Poking Holes in the Market Bubble Hypothesis

Nygren Commentary September 30, 2017

CSInvesting: We can’t increase our IQ but we can try to improve our critical thinking skills by seeking out opposing views to the now current din of pundits screaming that this “over-valued market is set to crash.”  1987 here we come.  What do you think of his arguments?  I certainly agree about how GAAP accounting punishes growth investments.  

At Oakmark, we are long-term investors. We attempt to identify growing businesses that are managed to benefit their shareholders. We will purchase stock in those businesses only when priced substantially below our estimate of intrinsic value. After purchase, we patiently wait for the gap between stock price and intrinsic value to close.

“All the company would have to do is raise prices 50% and the P/E ratio would fall to the low-teens.”   -Analyst recommending a new stock purchase

We are nine years into an economic and stock market recovery and P/E ratios are elevated somewhat beyond historic averages. So when an experienced portfolio manager hears a young analyst make the above comment, he hears alarm bells. But instead of seeing this as a sign that the market has peaked, we purchased the stock for the Oakmark Fund. But, more on that later.

For several years, the financial media has been dominated by pronouncements that the bull market is over. Throughout my career, I can’t remember a more hated bull market. Many state that a recession is “overdue” since past economic booms have almost never lasted as long as this one. But do nine years of sub-normal economic growth even constitute a recovery, much less a boom? If recessions occur to correct excesses in the economy, has this recovery even been strong enough to create any? Maybe recessions are less about duration of the recoveries they follow and more about the magnitude. If so, earnings might not even be above trend levels.

Bears will also point to the very high CAPE ratio—or the cyclically adjusted P/E. That metric averages corporate earnings over the past decade in an attempt to smooth out peaks and valleys. But remember that the past decade includes 2008 and 2009, frequently referred to as the “Great Recession” because of how unusually bad corporate earnings were. I’ll be the first to say that if you think an economic decline of that magnitude is a once-in-a-decade event, you should not own stocks today. But if it is more like a once-in-a-generation event, then that event is weighted much too heavily in the CAPE ratio. If the stock market and corporate profits maintained their current levels for the next two years—an outcome we would find disappointing—simply rolling off the Great Recession would result in a large decline in the CAPE ratio.

Higher P/E ratios are also caused by near-zero short-term interest rates because corporate cash now barely adds to the “E” in the P/E ratio. When I started in this business in the early 1980s, cash earned 8-9% after tax. Consider a simple example of a company whose only asset is $100 of cash and the market price is also $100. In the early 1980s, the $8 or $9 of interest income would generate a P/E ratio of about 12 times. Today, $100 would produce less than $1 of after-tax income, driving the P/E ratio north of 100 times. There is, of course, uncertainty as to whether that cash will eventually be returned to shareholders or invested in plants or acquisitions, but it seems that making a reasoned guess about the value of cash is more appropriate than valuing it at almost nothing.

A less obvious factor that is producing higher P/E ratios today is how accounting practices penalize certain growth investments. When a company builds a new plant, GAAP accounting spreads that cost over its useful life—often 40 years—so the cost gets expensed through 40 years of depreciation as opposed to just flowing through the current income statement.

But when Amazon hires engineers and programmers to help it prepare for sales that could double over the next four years, those costs get immediately charged to the income statement. When Facebook decides to limit the ad load on WhatsApp to allow it to quickly gain market share, the forgone revenue immediately penalizes the income statement. And when Alphabet invests venture capital in autonomous vehicles for rewards that are years and years away, the costs are expensed now and current earnings are reduced.

The media is obsessed with supposedly bubble-like valuations of the FANG stocks—Facebook, Amazon, Netflix and Google (Alphabet). The FANG companies account for over 7% of the S&P 500 and sell at a weighted average P/E of 39 times consensus 2017 earnings. In our opinion, the P/E ratio is a very poor indicator of the value of these companies. Alphabet is one of our largest holdings, and our valuation estimate is certainly not based on its search division being worth 40 times earnings. If one removed the FANG stocks from the S&P multiple calculation—not because their multiples are high, but because they misrepresent value—the market P/E would fall by nearly a full point. And, clearly, more companies than these four are affected by income statement growth spending.

