Sunday, June 1, 2014

Premature Selling Is Tough but Beneficial


The vast majority of investment literature for professionals is about smart buying. Most professional investors pride themselves on their timing of purchases and thus focus on current conditions. While nothing in the art form of investing is easy, buying correctly is much easier than selling. But as active investment managers we should feel responsible for doing the difficult tasks to earn our premium pay over the mechanics, extrapolators and closet indexers.

From a career standpoint, unfortunately there is little difference from selling too soon and being considered wrong. However, any who have experienced the emotional trial of selling into a declining market have learned that it is even more difficult. All too often what appears to be a market break is a hesitation in a continuing bull market. Nevertheless, I believe I have an obligation to protect against significant capital losses for both my paying clients and the non-profit institutions I serve as a volunteer.

As many of my readers have learned I believe that my two great learning experiences were learning to handicap (analyze) at the race track and taking responsibility for my troops as an officer in the US Marine Corps. Thus I approach my current responsibilities today. Based on past analyses of recorded stock market bubbles, I believe that the odds are that some time over the next five years we could experience a major global decline in many stock and bond markets. While as Marines we would prefer to attack than defend, we have learned to capture an advantage after a hard fight. After more than doubling from the bottom of March of 2009, we should prepare our defensive positions. The enemies, or if you will the losers, that we won our advantage from will try to recapture their lost ground.

Excessive enthusiasm is not currently present, but momentum is growing

At the peaks of classic market tops, both professionals and the general investing public often plan lifestyle changes to take advantage of the wonderful new era that the markets appear to be promising. People pull cash out of savings and all too often the equity in their homes to put into the market. I remember commuting on the train with an acquaintance who announced that he would no longer be going to a well paid job at a major company. He was going to say home and day trade one stock from the Dot Com Bubble that was sweeping the country and much of the developed world.

As we examine the current US equity market, bear in mind that the NASDAQ 100 Index (the 101 largest non-financial stocks traded on the NASDAQ* market) is selling at its highest price since September of 2000. Also the short interest ratio in these stocks has moved up to 5.02 days from 4.66 days just two weeks earlier. 
* Disclosure: Owned personally and/or by the private financial services fund I manage.

We are not there yet. Confidence is improving both in the US and elsewhere, particularly in Europe and India with both Italy and India’s stock market showing 14% gains. Stock and bond prices are moving up with little in the way of earnings, dividends, interest income, or economic support. If this momentum accelerates and the gap between market prices and fundamentals gets to be too wide, a sharp fall could occur. Jason Zweig in the weekend edition of The Wall Street Journal summed it up well; “Those with unrealistic expectations are the first to panic after the slightest disappointment.” Unfortunately too many won’t panic as they will believe that it is just a temporary disappointment which will be reversed shortly. When the second or third disappointment happens, assets will be dumped at whatever the available prices are. The term complacency is being used frequently which indicates that investors currently are not worried. Also the same lack of immediate fear is shown in the CBOE’s VIX measure that is at its lowest level in more than a year.

Six items to consider when disposing of funds or managers

Our investment practice is to invest in funds, mostly open-end mutual funds. Recently we were asked in a formal Request For Proposal (RFP) to manage an institutional account what would cause us to sell or redeem a fund. This is an on-going process, but is taking on additional importance now that we are preparing for a peak and subsequent decline.

  1. The first consideration is when a client’s needs change. We work with the client to anticipate changes both internal and external. Often in poor economic times various non-profits believe that they should increase their spending. We need to be able to support this change in planned spending rates. For corporate accounts poor economic conditions can cause lay offs which will affect retirement payouts. Also during poor periods some surviving companies see opportunities to make attractive purchases and thus cash is needed.
  2. The second consideration I learned from the phrase used by the late Sir John Templeton which is that there are better bargains outside of the portfolio than in it. This is an easy choice when the client only pays excise taxes or none. For a tax paying client including in the switching costs are tax estimates including state taxes as well as federal.
  3. The third consideration is when a portfolio manager or key analyst who is deemed to be critical to the investment results leaves or has significantly less time to devote to the fund. One needs to quickly assess the team around the manager who at least temporarily will manage the portfolio.
  4. The fourth consideration is one of too much success. Can the existing portfolio manager handle a sharp increase in assets?  A related consideration is whether the very success of the fund has brought in more high quality competition that will make the job of the portfolio manager more difficult.
  5. The fifth consideration is unexplained performance both on the upside as well as on the downside. Is the fund changing and why?
  6. The sixth consideration is if the management company undergoes a significant change in ownership or organizational structure. This is of particular importance if it affects the fees and expenses of the fund and the financial/psychic income of the key portfolio managers, analysts, and traders.

Note that performance ranking is not a direct consideration. If we do our job correctly and particularly understand the underlying portfolio, the performance over time will take care of itself.

Please share with me publicly or in private communications what are your rules for switching investments and how are you preparing for the next bear market?  
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A. Michael Lipper, C.F.A.,
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