On Bubbles

Charlie Bilello from Pension Partners pointed out that the CAPE is now over 30. His piece is balanced and well written as always but it won’t prevent others from using the data to once again proclaim that the market is expensive and that we’re in a bubble, etc. So far so good and I might even agree. But if the implication is that there is impending doom then I have to beg to differ.

Many writers, the eminent Larry Swedroe among them, have argued that the historical context of the P/E ratio has evolved. I find no reason to doubt them, so let’s take the shorter term relative movement as an indication of multiple expansion or contraction. In 1921-29, the CAPE ratio went from 5 to 30, for a gain of 6X. In 1982-2000, the CAPE ratio went from about 7 to 44, another 6X. The CAPE low of 2009 was about 12.5. Now I’m not about to forecast a CAPE of 75 (although within the realm of possibility, cf. Japan 1990), but surely an increase of mere 2.5X can’t be the end of this bubble if it can be called such? If this is indeed the coming-home-to-roost of all the QE by all the central banks since the great financial crisis then we will have much, much further to go. To say otherwise is to say “this time is different”.

I have been saying on this blog since last November that we’re entering a generational bull market. Currently the model is seeing a consolidation low in July, flat in August, but a truly maniacal phase for 12-18 months thereafter.

Speaking of bubbles, the Collaborative Fund recently published The Reasonable Formation of Unreasonable Things. Here are a couple of gems:

The majority of your lifetime investment returns will be determined by decisions that take place during a small minority of the time.

Bubbles are not anomalies or mistakes. They are an unavoidable feature of markets where investors with different goals compete on the same field. they would occur even if everyone was a financial saint.

It’s a hallmark of thought-provocativeness that the readers may draw different conclusions from the ones the author intended. It reads to me that one of the article’s main purpose was to warn long-term investors of the dangers of irrational pricing during bubbles. Pointing out the difference in goals and time frames was a beautiful rebuttal to EMH which sometimes is used to justify “buy at any price”. But to me the greater take away was the importance of the bubbles — rational, inevitable, and the driver of long term returns that those smooth, monotonically uptrending curves from a fantasy land called Excel would have you overlook.

Two recent articles by Jason Zweig (here and here), speaks to the difficulty of riding a bubble: specifically, a money manager Samuel Lee and his experience with Ethereum. Except in this case, the final chapter, or more than likely the second act, has not yet been written. Jason Zweig is too good a writer and has too much understanding to express an opinion other than saying it’s really hard. So here I would like to give myself some pointers that I hope to follow:

  • Participate — showing up is half the battle, especially when others are calling it a bubble.
  • Don’t be greedy. Position size control is paramount. Set a volatility limit as well as a position limit.
  • Do not envy those in earlier with a lower cost basis, nor those in later with a larger position.
  • Take profits, often. It’s impossible to catch the exact bottom or top. Play with the house’s money.
  • Do not take positions to justify a point.
  • The majority of the portfolio should be in an allocation that one would have in the absence of bubbles.

The last point is an import one for me. My speculative positions are benchmarked against cash, not the 60/40 much less 100% stocks. Why would it be otherwise if the bubble is expected to be short lived? Taking profits, even partially, forces one to re-evaluate the whole position.

We live in interesting times. I see three bubbles in progress or developing that require very different treatments. In cryptocurrencies, I have taken a position and am simply content to sell a little bit as prices rise. In PMs I have a 15% baseline allocation but trade around the cycles. Exposure can be increased by being in silver, miners, 3x ETFs and options while maintaining the same nominal allocation. In stocks and Nadaq in particular, I’m willing to increase the overall allocation along with highly leveraged option positions. These are in contrast to their neutral allocations of 0%, 15% and 45% (for all equities), respectively.

The next year or two should be very interesting.

Performance Tracking June 2017

For calculation methodology see this post. Tracking growth stocks and fixed income CEFs started in April’17.

For June my total portfolio returned 0.9% exceeding both SPY at 0.64% and 60/40 at 0.38%. YTD the total portfolio is at 8.3% vs. 9.18% for SPY and 6.43% in 60/40. In terms of stock picking, growth stocks lagged this month as can be expected from the headwind faced by leading tech stocks. The DGI stocks were strong in part because of the realization of dividend payment (cash basis on when they were paid, shifting about 0.3% from last month). When the growth and DGI stocks were taken as a whole, they slightly exceeded SPY for the past three months which was better than expectations. CEFs continue to be a highlight of the portfolio as previously mentioned. Cryptocurrencies were a positive driver despite entering a correction since BTC reached $3000.

AllocateSmartly is now tracking 37 different tactical and static allocations. In June, 0.90% would have placed my portfolio at third overall, albeit a distant third. YTD 8.3% would have been 11th out of 37. The active accounts’ YTD gain of 10.29% would have been 2nd overall.

Going forward I see a difficult summer ahead with continued consolidation in erstwhile leading stocks. Gold may finally find a bottom in July. I have been hedging my miners using DUST and I’m finally looking to buy more gold coins for my passive accounts. To be discussed further in an upcoming market commentary.

Pimco Taxable CEFs YTD

Someone posted a summary of Pimco taxable CEF YTD results to the MorningStar CEF discussion board, which I reproduce below.

The numbers speak for themselves. Of these I own PDI, PCI, and PFN, and I used to own PTY. In addition to taxable multi-strategy, I also own muni and bank loan CEFs. Together CEFs currently make up 22% of my active accounts. They’re one end of my bar-bell strategy in fixed income — the other end being stable value funds in passive accounts.

