invest(igations)

Bear-Market Investing

There is probably more disagreement about how to invest in stocks during a bear market than about anything else in investing. The disagreement centers around three fundamental points.

First, is it better to stick to the same strategy in a bear market as in a bull market simply because it’s impossible to predict when a bear market is going to start or end, and because you don’t want to miss the bounce? Or is it better to use some sort of market-timing signal to switch strategies?

Second, do you put a significant portion of your money into cash or bonds or a hedge, or do you stay just as long as you were during the bull market?

Third, if you stay long, do you switch strategies? This depends on the answer to a related question: can you learn anything about future bear-market strategies from past bear markets, or is every bear market different?

I’ll tackle these questions one by one.

1. Market Timing

First, market timing is difficult and often unreliable. But the anonymous author behind the brilliant Philosophical Economics blog (his Twitter handle is Jesse Livermore, the name of a legendary investor of the early twentieth century who made and lost millions and committed suicide in 1940) came up with a terrific method. It’s well worth your while reading his post In Search of the Perfect Recession Indicator.

Basically, the strategy is to go long unless the unemployment rate is rising and the price trend is falling. Unemployment is rising if the reported rate is above its trailing twelve-month moving average and price trend is falling if the S&P 500 is below its trailing ten-month moving average. “Livermore” found that this indicator beats all others over the period from 1930 to 2016.

So let’s take a close look at how this indicator would have performed over the last forty years.

First of all, there are a large number of false signals. You would have had bear-market signals on November 1, 1979 and April 1, 1980, both false, but only lasting a month. Then you would have been out of the market for the decline in late 1981 and early 1982. You would have remained long through the 1987 crash. You would have been hopping in and out of the market for several months in 1990, getting back in on February 1, 1991, then out again December 1 for a month. You would have left the market on March 1, 2001, when the S&P 500 had already dropped a good 19%, gone back in on April 1, 2002, but just for one month, and finally re-entered on May 1, 2003. You would have then exited on December 1, 2007 and re-entered on July 1, 2009, missing the first four months of the recovery, when the S&P 500 gained 38% from its lowest point. You would have remained long ever since, even through the almost-bear markets of May through October 2011 and May 2015 through February 2016. Still, even with all these false signals, you would be well ahead of someone who stayed long the entire time, assuming that person was invested only in the S&P 500 instead of using a more profitable stock-picking system.

So, yes, market timing is possible. It’s not neat and clean, and it’s hardly foolproof, but, as “Jesse Livermore” has shown, it’s better than simply sticking with an index through thick and thin. And there are far more sophisticated methods of market timing than this one. For some good examples, check out iMarketSignals.com.

But here’s the conundrum. If it were possible to develop a market-timing scheme that enables investors to avoid most bear markets, why would nobody have come up with it forty or fifty years ago? Stock-market indexes and the unemployment rate were both readily available in 1968. So why did nobody come up with this simple system back then?

The answer is complicated. As “Jesse Livermore” points out, the onset of the 1937 and 1945 recessions could not have been predicted by any of the commonly used recession indicators, including the unemployment rate, which only began to rise after the recession had begun and the bear market was well under way. And the strategy does not work very well in other countries, using their unemployment rate. In addition, it has frequently been the case that the onset of a bear market has been a cause of recession rather than the other way around.

But there’s also a question of logic. Let us pretend that the wisdom of the combined unemployment rate and S&P moving-average crossover method of market timing were accepted by 75% of market participants, which would certainly be the case if it could be proven to have actually worked. And let’s say that in July of this year, the unemployment rate started rising, but the S&P 500 was still well above its ten-month moving average (this has happened a number of times over the last fifty years). What would it take for enough market participants to sell their stocks to drive the S&P 500 below its ten-month moving average? Remember that 75% of market participants will believe that while the S&P 500 is still well above its moving average, no bear market will occur. Therefore, any dip in the S&P 500 will be eagerly bought by those market participants, and indeed no bear market will occur. In other words, any market-timing indicator that actually works and which depends on stock prices will render bear markets impossible. The real cause of a bear market is fear, and market-timing confidence and fear are incompatible. So we can take this scenario to the next logical level: if 75% of market participants had faith in the “Jesse Livermore” method of market timing, those same 75% of market participants would soon conclude that a bear market will never happen (or if it did they could get out in time), and the bond market would collapse since stock market indexes would be more lucrative and just as safe.

