Dear friends,

“And they’re off!” signals both the start of a horse race and the end of a class’s years at college.

Augustana just launched 485 more grads in your direction. It’s our 157^th assault on adult life, and one of our largest. I’m pleased that Mike Daniels was the student selected to speak at commencement but he’s so durn Augie. Mike’s a defensive lineman, but also a jazz musician. He’s an accountant, but also a first team NCAA Academic All-American. He’s been to Italy (with the football team), but also managed to sneak in three internships on his way to working for Deloitte & Touche. He’s a good man who overtly rejects “good enough” as a goal; that is not, he said, “the Augie way.”

They’re good kids. Be patient with them. They really do want to do right. They’re awfully bright. They learn fast. They work and play well together. They’re a lot more aware of the world around them than I was at their age. They’ll keep you young if you let them.

I’m not sure that they’re as relentlessly curious as we once were, but that’s mostly because they don’t have to wonder about the answers; they simply Google them. I’d grumble about their sense of entitlement, but every time I glance in the mirror I blush at the source of it. Their attention span is pretty short, I guess, and they seem incapable of focusing on one thing at a time. But I think that’s because they’re smart and they’ve learned the lesson we have chosen to teach them: do more and do it now! I’m not sure when it became common for 10^th graders to have resumes – and concerns about building resumes – but we’re there now. And if we wonder why Facebook and Instagram creep into their daytime hours, we might think about the number of work emails and texts that creep into their nighttime hours.

Celebrating commencement: from peril to Pollyanna, and back

Such events are normally festooned by modestly gaseous speeches from distinguished adults. For better and worse, no one is listening; words may flow into their ears, but they’re not lodging in their brains. Given the day, how could they?

Bill Gates, perhaps sensing the problem, decided to try a different approach to a valedictory address. He tweeted it. Here is Gate’s May 15th address to The Classes of 2017:

1. New college grads often ask me for career advice. At the risk of sounding like this guy…https://www.com/watch?v=Dug-G9xVdVs … [Snowball: it’s the “just one word: plastics” clip from The Graduate]
2. [Artificial intelligence], energy, and biosciences are promising fields where you can make a huge impact. It’s what I would do if starting out today.
3. Looking back on when I left college, there are some things I wish I had known.
4. For example, intelligence takes many different forms. It is not one-dimensional. And not as important as I used to think.
5. I also have one big regret: When I left school, I knew little about the world’s worst inequities. Took me decades to learn.
6. You know more than I did when I was your age. You can start fighting inequity, whether down the street or around the world, sooner.
7. Meanwhile, surround yourself with people who challenge you, teach you, and push you to be your best self. As @MelindaGates does for me.
8. Like @WarrenBuffett I measure my happiness by whether people close to me are happy and love me, & by the difference I make for others.
9. If I could give each of you a graduation present, it would be this–the most inspiring book I’ve ever read.
   
10. @SAPinker shows how the world is getting better. Sounds crazy, but it’s true. This is the most peaceful time in human history.
11. That matters because if you think the world is getting better, you want to spread the progress to more people and places.
12. It doesn’t mean you ignore the serious problems we face. It just means you believe they can be solved.
13. This is the core of my worldview. It sustains me in tough times and is the reason I love my work. I think it can do same for you.
14. This is an amazing time to be alive. I hope you make the most of it.

“It’s an amazing time … with serious problems … they can be solved.” It’s a call to action that Bernie Sanders echoed two weeks later: “In response to these very serious problems it seems to me that we have two choices. First we can throw up our hands in despair. We can moan and groan. We can withdraw from the public reality that we face. We can loudly proclaim that we can’t beat the system. That is one response. It is an understandable response but it is not an acceptable response” because the costs of despair are too high.

