Mauldin on Different Types of Risk

Research on Safe Withdrawal Rates

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RobBennett
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Mauldin on Different Types of Risk

Post by RobBennett »

Please scroll down to the subheading referring to "Alpha."

http://www.frontlinethoughts.com/articl ... =mwo050704

Juicy Excerpt #1:By moving into hedge funds and other absolute return strategies, investors were not necessarily lowering risk. They were exchanging one type of risk (beta or market based risk) for another type of risk (alpha or manager skill-based risk)....If we are in a secular bear market, as I argue, then stock market beta risk is precisely what you do not want. Beta or market based risk will yield disappointing returns in such an environment.

Juicy Excerpt #2:I also argue that small investors can find alpha in the stock market, even during secular bear markets, by finding portions of the market where larger funds and investors avoid or more specifically the micro-cap markets. This lack of interest and participation creates inefficiencies in the micro-cap portion of the market. Of course, as you would expect, that means more and different types of risk as well as the normal market risk.

Juicy Excerpt #3:During secular bears, history suggests you should seek absolute returns or alpha. It is a totally different process than during secular bulls like we saw in 1980 and 1990.

Juicy Excerpt #4:If we are in a secular bear, then almost by definition an index of absolute return strategies will beat the stock market. So what? The question is not whether you can beat a stock market that is losing money, but can you beat money market funds? Can you give me a return north of zero?

Juicy Excerpt #5:Of course, when valuations mean revert (and they always do) and the cycle changes, and as we move once again from a secular bear to a secular bull, then the type of risk you want is beta risk. It will once again be time invest in index funds, taking the volatility of the market.

Juicy Excerpt #6:Risk should be approached deliberately and with much thoughtfulness. Great pains should be made to avoid the risks you don't want and to accept the type of risk you do want.
Mike
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Post by Mike »

If we are in a secular bear...
This is the relevant question. Valuations alone do not guarantee that a bear will begin within any particular time period. The history of bubbles shows that they can go on for far longer than anyone expects. We may yet have another multi year run up before values revert to their historic average.
mannfm11
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Post by mannfm11 »

i write Mauldin quite often in response to his writings I get in email. I would like to read his book, but this is the first thing I have seen John write that might indicate that returns on about anythign could be negative. As more and more big money moves into hedge funds, there will be less and less return left for the average guy to make and he will move out of the market, leaving the hedge funds a zero sum game as a whole and a negative sum for their investors. I might note that General Motor is now using hedge funds for its pension funds. Hopefully, they are short their own debt or they could be in trouble.
mannfm11
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Post by mannfm11 »

I would say this is the early stages of a massive bear, not the continuation of a bubble. I think the bubble continued after Greenspan said it was a bubble in 1996. We still have a bubble mentality, but there aren't that many new chips to push stocks higher and much of the new float is being soaked up with new IPO's that cannot resist the still massive overvaluation that stocks are selling to the market. The Nasdaq, SPX and the Russel are about where they were at their peaks in mid 1998, not at some recent level of gain. People are now looking at close to 6 years of zero gains and in fact, due to the massive amounts of new money required to value the SPX in 1999, 2000 and 2001, losses. As for the Dow? The Dow has been rigged higher by a series of splits and component changes. The Dow we had in effect on the top would have read 13,000 at the peak instead of 11,800 interday. This puts the Dow too in the region of the 1998 peak and not where it is assumed to be now. One might gain an appreciation when they learn that they started fooling with the divisor on the Dow in 1928 and a bubble immediately followed. Manias don't hang in suspended animation like this, they make continued new highs like we did in the 1990's save 1994.

I think if you want an example, I would look at the long term Nikkei chart. The Nikkei has also been skewed upward, so the damage there is much worse than the 80% we saw lost as of the last bottom. 30 months into that bear, the Nikkei hit the 50% mark on the charts, just like the SPX. Since proper valuation of the SPX is in the 300-400 range, I expect the same to hold true here. It took several more years before the market made a new low. I think the action taken by the Fed and the Bush administration led to enough new money creation before the real grip of deflation took hold and we got a reprive, but it is only a reprive.

If you understand this to be a bubble, whether it goes back up or not, then you probably know not to play with it. One can know intellectually, but they cannot know emotionally. People don't do loss too well and they change their minds.
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Post by Mike »

If you understand this to be a bubble, whether it goes back up or not, then you probably know not to play with it.
Being a player by nature, I decided in the fall of 2002 to play the nascent economic recovery and Presidential election cycle by loading up on small cap value. I chose my SCV funds by short term momentum, since this strategy has historically provided a measure of protection in down markets. As the recovery expanded, I spread out a little into SCG, mid cap, and even a small amount of LCV. I am tentatively considering following the sell in May and go away strategy next Spring, but I may change my mind and sell early, or hold on longer depending upon unfolding events. So far, the election year is following its traditional script of doing poorly in the first half of the year, only time will tell if it continues on script and finishes strongly in the second half.

