# Return Distributions



## DeepState (1 May 2014)

KnowThePast said:


> Hey RY,
> 
> I am really enjoying your contributions to this [the - change by RY] forum, you have already given me enough ideas to research and play around with for a long time. Thank you.
> 
> ...




Thanks KnowThePast.  Please let me know what comes up and what challenges the theses that I have proposed.  They are just lift-outs from published and peer reviewed stuff from the major journals and not original to me anyway.  So, if you find something out of place....let's put it out there!  Or trade the heck out of it...first.

Black Swans are....painful.  Deep jump skews.  Depending on how you are positioned, either its a fabulous day or a stunned mullet day.  Taleb obviously had a lot to say.  I would point you to the Sante Fe institute for research in complexity theory for a really colourful way of thinking about it.  They brought together heaps if discliplines to figure out things like why crowds do crazy stuff, how DNA/RNA might have first formed.  All of these are Black Swans and it is useful to grab everything you can.  One of my favourites is the Sand Castle analogy by the now-deceased Per Bak.  You could code it in a few hours and watch it unfurl. And there you have an analogy for the kind of scenario you are metioning and pretty much anything you can imagine.

I also am a believer in Minski whose thesis is another way of saying Black Swan.

Any deeply integrated system which involves people or any positive feedback is susceptible to Black Swans.  The bigger that system, the bigger the potential event is. Financial markets and underlying economies, government and populace are all linked and hence this fits squarely into those requirements. 

Black Swans dominate your return profile.  Everything else hardly matters in the end.  That's why stock returns are highly leptokurotic and skewed for short time periods.  It's why options trade with skew for near term maturity, including in banks given the credit risk they bear is largely a blow-up risk.

They will happen and, as you say, the longer you go, the greater the likelihood you will encounter one. So what do you do?

Diversify.  Hold lots of stuff and, if they are somewhat uncorrelated, then you can survive the bumps.  But that's not enough, because correlations jump and effective diversity declines in sharp moves.  So here we get closer to something interesting. How can you ensure that diversity will exist in a correction?  After all, that's when diversity matters most?  

You suggest that value would be loaded into Mining Services and this might be an aggregation of risk.  If this is right, you will observe decreasing effective diversification within the Mining Services group of companies.  That is, the correlations between the stocks will increase.  That's a bloody big warning sign.  The same could be said of any sub-group of stocks that you could be concerned about.  You now need to adjust your portfolio to increase diversity if this is happening.  I wouldn't just use numbers.  I would be like you and think about it.  The right answer is judgment based.  I would not hesitate to put on positions that were not supported by statistical outcomes if I thought it was right.  Statistical tests do have error in them and knowing when it is a false negative and likelihood of that being the case is an important judgment.  It could also be that you know that the underlying systemic structure is poised in a tense state but simply has not encountered the kind of circumstance that would lead it to be visible in market prices.  Use everything you have at your disposal!  And even then we'll massively fail to catch a lot of things that go bump in the night.

There is also auto-correlation in volatility.  This is harvested by people who use GARCH type time series models or others like it like EWMA etc.  You can also spot it in options implied vol.  In reality, you need both because neither are particularly dominant over the other and a combo proves the best way forward in general.

After all that, you move to tail risk hedging.  Put a floor under you.  If you can't hack it, protect it.  Lay the risk you cannot bear off to the guy who can...and can back it. 

Also...having a long time horizon is one of the best things you can bring to the table.  This is longitudinal diversity.  Those deep skews and other bad behaviours of stock and other security prices, they largely disappear when horizons lengthen. If you can do that, things look pretty tranquil.  Rolling 20 year returns don't look very bumpy do they?  Rolling monthly ones look shocking.

How do you stop manual overrides from being abused?  One way is to be explicit about why you have the override, the kind of evidence you expect to see if this is true and a time line for removing it in the absence of contrary evidence.  I don't have a magic solution.  This is the area where people distinguish themselves from each other.  It's a judgment and often, those judgments are wrong.

I think the biggest thing is that you have to stay alive to play.  There is no certainty about the magnitude of Black Swans, so you need to know your butt is covered and this comes at a cost.  Or you can self-insure and hope the big one doesn't collect you before you depart this planet.


