Whale Hunter

“I’m completely comfortable when you get to those rare moments. I’m pretty comfortable calling all in, but you have to be in those rare moments. It only happens probably once every dozen years or so. It takes all the patience in the world to wait, wait and wait for the prices to just drop, drop, drop…but you get to a point where it’s virtually impossible to not get more money back than where the market is actually willing to sell you these securities.” – Jeff Gundlach, Real Vision interview October 9, 2020

Jeffrey Gundlach, the CEO and founder of DoubleLine, a $100B+ investment management firm, dubbed the “Bond King” by Barron’s magazine, described the investment world as being comprised of two different environments – alpha and beta markets in a Real Vision interview in late 2020. Financial alpha refers to the returns above expected benchmarks for an asset. An investor or money manager is considered to generate alpha when they select investments that outperform statistically-evaluated performance expectations. This statistically expected return for an asset is considered to be beta.

In Gundlach’s description, a beta environment is one in which asset prices have fallen significantly and the psychology of most market participants is extremely negative. This provides the opportunity to make significant allocations to chosen investments with limited worry about future performance.  Hedging and careful risk management strategies can be eliminated, as the opportunity for future performance is so much greater than the risk of loss. It’s the time to “push the pedal to the metal” and allocate funds aggressively, as these opportunities are quite rare and do not last. Aggressiveness is the hallmark of a proper strategy here, rather than caution. Alpha environments, on the other hand, are those in which assets are fairly or excessively priced, volatility is low, and investors are making investment choices as if the current and future prospects are guaranteed. This is a time where the market is very competitive. High return opportunities are, therefore, limited, and generating excess returns requires much more skill. Such periods require exercising strong risk management through hedging, smaller position sizing, or other means. Caution is the wise approach in these circumstances.

I believe that we are currently in an alpha environment, as Gundlach goes on to claim in the same interview. There are several common approaches to determining whether or not a market or environment is worth participating in.  These include technical analysis, where chart patterns are used to time entry and exit points; genius-match investing, where a talented investor with public holdings is identified and imitated; trend-following, which involves capturing significant sections of extended market moves(up or down); and buy-and-hold investing, in which shares of a company with expected long-term viability are purchased and held for periods of several years or decades.  The approach that is most simple and direct in understanding whether a market is in an alpha or beta environment is looking at valuations vs historical benchmarks. If valuations are at highs or lows seen once in a generation, or even longer, then you can feel fairly confident that you know whether it is time to go all-in or sit on the sidelines.

Technical analysis and trend following approaches have shown that if a market hits a new all-time high, it is likely to continue pushing higher, at least for the short-run. The S&P 500 and Nasdaq 100 both set new all-time highs within the past few days. As those highs have recently been exceeded, then further price rises are quite likely soon.

Given this caveat, what does valuation analysis indicate about the current market environment? I am not aware of any valuation metrics or serious commentaries that indicate U.S. stocks to be cheap at current levels. In fact, many stock index valuation measures indicate that current price levels are near or have exceeded historical price extremes. Seasoned and highly regarded investment managers from Charlie Munger, Jeremy Grantham, and Howard Marks, to newsletter writers such as Stansberry Associates’ Steve Sjuggerud, have all made statements or published remarks presenting evidence that recent price levels are near historical extremes.

For instance, Meb Faber of Cambria Investments, aggregated several charts and articles demonstrating current valuation and investor sentiment data earlier this year. One of the most arresting images was a graph showing U.S. CAPE ratios from 1980 through 2020. The CAPE ratio is a calculation of the price/earnings ratio determined by using average earnings, adjusted for inflation, across a 10-year time period.

HT:@GlobalFinData

At the time of the graph being charted, the level had only been exceeded one other time during the given timeframe- the tech bubble of the late 1990s. This metric currently sits at 38.

One of the easiest to understand measures of relative stock market valuation is the so-called Buffett Indicator, a measure named after Warren Buffett, who referred to this calculation in an interview many years ago.  The Buffett indicator is a ratio of total U.S. stock market value to total annual economic production(GDP).  In a very rough sense, a reading much over 1 indicates overvaluation and a reading significantly below 1 indicates undervaluation.  Many websites track this measure and provide the results for free.  One of the best is CurrentMarketValuation.com, from which the following charts were taken. The first shows the Buffett Indicator vs an exponential trendline.