Now let’s say, on the other hand, that a market-timing method were discovered that was completely independent of stock-market prices. It instead relied purely on other economic indicators, and was proven to have predicted every single bear market since 1929. And let’s say that 75% of investors believed in it. In that case, as soon as the indicators gave the signal, an incredible crash would occur and stocks would lose practically all their value overnight. As a result, most public companies would go bankrupt and the economy would go into a depression the likes of which the world has never seen. There would be, therefore, incredible efforts on the part of governments to jigger those economic indicators so that they would never indicate a bear market. (There may be some parallels here to quantitative easing.) Or perhaps the government would make it impossible to read those indicators by messing with the data or keeping it under wraps. No matter what, this scenario is nightmarish in the extreme, and could be the basis for an excellent dystopian story.

These two scenarios are pretty strong arguments against the existence of a generally acceptable (or proven) market-timing mechanism. If one existed, stock markets would cease to make sense.

2. Strategy in a Bear Market

Now let’s turn to the second question: in a bear market, do you put a significant portion of your money into cash or bonds or a hedge, or do you stay just as long as you were during the bull market?

If you’re investing using index funds and you’re confident you can get the re-entry point right, obviously you want to be out of the market during a bear market and putting your money in short strategies, cash, and/or bonds. If, on the other hand, you doubt your market-timing ability, or you’re confident in your stock-picking prowess, stay long or use a long-short strategy similar to the one hedge funds use.

Now I’ve backtested, using Portfolio123, the strategy that I use for my own stock picking—a microcap value-growth-and-quality strategy—and according to these backtests, it would have been a serious mistake to be out of the market during those periods. Even if my returns had been only half of what my backtests tell me they’d have been (a reasonable assumption), I would have made a lot of money in the first of the millenium’s recessions, and while I would have lost a lot in the second, the recovery in 2009 was quick and dramatic. So that answers the question for me. While using a long-short strategy during both recessions would have made me more money, there are significant costs and risks involved, and timing the re-entry point is very important.

So the answer here depends on the answer to two other questions. Can you time the end of a bear market? And do you have a winning value-based strategy for stock picking that consistently beats the index?

3. What do Bear Markets Have in Common?

Now for the third question: would a successful strategy for one bear market be successful in another?

Well, let’s create six different long-only strategies and test them out. I’m going to create ranking systems for a purely momentum strategy (with three factors), a size strategy (with two factors), a growth strategy (with three factors), and a value strategy (with four factors). The factors within each strategy will have equal weight. Then I’m going to combine two strategies, again equally weighted, at a time and test those against the S&P 500.

The stock universe I’ll test is all stocks on major US exchanges with a median three-month daily dollar volume of $100,000 or more, a minimum market cap of $25 million, and a minimum price of $1.00, excluding REITs and MLPs. The backtest consists of going long on the top-ranked fifty stocks and relabancing monthly, with 0.5% slippage for each rebalance. I’ll use the conventional timing for the bear markets, 3/24/2000 to 10/9/2002 and 10/9/2007 to 3/9/2009.

Here are the results, which are not annualized:

As you can see, by far the best strategy in the 2001 recession was a growth and value strategy, while that would have failed miserably in the 2008 recession. By far the best strategy in the 2008 recession was momentum and value, which did quite well in 2001; but a close second is the growth and momentum strategy, which would have fared miserably in 2001. All three value-based strategies would have done just fine in the 2001 recession, but in the 2008 recession, two of them would have underperformed the S&P 500. I haven’t tried it, but I suspect you’d find similar discrepancies if you added the almost-bear markets of 2011 and 2015.

Another way to look at bear markets is by sector performance. Lawrence Hamtil has helpfully broken down the last five bear markets by sector performance in his post Imagining the Next Bear Market - Part II. In the 1973-75 bear market, the best performing sectors were energy, materials, and staples; in the 1980-82 bear market, they were industrials, materials, and telecom; in the 1990 bear market they were health care and energy; in the 2001 bear market they were staples, materials, and financials; and in the 2008 bear market they were staples, health care, and utilities. In general, materials and staples performed the best, but materials did very badly in the most recent bear market. If you look at what sectors performed the worst, it’s all over the map. In the first bear market it was discretionary and financials; in the second, it was energy (nothing else came close); in the third it was discretionary and financials again; in the fourth it was technology and telecom; and in the fifth it was financials, industrials, and materials. In short, every bear market is very different.