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## McLovin (1 May 2014)

DeepState said:


> Any deeply integrated system which involves people or any positive feedback is susceptible to Black Swans.




My favourite example of the perils of positive feedback.

Yes, it's a bit OT.


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## DeepState (1 May 2014)

McLovin said:


> My favourite example of the perils of positive feedback.
> 
> Yes, it's a bit OT.




My favourite single line description of the potential for systemic collapse where humans are concerned:

A person is smart. People are dumb, panicky, dangerous animals, and you know it.

— Agent K


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## KnowThePast (2 May 2014)

DeepState said:


> Thanks KnowThePast.  Please let me know what comes up and what challenges the theses that I have proposed.  They are just lift-outs from published and peer reviewed stuff from the major journals and not original to me anyway.  So, if you find something out of place....let's put it out there!  Or trade the heck out of it...first.
> 
> Black Swans are....painful.  Deep jump skews.  Depending on how you are positioned, either its a fabulous day or a stunned mullet day.  Taleb obviously had a lot to say.  I would point you to the Sante Fe institute for research in complexity theory for a really colourful way of thinking about it.  They brought together heaps if discliplines to figure out things like why crowds do crazy stuff, how DNA/RNA might have first formed.  All of these are Black Swans and it is useful to grab everything you can.  One of my favourites is the Sand Castle analogy by the now-deceased Per Bak.  You could code it in a few hours and watch it unfurl. And there you have an analogy for the kind of scenario you are metioning and pretty much anything you can imagine.
> 
> ...




An awesome post RY, thank you.

This especially struck a chord with me:



DeepState said:


> Black Swans dominate your return profile.  Everything else hardly matters in the end.




While I wouldn't go to extreme of saying that they dominate, they certainly play a huge part. And as you say, it is staying alive and being ready for them that becomes the priority.

On hedging, there's obviously many different hedges one could have. What would you think of shorts as the main strategy?

Statistically, I do not like shorting. They are riskier than long trades, and I would expect the expected return from them to be worse as well. Having part of your portfolio in short positions, however, should partially protect you from most of the black swans and as an added bonus, have you in a ready position to pick up bargains (via short profits).

This is currently one of my areas of research, and I still haven't reached a conclusion. So I am just talking aloud to keep the discussion going and hopefully learn some more.


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## DeepState (2 May 2014)

KnowThePast said:


> 1. An awesome post RY, thank you.
> 
> 
> 2. On hedging, there's obviously many different hedges one could have. What would you think of shorts as the main strategy?
> ...




Hi KTP

1. Thanks very much.

2. The tail risk hedge is essentially a short position that kicks in more strongly as things deteriorate.  Hence it is a form of shorting and more positions are added as things deteriorate. Because you want to be decreasing your exposure as things deteriorate, something with a put option-like payoff for your main exposures is usually involved, or you can synthetically create them with linear instruments via stops, although this will be more slippery than options due to - slippage.

If you are running long-short strategies, then shorts will already feature. You might have put them on as part of a pair/risk-packet that found good value ideas relative to one another, or it might be just an outright position because you think some company or market sucks within a portfolio of other things you might be holding. But even then there are typically risks that can blow you up.  Even market neutral funds have such exposure.  

For example, a market neutral fund running tight pairs might have a long exposure to S&P 500 and a short on ASX 200.  This position obviously has risk, and the potential for Black Swan.  You would 'short / tail risk protect' this position by getting someone to write you an option on the difference via swap. That's totally BS for retail, of course.  Alternatively, you would have stops that shut the position down as things deteriorate.  These stops must always be on and updated frequently.

The concept is: what is your risk exposure? What can you hack? Protect the exposure that you can't handle via option or synthetic means.  

Cheers


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## KnowThePast (2 May 2014)

DeepState said:


> Hi KTP
> 
> 1. Thanks very much.
> 
> ...




Thank RY, this is extremely helpful for my thought process.

What about this risk of unlimited downside for shorts? Are we swapping one risk for another?


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## DeepState (2 May 2014)

KnowThePast said:


> Thank RY, this is extremely helpful for my thought process.
> 
> What about this risk of unlimited downside for shorts? Are we swapping one risk for another?




No probs KTP

A naked short has unlimited loss potential.  But, really, trees don't grow to the moon.