The second contains further analysis through the addition of ±1- and ±2- standard deviation lines to the indicator’s historical trendline. 

The second graph is particularly compelling, as it can be clearly seen that the current level exceeds two standard deviations and that this has happened only twice in the past 30 years. The prior instance being the internet stock bubble of the late 1990s.

An argument can be made that these metrics, though eye-opening, are backward looking, and therefore an off-center guide to understanding the current environment, as opposed to what educated estimates of future performance might indicate. John Hussman, creator of and advisor to the Hussman Funds, a collection of value-focused funds with a market cycle risk management strategy, is well-known in financial circles for successfully anticipating the internet bubble of the late 1990s and the Great Recession of 2007-2008 and consistently and frequently releases market commentary that is available to the public. This research typically contains graphs showing valuation estimates that he and his team have found to be best correlated with future expected returns, as well as estimates of those future returns.  I’m not quantitatively inclined enough to recreate these calculations and graphs, but I find them to be worth examining. Of these graphs, the depiction of market valuation vs subsequent 12-year returns is striking. Based on current market valuation, next 12-year returns are projected to be negative 6%.

Explanations of and justifications for these metrics are available on the Funds’ website.

I have come across 1 or 2 commentators who claim that valuations are not excessively stretched on a standard-deviation basis vs a selected baseline. I can’t fathom that there are any market followers who make a legitimate case that broad market valuations are currently inexpensive.  Now that my take on the current situation is synopsized, I am looking to explore potential options for profiting from a major shift in the market landscape. Future articles will focus on those opportunities.

If ice breaks while you are away from shore, it will be much too late to run to safety.

Disclaimer: I own put options on SOXX, which are expected to go up in value if a market correction occurs, and expect to sell or add to the position at any point in time.

A primary focus of the first post in this series of articles, Safe Ice-Part I, was the development of a personal approach to allocating investment funds. Gaining an understanding on what one’s own approach should be along with developing a framework and tools to understand the likely future returns and safety of principal for a given investment choice were given as the two elements of a personal method of investment. The initial post referenced The Battle for Investment Survival(G. Loeb) in developing a personal investment approach.  It’s When you Sell that Counts(D. Cassidy) will be used in this article to provide confidence in evaluating market tops and bottoms, as well as develop a quantitative indicator of when conditions for buying and selling aggressively may be warranted.

One of the principal tenants of this book is that periods of extreme undervaluation and overvaluation can be identified clearly, if one is willing to be a bit contrarian during such times.

“Mechanistic models that base predictions of one cycle on the size and length of its predecessor are (or on theory based simply on prior averages) doomed to failure. Live, proactive human beings, by observing psychological conditions in the market, can successfully identify areas of temporary extreme valuation, high and low…This is the essence of contrarian investing. No pretense is made here that exact tops will be identified and sold nor precise bottoms bought.”

Five factors were highlighted as particularly helpful identifiers of extreme periods of asset valuation:

1. Above-average longevity
2. Acceleration of price velocity on high volume
3. Extremely steep slope of price movement
4. Virtual unanimity of opinion; downplaying of risks(at tops) or opportunity(at bottoms)
5. A loud media drumbeat praising or bemoaning those above conditions

If an individual had the good fortune to have $10,000 of investable cash available in November of 1915 and speculated in the same stocks with the same proportions as represented by the Dow Jones Industrial Average(DJIA), and then sold in December of 1951, their cash(adjusted for inflation) would have grown to $10,820.50¹.  If the investor chose to reinvest the initial $10,000 stake along with their $820.50 of paper profits into a basket of stocks mirroring the DJIA and held it until December, 1980, their holdings would have grown to $11,896.54(adjusted for inflation), providing total profits of $1,896.54.

Source: Macrotrends.net

A speculator with $10,000 of investable cash who made the exact same allocation decision² as the aforementioned individual in November of 1982 would have had a portfolio value of $110,339.75 as of December, 2020. 