In addition, no discussion of stock valuations would be complete without some consideration of opportunities available in fixed income. Many experts argue that investors should sell their stocks because the current S&P 500 P/E of 19 times is higher than the 17 times average of the past 30 years. By comparison, if we think of a long U.S. Treasury bond—say, 30 years—in P/E terms, the current yield of 2.9% results in a P/E of 34 times. The average yield on long Treasuries over the past 30 years has been 5.5%, which translates to a P/E of 18 times. Relative to the past 30 years, the long bond P/E is now 90% higher than average. We don’t think the bond market at current yields is any less risky than equities.

The point of this is not to advance a bullish case for stocks, but rather to poke holes in the argument that stocks are clearly overvalued.

We think our investors would also fare best by limiting their in-and-out trading. We suggest establishing a personal asset allocation target based on your financial position and risk tolerance. Then limit your trading to occasionally rebalancing your portfolio to your target. If the strong market has pushed your current equity weighting above your target, by all means take advantage of this strength to reduce your exposure to stocks.

Now, back to the P/E ratio distortions caused by investing for growth. This highlights a costly decision we made six years ago. In 2011, when Netflix traded at less than $10 per share, one of our analysts recommended purchase because the price-per-subscriber for Netflix was a fraction of the price-per-subscriber for HBO. Given the similarity of the product offerings and Netflix’s rapid growth, it seemed wrong to value the company’s subscribers at less than HBO’s. But, at the time, streaming was a relatively new technology, HBO subscribers had access to a much higher programming spend than Netflix subscribers and Netflix was primarily an online Blockbuster store, providing access to a library of very old movies. Netflix had only one original show that subscribers cared about, House of Cards, and churn was huge as they would cancel the service after a month of binging on the show. Despite the attractive price-per-sub, we concluded that the future of Netflix was too uncertain to make an investment.

Today, Netflix trades at $180 per share and has more global subscribers than the entire U.S. pay-TV industry. Netflix provides its subscribers access to more than two times the content spending that HBO offers, making it very hard for HBO to ever match the Netflix value proposition. Finally, Netflix is no longer just a reseller of old movies. The company has doubled its Emmy awards for original programming in each of the past two years and now ranks as the second most awarded “network.” On valuation, Netflix is still priced similarly to the price-per-subscriber implied by AT&T’s acquisition of HBO’s parent company Time Warner, despite Netflix subscribers more than quadrupling over the past four years while HBO subscribers have grown by less than one third.

Last quarter, when our analyst began his presentation recommending Netflix, selling at more than 100 times estimated 2017 earnings, I was more skeptical than usual. His opening comment was that Netflix charges about $10 per month while HBO Now, Spotify and Sirius XM each charge about $15. “All the company would have to do is raise prices 50% and the P/E ratio would fall to the low teens,” he argued. Anecdotally, those who subscribe to several of these services tend to value their Netflix subscription much higher despite its lower cost. Quantitatively, revenue-per-hour-watched suggests Netflix is about half the cost (subscription fees plus ad revenue) of other forms of video. Netflix probably could raise its price to at least $15 without losing many of its subscribers. For those reasons, Netflix is now in the Oakmark portfolio.

So, is Netflix hurting its shareholders by underpricing its product? We don’t think so. Like many network-effect businesses, scale is a large competitive advantage for content providers. Scale creates a nearly impenetrable moat for new entrants to cross. With more subscribers than any other video service, Netflix can pay more for programming and still achieve the lowest cost-per-subscriber. As shareholders of the company, we are perfectly amenable to Netflix’s decision to forfeit current income to rapidly increase scale.

Because we are value investors, when companies like Alphabet or Netflix show up in our portfolio, it raises eyebrows. Investors and advisors alike are full of questions when investors like us buy rapidly growing companies, or when growth investors buy companies with low P/Es. Portfolio managers generally don’t like to be questioned about their investment style purity, so they often avoid owning those stocks. We believe our portfolios benefit from owning stocks in the overlapping area between growth and value. Therefore, we welcome your questions about our purchases and are happy to discuss the shortcomings of using P/E ratio alone to define value.

Scamming the Scamer–Funny!

and

SURPRISE! Look what just landed in my inbox today.  I wonder if THIS is FINALLY my chance to get rich.  Lucky me:

ZENITH BANK COMPENSATION UNIT, IN AFFILIATION WITH THE UNITED NATIONS.

ATTN: aldridge56@aol.com

How are you today? Hope all is well with you and family?, You may not understand why this mail came to you.