Gates’s endorsement of The Better Angels of our Nature drove sales of the book on Amazon through the roof, from about #12,000 to #2 in just a few days.  For those of us reluctant to slog through an 832-page tome (inside every fat book there’s a thin book struggling to get out), here’s the short version:

• Almost all of human history has been a bloody horror, often in a literal “ankle-deep in blood” sense.
• But, century by century, it’s gotten better because we’re able to use our brains to make the world more secure and humane.
• Nonetheless, we insist on romanticizing the past and demonizing the present, mostly because the present is a pain in our butts and the past can’t hurt us anymore.

Pinker’s bottom line: there is no time machine to let us return there and, if there was, no one but a fool would step into it.

Setting aside the furor that the book engendered (and it was furious), there is a powerful warning embedded in Pinker’s Pollyanna prose: an attempt to return America to some rose-hued Golden Age is not only doomed from the start (it didn’t exist and we can’t get there), but it’s also powerfully destructive. Rather than celebrate the world we have and grapple with its problems, we’d sink into delusion and denial, letting manageable problems swell into horrific ones. Which, of course, just encourages more denial and nostalgia.

The administration’s obsession with the coal industry has that flavor. The coal industry as a whole employs, from miners to secretaries, just over 50,000 Americans. Those are hard, often dangerous (my grandfather’s work in the mines almost kept him from, well, becoming my grandfather), often high-paid (the industry average is $28/hour) jobs in towns that need them; still, it is a tiny pool, being dried up by private competition rather than government fiat. Even if we were to magically increase employment in coal by 50%, it would still employ far fewer people than my local Hy-Vee grocery chain.

And so, to our new graduates, welcome to the world! It’s a wonderful place. It’s a horrible place. It’s yours, and ours. Time to get working!

Had I mentioned that my Ph.D. is in a non-quantitative field?

I’m trained as a debate coach and a historian of rhetoric. I have a visceral attachment to words, stories and ideas and a modestly anxious acquaintance with number. I mention all this as part of an apology and a mea culpa.

In our June issue, we urged people to take a realistic look at the risks embedded in their portfolios. In particular, we suggested that you should quickly calculate the likely downside you face in the sort of powerful corrections we’ve recently seen, 2000-02 and 2007-09. One way to do that is to multiply the maximum drawdown for each fund in your portfolio by its weight in your portfolio, then add the products together. The sum you see is an approximation of the amount by which your portfolio might decline in a bear market.

All of which would have worked better if I’d been paying more attention to Mrs. Zimmermann in fifth-grade math, when she introduced percentages. I ended up miscalculating the drawdown impact of two funds, which overstated my portfolio’s likely loss. Our colleague and data demon Charles later went in and refined the drawdown calculation from funds that are too new to have experienced the 2007-09 downturn.

Bottom lines:

1. My portfolio, which I think of as a conservative growth model, might well lose 30% in a sharp downturn, rather than the 33% I originally estimated. I might expect to take 3-5 years to recover those losses.
2. I’m pleased with my manager’s risk sensitivity. I looked for the closest match ETFs for my core holdings, to compare the impact that my managers have on downside protection. For some funds (FPA Crescent), there are simply no substitutes. For others, the comparison of losses in 2007-09 is instructive:
   

   	As a substitute for	My MaxDD	ETF’s MaxDD
   iShares Emerging Markets ETF	Seafarer	53%	60
   PowerShares Emerging Markets Sovereign Debt Portfolio	Matthews Asian Strategic Income	20	26
   iShares MSCI EAFE ETF	Artisan International Value	47	57
   iShares Morningstar Small-Cap Value ETF	Intrepid Endurance	19	53
   BLDRS Asia 50 ADR Index Fund	Matthews Asian Growth & Income	38	57

3. I’m deeply grateful for all the folks who took the argument seriously to detect the error and share it with us. Those include Thom Pickett, a senior vice president at Wells Fargo Advisors, as well as bee, willmatt72 and Vintage Freak on MFO’s always lively discussion board. Thanks guys!

PARMX: no longer “left behind by Morningstar”

As Morningstar’s priorities have shifted, they’re dropped coverage of hundreds of exceptionally strong funds. Our standard for “exceptionally strong” is funds that have maintained a four- or five-star rating over every trailing time period.

