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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Copyright © 2008 - 2013 A. Michael Lipper, C.F.A.,
All Rights Reserved.
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Intellectual Integrity

My brother has often quipped, “Would you believe that I am the smartest person in the room?” Most people immediately and correctly attack the question and miss the point. The point has to do with one’s belief ("would you believe") not the accuracy of the statement (smartest person in the room). Our lives as people, citizens, and investors are governed by our beliefs, not necessarily by convenient or inconvenient facts. In the realms of investing we, in theory, are protected against fraud that is incontrovertibly provable in court. What have proven to be much more damaging to us persons, citizens, and investors are lapses of intellectual integrity; intentional or not.

Gamblers’ choices

As I indicated in last weeks’ post  we are all gamblers. We cannot avoid gambling as to what the future will bring to us, good, bad, or indifferent. We make the choices as to our own actions based on our belief systems and the information that is in our possession. Much of what we use as information is derived from implications drawn from various levels of data with different degrees of reliability. In the normal course of events we make choices of which political leaders to support, where we choose to live, what jobs we take, what people/agents we choose to hire, what investments to make and in my case into what funds to invest our clients’ money. Before we immediately react and start to use the information that is on hand, we should ask the first part of my brother’s question, “Would you believe?”

Challenge the “facts” before using

We are aware of grade inflation both systematic and specific. We are also aware of résumé embellishment and political hyperbolae. Anyone who hires others is aware of the need to either disbelieve or at best filter what has been presented to us. In the investment world many answers are wrapped around a set of numbers as verification of some skills achieved in a convenient time period with the clear implication that the same supposed skill will be delivered in the future.  As we live in a time-constrained world, a media clip is meant to move portions of the swing voters, very quickly reviewed pre-screened résumés are being used by hiring managers for important positions. All too few questions are being asked to understand the full nature of what is being offered for our fast, but important decisions.

A prudent approach to examining individual security data

While I am very conscious of the costs of displays of data and the syndrome of “eyes glazing-over” from too much data, I suggest that the statistics on performance covering five and ten years as well as “since inception” results can raise the question as to intellectual integrity. Without understanding what is also happening during the period under study and particularly what a reasonable set of peers are doing does not put the data into appropriate perspective. Go back to the question as to the smartest person in the room. Are we talking about the fabled Thomas Jefferson, according to JFK dining alone in the White House, or a bunch of low achievers gathering somewhere, or a collection of Nobel Prize winners convening at Caltech? 

Another major concern of mine is that if long enough periods are chosen often the result will show misleading compound growth rates. 

Understanding under-performance is more important than celebrating the good

When I was following individual securities, I never felt that I understood a company until I found a period that they were working through problems, better yet that they had some failures along the way. Only when companies or athletes are seriously challenged does one get a clue as to their basic strength. I distinctly remember when IBM was behind in its technology and in effect, bet the company on the development and sale of the IBM 360 computer. If it had failed to deliver the promised performance, the company would have become another failed computer company. There are more modern examples of life-changing decisions that have worked; including the re-hiring of Steve Jobs at Apple and the merger of Bank One (including Bank One’s previous acquisition of First Chicago) into JPMorgan Chase. The particular set of screens that I like to utilize when analyzing companies is quarterly performance from the third quarter of 2007 until the first quarter of 2009. These periods will tell me how market sensitive their portfolios were and what changes were made during that period in terms of holdings and procedures, if any.

Focus on future investment choices

When we hire someone/firm or buy into a fund we are betting on various unknown futures. The one thing that we can be almost completely assured of is surprises. Our big risk is in choosing a candidate that has not had to recover from a bad period and particularly from an unidentified mistake. It is like going to the racetrack and betting late in the season on a horse which has a winning record of always leading from the front. What is that horse going to do when some other horse or horses are in front of the prior undefeated horse? For that horse, portfolio manager, employee, or political candidate this is a surprise situation.

Dealing with surprises and other disappointments

We are all human which is to say we make mistakes. Please protect me from persons who have never made a mistake, at least in their mind. We live in a very dynamic world where lessons should abound every single day. We need to find those that have intellectual integrity that not only admit mistakes but learn from them. In some respects the great Sir Winston Churchill made more mistakes than almost any other politician in the English-speaking world; but I believe he was the essential choice as the leader for Britain during World War II. He clearly learned from his past mistakes. He would have been a great portfolio manager in a different setting. However if one studies his actions, it is not a surprise to see him lose power after his great success and yet be recalled to leadership when conditions turned to need his strength.

Investment integrity demands

What is demanded by investment integrity is a discussion of losers as well as winners. Most importantly required is a discussion of what kind of environment helps the existing portfolio and what hurts. We would like to see who is being hired, are they complementary or supplementary? Are they broadening their knowledge base or just adding replacements to the present talent pool?

Please let me know how you handle investment surprises.

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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 MikeLipper.Blogspot.com .

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