changes the value of everyfinancial asset.He notes further that from 1964 to 1981, interest rates on long-termgovernment bonds went from 4.2 to 13.65 percent and from 1981 they wentfrom 13.65 to 5.09 percent.Putting this further to the test, let’s look at long-term governmentbonds and P/Es dating back to 1900 and buy the market whenever 1/(P/E)(the earnings yield) is greater than bonds. In other words, an investment inthe average company yields a greater dollar amount than a similar passiveinvestment in a bond. There are modifications we will make to this initialassumption, but first let’s test out the basic so-called Fed Model.Before examining the numbers in detail lets take a closer look at theFed Model in Exhibit 12.3.In Exhibit 12.3, the S&P 500 monthly chart from 1900 to 2004 is represented in the bottom pane. The top pane is the earnings yield of the S&P 500represented by the thick black line; the thin gray line is the yield of the 10year government bond. The horizontal axis is the timeline from 1900 to2004. The question an investor has at any given point is, Will investing incompanies yield me more money than I can safely get in governmentbonds? If a government bond is yielding 10 percent, for example, and that’smoney I can put in my pocket safely, and the average company is only earning me five percent on my money, then there’s no need to invest in stocks.This is an extreme example, but it expresses the point.As we can see in the graphic, the question did not really come into playfor the first seven decades of the twentieth century. There was a slight flirtation with it in the late 1920s, however, which erupted into the GreatDepression. And then earnings yields were higher by a fairly wide marginuntil the late 1960s.And why were these yields higher by such a wide margin? Peopleassumed that since bonds were so safe and a company’s earnings were sovolatile and unpredictable, the only way to get the prescribed margin ofsafety would be if earnings were significantly higher than what could beachieved by the appropriate risk-free bond. However, Buffett’s point,repeating a point made in the 1920s by Keynes when analyzing EdgarLawrence Smith’s book Common Stocks as Long-Term Investments, is that
P/E Ratios, Market Timing, and the Fed Model
EXHIBIT 12.3
199
Fed Model
Source: Fidelity Investments. Charts created by using Wealth-Lab Developer software.
companies retain their earnings. Then they reinvest the capital so theycould then return even more. In other words, their earnings compound, asopposed to a government bond, which only returns a fixed coupon. It is thispoint that makes stocks a more attractive investment than bonds, evenwhen the earnings yield is lower than the government bond yield.However, when the earnings yield first breached the 10-year yield in1969 (the vertical line in the graph), this flashed a warning sign to Buffett,who promptly shut down his hedge fund and decided to watch the action.
200
TRADE LIKE WARREN BUFFETT
When the earnings yield was significantly higher than the 10-year yield(the second vertical line in Exhibit 12.4), Buffett got his “buy signal” andmade his “oversexed in a harem” comment.After another brief dip and subsequent lift in the earnings yield representing the 1980–82 bear market, the earnings yield went more or less permanently under the 10-year yield. At any point, a traditional value investorusing the Fed Model could have argued that the market was overvalued,and many investors did, in fact, argue that. But other than brief pauses, themarket was basically a skyrocket until early 2000. It is this “regime shift”EXHIBIT 12.4
Source: Fidelity Investments. Charts created by using Wealth-Lab Developer software.
201
P/E Ratios, Market Timing, and the Fed Model
that occurred around 1982 that makes the traditional Fed Model difficult touse as a forecasting method for stock prices.However, just because there is a regime shift does not necessarily meanthere is no longer any relationship between bonds and earnings. From 1982on, it is more important to look at the relative relationship between the two.In other words, if bond yields move quickly relative to earnings or vice versa,then the market is most likely being either irrationally pessimistic withregard to the earnings potential of stocks, or irrationally optimistic.To prove my theory, I plotted the earnings yield (trailing 12-month coreearnings) of the S&P 500 back to 1982, and did the same for the 10-yearnote. Then I divided the bond yield by the earnings yield and bought thestock market whenever the ratio hit 1.5 standard deviations below its10-day moving average. Given that the yields are correlated, I’m simply buying the market when bond yields tank faster than earnings yields (or whenearnings yields go up faster than bond yields), regardless of whether one isabove the other. I’m then selling the market when the ratio gets back to its10-day moving average.To summarize the results shown in Exhibit 12.5, 14 trades were made,10 of which were profitable (giving the system a 71 percent success rate).The average gain per trade was 11 percent.
