April 2nd, 2017

Is a stock market correction coming?

The Trump Bump is approaching its 4-month birthday causing everyone to ask how long it will be before a correction? For a long time, we’ve envisioned a target of 2450 for the peak before the correction. On March 1, the S&P 500 touched 2400 on an intraday basis, or just 2% under the price target.

But things are in flux. The economy continues improving, business and homebuilder optimism is near record highs and the labor market is tightening generating wage increases for the first time in years.  The only fly in the ointment is the political backdrop and the risk that it poses for Trump’s economic agenda.

To not be caught off guard, subscribe here to receive the Stock Chartist newsletter every Sunday evening at 7:00 like the one below of March 19 and to be able to track the Stock Chartist Portfolio, including each buy and sell order as it happens.


Should We Sell Everything?

We’re hearing it more and more these days. “I think we should sell everything” and “The bull market is eight years old with only two pauses; it can’t go much higher” or “The Trump Bubble has to pop soon and I want to get out of the way.”  We can’t argue with these sentiments because they are logical and sound; but are they feelings to which we must respond and react? No doubt a correction is inevitable. It’s just that no once can predict with certainty when, from what level and how deep. A 5% correction from Friday’s 2378.25 close may come next week or a 30% correction could begin at S&P 2600 sometime this coming winter. Your guess is as good as the next guys.

What we can say with some certainty is that while the causes that bringing on the next correction will be different from previous ones, it will evolve pretty much the same as did those earlier ones. Everyone won’t jump off this speeding market train at the same time.  As a matter of fact, market sentiment may be in the process of changing from bullish to bearish even now. What we will be able to observe, however, is how slowly changing sentiment of the majority of investors reflects itself in the prices they are will to pay or forced to accept in their trades.

We have a couple of tools to help us deal with our collective xenophobia about the coming correction. For one, there’s our Market Momentum Meter which indicates the intensity of sentiment changes as measured by the rate and degree of price changes from historical trends. The second is that over a long stretch of history including 3 wars, 9 presidential administrations from both parties, many economic cycles including booms and busts …. through all that fundamental economic and political background noise, the market has inexorably rising at an average rate of 7.5% per year. During booms and bubbles it has contained by boundaries 45% above and below a trendline at the midpoint.

I’ve assembled a look back at the three prior corrections of this 8-year bull market. Granted, they all happened within the context of a soft economy back-stopped by the Fed’s Zero Interest, Quantitative Easing easy money policy so they could have been worse. But the next correction will happen within the context of an economy no on the mend, an administration, if they can get their act together, that promised tax, infrastructure, regulations reform programs and a Fed that continues finding ways to act constructively.

  • This is the 8-year Fed QE Bull Market that’s contained within the 7.5% Reversion to the Mean channel stretching back to 1939.  The purpose of including this is to show how long it took for each of the three previous corrections to evolve. S&P 500 - 2009-2017 Corrections
  • The 2010 correction:  Stocks got off to a good start in January but worries about European debt quickly deflated that early optimism. As the market got accustomed to these daily anxieties, and Greece managed to crawl out of its default hole, stocks started to crawl higher. On Aug. 27, Fed Chairman Ben Bernanke’s mere hint of another stimulus put stocks on an upward trajectory for the rest of the year. But let’s not forget May 6, when the “Flash Crash” shaved 10% of the Index in a matter of minutes only to have it recover by day’s end.
    S&P 500 - 2010 Correction
  • The 2011 correction:  From up 8% to down 12%, stocks finished 2011 with an annual change of 0.003%…about as flat as you can get. Investors are happy to put 2011 to bed.  From unrest in the Middle East due to the Arab Spring revolutions and Japan’s devastating earthquake to Europe’s worsening debt crisis to the ongoing bickering in Washington of the debt ceiling, stocks experienced some violent swings.
    S&P 500 - 2011 Correction
  • The 2015 correction: The year started with what we called the “Big Squeeze” as the market fluctuated in a narrow band and failing to breakout to new highs several times and instead plunged more than 10% in a week in late August on a wave of selling triggered by fears that China’s economic slowdown was turning out to be worse than feared.  Perhaps not coincidentally, the stall at the Big Squeeze was just below the intersection of two significant resistance trendline: the midpoint of the Reversion to the Mean channel and the top of the 2009 Fed bull market channel.A strong recovery after retesting the August lows failed again to penetrate the earlier ceiling as fears about China resurfaced causing markets to tumble again in January. We anticipated the big 30% corrections coming out of what appeared to be an emerging head-and-shoulders reversal top (with the Big Squeeze being the head) throughout the year. But the Fed again stepped in and prevented it from happening. The Meter returned to Bullish Green in April 2016.
    S&P 500 - 2015 Correction
  • Current: Which brings us up to date. The previous corrections took more than 4 months to emerge so, when the next correction comes it, too, should not begin with a sharp downdraft but a few months of fluctuations within a narrow trading range. The Meter has been unwaveringly Green since April 26,2016. It will take some time and sideways motion for the Meter to turn to yellow and red this time too. Our imaginary “ceiling” of the midpoint trendline is only 4% higher than Friday’s close.  But it’s only a benchmark and there’s no guarantee that it will stop the market euphoria that seems to be bubbling up.
    S&P 500 - 20170317

