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How Framing Affects Investment Decisions & Outcomes

by Ben Carlson, A Wealth of Common Sense

“We display risk-aversion when we are offered a choice in one setting and then turn into risk-seekers when we are offered the same choice in a different setting. We tend to ignore the common components of a problem and concentrate on each part in isolation.” – Peter Bernstein

Let’s say you were given fifty-fifty odds of either winning $8 or $32. Not a bad deal, but let’s also assume you were given a fifty-fifty chance of losing either $8 or $32.

You would think that either way you would feel pretty good about either option in the first set of odds and pretty bad about losing money in the second set of odds. Yet when this study was actually performed that’s not what happened at all.

The subjects actually felt slightly positive when they lost $8 because they avoided losing $32. But when they won $8 they reported a feeling of dissatisfaction because they didn’t win $32. They felt good about losing $8 because the gamble was framed in terms of losses and they felt bad about winning $8 because the gamble was framed in terms of gains.

This is what behavioral economists call framing. Framing refers to the fact that we tend to draw different conclusions from information depending on how it’s presented to us.

Another example comes from a research study that shows how doctors can actually change their patient’s mind about a surgical procedure based on how they frame their diagnosis recommendation. Patient decisions were much different when the doctor said “you have a 90% chance of survival” versus “you have a 10% chance of mortality.”

More patients opted in for the surgery when it was framed in terms of survival while more opted out when presented with the mortality option. It’s the same exact odds but just presented using a different point of view.

Framing occurs frequently in the financial markets because it’s the ultimate playground for gains and losses. We constantly see comparisons of market and economic data today versus those in the peak years or those in the trough years. Morgan Housel had a perfect take on this type of framing:


There will always be a point in time you can use to frame data to make it look positive or negative. You just have to ask yourself how reasonable your comparison is and how biased your conclusion will be based on how the data is presented.

Unemployment numbers can be framed based on gains since the height of the financial crisis or in terms of losses since the 1990s. Earnings numbers can be framed based on prior peaks or troughs. Economic growth and living standards can be framed against prior generations.

Here’s an example using different starting points for annual returns on the S&P 500 along with their ranks based on historical performance data:


Based on this data and how you want to interpret the numbers you could make the following arguments:

  • The 10 and 15 year numbers are well below long-term averages so the market can’t be too extended from here.
  • The 5 year numbers are well above average and are unsustainable so the market must either crash or see lower returns going forward.

The S&P 500 is currently right around the 2,000 point level. Here are two market scenarios  to consider — (1) The market shoots up by 20% over the next year to get to 2,400 before falling by 30% or (2) The market goes nowhere for the next year and then falls 16%.

Which situation is worse for investors?

Actually both scenarios end up with the same exact result because the S&P 500 finishes at 1,680. But the first option would be much more painful for investors because it would be framed in terms of gains that weren’t locked in before a huge drop as opposed to a much smaller correction in the second scenario.

And by the way, that 1,680 level on the S&P would take us back to levels seen in October of 2013. Did you feel pretty good about the stock market in October of 2013 when it was up 25% on the year at that point? I’m sure most did.

Perception can make a huge difference in how we feel about our finances at different points in time.

Investors can take advantage of data to reflect their confirmation bias while other times we’re simply tricked by how something is presented to us. Analyzing hard data is an important part of the investment process, but how it’s presented to us and how we frame it can have a huge impact on the perceived conclusions.

Understanding that we all have cognitive biases such as framing is half the battle for reducing errors.

