What we are reading on 6/30/2017

Here’s what we are reading today. We do not necessarily agree with the opinions expressed therein and we disavow any actual or implied investment advice therein. In no particular order:
Risk adjusted momentum
Another tax avoidance scheme for the wealthy!
Imagination versus willpower
Squeezing life out of that clunker
Retired or Fired: How Can Investors Tell If a CEO Was Pressured to Leave?
Well duh … science says don’t give your money to psychopaths
A contrary view on diversification
The psychology of misjudgment
State pension burdens grow worse …
Happiness research
Costs and Benefits of Consuming
Diversification = pain
A bond timing model
Time, time, time
Is there a case for local currency EM debt?

Inflation monitor as of 6/28/2017

Inflation has been trending downwards for decades.  We think the following factors have created this long-term trend:

  • an aging population that buys less
  • wage competition from third-world countries, due to globalization.

With talk of border taxes and rolling back globalization (at least partially), can we assume that the downward inflation trend will continue from here?  We don’t know, but we intend to track the numbers.  This post reviews a wide range of market-based and statistically derived measures of inflation.

Recent indicators suggest some softening of inflation.

Our takeaway:  the annual rate of inflation is probably 1.5%-2.5%.

Backward-Looking Measures

Consumer Price Index (CPI) – changes

The CPI is calculated by the government.  More than a few investors view the index with a degree of skepticism.

CPI:  +1.86%

Median CPI:  +2.23%

Core CPI:  +1.73%

Sticky CPI:  +2.14%

Trimmed Mean PCE:  +1.90%

Producer Price Index (PPI) – changes

The PPI is calculated by the government.  Some investors regard it with suspicion:

Finished Goods:  +2.61%


Wages are very important because they account for such a large portion of the cost of goods and services.

Average hourly earnings:  +2.46%

An increase in average hourly earnings does not translate into an equal amount of inflation.  Increases in productivity can offset (entirely or partially) the inflationary effect of higher wages.

Billion Prices Project

The billion prices project estimates the annual rate of inflation by using prices posted by online merchants.

As of the last publicly available data point, BPP estimates the U.S. inflation rate at annualized rate of about +0.1%.

Purchasing Manager’s Index

The Institute for Supply Management publishes the results of a monthly survey of their members, including a price diffusion index.  A diffusion index doesn’t tell us the rate of inflation, but rather what percentage of the survey respondents are seeing prices go up or down.

The survey results suggest no significant inflationary pressures.

Manufacturing Prices:  60.5

Services Prices:  49.2

Forward-Looking Measures

Treasury Inflation Protected Securities

In addition to ordinary bonds, the U.S. Treasury issues inflation-protected securities (TIPS).  By comparing the yields, one can infer the inflation forecast of the capital markets.

Ordinarily one should assign high credibility to this type of information. However, caution may be appropriate given extensive central bank manipulation of the credit markets.

Five Year Forecast:  +1.61% per annum (5Y Treasury Yield5Y TIPS Yield)

Ten Year Forecast:  +1.71% per annum (10Y Treasury Yield10Y TIPS Yield)

5-Year, 5-Year Forward Inflation Expectation Rate

Inflation expected from 5 years from now to 10 years from now:  +1.81%

Michigan Consumer Sentiment

1-Year Expected Rate of Inflation:  +2.6

5-Year Expected Rate of Inflation:  +2.6

ECRI U.S. Future Inflation Gauge

ECRI -1.4

Trend-based indicators

Crude Oil:  Downtrend = deflationary pressure

Copper:  Uptrend = inflationary pressure

U.S. Dollar:  Downtrend = inflationary pressure

Option strategies for momentum investors

Serious and informed momentum investors must worry about the potential overvaluation of their stock holdings. Lacking valuation support, momentum stocks can crash badly if the expected fundamentals fail to materialize.

Options may help mitigate some of the valuation-related challenges confronting momentum investors. A rational investor will consider using these strategies in ways that take advantage of over- or undervaluation of options.

Quarterly financial reports are an obvious source of risk for a momentum stock. Most momentum investors worry not just about the quarterly report, but about the risk of a negative earnings warning in the weeks leading up to the quarterly report.

Buying a put option can provide protection against capital losses. However, the option itself is likely to be too costly to implement this strategy systematically, quarter after quarter. One can offset the cost of buying the put option by writing other options.

