The Little Book of Bulls Eye Investing

John Mauldin is far too much of a gentleman to say “I told you so,” but he would certainly be within his rights to do so.

When Mauldin published the original Bull’s Eye Investing in 2003, he made his case that U.S. stocks were in the early stages of a secular bear market.  Today, nearly a decade later, he has been proven largely correct.  The S&P 500 is still below its 2007 all-time high and, far more significantly, still below the previous high set after the secular bull market of 1982 – 2000.  Adjusted for inflation, investors that held throughout this period would be sitting on some stinging losses.

The Little Book of Bull’s Eye Investing, published in 2012, is a shorter, more digestible update to Mauldin’s original magnum opus.  And Mauldin is adamant that, despite his belief that the secular bear still has a few years left in it, the book is not about “doom and gloom,” and “the world as we know it is not coming to an end.”  There is money to be made; it just so happens that you might have to look in unfamiliar places to find it.

Let’s start with a few definitions.  A secular bear market is a long-term period in which stock prices are flat or falling.  In practice, this has been anywhere from 8 to 20 years, with approximately 17 years being the average of the past century.

Investing in a secular bear is very different than investing in a secular bull.  As Mauldin writes,

In secular bull markets, an investor should search for assets that offer relative returns—stocks and funds that will perform better than the market averages.  If you beat the market, you’re doing well…

In a secular bear market, however, that strategy is a prescription for disaster.  If the market goes down 20 percent and you go down just 15 percent, you’d be doing relatively well, and Wall Street would call you a winner… But you are still down 15 percent.

In markets like these we face today, the essence of Bull’s Eye Investing is to focus on absolute returns.  Your benchmark is a money market fund.  Success is measured by how much you make above Treasury bills. 

Mauldin sees another five to six years of secular bear market conditions, “in terms of valuations, if not in price.”

This requires a little explaining.  In a secular bear market the price of most stocks falls or stagnates, but price is less significant that valuation.   A stock that cost $500 can be “cheap,” just as a penny stock can be “expensive.”

Value has to be measured relative to something—such as earnings, revenues, cash in the bank, or accounting book value.  In a secular bull market, investors become more and more optimistic about the future earnings potential of stocks and assign them higher and higher valuations, often to the point of absurdity.  By the time the S&P 500 reached its top in early 2000, the average price/earnings multiple was over 30, and it was not uncommon to see multiples of well over 100 on popular technology stocks.

But in a secular bear market, this works in reverse.  Investors get progressively more skeptical of future growth and assign lower and lower valuation multiples.  Today, more than twelve years after the last secular bull ended, the average price/earnings multiple is 15. That is less than half of the 2000 high.

Interestingly, throughout the cyclical bull market of 2003-2007 (in which the S&P 500 hit a new all-time high), valuations continued to shrink.  To keep things in perspective, had valuations remained at 2000 bubble levels, we would have seen the S&P 500 priced at 4,000-5,000—and the Dow Industrials priced at 40,000 or more.

Mauldin recognizes that markets go through long cycles of expanding and contracting valuations. But this is distinctly not the advice you are going to get from Wall Street or from most financial advisors.  Instead, they use modern portfolio theory (or, in Mauldin’s words, a “rigged” or “twisted” version of it) to justify a buy-and-hold investment plan under any and all scenarios.  After all, stocks “always” generate 7-10 percent returns over the long term.

Unfortunately, the “long term” can be very long indeed, particularly if you are in or near retirement.

Mauldin on Market Psychology

“The new era economists argue that we are now smarter than our fathers, something I understood implicitly when I was in my 20s,” Mauldin writes. “ Since then, as the father of seven kids, six of whom are older than 18, I have developed doubts.”

Speaking facetiously, Mauldin writes that “our emotional forebears invested without the wisdom that we now possess.  They didn’t understand that markets will go up eventually and that all you need to do is buy and hold and not worry about corrections and other transient phenomena.”

And naturally, we now have a smarter and more experienced Federal Reserve to step in and save us when need be.

All of this sounds good, of course.  We do know more about economics and about the workings of capital markets than our counterparts in prior generations.  But ultimately, it doesn’t matter as much as we would hope.  As Mauldin makes clear, emotion drives the stock market.

The biggest factor driving stock returns, in Mauldin’s view, is not earnings growth or underlying economic conditions.  It is investor perception of these, and as investors lose faith in the ability of equities to generate high returns, their selling creates a self-fulfilling prophecy that takes years to fully play out.  Thus, we have secular bear markets.

How To Invest in a Secular Bear

“The essence of Bull’s Eye Investing is quite simple,” Mauldin explains.  “Target your investments to where the market is going, not to where it has been.”

Fair enough.  But what about specifics?

