12. Putting It Together

By this point, your head is probably spinning. You’re thinking to yourself, what is this guy talking about? He’s giving me a piece of data here, you mutter, another over there, but all I really need is a quick and easy formula along with a user’s manual; something that will make tumultuous financial markets click into focus.

Believe me, I feel your pain (and that is more than just words). You’re going through exactly what I suffered when I began trying to read the market’s mind decades ago. Because I wasn’t just managing my own finances but was responsible for the retirement savings and financial well-being of thousands of clients, I knew that I had to find a way to address that confusion. The methodology that I have just outlined for you is the result of years of trial and the occasional error. This methodology has been a valuable way for me to impose at least a degree of order on the chaos that the financial markets can appear to be. Constructing a robust investment process such as this is a bit like building a new house, one that won’t let in the rain or snow, will withstand earthquakes and high winds, and will be comfortable to live in. What I have done so far is steer you to the right materials to build this new house: the investment equivalents of, say, bricks, mortar, copper pipes for the plumbing, and wooden joists. But when you build a house, you need architectural plans to tell you how deep the foundations need to be, how to appropriately support the second story, where to put the fireplace and chimneys, and so on. Similarly, when you construct an investment process, you need not only the right materials to help you make decisions (the metrics that make up each of the five factors that I’ve shared with you), but also a plan that enables you to use that data in the right way. Thanks to the Internet, you have at your fingertips more information than any other generation in history. Now it’s time to take a step back and look at the bigger picture: How on earth, with so much potentially useful data to draw on, should you go about selecting which tool to use at any given time?

Just as we all want to live in a house that corresponds to our own needs and preferences (one builder may need a home office; another, extra bedrooms to accommodate five children; a third, a self-contained apartment where the grandparents can live independently within the family), so everyone’s specific investment needs will differ. Similarly, this kind of global macro decision making needs to take place within the context of a well thought-out strategic asset-allocation plan that takes into account your specific return objectives, cash flow and liquidity needs, and risk tolerance. Only then can you judge which investment decisions and market shifts will have the greatest impact on your own portfolio. That is why a recipe that works for me or works for my clients may not be the right one for you, in your specific investment circumstances. Providing you with a “one size fits all” formula, while you may heave a sigh of relief today, would be doing you a disservice in the long run. I will react to the same metrics differently than you do, and that is just as it should be, because my goals and considerations are different from yours. Equally, the way that I respond to a given situation in managing my personal “point and click” trading portfolio is likely to vary from the decisions I make with respect to the broader funds that I run on behalf of others. So, although I can give you the tools and even some hints about how to design the right kind of plan, ultimately the final decisions are in your hands. This is the point at which investing becomes as much of an art as it is a science.

I can, however, steer you in the direction of some broad guidelines or strategies. Still, before doing so, I need to remind you of the myriad ways that your emotions will conspire against you in your efforts to use metrics to “read” the financial markets. We’ve already discussed some of these in detail earlier in this book, such as the psychological comfort that comes from being part of a crowd. In the spring of 1999, for instance, the Fed funds valuation metric was telling me loud and clear that it was time to lighten up on stocks. Doing so, however, meant I would have had to break ranks with my peers—never an easy thing to do or to explain. Of course, with 20/20 hindsight, the signal was absolutely accurate—and a 3-year slump began less than a year later—but at the time this was the only metric giving me a definite indication that stocks were overvalued and poised for a selloff. Indeed, other metrics were telling us not to panic, giving me a reason to stay invested and remain in my comfort zone. Market momentum was strong; investor sentiment was robust, with Investors Intelligence reporting that bulls outnumbered bears by a ratio of two to one, and Treasury market metrics suggesting economic conditions were improving. I fretted about the decision. Which metrics should I trust? Like any other Chicago Cubs fan, I enjoy sitting in a ballpark among thousands of like-minded people, cheering my team on. But just because I’m going to cheer them on doesn’t mean I’m irrational enough to risk my hard-earned capital (or that of my investors) betting on the risky proposition that they may, after more than a century, make it all the way to a World Series. Especially when at least one key indicator was flashing a warning sign. By the late summer of 1999, more metrics were coming into line with the core valuation signal and were giving me more confidence that my judgment to lighten up on stocks had been correct. Although the stock market was still advancing, fewer stocks contributed to each new high, and the yield curve was flattening.

