"Stocks on sale", "reversion to the mean", etc.

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"Stocks on sale", "reversion to the mean", etc.

Postby boggler » Mon Jul 01, 2013 1:37 pm

Many people on this forum assume that after large losses, an asset class will rebound. Furthermore, this idea underlies the "rebalancing bonus", in that buying when "on sale" via rebalancing ensures that you "buy low, sell high".

If this is true, why hasn't anyone (e.g. hedge fund) adopted a strategy of levering-to-the-hilt to buy as much as possible of the asset class "on sale", wait for it to rise, and sell it? Perhaps this reversion to the mean is not really true?
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Re: "Stocks on sale", "reversion to the mean", etc.

Postby lmpmd » Mon Jul 01, 2013 1:48 pm

Great question. Another way of wording this would be: traditional Boglehead philosophy is that timing the market is always a looser's game and can't be done. But also traditional accepted philosophy here is "buy when when stocks are on sale" - when the market is down. You are smart if you do this. How can both be accepted? Are these not contradictory statements? Let's hear some replies.
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Re: "Stocks on sale", "reversion to the mean", etc.

Postby Tabulator » Mon Jul 01, 2013 1:52 pm

Maybe it just means next time there's a 2008-style crash, you will have a chance to fly high if you can afford to spare some extra cash for a while.
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Re: "Stocks on sale", "reversion to the mean", etc.

Postby avalpert » Mon Jul 01, 2013 2:01 pm

Markets can remain irrational longer than you can remain solvent...
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Re: "Stocks on sale", "reversion to the mean", etc.

Postby Phineas J. Whoopee » Mon Jul 01, 2013 2:04 pm

So, one knows which direction it will go. Does one know when, or by how much (thanks nisi!)?

The market can remain irrational longer than you can remain solvent.

How many margin calls can you meet before one lands you in bankruptcy court?

That's why.

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Must buy it back or go to pris'n.
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Re: "Stocks on sale", "reversion to the mean", etc.

Postby LH » Mon Jul 01, 2013 2:23 pm

boggler wrote:Many people on this forum assume that after large losses, an asset class will rebound. Furthermore, this idea underlies the "rebalancing bonus", in that buying when "on sale" via rebalancing ensures that you "buy low, sell high".

If this is true, why hasn't anyone (e.g. hedge fund) adopted a strategy of levering-to-the-hilt to buy as much as possible of the asset class "on sale", wait for it to rise, and sell it? Perhaps this reversion to the mean is not really true?


Because there is no rebalancing bonus expectantly.

Really, rebalancing with stocks and bonds (past history not withstanding, where bonds beat stocks over 30years), means one will expectantly have LESS (due to expectantly rebalancing into the expectantly lower return bonds on average over time) than one would have without rebalancing.

Now, maybe one can make a case that say 10 percent bonds, 90 percent stocks could have an weakly expectant positive rebalancing bonus, versus 100 percent stocks...... Maybe. I am not making that case, nor saying that it is true. But everything else with stocks bonds the expectation is that one will have a negative rebalancing bonus.

rebalancing is done for risk control.


RTM is an interesting concept.

There WILL be mean reversion going forward....... problem is, we dont know what the forward mean will be. I recommend reading and rereading:

http://www.norstad.org/finance/rtm-and- ... g.html#rtm

We see stock market charts. Our eye draws the line from the starting point to the ending point. We notice that the chart goes up and down, but eventually it always comes back to that nice straight line in the middle of all the jagged ups and downs. Our common sense mistakenly calls this "mean reversion," and we think we are seeing something significant, when what we are really seeing is just a useless triviality (what we are seeing is an immediate consequence of the definition of "average" - if you take an average of things, some of the things are above the average, and some are below, and that information is not of much significance or use).


