Introduction
One of the main
differences between many brokers and a fiduciary investment manager is the focus
on the time to reward. The broker gets rewarded for transactions. The ultimate
rewards for the fiduciaries are the successful spending programs of the
beneficiaries of their work. I am a professional member of the second tribe.
Thus, I think about structure as well as selectivity as they evolve over time.
With the US and many
other stock markets on balance going up more often than going down, one of my
tasks is to avoid unforced declines. If the long-term secular pattern of rising
stock market prices remains, my beneficiaries will receive payments for their
reasonable spending plans. That is, if I as their discretionary manager avoid
unforced mistakes. Three mistakes that I try to avoid are Recency,
Overconfidence, and the misinterpretation of Volatility.
According to a study
mentioned by Gene Epstein of Barron’s
done by Professor Jeremy Siegel of Wharton and his former student at Wisdom
Tree*, in the last 144 years there has never been a 15 year period
when an investor who invested in the popular indices of the US stock market
lost money supporting the argument in favor of the positive secular trend.
Almost all of the accounts that I am responsible for have a current belief that
they will need to meet their payment obligations for 15 years or longer.
Recency
Like many of our
readers of last week’s post I was surprised to
find that recency is an acceptable word in our language. The word was listed in
a long list of biases that have hurt investors over time. Almost all
discussions about the outlook for the future of the stock market devote a lot of
time to the very current situation. In theory, that is what is known. (Actually
all we know is the outline of what happened not what made it happen; more on
this later in the discussion on volatility.)
Very little time is
devoted to the terminal prices of a considered investment. What does the current price of say $10 per
share tell us as to the odds that we will terminate our position at $5, $15, $
50 or $100? Most brokers shy away from guessing future prices over an extended
period of time, while investment managers need to ponder.
The question as to
future valuations is exactly why I have developed the concept of the Timespan L
Portfolios. I am aware that tomorrow the market could start to decline. Based
on history beyond the Wharton study I am prepared for a periodic correction of
at least 10% even though we have not had a five day consecutive period of
decline since 2009 and no 10% decline since, I believe, 2011. I believe that it
is reasonable to expect a 20% + decline at least once every 10 years and
roughly a 50% drop once a generation.
In the Time Span Portfolios
construct, the shortest duration portfolio to fund operational needs should
have an excess over planned spending of 10-20%, depending on when the last decline
occurred. Whenever the Operational Portfolio has completed its funding mission (which
may be in two years), just as a good US Marine Corps general does after he
commits his front line troops, he immediately reconstitutes a reserve element
to replace the tired-out or expended troops. Thus, I have created the
Replenishment Portfolio which will provide the next series of funding needs.
Because the Replenishment Portfolio has a longer duration of possibly five
years, it is reasonable that it may have to deal with a stock market decline of
50%.
Having the first two
portfolios in place, the third or Endowment Portfolio would have a duration of
15 years or possibly a little more and should be able to tolerate an all
equity-like risk. The general expectation for this portfolio should
parallel the return on equity that the major market indices generate from their
components.
Recognizing few if any
of today’s leading stocks are likely to be the better performing stocks well
into the next generation, a portion of the final or Legacy Portfolio should be
crammed with potential disrupters of the present structure of our economy.
Smart technology creators and probably more importantly, smart technology users,
will be predominate in this all equity portfolio.
Each of the four
Timespan Portfolios can be managed aggressively or conservatively as long as it
stays focus on its designated timespan.
Overconfidence
Overconfidence is a
risk that can grow exponentially the longer the period when doubt is
appropriate. Or, as Berkshire-Hathaway* CEO Warren Buffett said, until
everyone else recognizes the nakedness of those skinny dipping or in the next
parade of dignitaries when the king is marching naked.
My Grandfather who
spent his working life running a successful carriage trade brokerage firm used
to warn his grandchildren to stop being so certain. This was a difficult
message for me and I believe the others to digest. After all, we had just
learned a particular “fact” or relationship. Therefore, we were certain about
something and our Grandfather just was not hip enough to get it. Only with age
did I get to understand and appreciate his wisdom. When I see or hear the
various media pundits or others selling their wares with 100% positive
statements my risk avoidance mechanisms kick into my judgment apparatus.
Where are we today? Liz
Ann Sonders of Charles Schwab* quotes the late, great, an old friend
and consulting and data client, Sir John Templeton saying that “bull markets
are born on pessimism, grow on skepticism, mature on optimism, and die on
euphoria.” She thinks we are now in the third phase. Other sentiment indicators
are in agreement with positive ratings of 50-70%. She is probably right, but my
Grandfather’s caution comes to mind when I see the only Dow Jones stock price
index that is up for this short year is the utility index. This is a
continuation of the superior performance achieved in 2014. The only nagging
problem is that utilities at least three times before enjoyed good performance
on the basis of expanding price/earnings ratios which preceded a general market
decline. I remember that from a portfolio construction standpoint utility stocks
were generally used as bond substitutes.
Long-term treasuries were the best single large asset class in 2014 and
so it is understandable about utilities performance. While I hope Liz Ann is
correct, I am not retreating from my belief that if enthusiasm boils up we can
see both a 20% gain and 20% loss from current levels based on past history.
*Held by me personally or by the
private finance services fund I manage
Volatility
Volatility, either as
the price of the VIX or standard deviation, is not a measure of the potential
loss of capital. They are useful descriptors of price movement. The fundamental
problem is that they don’t explain price movements. In a prior post I warned
about the tyranny of the single last trade of the year. I find it somewhat ironic that traders from at
least two major banks have had their bonus expectations cut by about 10% due to
the market performance in the last two weeks of 2014. The reason this is ironic
is that most traders believe they can make money out of volatile prices. That is if
their bosses permit them to trade the market. A substantial portion of many
trading desk’s profits do not come from executed trades but “marks to market”
of the securities in their inventory. A number of financial institutions want
to be early in their public reporting cycle; thus they are, in effect, restrained
from trading at the end of the calendar year. Keen market observers noted that
in the last half hour of the last day there was still some insistent sellers,
probably for tax or statement purposes and little in the way of buyers, so in a
30 minute period market prices declined enough to make December a slightly
losing month as compared to a probable winning month.
The reason for dwelling
on the short-term price movement is that too many investors will interpret the
fall in December and now the newly crowned peak of the market at the close of
December 18th as having
lasting meaning rather than understanding it as an imbalance of buyers and
sellers in the last half hour
Question of the week:
Are we entering a new market phase?
__________ Question of the week:
Are we entering a new market phase?
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Copyright © 2008 - 2015
A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.
All Rights Reserved.
Contact author for limited redistribution permission.
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