How NCAV Investors Deal With Dangerous Market Peaks
With the market bubbling up to record levels, are you starting to feel squeamish about your portfolio?
Value investors have started to gripe about just how high the market has climbed since the Great Recession. Given that the economy hasn't come back to awe-inspiring levels, worry about a cyclically adjusted PE and overall market values that are approaching record highs is more than justified.
But, even if you feel that a big market correction is on its way, the type of correction that makes your knees shake, what's the best action to take? If you've already signed up to get the free net net stock checklist, you'll already know the answer.
Market Timing Will Time You Right Out Of Profits
Greenbackd came out with a great article a few weeks back. In it, he looked at the performance of various market timing strategies using the Shiller PE ratio from 1926 to 2013.
Market timing is essentially an attempt to avoid market drops by selling stocks while taking advantage of bull markets by jumping back into the market before it surges. By doing so, as the theory goes, you'll avoid losing money when the market drops but will be there for each rally, achieving superior investment results.
Nobody likes being hit with a big market drop. If you've been investing in overpriced securities then your portfolio can vaporize virtually overnight. It's no wonder then that market timing continues to be talked about as a viable investment strategy and peddled on business television programs.
The key phrase here, though, is "as the theory goes" because, while many people assume that market timing is possible, it's proven very difficult to employ in practice.
In a recent article, Greenbackd author Tobias Carlisle provided further evidence against market timing in favour of a well-stuffed portfolio. Investors who stuck to a rigorous discipline of market timing using the Shiller PE, as opposed to just maintaining a fully invested portfolio, ended up with far worse returns over the 87 year time period despite their extra effort. While the fully invested low PB strategy provided average annual compound returns of 20%, the various market timing strategies couldn't touch that figure, returning as low as 15% compounded per year.
In this above image, Toby Carlisle shows how a fully invested portfolio stacks up against portfolios of the same stocks but with additional market timing criteria attached. Here are the portfolio characteristics:
Fully Invested PB Value Decile - The low PB portfolio is always fully invested.
Sell at 1SD, Buy at -1SD - The portfolio is liquidated after the Shiller PE reaches 1 standard deviation above normal levels, and filled again after the measure reaches -1SD below the mean.
Sell at 2SD, Buy at Mean - Portfolios are moved into cash when the Shiller PE reaches 2 standard deviations above normal levels and filled when average levels are reached.
Sell at 1SD, Buy at Mean - Portfolios are liquidated and put into cash when the Shiller PE rises 1SD above normal levels, and filled at the mean.
Looking at the data, it's pretty obvious that, a rigorous program of market timing would have actually underperformed a fully invested portfolio. In the above image, none of the portfolios could match the ultimate growth of the model fully invested PB portfolio.
Keep in mind that graphs can be misleading. Beginning and end points play a large roll in how the actual returns look. In the above case, you'll notice that the gap between the fully invested and market timing portfolios consistently shrinks. This shows that returns are better on average over the time period despite trailing behind the market timing strategies until the final decade. That's a pretty strong argument for a fully invested portfolio for investors looking for the highest returns.
The only strategy that managed to beat the fully invested portfolio strategy was one that combined leverage when the market was depressed and hedging when the market was at dangerously high levels, on top of market timing. But, the excess returns over a fully invested portfolio were comparatively small given the increased chance of blow-up during a black swan event. What would happen if the market kept on going down, leading to a margin call? Being unlevered means being able to withstand vicious market turmoil. Value investors can do better than that.
If market timing isn't a very good strategy overall, is there anything an investor can do without having to be fully exposed to a dangerously overpriced market?
Fill Your Portfolio With High Quality Net Net Stocks
If you want to take full advantage of the fantastic returns that Benjamin Graham's net net stock strategy offers, then you have to keep your portfolio full of net net stocks at all possible times.
Anybody who's followed net net stocks for some time knows that it's impossible to buy as many domestic net nets as you'd like. Net net stocks crop up in large depressed markets. Both market size and pessimism are key. There is only ever a small number of net net stocks available in any one country but the more stock listings in a given market, the more likely it is that net nets will be available from time to time. Net Net stocks trade on the margins of the investment universe, and larger markets have more fringe stocks.
Deep market depression also helps. For any given market, the more depressed the market is, the more of these sorts of stocks will be available. When the market is depressed, stock prices in general sink, lowering prices relative to sales, earnings, cash flow, book value, and, of course, net current asset value. Conversely, a market rise will boost share prices relative to these same measures, making deep value investments that much harder to find.
Here's where modern Benjamin Graham investors have learned to excel. Instead of sitting on the sidelines, or de-worse-ifying into other investment strategies, smart value investors branch out into international markets.
There are a whole host of high quality first world markets available to you, and more than enough high quality international brokers who want your business. This even applies to American clients, who -- strangely -- always seem convinced that international investing is impossible due to their nationality.
As far as first world markets go, many of them conduct business and English and have financial controls or regulations that are at least as robust as those in America. Countries such as Canada, Australia, and the UK provide safe & profitable places for you to invest your money.
But, while no first world market can compare to the breadth of investments available in the USA, different markets tend to be in differing states of flux. When the American markets are frothing, in other words, other high quality international markets are offering up excellent net net stocks.
Concentrating your portfolio in the areas where the most attractive deep value investments are available means shifting your money out of frothy markets and keeping your net net portfolio stuffed full of highly profitable investments.
Take It One Step At A Time
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