Bottom line, all this talk about selling everything in anticipation of a correction that clearly is coming, at some time and at some point in the future is premature. We can be cautious, worry and even be anxious but we don’t yet need to act.

February 10th, 2017

Subscribers Alerted to the New Bull Market

I’m sorry for those of you who aren’t subscribers.  On August 7, 2016…..before the elections, and way before the “Trump bump” was launched……my subscribers were alerted to the fact that the market appeared to be building a head of steam and getting ready to melt up.

On the previous Friday, August 5, the S&P 500 closed at 2182.87. Since then, the market has advanced above 2300, or 5.9% higher. Furthermore, as explained in that report, we envisioned an interim target of 2450, or an advance of 12.2%, for some time in 2017. We began assembling a balanced portfolio of over 50 stocks since then that, almost unanimously, have performed as well or better than the average S&P 500 stock.

But  the only thing you can be sure of is that circumstances continually change. To not be caught off guard, subscribe to the Stock Chartist newsletter.


Heating Up On the Way To A Bubble Melt-up?

Because I’ve been looking down for so long that it feels uncomfortable to lift my head and start looking up.  The market isn’t yet shouting but has begun whispering that something has changed, something both fundamental and technical, action that’s been confirmed by a Perfectly Bullish alignment in the Momentum Meter’s moving averages.  Rather than being rebuffed at the 2175 level, a favorable jobs report Friday morning helped push the average to a new all-time high close of 2182.87.  The change could be as simple as investors no longer viewing “good news as bad” (since it gives the Fed room to raise rates) but instead “good news as good” (since it means strength in the economy and possibility of resumed sales and earnings growth).

S&P 500 - 20160805 ST

Rather than looking backwards for the correction that has yet to materialize, it may be possible that the market is warming up and heading towards the long-awaited melt-up.  What sort of technical obstacles or resistance levels might there as the market advances further into uncharted, all-time new highs territory?  About the only clues are in the “reversion to the mean” trendlines:

S&P 500 - 20160805 LT

The orange trendlines (solid for outer boundary and dotted for the mid-point) in the above chart ascend at approximately 7.5% and have contained all the market’s movement since 1939 through two Secular Bear Markets (1970′s and 2000′s), four wars (WWII, Korean, Viet Name and Middle-East Wars) and countless political and economic upheavals, domestic and international.  So they are “reliable precedent” indicating the possibility that the market’s next move could actually be an assault on the mid-point trendline at around 2450 in the S&P 500 Index, or 12% above Friday’s close?

Without getting carried away and turning euphoric, there are many rationales about why a move of this magnitude is possible, the primary of which is that the world is awash in cash looking for a place to be invested.  Before there’s general inflation of hard assets and wages there could well be an acceleration in financial asset inflation:

    • According to Moody’s, five companies, ( Apple, Microsoft, Google, Cisco and Oracle) were sitting on $504 billion, or 30%, of the $1.7 trillion in cash and cash equivalents held by U.S. non-financial companies in 2015, most of which was overseas to avoid taxes.  Both political campaigns may propose tax incentives for repatriating and investing the cash.