 Source: Macrotrends.net

That the buy-and-hold strategy for a broad index of stocks has returned 1,000+% over the past 39 years is a bit of an exceptional snapshot of time.  This does not prove point #1 above, but does seem to indicate that it is at least possible that we are currently experiencing such an environment at present.

I believe that points #2 & #3 can be demonstrated by a simple chart of the Nasdaq Composite Index. Volume has risen over the past 2 years, and does not appear to be at an extreme peak, but the value of the Nasdaq has clearly accelerated since the Covid-related dip in February and March of 2020. Although it isn’t unreasonable to expect a bounce off of those lows, the Nasdaq being up ~90% off of those lows does seem to be an unlikely expectation.

Source: MSN Money

On points #4 & #5, one can take time to reflect on what one has been hearing from friends, family, and in news coverage and assess qualitatively whether or not the conversations have become more less involved with the economy and investments in recent months, or even the past couple of years. Perhaps a game of word association would help bring clarity to whether this is occurring in your sphere or not…Bitcoin, All-time highs, yields, interest rates…My personal belief is that the conditions of both points are very much in effect at present.

1. Back-of-the-napkin calculations performed by using hand-picked data from the 100-year DJIA historical chart available on Macrotrends.net. Not a project that would be submitted for thesis approval at any MBA program.
2. I understand that the DJIA does not seem to be as representative of the state of the economy and markets as it once did and that other indexes may depict these variable more accurately. This makes the DJIA performance even more remarkable during this time frame.

I am not a financial services professional.  All information on this site should be regarded as informational or for entertainment only, and not as actual investment advice.

Disclaimer: I own put options on SOXX, which are expected to go up in value if a market correction occurs, and expect to sell or add to the position at any point in time.

Fishing is typically seen as a safe, (mostly)relaxing, warm-weather activity. While the weather is nice and temperatures are high, it can be an activity that is done at all hours- early, late, or overnight; it can be performed socially or in isolation; or casually and at the spur-of-the-moment. Even warm water ventures require operating safely and paying attention to the environment. Ice fishing can provide trophy opportunities as well, but environmental awareness becomes a much greater factor in successful operations.

For example, last December two fisherman on Lake Minnetonka, Minnesota had to pull themselves from the water after their ATV plunged through the ice as they were traveling to an ice fishing house on the lake. Both men survived, but local authorities gave cautionary advice to residents who were considering venturing out on the lake, as recent warm weather had degraded the ice in many places. It was cautioned that one could walk on the ice, if the depth of the ice was checked as one moved, but moving out on it in a vehicle was strongly discouraged as inconsistent ice depth could result in further accidents.

The point of this post is to help provide an understanding of the current depth of the ice as it relates to investing in the public stock and bond markets and to begin to develop a framework for dealing with the current conditions as a generalist investor. History is as strong a guide to current conditions as one is likely to get, with numerous articles and books having been written that express authors’ experience and wisdom across time that can be applicable to the current era. These works can be useful in constructing an individual approach to money allocation.  One part of the equation for developing a framework is gaining an understanding of what one’s own approach should be, with a second piece the outlook on likely future returns and safe return of principal.

I believe an interesting guide to the former has been expressed well in The Battle for Investment Survival(G. Loeb). The author first points out that anyone with excess savings becomes an investor: “Any earner who earns more than he can spend is automatically an investor. It doesn’t matter in the slightest whether he wants to be or not, or even whether he realizes that he is investing,” and goes on to clarify the objective of investing: “The real objective is fundamentally to store excess current purchasing power for future use.” Any decision involving extra capital is an investment decision, be it adding to cash savings, making an additional mortgage payment, or buying into a mutual fund. With this outlook established, Loeb continues by defining the objective for an investor as: “To achieve success, one must set the investment goal very high. Not only that but the goal must also be a speculative one, for only there lies safety – paradoxical as that may seem.” Further elucidation is provided a bit later: “It is absolutely futile to try to get results except by buying into anticipated large gains. It is far better to let cash lie idle than to buy just to ‘keep invested’ or for ‘income.” Investing for supposedly “safe,” small annual returns, a 6% target, for instance, is put forward as not likely to work as well as more speculative investing, as “Trying to invest for 6% is like trying to retire. You are the “absentee” creditor or part owner as the case might be. You sit back and stop thinking, letting the money work by itself.” His practical recommendation based on this outlook was to take ~10% of one’s available cash resource and use it to speculate in investments with the express purpose of catching a double with the allocation.