In regards to the recent meeting between the United Nations and the
Present United States Government to restore the dignity and Economy of the Nations. Base on the Agreement with the World Bank Assistance to help and make the world a better place for all with the sole aim of abolishing poverty.

We have been having a meeting for the passed 7 months which ended 2 days ago with the then secretary to the UNITED NATIONS.

This email is to all the people that have been scammed in any part of the world, the UNITED NATIONS have agreed to compensate them with
the sum of US$ 250,000.00 (Two Hundred and Fifty Thousand United States Dollars). This includes every foreign contractors that may have not received their contract sum, and people that have had an unfinished transaction or international businesses that failed due to Government problems etc.

Your name and email was in the list submitted by our Monitoring Team of Economic and Financial Crime Commission observers  (Creepy!  Is someone spying on me?) and this is why we are contacting you, this have been agreed upon and have been signed.

You are advised to contact Mr. Jim Ovia of ZENITH BANK NIGERIA PLC, as he is our representative in Nigeria, contact him immediately for your Cheque/ International Bank Draft of USD$ 250,000.00 (Two Hundred and Fifty Thousand United States Dollars) This funds are in a Bank Draft for security purpose OK? So he will send it to you and you can clear it in any bank of your choice.

This meeting was first held on the 8th of April 2003. You can view
this page for your perusal:  http://www.un.org/News/Press/docs/2003/ik344.doc.htm

Therefore, you should send him your full Name and telephone number/your correct mailing address where you want him to send the Draft to you.

Contact Mr. Jim Ovia immediately for your Cheque:

Person to Mr. Jim Ovia
Email: 1634150898@qq.com

Good luck and kind regards,

Any ideas of what I should reply?  I will split the profits!

Bulls Rampage

Increasing debt for equity swap

Sentiment bullish and prices high relative to the past.

Forced Selling-Golden Queen Mining

Here is an example of uneconomic selling–the price decline has nothing to do with the underlying operations or the price of the product the firm is selling (precious metals and aggregates).  The marginal seller sets the price no matter how unintelligent.  Seth Klarman always sought out these types of situations.

If you have an understanding of the company’s fair value, then you perhaps get a gift.  I heard from the grapevine that John Doody of The Gold Stock Analyst put out a sell recommendation because Golden Queen would defer paying dividends once the company reached full production so as to explore and expand the existing mine. His newsletter does NOT cover explorers, so he recommended selling.  The decision was correct for him, but his subscribers all tried to leave the room through the same exit.  GQMNF traded over 6 million shares or about 100 times the normal daily volume of 60,000 shares.  There is more selling likely over this week and next.

10/5/17

Correcting on Golden Queen (GQM.to)

http://incakolanews.blogspot.ca/2017/10/correcting-on-gold-queen-gqmto.html
When IKN gets one wrong, your humble scribe has no problem in eating a slice of humble pie. That happened last night when in this short post I wrote that the big share price drop in Golden Queen (GQM.to) was due to selling from the partner Clay family. That’s not right. In fact, the drop was due to John Doody issuing a sell call to his newsletter subscribers. Therefore, IKN corrects.
Widening the subject slightly, As for the real reason behind the GQM drop, the dumbass Doody has a really nasty track record of screwing his own subscribers this way. In fact the comment on the promising Alphamining blog here yesterday said it well:
“If the massive sell-off today was due to a newsletter writer’s recommendation and you are a subscriber, ask yourself if you really should follow his or her advice on small cap stocks with limited liquidity.  You’ll overpay to establish the position and you’ll get crushed when the herd heads for the exit, which may explain the action today.”
Or as one of the people kind enough to wrote into IKN this morning noted, “They did the same thing to Minefinders, Eldorado and most recently, as you are aware, Sandstorm. Each time was a great buying opportunity”. True that.
A good blog to help understand the junior resource sector: http://www.alphaminingblog.com/2017/10/wtf-why-fall-golden-queen-mining.html

Book Review: Pitch the Perfect Investment

Pitch the Perfect Investment, by two money managers who have also taught for many years at Columbia University’s Graduate Business School, can stop small caliber bullets or deflect a vicious sword blow with its heavy-gloss 496 color pages.  Bad jokes aside, is the book worth the $30+ for its intended audience, young professionals seeking an investment career or can other readers gain investing insights?