Yeah, with accumulation, and holding bonds for "dry powder" one does due to DCA buy "stocks on sale" this is counterbalanced by

1)holding lower yielding bonds instead of stocks in the first place
2)accumulation DCA is counterbalanced by "reverse" DCA in decumulation, you Sell more stock low, than you do when stock is high.
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Re: "Stocks on sale", "reversion to the mean", etc.

Postby Scooter57 » Mon Jul 01, 2013 2:31 pm

No one is quite sure where the mean really is for stocks.

I've read quite a few articles bolstered with impressive charts each arguing for a different mean.
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Re: "Stocks on sale", "reversion to the mean", etc.

Postby ObliviousInvestor » Mon Jul 01, 2013 2:44 pm

Scooter57 wrote:No one is quite sure where the mean really is for stocks.

I've read quite a few articles bolstered with impressive charts each arguing for a different mean.

And some people (e.g., Mandelbrot) have even made the case that there is no mean. (Or, depending on how you look at it, that any calculated mean is rather meaningless.)
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Re: "Stocks on sale", "reversion to the mean", etc.

Postby nisiprius » Mon Jul 01, 2013 2:47 pm

The classic exposition of this is a 1937 paper:

Cowles 3rd, Alfred E. and Herbert E. Jones (1937). "Some A Posteriori Probabilities in Stock Market Action". Econometrica 5 (3): 280–294

Image

They used different language than we do now, but what they found was three things, all important:

a) In the short term, they saw momentum (which they called "inertia");
b) Over periods on the order of several years, they saw mean reversion (They didn't call it that, I forget what they called it);
c) Most important, after spending about eight pages evaluating various systems for exploiting these effects, they concluded that "This type of forecasting could not be employed by speculators with any assurance of consistent or large profits."

People give it fancier names and do fancier math, but I think that's pretty much what is believed today.

I have a personal theory about "stocks on sale." I don't think factor-of-two differences in P/E are predictive. I think there are extreme deviations which are predictive but useless. The question you have to ask is "why did stock prices get so low?" I think I found the answer, in effect, in Benjamin Roth's The Great Depression: A Diary. During extreme depressions, everybody knows that stocks really are on sale, they really are priced at less than they are worth. So why doesn't everybody snap them up? Because they don't have any money to buy stocks with. That's how stocks got so low. People wanted to buy them but couldn't. In the 1930s "didn't have money" could be very literal--there was, simply, an actual shortage of currency. People with money in the bank could not buy stocks, because even sound banks were refusing to left depositors withdraw it!

Well then, you say, if stocks are so low that they are on sale, and if I am fortunate enough to have some cash to buy stocks, shouldn't I load up? The answer, again, is no, because when this happens, the situation is fraught with financial peril and if you're fortunate enough to have cash you'd darned well better hang on it, because some emergency may come along that may be far more important than buying stocks.
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Re: "Stocks on sale", "reversion to the mean", etc.

Postby YttriumNitrate » Mon Jul 01, 2013 2:48 pm

boggler wrote:If this is true, why hasn't anyone (e.g. hedge fund) adopted a strategy of levering-to-the-hilt to buy as much as possible of the asset class "on sale", wait for it to rise, and sell it? Perhaps this reversion to the mean is not really true?


It might be that long term leverage is expensive and on average the cost overrides the gains from the leverage.

If ProShares UltraPro Russell2000 (URTY) was set to return 3 times the change of the Russel2000 over a 30 year period instead of a 1 day period, I would totally be loading up on that (even with a 0.95% expense ratio).
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Re: "Stocks on sale", "reversion to the mean", etc.

Postby Chan_va » Mon Jul 01, 2013 3:12 pm

boggler wrote:If this is true, why hasn't anyone (e.g. hedge fund) adopted a strategy of levering-to-the-hilt to buy as much as possible of the asset class "on sale", wait for it to rise, and sell it? Perhaps this reversion to the mean is not really true?


Isn't that pretty much Warren Buffet's strategy? Except he doesn't use leverage because as others have mentioned, the time it takes to mean revert could be decades. And your debt service costs waiting for mean reversion will wipe you out.
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Re: "Stocks on sale", "reversion to the mean", etc.

