January 27, 2021

Talk Your Book: Investing in Fixed Income

Today’s Talk Your Book is presented by Smith Capital Investors: We spoke with Gibson Smith, founder and CIO, of Smith Capital Investors about all things fixed income. We discuss: How has the bond market changed over time? Why the interest rate market is not as easy as it looks Why it’s easier to outperform in fixed income Are flows impacting bond market performance? Will baby boomers put a cap on rates? Why ...

How America Invests (with Vanguard’s Ryan Barrows), Barry Ritholtz takes a victory lap, “That’s fascinating”

  Join Downtown Josh Brown on an all-new episode of The Compound Show. This week, a conversation about How America Invests with Ryan Barrows (Vanguard) and a brief visit with Barry Ritholtz (Masters In Business) on the inauguration and winning the election bet with Josh. You can listen to the whole thing below, or find it wherever you like to listen to your favorite pods! Listen here: Apple podcasts Spotify podcast...

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Leggett & Platt, Inc. (LEG) Dividend Stock Analysis

Linked here is a detailed quantitative analysis of Leggett & Platt, Inc. (LEG). Below are some highlights from the above linked analysis: Company Description: Leggett & Platt Inc. makes a broad line of bedding and furniture components and other home, office and commercial furnishings, as well as products for non-furnishings markets. Fair Value: In calculating fair value, I consider the NPV MMA

To continue reading, please click on the article title above...

“That’s Fascinating!” with Barry Ritholtz

Barry Ritholtz joins Downtown Josh Brown on the The Compound Show podcast this weekend, new episodes every Friday morning. Subscribe to our channel: https://www.youtube.com/thecompoundrwm?sub_confirmation=1 Listen to The Compound Show podcast: https://podcasts.apple.com/us/podcast/the-compound-show-with-downtown-josh-brown Talk with us about your portfolio or financial plan here: http://ritholtzwealth.com New to investin...

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Markets That Are Definitely NOT In a Bubble

If it feels like we’ve been debating a stock market bubble in the U.S. for a decade it’s because we have: November 13, 2020: Legendary investor is certain we’re in a bubble (Business Insider) December 27, 2019: U.S. stock market is a bubble (Forbes) April 5, 2018: ‘Epic’ market bubble is ready to burst (CNBC) August 9, 2017: Is the stock market a bubble? (USA Today) June 23, 2016: Uh-oh. Is...

George Carlin’s Aphorism

New York Times, 2021: Some QAnon believers tried to rejigger their theories to accommodate a transfer of power to Mr. Biden. Several large QAnon groups discussed on Wednesday the possibility that they had been wrong about Mr. Biden, and that the incoming president was actually part of Mr. Trump’s effort to take down the global cabal. “The more I think about it, I do think it’s very possible that Biden will be the...

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Data Update 2 for 2021: The Price of Risk!

Investors are constantly in search of a single metric that will tell them whether a market is under or over valued, and consequently whether they should buying or selling holdings in that market. With equities, the metric that has been in use the longest is the PE ratio, modified in recent years to the CAPE, where earnings are normalized (by averaging over time) and sometimes adjusted for inflation. That metric, though, has been signaling that stocks are over valued for most of the last decade, a ten-year period when stocks delivered blockbuster returns. The failures of the signal have been variously attributed to low interest rates, accounting mis-measurement of earnings (especially at tech companies), and by some, to animal spirits.  In this post, I offer an alternative, albeit a more complicated, metric that I believe offers not only a more comprehensive measure of pricing, but also operates as a barometer of the ups and downs in the market.

The Price of Risk

The price of risk is what investors demand as a premium, an extra return over and above what they can make on a guaranteed investment (risk free), to invest in a risky asset. Note that this price is set by demand and supply and will reflect everything that investors collectively believe, hope for, and fear.

Does the price of risk have to be positive? The answer depends on whether human beings are risk averse or not. If they are, the price of risk will be reflected in a positive premium, and the level of the premium will increase, as investors become more risk averse. If, on the other hand, investors are risk neutral, the price of risk will be zero, and investors will buy risky business, stocks and other investments, and settle for the risk free rate as the expected return.

