Introduction
Critical Time
For the US stock market, we may be at a critical time or juncture leading to materially higher or lower stock prices. Are we pausing in a correction or are we on the way to a full bear market of about twice the decline already experienced, or worse? Are we in the process of successfully testing the February bottom?
To me, as both an analyst/portfolio manager and a handicapper trained contrarian, I think the odds are good for the first, but not the second. To me, as an observer at the race track, favorites typically win about a third of the time. I look at sentiment readings and the mainstream media for clues. Given three choices, bullish, bearish, and neutral, the latest weekly survey sample of the American Association of Individual Investors (AAII) has pushed the bearish button to being a slight leader. Normally, most investors are bullish most of the time. Their views are being reinforced or led by large elements of the coastal media who are proclaiming the market slide as confirmation of the supposed failures of President Trump.
Using my training as a racetrack handicapper, I suggest the odds we are experiencing a successful test is better than 60%. Those odds are in the same neighborhood as investors’ own various mutual funds which are 67.74% in equity funds. (Strange how the 2/3 to 1/3 split is similar to the standard attack format for successful battles won by the US Marines.)
As focused as most investors are on the next general direction for the market, the key is not the tactical direction, but the answers to long-term strategic questions. Just as at the track, the key to walking away a winner in dollars is how one handles the betting money. The key to being a winning investor is reasonably answering the following strategic questions.
Critical Questions
The single most important question (usually not answered) occurs when someone asks for a stock recommendation. Until a stock is no longer trading, history suggests that it will have a plus sign in terms of its performance for some period. Thus, it is not whether this stock will rise in price, but whether it will rise over a pre-designated time span. Just as it is a mistake to bet on every race during your day at the track, it is also a mistake to have a single portfolio that one believes will be a winner for the current, intermediate, and long-term. This is particularly true today, with half the stocks disappearing over the last twenty years or so.
We have been an advocate for dividing institutional and individual portfolios into separate time-span portfolios. Different securities are likely to dominate the short-term or Operational Portfolio, Intermediate or Replenishment Portfolio, longer term Endowment Portfolio and the beyond the control of the current investor Legacy Portfolio. I would be pleased to work with subscribers to construct these portfolios. The following are not recommendations but illustrations as to what we would be looking for in the candidates:
• Short term/operational Portfolio - mutual funds with a balance of short-term high quality fixed income and high quality liquid stocks
• Intermediate/replenishment Portfolio - medium price/earnings ratio stocks paying average dividends
• Longer-term/endowment Portfolio - mutual funds of established growth companies with high return on tangible assets and p/e no more than 150% of market
• Legacy Portfolio - funds or companies that look to the next generation of leadership e.g. Berkshire Hathaway*
*Held in client and personal portfolios
One of the most difficult questions to deal with is the measurement of success. To the extent that a portfolio is meant to produce capital (principal, income or total return), the clearest measure is absolute return. If there is a competitive need to be fulfilled, then an external index or indices are needed. (University endowments are in competition to get the best faculty and foundations are in competition to get grants.) The critical key in choosing a measuring rod is how the index is constructed and changed, the rigor of measurement, data availability, and whether the proposed portfolio will be restricted to elements within the index. I have a bias in favor of using mutual fund indices and averages when they qualify. Some of the areas they cover include market capitalization, growth, value, and core, world equity and debt, sector funds, mixed asset funds, various types of bond and credit funds, and different types of money market vehicles.
Be very careful not to lump conventional mutual funds in with Exchange Traded Products (Funds and Notes). While both are registered under the Investment Company Act of 1940, they are designed and largely used differently than the larger universe of conventional mutual funds. Exchange Traded Products do not have cash to buffer market price changes and flows, they have relatively fixed portfolios and are primarily used to express specific long or short points of view. The bulk of their volatile flows come from trading organizations or advisors who trade their accounts. Recently, they have not been particularly good at handling these difficult markets. According to The Wall Street Journal which tracked the price performance of 72 stock indexes last week, including currencies, commodities and ETFs, there were no ETFs in the top 21 or bottom 27 slots. This suggests to me is that the market is reconstructing the winning and losing groups.
The purpose of comparing performances of various instruments is to create awareness of what is going on and to manage expectations. The result of measurement leads to an understanding as to what portion of one’s portfolio is for investment or speculative purposes. The answer is not always found in the nature of the instruments, but how and why the owner uses them. The market needs both investors and speculators as they often trade with each other to enlarge or reduce their universe. The changes in the value of investments and speculative vehicles are dependent on these trades. Market prices don’t generally move a lot unless investors are selling to speculators or the reverse. For example, during periods of high price momentum, with the exception of scale orders to enlarge or reduce the size of a position, wise investors should leave the action to the speculators.
Questions of the Week:
How many, if any, sub portfolios do you use?
What is the ratio in your own account of investments to speculations?
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A. Michael Lipper, CFA
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