Mauldin has a couple recommendations:

  1. Go for a deep value approach.  Invest like a Benjamin Graham by systematically buying companies that are priced so cheaply they can be cut up and sold for spare parts at a profit.  This requires time, research, and patience that many investors may find too onerous, but you simply are not going to be able to generate decent returns in a value strategy by buying and holding a mutual fund.
  2. Whatever your trading strategy, “cut your losers and let your winners ride.”  Set stop losses on your positions, and stick with them.   You should also have an exit strategy.  Set targets for profit taking before you actually invest.   And naturally, “do not fall in love.”  The stock will not love you back.
  3. Consider dividend-paying stocks as income  vehicles…but only if you are reasonably confident that a broad market crash isn’t around the corner.  During bear markets, dividend stocks fall less than the broader market.  But they still most certainly fall.
  4. Actively trade.  On this count, Mauldin is a little harsh, saying that only about 1 percent of his readers are really traders at heart.  “Any of the other 99 percent who venture in will be their cannon fodder.”
  5. Investigate alternative investments, and particularly absolute returns funds.  On this count, select your managers very carefully and be sure to do your due diligence.

Finally, Mauldin’s best advice, as a confessed “serial entrepreneur,” is to consider starting your own business if you have a good idea and have the endurance to see it through to the end.  Even in a low-growth “muddle through” economy, there are new opportunities.  It  is simply a matter of finding them and exploiting them.

The Little Book of Bull’s Eye Investing is a nice, succinct primer on John Mauldin and his approach to the investing process.  It offers no quick fixes or get-rich-quick advice, but it is a good book to keep readers grounded in reality.  I keep a copy on my bookshelf, and I recommend it to readers today.

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Japan’s Endgame Nears

I read a fact this week that I never expected to read in my lifetime: “The Japanese government is expected to announce Wednesday that the country recorded its first annual trade deficit since 1980″ (see ” End of Era for Japan’s Exports “).

Trade deficit? Japan?

Japan’s economy has been a slow-motion train wreck for the past 20 years. The bursting of the country’s 1980s credit, stock market and real estate bubble would have wreaked more than enough havoc on any economy. But on top of the normal debt deflation that would follow the bursting of a financial bubble, Japan adds the worst demographics of any developed country. Japan is aging rapidly, and its population is shrinking.

Most of the research on the effects of Japan’s demographics have focused on skilled labor shortages and pension funding. These are legitimate concerns, to be sure. But you don’t have to be an Ivy League economist to see that there is a much larger problem. The only business not affected by this downfall is the Japan’s オンラインカジノのおすすめランキング online casino which continues to provide players with the best casino experience.

If you own a business—anything from a world-class automaker like Toyota (NYSE: $TM) to a neighborhood corner café—you have a smaller pool of potential customers every year, and within that smaller pool a larger percentage are elderly consumers who buy less. Some companies grow at the expense of others, but it becomes a zero-sum game. Growth in the aggregate becomes impossible. The math simply doesn’t add up.

Unless, of course, you export. And this is what Japan has been quite adept at doing for the past 20 years. Until now.

In his 2011 book Endgame , New York Times best-selling author John Mauldin calls Japan a “bug in search of a windshield,” and it’s a great metaphor. Like a bug buzzing along a highway, Japan’s economy has bumbled along for the past two decades, not really growing but not imploding either. In the not-too-distant future, Japan may be in for a good “splat.”

Two things have kept Japan’s economy afloat all these years: its healthy trade surpluses and its government’s ability to borrow large sums of money at ridiculously low interest rates to fund enormous budget deficits. The high price of the yen and prolonged weakness in the United States and Europe are doing a fine job of denting exports. And soon, the low interest rates may be under attack.

Anyone reading this article is well aware of Europe’s debt woes. But Japan’s debts make Europe’s look like pocket change. Italy, the most indebted of the major Eurozone countries, started to see its market bond yields reach punitive levels when its debt-to-GDP ratio reached 120 . As a comparison, Japan’s debt-to-GDP ratio is an almost unbelievable 220 percent (IMF).

The only reason that Japan hasn’t had a run on its bonds is that they are all by and large purchased by domestic buyers. As Mauldin explains it in Endgame, “94 percent of all JGBs have been bought by the Japanese.” But demographically, Japan is fast shifting from a nation of middle-aged workers saving for retirement to a nation of elderly retirees liquidating their savings to pay their bills. The savings rate has been in stark decline.

The domestic demand for Japanese bonds cannot last forever, and when it dries up, Japan will find itself at the mercy of international banks and investors. Ask Greece and Italy how that worked out for them.

Japan can look forward to a currency and debt crisis that makes Europe’s look mild by comparison. Yet betting on Japan’s collapse is a little like fraternity hazing for macro hedge fund managers. It’s just a rite of passage that they have to go through. They short Japan’s bonds, lose a fortune, and learn a few painful lessons.

Knowing this, I’m not going to recommend you short the yen or Japanese stocks or bonds — yet. Wait until you see Japanese yields starting to creep up. And when they do, position your portfolio for the potential short of a lifetime.