“Every strike brings me closer to the next home run.” – Babe Ruth
In July of 2012 we penned What Babe Ruth Teaches Us About Investing, a post comparing the success of Babe Ruth as a hitter in the major leagues to the success of trend following strategies in the stock market. Today, over three years later, we revisit the Babe Ruth effect against the backdrop of collapsing stock and commodity prices. Our MarketVANE STOCKS and HARD ASSETS models are both currently on a 100% cash signal, so this conversation is especially timely for clients of Season Investments whose portfolios are largely on the sidelines.
Baseball, as we stated in our original post, is a game of statistics. More numbers, percentages and ratios are tracked in baseball than perhaps in any other sport, and batting average (the percentage of a players at bats that have resulted in a hit) is probably the most common statistic of them all. For the purposes of calculating batting average all hits are given equal consideration. Whether the player hits a garden variety single or a home run over the center field fence, both hits count the same towards his batting average.
While batting average is a good reflection of a hitter’s consistency, perhaps a more interesting measurement is the slugging percentage which is defined by the total number of bases divided by at bats. A double in this case would carry twice the weight of a single in the calculation since twice as many bases were gained. This statistic is a better depiction of the power and productivity of a batter, as it more accurately accounts for the fact that not all hits are equally valuable.
The table below first appeared in our original post. It depicts the results from ten at bats for two different batters. While Batter 1 got on base more consistently, Batter 2 exhibited more productivity as measured by total number of bases gained over those ten at bats. Thus, despite posting a smaller batting average Batter 2 finished with a much higher slugging percentage.
While there have been a number of baseball players that have shown more consistency at the plate, Babe Ruth holds the all-time record for career slugging percentage and is widely recognized as the most accomplished hitter of all time. His career batting average at .342 implies that roughly two-thirds of his at bats resulted in an out, meaning that every time Babe Ruth stepped up to the plate the most logical expectation would be that he would fail.
That said, Babe Ruth’s career slugging percentage was .690, meaning that for every ten at bats he gained roughly seven bases. If we divide Ruth’s slugging percentage by his batting average we find that his average bases per hit was over two. So despite failing roughly two-thirds of the time, the Babe was very productive at the plate over the course of his career.
There are many correlations between what made Babe Ruth such a great hitter and what makes an investment strategy successful. As we stated in our original post:
When we analyze a particular investment or strategy we look at a number of different factors, but two of the most important considerations are the probability of success (how confident are we that it will work) and the risk/reward profile (what’s the potential upside in comparison to the potential downside). Gauging the probability of success is akin to analyzing a batting average, while understanding the relationship between the magnitude of risk and reward is more akin to the slugging percentage.
MarketVANE, our proprietary trend following strategy for Stocks and Hard Assets, exhibits the Babe Ruth effect in that it has a relatively low expected batting average but a very high expected slugging percentage. The whole idea behind MarketVANE is that we are trying to capture a good amount (but probably not all) of the upside while sidestepping the bulk of the large drawdowns in the market. We wrote a couple of posts on this topic just a handful of months ago, so we won’t go back into the weeds here, but the following excerpt from The Trend Is Your Friend summarizes the idea well:
In its simplicity, trend following is an elegant solution to the age old conundrum of wanting (or needing) robust returns while simultaneously being unable to withstand the extreme volatility and drawdowns seen in the market from time to time. Unlike buy-and-hold, a trend following approach uses math to quantify the direction and the strength of the prevailing trend, and based on that analysis determines whether or not to be fully invested, partially invested or even all the way in cash. In doing so, this process offers the investor a built in stop loss against the types of major declines we saw in the bursting of the tech bubble and the financial crisis.
There is no such thing as a perfect investment strategy, and one of the clear drawbacks of the type of trend following model we’ve built in MarketVANE is the number of times our signals will be wrong. Sometimes the market begins breaking down and a sell signal is triggered just in time to miss out on the rebound. Or vice versa, sometimes a brief rebound within a longer-term bear market will trigger a buy signal only to watch the market roll back over and resume its downtrend. We call these signals “head fakes” because the market action begins moving a certain direction but does not continue doing so. Not only are these types of wrong signals possible, they actually happen more often than not. MarketVANE, in other words, has a low batting average.
In light of this, why do we continue to embrace MarketVANE as a keystone strategy for our clients’ Stock and Hard Asset allocations? You guessed it…the slugging percentage. While the majority of our “at bats” might result in an out (meaning they don’t produce outperformance vs the benchmark), when we do connect we make it count. Most head fake signals reverse themselves quickly and result in relatively small amounts of underperformance vs the benchmark, while the occasional home run signal can produce more than enough outperformance to make up for all the head fakes.
The table below displays the back tested results of our MarketVANE STOCKS model. Notice the two circled areas on the chart where the model produced significant value vs the benchmark. These two periods would be considered home runs, and they more than make up for the multiple head fake signals that are not even visible to the naked eye in the chart. This dynamic can also be seen in the maximum drawdown and up/down return capture statistics in the table on the left.
Despite the expectation of a low batting average, MarketVANE remains a valuable player on our investment roster given its ability to go to cash in major collapses. This brings us to current portfolio positioning. As we reported recently in The Better Part Of Valor, MarketVANE HARD ASSETS has been on a 100% cash signal since the end of June. MarketVANE STOCKS has since followed suit and we moved to 100% cash in that model as of the mid-September update. This is an interesting position for us to be in as it is very painful to be out of the market on big up days, but it feels quite good to be watching from the sidelines on days like yesterday when the market moves sharply lower. As explained above, the odds are that this cash signal will not add any value. However, the potential opportunity cost is well worth it given the fact that if we are on the verge of a major market collapse our client portfolios will weather the storm very well.
The great Ted Williams once said, “Baseball is the only field of endeavor where a man can succeed three times out of ten and be considered a good performer.” We think investing can be added to this list. We like MarketVANE as an investment strategy for the same reasons we like Babe Ruth as a hitter. We don’t have to be right with every trade, but we do want to maximize the magnitude of our wins relative to our losses over time. We fully expect to live through trendless periods in the market where this approach gets whipsawed back and forth, but over a long enough period of time we anticipate being able to produce superior risk-adjusted results for our clients by successfully aligning ourselves with dominant trends.
Author David Houle, CFA is a founding member of Season Investments. He serves as the firm's Chief Compliance Officer as well as sitting on the investment committee overseeing the management of client assets. David spent nearly ten years in various roles primarily managing individual client assets prior to co-founding Season Investments. David graduated with a degree in Finance from Colorado University in Colorado Springs in 2003 and earned the Chartered Financial Analyst (CFA) designation in 2006. David and his wife Mandy have three children and spend most of their free time with friends and family.
Transparency is one of the defining characteristics of our firm. As such, it is our goal to communicate with our clients frequently and in a straightforward way about what we are doing in their portfolios and why. This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities. It represents only the opinions of Season Investments. Any views expressed are provided for informational purposes only and should not be construed as an offer, an endorsement, or inducement to invest.