A small, concentrated position focused only on opportunities for large percentage gains is seen as the best approach to navigate the investment landscape. Such an outlook forces one to concentrate only on the best ideas that one may have or come across, and encourages active, rather than passive, management of the investment. Concentration encourages an instinct to look for large gains, as the impact to one’s bottom line would otherwise be negligible and not worth the effort, as well as the instinct to sell if a position goes against you and needs to be closed.  It tends to be easier psychologically to manage a small position, as one is not counting on the principle amount too greatly, and the emotional attachment to a position and fear of loss is not so great that it should be overly difficult to close it. “A backlog of cash is a great help in meeting emergencies and in freeing one’s judgment so that commitments are opened and closed for financial cause and not affected by need, fear, greed, or other human failings which are fatal to profitable security investment.” Combining this outlook with an approach that provides a selling discipline and broad overview of market conditions can actually be protective of an individual’s money, as one does not run the risk of total catastrophe and frees one’s research time for only the potentially outstanding opportunities. For developing the second leg of the approach, It’s When You Sell That Counts(D. Cassidy) is instructive in gaining understanding, and will hopefully provide the basis for a second post.

I am not a financial services professional.  All information on this site should be regarded as informational or for entertainment only, and not as actual investment advice.

I love road tripping.  Every chance I get to hit the road and explore, I try to take it.  I owe this passion for the rhythm of the road to my late father, who frequently took myself and the rest of the family on various excursions, ranging from short weekend jaunts to extended vacations through the Midwest and Old West.  My first drive out west occurred when I was 10 months old and the family trips continued until my father was no longer fully able to travel with my brother and I.  The road trip that left the greatest impression on me was in the summer of 1990.  We explored a high number of our country’s greatest national parks that summer, including Pike’s Peak, Bryce Canyon, the Grand Canyon, Glacier National Park, and Mount Rushmore.  Most were some degree of spectacular.  Yellowstone National Park, with its diverse range of beauty and natural oddities, was one of the high points.

Yellowstone’s splendor, however, was tinged by scars from a massive fire outbreak from two years earlier. From the summer through late autumn, many small, controlled wildfires combined to raze 793,880 acres, or 36% of the park’s surface area. On the single worst day of the fires, August 20^th, more acres burned than in all other fires combined since the establishment of the park.  Contributing factors to this massive fire included the prior winter being drier than normal, followed by a major drought that began in July.  These conditions were exacerbated by the effects of a pine beetle species killing a large number of trees from the late 1960s through the mid-1980s, which left a mixed stand structure of trees that allowed the fires to spread quickly.  Another major factor in the burn rate was a U.S. Forest Service policy.

From the late 1800s to mid-1900s, U.S. Forest Service fire policies were focused on suppression. This meant that small wildfires were extinguished as soon as possible, before they could grow large enough to have a sizable impact. The policy shifted to allow controlled burns in Yellowstone by 1972, although the fires were not large. This led to a timber stand with many older trees mixed with younger growth, which made the forests more vulnerable.  This policy also contributed to a proliferation of undergrowth and dead vegetation, which meant that fuel for the fires was plentiful. Over 250 small fires combined into a handful of larger fires that were nearly impossible to fight. It took contributions from over 25,000 people, with more than 9,000 in the park at one time at the peak of the blaze, to get the situation under control.