It’s easy to look back in time at a big turning point like that one. What you will find, as I have, is that applying a metrics-based process to the investment decisions you need to make today and tomorrow requires not only confidence but hard work and patience. To start with, not every turning point is as dramatic as that of 1999, so we all need to pay attention to the subtlest signals that financial markets emit in order to boost the odds of long-term outperformance. That’s why I study the metrics that make up each of these five factors every day of the week. It is why every day, every week, and every month I review my asset allocation in light of any changes and stand ready to recommend changing our weighting in any asset class or category depending on what those metrics tell me.

This is where we confront one more human foible: impatience. If what you are looking for is a simple, clear-cut recipe for investment success, I’m afraid you’re about to be disappointed. If I told you that whenever the price/earnings ratio of large-cap stocks creeps above x you need to take a teaspoon of psychology and mix it with 2 cups of valuation and a half-cup of momentum to get a clear buy or sell signal, I’d be selling you a bill of goods. Using factors is all about taking time to study and think about them; it’s about using judgment. Any game, whether it’s old maid or chess, comes with rules that players have to learn. But any moderately intelligent person can triumph at hearts after a few hours, whereas winning at chess or bridge—like “winning” in investing—requires an extra edge: strategic thinking. Of course, just as bidding conventions in bridge and acknowledged game openings or strategies in chess exist, there are some rules of thumb when it comes to the kind of quantitative-based global macro investment process I am urging you to devise. For instance, it’s generally a good plan to put your spare cash to work in a market that looks cheap in absolute and relative terms and that already seems to be moving in the right direction. But the key to strategic thinking is a kind of sixth sense that should be added to these five factors. Only time and a greater familiarity with the metrics that comes from using them will tell you when it’s time to ignore what one factor appears to be signaling, when to emphasize what another set of metrics is telling you, or when you need to give a greater weight than you have historically to another factor.

Let me show you some of the ways that different factors can work together, or conflict, in a real-life scenario that probably is still clear in your memory. Let’s go back to the aftermath of the bear market of 2000 to 2002, when all professional investors were eagerly awaiting signs that the market was about to begin a long-awaited recovery. Just as it had been hard for even risk-averse investors to abandon the bull market in late 1999, thinking of investing during the agonizing summer of 2002 was painful with the collapse of Enron and WorldCom fresh in our minds and the headlines. Nonetheless, by June 2002, I was champing at the bit. I knew that keeping an outsize position in bonds and remaining dramatically underweight in stocks wasn’t a tenable strategy for long-term outperformance. Keeping in mind that the first and most significant decision investors can or should make is how to divide their portfolio between stocks and bonds, I was waiting for the five factors to tell me when the moment of maximum opportunity and minimal risk had arrived. Only then could I take the next step and start exploring which segments of the stock market offered the best opportunities.

As I’ve pointed out, valuation is the lynchpin for any investment process. A compelling valuation argument must be in place for the portfolio structure you build to rest on solid foundations. So, if you’re looking for signs that large-cap stocks are about to outperform, turn to valuation metrics. Is the prospective earnings yield on the S&P 500 (the barometer of large-cap stocks) at least as rosy as that for the yield on an index of triple-B bonds? (Check any of the many available data sources for this information. To calculate the earnings yield, just take the forward price/earnings ratio on the S&P 500 and flip the numbers so that a P/E ratio of 14 becomes a 1/14th for a percentage of 7.14%.) If the fundamental metrics are sending encouraging signals, you can move on to other key factors, such as the economy: Is it expanding or contracting? Economic metrics that we have already discussed, such as the yield curve, should give you some clues. Cue the next factor: liquidity. How much dry powder is available in the market, and how great is the tolerance for risk? Again, looking at metrics will tell us how much capital is sitting on the sidelines; credit spreads will give us clues to how much investors want to be paid for taking on more risk, as spelled out in the pages of Barron’s, which tracks the spread between yields on intermediate-grade and top-tier bonds. (An additional tip: Downloading a decade’s worth of this data into a spreadsheet will give you a solid historical basis for comparison.) Now you can take a look at the fourth factor: market sentiment, or investor psychology. Use metrics to take the market’s emotional temperature: Are investors complacent or fearful? Finally, momentum, the factor that, in many ways, stands shoulder to shoulder with valuation as vital in shaping an investment decision. If valuation is giving you a green light but momentum metrics are telling you equally urgently that hitting the “buy” button would be dangerous, you need to watch out. Once momentum falls into place and all five factors align, it’s a beautiful thing.

Watching the market in the summer of 2002, all five factors did seem to be forming an encouraging pattern. By June, the S&P 500 had lost 18% over the course of the previous 12 months, enough to bring the forward earnings yield on the S&P 500 back above that on the 10-year Treasury note. The Fed model was telling me, loud and clear, that large-cap stocks were now more than 5% undervalued. It was the buy signal for which I had been waiting. But I still wanted the other factors to confirm that it was time to act on that green light, and the critical one—momentum—wasn’t obliging. Market breadth, measured by the ratio of the number of stocks advancing to those declining, kept telling me that the market was stuck in a funk. The result was a stalemate.