Note that nothing that I have said so far is premised on modern portfolio theory, or any academic view of risk premiums. It is true that economists have researched risk aversion for centuries and concluded that investors are collectively risk averse, and that the level of risk aversion varies across age groups, income levels and time. Some have developed models that try to measure what a fair risk premium should be, but to arrive at their conclusions, they have make assumptions about investor utility functions that are often unobservable and untestable. I have no desire to make this a lengthy treatise about the "right" risk premium, but will instead start with two assertions:

  1. Risk premiums can be estimated: You can back out the risk premiums that investors are demanding from the prices that they pay for risky assets. Put simply, if you can observe the price that an investor pays for a risky asset, and are willing to estimate the expected cash flows on that asset, you can estimate the expected return on that asset and net out the risk free asset to arrive at a risk premium. It is true that you can make mistakes on your expected cash flows, but your output should reflect an estimate, albeit a noisy one, of what investors are demanding as a premium.
  2. Risk premiums can and will change over time: Risk premiums are driven by risk aversion, and risk aversion itself can change over time. In fact, greed and fear, two big drivers of market prices, also affect risk aversion, with investors becoming more risk averse and charging higher premiums, when the fear factor becomes dominant. 
  3. When risk premiums change, prices will move: As risk premiums change, the prices that investors are willing to pay for risky assets will also change, with the two moving in opposite directions. Intuitively, if you want to earn a higher risk premium on an investment, holding cash flows fixed, you will pay less for that investment today.
The Price of Risk: Bond Market

All bonds, including those with guaranteed coupons, are risky, if you define risk as prices being volatile, since as interest rates changes, bond prices will change as well. Most bonds, though, are exposed to a second risk, which is that the bond issuer can default on coupon payments, making returns and prices even more uncertain. This is why corporate bonds are riskier than sovereign bonds, and sovereign bonds issued by shakier governments are riskier than sovereign bonds issued by governments that are unlikely to default. 

Bond Default Spread

If you accept the proposition that a bond with default risk is riskier than an otherwise equivalent bond (same coupon and maturity) issued by a default-free entity, the price of risk in the bond market can be measured by looking at the differences in yields between the two bonds. Thus, if a 10-year corporate bond has a yield of 3.00% and a 10-year government bond, in the same currency and with no default risk, has a yield of 1.00%, the difference is termed the default spread and becomes a measure of the price of risk in the bond market. 

At the risk of belaboring the details, it is not the yield that we should be comparing, but the yield to maturity, which is the internal rate of return on the bond, given how it is priced:

To compute the default spread over a 10-year period for a specific corporate bond (or loan), you would compute the yields to maturity on the ten-year corporate and treasury bonds and take the difference. Note that even this comparison is an approximation, but it yields a close enough value to work, and that it yields a default spread for a specific maturity. You could compute default spreads for other maturities, and compute the price of risk over 1-year, 2-year, 3-year periods and so on. 

Corporate Default Spreads: Current and Look Back at 2020

Corporate bonds are traded, and as a consequence, and you can use traded prices to estimate default spreads in the market. In the chart below, I compare default spreads at the start of 2021 with the default spreads at the start of 2020:

Source: BofA ML Spreads on Federal Reserve (FRED)

At first sight, it looks like an uneventful year, with spreads in 2021 mildly higher than spreads in 2020, but that comparison is deceptive, since default spreads went on a roller-coaster ride during 2020:

Source: BofA ML Spreads on Federal Reserve (FRED)
While spreads started 2020 in serene fashion, the COVID-driven market crisis caused them to widen dramatically between February 14 and March 20, with the spreads almost tripling for lower rated bonds. Given the worries about default and a full-fledged market meltdown, that was not surprising, but what is surprising is how quickly the fear factor faded and spreads returned almost to pre-crisis levels.