I’m not a professional trader or seasoned participant in the financial markets, but the parallels to the stock and bond markets are pretty clear.  Central bank policies enacted during the Great Recession of supplying tremendous amounts of money at very low interest rates has functioned as a suppression policy.  This supply of money has helped support asset prices of everything from single family homes to new tech startups to the entire financial markets.  Similar to the undergrowth that had built up over many years, the U.S. economy has enjoyed a record stretch of time without a recession, which has allowed for the possibility of stock market valuations to have become stretched.  The accumulation of factors has enhanced the potential for a terrific setback for the markets. No one knows whether coronavirus is the catalyst for the current correction to turn into a larger drawdown, but someday one will come.  How much heat can you take? It can always get worse, and cash can be a great safe haven.

I am not a financial services professional.  All information on this site should be regarded as informational or for entertainment only, and not as actual investment advice.

Disclaimer: I own put options on SOXX, which are expected to go up in value if a market correction occurs, and expect to sell or add to the position at any point in time.

I am not a roller coaster fan. When I was younger, my parents would take us on an annual trip to an amusement park for weekend getaways.  One of the main attractions was a wooden roller coaster with a drop of ~100 feet after an initial climb of the same distance. After a slow ascent up the incline, you would pause, or nearly pause, at the top for a brief second, then hurtle downward before coasting around several curves and small dips. I really enjoyed the smooth ride around the curves after the fall, but the drop was more drama than 13-year-old me was up for. According to Goldman Sachs, the oil industry moves in phases that remind me of that roller coaster.

In April of 2018, Goldman Sachs released a research report describing the oil and gas industry as moving through 3 distinct phases in an ~30 year cycle.  Those phases were the Expansion, Contraction, and Restraint phases.  In the Expansion phase, there is a real or perceived shortage of capacity to produce more oil. New entrants are drawn to production of the hydrocarbon and prices rise, with plentiful money for the ventures available through debt and equity financing.  The Contraction phase sees a drop in commodity prices as sufficient supplies are brought online to reduce the need for further investment.  A confluence of long-term capacity to produce, transport, and store oil along with a reduction of the inventory overbuild, moves the industry into the Restraint phase. The Restraint phase sees further industry consolidation, as large operators with tightly controlled and integrated operations and low capital costs come to control more of the industry’s assets and production.

The roller coaster template is easy to see as the long incline, Expansion, is followed by a rapid plunge, Contraction, and the less volatile coast to the end, Restraint. Examining annual oil prices provided by BP going to back to 1861, shows prices spiking to over $100/Bbl (adjusted to 2018 dollars) only three times since it’s discovery.  Each spike follows the roller coaster pattern.

It is my belief that the Contraction phase of this ride has not fully completed yet.  The average price going back to 1861, using the data referenced above, is $36/Bbl.  Average prices going back to OPEC’s initiation in 1960 is $50/Bbl. The post-OPEC average price calculation includes 2 of the 3 $100/Bbl price spikes, however, and which could point to a run-rate price much closer to the long-term average.

Price has stayed consistently higher than both of these price levels after bottoming in 2015-2016.  Price action over the past 4-5 years shows WTI oil prices with support around $45/Bbl and resistance in the $60/Bbl range, although pricing was greater than $60 for much of 2018.  I believe that until price returns to longer-term averages, another leg of the Contraction phase will likely complete on the way to the Expansion phase.

Disclaimer: I own put options on SOXX, which are expected to go up in value if a market correction occurs, and expect to sell or add to the position at any point in time.

I am not a financial services professional.  All information on this site should be regarded as informational or for entertainment only, and not as actual investment advice.

A long time ago in a high school far, far away, I passed or failed classes based on whether my grades on tests and homework assignments met certain absolute grading criteria.  If I understood the subject well enough and could remember this information on tests, I would receive superlative scores on my report card.  Scholastic performance by anyone else in the classes was theoretically irrelevant, as my grades were based on my individual knowledge and performance.  Upon entering college, I found that many professors chose to assign grades according to a bell (or other distribution) curve, meant to reflect the relative performance of the entire body of students in these classes, rather than an absolute performance standard.  This system was intended to be more equitable and reflect the quality of instruction, as well as student effort.  Such systems are certainly capable of being gamed, however.  If a top student had a poor showing, or could be convinced to underperform, students in the middle of the pack were in an excellent position to post a good score, without having excellent absolute performance.

