Where are the markets headed?

Gold miners update

A few weeks back I had written about an impending correction in gold miners and although the correction did happen, the miners went up a fair bit after my call and then corrected back to the levels at which I had exited.  Hence a small time and price wise correction is now in and the market has formed a base while working off the overbought condition. Since then the miners have now started to rally again and at this stage I believe that the miners are headed higher as the market is not as overbought as it was in April. A bigger correction will come but probably only after the miners have made a new high. In any case this is a long term bull market in miners after their worst bear market on record and it is far better to be in an experience some downside than to sit out and miss all potential upside. The valuations remain reasonable and the long term trend remains positive.



Global Equities:

According to most surveys and fund flow trackers, majority of people continue to remain bearish on equity markets globally, the sentiments are the same for emerging market equities as well as those near all time highs like S&P500.

3As a contrarian view, when bearishness is so pervasive, the likely path for the market is to head higher. I realize that US markets are trading at high valuations and as such the upside may not be much, nevertheless any breakout from the range that the S&p500 has been stuck in for almost 2 years will be quickly self reinforcing as the money on sidelines rushes in (valuations be damned!). Having said that, I personally don’t have any position in the broader US market as valuations just don’t appeal to me. However its the mining, agriculture and the oil space that I am quite bullish on due to their horrendous performance in the past few years.

Emerging markets on the other hand have started to move somewhat from their extremely low valuations and my personal view is that trend will only get stronger in weeks and months to come. The valuations and the dividend yields are just too tempting to be ignored in a world of negative bond yields.


The regions I favour in the EM space are: BRIC (F#$% you Goldman!)  and also Singapore, Korea and Vietnam.

My favorite play in the equities space right now is the natural gas related equities which were the worst hit in the oil rout over past 2 years. There are also indications that natural gas may replace coal in the years to come as the primary source of fuel for power plants.

4FCG is an equally weighted ETF focusing on companies engaged in exploration/production/distribution of natural gas. The sector has been devastated by the collapse in natural gas prices with current prices near 25 year lows

6and the current valuation of : p/b =  1.3 is stil low by historical standards. The bottom of the cycle was at p/b = 1 in Jan 2016.


There’s a lot happening with other commodity markets too (Silver, Steel, Food Grains, Oil) and I’ll cover that in  a separate post soon.

Smart Beta

Beware! The gold rush of Q1 2016

Earlier this year (Jan 28th to be precise) I had posted about my investment methodology and highlighted Gold Miners as an investment opportunity that I was allocating aggressively to at the time.  The timing of that article turned out to be extremely accurate as gold miners went into an amazing bull run  pretty much from that point onwards. That has since made them the best performing asset class so far this year.

First and foremost, let me be honest and confess that the timing of the article was pure and blind luck. I do not have any crystal ball and I did not see this coming . I do not profess any special skill in timing that trade.

However, this does not mean that there was no skill involved. The skill part of the trade was demonstrated when I had first highlighted gold miners as an investment opportunity after they had crashed in July 2015. That original article, highlighting GDX/GDXJ as great bargains is where fundamental and technical analysis techniques helped me identify the opportunity. The july levels turned out to be pretty much the bottom and the market stayed around those levels till earlier this year.

Having clarified that, I am now getting quite nervous about the speed and magnitude of the rally. The valuations, while still cheap by historical standards, are not in the dirt cheap category anymore.  Apart from valuations, in the near term its the speed of the rise that is a danger sign. To rise higher, a healthy bull market must have regular and meaningful corrections or the rate of the ascent should be moderate. In the current scenario, the mining stocks have risen across the board and in many cases doubled from their lows in a matter of weeks.

At this stage, gold miners are ripe for a price (15-20% drop ) and time  correction (lasting a few months). Of course, I don’t mean that this is guaranteed to happen or that the bull market is over. I am simply stating a scenario that is statistically highly likely as is typically observed in markets with similar moves.

Latest charts (22 April 2016 – morning)



Beyond the correction, the valuations remain reasonable and the long term bull market should continue. However in the near term prices are looking extremely deviated from their weekly moving averages and more often than not, such moves are not sustainable. I would be more comfortable buying a calmer market even if it turns out to be at a higher price (although unlikely that I would need to)

I have exited my positions in GDX and GDXJ and will reenter the trade when prices are nearer to the trend-lines, whether that happens via time or by price (or both) remains to be seen.

Smart Beta

Don’t be fooled by long term averages.

In introductory finance courses and from various financial media you may have been taught that the stock market returns  around 8- 10% per year.