Postby YDNAL » Mon Jul 01, 2013 3:20 pm

boggler wrote:Many people on this forum assume that after large losses, an asset class will rebound. Furthermore, this idea underlies the "rebalancing bonus", in that buying when "on sale" via rebalancing ensures that you "buy low, sell high".

If this is true, why hasn't anyone (e.g. hedge fund) adopted a strategy of levering-to-the-hilt to buy as much as possible of the asset class "on sale", wait for it to rise, and sell it? Perhaps this reversion to the mean is not really true?

This is how I reason this.
    1. We invest in a $1 Stock because (a) stocks are riskier [lose money] than non-stocks and (b) we hope to get compensation for the risk taken.
    2. If I buy this $1 Stock for $0.50 tomorrow, after a drop, the likelihood to lose money has been lowered yet the likelihood to make money is higher.
Why shouldn't I expect that buying at $0.50 today will sell for $1+ tomorrow ? ← that was my initial premise to begin with.
If we don't believe this, why buy Stocks ?
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Re: "Stocks on sale", "reversion to the mean", etc.

Postby archbish99 » Mon Jul 01, 2013 3:47 pm

YDNAL wrote:If I buy this $1 Stock for $0.50 tomorrow, after a drop, the likelihood to lose money has been lowered yet the likelihood to make money is higher.[/list]
Why shouldn't I expect that buying at $0.50 today will sell for $1+ tomorrow ? ← that was my initial premise to begin with.
If we don't believe this, why buy Stocks ?

Because whatever made the stock drop by 50% this morning wasn't known yesterday. Maybe the market has discovered that your (its) initial premise was flawed, and has corrected it. Or maybe the 50% drop is pure irrationality on a highly volatile stock and the expectation hasn't changed. You can't know without seeing what it does over time.
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Re: "Stocks on sale", "reversion to the mean", etc.

Postby Chris M » Mon Jul 01, 2013 3:54 pm

lmpmd wrote:Great question. Another way of wording this would be: traditional Boglehead philosophy is that timing the market is always a looser's game and can't be done. But also traditional accepted philosophy here is "buy when when stocks are on sale" - when the market is down. You are smart if you do this. How can both be accepted? Are these not contradictory statements? Let's hear some replies.


There is a subtle difference between market timing and buying when stocks are on sale. The buyer of stocks on sale buys in the expectation that prices will mean revert eventually. But he has no idea when this will happen. It could be tomorrow, it could be years from now. In the meantime prices could keep dropping--and dropping hard at that. If you have the financial wherewithal to ride out further losses, this strategy makes sense--as Chan_va noted, it's essentially Buffet's strategy (with the addition that he's looking for good stocks on sale).

The market timer, on the other hand, is trying to make a prediction as to when the mean reversion will take place. This is impossible, even Buffet would say he can't do it. The premise behind mean reversion is that the market sometimes overshoots, and stock prices drift away from the stocks' underlying value due to irrational pessimism or optimism. Identifying situations where prices differ from underlying value is possible, at least for a few gifted investors like Buffet. But to predict when the irrational behavior will end and prices return to values is a problem in mass psychology--which is most definitely not a predictive science.
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Re: "Stocks on sale", "reversion to the mean", etc.

Postby jda » Mon Jul 01, 2013 4:16 pm

Hedge fund companies are evaluate on a quarter to quarter basis.

As as individual investor, I have 20 year to wait but hedge fund companies don't.
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Re: "Stocks on sale", "reversion to the mean", etc.

Postby nedsaid » Mon Jul 01, 2013 10:18 pm

Investors need to pay attention to valuations. You want to buy low and sell high. The problem is that an expensive market can continue to go up and a cheap market can continue to go down. If you buy cheap, you increase your future returns and odds of success. But you do that with the knowledge that what is cheap can get cheaper.