FYI: I previously mentioned here Sept. 6th 2016, Pitch the Perfect Investment and Sept. 21, 2017 Pitch the Perfect Investment

Slide presentation:170926_Fordham_LC_final

The authors synthesized many academic publications for the reader to understand the subtleties behind concepts like the Wisdom of Crowds, market efficiency, behavioral finance, and risk into clearer language.  This book with its colorful diagrams can help you grasp the theory of a discounted cash flow model or “DCF”; DCFs are used throughout the book because as the authors say, “all valuation is at the core a DCF, either explicitly or implicitly, whether they (analysts and portfolio managers) admit it or not.”   Of course, it is a given that the young analyst can gain his or her own company and industry expertise so as to insert reasonable assumptions into the DCF model.

Investing is simple but not easy some say. This book provides the simple concepts in a colorful, insightful way, but you have to do the hard part—scratch out a variant perception while competing with many other professionals. Sobering.

The reader is taken through the basics of valuing an asset, a business, how to evaluate competitive advantage and value growth with simple examples (The Lemonade Stand).   The authors drive home the importance of differentiating between nominal growth and profitable growth.  Growth without competitive advantage earning a return above its cost of capital is useless or worse. Certainly, all investors must grasp those concepts.  Every page is festooned with color cartoons, diagrams, tables and graphs.  This is a visual text.

The most interesting part of the book for me was the Chapter 6, The Wisdom of Crowds.  As Buffett says, “You must know two things as an investor: how to value a business, and how to think about prices.”  If I can paraphrase correctly, the Wisdom of Crowds with an adequate amount of domain-specific knowledge and diverse views acting independently from each other on disseminated information will be a force to push price towards efficiency or intrinsic value.  My respect for market efficiency and the person on the other side of the trade from me was reinforced.  If you gain anything from this book, understand that earning an investment edge or variant perception is EXTREMELY difficult and rare.   The authors may have intentionally driven home their point with their example of Cloverland Timber Company.

In their example, the analyst had the domain expertise to notice a line in the financial statement that the Cloverland was undercutting its forests, then satellite imagery was used to assess the quality of the asset and arrive at a more accurate valuation than the market’s current estimate.  The information is available but not publicly disseminated.   I wonder how many analysts/portfolio managers have the time, energy, money, or inclination to go this extra mile?  If you are this able, then you deserve alpha.   What are the implications?

If diverse individuals with independent thoughts are required to have the “Wisdom of Crowds” operate effectively, how will investment firms with their hordes of MBAs and CFAs all taught the same concepts, reading the same newspapers, magazine, research reports, and attending the same investment conferences arrive at non-consensus conclusions often–or ever?

The Wisdom of Crowds gives you an understanding of how prices are set under normal conditions when the forces of darkness and “Mr. Mayhem” (cartoon figure in the book using a magnet to pull prices away from market efficiency; he is the guy you need to spot quickly) are not strong enough to pull prices sufficiently away from intrinsic values.  In other words, behavioral finance is complementary to efficient markets.  One can then recognize when the Wisdom of Crowds becomes the Madness of Crowds.  For an understanding of how prices are set by individuals in a free market, go to pages 79-185 in Man, Economy, and State by Murray Rothbard (Google: Man, Economy, and State.pdf) which has an analysis of how individuals set prices through direct exchange.

Another valuable chapter in the book is Chapter 9, How to Assess Risk.  When investors confuse uncertainty (unknowns) with risk (losing money), then opportunity may appear.

Paul Sonkin, one of the authors, gives sobering advice to students who dream of becoming money managers.  Page 151: “I’m not trying to discourage you from pursuing your dreams, but you should do it with your eyes open.  Do it because you love analyzing companies, not to make a quick buck. And, if your goal is to outperform the market, keep in mind how difficult it has been in the past and the fact that it will only be more challenging in the future.” Those are true words.  The investing profession may end up like acting.  Only the crazy brave will pursue.

Once you have finished Section 1, The Perfect Investment, you then learn how to “Pitch” the Perfect Investment.   Assuming you are diligent enough to acquire the information, assess risk, identify an actual mispricing, and know the catalyst, then convincing another of the merits of your investment should be the easy part.  Unfortunately, too many do not provide a convincing case for the merits of their investment.   An example, of a devastatingly compelling case: The truth shall set you free (liar, liar)

The authors lay out a framework below in this example:

Value or What Can I Make:  Market price is $90 but the stock is worth $140—time horizon is less than 18 months.