Corporate Cash Holdings

  • Institutional investors have been sidestepping equities and investing in fixed income instead.  With interest rates on the verge of moving higher and equities continuing to advance, they will begin rebalancing in favor of equities.
  • Foreigners continue to look at US equities as a safe haven.
  • Mergers, corporate buybacks and a dearth of IPOs have all contributed to a stock shortage just when demand is beginning to increase.

So rather than fighting it, we have to face “reality” and embrace it:

Reversion to Mean - lt

The market could be heading up the mid-point trendline and, if a bubble melt-up in equities does materialize, head all the way up to the upper boundary above 3500 in the next year or so.

March 1st, 2015

The Crash is Coming, The Crash is Coming!

The following piece appeared here on March 25, 2013 entitled The Known Stock Market World, almost exactly three years ago. I repeat it here because Paul Farrell just came out with another one of his dire, “end-of-the-market-as-we-know-it” predictions. What prompted Farrell to make his doomsday call in 2013 was the fact that the market was about to cross into all-time new high territory and he, along with many of the other gloom-and-doomers were saying that the market was about to swoon into a major correction. In today’s blast (see today’s MarketWatch), Farrell claims

“the crash of 2016 really is coming. Dead ahead. Maybe not till we get a bit closer to the presidential election cycle of 2016. But a crash is a sure bet, it’s guaranteed certain: Complete with echoes of the 2008 crash, which impacted on the GOP election results, triggering a $10 trillion loss of market cap … like the 1999 dot-com collapse, it’s post-millennium loss of $8 trillion market cap, plus a 30-month recession … moreover a lot like the 1929 crash and the long depression that followed.”

Everyone put a link to this MarketWatch article in your “stocks” Evernote folder, in your electronic calendar, where ever you can so that you’ll be alerted to it then, can quickly retrieve it (unless MarketWatch pulls the story by then) and can lobby to take away Farrell’s soapbox.

Back in 2013, it was clear that the market would be going to new heights, which it did.  In 2015, when we’re in the sixth year of a secular bull market, there’s no question there will be a correction soon.  But no one today can predict when it will begin nor how far it will carry the market down.  Anyone who claims to know, like Farrell, is taking you for a sucker.


imageI was asked to read Paul Farrell’s most recent blurb on the Wall Street Journal’s blog site Marketwatch.com entitled “New Critical Warning as 2013 shocker looms” in which he enumerates 6 new critical warnings, which added to the 7 he says were issued last year but to which there doesn’t seem to be a convenient link of the site.  This “critical warning” comes from Gary Shilling (the others came from Bill Gross, Nouriel Robini, Reinhart and Rogoff and Farrell himself.

Farrell clearly spells out that their vision of economic and market doom is rooted in their dislike and distrust for Fed Chairman Bernanke and his policies.  Is it professional jealousy?  Does it come from an contest between Keynesian and Austrian monetarist inside schools of economic philosophy?  In Farrell’s own words:

“Timing is critical at a turning point. We warned of the coming crash well in advance in 2008. We picked the bottom in March 2009. We are in the fifth year of an aging bull. These six Critical Warnings tell of a hard turning point dead ahead. Wake up. It takes time to restructure a portfolio. If you think you can do nothing and just wait for another year, you are like most investors: You just “can’t handle the truth.” Or you “have no idea what’s about to happen.” Or you believe “this time really is different.”

But the truth of the matter is that all these perma-bears have continually been calling for the market’s reversal and demise since last year, a 15% missed opportunity had you taken their heed and fled the market.  Was the turning point in 2012, in January 2013 or some undefined point in the future.  Why do these guys want us to sell equities?  Where do they want us to put our money?  Are they gold-bugs in disguise?

I’ve been reading much over the past couple of years from those who view a market reversal at the level of the previous all time high high as indisputable.  The reasons they offer could be technical, like Prechter’s obtuse Fibonacci reckoning, or fundamental economic, like those of Farrell, et al.  To me, it all sounds like a through-back to beginning of the Age of Discovery in the 1500’s when most believed the world was flat and you’d fall off if you sailed to the end.

1500 WorldYou could sail the Mediterranean Sea or Indian Ocean but sailing beyond the sight of land meant sure disaster.  It’s like the course the market’s followed since 2000, the Secular Bear Market seas.

Map of Known Stock Market

So long as we don’t venture outside the bounds, we know the landmarks, the levels at which the market pivoted in the past and has a probability of pivoting again in the future.  If the market reversed direction for a third time, we can guess, by looking at the above “map of the known stock market” where islands of rest might be and where it might reverse direction again.

