A Stock Market Peak Is Coming, What Should an Investor Do?

Introduction

While a somewhat premature warning of an on-coming market peak may be upon us, we need to think about the implications for our various portfolios.  I believe a sound investment advisor attempts with difficulty to anticipate major problems rather than being forced to react.

Growing evidence

Though no two market peaks are identical, many of them have similar characteristics. Expectations become elevated beyond normal valuations and knowledgeable bright people get sucked in with the belief that they can exit the burning movie theater before the mob behind them. With the benefit of their history (particularly of financial matters) and a cooler disposition, we Americans have a hard time believing our British cousins would get caught up into theses speculative surges. However, Sir Isaac Newton, Sir Winston Churchill and the famed British economist John Maynard Keynes all suffered major financial losses from the collapse of markets. Today the current versions of these “worthies,” many in the investment management business, are imploring us to get fully invested in equities. This is despite the combination of lackluster corporate sales growth and peak profit margins and the increasing prospect of higher taxes on the so-called wealthy.

In this last week both the Dow Jones Industrial Average and the Standard & Poor’s 500 reached new high points. We have come a long way from the bottom reached in March of 2009. Many of the pundits are looking for materially higher prices often with a “2 Handle” or 20,000 or 2,000 points respectively for the popular averages.

What are the signs of a peak?

Margin debt is at an all time high. With trading volume low, there is a presumption that those who are borrowing against their securities are institutions or sophisticated investors who are acting like hedge funds or other aggressive investors. While there is no public disclosure as to which security owned or to be purchased is the beneficiary of the borrowing of margin, I suspect that a good bit of it is to support being long or short Exchange Traded Funds (ETFs) or similar vehicles. In addition there is some borrowing to support “carry trades” where one borrows money cheaply and buys higher yielding securities.

What set my particular concerns off is when a retired CFO and CEO mentioned to me he was arbitraging interest rates by using low cost margin money. He probably does not need to do this, but it appears to be a sophisticated trade for a retiree to do. Some of the carry trade is in buying high yielding stocks and bonds globally. My concern is from a recent headline describing the frenzy as a “dash for trash.” More such evidence is needed before one can definitively call a top or peak.

If there is a peak, what should an investor do?

Before one initially invests in stocks, one should understand that 25% declines from peaks happen regularly, perhaps three times in every ten years. Once a generation, the drop has been 50%. After such a calamity, if companies don’t go bankrupt, their stock prices recover. I will share an extreme example of this. As a junior analyst I was doing work on the Radio Corporation of America (RCA). There was something of a celebration during the 1960s when the stock finally surmounted its 1928-29 high. In the 1920s RCA enjoyed the enthusiasm that the “Dot Coms” had in 1997-2000 era.  While this fact is of interest it should not be a mantra for investing. A better strategy has to do with time horizons.

Time horizon investing

Most institutions and individuals have multiple purposes for the proceeds from their account, but they think in terms of a single portfolio. I have been urging them to break up their investment portfolio into time horizons or Time Frame Portfolios. This principle works for wealthy investors as well as sophisticated institutional investors.

The first slice is the amount of money needed to meet current or near current obligations. Ideally the size of this portfolio will cover up to two years worth of expenses. Highly liquid, high quality, near cash investments should make up this portfolio. When the first slice is exhausted through payouts, it needs to be reconstituted out of the second Time Frame Portfolio which should be made up of intermediate high quality bonds and good stocks.

One way to look at these time horizon slices is the first is for the treasurer or controller.  The second slice should have an expected duration similar to the current CEOs career or the principal wage earner’s life. The third slice should have long-term duration similar to the way Warren Buffett buys operating companies and most of his selected major stock positions which he often says is “forever.”

Application of time horizons to peaks

Fears of peaks should eliminate securities with meaningful downsides from the first portfolio. Some small amount could be tolerated in the second portfolio. Not only could the third portfolio tolerate a declining price investment, it could look for an opportunity to add more.

Harvest time celebrations

This is the time of year in many cultures in the Northern Hemispheres we gather to celebrate the accumulated harvest. In the US we celebrate this coming week as Thanksgiving. My family and I have a lot to be thankful for our blessings. What I am particularly thankful is for an ability to convert some of our problems into opportunities for others as well as ourselves.

Please write and let me know about your:  Peaks/tops, time-horizon investing, and thankful opportunities this year.

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