Sleeping Beauty

I have been wanting to write something inspired about the markets but I have very little to say as frankly I feel like my emotional tank is running on reserves. I want to write something personal before making a simple but fundamental comment about the way to successful investing.

Yesterday I saw this post on Facebook which couldn’t have been more appropriate as we were admitting my 15yr old daughter into hospital for chronic fatigue syndrome and fibromyalgia. For those not familiar how debilitating this condition can be; over the last 5 months my daughter has been sleeping 20hrs a day fighting pain 24/7. Her life has simply been put on hold. No school, no socializing, no fun, frankly no life. For a parent to watch helplessly on the sidelines is one of life’s real challenges.

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The message I wish to draw from this difficult experience is simply that in life some of the most important principles are so basic that we tend to ignore their importance.

Watching my Sleeping Beauty sleep hour after hour I am realizing how precious every moment every experience is. When someone is denied something so basic as going to school, going out with friends, walking around without pain then we realize how blessed we are when we can do the basic things in life and how for granted we take these blessings.

It almost feels inappropriate to discuss the markets in the same context of this message but I feel we have lost our way when it comes to investing. If you think you are investing when you buy and sell shares on the market you are probably following some misguided belief. At the end of the day investing is about buying the market when its cheap and selling when its expensive. Do you get any simpler than that?

Norbert Keimling from StarCapital put some nice charts together using the CAPE (cyclically adjusted price-earning) ratio, otherwise known as the Shiller PE ratio to measure whether a market is cheap or expensive.

What you see is that the cheaper the market is in when you invest the better your future returns will be. The markets are breaking to new nominal highs, and the US is at its 2nd most expensive point in its history using CAPE, so you decide whether now is a good time to be investing in the markets.

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Operating Earnings Extrapolation & The Butterfly Effect

There is nothing like the emotional roller coaster that comes with managing an investment portfolio. Most of you don’t know me in this capacity but rather as an allocator of funds. To get my head back into the markets as an investor I decided last month to manage a hypothetical portfolio, in full view of all on the internet. I have done this for 2 reasons:

  1. I think I am a really good manager 😉
  2. The personal growth that comes from struggling ones own personal biases, is unmatched by almost all other professions in my opinion and will provide readers of this blog an insight into the “hero’s journey.”

So without further a due visit this link at any time to view my performance and follow the blog, my goal is to outperform the S&P 500 on a risk adjusted basis over the long term.

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Let us start this analysis by looking at a few valuation metrics at the market peaks and valleys. The key focus point here is that the chart presents P/E on an estimated 1yr forward operated earnings basis. As an aside most people simply rely on 1 year historic earnings. Readers of this blog and people who have read my commentaries for a number of years, will know I favour the Shiller/ CAPE 10 yr methodology. The current Shiller P/E ratio is 19.67 versus a 100 year mean of 15.53

S&P bubble Q4 2014

Let us look at how well people forecast 1yr forward operating earnings. The average forecast error is -2% with a large -17.9% std deviation. You can see that people don’t forecast trend changes too well.

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According to the S&P website the forecast operating earnings for 31 Dec 2015 is $131.01 which is a 14% increase on the preliminary 09/30/2014 actual of $114.51.

In 1890 Henri Poincare developed his three body problem the precursor to Edward Lorenz 1961 discovery of the butterfly effect which forms the basis of chaos theory. As per Wikipedia’s definition, “the butterfly effect is the sensitive dependence on initial conditions in which a small change in one state of a deterministic nonlinear system can result in large differences in a later state.”

So what does all this mean, what is my point? It is actually quite simple. I am trying to illustrate that people capitalizing a naive 1 yr forward earnings into perpetuity which has a notorious empirical history of being highly variable, is likely to have a devastating butterfly effect.