Pay attention to investor sentiment. If the shoe shine boys on Wall Street are bragging about their millions in paper profits from stocks, it might be a clue to lighten up on your stocks. If the end of the world is near according to the commentators, it might be a good idea to buy some stocks. Money flows in and out of asset classes are another good clue. It pays to zig a bit when the crowd is zagging. So in recent years, investors were pulling money out of stocks (when they should have been buying) and even more recently pulling money out of the bond market (guess what, Bonds are rebounding).

Don't go overboard on this. I would never be 100% out of stocks. If investor sentiment gets euphoric, sell some. The market could go even higher, you still will profit. If investor sentiment gets really depressed and down in the dumps, buy some. I would never be 100% in stocks either. Do this on the margins. I would certainly never use margin in trying to take advantage of these swings.

A good rebalancing strategy will accomplish a lot of what I am talking about.

I know this smacks of market timing. I don't advocate market timing other than at the extremes of euphoria and depression. Warren Buffett said it well, "Be fearful when others are greedy, and greedy when others are fearful." And even then, don't overdo it.
A fool and his money are good for business.
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Re: "Stocks on sale", "reversion to the mean", etc.

Postby YDNAL » Tue Jul 02, 2013 7:29 am

archbish99 wrote:
YDNAL wrote:If I buy this $1 Stock for $0.50 tomorrow, after a drop, the likelihood to lose money has been lowered yet the likelihood to make money is higher.
Why shouldn't I expect that buying at $0.50 today will sell for $1+ tomorrow ? ← that was my initial premise to begin with.
If we don't believe this, why buy Stocks ?

Because whatever made the stock drop by 50% this morning wasn't known yesterday. Maybe the market has discovered that your (its) initial premise was flawed, and has corrected it. Or maybe the 50% drop is pure irrationality on a highly volatile stock and the expectation hasn't changed. You can't know without seeing what it does over time.

Your answers don't sound too convincing.... maybe this... or maybe that.... you can't know the other.

It is really simple archbish99. You buy Vanguard Total Stk Mkt (VTSMX) at $1 in October 2007 and it is $0.437 by March 2009.
    1. When it is $0.437 you should expect it to be less risky and provide higher upside than in 2007.
    2. If you don't expect the original purchase at $1 nor additional purchases at $0.437 to provide return for risk taken over time - a longer timeframe, that is - then why buy the Total Market ?
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Re: "Stocks on sale", "reversion to the mean", etc.

Postby avalpert » Tue Jul 02, 2013 7:40 am

YDNAL wrote:
archbish99 wrote:
YDNAL wrote:If I buy this $1 Stock for $0.50 tomorrow, after a drop, the likelihood to lose money has been lowered yet the likelihood to make money is higher.[/list]
Why shouldn't I expect that buying at $0.50 today will sell for $1+ tomorrow ? ← that was my initial premise to begin with.
If we don't believe this, why buy Stocks ?

Because whatever made the stock drop by 50% this morning wasn't known yesterday. Maybe the market has discovered that your (its) initial premise was flawed, and has corrected it. Or maybe the 50% drop is pure irrationality on a highly volatile stock and the expectation hasn't changed. You can't know without seeing what it does over time.

Your answers don't sound too convincing.... maybe this... or maybe that.... you can't know the other.

It is really simple archbish99. You buy Vanguard Total Stk Mkt (VTSMX) at $1 in October 2007 and it is $0.437 by March 2009.
    1. When it is $0.437 you should expect it to be less risky and provide higher upside than in 2007.
    2. If you don't expect the original purchase at $1 nor additional purchases at $0.437 to provide return for risk taken over time - a longer timeframe, that is - then why buy the Total Market ?

I don't think this is correct. Just because you expected the original purchase to provide risk return over time doesn't mean that it will - or will at the same degree as if you purchased at any other time. If it didn't it wouldn't actually be risky. This is obviously what happens - someone who bought in March 2009 got much higher return for their risk than someone who bought in October 2007.