For example, one can structure a collar by buying the put option and writing a call option. A collar has the effect of limiting the stock’s move up or down. The strike prices of the put and call options determine the amount of potential movement.

If one doesn’t want to limit the upside with a collar, one can reduce the cost of buying downside protection by writing additional put options (in a put spread). The written options can have lower strike prices than the purchased option, later expirations or some combination of the two. The effect of a put spread is to reduce the cost of the downside protection for a limited decline in the stock price while amplifying losses beyond that point.

For example, let’s imagine the investor owns a stock trading at $30. For $2 he buys a put with a strike price of $30. The $2 cost is high, so the investor writes a put with a strike price of $25 (for $1.25). The investor has reduced the cost of downside protection from $2.00 to $0.75. The investor protects his capital against a price decline to $25. But further price declines (below $25) result in losses twice as large as owning the stock. Again: put spreads are not appropriate for risk averse investors.

What we are reading on 6/27/2017

Here’s what we are reading today. We do not necessarily agree with the opinions expressed therein and we disavow any actual or implied investment advice therein. In no particular order:
More on the indexation end game …
How to lose a half a million dollars
Vanguard Preps To Offer Actively Managed ETFs
Are there any Einsteins in the investment business?
Japan’s bubble
Lessons From The Last Bear Market
2017 v. 2000
College kids are investing in Ethereum
Conspicuous Consumption Is Over …
All Mental Models Are Wrong
The number of stocks keeps falling …
Are US stocks overpriced?
How to train smarter
An interesting app: Trim
Risk management with moving averages
Intensive Stock Research Can Be Injurious to Your Financial Health
The Third Mandate Is Official
Hussman’s latest
The Volatility-of-Volatility Term Structure
Improving U.S. Stock Return Forecasts: A ‘Fair-Value’ CAPE Approach
Unusual Early Retirement Withdrawal Strategy
The Problems with Indexing
Why Can’t ‘Winning’ Active Managers Keep on Winning?

Why asset shrinkers may be good investments

In a prior post, we reviewed two papers that make the case for asset growth as a stock picking method, but in an unexpected way:

  • avoid companies showing high rates of asset growth
  • invest in companies showing low rates of asset growth

The papers provided evidence that investing according to these criteria would have added value (at least historically – past performance is no guarantee of future performance).

In this post we speculate as to why the low growth companies appear to have produced higher returns than the high growth companies.  In our own investing we have greater confidence adopting a certain methodology if we can convince ourselves that there is a theory underlying what the data suggests.

  • Acquisitions:  we noticed that the highest growth companies in the Cooper paper show 84% asset growth year-over-year at the point of measurement.  We think it likely that acquisitions account for at least some of this growth.  We believe that the bigger the acquisition, the more likely the acquisition is likely to harm shareholder value.  It’s not just the risk of overpaying, but the difficulty in integrating a big acquisition.
  • Divestitures:  on the other hand, the lowest growth companies show asset shrinkage of -21% year-over-year at the point of measurement. It seems likely that a company shrinking that quickly must be selling assets, perhaps entire business units.  If acquisitions on average tend to destroy shareholder value, then perhaps divestitures will tend to add to shareholder value.
  • Management gets serious:  For the low asset growth companies, the Cooper data shows four years to progressively lower asset growth capped with a significant shrink (-21%) in the year of measurement. We have yet to meet the management team that would deliberately create a strategic plan with this profile.  We think it more likely that the progressively lower rates of growth demonstrate creeping fundamental rot and that in the year of measurement, someone has gotten serious about fixing problems: Either the CEO has cleaned house, or the Board of Directors has replaced the CEO.
  • Delevering:  if assets are shrinking it means that something on the right side of the balance sheet (probably liabilities) are shrinking as well. Reducing debt reduces the risk of financial problems, which could lead to improved stock returns going forward.
  • Execution risk:  executing the business plan can become very difficult at high rates of growth.  One must hire increasingly large numbers of people, train them and get them to work together.  Assets must be purchased and put to work.  In contrast, getting out of low profit businesses frees up management attention for more profitable endeavors.