Measuring against the past

Are default spreads today too low? There are two ways to answer that question. One is to look at their movement over time, and compare current spreads to historic norms. 

Source: BofA ML Spreads on Federal Reserve (FRED)

The default spreads at the end of 2020 are at the low end of the historical spectrum, and the contrast with the 2008 crisis is stark, since default spread surged in the last quarter of 2008 and did not come back down to pre-crisis levels until almost two years later. The other is to look at corporate defaults over time to see if markets are building in enough of a buffer against future defaults. 

Sources: S&P and Moody's

Default rates increased in 2020, with spillover effects expected into 2021, but the corporate bond default spreads do not seem to reflect this. One explanation is that the bond market beliefs that the worst of the crisis is over and that default rates will return quickly to pre-COVID levels. The other is the corporate bond market is under estimating both the risk and the consequences of default.

The Price of Risk: Equities

Equities are riskier than bonds (or at least most bonds), and it stands to reason that there is a price of risk bearing in the equity markets. While that price has a name, i.e., the equity risk premium, it is more difficult to observe and estimate than the default spread in bond markets. In this section, I will present both the standard approach to estimating the equity risk premium and my preferred way of doing so, with a rationale for why.

Estimation Approaches

Why is it so difficult to estimate an equity risk premium? The simple reason is that unlike a bond, which comes with specified coupons, the cash flows that you receive when you buy stocks are neither pre-specified nor guaranteed. It is true that some companies pay dividends, and that these dividends are sticky, but it is also true that companies are under no contractual obligation to continue paying those same dividends. This difficulty in observing the equity risk premium leads many to look backwards, when asked to estimate the equity risk premium. Put simply they look at a long time period in the past (50 years or even 100 years) and look at the premium that stocks earned over a risk free investment (treasury bills or bonds); that historical risk premium then gets used as a measure of the current equity risk premium. On my website, I update this historical risk premium every year, and the graph below reflects my January 2021 findings:

Download spreadsheet with raw data

Looking over a 92-year time period (1928-2020), for instance, stocks earned an geometric average return of 9.79%, giving them a premium of 4.84% over the 4.95% that you would have earned, investing in treasury bonds. If you buy into this measure of equity risk premiums, consider its limitations. First, it is backward looking and built on the presumption that the future will look like the past. Second, even if you trust mean reversion, note that the estimated premium is not a fact but an estimate, with a wide range around it. Specifically, the estimate of 4.84% for the equity risk premium from 1928 to 2020 comes with a standard error of 2.1%; the true ERP, with this error, could fall anywhere from 0.64% to 9.04%. Third, this premium is static and does not reflect market crises and investor fears; thus, the historical risk premium on February 14, 2020 would have very similar to the historical risk premium on March 20, 2020.

The alternative approach to estimating equity risk premiums is revolutionary and it borrows from the yield to maturity approach that we used to estimate bond default spreads. Consider replacing the bond price with the level of stock prices today (say, with the S&P 500 index) and coupons with expected cash flows on stocks (from dividends and buybacks), and solve for an internal rate of return:

Implied Equity Risk Premium: In General

The internal rate of return is the expected return on stocks, and netting out the risk free rate today will yield an implied equity risk premium. In the picture below, I use this process to estimate an equity risk premium of 4.72%  for the S&P 500 on January 1, 2021:

Download spreadsheet to compute ERP

It is true that my estimates of earnings and cash flows in the future are driving my premium, and that the premium will be lower (higher) if I have under (over) estimated those numbers. This approach to estimating equity risk premiums is forward-looking and dynamic, changing as the market price changes. In the graph below, I report implied equity risk premiums that I computed, by day, during 2020, in an effort to gauge how the crisis was playing out and keep my sanity.

Download spreadsheet with data


As with the bond default spread, the implied equity risk premium was extraordinarily volatile in 2020, peaking at 7.75% on March 20, before falling back to pre-crisis levels by the end of the year.

Market Gauge?

