Klein price-CAGR charts are a vestige of the BMW Method, the premise of which was that price growth reverts to a mean and this can be used like a divining rod to locate good investments. In this case, the S&P “is undervalued!”
While most other proponents of the BMW Method have long faded away, Denny persists in believing that price-CAGR charts show if an investment, or an index in this instance, is overprice, fairly priced, or undervalued. Which is all fine, but I suggest taking it with a grain of salt.
Kelbon has been on a search and destroy mission against the BMW Method for at least a decade. You’ll have to ask him why he hates it so much. It could have something to do with the BMW Conferences where he was not invited to attend for free.
Fool BuildMWell, the inventor of the Method was constantly looking to “push the envelope.” He started by looking at the historic DJI index and noticed that time and again it would reach a bottom and bounce back. He joined these low points which, to him, indicated the point below which the index would not go. He called this line the “low CAGR.” The first “push of the envelope” was to look at the individual 30 Dow Jones stocks. Jim claimed to have made good money using the method and kept pushing the envelope and encouraged others to do the same. One day he pushed too far.
Jim did his charts by hand. Mike Klein (Fool mklein9) pushed the envelope by creating computer generated charts on a weekly basis. There are some differences but Mike’s -2RMS line is close enough to Jim’s low CAGR line to make them comparable. Mike did some back testing and showed that RF was a better predictor of outcomes than RMS. Since the charts are generated by a computer program they keep churning out on a weekly basis. There is a small group of people who still use them.
The magic of markets is that they squeeze out any unnecessary profits. This is what makes truly free markets so effective in promoting economic growth. I say “truly free” because there are many ways to encumber markets as with monopolies, cartels, social programs, trade agreements, and other ways in which people try to twist the market in their favor. The stock market is no different. Any time you find a way to beat the market the market will try to find a way to stop you. Don’t ask me how it happens but it happens. That’s why bubbles form and burst.
In the case of the BMW Method I know exactly why it imploded, Jim pushed the envelope one step too far. Jim became convinced that the Method was infallible, a sure sign of Hubris. When financial entities started to drop in 2008 Jim started to buy at low CARG but many didn’t bounce back, instead some went bankrupt. By 2008 I was familiar with Nassim Nicholas Taleb’s work on Black Swans and his opinion that the financial industry was “bad black swan prone” and hence to be avoided. I made a couple of posts to that effect but they were ignored in the heat of battle.
While I was working at IBM in the late 1960s I had the opportunity to learn about their IMPACT inventory management system. For this discussion one concept is relevant. Items in inventory had to be classified as cyclical or not cyclical. This was done by creating consumption charts to see if one could detect some kind of seasonality. But it was not enough to see a hump or a dip at certain times, one had to find a logical explanation to eliminate chance occurrences. This led me, in time, to coin the phrase “It is not enough to know what a chart is saying, one has to find out why it is saying whatever it is saying.”
While most other proponents of the BMW Method have long faded away, Denny persists in believing that price-CAGR charts show if an investment, or an index in this instance, is overprice, fairly priced, or undervalued. Which is all fine, but I suggest taking it with a grain of salt.
Prices don’t revert to a mean, in and of themselves, and these charts, though perhaps of historical interest, are not far removed from reading tea leaves as a signpost to the future.
“It is not enough to know what a chart is saying, one has to find out why it is saying whatever it is saying” is the grain of salt that kelbon recommends. I have said it on multiple occasions on multiple Foolish discussion boards. It ruins his argument so he ignores it.
Is the BMW Method a failure? Not if applied where it works. Taleb forewarned that the financial industry was not a good place to use it. My own take is that it works on companies that have a long history of successfully doing whatever it is they do, companies like 3M. BTW, 3M’s original mining operations were a failure but their glue based products have been a huge success. For me one of the shortcomings of the BMW method was the long wait until a good company’s price crashed for no good reason, my attention span is way too short to play this game and I didn’t have an alert system to keep me informed. Yet the concept of CAGR is very powerful, my quest was how to use it without having to wait for these extreme drops in price. The BMW Method was instrumental in developing my current market strategy.
So yes, look at charts with a pinch of salt: “Find out why the chart is saying whatever it is saying.” Don’t throw it out with the bathwater.
Denny Schlesinger