Saudi Arabia, with support from the other ROPEC (Russia + OPEC) nations, is the curve-setting, A+ student of the oil producing world.  They are able to extract oil for a price below $5/bbl, with most of the world’s oil well extraction costs and break evens at several multiples of this number.  The curve that oil prices are graded on is something called comparative inventory and the underperformance item used by Saudi Arabia to lower the curve for everyone else is production cuts. 

Comparative Inventory

Art Berman, a geological consultant in the oil and gas sector, maintains an oil pricing model based on comparative inventory that is used in presentations to industry groups and leadership of exploration and production companies and capital groups in the energy sector.  Over the past 5 years, Art’s work shows that oil prices have moved up and down in conjunction with rising and falling levels of comparative inventory.  Comparative inventory, in this case, is the difference between 5-year average amounts and the current inventory level.  Although not as rigorous as Art’s models, graphing U.S. petroleum and products vs 5-year average levels using EIA inventory data allows one to quickly ascertain the general validity of his work.

The A+ student, Saudi Arabia, manipulates U.S. comparative inventories by increasing or decreasing their own production levels, which results in stockpiles in the U.S. moving up and down.  In 2014, Saudi Arabia boosted production at a time when U.S. shale production was recording impressive production gains, contributing to the realization of massive domestic actual and comparative inventory levels.  Crude pricing has tended to move in opposition to large changes in comparative inventories.  Inventory levels are near the 5-year average at present, which indicates that crude pricing could be quite volatile over the next few weeks and months if a new trend in inventories is established. 

Inventory Plus…

Given the enhanced chance of price volatility, what factor(s) could function as a catalyst to swing prices either up or down? Outside of sociopolitical factors, a significant change in U.S. comparative inventories would most likely shift prices a good amount.  A summary glance at the markets would indicate that inventories have been brought into alignment, assuming comparative inventories are used as the benchmark metric, and prices are similar to year ago levels, near the halfway point between recent highs and lows. These 2 factors alone would seem to portend a fairly stable trading range in the near future.  If inventories swung much higher, however, we would expect prices to drop.

There is a lightly discussed change in U.S. export laws that could result in such an impact.  Year-end 2015 saw the United States remove a 40-year ban on oil exports that was passed in 1975 to counteract the OPEC oil embargo and work to alleviate a supply shortage.  Exports had actually risen to around 500,000 Bbls/d from minimal levels during 2014 and 2015, and have shot up by over 5 times this amount to around 2,750,000 Bbls/d since passage of the bill that removed the export ban. 

Removal of the export ban has opened a release valve for domestic production that has prevented almost 3,000,000 Bbls/d from being added to inventory levels.  Comparative inventories would be at significantly positive levels if exports were added to domestic storage.

Conclusion

Adding exports to currently high inventory levels shows that pricing volatility should have downside price risk if current production levels are maintained or increased.  Saudi Arabia has lowered the curve by decreasing production since 2015, but if U.S production continues to increase and take export market share, it seems likely that Saudi Arabia will eventually quite putting wrong answers in the box and absolute performance will achieve relevancy once again.

…you could make a million dollars. He showed me that if you applied yourself, great things could happen. It is very easy to miss the point that you can really do it. — Bruce Kovner

Interview in Market Wizards by Jack Schwager

The purpose of the writing on this site will be to identify investment themes with high payoff potential that are executable and understandable by investors who are not financial industry professionals.

One of my favorite memories from my teenage years was catching a 4 lb smallmouth bass out of the back of a flat-bottomed boat while floating down a river near our home. I was not a great fisherman and would typically catch non-keeper bass or small sun perch, if anything at all. My brother and dad were with me in the boat, saw the fish as it swam by, and encouraged me to cast back toward it as we floated downstream. I did so, and hooked the biggest fish that I remember catching during that time.

The goal of my writing on this site will be to perform a similar function for readers: Identify interesting opportunities and help give courage to make an attempt that could help you catch a whale – or something large enough to make your day, even if it doesn’t break any records.

I am not a financial services professional.  All information on this site should be regarded as informational or for entertainment only, and not as actual investment advice.