Do I Feel Lucky?

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As of last week, the market continued to reflect a set of conditions that have characterized a wicked subset of historical instances, comprising a Who's Who of Awful Times to Invest. Over the weekend, Randall Forsyth of Barron's ran a nice piece that reviewed our case (the chart in Barrons has a problem with the date axis, but the original chart is in last week's comment Warning: A New Who's Who of Awful Times to Invest). It's interesting to me that among the predictable objections to that piece by bullish readers (mostly related to our flat post-2009 performance, but overlooking the 2000-2009 record), none addressed the simple fact that the prior instances of this syndrome invariably turned out badly. It seems to me that before entirely disregarding evidence that is as rare as it is ominous, you have to ask yourself one question. Do I feel lucky?

From our perspective, accepting stock market risk is not presently a venture that is priced to achieve reasonable investment returns (we estimate a likely 4.3% annual total return for the S&P 500 over the coming decade, and a great deal of volatility in achieving that return). Nor is market risk attractive on a speculative basis, given present overbought conditions, overbullish sentiment, and growing set of hostile syndromes (what we call Aunt Minnies) that have historically been associated with negative return/risk tradeoffs. Then again, what keeps slot machines spinning all around the world is the hope - despite the predictably and reliably negative average return/risk tradeoff - that this time will be different, and this spin will work out. So you have to ask yourself one question. Do I feel lucky?

Investors Intelligence notes that corporate insiders are now selling shares at levels associated with "near panic action." Since corporate insiders typically receive stock as part of their compensation, it is normal for insiders to sell about 2 shares on the open market for every share they purchase outright. Recently, however, insider sales have been running at a pace of more than 8-to-1. The dollar amounts are even more lopsided, as Trim Tabs reports a recent pace of $13 of insider sales for every $1 of purchases. Indeed, some of the weekly spikes have been to levels that are associated almost exclusively with intermediate market peaks, the most recent being the run-up to the 2007 market peak, the early 2010 peak, and the 2011 peak, all of which resulted in significant intermediate corrections or worse. Of course, it's sometimes the case that insiders are early, and therefore miss part of the tail of a market advance. So it might be worth ignoring the heavy pace of insider selling for a little while. But you have to ask yourself one question. Do I feel lucky?

As disciplined investors who align ourselves with the average return/risk profile that is associated with prevailing market conditions, we don't believe that this is a good time to take significant market risk in hopes of getting lucky. On an objective basis, we identify present conditions among the lowest 1.5% of historical periods in terms of overall return/risk profile. Maybe investors will get lucky, but the odds are still unfavorable.

It's likely that for some investors, our defensiveness since 2009 bleeds into a general inclination to take our concerns about risk with a grain of salt. On that subject, it's important to recognize that our defensiveness in 2009 did not result from unfavorable valuations or hostile indicator syndromes, but from the inability to distinguish prevailing conditions at the time from much of what was observed during the Depression-era. In response to the credit crisis, and what I continue to view as a misguided "kick-the-can" policy response, I insisted that our methods should perform well with reasonable drawdowns not only in post-war data, but also in Depression-era data (when for example, stocks lost two thirds of their value even after they were priced to achieve 10-year total returns in excess of 10% annually).

The resulting ensemble methods allow us to make distinctions that we were not able to make in 2009, but that period of stress-testing also left us with a "miss" (2009-early 2010) when the same indicators and methods that are so hostile today would have been much more favorable toward investment risk. One could ignore that fact, and use our miss in 2009 as a reason to ignore demonstrably hostile evidence today. But one would also have to overlook the fact that the narrow syndrome of conditions we observe today mirrors what we observed at the 2000 peak and the 2007 peak, and very few times in-between (including the 2010 peak and the runup to the 2011 peak - see last week's comment for a chart). Notably, whatever market returns we missed by being defensive too early in those instances were wiped out in short order anyway during the subsequent declines. Yes, stocks might move even higher before the present bull-bear cycle moves to completion. But you have to ask yourself one question. Do I feel lucky?

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