Now here’s the best stuff I’ve been reading this week:

  • Is it worth the time and effort of choosing a portfolio of active managers when you should focus on rebalancing instead? (Capital Speculator)
  • It wouldn’t be a new high in the stock market without a new scary chart (Jon Boorman)
  • Finance is a strange industry (Motley Fool)
  • The challenge is not portfolio construction but harnessing investor emotions (Reformed Broker)
  • 6 things to do in your early 20s (Millennial Invest)
  • Carl Richards: “We’re really good at taking a single sample and blowing it out of proportion.” (NY Times)
  • Confront the most brutal facts of your current reality, whatever they might be (Brooklyn Investor)
  • Eddy Elfenbein explains the stock market (Crossing Wall Street)
  • A few things that should always be at the forefront of investor’s minds (Irrelevant Investor)
  • The passive vs. active debate is a sideshow. There are many other big decisions that are more important (Abnormal Returns)
  • Salman Kahn: “The good news is that mindsets can be taught; they’re malleable” (Kahn Academy)

Q&A – Ask me Anything

Here we go again.  It’s the opportunity of a lifetime.  You can ask me anything.  Whether it’s how to kiss a girl properly, how to dance the tango, play the violin or any of the other things that I write about on a daily basis here.   Actually, I don’t know how to do any of the aforementioned things, but feel free to ask me some other stuff if you want to.

The Modern Day Widow Maker Trade

By GaveKal Capital

As treasury yields plunge again today to new 1-year lows (the 10 and 30-year treasury bond yields are both down 3bps to 2.33% and 3.07%, respectively), we are reminded of a popular trade over the last decade to short Japanese government bonds, which has aptly been named the “widow maker” trade. The trade seemed to make all the sense in the world with Japanese government dept soaring to new heights which would, as the logic went, inevitably cause the bond vigilantes to wreak their havoc on the JGB market. Instead, bond yields kept falling (from 2% in 2006 to just .49% today) and many a trader was carried out on a stretcher.

Despite most asset managers and economists declaring at the beginning of the year that US treasury yields can’t trade lower and will certainly rise in 2014, the exact opposite has happened, and if anything the trend lower in yields is accelerating. Admittedly, there are big differences between the US today and Japan in 2006, but there are also some similarities: low real growth, low inflation, worsening demographics, etc.

Another similarity is the pervasiveness of traders shorting US treasury bonds. The chart below shows the net position in futures and options contracts on 10-year treasury bonds for all non-commercial traders (i.e. the so-called “dumb money”) which is the red line on the left axis. The left axis is inverted and negative numbers indicate a net short position. We observe a highly negative correlation with 10-year treasury yields (blue line, right axis) in that the non-commercial traders seem to up their short positions as yields rise, and vice versa, and thus have usually been wrong at major turning points. At the beginning of the year the non-commercial trader net short position in 10-year treasury bonds was as the highest level over the last six years and today that same group is still net short despite the fall in yields. Over the past six years treasury yields haven’t stopped falling until the non-commercial traders adopted a net long position, and that level is still far off from here.

gk2 gk1

John Cochrane Talks About the “Asset Swap”

I missed this nice piece in the WSJ by John Cochrane.  It’s a very balanced perspective of QE.  I particularly liked this section which will sound very familiar to regulars:

“This policy is new and controversial. However, many arguments against it are based on fallacies. People forget that when the Fed creates a dollar of reserves, it buys a dollar of Treasurys or government-guaranteed mortgage-backed securities. A bank gives the Fed a $1 Treasury, the Fed flips a switch and increases the bank’s reserve account by $1. From this simple fact, it follows that:

• Reserves that pay market interest are not inflationary. Period. Now that banks have trillions more reserves than they need to satisfy regulations or service their deposits, banks don’t care if they hold another dollar of interest-paying reserves or another dollar of Treasurys. They are perfect substitutes at the margin. Exchanging red M&Ms for green M&Ms does not help your diet. Commenters have seen the astonishing rise in reserves—from $50 billion in 2007 to $2.7 trillion today—and warned of hyperinflation to come. This is simply wrong as long as reserves pay market interest.

• Large reserves also aren’t deflationary. Reserves are not “soaking up money that could be lent.” The Fed is not “paying banks not to lend out the money” and therefore “starving the economy of investment.” Every dollar invested in reserves is a dollar that used to be invested in a Treasury bill. A large Fed balance sheet has no effect on funds available for investment.

