Saturday, June 25, 2011

Your Investments Right Now:
Hold or Fold?

One of the techniques a former Director of Research of a major firm used in interviewing a candidate for hiring or promotion was to play poker with him/her. How the player handled him/herself, he believed, told him a lot about the person’s analytical abilities, risk-reward sensitivities, and to some extent, their integrity. In the modern era, poker has become both a casino and an electronic game. Regardless of how the game has evolved, there comes a point when each player has to decide to hold his or her position in the game by at least matching the last bet, or declining to do so by folding.

The investing game

While investing should be, and is for most people, a serious activity, some of the thinking that permits players to walk away from the table with their (hopefully augmented) chips, is useful. At every minute in the trading day the investor has the choice to stay in the game and accept today’s risks or to fold, perhaps to play on another day.

Okay coach, what do I do now?

As long as you don’t tell anyone, I will admit I do not know which way the market will go. I join both Peter Lynch and the late Sir John Templeton, who professed not to know (or to particularly care) about short-term movements in the market.

The rest of this post is in response to some members of this blog community who feel under pressure to do something.

The stock markets have been declining throughout the second quarter, which is about to end. The quarterly reports will attempt to focus on the first half results, which will be for the most part positive. Nevertheless, a lot of pessimistic comments are being generated by the single digit losses in the second quarter, and constant focus in the press on bad news. Uncertainty is a word that will be used by various political and economic commentators. Some may believe that there will not be sufficient clarity until after next year’s US elections for the Senate and President. (I placed the Senate first because in my mind it is more important in the long run as to the structure of the US, and to a lesser degree, international political and economic structure.) Some may feel that too much can and will go wrong, and want to exit or fold on some of their investments now. A good coach wants to win the current particular contest, but a great one wants his players to achieve long term success.

Don’t do “It” now

By definition, the optimal time to sell is when something is priced at an unsustainable level. With the exception of a limited number of new issues and some commodity plays, we are a long way from prior peaks or future valuations based on “normal growth and conditions.” Some with large unrealized profits may be concerned about the end of current capital gains tax rates. (If that were to happen, it would be in 2013.) For the ultra high net worth among us that are building inheritance and trusts for future beneficiaries, there is the after-tax risk of timing the re-entry into the market. Most of my clients are more concerned about the long-term future of their capital than the current size of their piles of poker chips.

I need to sell; what do I do?

The following is a series of thought patterns to guide the current seller:

  1. If you believe that we have rolled over into a bear market, examine the history of your fund or securities in the last couple of bad markets. We have recently done that on a list of funds of interest to a particular client. While we did find some funds that were in the lowest quintile in the last two bear markets (2000-2003 and 2007-2009), the reason they were on the list of funds of interest is that they had spectacular bull market performance. Thus, if you believe we are much closer to a bear market that might last until after the elections, one might choose to exit these funds. Be careful, getting the timing right near a bottom is very difficult. Most people come in to a subsequent rise late, after the easy money has been made in the early part of a recovery.

  2. If you believe that the current market recovery is getting old, you may want to look at your portfolios for your best performers. Have they done so much better than other investments to make their stock prices vulnerable? For some time small market capitalization stocks have done better than large-cap stocks. On average, Small-cap Growth funds are up +6.02% year-to-date through last Thursday, June 23rd, compared with the average Large-cap Growth fund being up +1.88%.

  3. Popular investments experience a crowd effect, with many of the well known pundits in or out of the media calling attention to particularly good results and/or intriguing personalities. People join the crowd late and usually take the pundits’ word that the touted security is a good investment. As expectations are not met quickly, the crowd dissipates, perhaps causing a redemption run. So if you must sell, look at the former media darlings.

  4. If you invest in sector oriented funds, keep in mind they can move much faster in both directions; and if you want to reduce your downsides you could cut back on these leaders, e.g., Gold and Silver oriented securities. At this point, one of the underperforming sectors is the Science & Technology group. Currently, there is much happening that may change the nature of competition among these companies, which creates both outsized risk and rewards; thus extreme selectivity is warranted. The worst performing sector in the US (and elsewhere) is the financial sector, with the average Financial Service funds down -5.27% year-to-date. As a manager and investor in a private financial services fund, I have mixed emotions. I am unhappy with the performance of the sector, but I can understand it, as can my long-term clients. On the other hand, any additional massive selling of the sector is likely to create bargain prices that we have not seen in many years.

  5. I believe the biggest risk to many portfolios is their high quality and short-term fixed income holdings. Except for TIPS (Treasury Inflation Protected Securities), the risk to your purchasing power is high and going higher in the other securities. At this point in the cycle I would suggest that there is more credit risk than current prices can accommodate. If you are cutting back on your equity exposures, I suggest you cut back on their “kissing cousins,” high yield securities and funds. The higher the current yield, the bigger the risk according to the market.

Twin Conclusions

Long-term oriented investors should hold on; this particular period of uncertainty will be over relatively soon. For those who feel they must exit some of their portfolio, do it wisely. Be willing to cut back on some of your outsized winnings.

As a paranoid spectator, I wonder whether there is any long-term significance in the fact that the plane crash earlier this week in Russia had five nuclear scientists from Iran who were purported to be working on the peaceful use of an Iranian reactor.


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