September 4, 2017: Invest And Speculate Revisited

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Invest And Speculate Revisited

By now, most our readers would agree that US stocks are extremely expensive based on many well known long term valuation metrics. Furthermore, it has also been widely pointed out that the future stock returns will be extremely low. John Hussman has argued for some time now that US stocks would virtually return nothing or even lose in the coming 12 years. A recent white paper The S&P 500, Just Say No by James Montier in GMO even predicts -3.9% annual loss in their 7-year forecast:

As always, the GMO white paper is full of good insights and we highly recommend it.

One of the main problems with these predictions is that they are often hit and miss: in fact, it would be highly unusual for someone or some firm to make consistently accurate (or ‘correct’) prediction. Often these predictions can come way earlier, only making investors lose their patience and dismiss them altogether.

The reality is that as always, there is no 100% bull’s eye prediction. If investors have a very long term investment horizon, these predictions will eventually be proven to be correct, with the expense of excruciating underperformance in a prolonged period.

To be pragmatic, one can choose to continue investing in stocks even when it’s very clear that they are very overvalued. In this case, like it or not, these investors actually turn into a speculator: they ‘hope’ or ‘speculate’ that stocks will continue to rise.

However, an investor can also turn into a ‘smart’ speculator when markets are overvalued: they can use long term timing or Tactical Asset Allocation(TAA) in those ‘overvalued’ periods. In the meantime, he/she can still become an investor when markets finally become undervalued.

We introduced this type of strategies in November 30, 2015: Investors and Speculators Combined. As US stocks are persistently stuck at a high level and it’s approaching closer and closer to a correction, we want to revisit this concept in some more details.

The portfolio

We now make the representative portfolio discussed in the previous newsletter available in our Advanced Strategies. We have changed this portfolio’s name from P Shiller Cyclically Adjusted PE 10 SO SU SMA 200 Days Total Return Bond As Cash And Strategic Switch Monthly 0.8x to P Invest and Speculate.

To recap, this portfolio becomes

Investor: when US stocks are undervalued, it buys VFINX (Vanguard 500 Index Investor) (or any S&P 500 index fund such as SPY). The valuation metric here is P Shiller Cyclically Adjusted PE 10 (CAPE 10). When CAPE 10 is less than 0.8 times of its long term average, it deems that stocks are undervalued.
Speculator: when US stocks’ CAPE10 is no less than 0.8 times of its long term average, it now chooses to become a speculator by investing in a long term timing based portfolio: P SMA 200d VFINX Total Return Bond As Cash Monthly. What this portfolio does is that when S&P 500 total return is above its 200 days Simple Moving Average, it buys VFINX, otherwise, it chooses to invest in a total return bond fund portfolio P_46880 (Schwab Total Return Bond).

Let’s look at its latest performance:

Portfolio Performance Comparison (as of 9/5/2017):

Ticker/Portfolio Name	YTD Return**	1Yr AR	3Yr AR	5Yr AR	10Yr AR	Since 12/31/2000
P Invest and Speculate	11.2%	15.0%	7.7%	13.2%	13.2%	12.5%
P SMA 200d VFINX Total Return Bond As Cash Monthly	11.2%	15.0%	7.7%	13.2%	12.5%	12.1%
VFINX (Vanguard 500 Index Investor)	12.1%	16.3%	9.5%	14.2%	7.5%	5.9%

Detailed year by year comparison >>

So the ‘investor and speculator’ is outperforming both ‘investor (VFINX)’ and ‘speculator (SMA 200d VFINX)’.

At this moment, the portfolio is in a speculator mode. It is still in the crowded trade: invests in S&P 500 (VFINX). So let’s first look at what it means to be a speculator.

Being a speculator

Currently, this portfolio’s owner (we don’t using ‘investor’ term here to avoid confusion) is speculating. As we are closer to a correction, it relies on the price/total return technical indicator, i.e. the 200 days moving average, to be ready to abandon stocks when they are in a downtrend.

If the future corrections are small enough, it’s possible that the portfolio will remain in the speculator mode, getting in and out of stocks many times, until an eventual big correction arrives to bring stocks’ valuation down to an undervalued level. This is what happened in 2009 (see below). Historically, markets always swing to two extremes: very overvalued and very undervalued. In a severe downturn, stocks can undershoot. For example, known investors predict that in the next big ‘one’, S&P 500 might correct as much as like 50% or even 60%. That will surely present a good opportunity to be a true investor.

Being an investor

Let’s look at what it means to be a ‘true’ investor. In the case that stocks are undervalued, this portfolio’s owner will simply invest in S&P 500 (VFINX), regardless of whether the index is below or above its 200 days moving average or any other technical/tactical indicators. The premise here is that when stocks as a whole are undervalued, they will eventually revert back to their mean, delivering some of their long term average returns (8-10% nominal annualized returns, see, for example, October 31, 2016: Economy Power And Long Term Stock Returns).

Simply put, when stocks are undervalued, investors can rest assured that by simply buying and holding S&P 500 index, it will eventually achieve a reasonable return (even though in an interim, it might still experience loss).

The advantage of holding stocks when they are undervalued is that one can avoid price whipsaws that often happen in a gloomy market environment. The whipsaws can be detrimental to a timing based strategy.

However, when stocks are overvalued, holding stocks can incur some big loss, at least for many years. In fact, for example, if one holds S&P 500 from now on, it will be very likely that he/she might lose money even after 10 years! Yes, maybe 20 years later, the investment will turn into some reasonable returns, but that only happens after so many years (like 20 years or even longer).

Looking closely the following chart:

we find that the portfolio became an investor in February 2009 when S&P 500 was at its lowest level. However, just in one month, it rose enough such that it was out of the undervalued level and the portfolio became speculator by adopting the moving average portfolio. This brief period helps the portfolio beat the pure moving average portfolio.

Summary

Given the current investment environment, it’s pertinent to revisit the invest and speculate combined strategy. Looking ahead, we will certainly encounter a bear market or a deep correction one day. This strategy presents a sensible, pragmatic and intuitive way to deal with an unruly stock market that can swing to two extremes.

Market Overview

As stated above, plenty of known investors have sounded alarm or shown uneasiness on the current overvalued and over-bullish stock market. Near term, however, investors are showing no sign of panic. Risk assets including US stocks, international stocks, emerging market stocks and REITs are still in an uptrend. We are cautious but should stay the course and stick to a good strategy just like the one above.

For more detailed asset trend scores, please refer to 360° Market Overview.

Now that the Trump administration has been in the office for more than half a year, it has stumbled and encountered many difficulties to implement its promised changes in terms of tax cuts, job stimulation and infrastructure spending. On the other hand, stocks continued to ascend, regardless of the progress. Looking ahead, however, we remain convinced that markets will experience more volatilities at some point when reality finally sets in.

In terms of investments, U.S. stock valuation is at a historically high level. It is thus not a good time to take excessive risk. However, we remain optimistic on U.S. economy in the long term and believe much better investment opportunities will arise in the future.

We again would like to stress for any new investor and new money, the best way to step into this kind of markets is through dollar cost average (DCA), i.e. invest and/or follow a model portfolio in several phases (such as 2 or 3 months) instead of the whole sum at one shot.

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