• The Fed is not “subsidizing banks” by paying interest on reserves. The interest that the Fed will pay on reserves will come from the interest it receives on its Treasury securities. If the Fed sold its government securities to banks, those banks would be getting the same interest directly from the Treasury.”

I like that.  Sounds like he’s adopted my “asset swap” view of QE.  Swapping red M&Ms for green M&Ms doesn’t help your diet.  That’s exactly how QE works.  Swapping T-bonds for reserves doesn’t mean the private sector has more financial assets or spending power.   And it certainly doesn’t mean that banks are willing to lend more.  Cochrane seems to understand endogenous money and reserve accounting which is pretty unusual for most mainstream economists.

So, the narrative appears to be shifting more and more towards the sorts of things I’ve been saying for the last 5 years.  Which means that we’ve basically wasted all this time focusing on potential transmission mechanisms for stimulus that were never going to happen.  And that’s 5 years of sub-par growth because we put our faith excessively in a program that does a whole lot less than people originally thought.

Better late than never I guess.

Understanding Your Real, Real Returns

Thornburg Funds has a new report out on understanding your real, real returns and it’s fantastic.  I discuss this topic in detail in my book, but they do a much better job covering this than I do.  So go have a read.

The chart below is super important.  Most people who get into investing think only of their nominal returns.  That’s the top line figure.  But what really matters to you is the bottom line.  And in the investment world that’s the real, real return you get.  That’s the after tax, after inflation, after fee return.  It’s the money that actually goes into your pocket relative to your purchasing power.


The interesting part of this discussion is that the mainstream media almost never focuses on this concept.  So we’re constantly fed this myth of generating 10-12% annualized returns in the stock market or generating high returns on housing.  The problem is, the stock market’s real, real return is only 5.97% over the last 30 years.  And single family real estate comes in at a pathetic 0.8%.  In other words, the return that actually goes into your pocket from these assets is substantially lower than most people think.  And that’s because most people don’t calculate their real, real returns.  They don’t properly consider adverse fee effects, adverse tax effects or the problem of purchasing power loss.

You can see the full details in the chart below.  Over the last 30 years every asset class has generated a far lower return than is generally touted.  Commodities are actually negative, as is cash while stocks and bonds are in the low to mid single digits:


We have to be realistic when we get involved in the process of portfolio construction and asset allocation.  Setting realistic goals is one of the most important things you can do because it will benchmark the way you manage your process over time.  Understanding your real, real returns is central to this.

Updated – added second chart.  



Three Things I Think I Think

The latest edition of three things:

1.  I wanted to start by just saying thanks to everyone who reads this site and supports my work.  I don’t say that enough.  Which is pretty crappy of me.

This website is a strange part of my life.  I would have never guessed I’d put so much time and effort into a website if you’d told me that 5 years ago.  But it’s been life changing in ways. I’ve learned so much from so many smart people and I appreciate all the nice people I run into here who give me great feedback and support what I am trying to do.  I won’t get all sappy on you, but thanks.  I mean that.

2.  Larry Swedroe drops the boom on John Hussman in this piece.   It’s a harsh criticism.  I have a huge amount of respect for John Hussman and Larry Swedroe.  They’re both brilliant guys.  And while John’s performance has been pretty, um, bad, in recent years, I do think Larry contradicts himself a bit.

The whole point of the article is to focus on long-term results and avoid forecasting.  He even quotes Warren Buffett.  But in berating Hussman Larry fails to point out that he’s demonizing John’s 5 year performance while quoting a guy who has also underperformed the S&P by his own metric for 5 years.  Yes, Buffett’s own annual reports have discussed the poor recent performance of Berkshire Hathway relative to the S&P 500 where book value per share has lagged the S&P 500 by 5.4% per year.  So it seems a bit contradictory to judge a manager’s short-term performance when you’re emphasizing a long-term perspective.

Anyhow, I think Larry makes some great points.  I disagree with his general point on forecasting since I think portfolio construction involves, at a minimum, implicit forecasts, but it’s a good pieces so go have a read.