While this might be true historically when you’re talking about long-run, annualized average returns,it’s actually quite rare to have individual years that give 10% returns. In fact, regular 10% returns per year in the stock market are a myth. So are 9% returns and 11% returns. In reality, over extended periods, it is hard to see any pattern of stable annualized returns.

cd-9Source: Bloomberg

As of end 2015, the S&P 500 index has actually returned 15+% annualized . That’s certainly way better than the long term average of 8 – 10% returns.

What you must be cognizant of is that returns in markets, occurs in clusters, i.e. there will be a few years or even a decade even when the market returns are way above the long term average and then the god times are followed by long periods of huge under performance.

Taking a simple long term average of these returns is not just meaningless but downright dangerous as you are expecting that you are going to be able to generate the long run average return just by buying and holding through these times. This is a fallacy as the outcome is completely dependent upon your starting and ending period. For example lets assume you had a 10 year horizon in year 2000 and you invested into the Nasdaq (4000-5000) at the beginning of 2000. Even in 2010, you so called “safe – buy and hold –  index investment” would have been down by over 40% and it would take another 5 years till 2015 to get back to the same levels (Nasdaq: 5000).

On the other hand if you had bought into the index in 2003 or in 2009, you would have seen amazing returns in less than 3 years after both of those starting points. This does not mean I am implying that market timing is easy  ( It’s not easy but its not impossible either…contrary to popular perception! Valuation based investing is essentially a version of market timing).

So next time some one quotes you a long term average return, the acceptable response is ” In the long term we are all dead!”

Smart Beta

Why is Smart Beta > Alpha

The first thing I strongly advise most people to consider is to Stop Investing in Equity Markets! What I mean by that slightly  misleading statement is that as an individual investor you must first of all stop trying to build a portfolio of specific stocks and if you must, limit such allocation to not more than 5-10% of your total portfolio.

There are several reasons for making this claim.

1) Understand Alpha: To put it simply, for equity investments in a particular market alpha is the return that your investment will generate above what a benchmark market index would have given you (for the same market). For example if your US equity portfolio gave you a return of 15% during a period in which S&P500 index was up by 10%, then the extra 5% return is the alpha you have generated.

Note: You are unlikely to be able to generate alpha!

The biggest problem of investing in stock markets is that it is incredibly difficult to generate alpha and to do it consistently over long periods of time is damn near impossible. There are notable exceptions to this like Warren Buffet, John Templeton, Mohnish Pabrai etc. however these are outliers and for the average person who has limited time, knowledge and resources on hand, it is a futile pursuit. I won’t get into the details of why it is hard to do, as the evidence is all around you. If you have been investing in the past you may already have experienced it first hand on occasions when all your trading/investing/speculating failed to generate a return better than the index.

So why is it that most of us like to chase alpha? I think it is partly because people don’t even realize how hard it actually is to do so. But the bigger reason is the emotional aspect: the fun in trading, the gambling high of buying/selling sometimes at a profit and sometimes at a loss. The ability to brag when your random stock pick did well and the ability to come across as a star among your colleagues/friends when conversation tilts towards finance. Most of us don’t even bother calculating how our self-managed portfolios really did in the long run compared to an index.

2) Minimize the instinct to gamble/speculate: The constant barrage of news/advertising/sales pitches from the financial media which always promises you that the recommended stock is the next big thing and that anyone can generate outsized returns is a fallacy. Of course it can happen to some people but the likelihood is similar to someone winning a lottery. This is probably the one single reason why most of us like to buy stocks and then hope for the next big win. Building a portfolio of individual stocks with the hope of striking big money with some of those stocks is like buying a stack of lottery tickets as a retirement plan.

Trust me I get it! I enjoy the whole process of identifying/researching (or at least what I think is research) and trading stocks. I wouldn’t stop it completely myself and I am not suggesting that you stop either. But from a wealth management perspective, you must realize that your whole portfolio should never be based on individual stock selection.

Stop trying to get rich quick by finding the next big thing and focus on getting a decent return on your investment which would help you beat inflation. The key is to focus on absolute performance rather than a random number based on some index.

There are all sorts of risks associated with equity investing and most of us realize that you must never put all your money in one stock. But what we often don’t ask ourselves is, how many stocks are enough to have a diversified portfolio? And how many of these stocks will you be able to research thoroughly and then monitor on a regular basis to identify if the companies continue to do as expected? And after you have done all this, how much alpha can you really generate?