On the flipside, we occasionally discover a fund that has been re-discovered by Morningstar. So, kudos to Parnassus Mid-Cap (PARMX). PARMX is a $2.4 billion, five-star mid-cap fund with a set of strong ESG screens. The fund was last covered six years ago (5/19/2011) when Kathryn Young concluded that you should “keep this fund on your radar, but give it time to mature.”

Apparently “time” translated to “about six years,” including five in which the fund handily beat its peers. On March 30, 2017, Wiley Green offered these highlights: “Parnassus Mid Cap has it all for environmental, social, and governance investors seeking mid-cap exposure … The team has executed well [and] the fund’s risk-adjusted performance shines, with lower volatility and better downside protection than the category and index during the same time frames.”

Morningstar prospects:  Hope for the little guy

Morningstar publishes a quarterly list of “up-and-coming or under-the-radar investment strategies that Morningstar Manager Research thinks might be worthy of full coverage someday.”

The list is available only by subscription but we received permission to share highlights.

Two funds went from prospect to full coverage: ClearBridge Large Cap Growth (SBLGX), a 20 year old, $7.4 billion fund, was recognized as a Bronze medalist while Vanguard Tax-Exempt Bond Index (VTEBX), which is not yet two years old, has been awarded a Silver medal.

Columbia Acorn Emerging Markets (CEFZX) was dropped entirely from the Prospects list because of the departure of manager Fritz Kaegi and turmoil at Columbia Acorn funds.

New prospects include

• Tributary Small Company (FOSCX). Our December 2016 profile described it as “one of the best small cap funds available to you.”
• Westwood SmallCap (WHGSX), a 10-year old small- to micro-cap blend fund. Nominally institutional, it has a $5,000 minimum.
• Morgan Stanley Global Opportunities, led by a protégé of star manager Dennis Lynch.
• GQG Partners Emerging Markets Equities (GQGPX). It’s a new fund by a star manager Rajiv Jain. You can get some sense of Mr. Jain’s thinking from our February 2017 Elevator Talk with him.
• LJM Preservation & Growth (LJMAX), an options trading fund. I’ve sort of given up on options funds and managed futures funds, so I’ll mostly nod here.
• Oppenheimer Fundamental Alternatives (QVOPX), a 28-year-old multi-alternatives fund with a team that’s now been in place for five years.

Congratulations to the prospects, and thanks to Morningstar for sharing them.

Thanks, too, to you!

William, Patrick, and Jason – thanks so much for your contribution. It means a lot to us. And, as always, our trusty regulars Jonathan, Deb, Brian, and Greg. We couldn’t do it without you. For those who’d like to make a contribution, you can see your options on the “Support Us” page. We always appreciate your help.

As ever,

“Put your trust in God but keep your powder dry.”

Oliver Cromwell, 1650, to the soldiers of the New Model Army as they prepared to forge an Irish river and head into battle.

Cromwell was a dour, humorless (or “humourless”) religious fanatic charged with squashing every Catholic and every independent thought in the British Isles because, well, that’s what God demanded. Famine, plague, deportations, mass death and deportations followed.

But even Cromwell knew that the key to victory was prudent preparation; faith did not win battles in the absence of the carefully stocked dry gunpowder that powered the army. There were time to charge ahead and there were times to gather powder.

With investing likewise: there are times to be charge ahead and times to withdraw. Most investors struggle with that decision. Why?