The shorts used as hedges offset the longs.  That's if you are using the same for same.  ie.  Hedge ASX 200 futures with stops (a stop is a contingent short).  You never end up at net negative (unless you design it to, in which case you become exposed to risk again on the short side and may, by symmetry, need to hedge your shorts with contingent longs).

If you have basis risk between your exposure to risk and the hedge instrument, say, hedging portfolio of ASX 20 with the SPI, then there is a theoretical possibility that the SPI can go to the moon as your ASX 20 basket craters.  In very broad terms, these tightly correlated trades were what LTCM got up to, hedge something with another thing which should move in tight unison.  For the most part, it did.  But they couldn't survive the journey because convergence did not happen before they ran out of buffer and were liquidated...the market knew they were in trouble as well, figured out what they were doing, and killed them too by forcing stops to be hit.  Being 100x leveraged most certainly did not help.

Estimate basis risk.  If you are doing it, it generally means you've run out of alternatives to hedge your risk and have to use proxies.  The usual way of doing this is to look at history as a starting point and then make some sort of adjustment.  Our Head of Risk globally said: look at the worst drawdown you've encountered and, maybe, double it.  However, if your trade is crowded, Black Swan risk exists here too. Strange things do happen.  For example, if the Volkswagon issue, which disrupted or at least raised the eyebrow of markets, arose in Australia and the stock was outside the ASX 20 this basis risk could be savage for a little while.  Give room on each trade to make sure you can hack that. In combination, if you are aware of risk aggregation, the chances of this blowing a true and permanent hole in your balance sheet moves into the truly remote category.  Usually your whole portfolio doesn't hang on concepts like basis risk if you aren't Meriwhether and running 100x leverage.


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## craft (2 May 2014)

DeepState said:


> The concept is: what is your risk exposure? What can you hack? Protect the exposure that you can't handle via option or synthetic means.Cheers




The best and simplest way to deal with risk you can't handle is to not take it in the first place. To do that you really have to be fully around the first two points and that's where I believe people should focus.


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## McLovin (2 May 2014)

DeepState said:


> My favourite single line description of the potential for systemic collapse where humans are concerned:
> 
> A person is smart. People are dumb, panicky, dangerous animals, and you know it.
> 
> ”” Agent K




That is very good.


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## sinner (2 May 2014)

What craft said can be empirically proved as true.

The cheapest and most effective "hedge" is to simply go to cash (at least, for long only systems). 

Here is a good, recent article from Bronte Capital on the days when your hedging doesn't work and what to do 

http://brontecapital.blogspot.com.au/2014/01/when-hedge-doesnt-work.html

Here is a scathing review of Talebs work by Eric Falkenstein, a low volatility proponent who I generally agree with. Not to say there aren't black swans, but that low volatility investing is long term profitable whereas lottery ticket (clipped left tail of the return distribution) investments are not so. 

http://falkenblog.blogspot.com.au/2012/11/taleb-mishandles-fragility.html

http://falkenblog.blogspot.com.au/2010/12/nassim-taleb-imitates-kanye-west.html


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## DeepState (2 May 2014)

sinner said:


> Eric Falkenstein, a low volatility proponent who I generally agree with. Not to say there aren't black swans, but that low volatility investing is long term profitable whereas lottery ticket (clipped left tail of the return distribution) investments are not so.




+1 and then some.


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## craft (2 May 2014)

sinner said:


> What craft said can be empirically proved as true.
> 
> The cheapest and most effective "hedge" is to simply go to cash (at least, for long only systems).




Nice to see you back Sinner with your extensive links to resources.


Just to make it clear - I personally don't endorse going to cash as a risk control measure. Don't like cash in the first place and secondly a major risk you face if you are forced to go to cash for risk management is the slippage in actually getting there.

Correlation bombs are what sends most people running for risk cover and liquidity just doesn't exist in those times.

Many think him irrelevant - but once again Buffett has the most relevant quote to summarise what I think is the best risk control.



> Only buy something that you'd be perfectly happy to hold if the market shut down for 10 years




Implicit in that quote is that you can justify and hold the investment based on the performance of the business itself and ignore the risks that others face by being reliant on market price to justify their investments.


