Mark Hulbert: Our Kindred Spirit (Smead)

by William Smead, Smead Capital Management

Mark Hulbert and I started in the investment business in 1980. He chose to create a business out of analyzing the results and psychological implications of investment newsletter writers. At Smead Capital Management, we formed a business to analyze publicly-traded US common stocks through the prism of our eight proprietary criteria. We enjoy his unbiased third-party opinions on current circumstances and his consistently good historical perspective. We, as a company, believe that psychology is a valuable discipline in investing and Hulbert provides some of the best information on US stock market psychology.

At Marketwatch.com, Hulbert shared two pieces which caught our attention on March 26th, 2013. The first was called, “Is market timing dead?” and the second was called, “Get out of junk stocks now!” Hulbert points out in the first one that the popularity of market timing and buy-and-hold common stock investing come and go with market peaks and troughs. Here is Hulbert’s explanation this phenomenon:

That’s because market timing goes in and out of popularity according to a fairly regular cycle: It is most popular at market bottoms (when advisers confidently pronounce that “buy-and-hold is dead”) and least popular at market tops (when buy-and-hold makes a big comeback).

He posits that those who would wish to time the US stock market should be vigilantly looking for the next juncture when market timing appears useless. He is given direct access to the investment newsletter writers and can best gauge their aggregated opinions. You are probably aware that we are not market timers, but we do like to have a handle on the way the vast majority of market participants view the stock market. He compared today’s circumstance to the last two major signals given by the market timing/buy-and-hold teeter-totter:

That said, the indicator did do a decent job of indicating the end of the last two bear markets.

• One week before the bottom of the 2007-2009 bear market—on March 2, 2009, to be exact—I wrote a column on buy-and-hold’s newfound popularity in which I concluded that “the final low may be closer than we think.”
• In March 2003, I devoted a column to the conversion of a prominent believer in buy-and-hold into a market timer. I wrote that “we’re closer than ever to the final low of the 2000-2003 bear market.” That column appeared on March 11, 2003, the exact day of the successful retest of the market’s bear market low that had been hit the prior October.

Hulbert believes that wholesale acceptance of the buy-and-hold methodology is not yet upon us, but warned that it could come in a matter of months, if the right circumstances develop.

In the second article, Hulbert shared historical information about bull markets as they related to “junk” or low quality stocks. Early in the average bull market following a recession, “junk” or low quality stocks drastically outperform the average stock. Who could forget the “dash for trash” in 2009, when the best performing stocks were the companies on the edge of bankruptcy in the depth of the recession? Here is Hulbert’s take:

The typical pattern, according to data going back to the 1920s compiled by Eugene Fama and Ken French, finance professors at the University of Chicago and Dartmouth College respectively, is for junk to outperform quality for no more than the first year of a bull market. Thereafter, market leadership shifts to the stocks of the highest-quality companies. Thanks in large part to the Fed’s easy-money policies, however, this shift hasn’t taken place — as Revlon’s and Wal-Mart’s performance attests.

Hulbert points out that junk has been outperforming for the last four years and has outperformed in the most recent leg of this bull market. He wonders how that could be and expects lower quality to under-perform going forward. We believe we have an explanation for why junk has done so well in this powerful secular bull market. In a “normal” cycle, the first-year move in the bull market would have been led by housing, banks, autos, and consumer discretionary companies like retailers. Housing, as a contributor to economic growth or stock market success, was nowhere to be found until about 18 months ago.

The second and third years of this bull market were dominated by unusually high commodity prices in an anemic economic recovery. By virtue of its intense cyclicality, we view commodity-related securities as “junk” or low quality. To us, cyclicality makes them sketchy because they don’t control the most important variables in their business. Barry Bannister and his research team at Stifel Nicolaus proved that commodities had never been better in the US than the ten-year stretch ending in July of 2011. This was backed by financial advisor and institutional investor participation in commodity investments via wide asset allocation. Therefore, “junk” led year’s one through three without any contribution from housing.

In September of 2012 housing-related investments, especially hyper-depressed home builders, began to explode in price. These huge price moves drove not only housing, but gave a multiplier effect to industries which are benefitted by their recovery. This includes durables like appliances, media and banking. Many “junky” companies were starved for affection until the housing industry rebounded.

Both of Hulbert’s pieces dovetail with our thinking at Smead Capital Management. First, we believe that institutional and high net worth investor’s significantly under-own US large cap stocks and until they do own a much larger and more historically normal percentage of their overall portfolio in them, buy and hold won’t reach a popularity level commensurate with killing this secular bull market.

Secondly, we believe that China’s attempt to avoid business cycles has artificially pumped up commodity markets and help misallocate capital in the US. We are of the opinion that the US economic recovery started 18 months ago when housing started to rebound. Lastly, we believe that buy-and-hold investing won’t regain popularity until the portfolio allocation to US large cap is ramped up over the next five years. In our opinion, this is exactly what would happen to cause Mr. Hulbert to be correct about calling for quality to outperform “junk” over the coming 12-24 months.

In conclusion, we like high quality US large caps as defined by our eight proprietary criteria for stock selection. We especially like high quality healthcare companies like Merck (MRK) and Medtronic (MDT). We also like consumer stocks including Nordstrom’s (JWN) and Walgreens (WAG).

Best Wishes,

William Smead

The information contained in this missive represents SCM’s opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. It should not be assumed that investing in any securities mentioned above will or will not be profitable. A list of all recommendations made by Smead Capital Management within the past twelve month period is available upon request.