1. Most investment products feed our worst impulses. The investment industry has come to be dominated by passive, fully-invested products over the past five years; not coincidentally, that period has seen just one break in the upward rush. In cap-based funds, more money goes to the best performing stocks in the index so markets get driven by the momentum of fewer and fewer stocks. In 2015, for instance, just four stocks accounted for the S&P 500’s entire gain.
2. Most professional investors worry more about accumulating assets than about serving investors. By most measures, the U.S. stock market is substantially overpriced but the cash reserves at mutual funds are low; Morningstar gives the average domestic funds cash at 4.2%. Why? Because, as Jason Zweig writes, “cash is now a sin.” Cash is a drag on short-term returns and investors fixated on 1/3/5 year returns have poured their money into funds that are fully invested all the time, both index products and the cowardly “active” managers who merely shadow them. The technical term for “skilled investors who do not attract assets to the firm” is “unemployed.”
3. Most of us are too optimistic. Most guys think of themselves as “good investors” or “above average” investors, mostly because “good” is such a vague term and almost none of us actually know how or what we’ve done. Quick quiz: what’s your personal rate of return over the last five years? How much of your portfolio was invested cautiously as the market approached its top in October 2007 and how much was invested aggressively at its bottom in March 2009? The honest answers for most of us are “dunno, dunno, dunno.”
   It’s not just about investing. 95% of us think we’re above average drivers. One 1965 study of drivers responsible for car accidents that put people in the hospital found the same: the majority of those drivers rated themselves as “really good.” Stan Clark, a Canadian adviser, wrote a thoughtful little piece on the phenomenon.

The result is that we’re tempted to take on too much risk, sublimely confident that it will all work out.

But it won’t. It never does. You need a manager who’s got your back, and you need him now. Here are three arguments in three pictures.

Argument one: stock prices are too danged high.

This chart shows valuation of the US stock market back to 1880; numbers get really sketchy before that. Valuation, on the left axis, is the CAPE P/E ratio which tries to adjust for the fact that earnings tend to be “lumpy” so it averages them over time. The “mean” or average value over 140 years is 16.8; as of late May 2017, we’re at 177% of the market’s long-term average valuation.

The U.S. market went over a CAPE P/E of 24 just three times in the 20^th century; it’s lived there in the 21^st. The market’s P/E at its February 2016 bottom was still higher than the P/E at its October 2007 top.

Argument two: Price matters.

Thanks for Ryan Leggio of FPA for sharing this chart and John Hussman for creating it.

If you overpay for something, whether it’s $72 million for a “franchise quarterback” who’s only started seven NFL games ever or 211 years’ worth of earnings for a share of Netflix stock, you’re going to be disappointed.

The chart above reflects the stock market’s valuation (measured by the value of the stock market as a percentage of the value of the “real economy,” so when the blue line is high, stocks are relatively inexpensive) overlaid with its returns over the following 12 years. With considerable consistency, price predicts future returns. By this measure, U.S. stocks are priced to return 2% a year. The only ways for that number to go up is for the U.S. economy to grow at an eye-watering rate or for prices to come down. A lot. Based on the market’s performance over the past 60 years, the folks at the Leuthold Group find that a return to the valuations seen in the average bear market would require a fall of 27-35% from where we were at the end of April.

Vigorous economic growth, even if possible, would be a double-edged sword. It might serve to justify current prices but considerable disruption of Corporate America would be required to achieve it. Three researchers at Research Affiliates, Rob Arnott’s firm, wrote in late May 2017:

[T]he ‘Trump bump’ reveals market expectations of continuing public policies prioritizing stability, inhibiting creative destruction, depressing yields and wage growth, and inflating a profits bubble. If instead the Administration delivers reforms that allow creative destruction, invigorate growth, and raise returns to capital and wages, then the lofty profits of corporate incumbents will be at risk.

Argument three: Market collapses are scary

I think of this as “the icicle chart.” Ben Carlson, one of the Ritholtz managers, wrote a really thoughtful essay, rich in visuals, in April. He posted it on his Wealth of Commonsense blog under the name “180 years of market drawdowns.” He provided this graph as an antidote to those relentlessly cheerful logarithmic “mountain charts.” Those are the ones that show the stock market’s relentless climb with just niggling little “oopsies” from time to time. Losing half your portfolio is, viewed from the perspective of a few decades or a century, just a minor annoyance. Losing half your portfolio is, viewed from the perspective of a guy who needs to meet a mortgage, fund a college education and plan for the end of a teaching career, rather a bigger deal. Mr. Carlson concludes:

…stocks are constantly playing mind games with us. They generally go up but not every day, week, month or year. No one can predict what the future returns will be in the market … But predicting future risk is fairly easy — markets will continue to fluctuate and experience losses on a regular basis.