3.  Morgan Housel writes just about the most honest thing you’ll ever read on the finance industry.  I won’t spoil it for you, but there are some dark corners in this industry that could use a bit of light.  And I think we’re moving in the right direction.  But there’s a lot of work to be done.



In Pursuit of Past Performance

By Ben Carlson, A Wealth of Common Sense

Morningstar had an interesting piece out this week about the alternative mutual fund universe. While Morningstar studies have shown that the most dependable predictor of future fund performance is low expenses, investors in this universe of funds aren’t following that advice:

From 2011 to 2013, only 36% of the net $58 billion that has flowed into alternative mutual funds has gone to funds in the cheapest quintile.

Here’s why this may be the case:

Part of the reason for the meager flows into cheap funds is that investors appear to be performance chasing, paying less attention to fees. The performance chasing may be exacerbated by the lack of alternative funds with significant track records.

And here’s what performance chasing looks like:

The recent stampede into Bronze-rated MainStay Marketfield (MFLDX), which has swallowed up one fourth of the $58 billion of net inflows since 2011, is a good example of money going after good returns. The $18 billion fund isn’t cutting investors any bargains. It has an expense ratio of 1.52% for its institutional share class, which falls right in the middle of similarly distributed alternative funds, despite its being the group’s largest.

To put this performance chasing into perspective, check out this graph from my friend Jake (follow him on Twitter @EconomPic) on the relationship between fund performance and the growth of fund assets:


The Mainstay Fund has been one of the best performing funds in its category so investors have predictably piled in.

Fundraising is aided by the fact that the fund’s mandate allows it to invest in not only stocks, but also bonds, commodities, futures, options and even ETFs. The portfolio managers also have the option to go short to try and profit from down markets. This is the holy grail for investors and obviously they don’t mind paying for it.

Most investors probably don’t understand what they’re getting themselves into with a fund like this.Investing in products you don’t understand can lead to familiar poor behavior. The Morningstar investor and fund return comparison shows how this type of strategy can magnify buy high, sell low issues:



The three and five year numbers for this fund are some of the worst I’ve seen on a behavior gap basis, underperforming actual fund returns by 6-7% annually.

These types of funds can be difficult to benchmark because they’re meant to behave differently than the typical stock or bond fund. This can cause investors to alter behavior if they don’t have the correct expectations.

The problem with a market timing, long/short strategy like this is that investor misbehavior gets amplified. You end up trying to time the timing of the fund which leads to what Charlie Munger calls the lollapalooza tendency when a confluence of psychological factors can act against you all at once.

It remains to be seen what the future returns will be from the Mainstay Fund after the large inflow of new money. Future fund returns won’t matter if investors continue to chase past performance.

A land where high fees reign supreme (Morningstar)

Random Walking (But Only When it’s Convenient)

Okay, I am a little OCD so bear with me here.  Actually, if you plan on reading any of my work in the future you’ll have to bear with me for 30-50 more years since I assume this sort of griping will be a persistent trend given how badly I think the worlds of modern econ and finance have been mangled by politically motivated theorists (assuming my OCD doesn’t kill me first)….

Anyhow, I was reading some more Burton Malkiel thinking on the markets when I came across this gem from 3 years ago.  In this piece trashing US government bonds, Malkiel does something very strange.  He makes the argument that dividend paying stocks are a good substitute for bonds.  Now, I’ve seen this argument a lot over the years and we have to be VERY clear about something:


Did I write that big enough?  Maybe not.  Let’s try again:


Okay, you get my point.  Of course, saying it isn’t enough.  There should be some empirical data to back up this assertion.  First, a bear market in bonds is nothing like a bear market in stocks.  When someone compares the two instruments it means there is a high likelihood that they don’t understand the capital structure very well and haven’t connected all the dots here.  A fixed income instrument has several embedded safety components that make it entirely different from stocks:

  1. It’s higher in the liquidation chain.
  2. It pays a “fixed income” over the course of its life.
  3. If held to maturity fixed income pays you back at par.
  4. The duration on a fixed income instrument is generally shorter than that of common stock.

