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Money Matters: A bull-and-bear naturalist

When it comes to investment losses, we're often our own worst enemies

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Barry Ritholtz, author of bestselling financial book, Bailout Nation, couldn't have visited at a more distinctly Winnipeg moment.

The leading equity researcher, columnist and frequent pundit on BNN, CNBC and many other TV networks was in town last month as the keynote speaker for Winnipeg's CFA Society 48th Annual Forecast Dinner.

As it happened, the mercury hit its lowest in more than a year at -34.9 C. A prolific blogger, Ritholtz even wrote about his experience walking outside from a downtown hotel to a Thai restaurant.

He didn't complain -- though he did mention how surprisingly painful the frigid conditions are even to a native New Yorker, no stranger to snow and ice.

Instead, he was fascinated, even recommending the experience, albeit he's not likely to jump at the opportunity again.

The blog entry is telling. Ritholtz is a curious guy. He even arrived a day early to check out the sights, bringing with him what he thought was the proper winter gear -- ski jacket, scarf, etc. -- to venture out into one of the most inhospitable urban environments on the planet.

Undoubtedly, this desire for understanding and experience has served him well as an investor and market commentator.

The lawyer-cum-trader-cum-equity-researcher is among the handful of market-watchers who predicted the collapse of the U.S. real estate market in 2007 and the ensuing credit crunch.

His book, Bailout Nation, is a biting condemnation of Wall Street and Washington, whose legislators put in place the laws that permitted banks to become too big to fail.

His conversational prose makes the book accessible even for readers with little market knowledge, but it is also compellingly researched, offering new insights about the meltdown and the history building up to it, making the book a must-read for even the well-versed market observer.

Yet despite signing books at the annual dinner, his talk involved little discussion about the malfeasance in the U.S. mortgage and banking industries.

Instead, Ritholtz focused on the fruits of his day job, analyzing data and charts -- in particular, those offering understanding of bull and bear markets for the last 100 years. And over top, he layered how investor psychology and behaviour play fundamental roles in these boom-and-bust cycles.

Ritholtz is neither bullish nor bearish about markets.

More than anything, he's uncertain -- except for a couple of things.

"I'm a big fan of talking about how every bear market is followed by a bull market, and every bull market is followed by a bear market," he said.

"It seems that a lot of people forget that. That's why you can end up with a lot of people who are always bullish."

And it's also why others are perpetually bearish -- foreseeing nothing but losses and sorrow.

"What I really want to talk about is broad market cycles and why humans get this so wrong," he said. "The biggest mistakes that most investors make have to do with their own behaviour. They're their own worst enemies."

Ritholtz pointed out bear markets can last several years. Between 1966 and 1982, the Dow Jones industrial average index stayed flat despite its many ups and downs along the way.

"With bear markets, you might not make a lot of progress when they're done, but there's a lot of up and down in the middle, and that's what seems to confuse investors," he said.

"Each up-and-down swing scares investors away, and by the time we get to the far end of that bear market, most of the public participants have been exhausted and want nothing to do with equities."

What he believes underpins booms and busts is investor enthusiasm, or a lack of it.

"The opposite of love isn't hate. It's indifference."

And once the investment climate reaches that "meh" mood, that's when bear markets end and bull markets begin.

"When I define what a bull market or bear market is, it's not driven by price," he said.

"It's driven by the psychology of investors making purchases or not."

One measure among many he uses to sample investor zeal is the price/earnings (P/E) multiple, which shows how much investors are willing to pay for every dollar of earnings.

"Not coincidentally, every one of those bear markets also has a P/E multiple contraction going on at the same time," he said.

"Every one of those bull markets has a P/E multiple expansion."

The 1982-to-2000 bull market saw the S&P 500 -- an index of the U.S.'s largest companies -- increase by 1,200 per cent. During that period, the P/E of the entire index increased from about eight to about 32.

"Nearly three-quarters of the gains were not based on improving earnings, but improving earnings multiples," he said. "It's people buying stocks and bidding higher and higher prices for one dollar of earnings, which eventually leads us to the bear markets."

