The Volatility Paradox – Explanation of How Low Volatility Leads to Higher Risk

Volatility tends to drop when market risk is building up and leverage is rising, luring investors into complacency. Indeed, the lower volatility justifies investors taking on more leverage; if volatility has dropped by a third, why not take one and a half times the leverage? This pro-cyclical dynamic arising from lower volatility in times of increasing risk-taking is the volatility paradox. The main take-away from the volatility paradox is that we shouldn’t use shorter-term, contemporary risk measures when they are very low.

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Half of the Price of a Common Stock is “Fashion”

One of the best interviews with the Kahn brothers was with the Ivey Value Investing Class in 2005 and there’s one part in particular that encapsulates the mindset required to be a successful value investor. Here’s an excerpt from that interview:

25.57 The only thing I can say is we maintain a really strict contrarian approach. So if something is very popular and everybody loves it and we’re buying it we have to say to ourselves what are we doing wrong here. Because I’d say half of the price of a common stock is ‘fashion’ basically so what we’re doing is we’re buying long skirts at the thrift shop when mini skirts are in favor. So we’re buying the long skirts for a dollar or two and then waiting till long skirts come back into Saks and if you can do that you’re halfway home you know you’re almost halfway home if you can just stick to being a contrarian.

 

Source: The One Thing All Value Investors Can Do To Get You Halfway Home – Irving Kahn

Find out What Four Legendary Investors Think of Market Valuations Today

Art Samberg, Mario Gabelli, Leon Cooperman and Russell Carson share their thoughts on today’s market valuations and the economy at the Columbia Business School’s 2017 Reunion Weekend.

Faith and Feedback in Investing

NYU Professor Aswath Damodaran is a well known expert in valuation, but he is also an investor in many of the companies he values.  His investment style is to look for companies in the market that are currently trading at a discount to what his valuation analysis shows is its intrinsic value.

He is kind enough to post these valuations and importantly the narrative and assumptions used in valuing the subjects in detailed posts and videos on his blog.  He is the ultimate teacher, who loves to instruct and puts all of his intellectual property online for free for anyone who wants learn.

In his recent post on his valuation and investment in Valeant Pharmaceuticals, he highlights an important and much overlooked part of investing.

Faith and Feedback

In both my valuation and investments classes, I spend a significant amount of time talking about faith and feedback and how they affect investing.

Faith: As an investor, you are acting on faith when you invest, faith in your assessment of value and faith that the market price will move towards that value. If you have no faith in your value, you will find yourself constantly revisiting your valuation, if the market moves in the wrong direction (the one that you did not predict) and tweaking your numbers until your value converges on the price. If you have no faith in markets, you will not have the stomach to stay with your position if the market moves against you.

Feedback: As an investor, you have to be open to feedback, i.e., accept that your story (and valuation) are wrong and that market movements in the wrong direction are a signal that you should be revisiting your valuation.

Source: Musings on Markets

How Bad Could Bond Market Losses Get?

A few years ago Vanguard performed a study to see how the Barclays Aggregate Bond Index would be affected by an overnight 3% rise in interest rates (something that has never actually occurred). They calculated what would happen if rates suddenly rose from 2.1% to 5.1% and showed the impact going out 5 years:

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You can see the immediate loss would be around 13% (they also noted that the worst 12 month loss ever in bonds was -13.9% in 1974). But because the yield on bonds would now be much higher, the expected return going forward would now be around 5.1% annually, meaning the breakeven would be just over 3 years. So not exactly a crash of epic proportions.

Source: How Bad Could Bond Market Losses Get?

How Renaissance’s Medallion Fund Became a Money Machine

The fabled fund, known for its intense secrecy, has produced about $55 billion in profit over the last 28 years, according to data compiled by Bloomberg, making it about $10 billion more profitable than funds run by billionaires Ray Dalio and George Soros. What’s more, it did so in a shorter time and with fewer assets under management. The fund almost never loses money. Its biggest drawdown in one five-year period was half a percent.

Source: How Renaissance’s Medallion Fund Became Finance’s Blackest Box – Bloomberg

REITS Look Alarming

REITs have been the darling asset class for the last few years, they out performed all other asset classes in 2010, 2011, 2014, 2015 and the first half of 2016.  After being up 13.7% through June 30th of this year they have almost entirely wiped out that gain and are about to go negative for the year.

The Vanguard REIT ETF which tracks the MSCI US REIT index is currently yielding 3.92%, not much of a premium over the riskless US 10 year Treasury at 2.35%.

REITs have benefitted from investor’s search (reach) for yield and low borrowing rates on properties.  That could be coming to an end with the rise in the 10 year Treasury, a looming rate hike by the Federal Reserve in December, and rising defaults on commercial mortgages.

Buyer beware, we could be looking at a repeat of the Master Limited Partnership (MLP) debacle in the second half of 2015.

WSJ -Trouble Brewing in Commercial Real Estate