Q1 and Q2 '15, compared to expectations for earnings and revenue growth for both quarters back on December 31 '14.

The Famous Fama - Investing is Gambling

Eugene Fama, the 2013 Nobel prize winner in economics, a professor at University of Chicago and a director and consultant for Dimensional Fund Advisors, recently said at a conference,

 I have one word for you and you're not going to like it - chance.

Of course, Fama is famous for his support of the Efficient Market Hypothesis (EMH) which states that the stock market is so efficient at pricing new information that investors can never beat broad market indexes such as the S&P 500. Fama's advice to investors is, 

You decide how much you want to tilt to these [types of risks and] returns and then you diversify the hell out of it," Fama said. Choose your asset allocation and then make sure you get fully diversified portfolios that get you there.

Investors who followed Fama’s advice lost enormous sums in the market crashes of 2000 and 2008. So many “anomalies” in the EMH have popped up that they gave birth to a new industry called behavioral investing that insists investors are not rational and make many mistakes.

In the short run, say under three months, movements in the stock market are essentially random. In the very long run the market tends to converge to the net present value of future earnings (NPV). So in both periods the EMH is correct. But in the medium run, the market deviates a great deal from NPV, and thus supports behavioral investing theories.

Austrian economics untangles the confusions of both the EMH and behavioral investing for serious investors. A chapter in my book, Financial Bull Riding, goes into more detail about what is wrong with both the EMH and behavioral investing schools of thought. Short run deviations in the market, such as what day traders attempt to profit from, are impossible to predict, while the long run trajectory offered by NPV is highly subjective because the analyst must forecast earnings (very difficult) and choose a discount rate (constantly changing). 

However, the medium term market is fairly predictable because it follows profits closely and responds to the risk tolerance of investors. The value may diverge from the long term NPV, but that doesn’t mean investors are irrational as behavioral investing insists. Investor risk tolerance and knowledge changes over time depending on circumstances, mostly profit reports. I use quarterly corporate profits and price/earnings ratios in the forecasts I publish on this blog and the model explains about 70% of the change in the quarterly averages. For economic and financial models that is a good fit. 

In addition, Fama and most analysts look to the percent returns of indexes as the standard measure for investment performance. For example, if the S&P 500 is up one year by 10% then your investments had better return more than 10% or you have failed. But as I show in my book, hedge funds consistently fail at matching the S&P 500’s percentage returns, yet make their clients far more money than those clients would have made passively investing in an index. They can do that by avoiding large declines in the market, such as happened in 2000 and 2008.

Professors like Fama forget that compounded interest works against the investor in bear markets just as it works for him in bull markets. To recover from disasters like 2000 and 2008, investors need extraordinarily good returns in bull markets. For a simplistic example, assume the stock market fell 30% at the beginning of the year and stayed down the entire year. Not only has the investor lost 30%, but he has forgone interest he might have earned in bonds. Then the market going up 30% the next year will not recover his losses because his base is lower. He will need about a 60% increase in order to recover his lost investment plus opportunity costs.

The Wall Street Journal printed a critique of hedge funds in the May 27, 2014 southwest edition page C6, with the headline “Hedge Funds Don’t Live Up to Their Billing.” The article said that HFR’s composite index of hedge funds returned 72% over the decade ending last month compared to a return of 100% for the Vanguard Balanced Index Fund, which has an allocation of 60% stocks and 40% bonds. Hedge funds got their names because the managers hedged against market downturns using short selling and derivatives. Hedging is the same as buying insurance against a market decline. Obviously, the costs of the insurance will weigh down returns in percentage terms, but will pay off handsomely after a disaster.

Studies have shown that hedge funds have significantly under performed the broad indexes in percentage terms while returning more to the investor in dollars than a broad index would. It sounds counter intuitive, but it’s worth checking out. As Fama said, “This is arithmetic, not a hypothesis.”

Of course, a better way is to learn how Austrian economics ties the stock market to the business cycle to fine tune your hedging as I show in Financial Bull Riding.

Is the stock market overvalued?

University of Pennsylvania’s Jeremy Siegel has been shooting again at Yale professor Robert Shiller’s stock market valuation model, the cyclically-adjusted price-earnings ratio, or CAPE, according to William L. Watts at The Tell blog on the MarketWatch web site at http://blogs.marketwatch.com/thetell/.

CAPE showed an adjusted P/E ratio of 23.57 recently, considerably above the long term average and an indication that the market is overvalued. Here is the chart of CAPE from Watts’ blog: