Is the trend really your friend?

“Many shall be restored that now are fallen and many shall fall that now are in honor.”
Horace, Ars Poetica.

We humans have a tendency to extrapolate recent trends into the distant future.  This approach doesn’t work in the real world. 

Stocks that roared from 1996 to 2000 were expected to keep roaring.  They didn’t.

The national housing market that hadn’t declined since the 1930’s was expected never to decline.  It did.

Extrapolating recent trends into the distant future is foolhardy.  And yet, people do it over and over again.

Once dominant IBM became less so.  The same can be said for Apple and Google today, or even Facebook and LinkedIn.  But, try telling that to the raving supporters of such companies.  You’ll be angrily told you don’t get it.

China is on the upslope and Japan on the downslope.  These trends, too, are unlikely to continue.  Such is the nature of things. 

Regression to the mean–the tendency of economic series to drift back to average–is a well-founded phenomena.  And yet, people expect present trends to continue forever.  They won’t.

Corporate profit margins are at all-time highs.  They won’t continue higher for long, or even stay at today’s levels.

Commodities have been roaring.  That trend will not go in one direction.

Bond yields have been going down since the early 1980’s.  That cannot continue indefinitely.

The U.S. government has never significantly defaulted on its debt.  Just a matter of time.

Small capitalization companies have done exceedingly well over the last 10 years.  The future will not look the same.

Emerging markets have been on a decade-long tear.  Anyone want to bet that will go on forever?

Trend extrapolation is a dangerous way to invest.  And yet, people keep doing it over and over again–and then losing their shirts.

A few trends last long, but they are the exception, not the rule.  Those who bet on a regression to the mean always look stupid in the short run, but then rich in the long run. 

So, why are so many suggesting, once again, that the trend is your friend?

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Is the trend really your friend?

Growing potential energy

They say patience is a virtue.  That doesn’t mean it’s a whole lot of fun.

Sometimes, I feel like Bill Murray in Groundhog Day, waking up to the same day each and every day and wishing the cycle would end.  Each day, I research individual companies with a focus on businesses with competitive advantages and good management selling at low prices.  On rare days, when prices deviate enough from fundamentals to merit action, I do some buying and selling.  And yet, the cheap companies keep getting cheaper and the expensive ones just get more expensive.  I’m waiting patiently for this cycle to end, but it’s not much fun. 

Unlike Bill in the movie, I’m not trying anything radical to break out of the cycle.  As Bill eventually discovers, the cycle ends not from bold or wild action, but from doing the right things.  The cycle of the cheap getting cheaper and expensive getting more expensive will end, too.  I just need to stay true to my purpose.

So, what allows me to maintain patience?  Just like I know virtue leads to happiness and diet and exercise lead to weight loss, I know that buying cheap and selling expensive works over time.  Added to this, I understand the concept of growing potential energy. 

Potential energy is the result of a force acting on an object over time.  When a spring is compressed, it has a lot of potential energy.  That potential energy is eventually turned into kinetic energy when the spring is released. 

The force, in this case, is crowd momentum causing the expensive to get more expensive.  That force, applied over time, is compressing a metaphorical spring, conversely making the cheap become cheaper.  That very process, though, leads to its own resolution.  Because the system is not in equilibrium, the longer and further the spring is compressed, the more dramatic the eventual release of kinetic energy when the spring’s potential energy is transformed.

I have to be patient because no one knows how long crowd momentum will compress the spring (6 years and running, so far).  But, knowing that the spring is just getting more and more compressed, creating a growing reserve of potential energy, makes it easier to be patient.  I know that the longer the spring is compressed, the greater the reward–the release of kinetic energy–once momentum runs its course.

Or, as 17th century philosopher Spinoza put it, all things excellent are as difficult as they are rare.  I’m feeling keenly the difficult and rare part, in time I will gain the excellence as well.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Growing potential energy

The dash to trash

When the stock market climbs or falls, it’s always interesting to see which segments are doing best or worst.

Not surprisingly, the stocks that have done best since the March bottom are some of the junkiest companies out there. This makes some sense because such companies were priced for bankruptcy last spring.

As early investors realized junky companies weren’t going under, they jumped at the chance to bag 200%, 300% and higher returns.

The problem with staying with such an approach, now that the trash rally has had its day, is that it’s hard to see how it can continue. Junky stocks have junky business models with weak competitive advantages, low margins, too much debt, etc. From here, there isn’t a lot of upside, and the downside is becoming more perilous.

In contrast, the best-run companies have hardly participated in the rally since March. Granted, they didn’t go down as far, but it’s nonetheless surprising that investors haven’t turned back to them now that the dash to trash has become stretched.

This is most likely due to the pervasive influence of momentum. Momentum investing is the process of buying what’s moving. If it’s climbing, buy it. If it’s sinking, sell it or sell it short. This process can continue for quite some time…until it doesn’t.

Predicting when is impossible, but predicting that it will end is a given. Or, as Herb Stein put it, “If something cannot go on forever, it will stop.”

At some point in time, investors will realize that junky companies have problems and aren’t delivering. That’s when investors will fall over each other trying to buy franchise, high-quality businesses that make money regardless of how well or poorly the economy is doing.

It’s no fun to be under-performing as the market makes a continued mad dash to trash. But, I’m not foolish enough to chase the heard, and I know it doesn’t work over the long run anyway. Or, as our mothers rhetorically asked us, “if your friends jumped off a bridge, would you follow?”

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

The (temporary) triumph of momentum over value

As I’ve mentioned before, momentum investments have been out-performing value investments over the last couple of years.

If you had just picked what had gone up in the past, it continued to go up.

Value investing, instead, focuses on understanding the value of a business and trying to buy below that value, thus providing a margin of safety (like building a bridge to handle more than you think it will bear over time).

Value has been, over the long run, one of the (if not the) smartest ways to invest.

Just because it hasn’t done well lately doesn’t mean it won’t do well in the future. In fact, quite the opposite is true–value investing is VERY likely to out-perform momentum investing in the near future.

As additional support for this contention, take a look at a recent Motley Fool article by Andrew Sullivan, CFA. In it, he gives you a flavor of the returns that are possible for value after it has under-performed.

Trying to time when momentum will out-perform value and vice versa is a fools errand, but, at times like this, it’s very easy to be patient and wait for value to begin out-performing again.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Value investor drought

Pity the poor value investors.

Although they have excellent long term records, value investor results over the past couple of years have been poor relative to the market.

Consider Bill Miller at Legg Mason. After beating the S&P 500 for 15 years in a row, he has had a dreadful 2 1/2 years. His performance has been so bad his mutual fund investors are leaving in droves.

Does this mean value investing no longer works? Should investors pursue another methodology? If value investing hasn’t worked, what has?

The answer is momentum. If you simply invested in the things that were going up, you would have easily beaten the market. Invest in natural resources, such as oil or gold, after they went up and they’d just keep going up.

Is that a good way to invest now? Not normally, and probably not going forward.

You see, the market goes through periods when one thing works and others don’t. This rarely lasts because everyone jumps on the bandwagon until it’s full and no one else is left to jump on board. I think we’re close to that point now.

The last time momentum out-performed value investing was in the 1998-1999 period. After that, value investing clearly beat momentum investing for several years running.

Usually, when the market goes down, value investing handily out-performs. But in this down market, momentum has been winning. You have to go all the way back to the early 1990’s to find a similar situation. Guess what happened after that? That’s when Bill Miller’s record 15 years of out-performing the S&P 500 began.

Don’t pity the poor value investors–JOIN THEM. Every time value investing has performed poorly in the past has proven to be an excellent time to get on the value investing bandwagon. Right now, people are getting off, and that’s precisely why you should be getting on!

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.