Moving With The Ups And Downs Of Stocks

Foreword from ShareInvestor

This article “Moving With The Ups And Downs Of Stocks” by Teh Hooi Ling was first published in The Business Times on 19 May 2012 and is reproduced in this blog in its entirety.

If asset prices have fallen below fair values, it’s OK to buy even as prices are continuing to sink. The rebound will come

A friend who has been working on a stock trading software program noted that when stock markets go up, they take the escalator. The ascent is gradual. But when they come down, they take the lift. It is sharp and time taken is short.

At the time when I spoke to him, in mid-April, he said he had made a return of 4 per cent on his total capital for the year. Not all his capital was in the market. Time was needed to deploy his funds.

At that point, of course he had underperformed the general market. The Straits Times Index (STI) was up by some 11 per cent up to that point. The S&P 500 also put on about 10 per cent for the year up till then.

But then he added that when the market turns down, he will outperform the market by a ratio of 3-to-1. I asked why. “Now, if you look at the stocks, those which went up, went up by one to 2 per cent. But those which came down, came down by 6 per cent.”

Indeed the market has turned, and has turned quite sharply. The last I checked with him, that was last weekend, he said the return from his short positions was about 4 per cent since the start of May. In other words, he made 4 per cent in about two weeks on his shorts as opposed to 4 per cent on his long positions over two months. Given how the market has done this week, the gains from his short positions must have been bigger by now.

And so it is the case, if we look back at the performance of the STI. The market usually takes a longer time to climb up, and it usually topples down rather fast.

For example, the STI climbed from 1,400 points to 2,400 points between 1992 and 1996. That’s a five-year period. From 2,400, it fell to 800 points by the third quarter of 1999, in three years or so.

Between 2003 and 2007, the STI ascended from 1,200 to 3,800 points. But over the next 11/2 years, it gave back nearly all that it made in the prior 41/2 years. It tumbled from 3,800 points to 1,500 points.

But the good thing is, the sharper the decline, usually the faster the rebound too. The STI clawed back all its losses within one year in 1999.

Having said that, the Singapore market has yet to regain the peak it reached in 2007. As at today, it is still some 28 per cent below the near 3,900 level it reached in early October 2007.

Perhaps this perfectly illustrates the point made by Ben Inker, head of asset allocation in GMO.

The risk of an asset, he reminded investors, rises with its valuation. Stocks at fair value are less risky than stocks trading 30 per cent above fair value because the expensive stocks give you the risk of loss associated with falling back to fair value.

That “valuation” risk leads to losses that should not be expected to reverse themselves anytime soon.

Meanwhile, a cheap stock can certainly go down in price, but when it does, one can expect either high compound returns from there, which makes one’s money back steadily, or a reasonable sharp recovery when the conditions that drove prices down dissipate, which will make your money back quickly.

“The loss is therefore temporary, although it may seem unpleasant while it is occurring. When an expensive asset falls back to fair value, subsequent return should only be assumed to be normal, which means that the loss of wealth versus expectations is permanent.”

In hindsight, we could say that back in 2007, stock prices were overvalued. As a result, we have yet to see prices climb back to those lofty levels.

So where are we today in terms of valuation? Stocks are expensive relative to GMO’s estimate of long-term fair value, said Mr Inker. “The trouble is, so are bonds and cash.

“If everything was guaranteed to revert to the mean over seven years, we would hold equity-heavy portfolios, because the gap between stocks and either bonds or cash is wider than normal.”

But he added that GMO is not certain that it will take seven years. And because cash and (most) bonds have a shorter duration with regard to changes in their discount rate than stocks do, fast reversion would lead to smaller losses for them than for equities. As a result, GMO is holding a portfolio lighter on equities than the seven-year forecast would otherwise suggest.

As things stand now, the fast reversion scenario seems to be playing out. In which case, values will emerge faster in the equities market.

But deciding when to pull the trigger is a tricky question.

Keynes famously said that: “The market can stay irrational longer than the investor can stay solvent.” And as Jeremy Grantham, one of the founders of GMO put it, for fund managers, the quote would be: “The market can stay irrational longer than the client can stay patient.”

Three Conditions

Many a times, we are too early – selling out too soon, and watch with regret as prices continue to rise. Or, we are too early to pick up stocks and are gripped by horrors as the prices continue to sink further.

According to Mr Grantham, one apparently can survive betting against bull market irrationality if you meet three conditions. First, you must allow a generous Ben Graham-like “margin of safety” and wait for a real outlier before you make a big bet. Second, you must try to stay reasonably diversified. Third, you must never use leverage.

“In my personal opinion (and with the benefit of hindsight), although we in asset allocation felt exceptionally and painfully patient at the time, we did not in the past always hold our fire long enough or be patient enough,” said Mr Grantham in his latest quarterly letter to investors. “It is the classic failing of value managers (and poker players for that matter) to get impatient and bet too hard too soon.”

For both the tech bubble, and the enormous bubble in the Japanese market, GMO was two to three years early in its calls in both cases.

Meanwhile, getting the timing right in a short call is even more crucial. One’s loss is limitless if the market continues to go against you. Which is why many wait for markets to turn first before putting in their positions. There is merit in trading the momentum given the herd mentality of professional fund managers and retail investors alike.

So in essence, my take is: If asset prices have fallen below their fair values, it is OK to buy even as prices are continuing to sink. The rebound will come.

In a bull market, allow for a significant margin above the fair value before selling out completely. Again, selling can be in batches.

But when it comes to shorting, it is safest to wait for a distinct turn in sentiment before putting in the trades.

Of course, these rules sound simple enough on paper. And investing is simple: Buy when it is cheap, sell when it is expensive. But as Mr Grantham puts it, it is simple to see what is necessary, but it is not always easy to be willing or able to do what is necessary.