As we are engulfed by talk of market bubbles and corrections, it is worth nothing that any question about the overall market can really be reframed as a question about the implied equity risk premium. If you believe that the current implied equity risk premium is too low, you are in effect also saying that stocks are overvalued, just as a judgment that the equity risk premium is too high is equivalent to arguing that stocks are undervalued. So, at 4.72%, is the equity risk premium too low and is the market in a bubble? One way to pass judgment is to compare the current premium to implied equity risk premiums in the past:

Download spreadsheet with historical ERP

On this comparison, stocks don't look significantly over valued, since the current premium is higher than the long term average (4.21%), though if you compare it to the equity risk premium in the last decade (5.53%), it looks low, and that stocks are over valued by about 15%. There is a caveat, though, which is that this risk premium is being earned on a risk free rate that is historically low. Consider this alternative graph, where I look at the expected return on stocks (risk free rate plus implied equity risk premium) over the same time period:

For much of this century, the expected return on stocks has hovered around 8%, but the expected return at the start of 2021 is only 5.65%, well below the expected returns in prior periods.

A Market Assessment

I know that you are probably incredibly confused, and I am afraid that I cannot clear up all of that confusion, but this framework lends itself to valuing the entire market. To do this, you have to be willing to make estimates of:

  1. Earnings on the index: You cannot value a market based upon last year's earnings (though many do so). Investing is about the future, and uncomfortable as it may make you feel, you have to make estimates for the future. With an index like the S&P 500, you can outsource these estimates at least for the near years, by looking at consensus forecasts from analysts tracking the index.
  2. Cash returned, relative to earnings: Since it is cash returned to stockholders that drives value, you also have to make judgments on what percent of earnings will be returned to stockholders, either in dividends or buybacks. To this, you can look to history, but recognize that it is also a function of the confidence that companies have about the future, with more confidence leading to higher cash being returned.
  3. Risk free rates over time: While it is generally not a good idea to play interest rate forecaster, we are in unusual times, with rates close to all time lows. In addition, your views on future growth in the economy are intertwined with what will happen to risk free rates, with stronger economic growth putting more upward pressure on rates.
  4. An acceptable ERP: As I noted in the last section, equity risk premiums have been volatile over time, and particularly so in years in 2020. The equity risk premium, added to the risk free rate, will determine what you need stock returns to be, to break even on a risk-adjusted basis.

It is only fair that I go first. In the picture below, I make my best judgments on each of these dimensions, using consensus estimates of earnings in 2021 and 2022 to get started, but then slowing growth in earnings to match the growth rate in the economy, which I approximate with the risk free rate. On the risk free rate, I assume that rates will rise over time to 2%, and that 5% is a fair ERP, given history. My valuation is below:

Download spreadsheet to value S&P 500

Based upon my inputs, the S&P 500 is over valued by about 12%, certainly not bubble territory, but still richly priced. You may (and should) disagree with my assumptions, and I welcome you to download the spreadsheet and change the inputs. Ultimately though, the judgment you make on the market will be a joint effect of your views on the economy and interest rates in the next few years. The table below summarizes the interplay between economic growth and interest rate assumptions, and the effects on the index value:

Use S&P 500 valuation spreadsheet to assess value effects

As you can see, there are far more bad possible outcomes than good ones, and the only scenario where stocks have significant room to rise is the Goldilocks market, where rates stay low (at close to 1%), while the economy comes back strongly. I know that the possibility of additional economic stimulus may improve the odds for the economy, but can they do so without affecting rates? To buy into that scenario, you have to belief that the Fed has the power to keep rates low, no matter what happens to the economy, and I don't share that faith. 

As many of you who have read my blog posts know, I am a reluctant market timer, but ultimately we all time markets, implicitly or explicitly, the former wooing up in how much of your portfolio is in cash and the latter in more overt acts of either protection or bets on market directions. Going into 2021, I have far more cash in my portfolio than I usually do, and for the first time in a long, long time, I have bought partial protection against a market drop, using derivatives. It is insurance, and like all insurance, my best case scenario is that I never need to use it, but it reflects my wariness about what comes next. I am not and don't want to be in the business of doling out investment advice, and I think that the healthiest pathway for you is to make your own judgments on interest rates, earnings growth and acceptable risk premiums, and follow that with consistent actions. 