EXHIBIT 12.5Trades Executed 1983–2002(based on extreme shifts in Fed Model)Entry Date
Price
Exit Date
Exit Price
% Change
2/1/19847/2/19843/3/19868/1/198612/1/19877/3/198910/1/19909/1/199212/1/199411/1/19969/1/19983/1/20008/1/2000
163.41153.16226.92236.12230.32317.98306.1414.03453.55705.27957.281,366.421,430.83
6/1/19843/1/19856/2/198610/1/19863/1/19899/1/19893/1/19913/1/19942/1/19961/2/19971/4/19995/1/20006/1/2001
150.55181.18246.04231.32288.86351.45367.07467.19636.02740.741,229.231,452.431,255.82
−7.8718.298.43−2.0325.4210.5319.9212.8440.235.0328.416.29−12.23
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TRADE LIKE WARREN BUFFETT
The overall point, it seems, is that relative difference is of more interest than static difference between the yields, contrary to what the FedModel suggests.Basically, it is clear that purely looking at P/Es or purely looking at theFed Model, which dates back to 1900, doesn’t do us any good. But it is alsoclear that through the years Warren Buffett has made some very prescientcalls timing the market, and his justification for these calls was some derivative of the Fed Model. The public’s expectation of earnings growth and thecompounded value of that earnings growth might change over time, as wellas the market’s feelings about earnings versus bond yields. However, anysudden movement (and by “sudden,” I mean over the course of months oreven years) could result in one of Buffett’s famous signals. The key is notsimply waiting for a P/E of five or interest rates less than two percent, but toaggressively act when the spread, in whatever direction, becomes irrational.
C H A P T E R 13
Buffett andDisasters
t the time of this writing halfway into 2004, the Nasdaq and Dow aredown on the year and the S&P is slightly positive. Volume is increasingly petering out and the daily ranges are hitting new record lows.One of the reasons given for this lack of exuberance is the threat of terrorism. If terrorists strike again on American soil, nobody wants to be left holding the bag. Although the United States has been spared a second majorattack until now, with so much bloodshed having gone on in places such asSpain and Russia, the idea that Al Qaeda might still be able to launch a majorattack is seen as an overhang on global markets.After September 11, 2001, when the markets shut down for almost aweek, nobody had any idea what would happen to the U.S. markets whenthey opened. Many wondered if they would even be able to open? To DickGrasso’s credit, he was able to organize the reopening of the New YorkStock Exchange and instill confidence back into the U.S. markets that business would continue as usual. However, even with the reopening of the markets, to say people were nervous about the future prices of their stockportfolios would be a severe understatement.It was into this void of confidence that Warren Buffett went on television and said “If you were a holder of stocks and a believer in the long-termgrowth of the U.S. economy on September 10, then you should be a believer
A
203
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TRADE LIKE WARREN BUFFETT
on September 12.” The idea is this: We have seen this before. The UnitedStates had not experienced the specific psychological and financial damagecaused by September 11, but the nation has nevertheless undergone shocksto the system that we have survived, and will continue to survive, thanks togradual increases in the overall stability of the system.With the help of my colleague Omid Malekan, I took a look at tenpotentially systemic shocks that have occurred over the past 70 years.In each case, we looked at where the S&P 500 was the day before theshock, the day after, the panic low during the ensuing week, and thenwhere the market was one week later, one month later, and six monthslater. A summary table of the results appears in Exhibit 13.11 at the end ofthis chapter.
THE INVASION OF POLAND(SEPTEMBER 1, 1939)The market barely blinked at the invasion, reaching its panic low a fewdays after the event and then not looking back for almost the next year (seeExhibit 13.1). Several possible explanations for this are:• Some sort of crisis event with Germany was certainly expected and builtinto the market.• Perhaps the United States felt that the situation with Germany would besomewhat contained with the countries immediately surrounding it.• After a 10-year depression, there might have been an expectation thatwar in Europe (for which we would be supplying the arsenal) would bea boost to the economy.
THE BOMBING OF PEARL HARBOR(DECEMBER 7, 1941)Perhaps the worst event in the United States’ history up until the 9/11 attacks,the bombing of Pearl Harbor brought the threat of an attack on American soil
Buffett and Disaster
EXHIBIT 13.1
205
Effects of the Invasion of Poland
Source: Fidelity Investments. Charts created by using Wealth-Lab Developer software.
to life. The market took several years to recover, although again a “buy duringthe dip” strategy would have worked well (see Exhibit 13.2).