Market losses are the one constant that don’t change over time — get used to it.

The ideal approach is a strong contrarian discipline; famously, being fearful when others are greedy and greedy when others are fearful. As Mr. Zweig wrote in May 2017:

Having the cash and courage to buy from [panicking sellers] at bargain prices is a good way to raise your future returns. Not joining them as blind-faith buyers is an excellent way to reduce your risk, now and in the future.

Managers who’ve got your back

There are only a handful of managers left who take all of that seriously. The rest have been driven to unemployment or retirement by the relentless demand: fully invested, price be damned. They typically follow a simple model: stock by stock, determine a reason price for everyone in our investable universe. Recognized that stocks are risky, so buy them only when they’re selling at a healthy discount to that price. Hold them until they’re around full value, then move on regardless of whether their prices are still rising. Get out while the getting is good. If you can’t find anything worth buying today, hold cash, keep your powder dry and know that the next battle awaits.

They bear a terrible price for hewing to the discipline. Large firms won’t employ them since large firms, necessarily, value “sticky assets” above all else. 99.7% of the investment community views them as relics and their investors steadily drift away in favor of “hot hands.”

They are, in a real sense, the individual investor’s best friends. They’re the people who are willing to obsess over stocks when you’d rather obsess over the NFL draft or the Cubs’ resurgence. And they’re willing, on your behalf, to walk away from the party, to turn away from the cliff, to say “no” and go. They are the professionals who might reasonably claim …

This chart reflects every equity-oriented mutual fund that currently has somewhere between “a lot” and “the vast majority” of their portfolio in cash, awaiting the return of good values. Here’s how to read it. The first two columns are self-explanatory. The third represents how their portfolios have been repositioned between 2011 (when there are still reasonable valuations) and now. Endurance, for example, had two-thirds of its money in stocks in 2011 but only a seventh invested now. The fourth column is fund’s annual return for the period noted (full market cycle or since inception). The fifth shows the fund’s Sharpe ratio, a measure of risk-adjusted returns, against its peers. The sixth column shows you how it’s performed, again relative to its peer group, in bear market months. The last column is the comparison time frame. I’ve marked decisive superiority in blue, comparable performance in amber and underperformance in red. All date is month end, April 2017.

No single measure is perfect and no strategy, however sensible, thrives in the absence of a sufficiently talented, disciplined manager. This is not a “best funds” list, much less a “you must buy it now, now, now!” list.

Bottom Line: being full invested in stocks all the time is a bad idea. Allowing greed and fear, alternately, to set your market exposure is a worse idea.  Believing that you, personally, are magically immune from those first two observations is the worst idea of all.

You should invest in stocks only when you’ll be richly repaid for the astronomical volatility you might be exposed to.  Timing in and out of “the market” is, for most of us, far less reliable and far less rewarding than finding a manager who is disciplined and who is willing to sacrifice assets rather than sacrifice you. The dozen teams listed above have demonstrated that they deserve your attention, especially now.

As I noted in my publishers letter this month, this article, originally published in May, contained a substantial and utterly boneheaded mathematical error. After we published it, two things happened: first, readers took the article seriously enough to find the error and report it; second, our colleague Charles, substantially revised the method for calculating the maximum drawdown for funds in my portfolio which haven’t been around for a full market cycle. Because those changes were material, we decided to re-present this article as a public service.

Sorry, I don’t have a really gender-neutral alternatives to “big-boy pants.”

In all likelihood, you might expect to experience considerable ugliness in financial markets in the months ahead. That’s not a timing call, it’s a statement of the obvious.

What’s behind it?

The bull market in stocks is now the longest in U.S. history. The second- and third-longest bull markets ended (1929, 2000) in horrendous routs.