This explains why fixed income is inherently safer than common stock.  We can see this in the performance data.  Since 1928 the 10 year US Treasury note has been negative in just 14 calendar years.  Those negative years averaged a -4.2% return.  Stocks, on the other hand, have been negative in 24 of those calendar years and with an average decline of -13.6%.  The worst calendar year decline in stocks was -43% while the worst calendar year decline in bonds was -11%.  So it should be clear that a bear market in bonds is very different from a bear market in stocks.

But what about high dividend paying stocks?  People often confuse dividends for making an equity instrument similar in some way to a fixed income instrument.  This is completely wrong.  An equity instrument that pays a dividend still lacks all of the aforementioned built-in safety components that differentiate fixed income from common stock.  It just means the company pays a dividend stream (which isn’t actually fixed and can be revoked at any point as many people found out during the financial crisis).

More importantly, dividend paying stocks can be atrocious performers at times.  And it’s often because high dividend paying stocks are leveraged companies who borrow funds to finance dividends and operations.  This was most obvious during the financial crisis.  Take for instance, the iShares Dividend fund which cratered -62% during the financial crisis.


Going back to Malkiel though – I had to chuckle at this bit of “Random Walk” advice from 2011 when he recommend buying AT&T stock because it’s a high quality dividend paying stock:

“Another strategy would be to substitute a portfolio of blue-chip stocks with generous dividends for an equivalent high-quality U.S. bond portfolio. Many excellent U.S. common stocks have dividend yields that compare very favorably with the bonds issued by the same companies.

One example is AT&T. The dividends paid on the company’s stock result in yields close to 6%, almost double the yield on 10-year AT&T bonds. And AT&T has raised its dividend at a compound annual growth rate of 5% from 1985 to the present.”

Since then AT&T has generated a 36% total return.  Not bad!  Except for the fact that the high quality blue chip index of the S&P 500 has generated a 67% total return over the same period.  In other words, Malkiel got trounced for engaging in the exact type of activity he mocked stock pickers for engaging in in this recent WealthFront blog post.  The level of inconsistency and hypocrisy in some of this writing disturbs me, to say the least.  One of the most influential thinkers in modern finance is just blatantly contradicting himself in these commentaries and yet people cite his work when it’s convenient to a certain perspective.  That’s rubbish in my opinion.

Okay, I’ll lay off Malkiel now.  But you should be starting to see a common thread in a lot of this work.  There are disturbing inconsistencies and misunderstadings in the views and framework that a lot of this work is built on.  And an entire industry has come to believe that this sort of thinking is a solid cornerstone for thought!

(pulls out hair)

Malkiel’s Mendacity

As I’ve developed an understanding of the macroecon and finance world I find the same disturbing trends across both fields – a highly politicized school of thought has dominated much of the thinking.

Regular readers probably know my views on mainstream economics, but I find many of the same problems muddying the waters in finance.  For instance, concepts like the Efficient Market Hypothesis and Rational Expectations are essentially conservative ideas constructed in a manner to establish an empirical argument against forms of government intervention.  They essentially say “markets do things better than governments so stay out”.  There’s a lot of truth to ideas like this, but they dominate the discussion to the point where they’ve become extremely counterproductive.  And yet people win Nobel Prizes for these ideas and the underpinnings of Modern Finance rest largely on this kind of biased thinking (no wonder they reject behavioral finance given how biased most of these economists are!).

I was reminded of this as I read this blog post by Burton Malkiel who scolds stock pickers for their performance in 2014. For instance, Malkiel, the father of Random Walk and a proponent of the Efficient Market Hypothesis, says you shouldn’t try to predict the future returns of assets because the markets are basically too efficient to outguess them.  That is, of course, unless he feels like predicting the returns of asset classes like he did before 2014 when he told people to avoid long-term US government bonds, the very best performing asset class so far in 2014 (zero coupon bonds are up an amazing 27.5% this year and 30 year bonds are up 17%+):

“Governments wrestling with large budget deficits, huge unfunded liabilities for entitlement programs, and high unemployment rates have adopted policies of keeping interest rates extraordinarily low.