What you can say looking back from March 2009 is that your expectation in October 2007 was not met - the reason you still invest in Total Market is because in October 2007, or March 2009 or today, while you cannot know with certainty that the expectation will be met, the expected returns are still positive with a premium over less risky assets because of that uncertainty.
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Re: "Stocks on sale", "reversion to the mean", etc.

Postby Scooter57 » Tue Jul 02, 2013 7:51 am

Of course, your TSM could drop another 50% over the next few months, too, and stay down for 20 years. The experience of the last 30 years in the stock market is unlikely to be repeated.

You shouldn't put money into stocks that you can't afford to lose. The dip in 2008 was remarkably short by historical standards. Look at what happened to stocks in the 1930s and the 1970s. After big drops they stayed low for years.
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Re: "Stocks on sale", "reversion to the mean", etc.

Postby YDNAL » Tue Jul 02, 2013 7:52 am

avalpert wrote:I don't think this is correct. Just because you expected the original purchase to provide risk return over time doesn't mean that it will - or will at the same degree as if you purchased at any other time.

There are NO free lunches in risky investments.
    1. Expect (no guarantee) return = expect risk.
    2. Alternatively, don't take risk and buy safety (a CD?) where you know exactly what you get - whether it helps meet your goals or it doesn't.
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Re: "Stocks on sale", "reversion to the mean", etc.

Postby Chris M » Tue Jul 02, 2013 9:35 am

avalpert wrote:
YDNAL wrote:
archbish99 wrote:
YDNAL wrote:If I buy this $1 Stock for $0.50 tomorrow, after a drop, the likelihood to lose money has been lowered yet the likelihood to make money is higher.[/list]
Why shouldn't I expect that buying at $0.50 today will sell for $1+ tomorrow ? ← that was my initial premise to begin with.
If we don't believe this, why buy Stocks ?

Because whatever made the stock drop by 50% this morning wasn't known yesterday. Maybe the market has discovered that your (its) initial premise was flawed, and has corrected it. Or maybe the 50% drop is pure irrationality on a highly volatile stock and the expectation hasn't changed. You can't know without seeing what it does over time.

Your answers don't sound too convincing.... maybe this... or maybe that.... you can't know the other.

It is really simple archbish99. You buy Vanguard Total Stk Mkt (VTSMX) at $1 in October 2007 and it is $0.437 by March 2009.
    1. When it is $0.437 you should expect it to be less risky and provide higher upside than in 2007.
    2. If you don't expect the original purchase at $1 nor additional purchases at $0.437 to provide return for risk taken over time - a longer timeframe, that is - then why buy the Total Market ?

I don't think this is correct. Just because you expected the original purchase to provide risk return over time doesn't mean that it will - or will at the same degree as if you purchased at any other time. If it didn't it wouldn't actually be risky. This is obviously what happens - someone who bought in March 2009 got much higher return for their risk than someone who bought in October 2007.

What you can say looking back from March 2009 is that your expectation in October 2007 was not met - the reason you still invest in Total Market is because in October 2007, or March 2009 or today, while you cannot know with certainty that the expectation will be met, the expected returns are still positive with a premium over less risky assets because of that uncertainty.


Here's another way to look at this. We buy stocks because we believe they will yield real returns in the long run. Specifically, we know they yield dividends at present, and we believe earnings will grow over time. We do not know this for a fact, but we do believe it--that's why we buy stocks.

What we do not know is what will happen to the third component of stock returns--the price the market will bear for a dollar of earnings in the future. This is the component that John Bogle refers to as the speculative component, and it may be higher or lower in the future depending on future investor sentiment. But if we buy when the P/E ratio has dropped, two things happen. First, we increase the dividend yield we will receive (just the same as buying a bond at lower price increases the bond's yield). And second, we increase the odds that the future P/E ratio will be higher than it was when we bought. In other words, P/E in the future will be some unknown value, x. If P/E today is y, and P/E, say, 3 years from today is z, and z<y, there is a greater chance that z will be less than x than that y will be less than x.
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Re: "Stocks on sale", "reversion to the mean", etc.