Now as I’ve written in my Seeking Alpha article The Ideal Stock Evaluation System?, I’ve developed a stock evaluation system. If you had used that evaluation system, in the same universe as above, buying stocks ranked 98 or better, you would have beat the market handily in both of the most recent bear markets, earning a total of 100.42% (not annualized) in the 2001 recession and losing only 43.28% in the 2008 recession. And a combined long-short strategy (shorting stocks ranked 2 or worse that are over $1 billion in market cap) would have done even better (if you don’t count interest and other costs): 3,363% in the 2001 recession (no, that’s not a typo: remember all those incredibly overvalued and utterly worthless stocks in 2000?) and a gain of 105.77% in the 2008 recession. But this all depends on perfect timing. If you were a few months late in realizing that the bear market in stocks was over in March 2009—for example, if you were relying on an end-of-month moving-average signal—you would have been better off not shorting anything at all. A long-short strategy was great in the 2001 bear market but only would have worked in the 2008 bear market given very good market-timing skills.

To conclude, the most logical approach, in my opinion, is to remain fully invested in stocks at all times using a sensible low-beta high-alpha stock-picking strategy that consistently beats the market. If you are comfortable with short-selling (I’m not), use the recession indicator that “Jesse Livermore” discussed and split your holdings between long and short positions during those periods, choosing your stocks wisely according to good fundamental techniques. Another way to hedge during a bear market is to buy puts, which, I confess, I’m not sophisticated enough to discuss. If your retirement account doesn’t allow you to pick stocks, go to cash or bonds in that account during the periods that the unemployment-moving-average system outlines. And remember: there’s no way to characterize bear markets—each one is different. How a system performed in one bear market will tell you very little about how it will perform in the next.

My top ten holdings right now: RCKY, TG, WSTL, PBIB, UWN, GTS, FSTR, PTSI, RCMT, FWP.

CAGR since 1/1/16: 50%.

My Models on Portfolio123

I have five designer models on Portfolio123 that you're welcome to subscribe to, and I'm launching a sixth today, which should beat them all hand's down as it's the closest to the one I use for my own investments. It's not identical, though, because Portfolio123 has a minimum price and liquidity requirement that's stricter than my own. It's called "Crazy Returns Microcap Model." Here are the stats for the backtest:

You won't be able to subscribe to this model until June, and it's very expensive. I'll post more about it when it's available. In the meantime, the other models, some of which have lagged their benchmarks since launch but none of which have lost money, can be found here:

small cap model

mid-cap model

large cap model

S&P 1500 model

ultra-low turnover model

My top-ten holdings right now: RCKY, TG, WSTL, PBIB, UWN, GTS, RCMT, MERC, PTSI, FSTR.

CAGR since 1/1/16: 49%.

Predicting EPS Growth

A few weeks ago a question came to me: how can we best predict a company’s earnings growth? So I designed an experiment to answer that question. The experiment is a little complicated, so I’ll discuss it at the end of this article. I’ll instead lead with my results, in reverse order: the factors most likely to predict future earnings growth.

In a tie for fourth and fifth place, with a 25% advantage over a random selection:

Stocks with strong operating earnings growth as measured by comparing the most recent quarter’s operating earnings (or EBIT) to the same quarter last year and dividing by the absolute value of the latter

and

Stocks with strong volume-weighted momentum, as measured by the ratio of the three-week volume-weighted moving average to the ten-month volume-weighted moving average.

On the whole, I found that measurements of past earnings growth were relatively useless for predicting future earnings growth. In fact, there tends to be a reversion to the mean. The stocks whose earnings per share have grown the most over the last twelve months are less likely to exhibit strong growth over the next twelve months than a random selection. But there was one exception: operating income growth, as measured by the most recent quarter. And indeed, if you look at Seeking Alpha’s articles on individual stocks, they very often use precisely this comparison. It’s a damn good one.

As for volume-weighted momentum, the reason this works is that companies with strong growth prospects attract investors, who bid up the price and are increasingly interested in buying shares.

