Juggling Dynamite

Financial commentary is so rife with rubbish most of the time that it is hard for real facts to get a thought in edge wise. Most frequently commentators talk their book, or cherry pick facts to support their supposed skill set. In truth the vast majority simply strap capital to market cycles for better and for worse, taking credit for any upside moves while denouncing the inevitable down cycles as unfortunate and “unforeseeable”. Droves of others speak confidently in theory, with no real time experience managing money successfully through live market cycles.

Those who have no meaningful risk management rules, often try to dismiss those who do. The most dangerous and reckless players are usually given to the most aggressive rants about how much “the market is up” or what others “missed out on” during a period of positive price trends. In reality what a “market does” within a particular time frame usually bears little resemblance to the cumulative gain or loss experience of an individual’s capital over a full market cycle.

Buy and hold or constant equity allocations as an investment strategy is a disaster in real life, and particularly during secular bears when stock valuations move from shockingly over-priced speculative bets, to systemically under-loved and finally valuable investments over the course of a volatile 15 to 20 year period. Nevertheless, perpetually allocating to stocks is the most common recommendation. The fact is that full cycles take some years to complete, and it is human nature to make short-shrift, emotional assessments at half-time.

Over the years, I have read many studies or comments on the merits of Technical Analysis (TA) as a risk management tool. Most begin inherently biased against the idea of risk exposure timing and so are quick to dismiss TA as voodoo. Others focus on day trading systems and conclude that the friction costs outweigh any capital benefit when compared with buy and hold.

Both of these conclusions miss the potential value of TA completely in my view. On a longer-term trend, over a full market cycle, TA used with objective discipline can be hugely beneficial in growing capital. But not in the way most expect. Not in “beating” the stock market in a given year or years of a bull cycle, but in protecting capital when it matters most–shielding it from losses during bear markets.

A new study looks at disciplined TA properly over full market cycles and confirms it valuable. See: Head and shoulders above the rest? The performance of institutional portfolio managers who use Technical Analysis.

By replacing the usual obsession with catching all the upside of market moves, with a focus on avoiding the highest risk periods and the capital losses that eventually follow them, effective risk management using TA can produce higher cumulative gains with a fraction of the volatility and capital risk over a full market cycle. I have been writing and speaking about all of this for years, and cover it in my book Juggling Dynamite. But this article on Dow Theory (another TA system) also does an excellent job of explaining the value of TA. Yes it can be done! Capital can survive and thrive through a secular bear market.

“Investors get blinded by performance. However, in real life, the investor is killed by draw downs. A 15% average performance is worth nothing if, somewhere along the road, there is going to be a draw down of -50%. Buy and hold is nice in theory, and it may work provided the investor has deep pockets (staying power) and psychological fortitude. However, in real life, very few investors possess both attributes at the same time. Thus, the publicized return figures of many investing strategies are not attainable in real life because the investor cannot endure the draw downs..”

You can read the whole article here.

After a wild 4 years of slumps and rallies and trillions of dollars in central bank interventions, the S&P 500 has now managed to rebound 120% from its March 2009 low and is within striking distance of its previous 2000 and 2007 cycle peaks. Interestingly stocks have only ever rallied this much in 4 years, within the context of other on-going secular bear periods in history.

Source: Cory Venable, CMT, Venable Park Investment Counsel Inc.

Nevertheless, recent action is prompting the usual trend-following suspects to declare that stock markets are now in the midst of a new secular bull market. In truth there is no reasonable evidence to support this thesis.

Historically every secular bear period in the past 200 years, has ended with bargain basement stock valuations that labor under-bought and under-loved through years of public revulsion of banks, stocks and “market makers”. Today while we have made some progress since this secular bear began in 2000, still elevated valuations (Shiller PE is 22 not 10), meager dividend yields (2% not 8), wildly bullish investor sentiment (twice as many bulls as bears, not the opposite), margin use at cycle highs (not crushed out), Porfolio Managers all in (with the lowest cash levels since the 2000 and 2007 peaks), retail investors now back at median levels of 40% equity exposure (not all out and screaming for the heads of their stockbrokers on a plate), market confidence high with ubiquitous faith in central bankers (not blaming central bankers for disaster), the volatility index showing near comatose complacency (at 13 not 40) consumer debt levels still near credit bubble highs, consumer savings rates anemic (less than 4% not more than 10%), still no serious criminal prosecutions of financial offenders in the works, still no significant changes to the cozy court of bankers and politicians, still weakening household employment, staggering fiscal deficits on top of zero rates and already prolapsed central bank balance sheets.

I could go on and on, but I know, wide-eyed optimism feels more fun than facts every day of the week. For those who do care to see truth though, this chart of the S&P market cap as a ratio over US nominal GDP also offers an excellent reality check. We see our own secular bear experience since 2000 here plotted as against the other secular bear periods since 1929. Until S&P valuations give back all of the excess of the prior secular bull period (1982-2000) and labor below the mean line for a period of years, crushing reckless capital and animal spirits into a pulp of misery, law suits, prosecutions and loathing, we are not likely to be through our secular bear yet. That said another very attractive cyclical re-entry point(like 2003 and 2009) is very likely not too far ahead. Those who can see through present noise, protect themselves and keep an eye on the horizon are likely to survive and thrive quite nicely. Moving against the madness of crowds now is the price rational people must pay to earn positive returns and mental strength through today’s extreme market cycles. Click here for larger picture.

Investor complacency is rampant. Advisors and managers who peddle harmful, self-interested, financial recommendations are hard at fresh marketing initiatives. The reckless are being foolishly revered and the business media are relentlessly helping to spin the web of folly. Remarkably, near a third cycle peak, 13 years into an ongoing secular bear market, most people remain immersed in a child-like understanding of market prices. Meanwhile capital risk to real people has doubtless not been this high since 2007.

Today the greatest risk is in acting as if the 50% market declines of 2001-03 and 2008-09 were unfortunate accidents or anomalies now behind us. The promise of fresh catastrophe lies ahead, as most still lack meaningful risk management strategies to protect capital from the ravages of the next cyclical bear market.

Those whose recommendations for constant equity allocations have devastated capital repeatedly since 2000 have been greatly encouraged by recent speculative advances. Their next victims follow hopeful and unsuspecting. Many will be harmed through ignorance. Many others though, have learned these lessons already. They should know better, but will succumb once more through various strains of impatience, ego, willful blindness and lack of personal discipline.