THE NORTH KOREAN INVASION OF SOUTH KOREA(JUNE 25, 1950)This was the first real clash with the post-WWII Soviet Empire that spreadinto the global Cold War. The market fell from $19.14 to $18.11 the day after,
206
EXHIBIT 13.2
TRADE LIKE WARREN BUFFETT
Effects of the Bombing of Pearl Harbor
Source: Fidelity Investments. Charts created by using Wealth-Lab Developer software.
reaching a low of $17.27 a month later until rallying up to $21.03 six monthslater (see Exhibit 13.3).
KENNEDY’S ANNOUNCEMENT OF NUCLEARMISSILES IN CUBA (OCTOBER 22, 1962)The idea that nuclear weapons were being aimed at the American shoresfrom just 90 miles away was enough to send the market down several per-
Buffett and Disaster
EXHIBIT 13.3
207
Effects of North Korea Invading South Korea
Source: Fidelity Investments. Charts created by using Wealth-Lab Developer software.
centage points (see Exhibit 13.4). What is most interesting is the ferocitywith which the market rallied in only a few months. The Cuban Missile Crisis did not begin and end the threat in one week. The threat, emboldened bya policy of MAD (mutual assured destruction), continued for the next 30years and is still not an issue that the world can ignore. And yet, the marketmore or less determined that if a nuclear war resulted, there would be bigger problems than the stock market, so the party started in 1962 and continued for the next seven years, resulting in the biggest bull market inhistory, until the 1990s came along.
208
EXHIBIT 13.4
TRADE LIKE WARREN BUFFETT
Effects of Kennedy Announcing Nuclear Missiles in Cuba
Source: Fidelity Investments. Charts created by using Wealth-Lab Developer software.
THE KENNEDY ASSASSINATION(NOVEMBER 22, 1963)Everybody who was alive then has an “I remember that moment” story aboutwhen Kennedy was assassinated. The impact struck the United States to thecore: Our young, youthful president who had stood up to the Soviets andmade them back off, was dead. It was inconceivable, and the market reactedappropriately that day, closing almost three percent down from its prior dayclose. But the bull market that had begun under Kennedy’s reign had anothersix years to go, and a week later the market was higher than it had been on
Buffett and Disaster
EXHIBIT 13.5
209
Effects of the Kennedy Assassination
Source: Fidelity Investments. Charts created by using Wealth-Lab Developer software.
November 21. Six months later it had gone from a low of $69.48 on the day ofthe assassination to $80.73 (see Exhibit 13.5).
OIL EMBARGO (OCTOBER 17, 1973)While a host of events served as a prelude to October 19, 1973, the actualannouncement by OPEC that it was raising oil prices almost 70 percent sentthe market into a swoon unrivaled until 1987 (see Exhibit 13.6). The marketquickly fell to its panic low three percent lower, and then 17 percent lowersix months later. However, it is interesting that one week after the embargo,the S&P 500 was actually two percent higher than it had been the day before
210
EXHIBIT 13.6
TRADE LIKE WARREN BUFFETT
Effects of the Oil Embargo
Source: Fidelity Investments. Charts created by using Wealth-Lab Developer software.
the embargo. One shock was not enough to bury the market. However,at the time there was a series of negative events, including:• The Arab-Israeli war, which began on October 6, 1973.• A recession caused, in part, by the 8.5 percent inflation in consumerprices.• The ongoing investigation into the Watergate scandal.
HOSTAGE CRISIS IN IRAN (NOVEMBER 4, 1979)The idea that somebody could, without fear of massive punishment, takeAmerican citizens hostage, was enough to send the market down several
Buffett and Disaster
EXHIBIT 13.7
211
Effects of Hostages Taken in Iran
Source: Fidelity Investments. Charts created by using Wealth-Lab Developer software.
percent during the days immediately after (see Exhibit 13.7). However,despite the fact that we were still in a languishing economy and a series ofbear markets, the market was able to rebound one week later, and was stillseveral percent higher one month and six months later.
IRAQ’S INVASION OF KUWAIT (AUGUST 2, 1990)Perhaps fearful of the slide that occurred in the 1970s when the oil embargostarted, the market immediately slid off when Iraq invaded Kuwait, goingfrom $355.52 on the day before the invasion to a low of $294.51 on October11, 1990 (see Exhibit 13.8). After the war began and once initial fears proved
212
EXHIBIT 13.8
TRADE LIKE WARREN BUFFETT
Effects of Iraq Invading Kuwait
Source: Fidelity Investments. Charts created by using Wealth-Lab Developer software.
unjustified about both the potential length of the war and the effect on oilprices, the market rebounded sharply, going to $409.52 six months to the dayafter the invasion, and setting the stage for the bull market of the 1990s.