YouTube Video


Spreadsheets

  1. Implied ERP for the S&P 500: January 1, 2021
  2. Spreadsheet to value the S&P 500 on January 1, 2021

Data Updates for 2021

  1. Data Update 1 for 2021: A (Data) Look Back at a Most Forgettable Year!
  2. Data Update 2 for 2021: The Price of Risk!


Happy New Year! Bubble Yet?

What a year it's been. Crazy. And what a crazy year it already is so far. I haven't been posting much because there hasn't really been much to say. Like everyone else, I am doom-scrolling and wondering when this nightmare will end.
 
I have no particular view on how Covid will play out, so have no opinion whatsoever on travel and other hugely-impacted sectors. My guess is as good as anyone else's, so I have done literally nothing in my portfolio since this all started. In fact, I don't think I have even bought or sold a single stock in all of 2020.

So to just get that out of the way. And all these predictions about what the world would like like post-Covid, as usual, is all nonsense. Just filler material for magazines, newspapers etc. Nobody really knows. Some say we will return, eventually, to what we were before. Others say no way, we are not going back into offices and stores. But the truth will be somewhere in between.
 
Howard Marks 
Anyway, I did notice a few things that made me want to make a post. One is that Howard Marks released a memo which was kind of stunning, I'm sure, for many value investors. His latest post, titled Something of Value discusses the comparison between growth and value and even Bitcoin. He acknowledges that recent business models may justify higher valuations than in the past, and even goes as far as to withdraw, for the moment, his previous judgement on Bitcoin; he now says he doesn't understand it as well as he thought, so will refrain from making a judgement on it for now. 
 
Buffett has always said that growth and value is joined at the hip, and Joel Greenblatt has explained that value investing is about buying something for less than it's worth, not just buying stuff that looks cheap on an absolute basis. So none of this is particularly new. 

But I guess Marks jumped into the discussion because there is so much talk about mean reversion and markets going back to value. Within that context, I have said that even though there are cyclical tendencies that seem to go back and forth between growth and value, a lot of the recent widening of the gap may be due to dying industries; many industries are going to literally be obsolete. And on the other end of the spectrum is the different dynamics of the large, profitable tech businesses.
 
I saw record stores go away very quickly, even when people in the industry kept telling me that it won't go away so fast as people love physical CD's, liner notes, plus people hate waiting for their music to download. Apparently, some of these people didn't understand the exponential nature of technology. Book stores shouldn't exist either (and yes, book-lovers keep telling me that they can't read on their phones or Kindles; that they need real books to touch. This too will change. This is not to say that small, specialty bookstores can't survive and exist). 
 
If you look around, and especially in the Covid world, you realize how the world is built around old technologies and capabilities. As Buffett says, if you were to rebuild something today knowing what we know now, and having the technology that we do now, would you build it the same way? (He actually asked if you would create the same company today from scratch, but close enough) Of course not. Think about that for a second, and you will see how much of what is in this world is obsolete. 
 
Anyway, as I said, do you really want to be short AMZN and long BBBY? Well, OK, BBBY had a tremendous rally off the lows, and look at GME!  Good thing I don't like to short things (and even if I did, I would never let a short go too far against me; I would cover quickly. I learned that lesson years ago. TSLA shows that many haven't learned that yet...). 
 
Back in my more short-term-speculating days, we would take something like Marks' recent memo and pass it around as a capitulation of a great investor, sort of like Julian Robertson throwing in the towel in 1999/2000, or Stanley Druckenmiller flipping and going long tech stocks during that bubble. 

My reaction this time, though, was that finally, he and much of the world is coming closer to my view. Which, of course, is sort of worrisome. I liked loving banks in 2011 when nobody loved them, and stocks pretty much all throughout this period as people kept calling this market a bubble. 