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## sinner (2 May 2014)

craft said:


> Nice to see you back Sinner with your extensive links to resources.
> 
> 
> Just to make it clear - I personally don't endorse going to cash as a risk control measure. Don't like cash in the first place and secondly a major risk you face if you are forced to go to cash for risk management is the slippage in actually getting there.
> ...




Hullo craft, thx, I think you will find that my participation is closely correlated to the types of discussion underway on the forum. 

Probably your experiences with "going to cash" are a bit different from mine, due to most of my experience being at the "global macro" level of sectors, indices and big liquid asset classes whereas from my understanding you tend to stick to single equity names on the ASX.



> Many think him irrelevant - but once again Buffett has the most relevant quote to summarise what I think is the best risk control.
> 
> Implicit in that quote is that you can justify and hold the investment based on the performance of the business itself and ignore the risks that others face by being reliant on market price to justify their investments.




I think it's extremely relevant, stocks are and should be viewed as representing the net present value of long term cash flows (just like all other investment securities) and therefore if you're not taking that into account it's likely that you are in fact speculating. The work of John Hussman on the inadequacies of the "Forward Operating PE" highlight this well. Interesting side note is that when it comes to predicting short term returns, valuations are useless. But when it comes to predicting long term returns (3,5,7,10Y), nothing does a better job than valuations.


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## sinner (2 May 2014)

and to highlight my last point, here is a different kind of "Return Distribution" chart, that of the distribution of returns over different starting valuations (in this case using the Q-ratio aka Tobins Q on the SP500)





From a paper by Mark Spitznagel titled "The Dao of Corporate Finance, Q ratios and stock market crashes", from back when he worked at the Taleb Universa fund...


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## sinner (2 May 2014)

and another distribution of (10Y) returns over starting CAPE (SP500)


From the (updated) seminal 2007 Mebane Faber paper "A Quantitative Approach to Tactical Asset Allocation"

you get the idea...


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## sinner (2 May 2014)

and finally if you look here 

http://gestaltu.com/2013/08/valuation-based-equity-market-forecasts-q2-2013-update.html

You can see how increasing the investment timeframe increases the explanatory power (r-squared) of almost any given valuation measure - although in the case of the 30Y column everything is less but I think that's because over periods >10-20Y then more variation can be explained by variations in inflation and interest rates etc


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## DeepState (2 May 2014)

Hi Sinner

Great stuff.  You have an awesome mental library facility. 

How would you reconcile the weaknesses of Price to Operating Earnings comment made by Hussman and the very juicy cross sectional predictability chart based on straight multiples just published above?

Cheers


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## sinner (2 May 2014)

DeepState said:


> Hi Sinner
> 
> Great stuff.  You have an awesome mental library facility.
> 
> ...




The weaknesses highlighted by Hussman are specifically in relation to the "Fed Model" using *Forward* Operating Earnings to represent the cash flows of the entire lifetime of the security...

"Long-Term Evidence on the Fed Model and Forward Operating P/E Ratios " - http://www.hussmanfunds.com/wmc/wmc070820.htm


> If an investor is going to use the current level of earnings to determine the reasonable price to pay for a long-term asset, it had better be true that those earnings represent a normal and sustainable level of profit. You wouldn't buy a lemonade stand by extrapolating the profits it earns in August.




Hussman is a big fan of CAPE and P/Sales, anything that better describes the cashflows of the security over its lifetime.

If you take the so called "Graham Value Stock Portfolio" from Scotts Investments (only just saw this recently) - http://www.scottsinvestments.com/2014/04/15/graham-value-stock-portfolio-update-5/ which is a sample value portfolio you can see using the trailing (rather than forward) OPE as a component of an aggregate value score it works OK in a practical sense and this is confirmed in academic research.

EDIT: Also the multiples above are CAPE as in PE10, not PE1 and Q ratio which is more akin to Price/Book. You can see from the r-squared graph that explanatory power for PE1 is much lower than PE10 for all timeframes.


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## craft (2 May 2014)

sinner said:


> and to highlight my last point, here is a different kind of "Return Distribution" chart, that of the distribution of returns over different starting valuations




And another from Crestmont research based on USA data.

20 year rolling market return based on starting P/E.


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## craft (2 May 2014)

This is interesting too.

especially the break-up of the 10 year return into components.