In third place, with 32% and 26% advantages:

Stocks with low cash-flow accruals, as measured by the difference between net income and operating cash flow, divided by total assets (32% advantage); and stocks with low balance-sheet accruals, measured by the difference between the average net operating assets the last twelve months and the previous twelve months, divided by average total assets over the last two years (26% advantage).

If your net income is low or negative but you have good, strong operating cash flows, you’re likely to see a nice increase in earnings in the near future. The same is true if you’re lowering your net operating assets efficiently (see my piece on this measure here).

In second place, with 34% and 33% advantages:

Stocks with a high current quarter’s EPS estimate as compared to the actual (GAAP) EPS the same quarter last year (34% advantage), and stocks with a high current fiscal year’s EPS estimate as compared to the actual (GAAP) EPS last fiscal year (33% advantage). The actual formula is to take the difference between the estimate and the actual and divide by the absolute value of the actual (if that absolute value is less than five cents, then divide by five cents instead).

I don’t pay attention to analyst ratings or target prices. But analysts definitely have a bead on future earnings.

And now, in first place (drum roll, please), with 42% and 41% advantages (the gold medal goes to . . .):

Companies with the lowest net profit margin (42% advantage) and lowest return on assets (41% advantage) are the companies with the highest earnings growth potential.

This may appear confounding at first, but it makes sense. These are companies with very low earnings and very high sales (if you’re looking at profit margin) or very high assets (if you’re looking at ROA). They thus have the highest potential for growth.

Factors that made relatively little difference to growth potential include those based on free cash flow, analyst ratings, asset turnover, and many others. Companies with high returns—whether that be return on capital, return on equity, or high margins—were significantly less likely to experience strong earnings growth than the average company.

Now, of course, there are plenty of other things to look at when considering buying shares in a company than its potential for earnings growth. But it appears to me that investors should be cautious when using measures like ROA, profit margin, and previous EPS growth—which are all negatively correlated with future earnings growth—when looking at which stocks to buy.

Now here’s the experiment. First, I chose a factor. Using Portfolio123, I ranked the stocks in the Russell 3000 according to that factor fifteen months ago, and chose those ranked in the top quintile (20%)—about 600 stocks. Then for each of those stocks I looked at the percentage change between the most recent four quarters’ EPS and that of the previous four quarters. If the stock had more than a 15% increase in EPS, it got a point. (The reason I ranked the stocks fifteen months ago and then looked at trailing twelve-month EPS growth now is because I wanted to make sure there was no overlap between the factor measurement and the EPS reporting.) Now I had a number—out of those 600 stocks in the top quintile, 266 (for example) reported EPS growth higher than 15%. And I could compare that number to a baseline, which would be derived by looking at all the Russell 3000 stocks and dividing the number with EPS growth higher than 15% by five. I then moved the entire experiment back two years, four years, six years, and eight years, and repeated it. And I tested a large number of different factors.

So, considering these criteria, which are the stocks most likely to experience strong EPS growth over the next year?

Well, currently there are no companies in the Russell 3000 that are in the top quintile for all of these measures. But we could use a ranking system instead. If we take the eight winning factors and weight them evenly, the top ten stocks in the Russell 3000 right now are: Crocs (CROX), DMC Global (BOOM), Molina Healthcare (MOH), Twitter (TWTR), Kadmon Holdings (KDMN), Casella Waste Systems (CWST), Fluidigm (FLDM), Splunk (SPLK), Chegg (CHGG), and Envestnet (ENV). Now I would not recommend investing in all these stocks by any means. You not only want growth, but growth at a reasonable price. I do, however, predict that their EPS growth over the next fifteen months will be strong.

As for stocks I would recommend, Russell 3000 stocks with tremendous EPS growth potential that also rank highly in the evaluation system I intend to shortly offer to the public, they are: Verifone Systems (PAY), Diodes (DIOD), Unisys (UIS), L.B. Foster (FSTR), Heidrick & Struggles International (HSII), Bloomin’ Brands (BLMN), Acorda Therapeutics (ACOR), Citrix Systems (CTXS), Orthofix International (OFIX), and Endurance International Group Holdings (EIGI). All of these companies are in the top five percent of both ranking systems.

My top ten holdings right now: RCKY, WSTL, TG, RCMT, PBIB, MERC, UWN, PTSI, FSTR, BCML.

CAGR since 1/1/16: 48%.