But if half the stocks break into their own all-time new high territory and cause the index, by definition, to also begin to venture into uncharted territory then where will the first island be?  Where might we hit and wreck on a market/economic shoal or reef?

Bottom line: are you someone who has the confidence to sail where no one has ever sailed before to discover new lands and new wealth?

Technorati Tags: ,

January 14th, 2015

Homebuilders Building Foundation For Next Move

ImageSomething I learned long ago is that “industry group controls 30% of a stock’s price movement.”  So a logical place to begin the search for stocks with better than average relative strength but lower than average risk is by narrowing the available universe down to a select few Industry Groups.

One academic research study concluded that “a mutual fund manager’s success in identifying and emphasizing specific industry sectors in their portfolio was a far better forecaster of the fund’s performance than ability to pick individual stocks.”  Although the statistics were compelling on their own, they were even more impressive because the study found that managers with good industry-selection abilities were likely to continue to outperform their peers over many successive periods.

Through our Stocks on the Move scan, we’ve recently noticed that in addition to significant money flowing into REITs pushing their prices higher as discussed previously, the Scan also filtered out a significant percentage of stocks from a related industry group: homebuilders.  The Scan from a few days ago produced the following results:

Stocks on the Move Scan

A quarter of the stocks generated by that scan were REITs, or 13.3% of all REITs (REITs represent 6.3% of all listed stocks).  Homebuilders, on the other hand, represented only 4% of the stocks generated by the scan but those 7 stocks were a quarter of all the homebuilders (homebuilders represent only 0.4% of listed stocks).  Although homebuilders represented a small percentage of the stocks generated by the Scan, more homebuilders met the scan criteria.

One thing you should know about the Homebuilders Industry Group is that among all the groups, homebuilders tend to generate similar chart patterns and consistently move together.  In Chapter 15 of Run with the Herd entitled “Segmenting the Market”, I presented the following data on homebuilders in the periods leading up to and during the Financial Crisis Crash of 2007-09:


The percentage price moves of all the homebuilders weren’t identical but they were in the same direction and on orders of magnitude similar relative to the average S&P 500 stock.  Over the six years to year-end 2005, the S&P 500 declined 15.0% while homebuilders appreciated anywhere from 404% to 1275%.  From the end of 2005 to the trough of the Financial Crisis, the average S&P 500 stock declined -49.3% while homebuilders lost anywhere from -62.3% of their value to over -90%.

It looks as if we’re facing a similar situation today.  After their huge 100+% recovery off the Financial Crash bottom, most homebuilders have been constructing a consolidation pattern throughout 2013-15.  But now members of the group are showing signs of being ready to exit across to the top of their respective consolidation patterns.  Using a typical “rule-of-thumb”, the percentage move following a consolidation should be approximately the same as the percentage move preceding it.  Using XHB, the ETF for the group, as a proxy that represents a move to approximately 65-70 (click on image to enlarge):

Homebuilders - 20150111

Five homebuilders whose similar charts clearly depict these consolidation patterns are (click on symbols for charts):

However, a word of caution.  If the market turns ugly and does enter what turns out to be a 25-30% correction then these patterns could turn from being consolidations into reversal tops and momentum reversing causing breakouts through the bottom boundaries.  These charts don’t predict … they only indicate that supply and demand has remained fairly balanced for nearly two years and, once it begins, momentum will generate an extended move in either direction.

Fundamentals like low interest rates, increased residential rental rates, increased consumer liquidity and savings from lower gas prices and improved job picture suggest that the breakout, when it does take hold, will be on the upside.

Technorati Tags: , , , , ,

July 2nd, 2014

Easy, Fun and Profitable Shopping

imageIt’s been quite some time since I wrote something for the public side of Stock Chartist but it sometimes the market feels like the “good ole” times so it gives me the urge to put some thoughts down again and share them with all of you.  By the “good ole” days, I’m referring to the beginning of the bull market, like July 23, 2009 and March 2, 2012 when I wrote “Stock Picking Now Feels Like Shooting Fish in a Barrel“ and Part 2, respectively.