Whenever that happens, and especially whenever a crucial turning point may be at hand, (something that only happens a few times in a decade), I turn to the secondary factors and dig more deeply into the metrics there to see what they tell me. By the middle of 2002, the bear market had taken a toll on investors’ psyches, and bears outnumbered bulls by two to one. By December, with the key valuation metric egging me on by reminding me that large-cap stocks were now 30% undervalued, bearishness was growing, and market sentiment was also pointing in the same direction. All that I needed to tell me that it was safe to jump back into the stock market, I concluded, was a positive reading on the momentum front. That came at last in March 2003, when the market’s breadth began to improve. At last, more stocks were advancing than declining in any given trading session. A month later, the S&P 500 climbed more than 4 percentage points above its 200-day moving average. At last: an attractive entry point! I recommended being underweight to overweight in stocks in clients’ portfolios, and over the next 12 months watched the S&P soar 23%.

I’m not suggesting that catching the end of the 2008 bear market will be simple or straightforward. But using metrics in this way—carefully, with patience and discipline—you will be able to feel your way back into stocks when the time is right, whether that is on the day you first read this or perhaps not for another two or three years. At some point, it will become clear to you, reading the signals that metrics are sending, that investing still more in the safe haven of Treasury securities will amount to investing in an overpriced market. Whenever a particularly dramatic rally or selloff has occurred, as happened during the fourth quarter of 2008, it’s particularly important to monitor metrics. It is during the times when the upside/downside risk is less visible that discipline and strategic thinking come into play. To be successful—to capture or at least be aware of all the potential investment opportunities on a global macro basis—you need a process that reviews all your options on a regular basis, even when you’re not looking for an entry point into a depressed market or a clue that it’s time to take your money out of one that you already suspect is significantly overvalued. In other words, you need a disciplined approach.

Although there is no one-size-fits-all investment process, you should apply some rules of thumb when studying and using metrics to reach an investment decision, whether you’re contemplating a major asset-allocation shift or simply undertaking a routine review.

Think about what the metrics appear to be telling you. Don’t accept the signals they appear to be sending without question or further thought. In early 2006, the yield curve inverted: Suddenly, the yields on the shorter-term Treasury securities were higher than those on longer-dated Treasury notes. This time around, however, the yield curve inversion reflected a global liquidity rush as trading partners in the emerging markets (notably China) parked their surplus in U.S. Treasury securities, distorting the yields on those Treasurys.

What might be happening in the financial markets that isn’t yet showing up in the metrics (for one reason or another)? Are the metrics telling you the whole truth? In the immediate aftermath of the September 11 terrorist attacks, investors weren’t reacting only to events but to the atmosphere of uncertainty that those events had created. What would the fallout be from another terrorist attack? That kind of hour-to-hour uncertainty translated into a lack of trust in the authorities, ranging from political leaders to corporate CEOs, a lack of trust that later disclosures of corporate malfeasance at companies such as Enron seemed to validate. Most important from the perspective of an investor, it translated into an absolute and utter risk aversion. Investors may not have been able to control what the terrorists might do next and the risks linked to terrorism, but they could control whether they invested capital in the financial markets. Not surprisingly, they sat on their cash. In that environment, traditional liquidity metrics didn’t reflect fundamentals.

Ask yourself whether there are new metrics available that might provide a better picture of the investment landscape. The world is in a state of flux. New markets emerge that behave in new and different ways, and tried-and-true metrics may give way to new and improved quantitative tools. Years ago, for instance, measuring equity mutual fund cash balances as a percentage of total equity mutual fund assets was a useful liquidity metric. These cash balances theoretically represented money available to be put to work in the market (and could thus fuel a future rally). As investors flocked to index funds, however, mutual fund managers trying to beat an index couldn’t afford to let much cash sit idle for long. Monitoring cash balances became obsolete because the data point no longer had any real significance; the fact that they were low had little or nothing to do with how managers viewed market valuations or opportunity.

