Entering the Most Dangerous Market Phase: In Three Parts

Introduction

Many years ago I heard an unoriginal line in the elevator (lift for my British friends) coming down from the New York Stock Exchange Luncheon Club. “Do you know how to make a small fortune,”  the old floor broker asked then he quickly supplied the answer, “start with a large one.”

There are two important axioms about a major stock (and bond) market decline.

1.    Big losses are only possible after big gains. This is not quite as earth-shattering as Sir Isaac Newton’s discoveries. But the result to one’s portfolio is indeed grave.

2.    Historically by far the biggest loss suffered by investors is not the decline from the peak to the bottom. A much larger loss over time is sustained by the disheartened investors who feel foolish or embarrassed by the loss and withdraw from participating in future markets. One of the reasons that those of us who entered the US market in the mid to late 1950s did so well was that many of the more senior investors were concerned about another Roosevelt 1937-38 type collapse and so were sellers and not buyers.

Part 1: The Market Can Go Higher

My last several posts focused on some of the pre-conditions present in past peaks. I am not flashing red lights for investors to come to a stop of what they are doing. I am stressing that I perceive the need for additional caution. I fully recognize that the stock markets in many countries can get further extended by those who are focusing on the upside by touting the following points:

1.    In a chart supplied by Strategas Research Partners and T. Rowe Price^*, after 57 months of expansion of the last 13 Bull Markets, the average gain was 165% which compares with our present rise through mid November of 164%. Thus we are on track in terms of up phases. There were four Bull Markets which showed further up-side. In terms of greater S&P500 advances the 1990-2000, 1932-37, 1949-56 and the 1982-87 Bull Markets performed greater than we have achieved in this phase. The first two on the list had gains of about twice to three times what we have gained so far. So there is potential for more upside. Morgan Stanley^* is leading the cheering section with a published view that we will see 2014 on the S&P 500 in the year of same number.

2.    The financial conditions in Europe are not only not getting worse, but Moody’s* is selectively raising up various lowly-rated sovereign debt ratings. (In the end, if he could have held on, Jon Corzine would have made money on MF Global’s leveraged bet on the euro.)

3.    Surprising to some, the US domestic economy is showing a pickup in growth. One might wonder whether what we need are more bouts of government shutdowns to help productivity?

4.    There appears to be some chance that we won’t see another US government furlough program as some members of Congress are putting together a budget that takes us through next year’s elections.

Part 2: Deep Structural Problems Are Not Being Addressed

All is not well or improving in our world with some very serious structural problems not being part of current proposals.

1.    We live in a paradoxical world where there is substantial unemployment and under-employment at the very same time that businesses cannot find qualified applicants to fill job openings. The missing elements for the employers are not just a mismatch of training skills. In talking with employers what are missing are basic academic skills, work and discipline attributes as well as work-oriented integrity. Even with an expanding economy many may not find work. In effect we have structural unemployment.

2.    Around the world the size of individuals’ retirement capital is significantly insufficient. To the extent that this lack of retirement funding is going to be addressed by individuals, the only place that they can get the money is by spending less and saving more which will hurt our consumption models.

3.    As a nation there is every chance that, in aggregate, US health care costs will go up beyond various budget assumptions. The strong odds are that society will pay more with less-strong odds that the quality and efficacy of health will improve to the same degree as costs will rise.

Part 3: The Trap is Being Set

There is nothing that I have laid out in this post that is startling new. Most investors will focus on Part 1, the upside. With the rising momentum people will not be overly concerned about Part 2, the problems not being addressed. This behavior is similar to the aforementioned Sir Isaac Newton who bought and then sold out of the parabolic rise in the South Sea Bubble caper only to be sucked back into re-purchasing out of envy and then again lost all that he had committed in the subsequent collapse. He fulfilled the same role that my professor friends at Caltech have demonstrated in the study of the brain which focuses on past successes or pleasures. As a junior securities analysts we quickly learned of the power of the greater fool theory. For a long time fools have more buying power than prudent investors.

What to Do?

I have five suggestions:

1.    Be careful it is easy to get sucked in, many bright people will.

2.    Focus on investment with well-financed companies that have quality products and services that remain essential in the future. You probably will earn less, but probably will also lose less.

3.    Reduce the ratio of your net purchases to your net sells. While cash is the equivalent of trash today in these low interest rate markets, Warren Buffett has amply demonstrated his acumen at Berkshire Hathaway^*, emphasizing the value of cash during periods of stress and accepting under-performance until the rising cash pile can be used dynamically.