In the early stages of the bull market, it almost didn’t matter which stock was picked, it was just more important to put money to work.   If you happened to pick a stinker, you cut your losses quickly and rolled the money into something else that worked.  Unbelievably, the situation is almost the same today (when looking at the charts) even though it’s been five years since the bull market began on March 9, 2009.

Back in 2006-7 I was looking to save some trees and reduce my overhead by eliminating subscription, like Investors Business Daily.  While I liked many of their concepts I found their approach to market timing to be weak; it seemed like they followed Cramer’s “there’s-always-a-bull-market-out-there-somewhere” principal.  I’d moved beyond that by having developed my own Market Momentum Meter approach to market timing.  But when it came to stock picking, there was nothing wrong with their “Stocks on the Move” approach.  I was able to replicate the factors IBD used into one of the automatic scans in my charting software (Worden Bros. Telechart).

Those two posts in 2009 and 2012 were based on My “Stocks on the Move Scan” (click on the 2009 article like above for a complete description of the scan), the same scan that I use today. Scans are used to filter out from the universe of over 4000 stocks, those stocks that meet various user defined criteria.  Scan aren’t “silver bullets”, they don’t give you the complete and final answer but they do present a place to begin.  Depending how precise the criteria, scans can screen out anywhere from 50 to 300 stocks that meet the parameters.

As a matter of fact, over the past 4 weeks, the Stocks on the Move scan has flagged about 300 stocks that fit its criteria.  I’ve taken the stocks that are screened each week and perused these stocks’ charts to further whittled the list to arrive at 92 stocks that looked like they had or were about ready to breakout the topside of various chart patterns.  We assumed with some confidence that they will likely cross those upper resistance boundaries because the total market as measured by the all the major indices (Dow-30, the S&P-500, the Russell-2000 and the NASDAQ composite) had or were about to make new highs.

I posted the 92 stocks in Watchlists on the members-only side of the Stock Chartist blog.  Since posting them, I’ve been swapping the underperforming or lagging stocks in my Portfolio for the new names on those Watchlists.  With over 90 stocks from which to pick, I knew there was a high probability that most would wind up being winners, winners big enough compensate for the few selected that might turn out to be losers or laggards.

Here’s the scorecard:

Scan results

Of the 92 stock candidates for selection, 3 out of 4 generate gains and only 25% a loss (only 2 had losses of 8%).   But avoiding losses isn’t sufficient.  Of the stocks in the list, 63% outperformed the S&P 500 Index from the time they were added to the list and their average gain was 4.4 percentage points better than the S&P 500 over the same period.  Of the 37% that underperformed, their losses so far were 2.6% under the S&P 500.

If you had selected a basket of the stocks generated by this scan, the odds are that you would have outperformed the S&P 500 over the same period.  Get your shopping cart ready, the shopping is easy, fun and can be profitable.

August 8th, 2013

Portfolio Management: Part 4 – “Preservation” or “Growth”? Why Not Have Both

Asset Allocations


The debate about portfolio management centers on whether one needs to “predict” or “react” for good performance.  The professionals settle that for themselves by claiming that since no one can predict the future, the best anyone can do is to diversify into many different asset classes (i.e., equities, fixed income, commodities, currencies, domestic and foreign, income and growth, large and small capitalization).  Economists like John Mauldin fall into this camp.  He and other perma-bear economists have been seeing top for most of the last 10-15% of the market’s move.  Mauldin recently wrote:

“This is a terrific time to take some profits and diversify away from the growth-oriented risk factors that dominate most investors’ portfolios. Instead of concentrating risk in one asset class or one country, investors can boost returns and achieve more balance by taking a global view, by broadening the mix of core asset classes, and by weighting those return streams to achieve balance across potential economic outcomes (rather than trying to predict the future) …..


broadening this mix of core assets – so that you have some element of your portfolio that responds positively to every potential economic season – and managing the relative allocations to each economic scenario may be your biggest opportunity to add value in the investing process.  You have a lot to gain from diversifying as broadly as possible, eliminating unrewarded costs, reducing your reliance on equity risk, and reining in the emotional mistakes that often lead investors to dramatically underperform.”