I do mitigate my risk a bit by being only 60% equity at present, with part of my non equity position being in commodities. You are probably appalled at my strategy, but I have a hard time seeing the market reverting to mean valuation with the large boomer cohort being forced into equities by the tax code (section 401k). Maybe you can talk some sense into me before it is too late. I find your posts thought provoking.
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Post by JWR1945 »

Juicy Excerpt #4: If we are in a secular bear, then almost by definition an index of absolute return strategies will beat the stock market. So what? The question is not whether you can beat a stock market that is losing money, but can you beat money market funds? Can you give me a return north of zero?
I just purchased some 2.5% (yield to maturity, real) long-term TIPS on the secondary market. This is the first time that I have ever bought anything other than stocks. I think that 2.5% (real) interest is typical of interest rates and it is likely a to be fair rate if I actually do hold these TIPS to maturity.

If today's benchmark should be money market funds, I think that I will be doing OK. And, yes. I think that money market funds will be a good benchmark for quite a few years into the future.

Here is my question: how high of a real yield to maturity should I seek in the future? My guess is that 3% is about the highest level that we can talk about realistically. I doubt that we will see the 3.5% and 4.0% levels anytime soon.

But I do not know what interest rates to seek. Should I be satisfied with 2.8%? Should I hold out for 3.2%? I don't know. I will appreciate any assistance in this regard.

Have fun.

John R.
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Post by JWR1945 »

Mike wrote:I do mitigate my risk a bit by being only 60% equity at present, with part of my non equity position being in commodities. You are probably appalled at my strategy, but I have a hard time seeing the market reverting to mean valuation with the large boomer cohort being forced into equities by the tax code (section 401k). Maybe you can talk some sense into me before it is too late. I find your posts thought provoking.
I have not checked this out yet. This is still a working hypothesis.

IMHO, the reason that it was so hard to prove reversion to the mean is that valuations were left within the data. Remember that with statistical tests, measured uncertainties (variances and standard deviations) are not necessarily caused by random factors. They can be unidentified or unknown factors. They can even be known factors that have not been taken into account when applying statistical tests.

IMHO (but not known for a fact), if we were to extract the very slowly varying valuation trends (as seen in the P/E10 data), we would see an exceedingly strong mean reversion effect.

These valuation trends are what John Bogle means when he talks about a speculative return. They vary slowly, but they can swamp out other effects for a long time. At some point, buyers refuse to pay higher prices for the same income stream, to move from bubble to super bubble, and the trend reverses. We typically think in terms of two bad decades in stocks followed by one spectacularly profitable decade. The time periods are not to be trusted. But by looking at valuations and their slowly varying, but strong changes, there is much more predictability in the market than might otherwise be expected. These are caused by human factors, including demographic factors. The main thing is that we know what to look for: how much people are willing to pay for a future income stream (along with its uncertainties). P/E10 is useful for this purpose, but it need not be the only indicator.

Have fun.

John R.
Mike
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Post by Mike »

Remember that with statistical tests, measured uncertainties (variances and standard deviations) are not necessarily caused by random factors. They can be unidentified or unknown factors. They can even be known factors that have not been taken into account when applying statistical tests.
I suppose that this is the reason I have not gone 0% equity. Factors such as the desire of politicians to get reelected are not currently incorporated into our model. Many of these factors are hard to quantify, but the historical record shows their influence nevertheless. At present, interpreting our models is more of an art than a science. Incorporating many factors into our models, such as short term interest rates, money supply growth, tax law, demographics, etc... will make the model more accurate. Until we can figure out a way to incorporate the many factors that affect the market, interpretation will require a bit of human judgement. The models are quite useful as is, but they are incomplete. None of our models can show why the earnings 10 yield has grown so high, so they cannot predict when the earnings 10 yield might fall again. They do show that this is a time of unusual danger in the S&P, so risk reduction strategies should be used. I will probably not buy back my TSM index funds for long term holdings until valuations return to normal, but I do continue to employ some equity using strategies that have historically reduced the risks involved in holding equity.
RobBennett
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Post by RobBennett »

Incorporating many factors into our models, such as short term interest rates, money supply growth, tax law, demographics, etc... will make the model more accurate.

My guess is that it is going to be exceedingly hard to pull off what you suggest here, Mike. I don't object to anyone giving it a try. But my sense is that there are a good number of non-valuation factors affecting stock market returns at any given time, some in a positive direction and some in a negative direction, and that it will be hard to identiify the extent of the influence of the various effects.

Valuation is a special factor in several respects. One, it appears generally to be the most important factor. Two, we have reasonably good tools for assessing valuation. And, three, valuation is something that you can assess prior to making the investment; it is in an important sense an elective factor. That is, you can elect not to invest in stocks at times in which the valuation level does not permit stock purchases in line with your investment goals.

