Revisiting my personal rules for investing

In my posts on LinkedIn this week, I followed a theme that revisits my personal rules of investing. I have done a Substack about those rules in the past, more from the viewpoint of how I formed them over time. You can find that blog in the archives but for those that didn’t read it here they are:

Rule #1: Stay humble

Rule #2: Learn from your losses

Rule #3: Keep your powder dry

Rule #4: Maintain intellectual curiosity

Rule #5: Stay unbiased

Rule #6: Understand both sides of the argument

Rule #7: You will be rewarded if you are out of consensus

Rule #8: Help others

I will share the posts about each rule below but right now I want to focus on that last rule - help others. I notice that many people have been gracious and pledged that they would be willing to pay for a subscription. That is very nice but I don’t do this for the money as I am lucky enough to not have to. I do it to help others by hopefully passing on some of the lessons I have learned in 30+ years in institutional finance. I call it demystifinance. However, I do admit it takes me a fair bit of time to work through this and so I appreciate those that pledge support as it shows the work is worth it.

In the spirit of helping others, given we are coming up on the holiday season and Giving Tuesday, if you are so inclined, I would just ask that you donate to one of my favorite charities - the Evans Scholars Foundation. This foundation gives full tuition and room & board scholarships to high school aged caddies. These are kids who spent their summer vacations from school going to work at a golf course every day at 6:30 A.M. Not only are they hard-working, but they also must be in the top 20% of their class academically and be in financial need, unfortunately an easier hurdle to pass for many. These Evans Scholars end up with higher graduation rates and higher grade point averages. They work at the best firms in the world. The best part? They give back to the program to help those just like them. How do I know this? I was fortunate enough to be an Evans Scholar and have been active in the program for the last 30+ years after I graduated.

I will put a link for you to donate to the Evans Scholars below. Before I do, here is the blog this week on my personal rules of investing. Hope you enjoy!

Rule #1: Stay humble

Chart of the Day - humility

At church yesterday, the priest talked about the virtue of humility in his homily. This was one of the key takeaways of the readings we had & arguably a virtue in short supply in a virtual world where everyone seems to be crushing it, if you ask them

It was an early mass because I was playing golf afterwards. We are running out of good golf days in the Midwest & this seemed like the last. There may be nowhere better to learn the virtue of humility than on a golf course, especially if you haven't picked up your clubs in a month

I played with a couple of friends who were very successful growth stock managers & are now enjoying the good life. These are fun rounds because not only is there good competition, but we always catch up on markets. It also takes our minds off the Chicago Bears

They are loyal readers of my Substack where this week I wrote about the bullish argument, at least what I understood, & said I didn't find most of it very compelling. I asked for pushback or feedback & I got some of both over 18 holes

The key things I seem to be missing are around the nuance around each argument. Maybe I have one interpretation but there is a more bullish spin that I need to consider

Rates - The Fed has clearly stopped & markets always rally when the Fed stops hiking rates. Most see 100 bps of cuts next year (futures do) & this is another tailwind for multiples which have averaged 18x post GFC

Earnings - yes guidance was lowered for next year. Growth rates have fallen from about 11% to about 8% however companies tend to beat by about 3% so earnings next year will probably be up double digits or in the $250-260 range

Economy - a soft landing is built in but even if there is a recession it is not a Q4 event (those who track it more closely to me such as Piper, do see it as a Q4 event). Stocks won't sell off until we see negative earnings. When we do, the Fed will be cutting

Technicals - most importantly, we are in the seasonal sweet spot for stocks & held support levels at the moving average. We have moved up to trendline & moving average resistance but thru there we see new highs. Weekly views are much more bullish than daily views

Putting it together if we see $250 eps & a 19 multiple, there is no reason not to see 4750+ The chart today shows the technicals & while it did break the moving average and trendline support, it has re-taken that & looks higher. The MACD has turned up tho the high level of Williams %R may suggest we fail at resistance

This feedback was humbling. The markets are always humbling. However, this is very important to see the other side of the story. In markets, being too early is the same as being wrong.

Between the golf course & the markets talk, it was definitely an opportunity to learn the virtue of humility, just as the start of my day foreshadowed

It is always best to Stay Humble ... but also Stay Vigilant

Rule #2: Learn from your losses

Chart of the Day - learn from your losses

Along the lines of staying humble, my 2nd rule of investing is to learn from your losses. While this is one of those maxims that makes sense to say, it is very hard to do in practice. It is human nature to focus more on previous or current gains & less on what you got wrong

However, learning is done from introspection & attribution of the ones that didn't work out. How can you ensure, by adapting one's process, that the loss won't happen again

I have a bias, well many, but one in particular when it comes to investing. I always favor the mean-reversion trade. Perhaps this is my training in relative value as an options market maker or as a long/short HF PM

Either way, I am always drawn to this underdog story. However, what I have learned, from my losses, is that these mean reversion stories will never work without a catalyst. What is the trigger that will get people, who are leading to this anomaly, to change their minds

Today I submit 3 charts, all of which scream for mean reversion, but none of which have a catalyst right now. Apologies for the poor quality but when I try to do more than one chart this seems to happen on LinkedIn.