What these portfolio managers don’t understand is that one doesn’t necessarily have to predict where the market will be next week, next month or next year.  They claim that the only way to protect a portfolio against uncertainty when funds need to be withdrawn is to allocate assets among different classes based on today’s predictions and then rebalance periodically.  But an alternative approach is to aim for the highest returns while at the same time reacting and responding to abnormal and unexpected volatility immediately after it occurs.

In the previous article about the “Ultimate Buy-and-Hold Strategy” , the basic premise was that by assembling a specific mix of asset classes for a very long time (actually, 42 years) you would have reduced the volatility of a portfolio without significantly and not reduced its return.  However, nearly everyone would agree that, looking back with the benefit of hindsight, it would have been wonderful to have had the foresight to assemble a portfolio in 1970 and hold it until today, or 42 years.  But would that same approach produce the best results if you were to assemble the portfolio today, at the end of a 13-year secular Bear Market?  Thirteen years hence would we be better off if we assumed today that the next 13 years would be more similar to the 1982-2000 Bull Market than either the secular Bear Markets of the 1970’s and 2000’s?

We can’t predict the future but the odds are that the next 13 years won’t be even similar to the past 13 years.  Using the same data as Merriman’s, the “Buy-and-Hold” portfolio management approach delivers much different results had the portfolio started at different points and had different end dates?  As an alternative test, four hypothetical $200,000 portfolios were split into two parts, 60% in equities and 40% in fixed income, and rebalanced annually.  The annual returns since 1970 for equities and fixed income securities came from the St. Louis Federal Reserve Bank.  The four test portfolios were:

  • 1970-2012 (the 42 year “buy-and-hold” base case),
  • 1982-1999 (the last 17 year secular bull market),
  • 2000-2012 (the current 12-year secular bear market) and
  • 1970-1982 (the previous 12-year secular bear market).

There’s no question that, regardless of when the Portfolio was originally created, the 60/40 blended portfolio would always have been less volatile (as measured by the standard deviation of the portfolio’s annual change in value) than a 100% stock portfolio but more volatile than a 100% fixed income portfolio (click on images to enlarge).

Portfolio 1970-2012
Portfolio 1970-1982
Portfolio 2000-2012
Portfolio 1982-1999 But what is also true is that at end of the holding period, your portfolio would be worth more if you had been 100% in stocks than if you had blended in a percentage of fixed income …. sometimes much more.  As a matter of fact, if you had started your portfolio at the beginning of 1982 and held it somewhere close to the top of the Secular Bull Market when the Tech Bubble burst, then your portfolio would have delivered an average annual 19.12% and wound up worth 166% of the 60/40% mix and 388% of a fixed income only portfolio.  [Due to the spectacular decline in interest rates since the crash of the real estate bubble in 1977 – a trend that was as unprecedented as the secular bull market of the 1980-90’s – a fixed income portfolio would have out-performed an equity portfolio by 152% but neither delivered much more than 7.2% average annual return for the 12 years.]

As I see it, you shouldn’t have to pick a single goal.  Are you wealthy enough to focus on “preservation” rather than “growth” in your portfolio?  Are you so preoccupied in other matters than you can’t react to changes in trend of any particular asset class; remember, both the Tech Bubble burst and the Financial Crisis evolved over 6 months.  Catch up on the major economic and business news once a week, make only incremental adjustments (i.e., not more than 10% of the portfolio at each decision) and you’ll be able to manage your portfolio.  You don’t need to predict the future you only need to review, react and respond as changes demand.  Portfolio management shouldn’t be day-trading but it can be more than just a “buy-and-hold” portfolio.  You can generate growth as well as preserve your capital.

Technorati Tags:

July 29th, 2013

Portfolio Management: Part 3 – Is Passive or Active Better?

Portfolio Management Action Reaction

In the previous article, I accused investment managers of encouraging their clients to “focus on the risks of losing principal rather than on opportunities for portfolio growth“.  I suggested that their aim was to match what you identified as future demands on your finances “with various funds they believe will minimize the risk of your not having the full amount when it was needed.”

This was reinforced to me when I came across an article in MarketWatch, entitled “The Ultimate Buy-and-Hold Strategy” by Paul Merriman in which the author states that his approach works “in portfolios big and small, doesn’t rely on predictions or require a guru or special knowledge of the markets or economy.”  He claims that his overriding goals are to build portfolios that deliver returns that exceed those available in “industry standard 60%stock/40% fixed income allocation” portfolios while subjecting investors to no additional risk as measured by the standard deviation of the Portfolio’s fluctuations.

