This week’s “Chart for the Curious” offers less optical intrigue and requires more “Curiosity” than our normal Friday missives. The piece reads more like our typical Quick Takes.

Having just published our key take-aways on the legendary Andrei Shleifer’s book, Inefficient Markets, we thought it worth following up with an example of some of the behavioral errors his work discusses.

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Below we chart the trailing three-year returns by sector for the S&P500. We have sorted the sectors from worst to best. The performance dispersion is massive.

Returns by Sector Over the Last 3 Years

As we explained in our recent research, great inflation of the 1970s, multiples in IT are at record wides with Energy which also happens to be at a record low weighting in the S&P500. We believe this indicates rampant optimism in Tech and outsized pessimism in Energy.

Tech’s stock prices have never been more expensive relative to Energy, as seen in Fig. 2 below. As long-time subscribers know, KCR does not set price targets. With that said, over the longer term, we believe the risks, including low-interest rates and possible inflation, make Energy an obvious and inexpensive hedge for many portfolios.

Energy has Never Been as Cheap Relative to IT than it is Today

Future Performance Forecasts May be Unreliable

As adherents of Behavioral Economics & Finance, our investment strategies are predicated on a field of study that is as intuitive to understand as it is difficult to practice.

Subscribers to our work know that back in September, we noted that investors’ market forecasts were for annual returns of 17.5% in excess of inflation. In our CFTC last Friday, Best Stocks for a Recession, we went back to 2011 when Gallup resumed their polling of investors.[1]

In 2011 investors predicted “GOLD” would be the best performing asset class for the next decade. As we discussed in that CFTC, that was a disaster. Gold has been roughly flat while the market rose nearly 400% in the years since.

Why did investors jump from mutual funds and optimism to a commodity like gold? The market’s crash from the record highs in October of 2007 to the bear market low in March of 2009 saw the S&P500 Index plummet by a staggering -55%.

Stocks were sold indiscriminately as earnings reports from over-leveraged financials foisted disaster on an expensive market dependent on leverage. Gold, however, ROSE 25% during the debacle.

Returns by Sector October 2007 March 2009

To summarize: after a period when nearly every sector was ruthlessly massacred, we saw that investors extrapolated those recent results and jumped to…GOLD. They did this at precisely the wrong moment, as seen in the chart below.

Gold vs SP500 since the GFC

What are we Seeing in Other Survey Data Today?

Survey data is often viewed as a bit of a “dark art” by researchers. The questions change, the respondents change, and it is often derided as “noisy.” We revisited a working paper from the National Bureau of Economic Research on investor expectations for returns and outcomes published in 2012.

Written by Robin Greenwood and Andrei Shleifer, they used data from Gallup, the American Association of Individual Investors and several other sentiment surveys. Across all the data, they find that “…investor expectations tend to be extrapolative: they are positively correlated with past stock market returns, as well as with the level of the stock market…” They also find that “…these measures of expectations are highly correlated with investor inflows into mutual funds.”[2]

Summarily, Greenwood and Shleifer find that investors’ return expectations are high when recent market returns are high, and they are low after periods of market weakness. Investors also invest the most at the highs and redeem aggressively at the lows. Research has shown these trends are present at the single stock level as well.

With investors on social media platforms swarming in and out of options creating gamma squeezes on even massive stocks like Tesla, we ran the put-call ratio. The put/call ratio explains investors’ actual positioning based on puts purchased vs. calls purchased.

Investor positioning today is at levels last seen in the bubble. At the market, sector, and stock level, we encourage caution. With that said, our research has documented the stunning opportunities the euphoria in some stocks and sectors has created in blue-chip stocks.

Put to Call Ratio Looks Similar to the Run up to the Dot Com Bubble

Here is the data from the American Association of Individual Investors, one of the data sets used by Shleifer and Greenwood. Somewhat surprisingly, this group has come off very high levels of optimism only recently.

Bull vs Bear Sentiment Coming off Recent High Levels of Optimism

One of the things we would note about AAII is that they have been around for a very long time. Their members and level of sophistication are high. Think about how many people bear trading on Robinhood today are part of this group?

We highly doubt AAII’s members are part of the explosion in new brokerage accounts opened by inexperienced investors in the past couple of years. This was a topic we discussed in Value Investing & Manias.

In many ways, we think AAII’s members have become more like sophisticated financial advisors. We see how the typical individual investor’s expectations have disconnected from financial advisors’ views over the past few years in the chart below.

Investors Expectations are Diverging from Financial Advisor Expectations

And this is, in fact, why we are so aggressive in encouraging investors to seek counsel from experienced representatives!

Our CFTC next week uses another set of survey data to highlight an asset class that investors have overwhelmingly agreed is the best place to be for the long term. In that piece, we will explain why we believe this consensus view is wrong.

  1. As a reminder for our Financial Advisors: our models are available on a continuous basis, and most have been in production for over a decade.  If you are looking for simple, concentrated, low turnover, and tax efficient model portfolios we would like to talk with you.  KCR also offers a wide range of easy-to-use but sophisticated tools.  Our toolkits can help identify mispriced stocks with the best and worst risk/reward characteristics, estimate a stock’s duration and warn you when a company is engaging in low-quality accounting. Over the last 12 years, KCR has built and offers time-tested and class-leading products built by experienced and proven money managers for fixed to low prices.
  2. Kailash Capital’s sister company, L2 Asset Management, runs market neutral, long/short, large-cap, and mid-cap long-only portfolios with a value and quality bias.  L2 employs a highly disciplined investment process characterized by moderate concentration, low turnover, high tax efficiency, and low fees. While nobody can predict the future, we believe the recent resurgence in risk-adjusted returns seen across all products is the beginning of what may be a long period where speculation is punished, and prudence and patience rewarded.

[1] Gallup’s survey data began in 1996 but the nature and content of the material has changed over time.  From November of 2009 through February of 2011, the survey was shut-down. Data between 2009 – February 11th is unavailable and survey methodologies have changed over the years.

[2] Expectation of Returns, Robin Greenwood & Andrei Shleifer, January 2013


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