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Don't Blame the Market

Disguised market timing is no excuse for poor performance

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Jun 20, 2017
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Over the past decade, a number of renowned value funds have significantly underperformed the market.

Fascinated by this fact, I read the most recent 10 years investor letters of most of the underperforming gurus. As I covered in my last article, there’s a variety of excuses, some legitimate and some dubious at best. All concluded that the strategies will work in the future because they have worked in the past; before the underperformance began, none suggested a change was needed. What I found disturbing is not necessarily the excuses but the inconsistency between what they say versus what they have done. But perhaps that’s ubiquitous so I’ll leave that out of today’s discussion.

The readings led me to two quotes from Warren Buffett:

  1. “You can learn a lot just by observing.”
  2. “You should learn as much as possible from other’s mistakes.”

They also remind me of the combination of a few investment adages that are frequently cited by the great

Howard Marks (Trades, Portfolio). I find them relevant in today’s markets, as they have always been.

“It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so.”

“It's important to remember that overpriced is far different from going down tomorrow.”

“Sometimes being too early is indistinguishable from being wrong.”

“Should happen is different from will happen. The most probable outcomes fail to happen all the time and even if they happen, they fail to happen on time.”

“Improbable outcomes happen all the time.”

Let me review an excuse I take most issue with:

Calling the market expensive and holding a large percentage in cash every year since 2012-2013

A few gurus have been calling the market expensive since 2012-2013 as the price-earnings (P/E) ratio (especially the Shiller P/E ratio) has suggested so since then (see chart below).

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As a result, they have been holding more cash and less equities in the portfolio. Recently a few of them have been using an extended period of large percentage of cash holdings as an excuse for underperformance. I personally reject the notion that one should only look at equity returns as opposed to the total portfolio returns when evaluating performance.

First of all, cash is an investable asset class with an expected normal return of 0%. Holding a large percentage of portfolio in cash implicitly implies that one thinks that the opportunity cost of holding cash namely holding other assets such as stocks  is justified. Assuming a holding period of three to five years, one must assume the prospective return of cash is superior to the prospective return of other assets in the next three to five years, which implies a negative three- to five-year prospective return for other assets such as stocks and only in obvious bubble territories such as the nifty 50 bubble, the tech bubble and the housing bubble years had the prospective return of stocks been obviously negative.

On the other hand, I can also relate to the notion that we should always keep some cash in the portfolio as preparation for the no-brainers that happen infrequently and transiently. But the trick is, you have to bet heavily when such opportunities present themselves. When this happens, cash level goes down and a large equity position emerges.

Now let’s see how the aforementioned adages apply here:

“It's important to remember that overpriced is far different from going down tomorrow.”

  • You may have come to the conclusion that the market was overvalued in 2013 but that doesn’t mean the market will go down in 2014 immediately.

“Sometimes being too early is indistinguishable from being wrong.”

  • If you call the top in 2013 based on the Shiller P/E and have stayed out of the market or have a lot of cash in the portfolio, you borderline being wrong.

“Should happen is different from will happen. The most probable outcomes fail to happen all the time and even if they happen, they fail to happen on time.”

  • You can say that the market is overvalued and should go down in 2013, 2014, 2015, 2016 and today. But even if you are right about the valuation, in a mildly to moderately overvalued market, you still have to make allowance for the fact that the most probable outcomes fail to happen all the time.

“It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so.”

  • We know for sure that the Shiller P/E has been high for a few years. But that doesn’t mean we know for sure that the market will go down once, say, the Shiller P/E hits 25, or that the Shiller P/E will revert back to the historical average, which is a lot lower. Inflation, interest rate, macro factors, business fundamentals and a lot of other factors affect the market valuation. In other words, the predictive utility of the Shiller P/E is not a sure thing, but if you act upon it based on the assumption it is a sure thing, then you get in trouble.
  • Before the election, everybody thought if Donald Trump won, the market would tank. After the election, the market marched on even though the uncertainty level keeps going up and the market is supposed to abhor uncertainty. Again, if you think you know for sure that Hillary Clinton would have won, or if you think that you know for sure that if Trump won, the market would have collapsed, it has been proven it just ain’t so. And if you think you know for sure that Trump’s unpredictability will create market turmoil in the early days of his presidency, you’ve been proven wrong. It just ain’t so.
  • On the other hand, we can acknowledge that we don’t know what the market will do in the next year or the next two years but still make intelligent decisions nevertheless. There were plenty of fat pitches during the past five years in an elevated market.

The correct attitude in the past five years is exemplified by Oaktree: Invest but with caution. You can be defensive most of the time and shifted toward offense in August 2015 or early 2016. You can lower the portfolio turnover and bet bigger but less frequently. You can make more special situation investments. Or you can invest globally where the market is cheaper. There’s always something to do. Holding a lot of cash for an extended period of time because a money manager claims that the market is expensive is not the most prudent behavior.

I also want to clarify that I only take issue with holding a large percentage of portfolio in cash for an extended period of time and not acting on opportunities, and using this as an excuse for underperformance. I have no problem with temporarily holding a lot of cash. And I certainly have no problem with an investor who holds a lot of cash because he or she truly can’t find bargains due to various limitations such as circle of competency and time constraints.

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