To prove that his portfolio had returns greater than 8.5% and a standard deviation of no more than 11.6% (the long-term experience of a typical “industry standard portfolio”), Merriman assumed creating a hypothetical $100,000 in 1970 and allocating the funds into index funds and exchange-traded funds.  He concluded that over 40 years, “by far the biggest contributor to investment success (or lack of it) is your choice of asset classes.”  In other words, it’s not when you bought but what you you bought and that you not trade any of the individual securities during the period that improved results.

The conclusion sounded similar to notions I’ve heard over the years from the Efficient Market Theory crowd, the folks I wrote about extensively in my book, Run with the Herd.  According to the theory,

“Many investors think success lies in buying and selling at exactly the right times, in finding the right gurus or managers, the right stocks or mutual funds.  But being in the right place at the right time depends on luck, and luck can work against you just as much as for you.  Your choice of the right assets is far more important than when you buy or sell those assets.  And it’s much more important than finding the very ‘best’ stocks, bonds or mutual funds.”

Merriman takes a step-wise approach to assembling his “ultimate” portfolio by starting at the 60/40 mix and then adding higher return, lower volatility asset classes in relatively arbitrary proportions.  He then measures how much $100,000 would have grown to over 42 years, rebalancing the portfolio annually to keep the percentages fixed and what the volatility (how much the portfolio might have fluctuated over the period) might be.   The process results in the following model portfolio (right column is the end result):Buy and Hold Portfolio

The advice offered by most investment advisers is similar to  Merriman’s Ultimate-Buy-and-Hold Portfolio: assemble a portfolio of a diversified list of ETFs or mutual funds (which translates into hundreds or thousands of individual securities) and hold it for the long run (20 to 30 years).  It doesn’t matter when you by only that you hold the portfolio long enough for economic growth to make up any and all bear market draw downs (i.e., losses).   So the trickiest part of the Ultimate Buy-and-Hold Strategy is matching the right level of risk for each individual investor’s financial needs, in other words, the most important asset-class decision an investor makes is what percentage that investor should have in stocks and how much in bonds to his portfolio’s volatility to his future financial needs.

The final makeup of the Ultimate Buy-and-Hold Strategy is in the right-hand column and this hypothetical portfolio would have generated an average annualized return of 10.5% (compared with the 60/40% portfolio return of 8.0%) with a much lower volatility (11.7% vs. the standard portfolio of 17.0%) over 42 years.  However, at the end, Merriman discloses the caveats (my emphasis added):

“Every investment and every investment strategy involves risks, both short-term and long-term.  Investors can always lose money.  The Ultimate Buy-and-Hold Strategy is not suitable for every investment need.  It won’t necessarily do well every week, every month, every quarter or every year.  As investors learned the hard way in 2007 and 2008, there will be times when this strategy loses money….. this strategy requires investors to make a commitment.  If you are the kind of investor who dabbles in a strategy to check it out for a quarter or two, this strategy probably isn’t for you.  You may be disappointed, and you’ll be relying entirely on luck for such short-term results….. [the strategy] is not based on anything that happened last year or last quarter.  It’s not based on anything that is expected to happen next quarter or next year. It makes no attempt to identify what investments will be “hot” in the near future…. strategy is designed to produce very long-term results without requiring much maintenance once the pieces are in place.”

But here’s another catch!  According to Merriman, ” the best way to implement this strategy is to hire a professional money manager who has access to the institutional asset-class funds offered by Dimensional Fund Advisors (DFA).”  So is the study unbiased?  Is it self-serving?  Was there be any doubt as to what the study’s conclusions would say?

There’s wisdom in the saying “timing is everything” or it wouldn’t have survived for as long as it has?  You could still be trying to break even on a portfolio of large tech stocks like Cisco, Oracle, Microsoft, Ebay and Amazon had you bought them in 2000, at the peak of the Tech Bubble.  If you had bought your home in 2006 hoping that it would continue increasing in price and some day be your retirement nest egg then you’d have to put off retirement since it fetches a 10% lower price today.  You could have sold the gold coins inherited from a grandparent for $750/ounce in 2009 thinking the precious metal prices just couldn’t possibly continue increasing but recently discovered that it hit a peak of $1700 just two years later.  Or you might be that person who continues buying long-term government bonds today without questioning whether the secular bull market in fixed income securities be close to peaking; let’s ask them whether timing is important 3-5 years from now when his principal had declined 35% in value.