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## sinner (2 May 2014)

and lastly, to make sure OPs question isn't left unanswered I present 

I recommend having a read of " A Value Investor’s Perspective on Tail Risk Protection:An Ode to the Joy of Cash" by GMOs James Montier, presented here http://trendfollowing.com/whitepaper/JM_TailRisk_611.pdf

as a well researched and thoughtful perspective on the topic (which interestingly enough also shows how simple rebalancing 75/25 stocks/cash can outperform in certain market regimes)

EDIT: even something for craft in there



> As Warren Buffett has said, holding cash is uncomfortable, but not as uncomfortable as doing
> something stupid


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## DeepState (2 May 2014)

sinner said:


> The weaknesses highlighted by Hussman are specifically in relation to the "Fed Model" using *Forward* Operating Earnings to represent the cash flows of the entire lifetime of the security...
> 
> 
> Hussman is a big fan of CAPE and P/Sales, anything that better describes the cashflows of the security over its lifetime.
> ...




Yup.  Thanks.

Basically stabilized earnings produces better outcomes than unstabilised ones. Part of this can be overcome by looking within economically coherent sectors or, otherwise, groupings.  The cross section there applying Fwd whatever should be comparable to a higher degree than across the entire market.  Two lemonade stands have earnings that a more comparable than lemonade vs iron ore.  Hence cyclical peaks and troughs ought to match up more closely and the differences in the valuations should provide a better indication of future cross sectional return. Even then, the CAPE style measures should still be enhancing where firms have stable growth patterns.

I still have no good answer for firms coming into profitability after a build phase or which are moving into resource depletion.  CAPE style measures would probably kick off misleading signals.  Nothing is perfect I guess.  

Thanks for the EDIT.  What's what I needed to see.


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## sinner (2 May 2014)

DeepState said:


> I still have no good answer for firms coming into profitability after a build phase or which are moving into resource depletion.  CAPE style measures would probably kick off misleading signals.  Nothing is perfect I guess.




Not 100% certain but I think you can use Price/Sales, which is essentially Price/Earnings-adjusted-for-profit-margins (at least according to Hussmans latest missive) but as you noted this requires more due diligence to ensure not just idiosyncratic but also relative valuations.


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## DeepState (2 May 2014)

sinner said:


> Not 100% certain but I think you can use Price/Sales, which is essentially Price/Earnings-adjusted-for-profit-margins (at least according to Hussmans latest missive) but as you noted this requires more due diligence to ensure not just idiosyncratic but also relative valuations.




Price to Sales, Price to EBITDA, Price to CF, trend as opposed to CPI adjusted of the lot are all used.  All work.  It's bloody amazing.  Particularly at aggregate market levels where things are pretty much as stable as we are practically going to find and thus suitable for extrapolation via such means.

Even still, inside a market, the firms in those situations as first sale or depletion would have hockey stick up/down sales etc. and trend adjustments will lead us to come to the wrong conclusions.  Guess we need to still lift our heads and think.  Dammit.

Thanks


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## craft (2 May 2014)

sinner said:


> and lastly, to make sure OPs question isn't left unanswered I present
> 
> I recommend having a read of " A Value Investor’s Perspective on Tail Risk Protection:An Ode to the Joy of Cash" by GMOs James Montier, presented here http://trendfollowing.com/whitepaper/JM_TailRisk_611.pdf
> 
> ...




I find Montier excellent.

Liquidity value of cash has always been a perplexing question for me. KTP resparked the question below when he eluded to the liquidity value of short positions at opportune times to go long.

The way I think about it is to add an option value to what I could get from  cash (or a short side approach etc). 

So cash will get you about 4% now and I add a % to that figure for the extra I could make if I waited to invest as opposed to investing now. – That becomes the hurdle rate where I would stay in cash rather than deploy it. 

Estimating the liquidity option value is pretty subjective – it depends on so many unknowable future events. For me and my skill/temperament set I think its somewhere around 3%. Mostly I can find some opportunity that meets a (current minimum 7%) hurdle rate and don’t tend to delay purchase.  So my cash exposure is generally limited to only liquidity buffer for 5 years of living expenses.


