Don’t Be A Cowboy

Look, I get it. For nearly a decade now, every correction has met been met with bravado, chest thumping, and euphoria. “Awesome! Now things are on sale!” I can already hear the virtual cheers from the Twitter rafters echoing loudly as the flood of retail money buys the dip. And you know what? That has been absolutely the right call. It may be the right call on this correction. In fact, it probably is. The evening following yet another day in a month full of bad days, I think every investor should consider a few things.

Valuation Matters

Any investment strategy simply needs to acknowledge the Nobel prize winning work of Robert Shiller and fit it into its ethos or it is not a strategy. Unlike most Nobel prizes which are typically awarded for esoteric nonsense of no use to anyone, Shiller’s work is very easy to explain. In fact, a simple graph depicts it. It says that long term equity returns are nearly entirely explained by starting equity valuation:

This view is simply not congruent with any idea of “Time In The Market,” which suggests the general trend of a market is always upward but unpredictable. However, if the market is unpredictable, Shiller’s line (illustrated above) could and would not exist.

“Time In The Market” is, to my mind, therefore total bullshit. A fairy tale paradigm designed by those seeking to absolve themselves of the pain and guilt of having made crappy investment decisions. None of which is to say I (or anyone else) can predict the market today, tomorrow, or even a year from now. But current valuations must provide the investment bearings for longterm returns, and anyone’s plans MUST either incorporate or explicitly ignore Shiller’s work:

valuation vs forward return

Two Bad Things

Growth in equity prices ultimately require growth in earnings. When earnings growth doesn’t occur (see Emerging Markets Are Trash for a case with zero earnings growth), returns are tepid and stagnant. Tax reform imparted a massive gain to corporate earnings and was priced in during the fourth quarter of 2017, so unfortunately that well is dry.

The current 2 stories dominating the economic news cycle are both bad for stocks: higher interest rates and tariffs. Higher interest rates increase the cost of financing for corporate bonds. Higher interest costs = less money in profits = less earnings. On the tariff front, money wants to run freely and unencumbered like some kind of Mongolian horde of old. Tariffs cause suboptimality to creep into the system; if it was profit maximizing to make a bunch of low margin added stuff in the US, it would have already been made here to begin with. Less profit maximization = less profits (by definition) = less earnings.

Upside / Downside

The landscape is therefore one in which 1) earnings are very expensive by historical standards and 2) the ability to grow earnings looks challenging. The downside case is therefore amazingly easy to envision. As this graph demonstrates, we are (by historical comparison) well into the cycle of rate increases which defines the very phrase ‘late cycle.’:

rate hikes to yield inversion

What is the upside for staying in the market? Perhaps a surprise trade breakthrough, accompanied by the Fed relaxing interest rate policy, all while Europe dodges a recession and US wage costs stay muted? And even if all that happens, how much time are you playing for before the next recession?

Know what your beliefs are and why you believe in them, even (perhaps especially) if you disagree with me. Don’t risk that which you do not need to risk. Do the analysis and formulate your plan now and not while economic catastrophe is unfolding.

Don’t be a cowboy.

This article is for informational purposes only and is not investment advice, nor is it a recommendation to buy or sell securities. Consult with an investment adviser for any actionable advice. 

5 Responses

  1. Ohhh, that’s so hard though! I do agree with you. I’m certain there is more bad news then good news coming in the next few years… unless all the “bulls” (best cowboy reference I could come up with) line up perfectly. It’s so difficult to go all cash and just wait (and who knows for how long) for the market to breakdown. Big physiological hurdle to get over there. Great article, I look forward to reading more of your stuff!

  2. Ckarion says:

    Let me test my understanding. We are late in the cycle so the next years should see a recession and very slow recovery – so if one has a set it and forget it dollar cost averaging approach one can expect to gobble up stocks with low valuations for several years after the crash, which will practically guarantee high yields in 10 years or so?

    • FatTailed says:

      Let me clarify slightly… my view is that returns for whatever assets you currently own NOW are likely to be poor over the next decade or so.

      If you are early on in your investing career, then to some extent using DCA will help simply by virtue of the fact you don’t have much right now to earn a poor return on. Since your future savings will be a much bigger piece of the investment pie, then that is probably fine.

      If on the other hand you have several million dollars saved, then my view is that the next recession will present a better entry point then the current market.

      In fact, as a follow up post, I’m going to compare the following approaches:

      1) Buy and hold stocks
      2) Buy stocks when the NBER declares a recession and hold for 5 or 6 years, then sell and go to bonds.

      I will calculate what %-age of time #1 has beaten #2 historically and (more importantly) what the risk reduction of #2 is relative to #1. Stay tuned.

  1. October 26, 2018

    […] Don’t Be A Cowboy – Fat Tailed and Happy […]

  2. November 1, 2018

    […] In a recent work, I wrote that “Time In The Market” is total bullshit: a fairy tale paradigm designed by those seeking to absolve themselves of the pain and guilt of having made crappy investment decisions. I stand by that statement because to a huge extent, risk management comes down to the comparatively simple concept of business cycle investing. There is a huge distinction in my mind between the strategic, multi-year decade-to-decade positioning that someone engaging in business cycle investing might undertake compared to explicit ‘market timers,’ who, for the most part, engage in pseudo-intellectual nonsensical analysis to try to day trade the market. At its core, my philosophy of business cycle investing is simple: I want to buy when recessions are underway and get the hell out before the next recession hits. […]

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