It is true they use leverage and have high fees relative to bond index funds. But they also offer liquidity and after-fees performance not normally seen in public investment vehicles, with the exception of perhaps BDCs and mortgage REITs. I’ve owned CEFs for well over 10 years. During this time, I have looked at P2P lending, real estate crowd sourcing, and other private vehicles and never found a reason to bite.

Note: This is not investment advice, do you own DD!

Cryptocurrency Correction

Cryptocurrencies have been correcting since June 12 when Bitcoin price reached $3000. The bounce out of the May 25-27 correction produced a new high but had a lot of internal weakness. Bitcoin is leading the entire crypto universe down, with Ethereum correcting even further than BTC.

Left for its own devices, the correction may last a few months at least. The big unknown is the UASF on Aug 1, meant to address the scaling issue but may leave Bitcoin irreversibly split. That would be a nightmare scenario.

I sold a chunk of coins on June 24 and a quick summary of my crypto experiences so far is as follows: Mar’17, deposited 0.1X; withdrawn so far, 0.068X (68%); coins left, ~0.28X. When I first started, I saw the outcome as bi-modal: it will either take-off or crash to zero. The realization justified a small allocation (~1% of the active accounts). The table below shows the peak and correction so far in BTC, ETH and LTC. Also shown is what I consider as the likely correction targets, as well as my cost basis. It’s amazing that Mar’17 can be considered early here and disaster will have to strike for me to lose money.

Longer term, if one considers Bitcoin to be a competitor to gold and that current monetary gold total about $3-4 trn, it wouldn’t surprise me to see BTC increase 100X. That would bring BTC to about parity with today’s monetary gold marketcap which will surely increase by that time. Of course, I don’t know for sure and I don’t know if another crypto will supplant BTC. There is plenty of evidence that institutions are getting involved, which makes it either 4th or 5th inning using everybody’s favorite baseball analogy.

The Arithmetic of Prudence, Part 3

Part 2 of this series dealt with the asymmetry of marginal utility and that prudence often requires maximizing the probability of reaching a minimum objective rather than maximizing the expected portfolio value. This is especially true when one or more of the following applies:

  • The time horizon is short, e.g. < 10 years.
  • The investor is a prodigious saver; i.e., less reliant on returns to reach goals.
  • The portfolio is in distribution.

The table below summarizes my portfolio recommendation depending on the life stage of the investor.

The demarcation between early and late accumulation, early and late distribution are 10 years to and from the retirement date, respectively. Other authors have referred to the decade before and after retirement as the retirement red zone. Michael Kites recommends a “bond tent” from 10 years before to 15 years after retirement. It has a more elongated taper but based on the same principles.

The recommendation is for principles only. There isn’t specific allocation recommendation due to the enormous variation in individual risk tolerances. 70% stocks/30% bonds may be ultra conservative to one and a roller-coaster ride to another. However, the relative measures of risk ought to hold for the same investor at different stages of his investing life. I also believe in the soundness of some popular advices: greater allocation to equities during early accumulation and the use of annuities (SPIAs) for baseline income during late distribution.

As laid out in Part 2 of this series I advocate sacrificing some growth for reduced volatility in late accumulation and early distribution. The need to do so is recognized by mainstream writers but I find their typical advice of increasing the fixed income allocation too simplistic. I have written about the alternative asset classes in Beyond 60/40. In my own portfolio I continue to explore cost-effective ways to incorporate these assets consistent with modern portfolio construction methods such as risk parity, minimum correlation and maximum diversification but tailored to an individual investor with a desire to reduce trading frequency.

We live in an age where competition in the financial services industry has given the individual investor access to an unprecedented array of products at reasonable costs. Of course, not all of them make sense and the onus is upon us to separate the wheat from the chaff. But quite often I see in the PF blogosphere and forums an avoidance on principle. In some there is a suspicion to all things from the financial services industry, a suspicion no doubt born out of experience with its dodgy business practices. In others, it feels like a fundamentalist fervor against anything not a 3-fund portfolio. Whatever the reason, the majority of the DIYers continue clinging to 60-year old portfolio construction methods. I have never tried to convert anybody but have always read forum (e.g. Bogleheads) exchanges about alternative assets (typically gold) and portfolio construction (slice-and-dice, factors) with interest — when emotions are high and arguments are well-thought it makes a great spectator sport!

In the table I had the same recommendation for both late accumulation and early distribution. For obvious reasons my mental efforts have been directed to late accumulation. After the retirement threshold I can see greater emphasis on income generation: increasing allocation to CEFs, higher yielding stocks, more aggressive option writing, and less emphasis on speculative assets. The asset categories will remain the same but the percentage will differ. I expect tax considerations to play a larger role than return-volatility trade-offs.

Speaking of the distribution phase, two recent opus (both are deserving of this word) contributed significantly to our understanding: a series by EarlyRetirementNow and the work by none other than the great Bill Sharpe. Bill Sharpe also called decumulation “the nastiest, hardest problem in Finance”. It is indeed difficult, if not insoluble, if the requirements are:

  • The only allowed assets are equities and bonds.
  • The allocation is static or follow a simple age-dependent formula.
  • The withdrawal rate is anywhere close to 4%.

As they say, 2 out of 3 ain’t bad. Variable withdrawal strategies can help, but critics will say they’re market-timing in disguise: in effect, if not on purpose. PortfolioCharts has repeatedly shown the benefits of gold in increasing the safe and perpetual withdrawal rates, but gold haters will continue to hate. I suppose that leaves getting more money/requiring less as the fool-proof way of ensuring success. But try to tell that to a 23-yr old ER-aspirant!

So far as my own plan is concerned, none of the three bullets apply. But since I’m far from the Epicurean ideal, I’ll be working for another 10-12 years yet!