Catalyst: Or Who else will figure this out:  Activist with a good track record is pushing for a sale.

Mispricing: The activist did an independent appraisal which the market is unaware of showing a substantially higher value than the company appraisal.  Also, the presence of the activist does not appear to be priced into the stock.  The market is unaware of the activist or does not think he will be successful.

Downside:  Limited. Timberland is a hard asset.

For another example of a forceful investment case with an implied catalyst: Other People’s Money Does Danny Devito provide a strong case? Does he show how much one can make, lose, what is the market missing, and the catalyst?

If you truly have a variant perception, then this is usually your reception: Michael Burry’s Variant Perception

And, only if you are right, and you make the decisions can you present this way: Michael Burry’s Investors  If you read the book, The Big Short, ironically you know that Michael Burry was not making a macro bet, but on the impossibility of individual mortgage holders to make their mortgage payment when asset prices decline and/or interest rates reset higher.

An investment edgeThere are only three ways to gain an edge

In summary, while I do not agree with the book-jacket blurb:

Mr. Nicholas Gallucio, CEO of Teton Advisors, who said, “In this era of hyper-competition on Wall Street ……even the smallest edge can make the difference between success and failure. Pitch the Perfect Investment will give the professional investor that edge.”  I do believe the book is worth $30 for a beginning and intermediate investor who wants to refine their understanding of key investment concepts and to review how to make clear and convincing investment pitches.   Even if an investor does not have a boss to pitch to, the investor should always write down a succinct investment case for each investment.

Remember, I’m biased. I’m a cheapie who went Dutch on his honeymoon, charged an entrance fee, and had a cash bar.  Sure, I made a profit, but the divorce cost a fortune.  Perhaps, I confused price with value.

PS: Graham and Dodd Oct 2017

Pitch the Perfect Investment

I have not seen the videos in the link below.  Let me know if you learn anything practical.

Pitch the perfect investment (videos)

Home

Listen to the interview: https://soundcloud.com/valuewalk/pitch-the-perfect-investment-with-paul-sonkin-and-paul-johnson

Other than seeing the videos and listening to the interview, I have yet to read the book.  The book may help an analyst learn how to form their ideas into a concise report.   Remember than many money managers have nano attention spans, so you must get your idea across quickly in a compelling way.

That said, one area that might not have been covered is how to KNOW THYSELF!    What approach fits your interests, skills and talents and how do you accomplish the goal of knowing your circle of competence?   Then how do you learn from mistakes?  How do you track your learning and results?   Because of randomness, learning from past investments is more difficult than it appears.  Spend as much time studying yourself as the company you are pitching!

The above is not a knock on the book; I believe self-knowledge is an underemphasized skill of the investment game.

UPDATE: 9/27/2017 http://pitchtheperfectinvestment.com/2017/09/27/92617-video-from-book-launch-event-at-fordham/     A more recent set of videos explaining the motivation for the book.

Charts: Every Picture Tells a Story Don’t It? –Rolling Stones

Above is a chart of the Barrons Gold Mining Index, the oldest mining index available.

Above are chart analogs of past bear markets in gold-mining stocks. Rather than using charts to PREDICT the next “Head and Shoulders Bottom” or the next ROUNDING BOTTOM (How about I show you MY bottom?) what can charts tell you about this PARTICULAR industry?   How is that information useful? Or is it?

Note the hedged comments of the publisher of the above charts. https://www.bullionvault.com/gold-news/gold-bear-010420161

Charts have never shown (based on my research) to have any statistical predictive value because of the subjective nature of interpretation–there are always two sides to a chart. Buffett stopped charting when he could flip the chart over and get the same answer.   Note this article https://seekingalpha.com/article/82372-adventures-in-technical-analysis-jim-cramer-edition

Now onto the bull market analogs.

Bull Market Analogs Article

Notice the difference with these charts of housing and banks.

What might account for the difference in the chart patterns?  What do the charts tell you about the mining industry?  IF–god forbid–you did wish to invest in precious metals miners, how might you adapt your strategy?  What explains (mostly) the shape of the above charts?  It is perfectly rational to avoid the industry but what do the charts tell you about the structure of the industry? Whip out your competitive analysis books or http://mskousen.com/economics-books/the-structure-of-production/ and post your thoughts.

 

Hedge Fund Analyst FINAL EXAM QUESTIONS

Investing might be considered decision-making under uncertainty. Therefore the following exam.

