1/1/2015 End of the Year review

Sector Model	XLI	-1.43%
Large Portfolio	Date	Return	Days
ESI	8/4/2014	-32.84%	150
EDU	10/27/2014	-8.68%	66
PLT	11/6/2014	1.84%	56
UVV	12/2/2014	10.73%	30
JOY	12/8/2014	-9.46%	24
SWHC	12/9/2014	-1.66%	23
MRVL	12/10/2014	-1.69%	22
RS	12/11/2014	0.10%	21
BBRY	12/24/2014	1.67%	8
MWW	12/29/2014	-0.86%	3
(Since 5/31/2011)
S&P	Annualized	12.59%
Sector Model	Annualized	24.97%
Large Portfolio	Annualized	21.50%

 

A look back and a look ahead.

First, a look ahead.

I have no crystal ball.  I don’t time the market.  I just look for stocks that seem cheaper than other stocks in respect to adaptive metrics of my model.  If I were to start January 1, 2015 with cash I would look to buy:

JDS Uniphase	JDSU	ELECTRNX
Career Education	CECO	EDUC
Cliffs Natural Res.	CLF	STEEL
Arch Coal	ACI	COAL
Monster Worldwide	MWW	ADVERT
LeapFrog Enterpr. 'A'	LF	RECREATE
Southwestern Energy	SWN	GASDIVRS
Kelly Services 'A'	KELYA	HUMAN
Albemarle Corp.	ALB	CHEMDIV
Amer. Vanguard Corp.	AVD	CHEMSPEC

 

A lot of these stocks have had a no good, horrible, very bad year.  I’ve also lost money with CLF in a most spectacular collapse. ACI is being bankrupted by a President who came into office promising to do just that.

What goes down does NOT have to come back up.  Some stocks go to zero.  If they didn’t, then investing would be relatively easy.  Well managed ETFs are less likely to go to zero, of course, and I noted the other day that XLE would be a reasonably sound lifetime hold.

Now for a look back.

My worst trade: ESI lost 45% in the first few hours I held it, and if I had simply bought it one day later I would be up over ten percent instead of down over thirty.  Stocks are dangerous, and if you push the fundamentals too far you can find yourself in a rather painful situation.  ESI still doesn’t have corrected earnings for a good portion of the year, and they are over burdened with some real estate that they need to unload (I sympathize with that position from my own painful real estate adventures).

The Sector Model, on the other hand, ticked along as expected for the year:

	2013	2014
S&P	29.60%	11.39%
Sector	42.36%	36.12%

 

It beat the S&P, and it beat its back-tested benchmark.  That’s about all anyone can ask for.

It would have done better in the early part of December if I had better market data.  The Yahoo feed was corrupted and I rode XLB down for well over a week instead of XLF during that nasty drop.  To make matters worse, December ended with a series of whipsaws that caused me to miss a trade or two – (again) a better real time data feed would have solved that problem.

My New Year’s resolution is to ditch Yahoo and find a better feed.

Although my own account had a good final return, at times it felt like it was more trouble than it was worth:

 

A linear regression for the year would show my account ending very close to the median forecast line, but the standard deviations are uncomfortably large.  Fama would not approve.

To make matters worse, I would have been down for the year if I eliminated the best two week period in late October.  I was extremely pessimistic in early October, and would have cashed out if I have been trading on gut instinct or trying to time.

I’m showing this chart as an object lesson: timing the market is a fool’s errand.  This is NOT a clean year.  It had some really bad trades mixed in (one of which I’m still holding).  The volatility was hair-raising at times.

If you are prone to panic, sometimes you are better off NOT looking.

Another object lesson to take here is the trouble a Hedge Fund would have experienced this year.  Hedge Funds are designed to manage risk.  The volatility of individual stocks created an environment in which a hedged approach would have wiped out any potential gains one could have.  The only type of managed funds that could have systematically made money by the end of the year would be unhedged approaches with a small management fee.

Read that last paragraph again.

Yes, I meant what I wrote.

Hedging COSTS you money in times of volatility because such a fund typically holds individual stocks against an index.  That makes the fund’s volatility to be greater than the index itself by virtue of the fact that it holds less stocks than the total index.  Rather than managing volatility, it locks it into a loss.

The reason is that funds typically mistake “volatility” for “risk.”  The precise opposite is true.  When stocks are cheap, they are at the maximum point of volatility.  Beta is through the roof.  A value investor buys fear and sells complacency.  The control of risk therefore should not be in terms of Beta, but in terms of earnings and price mean reversion.  A stock with an unusually bad earnings year will have a high current P/E because the earnings are down worse than the price, but the regression for both earnings and price indicate that a reversion to the mean would reduce current P/E even as price is increasing, because earnings will be increasing as well.  (Note that I’m talking about current P/E instead of cyclically adjusted P/E).

Conversely, a stock with an unusually good year is likely to revert down to the mean instead of up.

All of this brings us to the conclusion that “value” is found when current fundamentals are worse than normal. And risk is reduced by buying stocks that have already terrified investors away.  In other words, buying at the greatest point of perceived risk is the best way to profit as perceived risk begins to fade.

I had an annoying year. Hedge Funds, on the other hand, should have had an extremely bad year.

Tim