Well, even among the professional fund houses with analysts, economists and portfolio managers, on average only about 40% of the funds actually beat the index over a 1 year period and the percentage declines rapidly as the time frames are extended.


So if you are an individual who will potentially be investing in the market for the next 5, 10, 20+ years and if you were to pick and choose your own stocks, odds are that you would fail to beat the index consistently. In fact in all likelihood, you may end up doing even worse than the fund managers, given your lack of resources and time dedicated to thorough research. Again, I am not saying no one can do it, I am saying most people don’t have the patience or perseverance to do this over the long term. If you truly believe you can, my only suggestion is to start small and grow the self managed portfolio over time.

So why then, would you waste your time and effort in trying to design a portfolio and then manage it when you can easily invest in a managed fund or even an Index fund such as an ETF? In fact for many developed markets, Index fund ETFs are probably your best investment option as most fund managers have a hard time beating them (an even better option is equal weighted index ETFs, provided you can find one for your target sector/region). Choosing the right fund manager who can generate alpha consistently is almost as hard as building a portfolio that does so consistently as such you are probably better off mimicking the index.

This is not to say that all actively managed funds are bad because there are several advantages that you get via mutual funds. While ETFs are often a good option to consider there may be some issues you need to consider such as:

# Non-Availability of an ETF focusing on the desired region/sector/strategy.
# The ETF may not be actively traded as such liquidity will be an issue when you want to sell it also the bid ask spread may be quite high.
# ETF exists but is traded on an exchange that you do not have access to.
# ETF may not be denominated in a currency that you want your investment in.
# Some banks allow you to take a loan against your mutual fund investments but this option is usually not available for ETFs.
# For emerging markets, it has been observed that active management does add value to the process and a higher proportion of professionally managed emerging market mutual funds generate alpha than for developed markets.

Instead of doing stock specific research, it is most critical to spend your effort in identifying the right region/sector/asset allocation and use fundamental as well as technical analysis methods to identify the product as well as the time to invest in it.

Managing beta, which I define as focusing your efforts on ensuring investing into the right markets/sectors indexes (trading at low/reasonable valuations) is what I focus on.

And the most interesting thing is this: If you do are able to implement the above strategy well, i.e. make diversified investments of low valuation indices , overtime that portfolio will outperform a market cap weighted index i.e. technically you would get alpha!

This is what I meant by Smart Beta > Alpha.

The mathematics of a bear market

Before getting into the details of bear market mathematics, I want you to ask yourself a question: “How much downside are you capable of experiencing  in an investment (as a percentage) before you will panic and sell everything?”

Go ahead –  give it a few seconds of thought! ( and be honest to yourself! no one is listening)

In my experience two things usually happen whenever I have asked this question

  • Most people consciously overestimate the percentage figure for the possible loss in investment value that is acceptable to them.
  • at the same time they subconsciously underestimate the absolute value that their selected percentage figure will represent in an actual investment portfolio.

For example, many people comfortably say that they can tolerate a 30% decline in investment value before they start to worry (the word panic is probably more accurate). However, if you were to ask the same person how much decline can they tolerate in a hypothetical million dollar portfolio, then their answer usually is 100 – 200K! (actually it depends on the individual’s net worth but I am just giving an example).

Just by giving an absolute figure to the investment portfolio the risk tolerance reduces considerably, and the implied percentages are drastically different than the stated one. In fact, if I asked the question again by increasing the portfolio amounts to greater levels, the absolute amounts keep getting lower.

Risk tolerance seems to decrease exponentially as the absolute amounts at risk increase. This is not a scientific study but something I have observed repeatedly overtime (maybe someone should do a study on this!).

Logically it makes some sense as the utility values of large absolute amounts is high and most people find it easier to think in those terms rather than a vague percentage which treats a 30% loss on $100 the same as a $3mil loss on $10 mil.

However, when speaking on investment portfolios, all our assumptions are based on the percentage figures of risk tolerance and as such it ignores the behavioral psychology that comes into play when bear markets strike.

So this is the first part: People overestimate their risk tolerance repeatedly and as such are unprepared to face true bear markets.

The second issue, which unfortunately only a small number of people realize, is that a 50% loss on an investment followed by a 50% gain on it is still going to result in a net loss. The math is simple enough:

  • assuming you start with a $100 investment
  • The value drops by 50% so now its worth $50
  • The investment recovers and goes up by 50%, but now the starting point is $50 since that’s what it is worth now
  • a 50% gain on $50 is $25 so the final value is $75
  • You are still down 25% from your initial investment. You actually need a 100% return on an investment that has gone down by 50%, just to get back to par.

