Sunday, December 22, 2013

Thinking About Selling


For the last several posts I have been dwelling on the coming peak in stock markets. I have not been predicting that the current record levels are the peaks before major declines; however I am suggesting that many of the characteristics of a classic top are showing up.

The difference between smart and loud people

We are experiencing the beginning of an enthusiasm epidemic. The clamor of some media pundits echoing comments by economists and a few real market movers is almost becoming deafening. (I wonder whether there are any quiet bulls!) When I parse what they are actually saying I discover that they are looking for another year of rising stock prices and they are willing to see declining bond prices. This was reinforced to me this morning, when leaving our local gym I ran into the director of research of one of the smart new research firms. He said he felt that there was another good year ahead before the size of the government sector’s debt including the central banks would create instability.  This is the equivalent of believing that he can safely dismount from the tiger of “the greater fool theory” that I have written about previously. I earnestly hope he can.

In our continuing discussions with portfolio managers of successful small market capitalization mutual funds, I find they are not waiting to begin their exiting strategies. Quite a number have taken the steps of restricting the amount of money coming into their portfolios by closing their funds and their separately managed accounts to new money. One fund has already started a program of reducing the size of its commitments to some winning positions. Another technique being followed by some is not to fully invest the latest surge of new money that has entered their shop. Their cash build-up already approximates 60% of their maximum cash positions.

What to Do?

In terms of stock positions, one should start to think about net selling slowly. I stress net selling. At all times I would urge investors to follow my late friend, Sir John Templeton’s advice to always seek out better bargains. While a switch may improve the long-term results of one’s equities, it does not reduce the overall market risk of the stock portfolio. What I am suggesting is to begin to plan to reduce the overall commitment to equities. (For me this is a nerve-racking move as I have been long stocks for the last 40 years.)

The One-year Timeframe Portfolio

As regular readers of my posts, you are aware of my concept of dividing one’s portfolio into separate time horizon-oriented sub portfolios, or “Timeframe Portfolios.” At the minimum one should have at least three sub portfolios with time horizons of one year, five years, and ten or more years. My immediate focus is on the one year which is both for the net cash generation to meet current needs and the result most amateurs focus on in their discussions in mixed investment committee meetings with non-professional investors. For this section of the portfolio a selling program is needed to meet cash and competitive needs. The object of the exercise, while enjoying the probable rising market prices, is to raise sufficient cash to meet funding requirements. My suggestions are first to decide how much cash is required at the end of the year and then plan to sell an amount each month or quarter.

The next approach is to set price levels for each position that is a reasonable one year goal. Whenever the price is reached, sell the position and include the proceeds in the required cash raised for the month or quarter. Finally, there will be events, some positive and some negative that will cause the stock price to gyrate. Either way it would be a good time to exit the one year position.

The Five-year Timeframe Portfolio

The middle sub portfolio or the five year portfolio has a different set of issues and therefore suggestions. What is absolutely clear to me is that sometime over the five years stock prices will take a nasty hit, most likely in the 25% range, but possibly as much as 50% before returning to an upward path. The critical question facing this portfolio is, “Who will see the results?” If the only reviewer of this portfolio is its owner, then a sound growth-oriented portfolio would make the most sense as stock markets tend to rise three out of four years. However, if the portfolio is likely to be reviewed by a critic, a significantly different strategy might be best. To be over-simplistic, owners want upsides, critics want to avoid declines. 

Most of the time the discipline of a value-oriented portfolio has had less chance of declines. The overall characteristic of a value portfolio is that the stocks are selling significantly below their perceived intrinsic value. (Not so far below that only a small minority of investors would perceive the same value. These portfolios are often labeled “deep value” and better left in the hands of keen professionals.) Most often to keep value stocks from declining at the same rate as more aggressive growth-oriented stocks, the value stocks pay a dividend and may have a practice of buying back their shares from their shareholders. The dividend yield on these stocks should attract some additional buyers if the stocks go down in price and their yields rise. Currently the ten worst performing stocks in the Dow Jones Industrial Average (DJIA), often known as the “Dogs of the Dow,” have dividend yields of between 3% and 5%. Many so-called value stocks have similar or somewhat smaller yields. And this is what makes them more vulnerable today. 

For months the general stock market has been discounting the beginning of the Federal Reserve’s tapering and bond yields have been rising.  Over long periods of time when bond yields go up, stock yields go up and stock prices weaken. When this happens the partial safety net from dividends become less strong for value stocks. In addition, many value stocks are from companies that require significant capacity expansions to produce the same or higher dividends in a period of rising costs. I am increasingly concerned about some of these in the energy business. Quite contrary to past beliefs there is a multiple year threat of over production of oil which will lead to lower prices. Nice for us as consumers, but it is not a favorable outlook for maintaining or growing dividends. Thus, my recommendation for value-focused portfolios is to reanalyze the intrinsic value calculations as well as the value of future dividends as a price support for the stock.

Bond prices are declining

Contrary to much of market history, we have until very recently enjoyed having bond and stock prices rising at the same time. In the past their price movements have been inverse to each other.  As mentioned the markets have already sensed the slow pullback of the manipulations by central banks to keep interest rates artificially low. In addition, while it is clear some of the most damaged European economies have stopped shrinking and may be rising a small bit, the rating agencies are slightly lowering a number of the sovereign bond ratings. They are showing appropriate concerns as to the willingness of political leaders to continue the various austerity policies that helped to give confidence to the funders of the turnarounds. Removing this discipline runs the risk of a 1937-38 Roosevelt Recession which may well have been a contributor to setting up WWII. With the high-quality bond markets showing signs of nervousness, the yield spread for high yield, if you will junk bonds, will widen.  If this were to happen it will make the current wall of refinancing more expensive, perhaps prohibitively. Without support from the fixed-income world many of the expected merger and acquisition deals are going to be delayed which could hurt the value stocks.

When one hears of transactions, one should make the judgment whether the buyer or seller is smarter. I am very selectively and for specific purposes slowly beginning to sell a little bit.

Please let me know what you are doing.   
Did you miss Mike Lipper’s Blog last week?  Click here to read.

Did someone forward you this Blog?  To receive Mike Lipper’s Blog each Monday, please subscribe using the email or RSS feed buttons in the left column of 

Copyright © 2008 - 2013 A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.

No comments: