Top 29 Reasons to Be Bearish Again

3 11 2009


Congratulations is due to Warren Buffett and all others who stood up against the foolishness of market timing during the short period between 1982 and 1999, and focus only on US stocks.   The mere act of selecting this time and place is a fairly spectacular act of market timing.  But if you look at any other period of time or practically any other market, failing to time the market turns out to a bad idea.  Just to take one example, during the 53 years between September 1929 and July 1982, stocks, adjusted for inflation, declined 37%.  Of course, that’s just an arbitrarily selected time period, but stocks are not always good investments.

In fact, right now, they suck.  The naked analyst is short stocks.  Stocks are massively over-valued and the recession is about to get worse, not better. 

The Stock Market is Naked Too

Actually, since roughly 30% of the movement in the average stock is directly related to movements in the market, the naked analyst wonders:  if you can’t analyze the market, what makes you think you can analyze a stock?

The market has earnings, and it has a price.  The earnings growth of the market is in fact a lot easier to forecast than the earnings of any individual company.  The price has a beta of 1.0 and an alpha of 0.  This is not only better than most fund managers achieve, it also never changes.  I like things that never change because it’s pretty easy to forecast them.   Finally, like any other stock, there is an infinite amount of bullshit pretending to be an explanation for the current price.  So you see, there’s nothing special about the market at all.  It’s completely naked, just laying there in bed, waiting for me to analyze it.

Since 1872, earnings have grown at an average rate of 5.9% + inflation.  Stock prices during the same period, rose at, would you believe, 5.9% plus inflation.   Stock prices never diverged more than about 50% from that trend until 2000, and earnings never did until 2009.


In theory, stocks compete with interest-bearing securities, so the higher the interest rate, the lower the P/E multiple should be.  Unfortunately, the data proves otherwise.   There is zero correlation between interest rates and stock prices.  This is not so surprising if you think about the standard equation for discounting the value of a stream of cash flows.  

                                 P   =   E / (( Rf + rb )-g)

          Where P = price, E = earnings, rf=risk free rate, rb = expected rate of return * beta, and g = growth rate.

                The overly simplistic Fed model measures the P/E against interest rates, which is simply:  P = E/Rf.    This formula completely neglects to account for the possibility of changes in growth rate or expected rate of return.  The funny thing is, these two items turn out to be a lot more important than interest rates and, wouldn’t you know it, are most often inversely correlated to interest rates.  Interest rates tend to go up when the economy is strong, which is the exact same situation that tends to cause risk aversion to go down and growth expectations go up.  Because these other considerations have a very strong tendency to cancel each other out, we can construct a model that is far simpler than the fed model and at the same time more accurate.

                               Price = En * 13.8


                 Where En = normalized earnings.

 This model has an r2 with the market of .75, which isn’t perfect, but it beats getting poked in the eye with a hot fork.

 Based on normalized earnings of $62.26, our 13.8x model suggests the fair price for the S&P500 is 649.5.   If you can buy the index at less than this, your long term return swill be greater than 5.6% + inflation + dividends, but since the current share price is more than 2 standard deviations above this normal level, good luck with that. 

What Makes a Really Bad Short


Those who use valuation to set target prices will consistently be disappointed – stocks rarely trade at their fair value.   Valuation can tell us something though, if we break stock market history in to quintiles according to the level of prices relative to the fair value.   From this exercise, we can determine that buying at high quintiles is significantly less profitable than buying at lower quintiles.  The current price is in the 4th quintile.  Investors who bought the index at prices within this quintile, on average, lost money in the subsequent year.  The odds of losing money are 45.2%.  Interestingly, the odds of still being in the hole even 3 years later are still 19.5%.   

But short sellers lost money too!  On average, the market was down only in the first year, and even then, not by enough to pay the interest rate on the borrowed stock.  The odds of a short-seller making more than 10% are only 23% in the first year, and diminish to 19% by the third year.  That is not statistically different than the average for all times.    

There is a better way to look at the data though.  Until the year 2000, though, stocks had been at this level only three times before.  In each case, stocks fell more than 70% in real terms before hitting their final bottom.  That is an unacceptable risk, but these declines were not caused by high share prices.  There were some really serious catalysts that occurred to cause the declines, in most cases, serious declines in earnings.  The high share prices only exacerbated the problems.
      Please note, this approach is not so usefull for short-term forecasting.  True, the average quarterly real return for the S&P for all of recorded history is 1%, and the average for anyone buying at the current level of divergence from fair value is much less, only 0.45%, it is still positive on average.  Ninety-five percent of the returns are between -8.34% and +7.9%.  This is not that much different from the range for all time, which is -7.5% to +8.5%.  
        The average for monthly returns for all time is 0.3%, with 95% of the returns falling within a range of -3.9% to 4.2%.  If you buy at the current level, the average is negative, but only -0.1%, with 95% of the returns falling between -4.3% and +4.2%. 
         These short-term odds don’t change much no matter how much higher we go.  This is why short-term investors are so emboldened, and why the markets are ultimately capable of becoming so over-valued.                               

To make a good short, we would have to have good reason to expect some sort of similar catalyst in the near future that would force these brave short-term investors to retreat or even disappear.  Here are the top possibilities:


1.            Every recession in the last four decades has had at least one positive quarter-to-quarter GDP reading, only to be followed by a renewed downturn.  This recession might be different, but I don’t see why.

2.            Almost all of the apparent 3.5% growth in the third quarter’s GDP came from non-recurring contributions: cash for clunkers; first-time home buyers’ tax credits, and  involuntary inventory buildup. 

3.            My contacts in the real-estate business tell me about 45% of transactions they are seeing are bank-controlled, and prices of homes in this category are still falling.  Any change in bank policy could drastically change the outlook for housing. 

4.            Employment surveys have apparently been missing 200k job-losses per month and these will be corrected with revised data in February.  Those who lost their jobs will stop spending money long before the data is released.

5.            A study by Societe General shows that between 2000 and 2008, the S&P performance outside the reporting season was 7% lower than inside the reporting season, and that more than 100% of the reporting season gains occurred in the first three quarters.

6.            A good reason for number 6 above is that the first three quarters reports are not audited.  The fourth one is, and fourth quarter earnings are always below trend established in the previous three quarters.  That’s not surprising, given the standard of ethics on most American boards.  What’s surprising is that the market hasn’t figured this out yet. 

7.            According to Bloomberg, consensus forecasts indicate earnings growth for the average company of 31% to 25% in each of the next 7 quarters.  Nice try.

8.            Consensus forecasts for operating earnings indicate that analysts believe margins will exceed record levels by the end of 2011 – exceeding the previous records set in the years leading up to 2007, when leverage was preferred over balance sheet strength and a political climate that was hostile toward labor, causing the naked analyst to wonder, “Are they all just stupid?  Or just lazy?”

9.          The second wave of re-sets for Alt-A and Option ARMs has just begun, following a lull since last March. 

10.          Major credit losses are continuing unreported as a result of FASB change last spring.  The naked analyst feels this change will eventually prove disastrous.

11.          Despite massive increase in M1, broad money continues to contract.

OK, I lied.  I have only come up with 11 reasons so far, but you get the point.  




If You Want to Make God Laugh, Tell Him Your Investment Style

22 10 2009

German researchers wishing to find the genetic determinants to stock picking skills recently played an interesting trick on their test subjects. (Hauke R. Heekeren , et all 2009).1   The game rewarded contestants with points for discerning patterns and making the best choice from several options.  The fun part started when a player chose the best answer seven times in a row, at which point, the researchers suddenly changed the pattern.  

Subjects in the lab experiment scored highest when they could quickly adjust to outcomes that didn’t match their expectations.  This is an excellent model of how the stock market works.  Once a pattern is widely recognized, it changes.  We all know this, so to prevent those with natural stock-picking talent from having an unfair advantage and to keep all the mediocre fund managers gainfully employed, we designed the concept of investment styles.

Academic research demonstrates that none of the standard investment styles ever add any value (Laurent Barras, et all, 2009)2,   Thank goodness.   There are just too many people out there beating their benchmarks every year!  Fortunately the winning funds used methodologies that only worked extremely well for a limited period of time, and then, for no reason at all, God, or somebody, just stepped in and changed the rules.    The purpose of the investment style, of course, is to prevent any of the really clever fund managers from adapting to the change, and for the most part it seems to work.  Of course, there will always be some fund managers who try to cheat on this system by engaging in what is known as style drift.   These fund managers will only get caught if they perform abnormally well, in which case, the simple solution is to fire them.  

Style Counsel

The problem for anyone trying to integrate a group of effective industry analysts into a cohesive team when you have already promissed your sponsors that you will follow a given investment style is that the factors that contribute to success in any one sector are almost always different from any other sector.  An overly zealous adherence to investment style can have a devastating effect on the performance of individual analysts within a firm.   Let’s start off with a very simple example.   The Low Price book anomaly has been known to add very persistent excess return to both Long only and Long/Short books in Japanese Equities.  (Please see figure 1.)  At least it used to, but  let’s say you’re a Value Fund that has gotten religion about this anomaly and then you hire a retail analyst with a reputation for very sound valuation-driven research.  Now you are in trouble.  Low Price/Book strategies are about the surest way to lose money in Japanese retail stocks that was ever invented.  (Please see figure 2). 




In my view, the best way to deal with this is to hire an analyst who has enough confidence to tell his boss to fuck off whenever she feels its appropriate.   Very painstaking and scientific research demonstrates that it takes about 7 years for an analyst to develop this level of confidence, so never hire anyone with less than 7 years of experience.   

Managing Angels

Fortunately for those of us who need to live with them, experienced analysts can still make horrible mistakes.  As a manager, you need to be able to distinguish between routine mistakes that happen every day and are best used for opportunities to build character, and those mistakes that prove we have somehow lost the plot.  Figure 3 shows the performance of low EV/EBITDA vs high EV/EBITDA within the technology sector.  Notice how outstanding this simple metric performed between 200 and 2006.  Then it just failed.  This is a potential game changer.  In my view, a good analyst will usually pick up on this change even faster than a trader or a PM, but no one can be a genius at every turn.  Even Michael Jordan needed a coach once in a while.   The worst thing you can do in such situations is to pretend that you know more than the analyst.   Do you imagine that Phil Jackson ever really tried to teach Michael Jordan anything about how to play Basketball?   That probably wouldn’t have worked so well.  



What you can and must do in such situations is to show that you are monitoring the performance fairly, and that you are measuring the underlying attributions of that performance in a way that is at least careful and hopefully very clever.  If you have good attribution data, make it available to the analysts on an internal website.   Good analysts will learn to use it themselves without being prompted.  If not, you can ask them, “Why isn’t EV/EBITDA working anymore?”  If they don’t have an answer, tell them that this is information that you need to have.  You’ve made your point without making it personal and without assigning any blame to anyone.  If you don’t have the precise attribution data, you will have nothing constructive to offer. 

Style Creeps

Don’t get me wrong.  There are certain types of style drift that no sensible naked analyst would approve of.  If you sell yourself as an expert on US Health Care stocks, for example, please don’t invest my money in Bolivian Bonds.  But as long as you stick to what you know, there’s never any need to set yourself up to win this year’s Darwin awards.  Remember, it’s not the strongest or the smartest who survive.  It’s the ones who adapt.

1.        Genetic variation in dopaminergic neuromodulation influences the ability to rapidly and flexibly  adapt decisions, Lea K. Krugel, Guido Biele, Peter N. C. Mohr, Shu-Chen Li, and Hauke R. Heekeren

2.     Most recently, Barras, et all, in a study of 2,076 funds, found that just 0.6% had alphas exceeding zero. Barras, Laurent, Scaillet , O. and Wermers, Russ R., False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas (April 20, 2009). Journal of Finance, Forthcoming; Swiss Finance Institute Research Paper No. 08-18.

If You Meet a Tiger in the Jungle, Offer Him Your Umbrella

15 10 2009

Almost everyone I meet on the buy side has a story about a sell-side analyst they hired who didn’t work out.  Most are able to extrapolate from just one or two isolated incidents like this into some complicated theory of how evil incarnate emanates from the sell side, but most of the available research, as well as my own experience, refutes these theories categorically.    Boris Groysberg, et al March 20071, found that buy-side forecasts were just plain inaccurate, and that buy-side analyst’s recommendations consistently under-performed sell-side recommendations, despite all the well-documented conflicts of interest in sell-side research.  But forget about that. Groysberg found a couple of other things that were even more disturbing:

1.      Buy-side firms who rely solely on sell-side research out-perform those that hire their own internal analysts.

2.      Buy-side firms who hire from the sell-side do not hire poorly, but the performance of sell-side analysts deteriorates substantially after joining the buy-side.



 My experience as head coach for a team of 15 analysts was significantly different from what appears to be the norm, and I have some thoughts about this that I’d like to share.    In our case, even long after joining our firm, the analysts with primarily sell-side experience vastly outscored their colleagues with primarily buy-side experience in every category that we kept data on, except the very subjective category of teamwork, where they scored dead even.   

Groysberg hypothesized that the sell side’s stronger performance is a result of much more competitive environment.   Our environment was highly competitive and extremely hard on the ego.  Everyone’s recommendations were available to everyone else – there was no privacy.  The performance of every recommendation was tabulated relative to each analyst’s benchmark and everyone’s track record was public.  In addition, the implementation team, consisting of a PM, Chief Trader, a trade-desk analyst, and myself were all constantly in touch with key sell-side analysts, and sell-side ideas were as likely to get into the portfolio as internal ideas, possibly more so.  At the same time, we were totally intolerant of any behavior that might stifle an idea or hurt someone’s feelings.   Constructive debate was always encouraged, but no one was ever allowed to make personal or degrading comments.   Analysts and fund managers alike were expected to make mistakes on a regular basis.  If they didn’t make enough mistakes, I knew they weren’t really trying hard enough.   About the only thing you could get scolded for was being rude to a broker.

Groysberg also hypothesized that the sell side benefited from significantly higher frequency of meetings with management.  In our case, we snuffed this disadvantage out completely.  Our analysts made as many as 5 management contacts per day and were encouraged to never have lunch or dinner alone.    Often the contact was no more than a phone call, but for the average analyst, this meant more than 1,000 meetings or phone calls per year. 

Another advantage of the sell side is that they spend about 30% to 50% of their time marketing, and through these inter-actions with institutional investors, they subject their ideas to very broad scrutiny.   Most buy side analysts get none of this and are pretty happy about it.  One of my most important and most difficult roles was to read and provide feedback to every written report that went into our research data base.   It would have been a lot easier, but remember, I wasn’t allowed to say anything that would hurt anyone’s feelings.  Analysts were also required to submit to a weekly grilling by the implementation team.  None of the analysts enjoyed this, and we ran up against a great deal of resistance when this system was first instituted, but I could see very clearly that analysts were preparing their arguments much more effectively once they knew that there would be scrutiny beyond the mere thumbs up or down by the PM.   

There was one thing that Groysberg didn’t think of though, and that was probably because it would go against everything his finance professors ever taught him, and, yet it is probably the most over-bearing and pointless burdens that any asset management company ever straps on its analysts.   Sell side analysts are free to find whatever works for them and their sector.  They are usually free to find whatever fans they can from a multitude of massively divergent clients.   And because each industry and each analyst is different, what works for one is unlikely to work for another.  Rivalry within the brokerage community helps to ensure that a larger percentage of analysts are likely to be on the cutting edge of whatever is working at any given era.  

But once a great analyst enters the Dark Side of buy side investment policies, there will usually be a single methodology that is approved to the exclusion of most others.  This is so widespread that most firms just assume it is the common sense thing to do, and it is, provided your objective is to destroy creativity, motivation, and performance all in one go.    

We never screened our recruits for investment style.   If someone has figured out a way to beat the market consistently, we didn’t really care how they did it.   In fact, if they weren’t doing things a whole lot differently than we were, it didn’t make much sense to hire them.  My job was to figure out what their edge was and try to prevent our corporate culture from sabotaging it.  Allegorically, I was offering them my umbrella, to shield them from the constant rain of irrelevant bullshit and idiotic policies that prevade almost any well meaning establishment. 

A good analyst is knowledgeable, creative, courageous, and hungry.  In my view, a buy-side operation is a costly and ineffective environment for teaching any of these skills.  Let the sell side do this, and learn how to manage the wealth of resources that spring up from this inexhaustible well.  



Groysberg, Boris, Healy, Paul M., Chapman, Craig J., Shanthikumar, Devin M. and Gui, Yang, Do Buy-Side Analysts Out-Perform the Sell-Side? (March 2007). Available at SSR