A bear market is defined by the opposite: an unwillingness to pay for every dollar of earnings. And most bear runs end when the P/E hits eight, he said.

We're at about 13 for the U.S. markets now, but the wild card today is the U.S. Federal Reserve. Its policies -- quantitative easing and rock-bottom interest rates -- have propped up markets.

On top of that, bonds aren't behaving as they should in a typical cycle. Because of the low interest rates, bonds should be unattractive because if rates rise, existing bonds lose value. Yet bonds continue on their bull run that has gone on since the 1980s when interest rates were in double digits. No one should be interested in a 10-year U.S. Treasury yielding less than two per cent.

Yet investors want them.

"It's not that the U.S. is such a desirable, reliable and safe producer of credit," he said. "It's that in the land of the blind, the one-eyed man is king,"

Needless to say, uncertainty prevails. We're at the end of a bear equities market that has lasted a more than a decade.

Or maybe we have many more years of ups and downs left before we hit a long-term upward trend again?

Compounding the problem, he said, is we can't rely on experts, particularly those pundits on TV.

"My wife will tell you exactly what sort of idiot I am, but I meet these people and I'm like, 'How are you gainfully employed?' " he said. "The people on TV -- somewhere between 40 to 60 per cent of them honestly have no idea what they're talking about."

Ritholtz is no stranger to TV himself, but he said he makes a point of regularly defining his limitations and playing devil's advocate before making investment decisions.

"If you have to be able to argue for and against, then you really know that decision inside out, upside down, forward and backwards," he said.

It's also not a bad idea to dwell on past mistakes. Ritholtz does so yearly, a mea culpa examining his worst trades.

"If you don't admit your errors and figure out where you went wrong, you'll never understand how to improve."

giganticsmile@gmail.com

 

QUICK FACTS

On the web: Check out Barry Ritholtz's blog, The Big Picture. It's updated a few times daily more often than not, featuring an assortment of charts and other interesting odds and ends from the financial world. He also includes a daily list of readings from blogs, magazines and newspaper from around the world -- www.ritholtz.com.

More about Ritholtz: His day job is CEO and director of equity research at Fusion IQ. An online quantitative research firm evaluating financial data of about 8,000 stocks, it prides itself on providing institutional-quality research to the general public at a reasonable price. His former gig was chief market strategist managing about $5 billion in assets for Maxim Group, an investment bank in New York.

Learning the tricks of your trade: Ritholtz is a student of behavioural economics, a.k.a. the psychology of finance. Its focus is uncovering the cognitive errors people make when managing money.

Here are three of the bigger mistakes Ritholtz touched upon in his recent talk in Winnipeg:

We're not as good as we may think: People aren't very good at evaluating their own abilities, which makes sense, since it's hard to be objective. Yet we tend to evaluate ourselves differently when we're doing something we're actually good at compared to something we're not very good at. "It turns out that if you're really mediocre at something, you really have no idea that you really stink at it," he said. "You just assume you're pretty good. But when you're really good at something, you know all the things you're doing wrong."

The false hope in the confident: As previously noted, Ritholtz doesn't have much faith in the well-spoken, confident pundit, and for good reason. "Their expertise is widely overstated. The more confident an expert sounds, the more likely they are to be believed by the public." People like certainty, even if it's wrong, over-nuanced uncertainty, even if it's truthful.

Believing is seeing: We tend to see what we want in life, especially investing. "What we expect to see impacts what we actually see," he said. To that end, most people read things that agree with what they think. Yet it's very hard to do the opposite. "You're thumbing through a report and you think 'This guy is an idiot!' " Ritholtz said. "He may or may not be an idiot. What you're really saying is, 'This guy disagrees with my preconceived notions.'"

A passive New Yorker: One might assume Ritholtz, an equities researcher, would be a proponent of active investing -- picking stocks. Yet he's not. "I started out in this business as a trader and I did pretty well except in months that I did pretty poorly," he said. "I eventually came to the conclusion that it is far more random than I was comfortable with and came around to believing that over long periods of time, 30 to 40 years, a broadly based asset-allocation model that is passive will outperform 80 per cent of everything else."

Republished from the Winnipeg Free Press print edition February 2, 2013 B10

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