What we are reading on 6/23/2017

Here’s what we are reading today. We do not necessarily agree with the opinions expressed therein and we disavow any actual or implied investment advice therein. In no particular order:
Thoughts on Why the Stock Market Keeps Going Up, Up, Up
When “Helicopter Parents” Hover, Even in Workplace
CAPE Fatigue
Hyperbole or Reality? Investor Response to Extreme Language in Earnings Conference Calls
Hidden In Plain Sight A Powerful Way To Beat The Market
Option writing as a strategy
Blockchain 101
Ethereum, the digital currency
Great News: There’s Another Recession Coming
Walker’s Manual of Unlisted Stocks
“You want winners?” – A story of crazy speculation
Pension Funds Have $4T Hole, Even A 5% Market Decline Could Be Catastrophic
Data Says Fed Is Making A Mistake
ETF Watch: Horizons Plans Covered Call Fund
Feds Labor Market Forecasts Don’t Make Sense
How to implement the Magic Formula investment strategy
Reasons It is So Hard To Think Like A Scientist
Where in the World Can Value be Had in the Equity Markets?
The Emotion That Does Motivate Behaviour After All
Taking Notes Has This Ironic Effect On Your Memory
What Your Sleep Position Says About Your Personality

Asset shrinkage and value investing

A contrarian is one who, “takes an opposing view, especially one who rejects the majority opinion.”  Value investing and contrarianism go hand-in-hand.  Stocks that are trading for less than their intrinsic value usually are held in low regard by the consensus.  That is why they are undervalued.  At a minimum, the value investor will take the view that the price of the stock more than compensates for whatever fundamental problems confront the company.  He may also take a contrary view on the fundamentals, too.

Would the value investor find it beneficial to extend his contrarianism to the growth?  It is almost axiomatic among investors that a growing company will have better stock return prospects than a stagnant company.  But two papers cast significant doubt no this belief.

In “Asset Growth and the Cross-Section of Stock Returns,” Cooper, Gulen & Schill (2008) demonstrate that the companies with the lower year-over-year growth rates of total assets produced higher subsequent stock returns and vice versa.  The effect persisted after controlling for the market return, valuations and size (and a number of other variables, too).  Their analysis applied to a data set of U.S. stocks.

With this kind of study, one must worry if the researchers did a good job in designing the study, if they didn’t commit some procedural or methodological error, or if the results were just a fluke.  One can be a bit more confident if the results are similar using a different data set.

Fortunately, other researchers have followed up.  For example, Li, Becker and Rosenfeld extended the analysis in their paper, “Asset Growth and Future Stock Returns: International Evidence,” from a U.S. data set to an international data set.  This second paper is important because the researchers use a different set of data than the first paper. The encouraging news:  Li, Becker and Rosenfeld were able to demonstrate similar results in the history.

Because both papers found that the effect persisted even after controlling for valuations, value investors may find that adding asset shrinkage to the list of desirable variables could improve investment performance.

Of course, these results were found in the financial history and the results do not attempt to simulate what might have occurred in a real-world portfolio.  Past performance is no guarantee of future results.


Fundamental Research – pro and con

Early in my career I made investment decisions on the basis of intensive fundamental research.  I switched to quantitative techniques after about eight years.

By intensive fundamental research, I mean talking to a company’s management, talking to analysts of a company, reading all of the financial reports, researching the industry, etc.  I found that such activities, on average, did not pay off as nicely as a quantitative approach.

Here are some of the problems I encountered:

Quality of management

The quality of management is critical to the future of a company.  However, I found it difficult to make money in attempting to evaluate management quality.

First, if management is good then one should see evidence of their skill reflected in superior corporate financial performance.  So, in one sense, one can rely on quantitative techniques alone to discern management quality.

Second, one should be wary of the idea that high quality management is worth something beyond the valuation justified by the company’s financial performance.  Surely the quality of management will be reflected in superior corporate profitability.  If one is not careful, one could “pay up” for superior profitability and then “pay up” again for quality management, when in reality the former is a function of the latter.

Third, it is difficult to determine whether credit for superior financial performance is due to management or to the business.  A great business can show superior profitability in spite of mediocre management.  A lousy business may show terrible profitability in spite of outstanding management.


In theory, fundamental investors should have an advantage over quantitative investors.  Fundamentalists have access to everything that the quants have, but they can also attempt something that quants tend to avoid:  forecasting what will happen.

In practice, the value of forecasting is at best uncertain.  Its value compared to the cost of forecasting is poor for the following reasons.

First, forecasting in a way that contributes to investment returns is very difficult.  You have to guess the future correctly, which is difficult.  But you also have to get the timing right.  It is not useful to say that something will happen at some point over the next ten years.