Ten-year U.S. Treasury bonds yielding 3% provide neither generous returns nor an adequate margin of safety to make a shift from equities to high-quality bonds an unambiguous risk-reducing strategy.”

I remember the article vividly because it jumped out at me as being so obviously hypocritical and erroneous.  What’s ironic here is that Malkiel is not only picking assets specifically (something his own theories say you shouldn’t try to do), but he’s making what is obviously an erroneous political argument.  The US government is not at risk of some type of Grecian moment because of “unfunded liabilities”.  The US government is not going bankrupt yet he paints the government’s debt situation as something dire that warrants an underweighting in the asset class.  Malkiel is basically saying he knows more than the markets do so you should listen to him and underweight US government bonds. Malkiel might not like all this government debt, but it should have NOTHING to do with his theories on finance.  But he is clearly just making a political argument masquerading as financial analysis.  Sadly, that’s what much of modern finance and modern economics is – just politics masquerading as science.

This is important stuff.  And if I am right then the future landscape of modern finance and mainstream economics will look very different than it does today because lots of people are going to realize that the underpinnings of the current thinking aren’t just a little bit wrong, but very wrong.


The Unintended Consequences of Risk Avoidance

By Ben Carlson, A Wealth of Common Sense

“Risk control is the best route to loss avoidance. Risk avoidance, on the other hand, is likely to lead to return avoidance as well.” – Howard Marks

The investment fee wars continue to heat up as scale becomes more important than the actual size of the expenses. Here’s the latest from Investment News:

TD Ameritrade Inc.’s retail advisory service this week received a green light from securities regulators to offer a full refund of fees to customers whose investment portfolios decline in value.

The brokerage plans to offer the rebate to new clients of its Amerivest managed-accounts service, which currently costs between 0.3% and 1.25% of assets annually, if their investments post negative returns in two consecutive quarters.

TD Ameritrade professionals will manage your portfolio based on a risk tolerance questionnaire. The deal is that if you use this service and see two down quarters in a row you get to recoup your advisory fees.

As with most sales pitches in the finance industry, this sounds great in theory, but leaves much to be desired in reality. Unfortunately, these types of offers always come with unintended consequences because we humans are guided by incentives above all else.

If earning positive returns over any six month period is one of the main goals for these managed funds there could be a huge misalignment of risks. Certain clients could have a high tolerance for risk and be able to withstand periodic losses but the portfolio managers would be incentivized to dampen volatility to avoid drawdowns and fee rebates.

Many investors have learned the hard way that trying to beat the market over shorter time frames can be more trouble than it’s worth. A singular mission to outperform can actually lead to underperformance. The same logic applies when trying to minimize losses. A sole focus on downside protection usually leads to the opportunity cost of no upside participation.

An illusion of safety in the short-term can lead to problems in the long-term. Judging your portfolio or your financial advisor over a six month period is a recipe for failure. No strategy can be assessed over that short of a time frame.

Also, while fees are important over the long haul, investor behavior is much more important. Investors need to make sure they aren’t sacrificing other areas of portfolio management in a push to only reduce fees. Lower investment fees are only one of the many risk management techniques needed for a successful portfolio.

It’s also true that historically, a diversified portfolio doesn’t lose money two quarters in a row that often. It happens, but it’s fairly rare. Here’s some quarterly data using the Vanguard Total Stock Market Fund and the Vanguard Total Bond Market Fund as well as a 60/40 portfolio of the two going back to 1992:


Quarterly losses in stocks, bonds or even a diversified portfolio happen about once every four quarters. On the flip side, these funds have been positive roughly 70-75% of the time. But two down quarters in a row for the 60/40 portfolio has been rare:


It’s happened six different times since 1992 if you count the six quarterly losses in a row from 2007 to 2009 as three different instances. So around 14% of the time or just under once every two years.