Shiller
And then Shiller said recently that the market is not all that overvalued if you adjust it for real interest rates. I saw a chart of that somewhere, but can't find it now. I was going to paste it here, but I guess you can imagine what it would look like. It would look very different than the scary looking raw CAPE-10 charts.

I've been saying this for years, that even if we adjust long term rates back to 4% (from slightly over 1% now), that the market can be fairly valued at 25x. 
 
I think I said something to the effect that, if, over the next decade, long term rates average 4%, I would not at all be surprised if the market P/E averaged 25x over that period. This means that the market can get up to 40x P/E in euphoric times and go down to 12x in panics. Remember, back in more 'normal' times, we thought that P/E's were normal at around 14x, and during bubbles, it went up to over 20x, and panic lows were around 7x P/E.

So that's all I'm doing. I'm taking what a future normal P/E ratio might look like and then giving it a high/low range based on what the market used to do around the average in the old days. 

I know people argue that interest rates and earnings yields only correlated for certain parts of history, and hasn't done so in the longer term and in other countries. But I can't get around the fact that asset prices are largely determined by interest rates, so there should be a relationship. 

Anyway, I think a lot of people are anchored to this idea that a normal P/E ratio is around 14x and think interest rates should be in the 6-8% range. 
 
People often say that if interest rates tick up, we will no longer be able to justify these high P/E ratios. This is true. But again, we would have to see long term rates go above 4% for us to even worry about that. Sure, the market is going to tank if we get rates to 1.2%, 1.5%, or even 2.0%. Markets will react to that for sure. But, when that happens, keep in mind that ALL of my comments are assuming a 4% long term rate.

Singularity
By the way, I still recommend the same old books for investors, like Security Analysis, but the book that may have had the most impact on me in terms of investing in more recent years might be The Singularity is Near. I've owned this book for years but only read it in the past few years. This really explains what is happening in the tech world. When I read this, I immediately understood what is going to happen to a lot of businesses, so it helped me stay away from them, and made me appreciate the 'winner-take-all' businesses. The moat in this century is very different than the moat that Buffett talks about. Well, Buffett never restricted his definition of moats to old-world businesses.

Anyway, with a lot of challenges ahead, I don't know if these winner-take-all businesses will keep winning. There is a lot of pressure to rein in these folks, but I don't know how successful that will be. We don't want to kill the golden goose in this country. 

Market Strong While the World Suffers
People talk about this all the time. With so much suffering, joblessness, starvation and death, the market continues to make new highs. Our nation's capitol is stormed and D.C. today looks like the green zone in Iraq. And yet, the market continues to make new highs. What's up with that? 
 
Well, first of all, the odds of a 'coup' succeeding was always zero (let's not debate what you want to call that. I don't care either way). There was no chance a civil war would have started. The question was always just how many people are going to get hurt. So the market not reacting to that is not abnormal at all since the market reacts to future potential earnings and economic growth, which is still intact (whatever you expect). 
 
And as for the economic, social and physical suffering in the world, when the government writes such huge checks, that money tends to go straight to the bottom line of a lot of companies. OK, maybe mostly to AMZN, WMT, COST, TGT and other big corporations. But guess what? Those big corporations are all listed companies, right? So small businesses (that are not listed) fail. Small restaurants go out of business. You want to eat out? Guess who is left standing? Yes, the national and international chains. So profits are moving from unlisted entities to listed entities. That is kind of huge when you think about it.
 
Look at CMG. I have been a fan for years, and have owned this for years (first purchase was in the $30s).  Even I think it's nuts how expensive it is. But they are just taking market share, or soon will do so because of Covid. I know this is not permanent, and eventually things will go back to normal. But I wonder how much  business will go back. If you are going to start a new business, who wants to open a new restaurant when insurers won't cover for pandemic closures? And who knows when the next one will come? Experts say that Covid-19 is not even the "big one" they are worried about.

