Sunday, December 26, 2010

Perspectives Change With Your Viewpoint

Inside Out

I am writing this blog in the midst of the Blizzard of 2010. There is something almost universal in the northern climes of the Northern Hemisphere this year, as snow is disrupting travel plans and family functions in many parts of the US and Europe. At the moment, we are lucky, as all of our loved ones are with us or are snug in the homes of the family. Looking out the window from our well prepared homes, the falling snow has a pleasant and mystical glow about it. Our California grandchildren are visiting us and are thrilled, as this is quite a wondrous sight for them.

The very same gentle snow being whipped around by a significant wind is treacherous to travelers and unfortunately there will be many accidents, perhaps some loss of life. At best, the travelers and the various service people will be delayed and made uncomfortable. Looking at the falling snow, their perspective is very different than that from our comfortable place. Just as the difference from being snug at home versus being out in a blizzard changes one’s perspective of snow, an individual’s investment positions also change one’s view on the various markets being tossed around by the elements of supply and demand.

Which Direction is the Wind Blowing?

As the regular members of this blog community know, I am on record believing that the stock markets will challenge and probably exceed their old highs reached in 2007. I learned a long time ago one should never predict both the magnitude and the timing of a price move at the same time. Further, my initial prediction stated clearly that it is unlikely that the first assault on the old highs will be successful. Just as the size of the snow flakes and the speed and direction of the wind are important nuances in understanding the ultimate size of the snowfall and when it is likely to end, there are now nuances that are affecting my earlier market prediction.

The first concern is directed at the likelihood of a strong, sustained surge in the various stock markets. With each new bullish pronouncement by various pundits, the odds decrease on a quick 20%+ move. In the weather sense, all of these talking head comments create a vortex; they are chasing their own tails without providing much in the way of forward movement. They are successful in moving the snow from one snow bank to another, but not moving the storm out of the vicinity.

My second concern is continuing to follow the Barron’s Confidence Index. The index measures the ratio of the yields of high quality bonds to those of intermediate quality. When the index rises it is predicting with some degree of accuracy a rising stock market. Most of the time the index is flat with movement limited to a portion of a single basis point. While any week (and particularly a holiday-shortened week) can be an aberration, the recent decline of 1.4 makes me question the likely near term upward move of the market.

Are New Snow Plows Needed?

The final successful assault on an old high is often led by fresh troops, or if you will, leaders. As portfolios now contain domestic stocks that are not found within the lists of 30 (DJIA), 500 (S&P500) or 3000 (Russell), I tend to use the widest available list encapsulated in the Vanguard Total Stock Market Index fund. A large number of funds are beating this indicator as we are coming to the close of 2010, according to my old firm, now known as Lipper, Inc. According to its December 23d report, and focusing on each of the 20 US Diversified Equity fund averages, eight groups were superior to the higher standard of the total stock market index. (Ten investment objective fund averages gained more than that of the narrower S&P 500. The average Diversified Equity fund also beat the 500.) Perhaps more significantly, of the 20 sector categories, half were better. Normally new index highs are led by an over-weighted concentration of investments in the index. We may be slowly marshalling the strength of the leadership needed to breach the resistance likely to be found at the old high points.

Each week we look at the performance of the 25 largest SEC registered mutual funds. Using the same benchmark as we did above, only SPDR Gold fund gained more this year. As these 25 funds were the largest, they were the leaders of the fund business. Over the last five years 15 out of the 25 produced better results than the broadest measure. Following military tactics as I learned them, the final assault will rely on the big guns.

Currently, Small Capitalization Beats Large Capitalization

In looking at this year’s performance, it was the relative size of the market capitalization in the portfolios that led to the better performers. The best performers were the small caps, closely followed by the mid-caps and further down the line the multi-caps. On average, all three of the large cap categories, (growth, core and value) underperformed. The chances of a successful breach of the resistance at the former highs will, in my opinion, rest on large cap performance. In particular, leadership by large cap growth funds would set the tone for the sustained optimism required to bring most investors out of their snug homes.

In the Meantime

During market declines investors often make lists of stocks with attractive buy prices. My guess is that seldom do these lists get fully utilized. However, the technique can be applied now, probably with good effect. Many of us have portfolios embedded with significant unrealized capital gains. As mine do, these portfolios have a few or more holdings that are currently being held at a loss relative to purchase price. In general, I believe one’s entry level into a position is a historic accident when viewing future transactions. However, if you choose to continue to hold a losing position after a year of generally rising stock prices, you must believe that the loser will morph into a butterfly and fly up to the sky. If that is your view (or your handcuff), before year-end you should buy more of the loser. Next year you can choose to reduce your position after 31 days and lower your entry cost. I suspect that as we mount our move to higher levels, the sustained loss will have value to offset new gains. If you are not willing to buy more of an investment, particularly a losing one, shouldn’t you free up your capital for better uses?

These are my thoughts during the Blizzard of 2010.

May 2011 bring to you every bit of happiness you desire.
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