The top chart shows the relative performance of the equal weight S&P 500 to the market cap weight S&P. It is clear from this that there are 7 stocks that are driving performance. In fact year to date, the equal weight index performance is down about 50 bps. It is the worst relative performance in 5yrs

This tells me that the tightening of fincl conditions is having a negative impact on the economy overall. However, we don't see it in the 'stock mkt' if we only look at one benchmark. Seven cash rich companies with top mkt share are doing well. Everyone else? Not so much. What changes that?

The middle chart is of a similar vane. It is the performance of small cap stocks vs. S&P 500. The worst relative position since before the GFC. Small cap earnings have been awful. A higher domestic influence perhaps. Less availability to capital for sure. Different sector mix maybe

What changes this and gets people to start buying small caps vis a vis the large caps? Just because the level is the lowest relative in 13+ yrs doesn't mean its a buy. It will have to be a positive catalyst around earnings which show no sign of improving. There is a recession, just in small caps

The bottom chart is the relative performance of international stocks vs. US stocks. Again, the worst relative performance in a decade. Many countries around the world are in a recession or close enough. The US, at least 7 stocks in it, look like a soft landing. What changes this relative performance?

What do I learn? All year long I have fretted about the higher cost of capital & negative impact on economy & stocks. It has actually happened if I look at the equal weighted S&P, small cap stocks or intl stocks

Learn from your losses and ... Stay Vigilant

Rule #3: Keep your powder dry

Chart of the Day - dry powder

One of my other rules of investing is to keep dry powder. Often times we look at cash as a drag on portfolio returns. In fact, BAML has a contrarian indicator that looks at mutual fund cash & when too high, it gives them a buy signal. The idea is people can't afford to sit on cash for too long

However, as Warren Buffet likes to tell people, cash is not only a potential drag on portfolio returns. It is also dry powder for taking advantage of opportunities when no one else can because they are fully invested (& likely underwater)

Buffet just told us in his 3rd qtr earnings that he is very much in favor of having dry powder right now. How much so? Berkshire is sitting on $157bb of cash, most of it in T-bills, earning 5%+

Of course, Warren isn't marked to market like a lot of institutional fund mgrs. He isn't going to get a quarterly call from an investor yelling at him for not investing & being told 'you are paid to invest not sit in cash'

This is one of the reasons we have the behavioral biases that lead to a Santa Rally or to a BAML contrarian indicator driven by cash levels. It may not be so much what an asset mgr feels as much as what the asset owner behind the asset mgr feels. Either way, it leads to a result

Stepping back, I always like to have an idea of what the margin of safety in the investment is. This is another concept that comes from Graham & Dodd but is made popular by Buffet

For this I look at the free cash flow yield for the stock mkt & compare it to corporate bond yields & govt bond yields. These are the choices put in front of investors

I prefer FCF yield to earnings yield because earnings can, & are, manipulated more often than not. Cash is king when I assess the potential risk of the investment

I draw three circles here. On the far left is the late 90s bull mkt. The middle circle is the great fincl crisis. the far right is now. There are some takeaways from each

The far left we can see FCF yld well below corp bond ylds & govt bond ylds. Stocks were wildly overvalued. Not only was there no margin of safety but investors were paying a premium to take more risk

Fast forward to the fincl crisis & investors shunned stocks. We see the FCF yld spike higher, well above govt ylds & above corp bond yields too. Any risk being taken was higher in the capital structure given we looked bankruptcy in the eyes

Where are we now? FCF ylds have moved 2.6% below copr bond ylds and 0.6% below govt bond ylds. Again, investors are paying a premium to take risk. As Buffet would say, there is no margin of safety priced built into stocks

As Buffet would do, it may be time to have a bigger than usual cash stock pile to use as dry powder

Rule #4: Maintain intellectual curiosity

Chart of the Day - intellectual curiosity

Another personal rules of investing is one that encourages me & others to stay thirsty in the quest for knowledge. The one factor we hear from all companies that are recruiting on campus is they want to see students with a natural intellectual curiosity

I couldn't agree more that this is the most important tool in your toolkit. Technical skills needed change over time. The key is to keep pushing yourself to stay on top.

In that vein, I have embraced AI this semester. I have encouraged students to use it to answer homework questions & pushed them to see what AI gets correct & what still needs work.

So, I asked Chat GPT about the current market set-up, feeding in the information about the current bullish argument. This is what it said:

"As an investment strategist, when evaluating the potential direction of the stock market, it's essential to consider a combination of factors, including economic fundamentals, earnings, valuation, & technical analysis. Let's break down each aspect:

Economic Fundamentals: If the fundamentals of the economy are slowing, it can exert downward pressure on stock prices. A weakening economy may lead to reduced consumer spending, lower corporate earnings, & uncertainty in the business environment. Historically, a slowing economy is often associated with lower stock market returns.