But this is the easy part! While the example above may be well known to a small group, an even smaller number of people realize is that as your initial drawdown (drop in value) keeps on getting higher, the required returns to just get back to par (starting value) keep rising exponentially.

Here’s how the required return chart looks like for various drawdown levels. drawdown4bHow to read the data/chart above: The investment drawdown % figures are represented by the blue line with the data points overlapping it. The corresponding required return % figures (just to get back to the starting value of 100) are plotted on the y axis.

You can see that at 50% drawdown the required return value is 100% and beyond that it keeps rising exponentially. A 90% loss for example requires a 900% gain to get back to 100.

I have only plotted up to 90% drawdown,  as above those levels, the required return figures are literally going off the chart! The data is in the table above the graph for reference.

If you ask me, this is by far, the scariest chart I have ever seen in finance and it never fails to remind me the importance of buying things that have limited downside and also to cut my loss if and when I am wrong!

Second part: Most people don’t realize how much of an issue a deep drawdown on an investment is. An investment that goes down 70 – 80% has a huge uphill climb to make for you to get back to par. This is why its critically important to buy things that do not have huge downsides.

The mathematics of a bear market

Let me give you a scenario with the following conditions:

  1. There is a stock X that is going to fall by 90% over the next one year and thereafter it will triple in value.
  2. Lets now assume that you will be traveling during the few days it will be down 90% (from the top)  and as such you will not be able to do the trade.  By the time you return from your trip the price would have rebounded 3 times from the bottom.
  3. You are a prudent risk manager and have given a standing instruction to your broker for a stop loss order for any investment that falls below 30% of its value.
  4. You will be able to invest in X on date D just before you travel, by then the price will be down 80% and you know it will fall down to 90% and recover quickly thereafter.

Would you invest in X on date D? (Having read the above section, I am sure you would not decide to invest in it right now.)  Read the conditions again if you want to.

A large percentage of people say yes to this “opportunity” where we are investing when know exactly how the future plays out. And it is the same large percentage of people who would not make a dime on the investment X (instead will take a loss), even though it really is a great investment.


This is what happens:

Let’s say X starts at $100 today and as mentioned and by date D its trading 80% down, i.e. at $20. Due to your trip, you are happy to buy it at $20 as you expect it to bounce back by the time you return.

Note that at 80% down from the starting value is $20 but at 90% down the value is $10! This is an additional 50% drop from your purchase price of $20!

The gap between 80% and 90% drawdown is an additional 50% drop from 80%.

And since you had given a standing instruction for cutting all trades at 30% loss, your broker would have sold X at $14 (30% down from $20), so you would have made a 30% loss instead of a possible 50% gain had you held it all the way through. (3x return from $10 means X is at $30 after your trip i.e. a 50% gain over your cost of $20)

Shocked? Good!

Of course, in reality, we would only know condition 3 beforehand, as all other values in the example above will be unknown. Also, condition 3 won’t really be exercised by a broker but your own psychology when you see that your new investment that you just bought dropped 50% in a matter of days (you won’t always be on a trip without access to your trading account!). The natural tendency of straight line extrapolation of recent events will make you question your beliefs and all signs will point to the investment going to 0.

This means if you are not capable of handling the downside (volatility) while ensuring that it is not so huge that it becomes an impossibility to recover from, you are probably going to end up losing money on investments that eventually become great.

This is exactly why value investing, while so easy to understand, is so difficult to practice. Most people don’t understand the impact of buying something at the wrong price when the downside is high, and then the psychological aspects of maximum acceptable drawdowns come into play.

Nowadays it has become fashionable for everyone to consider themselves a value investor and they start to see “value” when a particular investment is down 10-15% whereas downsides of 70 – 80% are not uncommon in individual stocks and sometimes even across entire indices/sectors.

Finally : Protecting the downside is the most important thing about investing since getting that wrong will usually make even great investment ideas worthless. The conundrum is that once you have estimated the downside to be less at a given point, you have to ignore all future downside (volatility) from then on (as the scenario above demonstrated).

As a value investor, it is important to buy low but it is even more important to have the patience to hold on when the cheap asset goes down further. This of course is much easier said than done, as behavioral psychology indicates that people have different thresholds for psychological pain and also that the pain of losing a certain amount of money is twice as much as gaining an equal amount of profit (loss aversion).

So…did you think value investing was going to be easy?

Charlie Munger on investing: “It’s not supposed to be easy. Anyone who finds it easy is stupid.” as quoted in Howard Marks “Its not easy”