Some Rambling Thoughts on Investing Philosophy

I’ve previously written a blog post about the key tenets of my investing philosophy that were more about the actual practice. In contrast this post is a collection of more fundamental views.

On the human condition in investing and its axiom

First of all, the human condition as it pertains to investing is that we can never be sure of future returns. The typical investing time horizon and the nature of returns is such that we have one life to live and the return will only be known at the end by which time it’s too late to change anything. Given the stage of my life, I’m obsessed with maximizing retirement date certainty. I spend much time thinking about two approaches to taming the (downside) volatility without compromising return potential: asset class diversification and market timing done correctly.

“Buy low sell high” is the only axiom of investing, everything else is derived from, therefore subordinate to, it. There are heuristics or rules of thumb that are derived from experience. But no matter how much experience it’s based on, or how authoritative a figure it comes from, a heuristic can never over-rule the axiom. For example, I invest in PMs and cryptocurrencies with the goal to “buy low sell high” even though they don’t conform to someone’s notion of productive assets. The word speculate as opposed to invest is used to describe, often derogatorily, such activities by some. To me, the word speculate carries no negative connotation. As a matter of fact, I believe successful speculation requires above-average understanding of human psychology and macroeconomics, as well as superior mental discipline. So no, I don’t mind being called a “speculator” at all.

On diversification, market timing and bubbles

The benefits of diversification with uncorrelated assets is mathematically derivable. It does not derive its validity from backtesting, although backtesting confirms it works. I consider that a first level corollary to the axiom of investing. There aren’t that many of those either — “costs matter” is another. Early literature of “Modern” Portfolio Theory which was developed in the 50’s focused on the two-asset universe of stocks and bonds. For a long time they were the only options available to individual investors; however, in this day and age, it’s sad to see how much of the investing public is still operating with this now self-imposed limitation. I’ve grown used to the resistance to alternative assets displayed on forums like Bogleheads and MMM. These days I click on threads about gold and cryptocurrency with the anticipation of a spectator at a UFC event. I’m usually not disappointed.

I’m an avowed market-timer, one that’s primarily interested in cycles of years duration or longer. The combination of market-timing and freedom to speculate allows me to take advantage of asset bubbles. The mainstream views bubbles as unavoidable evils of the free market, and the ability to hold through them with clenched teeth and unwavering asset allocation the ultimate financial virtue. I’d like to offer a different point of view. We know that bubbles appear with some regularity: PMs in early 80’s, Japanese stock and RE in early 90’s, dot com bubble of 2000, the housing bubble of ’07; and depending on who you ask on-going and near future: bond, cryptocurrency, Nasdaq and PMs. Given the length (build up, blow-off, collapse) and magnitude of these bubbles there is a possible variant perception: that the bubbles are the main acts, and the supposedly normal markets merely a chorus in the background on this financial stage of ours. According this view, a portion of our portfolio should be expressly directed towards taking advantage of bubbles, while the rest under the traditional asset allocation geared towards the “normal” market that are the plateau from which the bubble peaks rise. It takes great skill to ride a bubble due to the great emotion and hype invariably accompany each and that no two bubbles are alike. But successfully negotiating even just one could set one up for life, or at the minimum build a significant base from which compounding with a traditional allocation will ensure a comfortable retirement. For additional thoughts on riding asset bubbles see here.

On passive vs. active

Hardly a week goes by without encountering an article on the active to passive transition. I personally use them both for strategy diversification. Index funds are a great invention: for someone not inclined to put in the time and effort there is no better investment vehicle. In all likelihood the trend of active funds to passive will continue, especially in a bull market where hedging degrades performance. I believe that in so far as passive investing puts more money in the pockets of the public, more capital may be attracted into equities than would otherwise, further perpetuating equity bubbles. I also believe it’s possible for passive to become too big: market orders can be market distorting when passive is the only game in town.

I could probably go all indexing in the equity portion of my portfolio — my goal for actively picked stocks is to match the return of SPY anyway. One reason for staying with individual stocks is that it affords greater opportunities to write options, at the least when the goal is to have them expire OTM. Another reason is that even though I’m a lousy stock picker now, there’s always a chance that I’ll improve, and I’d like some incentives for doing so. Somewhere inside there is a voice reminding me too much of even a good thing can be problematic. Nothing has manifested yet but I have been thinking about how index funds may distort the market and how vulnerable they can be:

  • Index funds take money away from high shareholder yield (dividend + buyback) companies to distribute among the entire index, assuming the majority re-invests distributions. This will create a disincentive for shareholder yield.
  • Suppose a hedge fund builds up a large position in an index member. It can use artificial trades to increase the price before dumping it to index funds.
  • It behooves to ask, in the example above, how a hedge fund could build up a large position in the first place. Index funds won’t be selling unless there is wide panic. But to generate wide panic just to load up on a stock may be too much to ask, although there may be specific external events in certain sectors that can create opportunities. Other possibilities include an index member acquiring a non-index member by issuing stock, or a particularly large buy-back that creates forced buy/sell conditions for the index funds can be taken advantage of. The most likely scenario remains when there is deterioration in the fundamentals of an index member, and a hedge fund can dump its existing position or simply go short after artificially elevating the price.
  • The issue of stock-based acquisition requires further scrutiny. Recall that was a game CSCO played masterfully during the dot com era when using its high P/E stocks to buy low P/E companies provided an instantaneous boost to its numbers. Will we see them again (a large cross-border deal should do the trick) when index funds gladly foot the bill?
  • Lastly, there is a danger of net capital flows out of index funds as baby-boomers retire.

Let’s be clear: these are not things that are happening now but what could happen when index funds become dominant. Various people has put the line at 90%. Personally I see it as a question of when, not if. That’s why I intend to maintain an active component lest getting swept away when the tide comes back in.

So there you go, some disjointed ramblings that should give better context to my investment decisions. I hope you find them somewhat thought-provoking.

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.