4.    Remember that future opportunities will occur and in the long run that will be good for you.

5.    Use the time horizon strategy I have previously suggested separating your intermediate time horizon investments from your longer-term investments. (Please contact me if you would like these posts emailed to you.) The intermediate investments should be current price-oriented. When the bidding for these good companies gets excessive on a historic basis, be a supplier (seller) into the market. Ride out your long time horizon investments and when they periodically decline due to short term factors buy more.

Do You Disagree? Please let me know I am always anxious to learn from wise people.

^*Stocks of the companies mentioned are either owned in my private fund or are in my personal portfolio or both.

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How to Recognize Risks Before They Bite

While no one rings the attention-getting bell at the peak or bottom of a market, there are often plenty of warning signs. The biggest sign is growing enthusiasm for whatever is the current trend. I perceive that there are some flashing yellow signs suggesting that there may be problems ahead, both for me personally and for some portfolios that are my responsibility.

Previous “Rules” Based on a Different Economy

Last week in the second of a two part blog post, I gave the impression that the next major move is up. Like most people that choose to get out of bed in the morning, I am gambling that things will be good for me that day, if not beyond. To balance this bullish point of view I should recognize that there are a number of structural problems which may put the timing of the expansion in question. The first is the liquidity risk which brought down Bear Stearns and Lehman Brothers, as well as most people facing foreclosure. At the end of their day they did not have the cash to meet the immediate call on their assets. Most personal financial consultants initially urge individuals to have at least one month’s expenses in the bank. By early middle age the pot should be three months, and later one year. All of those ratios were essentially based on the historic experience that a young person could find a job in a month. By age thirty it might take three months and by fifty a year. In a corporate context, for many years the IRS threatened various companies which amassed a lot of cash with a possible surcharge if they did not pay out dividends or use their cash. All of these “school solutions” were based on a different economy than what we have been in for sometime. With at least one quarter of the unemployed and underemployed without a full time paycheck for at least two years, a reasonable contingency fund probably should be built up to a two year level of reduced expenses. In addition, companies have to determine how long they can keep their doors open and maintain critical employee skills in an extended period of an economic slump.

Voluntary and Involuntary Savings Rates

In reaction to these present realities, private sector savings rates have moved up. This is not as positive a sign as we would like to believe. The growth in savings has largely been a function of paying down debt. Actually in most cases the pay downs were involuntary and accomplished through foreclosures or bankruptcies. One should watch bank deposits as well as mutual fund gross sales to spot voluntary saving. What makes the situation worse is that a decline in private sector borrowing is totally offset by expanded government borrowing for low return investments.

A Bull Market, When?

The reason to watch bank deposits and mutual fund gross sales is to begin to gauge the liquidity preference of the population. I suspect that as a reaction to the aforementioned rules of thumb proving to be inadequate, that consumer reserve levels will rise above historic levels. As long as the money isn’t put under the mattress it will be in the hands of various financial services intermediaries who hopefully will make high quality loans to any who wish to accept their own liquidity risk. Only when the public either directly or through 401(k) and similar vehicles invests in equities, will we seeing a rip-roaring bull market. (Note I said when, not if.)

Replacing Structural Underemployment

Another burden that our society has to carry is the weight of the structurally unemployed or underemployed. Many of the jobs of old have been permanently replaced by automated technology. My faith is that technology will enable new products that will provide employment. An example may help. In a bout of the new form of conspicuous consumption, I recently bought Ruth an iPad to match mine. The wonderfully helpful sales person at the Apple store was a former mid to high level executive from a tech company. In her sales pitch (which we had to wait for), she said that Ruth now had the “single most sought-after item in the world today.” While this is a bit of hyperbole, the hyped demand did fill one of the bigger stores in the Mall. We learned that if we wanted help from Apple’s “Genius Bar,” in other words their help desk, we needed to make an appointment by phone or email. Hundreds of thousands of new applications for this and other consumer gadgets are now available to support these items. I am sure that we will see consultants and teachers putting out their shingles to be of help.

Another example is the advent of hybrid cars and particularly trucks, creating needs for different kinds of mechanics and service stations. Gradually I hope we will whittle away the structurally unemployed, but as a society we need to come up with a productive and humane answer for the structural underemployment. Without an effective solution, there will be much more risk.

Until these economic problems are successfully addressed we will be operating significantly under capacity utilization. While these challenges may retard a demand driven inflation, it suggests that we won’t see historically high market valuations soon.

What all of the above is suggesting is that my bullishness could be premature. What do you think?

Next week I intend to write on the risks to fixed income investors and the possible misplaced enthusiasm for emerging and frontier investing.

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