Losses are inevitable in the markets, but most of the time stocks and bonds have gone up historically. The problem with a complete aversion to risk is that it can lead to a lack of rewards. Risk management is prudent while risk avoidance can lead to unintended consequences.

TD offers refunds to managed-accounts customers with losses (Investment News)


Rosenberg: the Next Recession Could be 4 Years Away

Talk about a flip in perspective.  David Rosenberg, who had been bearish for years, has turned into one of the biggest bulls on Wall Street.  The Gluskin Sheff analyst now says his recession forecasting model could be pointing to another four years of economic expansion (via a recent note of his):



That’s pretty interesting.  We know that the probability of a tail risk event increases dramatically inside of a recession.  So if DR is right then that means the macro trend could be higher for several more years to come….

It’s Time to Eliminate the Term “Passive” Investing

John Rekenthaler of Morningstar wrote a good piece today pointing out that the “active” vs “passive” debate is the wrong question.  He’s right.  We really shouldn’t be concerned at all with these labels.  After all, they are relatively meaningless marketing terms that have been constructed for no other purpose than to differentiate one product from another.  But there’s a more worrisome trend at work here and I think it deserves a lot more attention.  The fact is, most of the adherents of “passive” indexing are not only misconstruing the discussion, but they are working with an underlying model that is inherently flawed.

As I’ve explained in detail in several past posts (see below), there is nothing in the world of investment products that allows you to be a pure “passive indexer”.  That is, the ONLY pure indexing approach is buying the Global Financial Asset Portfolio and taking “what the aggregate market gives you”.  This portfolio isn’t available though.  You can come close to replicating it by building a 40/55/5 stock/bond/REIT portfolio, but you can’t achieve it perfectly.

What most “passive indexing” strategies really do is pick assets.  That’s all they are.  For 30 years they have constructed a clever marketing pitch berating “stock pickers” without thinking through their own approach entirely and realizing that they are also asset pickers inside of a broader aggregate.  “Passive indexers” determine an asset allocation by taking all sorts of theoretical underpinnings and then make an implicit (some might say naive) forecast about the future that is the precise equivalent of saying they can “beat the market”.  Do you own a “passive 60/40″ stock/bond portfolio?  You are declaring to the world that you think stocks will outperform the (approximate) 40/55/5 stock/bond/REIT allocation of the GFAP.  You are saying you are smarter than “the market”.  You are saying you can pick assets better than “the market”.  You are an active asset picker.  

More importantly, anyone who understands the GFAP from macro perspective knows that it’s an ex-post construction of an index that is basically a rear-view mirror bet hoping that millions of issuing entities are making “efficient” decisions based on the assets they’ve already issued (there’s a contradiction in the Efficient Market Hypothesis there that is the width of a Mack Truck).  Of course, there are times, like the last 25 years, when the GFAP is not just wrong, but tremendously wrong (buying the purely passive 60/40 stock/bond GFAP portfolio in 1980, for instance, generated far worse risk adjusted returns than a bond heavy portfolio did).

Now, don’t get me wrong here – a lot of the general message underpinning the concept of “passive investing” is great.  I love indexing.  Diversification is tremendously important.  Costs are HUGELY important.  Trading can be terrible for your wealth.  But “asset picking” (which is what all asset allocation ultimately comes down to) is totally necessary.  It’s the only way we can construct portfolios that align our risk tolerance and financial goals with a certain set of appropriate assets.

So yes, it’s time to dump the “active vs passive” jargon.  It’s just marketing terminology sold by firms with a vested interest in one or the other.  More importantly, if your advisor or “expert” investor friends use the term “passive investing” they probably haven’t thought all of this through from a macro perspective which means that the entire foundation and rationalization of their approach could be flawed.