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## sinner (2 May 2014)

DeepState said:


> Even still, inside a market, the firms in those situations as first sale or depletion would have hockey stick up/down sales etc. and trend adjustments will lead us to come to the wrong conclusions.  Guess we need to still lift our heads and think.  Dammit.
> 
> Thanks




Make an arbitrary decision like "all stocks in universe must have 5Y earnings history" and then rank on earnings stability (e.g. rolling standard deviation of QoQ earnings change - or similar measure)...


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## craft (2 May 2014)

DeepState said:


> Price to Sales, Price to EBITDA, Price to CF, trend as opposed to CPI adjusted of the lot are all used.  All work.  It's bloody amazing.  Particularly at aggregate market levels where things are pretty much as stable as we are practically going to find and thus suitable for extrapolation via such means.
> 
> Even still, inside a market, the firms in those situations as first sale or depletion would have hockey stick up/down sales etc. and trend adjustments will lead us to come to the wrong conclusions.  Guess we need to still lift our heads and think.  Dammit.
> 
> Thanks




Once you found the spot to go fishing nothing beats bottom up business analysis


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## DeepState (2 May 2014)

craft said:


> And another from Crestmont research based on USA data.
> 
> 20 year rolling market return based on starting P/E.
> 
> View attachment 57815




The P/E should really be adjusted for discount rates prevailing at the time.  A stock at p/e 10x is much cheaper when bonds are at 2% than when they are at 10% all else equal.  If you look at charts showing P/E vs interest rates it shows a relationship between P/E and interest rates as might be expected.  So I'm puzzled as to why CAPE is always shown in absolute terms vs subsequent equity return (which really should be equity risk premium).  

This is all theoretical BS, but a lot of the people producing this stuff often go to the trouble of making heaps of different adjustments to make the underlying concept more accurate.  But not here.  Shiller uses these straight up....and everyone else follows. It also has strong empirical outcomes.

I raise this because CAPE shows US as being in the drop zone.  US 10yr is 2.62%...If that's what you can buy bonds for, a fair P/E should be higher than usual.  And, in a recent interview, Buffett, who uses a cash rate type discount rate indicated that the market is in the fair value zone.  This is entirely different conclusion to CAPE.


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## DeepState (2 May 2014)

craft said:


> Once you found the spot to go fishing nothing beats bottom up business analysis




I'll pay $1 for that.


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## craft (2 May 2014)

DeepState said:


> The P/E should really be adjusted for discount rates prevailing at the time.  A stock at p/e 10x is much cheaper when bonds are at 2% than when they are at 10% all else equal.  If you look at charts showing P/E vs interest rates it shows a relationship between P/E and interest rates as might be expected.  So I'm puzzled as to why CAPE is always shown in absolute terms vs subsequent equity return (which really should be equity risk premium).
> 
> This is all theoretical BS, but a lot of the people producing this stuff often go to the trouble of making heaps of different adjustments to make the underlying concept more accurate.  But not here.  Shiller uses these straight up....and everyone else follows. It also has strong empirical outcomes.
> 
> I raise this because CAPE shows US as being in the drop zone.  US 10yr is 2.62%...If that's what you can buy bonds for, a fair P/E should be higher than usual.  And, in a recent interview, Buffett, who uses a cash rate type discount rate indicated that the market is in the fair value zone.  This is entirely different conclusion to CAPE.




Some more on inflation (discount rate driver) in relation to PE from Crestmont.





Crestmont do (and I agree) consider discount rate in their assessments. From their latest P/E report.



> CONCLUSION
> Today’s P/E is approximately 26; the stock market remains in secular bear market territory””
> close to the mid-range of fair value *assuming a relatively low inflation and low interest rate
> environment*.


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## KnowThePast (2 May 2014)

sinner said:


> and lastly, to make sure OPs question isn't left unanswered I present
> 
> I recommend having a read of " A Value Investor’s Perspective on Tail Risk Protection:An Ode to the Joy of Cash" by GMOs James Montier, presented here http://trendfollowing.com/whitepaper/JM_TailRisk_611.pdf
> 
> ...




Thanks sinner!

It was his book that initially got me thinking of shorts as a hedging strategy.

DeepState, thanks for the answer once again.