Also, when there is stimulus where the government cuts taxes on the rich, a lot of those savings aren't injected back into the economy. Maybe they go into bonds or cash balances. Some of it will go to spending. Some go into real estate and other investments. But when you write checks to lower income folks, they are going to be more likely to spend a bigger percentage of that. 

Well, having said that, I know there is data showing that a lot of that money actually didn't get spent, but went to pay down debt, savings, and some to Robinhood trading accounts, and probably into Bitcoin. 

Renaissance Technologies
By the way, (and what's a Brooklyn Investor post without a random tangent / digression), people are wondering how the Medallion fund can return 70% while the institutional funds for outside investors are down 20-30%. Well, when they announced the new funds for outside investors, I knew it wasn't going to work, or wasn't going to be as good as the Medallion fund. 

This is a very important point to keep in mind. The Medallion fund has such high returns and is much more stable because they do a lot more trades and analyze every anomaly with many more data points. I was once involved in HFT / stat arb, and we had tons of data to work with even from the past three months, as we had every single trade (tick data) for every single stock, or at least the listed stocks. That's a lot of data. With that kind of data, when you find an anomaly, you are going to have a very, very statistically robust way of testing to see if it is meaningful, and you will have plenty of opportunities to make those trades to actually realize that statistical edge. And when you do so many trades like that, your returns tend to get more consistent, which means that you can lever up, which further boosts your returns. Just imagine the lumpiness of your daily revenues in a casino with 10 slot machines vs. one with 10,000 slot machines.

Now, if you try to apply some of this to longer term data, say, daily data, you suddenly have a small fraction of data to deal with. And, to me, much more significantly, you are now dealing with data that the human eye can see (such as P/E ratios, opening and closing prices). Anomalies found in tick-data is invisible to humans, and only visible to machines that have access to the data and models that can process and analyze them. 
 
Put it this way. If you use daily closing prices, there may be 253 prices per year. Over 100 years, that's 25,300 data points. Now, a fast model might use tick data, but let's assume you use prices from every second of the day. If there are 6.5 hours of trading per day,  that's 390 minutes, or 23,400 seconds per day. So in one day, a stock can generate almost as much data as a 100 year history of a stock using daily prices. Go back 3 months and you see how much data you can work with. So when Renaissance says there is not enough data for their longer models, this is what they mean.

Looking at it this way, you see how silly the bubble-callers comments are. They are making predictions based on something that happened, like, two or three times in the past century (some include all the bubbles in history, but it's hard to compare other bubbles to the U.S. market). That's not a lot of data points to test the robustness of any claim you make. 

So when people say, this is like 1929, 1987 or 1999, well, for it to be meaningful, you would have to have at least 30 of those events with the same variables at the same levels with most of them giving the same or similar results for it to be meaningful. 

There was a famous quant fund that went belly up in the 90s, and it was shocking what kind of trades they were making. The analysis was something like, the last ten times this has happened, the market did this on average. It's like, what? You are going to make a prediction on only ten samples?!  That makes no sense at all. 

And yet, there are still plenty of people still making those sorts of predictions. They see that P/E's were over 20x in 1929, 1987 and 1999 so assume that every time the P/E gets over 20x, the market is going to crash. Or something like that. And then they line up all these valuations metrics to show how insane everything is when they are all actually showing a single metric as they are all related / correlated factors; any statistically robust, well-built model would assign most of them as a single factor. For a statistical model to be meaningful, input factors have to be uncorrelated.

The fast models used by Medallion (of course, I have no idea what they do, but do guess they are very fast models) and others use a lot of data and only make trades where there is a statistically meaningful chance that it will be profitable. And they will make enough trades for that statistic to play out. For example, if you have a 60% chance of success, but you are going to die because there is a 40% chance of death, then that's not a good bet. But if you can roll a dice that is 60% in your favor and you are allowed to roll it 100 or 1000 times, then that's a good bet. Odds are in your favor and you have enough opportunities for that statistic to be meaningful.