THE FIRST BOMBING OF THEWORLD TRADE CENTER (FEBRUARY 26, 1993)This is the best example of a crisis that instilled panic but was largely forgotten (to everyone’s regret) almost immediately. The market began asharp dip immediately following the bombing, going from a close of $442.34the day before to a low of $440.98 right after the bombing, three percent
Buffett and Disaster
EXHIBIT 13.9
213
Effects of the First Bombing of the World Trade Center
Source: Fidelity Investments. Charts created by using Wealth-Lab Developer software.
lower, to actually closing higher on the day at $443.98 by the end of the day.Worries that there would be a repeat incident were largely unfelt as themarket moved upwards the rest of the year, closing at $461.04 six monthslater (see Exhibit 13.9).
THE TERRORIST ATTACKS OFSEPTEMBER 11, 2001This event really was the worst of every situation. We were already in arecession and severe bear market. The attack on American soil was the
214
TRADE LIKE WARREN BUFFETT
worst ever, and it was an attack against the heart of the financial capital ofthe country. Additionally, oil prices spiked immediately afterward and themarket closed for the longest period since the beginning of World War I.The panic was severe, resulting in a low of $944.75 compared with themarket close of $1092.54 on September 10, 2001 (see Exhibit 13.10). Inaddition, the next six months saw the bankruptcy of Enron and the splintering apart of stock market favorites Tyco, WorldCom, and dozens ofother companies. And yet, the market closed at 1165.55 six months later onMarch 18, 2002. Exhibit 13.11 shows a summary of the figures for each ofthe preceding events.
EXHIBIT 13.10
Effects of 9/11
Source: Fidelity Investments. Charts created by using Wealth-Lab Developer software.
215
9/11/2001
Kennedy AssassinationOil EmbargoHostages Taken In IranIraq invades KuwaitFirst WTC Attack
Kennedy Announces Nukes in Cuba71.62110.01102.51355.52442.341092.54
9/11/2001
55.59
11.189.3519.14
1038.77
69.61109.16101.82344.86443.38
53.49
11.298.9718.11
944.75
69.48107.499.49332.22440.98
52.55
None8.417.44
S&P at Prior Closing PriceCloseNext Day Panic Low
10/22/196211/22/196310/19/197311/4/19798/2/19902/26/1993
6/25/1950
9/1/193912/7/1941
Date
Summary of Effects of Catastrophic Events on the Stock Market
Invasion of PolandBombing of Pearl HarborNorth Korea invades South Korea
Event
EXHIBIT 13.11
1003.45
55.7273.23111.38103.51339.94446.11
17.64
12.698.74
1 weeklater
1077.09
73.81100.73106.79323.09447.78
60.81
12.888.8817.27
1 monthlater
1165.55
80.7393.75106.38409.53461.04
70.14
12.068.4721.03
6 monthslater
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TRADE LIKE WARREN BUFFETT
DON’T FIGHT THE MARKETIn its history, the United States has been attacked several times and threatened with nuclear weapons. Its leaders have been assassinated and financialshocks have been inflicted on its markets. The world has been in peril onmany occasions over the past century as well. Each time, however, the market has absorbed the shock and moved past the event. Perhaps the purveyors of doom and gloom can claim that next time, things will be different. ButI doubt they will be.In the book Trade Like a Hedge Fund,1 I analyzed the results of simply buying every dip that occurred, both on stocks and on the markets asa whole. Although Buffett never uses mean reversion as the sole basis of atrade, it is helpful to know that simply using the mean reversion in a decision to buy has a high probability of success, regardless of the other factors that Buffett uses to decide on a trade. The mean reversion nature ofstocks adds to the margin of safety when making a trade or an investmentbased on fundamental factors, such as liquidation value or P/E.
THE 10 PERCENT PULLBACKThis system involves the following two steps:1. Buy a stock that is 10 percent lower than the prior day close.2. Sell at the end of the day.
The data includes all S&P Mid-cap 400 stocks over the past five years. Ichose mid-cap to avoid any “size effect,” but the same test can obviously beperformed on any subset of stocks. Five years is not long enough if you aredeveloping a thorough trading system. That said, a five-year period doestake us through some rises and falls in the bull market of the 1990s as wellthe nonstop bear market of the 2000s.
1
Trade Like a Hedge Fund, James Altucher, John Wiley & Sons, Inc., 2004.