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## craft (5 May 2014)

DeepState said:


> The P/E should really be adjusted for discount rates prevailing at the time.  A stock at p/e 10x is much cheaper when bonds are at 2% than when they are at 10% all else equal.  If you look at charts showing P/E vs interest rates it shows a relationship between P/E and interest rates as might be expected.  So I'm puzzled as to why CAPE is always shown in absolute terms vs subsequent equity return (which really should be equity risk premium).
> 
> This is all theoretical BS, but a lot of the people producing this stuff often go to the trouble of making heaps of different adjustments to make the underlying concept more accurate.  But not here.  Shiller uses these straight up....and everyone else follows. It also has strong empirical outcomes.
> 
> I raise this because CAPE shows US as being in the drop zone.  US 10yr is 2.62%...If that's what you can buy bonds for, a fair P/E should be higher than usual.  And, in a recent interview, Buffett, who uses a cash rate type discount rate indicated that the market is in the fair value zone.  This is entirely different conclusion to CAPE.




Hi RY

This might interest you in relation to ERP and the Aust Market.




It was a pretty good indication in June last year when last discussed.

https://www.aussiestockforums.com/forums/showthread.php?t=23385&p=710550&viewfull=1#post710550


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## DeepState (5 May 2014)

craft said:


> Hi RY
> 
> This might interest you in relation to ERP and the Aust Market.
> 
> ...




Thanks Craft.  Appreciate it. Nice chart and mostly in line with what I expected to see - in terms of the inverse relationship.  Interesting that the time series was broken into the pre-float regime and post-float.  Pre-float ERP showing much more elasticity to 10 year yield and much more poorly fitting than the post-float era.  Guess that the loss of that source of economic flexibility meant that the markets absorbed more of a hit than they do today, under the current monetary regime.  Also, the composition of the index then was much more heavily tilted towards resources than they are today.  So I guess it all makes sense.  

However, the steepness of the relationship in the post float era also suggests that the change in ERP is largely driven by changes in the bond yield with little left for PE rerating.  In other words ERP is less sensitive to the level of 10 yr bond rate than before.  To the point that PE doesn't move all that much for different interest rate levels. This is a correlation, not causational statement.  That's puzzling. It suggests a very weak relationship between PE and bond yields. And, whilst moving to AUD float can expect to absorb some economic shocks, I did not expect this.

This is a kind of "Fed Model".

Despite the theoretical attraction (I think what we do should match some underlying theory or at least rough economic understanding of a stable relationship if no formal theory has been developed), we then have the fly in the ointment of Hussman who said in his latest note ("The Future in Now"):

"The Federal Reserve has stomped on the gas pedal for years, inadvertently taking price/earnings ratios at face value, while attending to “equity risk premium” models that have a demonstrably poor relationship with subsequent returns. As a result, the Fed has produced what is now the most generalized equity valuation bubble that investors are likely to observe in their lifetimes."

If our theory does not match the reality in terms of the chart and then Hussman....then, what the heck?

This may also be tangentially relevant to you in terms of using long term valuation measures to determine intrinsic long term valuation - not taking anything at all away from the concept you are pursing and which I am as well in terms of market aggregates.

Thanks for the provocation.  Shall look into this a bit further.  It doesn't make immediate sense to me but the results are the results.

Thanks again for all your contributions.


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## craft (5 May 2014)

DeepState said:


> Thanks Craft.  Appreciate it. Nice chart and mostly in line with what I expected to see - in terms of the inverse relationship.  Interesting that the time series was broken into the pre-float regime and post-float.  Pre-float ERP showing much more elasticity to 10 year yield and much more poorly fitting than the post-float era.  Guess that the loss of that source of economic flexibility meant that the markets absorbed more of a hit than they do today, under the current monetary regime.  Also, the composition of the index then was much more heavily tilted towards resources than they are today.  So I guess it all makes sense. .




I split the time series based on the logic that the a floating currency does a fair bit of the economic lifting - the fit of the data seemed to agree with the logic. 



DeepState said:


> However, the steepness of the relationship in the post float era also suggests that the change in ERP is largely driven by changes in the bond yield with little left for PE rerating.  In other words ERP is less sensitive to the level of 10 yr bond rate than before.  To the point that PE doesn't move all that much for different interest rate levels. This is a correlation, not causational statement.  That's puzzling. It suggests a very weak relationship between PE and bond yields. And, whilst moving to AUD float can expect to absorb some economic shocks, I did not expect this.
> .