Earnings: Slowing earnings growth can be a negative signal for the stock market. Stock prices are closely tied to corporate profits, & if earnings are declining or growing at a slower pace, it may lead to lower stock valuations.

Valuation: If stock markets are overpriced relative to other assets like government bonds, it implies that stocks may be overvalued. High valuations can make stocks vulnerable to corrections or declines, especially if earnings don't support the valuations.

Technical Analysis: A strong technical analysis picture can suggest short-to-medium-term price momentum or positive investor sentiment. However, technical analysis alone doesn't provide a complete picture of the market. It can be a useful tool for identifying potential entry & exit points, but it should be used in conjunction with other factors.

In this scenario, even if the technical analysis suggests short-term strength, the overall outlook for the stock market seems challenging due to the weakening economy, slowing earnings, & overvaluation.

While stock markets can continue to rise in the short term, these negative fundamentals could eventually exert downward pressure on stock prices.

It's important to recognize that market conditions can change quickly, and various factors, including government policies, geopolitical events, & investor sentiment, can influence market movements."

In being curious, I also suggested this year that I would get my disruptive technology exposure in Ether instead of NDX. The chart today is the YTD returns of each

Rule #5: Stay unbiased

Chart of the Day - stay unbiased

I was having a conversation with a colleague yesterday about a derivatives academy I will be starting in the Fall of 2024 at UIUC. We spoke about the learning outcomes I had for the academy & how I would define success for the students

As we brain-stormed how I could implement certain aspects of the academy, we thought of the various markets & instruments I could use. One of those markets we discussed was digital assets

I was not surprised because this person was behind iBlock our own blockchain at Gies College of Business. It is the first blockchain created by a business school. It is natural for us to want to explore derivatives & trading in the digital asset or cryptocurrency market

One of my 8 rules of trading/investing is to stay unbiased. A good trader understands the probabilities, understands the reward to risk of a trade or investment idea. She does not allow bias to creep in

However, it is human nature to have biases. There is an entire field begun by Kahneman & Tversky, then advanced by Thaler, about behavioral finance which challenges the efficient markets hypothesis because of these identifiable biases people have when it comes to investing

It is difficult to stay unbiased when it comes to cryptocurrency. It is difficult to stay unbiased when trading any product. So combined, it is very difficult to stay unbiased when trading cryptocurrency

However, a good trader needs too. A good trader also needs to understand what ultimately drives the cash flows beneath every asset. It may be the staking yield one can earn in ETH & how locked up, or not, ones asset is when it is staked. What does this mean for liquidity & scarcity value. How competitive is the yield?

A good trader also needs to know the value prop of Bitcoin for the miners, who ultimately create the liquidity in the market. The miners earn rewards for validating a block in the block chain. This is the payout for the upfront compute & energy cost they face

The rewards for Bitcoin mining are reduced by half roughly every four years. When Bitcoin was first mined in 2009, mining one block would earn you 50 BTC. In 2012, this was halved to 25 BTC. By 2016, this was halved again to 12.5 BTC. In 2020, the reward halved again to 6.25 BTC

Next year it halves again. There is a fixed supply of Bitcoin & the halving reflects the waning supply. If demand remains constant what happens to price?

The chart today has a vertical line at each halving & shows the price action in the months & year after. This is a log chart so I can fit it on here but you can see BTC rallies sharply after each halving even tho it is a known event. It is supply & demand

You can do what you will with this information. For me, I will try to stay unbiased as I assess how to trade it. Either way, it is a test of all of our biases

Rule #6: Understand both sides of the argument

This was basically the gist of my entire blog last week. I am not going to go through it again but I will put the link to it here: The bullish argument - by Richard Excell - Stay Vigilant (substack.com)

Rule #7: You will be rewarded if you are out of consensus

This builds a little bit on the learn from your losses post. I always want to know what consensus thinks. This is not to say consensus is wrong. This is to say that consensus will tend to take prices of assets too far on one direction or another. If you get into a position - long or short - at the wrong point, the wrong price, you will have weaker hands and less staying power in that position. From a behavioral standpoint, you will feel the losses more sharply and be inclined to behavior. There are many indicators I look at for this, but one good one is the CNN Fear and Greed Index that itself is a composite of 7 indicators comprising technical analysis, options trading and market flows. It is a good one-stop-shop for whether the market is leaning too far in one direction or another.

Maybe surprising to many, if we look at the indicator this week, we see it registering Fear. I think given the market was up last week, this might surprise people. You might even think - everyone must be bullish if the market is higher. However, the internal action of the market can be fearful even if a few names are moving higher, or more realistically, if short-covering and futures buying are driving the market. That was the case last week.

If you are aware of the market consensus is, and you have a variant view, you can learn to generate higher risk-adjusted returns.

Rule #8: Help others

I told you above about the Evans Scholars. If you do wish to donate and help others, please use this link

https://wgaesf.org/

There should be a box when you donate and if you would kindly put “Stay Vigilant” in that box, I will be able to find out from the organization how much was donated, so that I can match the donations.

Thank you for everything and remember to …

Stay Vigilant