Margin Debt Is Acting Curiously

By GaveKal Capital

The unique behavior margin debt held in NYSE accounts this year continued in July. After looking like it had reached a structural peak in February, margin debt surged back in June. Now the latest data point for July shows NYSE Margin Debt dropped by about $4 billion. Technically, the peak in February still holds as it is about $2 billion higher than the level reached in June. However, if in hindsight February is the peak, margin debt is certainly acting uncharacteristically compared to previous peaks in the equity market.  Lastly, net margin debt reach an all-time high in July 

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The Housing Market is Softening

The US housing market appears to be softening a bit after a torrid run-up in the last 18 months. National home prices, as tracked by the Case Shiller index, had jumped at nearly a 15% rate of change year over year as of earlier this year.  But the pace of change has slowed markedly in recent months to 8%.



The CoreLogic Home Price Index is showing a similar trend with prices slowing to 7.5% in recent months.  The average annual price change in 1978 has been about 5.5% so we appear to be coming more in-line with the historical average.




Recession Or Expansion – How Much Does It Really Matter To Equity Investors?

By GaveKal Capital

Is the US economy about to lift-off out out of the recovery phase and enter into a self-sustaining expansion? Or is the US economy cratering towards a debt constricting, deflationary recession? Few questions in economics or finance garner as much emotion and flamboyant diction as to where is the economy “heading”. Instead of prognosticating on the difficult question of where the economy is heading, today we want to ask how much does it really matter to equity investors where the economy is?

For our data needs today, we are going to use the Dow Jones Industrial Average going back until 1900. Of course we are aware of the limitations of using the DJIA, however, it does have the important advantage of 114 years of history. This extended history allows us to analyze the Pre-WWII era against the Post-WWII era which one will soon see plays an important role in determining how much the economic environment plays into stock returns. We will also be using the NBER official business cycle dates to determining whether or not the US economy was in a recession or an expansion.

Regardless of whether or not the US was in a recession or an expansion, the average market return during any economic phase is a healthy 24% (figure 1). The median is quite a bit lower at 9% indicating positive skew in the data set. The average max drawdown during any phase is -15%, with median max drawdown of -9% during any phase.

Figure 1 – Total DJIA Series


When we begin our data slicing and break out the returns based on the type of economic phase the US was in, the performance data skews heavily in favor of expansions relative to recessions. In Figure 2, we show the average and median returns when the US is in an expansionary phase. And in figure 3, we show the returns when the US in a recessionary phase.

Looking at these two figures, without a doubt it has been much to be an equity investor during an expansion that during a recession. The average market performance in 60% higher and the median market performance is 37% higher. Just as important, the max drawdown is significantly less in an expansion relative to a recession.

Figure 2 – Expansionary Phase


Figure 3 - Recessionary Phase


We tipped our hand to this earlier, but now let’s analysis pre-WWII and post-WWII returns based on economic phase. Doing so we find a couple of interesting characteristics:

  • Market performance during different expansions pre-WWII were more similar and had less skewness as indicated by their much closer average and mean returns (Figure 4) compared to the market returns post-WW2 (Figure 6). The max return is higher after WWII and the median return is slightly lower.
  • Recessions were harsher to investors prior to WWII (Figure 5). The median market return during a recession was -9% before 1946 while the median market return since is actually positive (3%) (Figure 7). Max drawdown highlights this as well as the median max drawdown was 11% deeper before WWII (26% vs 15%).

Figure 4 – Pre-WWII Expansion Phase


Figure 5 – Pre-WWII Recession Phase


Figure 6 – Post-WWII Expansion Phase


Figure 7 – Post-WWII Recession Phase


So yes, the economic phase matters to equity investors. However, it has mattered less since WWII. Why is this case? There may be myriad of explanations such as companies leveraging technology to ride out the business cycle more profitability or globalization of sales and profits. Or perhaps it has more to do with the monetary policy backdrop, such as going off the gold standard, than it has to do with other factors. Most likely, it is a combination of many reasons working together. Regardless, it is clear the economic phase is still important to equity investors but as we are reminded nearly every quarter by “professional” forecasters, it is anyone’s guess as to which phase we are headed.

(source for all data above is from Dow Jones, Gavekal Capital, NBER)