The steepness of the relationship surprised me a little bit as well, but I guess that's why we look at data. One important thing to remember (and may not be obvious if you didn't look back at the linked thread) is that the Earnings used to calculate ERP is "Trend Earnings" Both trend earnings and regressed GDP earnings are above current earnings in Aus at the moment.




DeepState said:


> This is a kind of "Fed Model".
> 
> Despite the theoretical attraction (I think what we do should match some underlying theory or at least rough economic understanding of a stable relationship if no formal theory has been developed), we then have the fly in the ointment of Hussman who said in his latest note ("The Future in Now"):
> 
> ...




I don't have much trouble reconciling what I am seeing in Aus data to what Hussman is saying about US. We are a different market, we have a stronger currency at the moment, Current earnings are below trend. We have higher interest rates. The updated chart has moved away from indicating the type of potential it did in June last year, but it's more indicative of fair (considering inflation/interest rates) than overvalued.


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## DeepState (5 May 2014)

craft said:


> 1. The steepness of the relationship surprised me a little bit as well, but I guess that's why we look at data. One important thing to remember (and may not be obvious if you didn't look back at the linked thread) is that the Earnings used to calculate ERP is "Trend Earnings" Both trend earnings and regressed GDP earnings are above current earnings in Aus at the moment.
> 
> 
> 2. I don't have much trouble reconciling what I am seeing in Aus data to what Hussman is saying about US. We are a different market, we have a stronger currency at the moment, Current earnings are below trend. We have higher interest rates. The updated chart has moved away from indicating the type of potential it did in June last year, but it's more indicative of fair (considering inflation/interest rates) than overvalued.





Thanks again Craft, truly inventive. 

1. I caught the link and see you are using trend (and have calculated GDP inflated).  So you have produced a type of Earnings as per Shiller except his standard measure inflates earnings by CPI/PCE or its equivalent and divided it by current market.  These show that Australia is under-earning relative to trend.  I agree, based on my own stuff, via chart below which is prepared on exponential trend over the last 10 years (the Shiller period and long enough to detrend, yet short enough that comparative universe issues don't become overwhelming).




The steepness of the line indicates that trend-adjusted PE doesn't move much. Almost all of the Equity Premium as you measure it is driven by variation in bond yields.  So the signal could readily be used for bond yield forecasting rather than equity return forecasting.  How ironic! Here we are hunting for cheap/rich equities and what we find instead is a bloody strong forecast variable for 10 year bonds!  Very Newton-like.  Most discoveries are accidential, I guess.

2. I think we are talking about different things here.  On the grounds of this type of analysis and its close variants, I agree that the US is expensive to some extent and Australia screens up as in the fair value range.  The issue is that Hussman claims this sort of equity risk premium model, roughly what the Fed uses, has poor forecasting power.  He just uses straight up Shiller measure and this shows to have a lot of predictive power, presumably more than these models.  That cheeses me off!

Part of the answer to that quandary may lie in the fact that the effort to adjust for interest rates actually detracts from forecasting power.  There are several good reasons why this might be in practice.  These defy standard theoretical valuation approaches which do not take into account the forecasting power inherent in bond yields.  Hence they represent a challenge to what we are attempting here.  I like the basis of the approach and I use it as a stepping stone for the calculation of a discounted cashflow-based valuation metric which takes a few other things into account, but, according to Hussman at least, we are barking up the wrong tree.  I think he's cleverer than me...so I guess I'm screwed. Not.


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## craft (5 May 2014)

Daily ASX200 EPS –You have access to good data! – supplier?

The reconciling with Hussman was only in regards to his conclusion that US is expensive whilst I think the data shows Aust is fair.  I haven’t followed him closely enough to comment on the correctness or otherwise of  what he thinks does or does not have predictive power. (and besides as you might guess - I don't care either)

Cheers


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## DeepState (5 May 2014)

craft said:


> Daily ASX200 EPS –You have access to good data! – supplier?




EPS data supplied from pretty much all the active brokers, as adjusted.  So these are 'above the line' figures. Rolling 12 months are calculated by splicing these together as required via an appropriate weighting scheme.  Data aggregator is FactSet.


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