You must answer BOTH questions correctly to be hired.  You are now in the final pool of candidates to work for a big hedgie fund. Now comes

Question 1:

Imagine playing the following game,  At a casino table is a brass urn containing 100 balls, 50 red and 50 black.  You’re asked to choose a color.  Your choice is recorded but not revealed to anyone, after which the casino attendant draws a ball randomly out of the urn. If the color you chose is the same as the color of the ball, you win $10,000.  If it isn’t, you win nothing-$0.00.

You are only allowed to play once–which color would you prefer, and what is the maximum bid you would pay to play? Why?

Question 2:

Now imagine playing the same game, but with a second urn containing 100 balls in UNKNOWN proportions.  There might be 100 black balls and no red balls, or 100 red balls and no black balls or ANY proportion in between those two extremes.  Suppose we play the exact same game as game 1, but using this urn containing balls of unknown colors.

What is your bid to play this game IF you decide to play?   How does the “risk” in this game (#2) compare to game (#1)?

Take no more than a minute.   So are you hired?!

Answer posted this weekend.

ANSWER (9/10/2017)

A Reader provides a clearer distinction in Question2:

Your second problem is ill-specified for your desired effect . You write that all combinations of red/black balls within the 100 ball population ARE possible; you don’t say they are equally probable. You need to assume them to be equally probable in order for the reader to infer that the expectations are identical between problem 1 and problem 2.

The reason being is that without defined probabilities on the possible ratios the long run frequency of draws from the second bag isn’t calculable. Hence the expected value cannot be computed and therefore cannot be used in comparison to the EV of problem 1 (you need probabilities in a probability weighted average after all).

You could suggest that the offeree has a 50/50 chance of choosing the correct colour (even if the long run frequencies are not known). But this not an argument born from expected value. This is an argument of chance and it assumes the offeree has no additional information from which to make their decision (which is hardly ever the case).

There are 100 possible choices for the proportion of red/black: 100 red balls/0 black balls, 99 red balls/1 black ball etc., 98/2, 97/3     with 100%, 99%, 98%, 97% probability of choosing a black ball all the way………… to 2 black balls/98 red balls, 1/99, 0/100. Put equal weight on them since random.  When computed, the average of the expected payoffs across all these alternative realities, one got an expected value of $5,000, the same as Game 1.

The two games describesthe Ellsberg Paradox, after the example in Ellsberg’s seminal paper.  Thinking isn’t the same as feeling.  You can think the two games have equal odds, but you just don’t feel the same about them.   When there is any uncertainty about those risks, they immediately become more cautious and conservative.  Fear of the unknown is one of the most potent kinds of fear there is, and the natural reaction is to get as far away from it as possible.

So, if you said the two games were exactly similar in probabilities, then A+.  The price you would bid depends upon your margin of safety/comfort.   You would be rational to bid $4,999.99 since that is less than the expected payoff of $5,000.  But the loss of $4,999.99 might not be worth it despite the positive pay-off.  A bid of $3,000 or $1,000 might be rational for you.   The main point is to understand that the two games were similar but didn’t appear to be on the surface.

The Ellsberg paradox is a paradox in decision theory in which people’s choices violate the postulates of subjective expected utility. It is generally taken to be evidence for ambiguity aversion. The paradox was popularized by Daniel Ellsberg, although a version of it was noted considerably earlier by John Maynard Keynes.  READ his paper: ellsberg

Who was fooled?

Anyone not answering correctly or NOT answering has to go on a date with my ex:

The Stock Market: Risk vs. Uncertainty

Life is risky. The future is uncertain. We’ve all heard these statements, but how well do we understand the concepts behind them? More specifically, what do risk and uncertainty imply for stock market investments? Is there any difference in these two terms?

Risk and uncertainty both relate to the same underlying concept—randomness. Risk is randomness in which events have measurable probabilities, wrote economist Frank Knight in 1921 in Meaning of Risk and Uncertainty.1 Probabilities may be attained either by deduction (using theoretical models) or induction (using the observed frequency of events). For example, we can easily deduce the probabilities of the possible outcomes of a game of dice. Similarly, economists can deduce probability distributions for stock market returns based on theoretical models of investor behavior.

On the other hand, induction allows us to calculate probabilities from past observations where theoretical models are unavailable, possibly because of a lack of knowledge about the underlying relation between cause and effect. For instance, we can induce the probability of suffering a head injury when riding a bicycle by observing how frequently it has happened in the past. In a like manner, economists estimate probability distributions for stock market returns from the history of past returns.