Second, forecasting is not enough.  You have to come up with a forecast that is meaningfully different than what most investors expect.  If your forecast is the same as everyone else’s then there is no reason to expect an opportunity.

Third, you have to anticipate the market’s reaction to your forecast.  If you have a different forecast and you are right, all of your work will amount to nothing if other investors do not react to whatever happens.

So, earning a return by forecasting strikes us as very, very unlikely to succeed:  You have to come up with a forecast that is different than everyone else; you have to get the timing right; and you have to predict how other investors will react.


The unstructured nature of fundamental stock research tends to allow greater bias in thinking.  For example, this style of research allows one to find patterns in information that have little practical value in selecting stocks.  Or, one may gravitate towards fundamental data that tends to confirm pre-existing beliefs instead of fostering new thinking.


That’s not to say that all research beyond the quantitative model has no value.  We think fundamental research can help in limited ways, such as:

  1. Verifying that the quantitative models are working with the right data; or
  2. Attempting to identify what, if anything, the quantitative models are overlooking.  Such insights could form the basis for new quantitative research projects in the future.

What we are reading on 6/20/2017

Here’s what we are reading today. We do not necessarily agree with the opinions expressed therein and we disavow any actual or implied investment advice therein. In no particular order:
Getting stuff done
JPM raises money for distressed shipping investments
Focus on what you can control
Asset allocation, momentum and diversification
Is passive in a bubble?
How what we read affects us
Improving break time
An easy way to get more time?
Amazon, Whole Foods and the Restaurants
An expensive mistake: not completing college in four years
Another benefit to low-carb eating
The timing of earnings news
Maybe we shouldn’t talk publicly about our stock picks?
Can Two Schools of Thought on How Stock Investing Works Co-Exist?
The Passive Investing Mirage And The Disintermediation Of Active Mutual Fund Managers
Morningstar analyzes market neutral funds
Which Has It Right, the Stock Market or the Bond Market?
Factoring in Factors
Argentina (!) Sells 100-Year Dollar-Denominated Junk Bonds
Amazon to Slash Jobs at Whole Foods, Dump Cashiers, Switch to Cheaper Products in Price War with Wal-Mart
Jim Rogers Bracing For Crash
We Are All Insurers Now
How I Ditched Debt: Lauren Greutman
Another Part Of The Real Estate Market Is Starting To Crumble
Its Time For Wall Street To Stop Its Wishful Thinking About Washington
Leave Illinois alone?
How to wind down a $4 trillion balance sheet
The Search for Crisis Alpha: Weathering the Storm Using Relative Momentum
Risk And Return Within The Stock Market
Terrorist psych
Weekend reading: The value versus growth battle continues
Is inflation breaking out?
The Dead Giveaways of Imperial Decline


Outcome bias

Outcome bias reflects the tendency for people to evaluate a decision making process in a manner that is consistent with the already-known outcome of the process.  For an investor, outcome bias has an impact on process improvement, i.e., what lessons the investor learns from his successes and failures.

For example, let’s imagine that an investor is testing with real money two distinct investment processes.  After a period of time, he intends to use the real money test to select one investment process for a substantial capital commitment.  One of the processes does well, the other not so well. One would expect the investor to be more positively disposed to the the process that performed better.  Outcome bias predicts such behavior.

But a link between the quality of an investment process and its performance can be difficult to establish.  From a statistical perspective, investment returns are very noisy.  This means that for even a high quality investment process, a lot of the returns are inexplicable.

Returning to our example, let’s imagine that the first investment process calls for owning stocks with trading symbols starting with the letters “A” through “L.”  The second investment process calls for owning stocks with trading symbols starting with the letters “M” through “Z.”  One of the two investment processes will produce the higher return.  What does this tell us about the quality of the two investment processes?  Absolutely nothing!  And outcome bias may have no effect when the investment processes are so obviously silly.

But what about investment processes that appear credible?  What if the first investment process has a clever new way to measure the intrinsic value of a stock, and the second investment processes uses a more traditional valuation approach?  If the first investment process performs better in the test, outcome bias will cause the investor to regard favorably the quality of that investment process.  Given that the first process is “new” and “clever” and it actually has produced a good return, the investor may feel confident in committing a serious amount of capital.  But does the performance actually prove anything?  It is hard to say.