Postby LH » Wed Jul 03, 2013 10:59 am

nisiprius wrote:The classic exposition of this is a 1937 paper:

Cowles 3rd, Alfred E. and Herbert E. Jones (1937). "Some A Posteriori Probabilities in Stock Market Action". Econometrica 5 (3): 280–294

Image

They used different language than we do now, but what they found was three things, all important:

a) In the short term, they saw momentum (which they called "inertia");
b) Over periods on the order of several years, they saw mean reversion (They didn't call it that, I forget what they called it);
c) Most important, after spending about eight pages evaluating various systems for exploiting these effects, they concluded that "This type of forecasting could not be employed by speculators with any assurance of consistent or large profits."

People give it fancier names and do fancier math, but I think that's pretty much what is believed today.

I have a personal theory about "stocks on sale." I don't think factor-of-two differences in P/E are predictive. I think there are extreme deviations which are predictive but useless. The question you have to ask is "why did stock prices get so low?" I think I found the answer, in effect, in Benjamin Roth's The Great Depression: A Diary. During extreme depressions, everybody knows that stocks really are on sale, they really are priced at less than they are worth. So why doesn't everybody snap them up? Because they don't have any money to buy stocks with. That's how stocks got so low. People wanted to buy them but couldn't. In the 1930s "didn't have money" could be very literal--there was, simply, an actual shortage of currency. People with money in the bank could not buy stocks, because even sound banks were refusing to left depositors withdraw it!

Well then, you say, if stocks are so low that they are on sale, and if I am fortunate enough to have some cash to buy stocks, shouldn't I load up? The answer, again, is no, because when this happens, the situation is fraught with financial peril and if you're fortunate enough to have cash you'd darned well better hang on it, because some emergency may come along that may be far more important than buying stocks.


Ditto.

There is not just two sides to a coin, it's more like 1000 sides to an object,likely fractal, that one doesn't know the shape of.

Take now, If I was Econ101 student in 2040, and the stock market does anything near their historical 7 real in the years from now to 2040, the past few years have been the time to LOAD up on debt. Become leveraged, invest in market. Debt is on sale, leverage on sale, yet what do,people want to do, pay off mortgage! It's classic buy high sell low behavior. Yet the Econ 101 student in 2040, will say if he had been here, a 40'year old, he wold take out a bigger mortgage at 3.5 percent 30 fixed to the max, which after tax benefit, is expectantly FREE given 3.2 inflation rate average, invest in market..... No brainer......

We look at the Dow chart from early 1900s to now, and just see squiggles in the 1930s, where the people who were there see hopelessness, hunger, trauma, and maybe even terror. Very different things.

Prices whether for money, or stock, get low for reasons.

Ex post, is just a bunch of simplified stories, describing what we can see of the whole picture, which is very little. The ex post stories, may be wrong in reality, but are de facto considered true. They sound good, and match up human mind to what has happened in past. That and real reasons are not necessarily the same. No way to redo to experiment.
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Re: "Stocks on sale", "reversion to the mean", etc.

Postby magician » Wed Jul 03, 2013 11:03 am

boggler wrote:Many people on this forum assume that after large losses, an asset class will rebound. Furthermore, this idea underlies the "rebalancing bonus", in that buying when "on sale" via rebalancing ensures that you "buy low, sell high".

If this is true, why hasn't anyone (e.g. hedge fund) adopted a strategy of levering-to-the-hilt to buy as much as possible of the asset class "on sale", wait for it to rise, and sell it? Perhaps this reversion to the mean is not really true?

Reversion to the mean might be true, but to profit from it you have to know what the mean is. I suspect that most investors . . . don't.
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