Whereas risk is quantifiable randomness, uncertainty isn’t. It applies to situations in which the world is not well-charted. First, our world view might be insufficient from the start. Second, the way the world operates might change so that past observations offer little guidance for the future. Once bicyclists were encouraged to wear helmets, the relation between riding the bicycle—the cause—and the probability of suffering a head injury—the effect—changed. You might simply think that the introduction of helmets would have reduced the number of head injuries. Rather, the opposite happened. The number of head injuries actually increased, possibly because helmet wearing bikers started riding in a more risky manner due to a false perception of safety.2

Typically, in situations of choice, risk and uncertainty both apply. Many situations of choice are unprecedented, and uncertainty about the underlying relation between cause and effect is often present. Given that risk is quantifiable, it is not surprising that academic literature on stock market randomness deals exclusively with stock market risk. On the other hand, ignorance of uncertainty may be hazardous to the investor’s financial health.

Stock market uncertainty relates to imperfect information about how the world behaves. First, how well do we understand the process that generated historical stock market returns? Second, even if we had perfect information about past processes, can we assume that the same relation between cause and effect will apply in the future?

The Highs and Lows of the Market

Warren Buffett, the world’s second-richest man, distinguishes between periods of comparatively high and low stock market valuation. In the early 1920s, stock market valuation was comparatively low, as measured by the inflation-adjusted present value of future dividends. The attractive valuation of stocks relative to bonds became a widely held belief after Edgar Lawrence Smith published a book in 1924 on stock market valuation, Common Stocks as Long Term Investments. Smith argued that stocks not only offer dividends, but also capital appreciation through retained earnings. The book, which was reviewed by John Maynard Keynes in 1925, gave cause to an unprecedented stock market appreciation. The inflation-adjusted annual average growth rate of a buy-and-hold investment in large-company stocks established at the end of 1925 amounted to a staggering 32.13 percent at the end of 1928.

On the other hand, over the next four years, this portfolio depreciated at an average annual rate of 17.28 percent, inflation-adjusted. Taken together, over the entire seven-year period, the inflation-adjusted average annual growth rate of this portfolio came to a meager 1.11 percent. Buy-and-hold portfolios in allegedly unattractive long-term corporate and government bonds, on the other hand, grew at inflation-adjusted average annual rates of 10.18 and 9.83 percent, respectively. This proves Buffett’s point: “What the few bought for the right reason in 1925, the many bought for the wrong reason in 1929.” One conclusion from this episode is that learning about the stock market may feed back into the market and, by changing the behavior of the market, render our “learning” useless or—if we don’t recognize the feedback effect—hazardous.
Is Tomorrow Another Day?

Risk and uncertainty are two concepts that stem from randomness. Neither is fully understood. Although risk is quantifiable, uncertainty is not. Rather, uncertainty arises from imperfect knowledge about the way the world behaves. Most importantly, uncertainty relates to the questions of how to deal with the unprecedented, and whether the world will behave tomorrow in the way as it behaved in the past.

This article was adapted from “The Stock Market: Beyond Risk Lies Uncertainty,” which was written by Frank A. Schmid and appeared in the July 2002 issue of The Regional Economist, a St. Louis Fed publication.

(Source: St Louis Federal Reserve)

A Review: The Bre-X Scandal

The Peak
It was touted by media and banks as the “richest gold deposit ever”
In December 1996, Lehman Brothers Inc. strongly recommended a buy on “the gold discovery of the century.”

Bre-X’s salted samples were never checked by a third party, people wanted to believe so they never questioned the rising price of the stock. Do not ignore the warning signs.

Patience is paying off in http://csinvesting.org/2017/05/12/a-tontine/

When is a P/E not a PE: Case Study in Indexing

A tutorial on the dangers of Indexing investing. 

Know what you are doing IF you buy index funds!  You can learn a lot by studying Horizon Kinetics.  The video provides a valuation of the index and how to think about investing or not in indexes.

http://horizonkinetics.com/market-commentary/2nd-quarter-2017-commentary/

Also, more on indexing here:

Q2-2017-Commentary_APPROVED_FINAL

Q1-2017-Commentary_FINAL-1

Q4-2016-Commentary_Final

Q3-2016-KAM-Conference-Call