217
Buffett and Disaster
As for our position size, let’s assume we start off with $1 million and use$50,000 per trade (five percent of portfolio per trade). The results are shownin Exhibits 13.12 and 13.13.Since January 1, 1997, the 10 percent pullback system did about 8,200trades, 60 percent of which were profitable, with an average profit per tradeof 1.4 percent. The maximum drawdown of the system was −3.5 percent asopposed to −40 percent for a buy-and-hold strategy (as evidenced by thethick blue line in the equity curve in Exhibit 13.13).
EXHIBIT 13.12
10% Pullback SystemAll Trades
Starting CapitalEnding CapitalNet ProfitNet Profit %Exposure %Risk Adjusted ReturnAll TradesAverage Profit/LossAverage Profit/Loss %Average Bars HeldWinning TradesGross ProfitAverage ProfitAverage Profit %Average Bars HeldMax ConsecutiveLosing TradesGross LossAverage LossAverage Loss %Average Bars HeldMax ConsecutiveMax DrawDownMax DrawDown $Max DrawDown DateStandard ErrorRisk Reward RatioSharpe Ratio of Trades
$1,000,000.00$6,744,820.50$5,744,820.50574.48%7.50%7,663.94%8,197$700.841.42%1.004968 (60.61%)$12,969,821.00$2,610.675.30%1.00413229 (39.39%)$−7,224,984.00$−2,237.53−4.54%1.0025−3.54%$−142,059.754/14/2000$335,618.533.353.24
Buy & Hold
$1,000,000.00$1,998,198.00$998,198.0099.82%100%99.82%397$2,514.3599.85%1,499.00282 (71.03%)$1,101,028.75$3,904.36155.07%1,499.0014115 (28.97%)$−102,831.17$−894.18−35.56%1,499.005−40.43%$−1,107,053.2510/9/2002$258,692.670.910.16
Source: Trade Like a Hedge Fund, James Altucher. Copyright © 2004 John Wiley &Sons, Inc.
218
EXHIBIT 13.13
TRADE LIKE WARREN BUFFETT
Equity Curve for the 10% Pullback System
Source: Trade Like a Hedge Fund, James Altucher. Copyright © 2004 John Wiley &Sons, Inc.
AN ALTERNATIVE PULLBACK METHODUse the same procedure as above, except instead of holding for one day,hold for one month. The data set includes 11 Nasdaq 100 stocks over thepast eight years. The simulation starts with $1,000,000, using $2,000 (0.2 percent of equity) per trade.The results are shown in Exhibits 13.14 and 13.15.
219
Buffett and Disaster
EXHIBIT 13.14Period Starting
1/24/19951/2/19961/2/19971/2/19981/4/19991/3/20001/2/20011/2/2002
Chart of Annual Returns of 10% Pullback Method #2
$ Return
% Return
% Max DD
Exposure
Entries
Exits
99,167.25108,217.5070,164.13358,756.75247,274.00168,689.00565,377.88153,366.75
9.929.855.8128.0815.118.9627.555.86
−1.48−2.86−2.12−5.51−2.01−14.45−16.89−7.50
5.768.248.2512.448.9123.2418.7312.49
3515696379899213,1122,4751,867
3015986059869192,7992,7701,764
Average annual returnStandard Deviation of returnsSharpe RatioAverage return per tradeAverage return per winning tradeAverage return per losing trade
13.89%9.071.538.16%28.82%−18.67%
Source: Trade Like a Hedge Fund, James Altucher. Copyright © 2004 John Wiley &Sons, Inc.
EXHIBIT 13.15
Equity Curve for the 10% Pullback Method #2
Source: Trade Like a Hedge Fund, James Altucher. Copyright © 2004 John Wiley &Sons, Inc.
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TRADE LIKE WARREN BUFFETT
EXTREME ADVANCES/DECLINESThe system involves:1. Buy the Mid-cap ($MDY) index at the close of the market if the num-
ber of advancing stocks minus the number of declining stocks is lowerthan −300.2. Sell in two months.
Since 1996, the system makes the trades shown in Exhibit 13.16.Not a lot of trades are generated—only nine, six of which are profitable. However it is interesting to see that those days of extreme marketreactions to the downside, where everyone was selling everything, calledsignificant market bottoms over the past six years.Even in the midst of disaster, it is important to take a step back from thepanic and remember that we’ve most likely seen similar levels of panic inthe past. It is times like these, whether it was during the oil crisis of the mid1970s, or even the aftermath of 9/11, that investors like Warren Buffett oftenmake their best purchases.EXHIBIT 13.16
Extreme Advances/Declines System
Entry Date
Entry Price
Exit Date
Exit Price
% Change
Bars Held
10/2