Metanoia Financial

The investment community lost one of its more colorful characters last week with the passing of Martin F. Zweig, a prominent market pundit, author, and chairman of Zweig-DiMenna Associates LLC, a New York investment firm. His death also marks the close of another chapter in the long-running debate on the virtues of market timing.

Zweig took a keen interest in stocks as a teenager, and after earning a PhD in finance from Michigan State University, he began writing investment newsletters while teaching in New York. He launched The Zweig Forecast in 1971 with a handful of subscribers and continued to publish it, with considerable success, for the next 26 years. Zweig loved numbers (including baseball trivia) and was closely associated with statistical measures of monetary policy and market momentum that he combined into what he called a “super model” to assess market conditions. He is credited with introducing the put/call ratio, a measure of investor sentiment, to the toolkit of market forecasters. He transitioned to money management, and in October 1986, he launched the Zweig Fund, a closed-end mutual fund that relied on his analysis of market trends to adjust its exposure to stocks and bonds.

Zweig was a frequent contributor to both print and broadcast media and wrote numerous articles forBarron’s, a weekly publication with a devoted following among those seeking comprehensive market statistics. Perhaps his finest hour was an appearance on the television show Wall Street Week with Louis Rukeyser on Friday evening, October 16, 1987. When his host asked him to comment on assertions from other market commentators that the “bull market is dead,” Zweig replied he was expecting a crash but was reluctant to say so publicly. It was too similar, he said, to shouting “fire” in a crowded theater. Zweig’s prediction proved eerily accurate: The Dow Jones Industrial Average fell by a staggering 29.2% in chaotic trading the following Monday, an even bigger setback than the combined losses from Black Monday and Black Tuesday in October 1929. The Zweig Fund emerged relatively unscathed: According to a profile several years later in SmartMoney, the fund had 58% of its assets in cash leading up to the crash, and experienced a loss of only 6.2% on October 19. Traumatized by the unprecedented market break, many investors sought out advisors or analysts who appeared to have avoided the debacle. Zweig’s reputation as a financial expert soared. For years, he was introduced as “the man who called the crash.” The headline of Zweig’s obituary in the Wall Street Journal described him as a “master market timer.”

Zweig was not the only analyst to predict the 1987 crash, but his appearance on Wall Street Week was so visible and so perfectly timed that his status as an astute financial guru was greatly enhanced. By the time SmartMoney published its profile in 1995, his firm was managing nearly $4 billion in assets. In 1999, Zweig purchased a multistory penthouse above the Pierre Hotel, the most expensive residential transaction in New York City up to that time.

Should investors seek to enhance their returns by applying Zweig’s statistical timing tools? The evidence is mixed at best. Zweig’s October 1987 market call was on the money, and the Hulbert Financial Digestonce reported that The Zweig Forecast ranked first among market newsletters for risk-adjusted performance. Many investors have discovered, however, that making one or two great predictions is often insufficient to generate above-average long run results—you have to be right over and over again to outperform Mr. Market.

Moreover, it appears that achieving excess returns with real dollars is more challenging than making prescient forecasts in a newspaper column. Annualized return for the Zweig Fund from inception in October 1986 through January 31, 2013, was 6.79% calculated from net asset value and 5.84% based on NYSE closing share prices. (The latter figure reflects the difference between the fund’s reported net asset value and the market price of the shares in NYSE trading.) Over this same time period, the annualized return was 9.84% for the S&P 500 Index and 7.90% for a static mix allocated 30% to the S&P 500 Index and 70% to the Barclays Aggregate Bond Index. A tilt toward small cap or value stocks within these indices over this period would have produced even higher returns.

Market timers often acknowledge that their signals do not provide sufficient guidance to outperform a buy-and-hold, 100% equity strategy. Their goal, they say, is to avoid major bear market losses by holding a large fixed-income allocation during market downturns and capturing a meaningful portion of equity market rewards by increasing stock holdings during the upswing. Reducing bear market losses may be a laudable goal, but as this example shows, it can also be pursued with greater simplicity by adopting a lower equity exposure at all times and ignoring the costs and frustrations associated with constant fiddling.