Are you keeping an eye open for even the most unlikely or unexpected possibilities? Sometimes that means battling your preconceptions. Commodities, for instance, are an asset class that has for decades at a time languished on the sidelines. Unlike stocks or bonds, owning gold, oil, or copper futures doesn’t generate any cash flow or dividends. (Indeed, thanks to the structure of these markets, anyone who wants to maintain a position in commodities has to pay for the privilege.) It’s hard to monitor fundamentals: No entity such as Gold Corp. or Copper Inc. reports quarterly profits or losses and discusses risk factors in filings with the Securities and Exchange Commission. Therefore, figuring out the “fair value” of a commodity itself (rather than a mining company, say) may be nearly impossible. When it comes to gold, a commodity whose value lies strictly in the eye of the beholder and that has very few industrial uses, the task is even trickier. And yet, bypassing commodities isn’t the answer, either. While the period from December 1986 through November 2007 saw a measly 2.3% annualized return for the Commodity Research Bureau’s index of spot commodity prices (compared to 11.4% for the S&P 500 and 7.7% for bonds), at times throughout that period investors who spotted temporary supply/demand imbalances could have made a lot of money, particularly in the bull market of 2003 to 2007.

Just because familiar metrics aren’t there or don’t work in a familiar way doesn’t always mean that an asset class is a bad idea. Over a 5-month period in 2001, the Federal Reserve slashed its key lending rates, bringing the Fed Funds rate and its companion interest rate down to 3.5% from 6.5%. The goal was to fight off a potential recession; the result was a clear buy signal for commodities. But the thought of adding commodities to private client accounts was unusual, to say the least. If I was going to go out on this limb, all five factors needed to be in alignment, I decided. But despite the growing importance of commodities to many investors, the market had only three useful sets of metrics: the relationship between the Fed Funds rate and the consumer inflation rate, the 200-day moving average of an index, and the breadth of any index move. That’s it. I would have to find a way to rely on what I would normally consider to be inadequate data. Ultimately, in March 2002, the Dow Jones AIG-Commodity Index finally climbed more than 4 percentage points above its 200-day moving average. At last the commodities market’s fundamentals seemed positive, in both absolute and relative terms, and the momentum indicators were in place. Thankfully, at about the same time, PIMCO, a global investment management firm, introduced their Commodity Real Return Fund, so gaining access to commodities became as easy as buying mutual fund shares at just the right point in time. As a result, we recommended a portion of client portfolios be allocated to commodities, and over the next 4 years we generated annualized returns of 16.7% from this move in a period when the S&P earned a much more modest 9.3% on an annualized basis. We closed out those positions in 2006 when the commodities index fell more than 4% below its 200-day moving average and as Federal Reserve policy makers began to raise interest rates once more.

What asset class do I sell to generate cash to invest in the commodities market if I spot another opportunity there? And when I sell an investment, where do I direct the proceeds? Almost as important as the investment decision itself is the origin of the proceeds used to fund the investment. Sometimes the ultimate source or use of funds can be as challenging as the investment itself. In the absence of any terminology devoted to this tricky subject, a veteran investor and friend of mine, Ron Laughlin, once dubbed the asset class or securities purchased with the proceeds of a sale a “gazinta,” a nonsense word derived from the phrase goes into (as in, “what the proceeds go into”). For the most part, you won’t need to resort to nonsense words like that. The metrics, if you calculate them properly and use them consistently, will offer you a cool and unbiased view of the relative merits of each investment option. Ultimately, however, the answer will hinge on your personal attitudes and circumstances—and it’s one point where it’s appropriate to consider your own biases, such as your tolerance of risk. You might conclude that this global macro approach to investing is appropriate for only part of your portfolio, where you are comfortable making gradual shifts in asset allocation. If you are concerned about the tax consequences of making portfolio changes, you may decide to limit your active asset-allocation decisions to portfolios sheltered from taxes, specifically retirement accounts such as IRAs and 401(k)s. (Alternatively, you might be a more aggressive investor with a longer-term horizon and less tax sensitivity and thus more comfortable with making frequent, larger allocation shifts, including style tilts across the entirety of your portfolio.) Suppose that all five factors agree that stocks look pricey. One investor might react by slashing his allocation to stocks and even establishing a short position that would allow him to profit from future declines in a major market index. Another might simply decide to take some extra cash that might otherwise have been allocated to buying stocks over a period of time and direct it toward another asset class instead, leaving her core holdings untouched. The two approaches will result in different returns and incur a different degree of risk. Both, however, fall under the broad outlines of my factor-based approach to investing, and both are equally appropriate as long as the investors have considered carefully their personal circumstances as well as what the factors say about the investment environment

