This is part of the series written exploring the myths in popular investing as exposed in Michael Dever’s new book, “Jackass Investing.” In the book, Dever uses experience from three decades of hedge fund management to explore how the conventional wisdom in investing and portfolio management preaches little more than gambling.
By Joseph Hogue, CFA
George Costanza and “The Opposite.”
Myth #3: “You Can’t Time the Market,” begins with an analogy to a Seinfeld episode where George realizes everything he has ever done has been wrong, and so decides to do the opposite of whatever his instincts tell him. Looking over some of my investment bets over the last ten years, I wish I could go back and employ a similar strategy. Of course, we don’t call it, “the opposite strategy,” in the investment community it’s better known as contrarian.
Individual Investor vs. Mr. Market
The author starts off chapter three, after the aforementioned and appropriate Seinfeld reference, with a study by DALBAR Inc. showing the returns over the past twenty years for stock funds and bond funds compared with the realized returns of average fund investors. The result is rather surprising, the average investor underperformed the static buy-and-hold portfolio by more than 5% per year. During the period, the average stock mutual fund gained about 8.2% on an annualized basis while investors only realized about 3.2% during the same period. The difference is even larger between bond returns and bond investors. During the period, the average bond fund returned 7.0% but the average bond investor only realized a gain of 1.0% on an annualized basis. Investors are notorious for jumping in and out of stocks and bonds at exactly the wrong time. This leads to higher taxes, higher commissions, and lower returns.
The chart shows the results of the study and really tells the whole story. Investors should put their money to a buy-and-hold investing strategy and be done with it, right? Well, if you’ve been following this series you would know that buy-and-pray isn’t the solution either. In the last article, A Semi-Active Strategy to Beat Buy-and-Hold, I discussed several reasons why buy-and-hold is a faith-based system of investing and will not produce returns going forward. I also outlined a simple, semi-active strategy to take advantage of some of the strategies outlined in the book. Part of the strategy included using a portion of the equity portfolio, between 40-60%, for return-enhancing and diversifying strategies. It’s these strategies that the book is built around. Helping investors understand the concepts they need to develop and implement trading strategies.
Most investors that have been around long enough and have tried trading parts of their portfolio are now shaking their heads and saying, “I’ve heard this song before and I’ve tried timing the market before. The markets are too efficient and just can’t be timed.” You’d be right if you are part of the ‘average’ investor group in the DALBAR study. Most investors’ concept of timing the market is to read a few news articles, watch a few hours of CNBC, and then try to guess how much of their money to put in or take out of stocks. This kind of finger-in-the-air market timing is why the average investor underperforms the market so poorly. Listen to this quote from the author and fess up if it sounds like something you have done:
“The vast majority of people do not manage their money pursuant to a plan. They jump in at the top and bail out at the bottom. They get a tip and they buy a stock. That stock starts to drop and they get anxious and sell…Virtually none of their buy/sell decisions are executed pursuant to a plan. Their results reinforce the cliché that failure to plan is to plan for failure.”
The fact is that everyone times the market. Whether you decide to invest or not, when you decide to buy and sell, and which markets you decide to own are all timing decisions. Unless your investments disappear from your paycheck and go to a worldwide investable asset-mix index, then you are making a timing decision. Before you rush out to invest in the index, read myth #4 of the book, which shows how the indexes are built around arbitrary rules and not necessarily for any concern to returns or potential for appreciation. Basically, it’s a Catch-22. You are already timing the market, so you might as well know how to do it right.
Role Models for Market Timing
The author next recounts the story of Baron Rothschild’s famous ‘blood in the streets’ quote and tells how Warren Buffett timed both the 2008 collapse of the market and the 2009 rebound. In fact, Buffett’s firm had 28% of its market capitalization in cash going into the fall of 2007. I remember salivating at some of the deals he was able to work out with Citigroup (C) and the other banks for preferred shares at the height of the crisis. Buffett was able to get 10% on his Goldman Sachs (GS) preferred shares when all other preferred series were only paying out 5.8-6.2%, and he eventually made $4 billion dollars on the stake.
Mr. Buffett uses his leverage remarkably, and his strategy can teach you a thing or two about valuation, but most investors won’t be able to time the market as he does. Investors without the power and leverage of the big dogs need to exploit their own advantages. One of these advantages is the ability to short the market or individual stocks, something I discussed and offered action strategies in the series. Another advantage the regular investor has over the institutional players is the ability to incorporate flexible trading strategies without worrying about market impact. Market impact is the effect on an investment’s price when a big order comes through at once. The institutional traders have to break up their orders over days or weeks and hide them in different routing systems so they don’t drive the stock’s price up before they can get the entire order completed. Additionally, they must trade in stocks and funds with high enough volume to allow a quick exit if things turn south.