It’s safe to say that no one worked more diligently or enthusiastically than Martin Zweig to tease out tomorrow’s stock prices from today’s data. But the evidence suggests that even the most dedicated student of market statistics is unlikely to meet with long-run success.

REFERENCES

Stephen Miller, “Master Market Timer Had Front Row Seat,” Wall Street Journal, February 19, 2013.

William Yardley, “Martin Zweig, Who Forecast ’87 Market Crash, Dies at 70,” New York Times, February 22, 2013.

Zweig Fund performance data, www.virtus.com, accessed February 22, 2013.

John Anderson, “Running on Empty,” SmartMoney, September 1995.

Dow Jones data provided by Dow Jones Indexes.

S&P data provided by Standard and Poor’s Index Services Group.

Barclays data provided by Barclays Bank PLC.

Human beings have an astounding facility for self-deception when it comes to our own money.

We tend to rationalize our own fears. So instead of just recognizing how we feel and reflecting on the thoughts that creates, we cut out the middle man and construct the façade of a logical-sounding argument over a vague feeling.

These arguments are often elaborate, short-term excuses that we use to justify behavior that runs counter to our own long-term interests.

Here are ten of these excuses:

1) “I just want to wait till things become clearer.”

It’s understandable to feel unnerved by volatile markets. But waiting for volatility to “clear” before investing often results in missing the return that can accompany the risk.

2) “I just can’t take the risk anymore.”

By focusing exclusively on the risk of losing money and paying a premium for safety, we can end up with insufficient funds for retirement. Avoiding risk can also mean missing an upside.

3) “I want to live today. Tomorrow can look after itself.”

Often used to justify a reckless purchase, it’s not either-or. You can live today and mind your savings. You just need to keep to your budget.

4) “I don’t care about capital gain. I just need the income.”

Income is fine. But making income your sole focus can lead you down a dangerous road. Just ask anyone who recently invested in collateralized debt obligations.

5) “I want to get some of those losses back.”

It’s human nature to be emotionally attached to past bets, even losing ones. But, as the song says, you have to know when to fold ‘em.

6) “But this stock/fund/strategy has been good to me.”

We all have a tendency to hold on to winners too long. But without disciplined rebalancing, your portfolio can end up carrying much more risk than you bargained for.

7) “But the newspaper said…”

Investing by the headlines is like dressing based on yesterday’s weather report. The news might be accurate, but the market usually has reacted already and moved on to worrying about something else.

8) “The guy at the bar/my uncle/my boss told me…”

The world is full of experts, many who recycle stuff they’ve heard elsewhere. But even if their tips are right, this kind of advice rarely takes your circumstances into account.

9) “I just want certainty.”

Wanting confidence in your investments is fine. But certainty? You can spend a lot of money trying to insure yourself against every possible outcome. While it cannot guard against every risk or possible outcome, it’s cheaper to diversify your investments.

10) “I’m too busy to think about this.”

We often try to control things we can’t change—like market and media noise—and neglect areas where our actions can make a difference—like the costs of investments. That’s worth the effort.

Given how easy it is to pull the wool over our own eyes, it can pay to seek independent advice from someone who understands your needs and circumstances and who holds you to the promises you made to yourself in your most lucid moments.

Call it the “no more excuses” strategy.

Bill Miller is one of the most closely watched money managers in the industry, so it was big news when he announced his decision last week to step down as portfolio manager of Legg Mason Capital Management Value Trust (LMVTX) early next year. His departure also adds an intriguing chapter to the long-running debate regarding the value of active stock selection.

Miller’s most frequently cited accomplishment is the fifteen-year period from 1991 through 2005, during which Value Trust outperformed the S&P 500 each calendar year, the only US equity fund manager to have ever done so. His success attracted a wide and enthusiastic following: Morningstar named him Portfolio Manager of the Decade in 1999, Barron’s included him in its All-Century Investment Team that same year, and a Fortune profile in 2006 described him as “one of the greatest investors of our time.” A former US Army intelligence officer and philosophy student, his formidable intellect covered a wide range of interests, and he believed that conventional investment analysis could be enhanced with insights drawn from literature, logic, biology, neurology, physics, and other fields not obviously related to finance. His expressed desire to “think about thinking” suggested an unusual ability to assess information differently from other market participants and arrive at a more profitable conclusion.

Miller’s bold and concentrated investment style would never be confused with a “closet index” approach. Big bets on Fannie Mae, Dell, and America Online, for example, were rewarded with handsome gains (as much as fifty times original cost in the case of Fannie Mae). Unfortunately, similar bets in recent years revealed the dangers of a concentrated strategy as heavy losses in stocks such as Bear Stearns and Eastman Kodak penalized results. For the five-year period ending December 31, 2010, LMVTX finished last among 1,187 US large cap equity funds tracked by Morningstar. Considering the enormous variation in outcomes among these carefully researched ideas, Miller’s overall investment record presents an interesting puzzle: How can we disentangle the contribution of good luck or bad luck, of skill or lack of skill?

Over the May 1982–October 2011 period, annualized return was 11.28% for the S&P 500 Index and 11.76% for the Russell 1000 Value Index. Value Trust slightly outperformed the S&P and underperformed the Russell index by over 0.40% per year. A three-factor regression analysis over the same period shows the fund underperformed its benchmark by 0.08% per month.

Do these results offer conclusive evidence of the failure of active management? Not necessarily. The fund’s expenses are above average at over 1.75% and provide a stiff headwind for any stock picker to overcome. Gross of fees, the fund’s performance over and above its benchmark goes from –0.08% to 0.07% per month. This swing from negative to positive raises an interesting point that Ken French speaks to at every Dimensional conference. There are almost certainly some mistakes in market prices and almost certainly some skillful managers who can exploit them. But who is likely to get the benefit of this knowledge—the investor with his capital or the clever money manager? If stock-picking talent is the scarce resource, economic theory suggests the lion’s share of benefits will accrue to the provider of the scarce resource—just what we see in this instance.

To cloud the discussion even further, both of these results, positive and negative, flunk the test for statistical significance; in neither case can they be attributed to anything more than chance. So even with twenty-nine years of data, we cannot find conclusive evidence of manager skill—or lack thereof. This is the inconvenient truth that every investor must confront: The time required to distinguish luck from skill is usually measured in decades, and often far exceeds the span of an entire investment career.

Miller is well aware of the challenge of distinguishing luck from skill and has conspicuously declined to boast about his results, even when they were unusually fruitful. He has acknowledged that topping the S&P 500 each year for fifteen years was an accident of the calendar and that using other twelve-month periods produced a less headline-worthy result.

Commentators have said that Miller has “lost his touch” or that his investment style is no longer suitable in the current market environment. These arguments strike us as the last refuge for those who find the idea of market equilibrium so unpalatable that they search for any explanation of his change in fortune other than the most plausible one—prices are fair enough that even the smartest students of the market cannot consistently identify mispriced securities.

Where does this leave investors seeking the best strategy to grow their savings?

When asked by a New York Times reporter in 1999 to sum up his legacy, Miller replied, “As William James would say, we can’t really draw any final conclusions about anything.” Twelve years later, this observation seems more useful than ever. And investors would be wise to treat even the most impressive claims of financial success with a healthy degree of skepticism.

REFERENCES

Andy Serwer, “Will the Streak Be Unbroken,” Fortune, November 27, 2006.

Edward Wyatt, “To Beat the Market, Hire a Philosopher,” New York Times, January 10, 1999.

Tom Sullivan, “It’s Miller Time,” Barron’s, October 12, 2009.

Diana B. Henriques, “Legg Mason Luminary Shifts Role,” New York Times, November 18, 2011.

S&P data provided by Standard & Poor’s Index Services Group.

Morningstar data provided by Morningstar Inc.

Russell data copyright 2011, Russell Investment Group 1995-2011, all rights reserved.