But, I can almost hear you ask, aren’t there some rules of thumb associated with the five factors that apply to all investors? Absolutely. So the first question always to ask yourself is whether stocks look like a safe and attractive investment, relative to your other options, whatever those may be. Indeed, given the long-term tendency of stocks to outperform bonds (as noted at the beginning of this analysis, over the past 18 years, stocks have delivered annualized returns of about 10.5%, compared to 8% annualized returns from bonds), any investor with a long time horizon should consider an equity-oriented portfolio. (True, stocks have been a horrible place to be for the past decade as a whole—but during multiyear periods during that decade, they have fared well...hence the importance of monitoring your portfolio constantly.) The reason to include bonds in the mix is the fact that most of us don’t have a multidecade investment horizon. But only after you’ve decided how much of your portfolio you can allocate to stocks, based on your personal risk tolerance, return objectives, and other circumstances, can you decide how to divide up that allocation. Once you have decided that the entire stock market universe, domestic or international, looks appealing based on the five factors, you can drill down one step. Convention and common sense dictate that we should compare any alternative stock investment to the ultra-liquid bellwether of the S&P 500. What do factors such as fundamentals, momentum, and psychology tell you about small-cap stocks, on that relative basis? Or emerging markets? You can use the five factors to tell you where the “sweet spot” is within the global stock market universe just as you did when evaluating an entry or exit point to stocks as a whole, or when comparing stocks to bonds or commodities. Repeatedly, valuation and momentum emerge as the most important of these five factors, whether you are trying to understand whether growth or value stocks appear most attractive or if you should be overweighting large-cap stocks at the expense of their smaller peers.

Can metrics identify turning points within asset classes as well as between them? Metrics are useful whenever you need to measure the absolute or relative attractions of any group of investments. I have found studying the five factors very helpful in navigating one of the most basic decisions: whether and when to shift money from large-cap stocks to small-caps, or vice versa. At the beginning of 2007, the Russell 2000 Index, a benchmark of smaller stocks, had just wrapped up a 6-year stretch during which its components soared 76%, compared to a gain of 19% for the S&P 500, the large-cap stock benchmark. Valuations were so extreme that everyone knew it was only a matter of time before the small-cap rally sputtered to a halt. Not surprisingly, I was glued to my models and anxiously watching all five factors, looking for them to align in telling me that it was finally time to reduce or eliminate my exposure to small caps. The valuation picture was clear, and the psychology part of the picture was taking shape, too. The momentum factor finally kicked in during the first week of July 2007, when the Russell’s return relative to the S&P 500 slipped below the 10-month moving average, and my team and I responded by recommending that we shift a portion of our small-cap stock allocation over to larger stocks.

Making timely allocations like that is what all the metrics that collectively make up the five factors are all about. Navigating the financial markets is never simple or straightforward, as the events of 2008 reminded us all too clearly. Globalization adds one level of complexity, the proliferation of new investment products and new strategies another. Today, investors in Boise can purchase Mexican pesos or Thai infrastructure stocks as readily as they can a large-cap U.S. index fund, or could opt instead to snap up an exchange-traded fund based on alternative fuels. Each new investment opportunity brings with it the potential for success in the shape of a few percentage points of additional return each year. As baby boomers head toward retirement, that extra smidgen could spell, cumulatively, the difference between a comfortable retirement with few financial worries and one where an unexpected surge in gasoline prices knocks your budget off kilter. For younger investors, or those whose assets are large enough that they have few financial worries, the challenge is different. How can they winnow through the constantly expanding opportunity set in search of the best combination of risk and return?

Complexity can be a good thing, especially when it comes to investment opportunities (at least for those with the ability to manage that complexity). Some investors will need only guidance on when to buy and sell—how to identify when the risk-adjusted returns in various markets look most compelling. Others will need more help in managing their portfolios. All, however, will benefit by constructing an investment process firmly rooted in the conviction that a successful portfolio is one based on analysis rather than hunches, emotions, and tips. Moreover, basing that process on quantitative tools means that anyone can find any part of the market more understandable.

The metrics that we have explored and discussed in this book, and which collectively make up the five factors on which I base my own investment model, are just tools. They are available to all investors to use creatively to answer the questions that preoccupy and perplex them the most. I might ponder the small-cap/large-cap asset-allocation question, because that is the most pressing issue for me and my clients. But you can use the same factors to consider whether Indian or Chinese stocks offer the best way to “play” the emerging markets story. One thing is certain: We’ll all be looking for the signs that the stock market rout of 2008 will reverse itself...

The universe of investment opportunities is so immense that as long as you are only following someone else’s footsteps on the ground, you will never be able to appreciate it, much less seize the opportunities it offers. Only by taking to the sky and looking down at the investment landscape can you begin to deploy these metrics in your search for the ideal place to put your capital. From my own view 30,000 feet off the ground, the view is always enticing.