This is how casinos work. You want as many slot machines and gaming tables as possible, with as much capacity utilization as possible. With a slight edge in your favor, you can print money. 

People who try to forecast the markets with flimsy models using very few data points is like a guy trying to run a casino with one or two slot machines, and wondering why he is getting killed. Well, most of them don't even have the odds in their favor as they haven't even calculated that correctly.
 
By the way, digressing from a digression, this is the same reason why most technical analysis is garbage. Books will show you all these amazing crashes following trendline breaks, head and shoulders tops and bottoms and whatnot, but they never show you the patterns that didn't work out. How many trendline breaks didn't lead to a crash? If you can't answer that question, then it is totally meaningless. Early in my career, I spent entire days and nights sitting in front of a computer (for one of the top hedge funds) trying to validate everything I was reading in books about technical analysis, and was unable to validate any pattern; needless to say, everything was random!
 
So next time you hear someone give you this technical baloney, ask them for data to prove it.
 
Anyway, moving on...

So, Are We in a Bubble?!
OK, so there is a lot of anecdotal evidence that there is a bubble going on. IPO's, SPACs, Robinhood trading, Bitcoin, just all sorts of stuff. 

Sure, there is a lot of speculation going on, and there are a lot of things I would stay away from. 

But at the end of the day, for me, as a stock investor, I just care about valuations. Is the stock market in a "historic bubble"? I don't know, but it doesn't really look like it. 

With interest rates at zero, and negative real interest rates, and all this monetary  AND fiscal pump priming, the market should be at 40-50x earnings. Well, I mean if this was a real bubble, it would be there. At that level, then yes, I would worry that we are in a bubble, and I would probably increase my cash position substantially (despite my "don't  time the market!" stance). Even at over 30x, I would probably go carefully through my portfolio and dump stuff that is not 'reasonable'. Or I would do it in a more conservative way. Well, this is something that should be done every day anyway.

But now? It really doesn't feel that way to me. I am not predicting that we would get there, and I definitely would prefer it not do that as it would be quite a hassle. You could potentially be looking at decades of no returns from the stock market, like Japan. So I would want us to avoid that.

Speaking of Japan, the Japanese stock market hasn't yet recovered it's 1989 high. In that kind of bubble, yes, I would worry about owning stocks. But remember, P/E ratios back then were 60-80x for the whole market. That's too expensive to grow earnings into in a decade or even two, not to mention the government spending the first two decades preventing any restructuring etc... that would help the market recover. It was all about protecting / defending the status quo. Things seem to be changing slowly recently, though. 

So, if we see that here (that kind of insane P/E), then yes, even I would start pounding the table to dump stocks, regardless of interest rates.

But I don't see that. In some places, yes, valuations are silly, but who cares? If you owned, say, BRK in 1999, who cares what the market valued Pets.com at? Just don't buy Pets.com! 

This is another long post for another day, but there is hope even in a mega-bubble situation. We saw it in 1999 when reasonably priced stocks did really well through the bubble collapse. Even in Japan, I think there were some really good, solid, blue-chips that did really well after the bubble. Small and medium caps did really well too. So hopefully, there will be opportunities even in that scenario.

People constantly worry about 20-30% corrections. I don't worry about those at all, and I assume we will have a lot of those over even the next 3-5 years. I don't care about things like that too much. In fact, I don't even worry too much about a 1999-like bubble, because if you look back, if you owned solid, decent stocks and held on through it, you would have been fine. I expect the same going forward. 

For me, I would only worry about a situation like 1989 Japan where things were so expensive that it might take years to work off the valuation, but even then, as I said, I would focus company by company and not worry too much about the overall market.


The Dow Jones under Donald Trump

Ryan Detrick (LPL) has some data on inauguration to inauguration returns for each modern President. The outgoing guy’s numbers were pretty good. He should get some credit (tax cuts fueled increased buybacks + dividends), but not as much as the Fed and Treasury’s response to COVID-19. There are always too many variables to credit or debit a President too much for stock market performance… Here’s LPL...

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