The way that I think of this is that you choose the valuation level at which you enter the stock investment. And then you use the historical data to determine the range of possible returns you are likely to receive as a result of all the various non-valuation factors. If you purchase at Value Level A, you can expect to receive a long-term return of something betweeb A plus X and A plus Y; whereas, if you purchase at Value Level B, you can expect to receive a long-term return of something between B plus X and B plus Y.

You might purchase at an unattractive valuation level and still end up with a not so terribly bad long-term return; and you might purchase at an attractive valuation level, and still end up with a not so terribly great long-term return. Still, knowing the effect of the purchase-price valuation level (or the retirement-day valuation level, depending on the purpose for which you are performing the analysis) permits for a far better informed investment decision.

I suppose that this is the reason I have not gone 0% equity.

There are lots of factors that go into the question of selecting an asset allocation level. I believe that valuation levels affect long-term stock returns (and thus SWRs) as a matter of "mathematical certainty." I do not believe that all investors should today be at a zero percent stock allocation. I believe that we have lots and lots of work ahead of us before we will be able to offer informed guidance as to what sorts of asset allocations should be held by investors in all of the many possible sorts of investing circumstances.

I don't believe that a 74 percent S&P stock allocation is "optimal" at the stock valuation levels applicable today. That's the proposition to which I was responding when I kicked off the Great SWR Debate two full years ago come Thursday. I like to think that there is hardly anyone anymore who still believes in his or her heart of hearts that a 74 percent stock allocation is "optimal" according to the historical data.

JWR1945's work has put some stunning possibilities before us, and I hope that we will explore each last one of them in the months and years to come. It would be a mistake in my view to try to reach too far too fast in terms of the conclusions that we draw from the work he has done. We need to think through the implications of his work, scrutinize the logic behind it, question it, test it, and gradually firm up our thinking on a whole host of issues.

I think we are on track to discover some most exciting stuff. I am optimistic about the future of this board, the future of SWR analysis, and the future of the FIRE movement. I am just trying to raise a note of caution here, however, so that we not feel a pull to try to advance too far too fast. It is safe to say that there are serious risks in having a high stock allocation at today's price levels. It is reaching a bit to say at this point what asset allocation is "optimal" for any one particular investor, in my view.
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Post by JWR1945 »

Mike wrote:I suppose that this is the reason I have not gone 0% equity....Many of these factors are hard to quantify....At present, interpreting our models is more of an art than a science....They do show that this is a time of unusual danger in the S&P, so risk reduction strategies should be used. I will probably not buy back my TSM index funds for long term holdings until valuations return to normal, but I do continue to employ some equity using strategies that have historically reduced the risks involved in holding equity.
I am very comfortable with positions like this.

Mike is making knowledgeable, informed decisions. He is in excellent company when he decides not to go to 0% equity. For example, Benjamin Graham argued strongly against any stock-bond allocation outside of the range of 25%-75% to 75%-25% at a time when a 100% bond allocation looked best [in the early 1970s]. History has supported his recommendations.

Have fun.

John R.
hocus2004
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Post by hocus2004 »

Here's Mauldin on Single Derivative Thinking:

http://www.frontlinethoughts.com/articl ... =mwo082704

Juicy Quote 1: "We enter full-tilt, no-holds-barred into the debate as to whether you should mindlessly buy and hold, or whether you should apply some more thoughtful criteria to your investments and retirement portfolios. "

Juicy Quote #2: " During the "debate," I repeatedly pointed out I do not endorse day trading for the large majority of investors...I am more like decade-trading for the average investor. I just want to use value as the criteria. But Paul ignores value because for him over the long term, buy and hold works. Today, or 1976 or March of 2000 is a good time to start."

Juicy Quote #3: "First derivative thinking would be simply projecting past price performance into the future. And that is what Farrell does....I might agree with that view for investors with few choices (as in many 401k plans) if we could make the long period of time 126 years rather than a mere 26 years..... I would politely suggest that we need to at a very minimum look at the second derivative of investing and that would be value. "

Juicy Quote #4: "Anything is possible, but not all things are likely. It is doubtful we aspire to a P/E of 40, let alone 97, once again in our lifetimes, and if we do, it will prove to be just as ephemeral....one day in the future I will also become a believer in buy and hold of the Vanguard 500 as part of a reasonable asset allocation program. But that is not this day"

Juicy Quote #5: "Let's be clear on one thing. If you are a lazy investor, you will earn the rewards of being a lazy investor. In secular bull cycles, when values are rising, when a rising tide lifts all boats, those rewards are a good thing. But when you are on the wrong side of the value curve, it is a prescription for working long past your retirement. "
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