The Action Strategy section of the book (available on the book’s website) outlines a sentiment strategy that investors can use to take advantage of the ‘average’ investors’ attempt to time the market. The strategy is a detailed, contrarian method using money flow data. When investors start pouring money into funds, a sign of bullishness, the strategy gives a sell-signal. When investors start panicking and pull money out of funds, the strategy gives a buy-signal. The strategy presents some impressive returns versus the S&P500 Total Return Index over the three years ending December 2010, beating the index by 19.7% and with lower volatility.
I’ll leave you to look into the chapter’s action strategy for yourself, and will instead go through a couple of other strategies. The chapter focuses on a contrarian mindset to trading. If the average investor is a horrible market-timer then it might be time to consider Costanza’s strategy of doing the opposite.
The Russell Contrarian ETF (CNTR) is designed to select U.S. large-cap securities that will produce a return similar to that attained by professional portfolio managers using a contrarian discipline. As would be expected, the fund’s average price-to-earnings ratio is lower than the overall market at 10.9 times. As of the end of September, the fund held its largest positions in financials (30.0%) and consumer discretionary (20.6%). If you believe that the U.S. is not heading into a recession, something that stocks and bonds have recently priced in, then this fund should be on your radar.
The same outlook may be applied to the Russell Small Cap Contrarian ETF (SCTR) which invests in a contrarian methodology but in U.S. small caps. The fund’s net expense ratio is a little higher than the large-cap fund at 0.45% versus 0.37% respectively. The fund just launched on August 15th of this year, so performance data is not available. The fund includes stocks with low historical price-to-sales and low book multiples in an effort to find ‘deep value’ stocks.
While the chapter deals mainly with timing the market in general, a contrarian investment strategy is often used with specific stocks as well. Many contrarians will watch for 52-week lows in individual shares as the overall market is flat or reaching higher. The caveat is that if a rising tide is not able to lift these shares, then there is a good chance that there’s something fundamentally wrong. Investors looking for good contrarian picks should use another metric, most appropriately the Altman-Z Score, to judge the company’s financial stability. Working this individual equity contrarian strategy into our advantage in stocks with lower liquidity, we can begin to see steps in the screening process.
The GEO Group (GEO) provides government-outsourced services specializing in management of correctional, mental health, and residential treatment in the U.S., Australia, South Africa, and the United Kingdom. With austerity measures in government spending around the world, it’s no wonder the stock is under pressure. There’s little doubt of the ongoing need for these services though, so there is still a future for the company despite its -27.7% fall over the last year. The stock is off its 52-week low by only 3.4% and has 6.9% of its shares outstanding shorted. This means that many investors see further downward pressure, but will need to buy the shares at some point to close out their position.
West Pharmaceutical Services (WST) manufactures and sells components and systems for injectable drug delivery and plastic packaging. The company announced a consolidation in its operations last December and has been under selling pressure since May. Downward momentum has increased with the rest of the market since July. As with GEO, the company is well-positioned in a strong industry and should rebound to its highs at $47 a share. The stock is off its 52-week low by only 4.6% and has 7.3% of its shares outstanding shorted. Both companies’ return-on-equity is positive, with 16.4% and 7.9% for West Pharmaceutical and GEO Group respectively.
For those wanting some large-cap contrarian exposure, you may want to look at Walgreens (WAG). The company operates a chain of drugstore and convenience retail across the the United States. It’s fallen with the rest of the market but shares have been under even more pressure lately as the company tries to renew its multibillion-dollar contract with Express Scripts (ESRX). I think the deal gets renegotiated as both sides are fairly mutually-dependent. The stock is off its 52-week low by only 7.3% and has 2.3% of its shares outstanding shorted. The price has significant room until it comes up against its 52-week high, currently trading 25.3% under its high.
The Progressive Corporation (PGR) is another large-cap contrarian pick. The company operates 54 subsidiaries and a mutual insurance affiliate servicing personal and commercial auto coverage and other specialty property-casualty insurance. Piper Jaffray (PJC) just lowered its price target on the stock, even as Barclays (BCS) upgraded the shares. The shares have underperformed the S&P500 by about 15.4% over the last 12 months and are just 4.9% above their 52-week low. Both companies’ return-on-equity is positive, with 16.9% and 18.6% for Progressive and Walgreens respectively.
The point of the action strategies included in this series, and those in the book, is not so much to allow you to replicate them in your own portfolio. Though most are entirely replicable and provide enhanced returns, any trading strategy poorly understood and simply replicated is a recipe for the poorhouse. The book is about seeing the myths and pitfalls in the common practice of investing and being able to develop your own strategies to profit from the uninformed majority. This is done by understanding what really drives returns to an investment, whether it be investor sentiment, supply-demand factors, regulations, or any number of factors. Using several strategies, each with different return drivers, will allow you to truly diversify your portfolio and provide the highest-safest return. Please see our site for a complete list of the articles in the series.
Additional disclosure: This series has been written on a contracted basis with the book's author. The opinions expressed in the article are those of Efficient Alpha and not necessarily those of the book's author. Efficient Alpha has been contracted to describe strategies and concepts used within the book but not to promote or recommend any strategies, the author, or the author's services.