Market valuations, by any reasonable measure, are very extended. There are a million ways to calculate valuations and estimates of “fair value.” None of them say “cheap!” Almost all point to a market that’s at the top of its normal valuation range; by some measures, at the 99^th percentile for its valuations.

The economy has not generated substantial earnings growth and the Congress does not seem poised to act constructively (or at all) to encourage it. At the same time, inflation (the PCE index) rose at its fastest rate since 2011.

The generally-pessimistic institutional investor Grantham, Mayo, van Otterloo (GMO) publishes monthly estimations of likely market returns over the next 5-7 years. It doesn’t involve a crystal ball, it simply assumes that the market returns to historically normal values; it’s a measure of what would happen to your portfolio if, by the end of 5-7 years,  profits, price-to-earnings ratios and inflation returned to rates that are normal by historical standards.

So, in inflation-adjusted terms, they estimate that high-quality U.S. stocks will earn zero and emerging markets stocks will earn a bit. Former Vanguard CEO Jack Bogle is more generous, by far, and estimates that you might be able to make 4%.  As we noted last month, there are two ways to get there: with a bang, or with a whimper.

Jason Zweig, one of the sharpest of all the folks writing about finance, wrote an entirely fascinating and horrifying column in late April, “Whatever You Do, Don’t Read This Column” (4/30/2017). His most startling finding is that rich investors now expect to make more than ever before. Jason attributes it to faith in “an investing tooth fairy.”

Here’s our suggestion: check now to see if you’re ready for either possibility. GMO’s Ben Inker stated the obvious in the firm’s most recent quarterly letter (1Q2017): “It is impossible to determine if you are taking an appropriate amount of risk without understanding what the downside is for your portfolio, which means you simply have to do the exercise of understanding what can go wrong.”

One quick-and easy way to answer the “how bad could it get?” question is to look at your funds’ maximum drawdown; that is, the biggest loss they’ve suffered during the current market cycle.

Multiply the size of the loss by the weight of that fund in your portfolio. As an illustration, I’ve done the calculation for my non-retirement portfolio for you. I used the MFO Premium fund screener to isolate the maximum drawdown for each fund during the current market cycle which began in October, 2007.

Here are the funds that were actually around for the entire cycle:

Those funds represent 55% of my entire portfolio. If they repeat their maximum drawdown, they’ll cost my portfolio about 16% of its total value.

What about newer funds? That’s a little tougher. None of them have been around long enough to experience a major drawdown event, so I had to estimate. Once again, I used the screener. First, I found average maximum drawdown by fund category since October, 2007. Second, I adjusted this average by the ratio of each fund’s volatility to average volatility since fund inception. (For this exercise, I used standard deviation as the volatility metric.) You’ll notice in the table below that I tend to invest in funds that experience lower volatility than their category peers.

If you do that, you end up with a loss of about 30% in my portfolio, despite its cautious allocation. Currently, my allocation is just about 50/50% equity/fixed income, placing my overall portfolio in Lipper’s “Mixed Asset Moderate Allocation” category:

… a mix of between 40%-60% equity securities, with the remainder invested in bonds, cash, and cash equivalents.

The average maximum drawdown for funds in this category during the last bear market was -35%. If we look at the recovery times for my funds (that is, how long it took them to regain their previous peaks), there’s a good chance that I’d be in the red for three years or more.

So here’s the question: if I lost about one-third of my lifetime savings, what would I do? Could I ignore the loss, or would I react unwisely to it? Remember, at the point that I’d lost 30% of my total nest egg, I’d have no assurance that the losses would ever end (the early 1930s crash dropped the market by 90%).

If you don’t know how bad the loss in your portfolio could be, find out now! That’s the cheapest and best advice you’ll get in a year. You can’t plan without knowing, and you can’t react intelligently without planning.

We have faith in you, and we’ll help as much as we can. But you really need to start checking now, before the market scares you into doing something spectacularly unwise.