Timing does matter for individual securities, it matters when it comes to your portfolio and it matters for your financial well-being.  Portfolio management should be an active process not a passive one.  It’s a cop-out for investment advisers to tell you to predict your financial needs but not to try to predict the returns and future value of your investments.  There is an alternative.  There is a difference between predicting and reacting and it’s the same as the difference between gambling and managing your investments.  Market timing isn’t predicting the market’s future direction, it’s reacting to changes in the market’s trend as you see them taking place.  Strategies like the Ultimate Buy-and-Hold Portfolio doesn’t sound like management to me.  It sounds more like gambling that my portfolio isn’t depressed due to a bear market just when I need to unexpectedly withdraw funds or for planned needs.

The next article will focus on various types of risks and their relationship to portfolio management.

Technorati Tags: ,

July 15th, 2013

Portfolio Management – Part 2: Managing Against Risks Today

Risk Management Process

Risk Management Process

I bought my first stock with gift money and money saved from summer jobs when I was in high school in the hopes of trying to make some extra spending money.  So, obviously, I looked only for stocks that I thought, based on their charts, would appreciate fairly quickly.  When I was lucky enough to buy one that did appreciate 20-40% in short order I felt both smart and proud that I then had some extra spending money to buy some of the latest sweaters and shirts, to go out on dates and to replace the gas I’d used driving my parents’ car around.

I must confess, looking for winners was my exclusive objective for many years.  What I hadn’t done nor even gave much thought to was what most financial advisers recommend should be done first.  I never consciously evaluated my tolerance for risk (truthfully, I was actually a stock market gambler) nor my objectives beyond winning in the stock market game.

I’ve had friends tell me

  • they want to keep a year’s worth of their normal cash requirements on hand as insurance it might needed or
  • they want their investments to generate a high dividend or interest yield because they need the income for living expenses without having to dip into principal or
  • they pay 1-2% of capital to an investment advisor and wish they could manage their money themselves but just don’t have the time to do it or
  • they have always invested exclusively in fixed income securities because they liked the security and steady income stream it provided but with rates being so low they have to now look at some stocks; what should they put their money into now that’s safe, they ask?

Wall Street has an answer to these questions and concerns.  They can deal with investors who make the mistake of merely wanting to make money in stocks and they call it “portfolio management”.

SEI Investments Co. is a publicly-owned investment management firm who, according to their Yahoo Financial profile, provide wealth management and investment advisory services to corporations, financial institutions, financial advisors, high net worth families, banks and trust institutions, investment advisors, financial planners, not-for-profit organizations, and pension plans.  Like other similar firms, their service offering is neatly package in what they call a “client-centric approach to wealth management“.

According to a brochure they provide to prospective clients and investment advisors [I’ve added the emphasis]:

“Goals-based investing offers a client-centric approach to wealth management, above and beyond investment management. It allows the advisor to combine the traditional methodologies of modern portfolio theory with the latest research on investor behavior.


The value of a goals-based investment strategy is that it goes beyond traditional yardsticks like relative performance against a benchmark. The focus is on goal achievement, which is what distinguishes SEI’s approach from others. Investment strategies are specifically designed around client goals, and performance is measured by the clients achieving their goals.


Goals-based investing involves creating a separate portfolio for each goal, as opposed to lumping all assets into a single portfolio. Whether the client is saving for retirement, funding a four-year education, or passing wealth to their heirs, there’s an investment strategy specifically tailored to meeting that goal.”

Other investment advisory firms offer similar approaches.  For example, another describes their approach this way:

“Through personal discussions and/or use of a Risk Tolerance Questionnaire, goals and objectives based on a client’s particular circumstances are established. We then develop a client’s personal investment policy and create and manage a portfolio based on that policy. During our data-gathering process, we determine the client’s individual objectives, time horizons, risk tolerance, and liquidity needs. As appropriate, we also review and discuss a client’s prior investment history, as well as family composition and background.”

What these firms are really saying is that they will help you focus on your goals and then divvy up your assets into a number of different buckets, selecting mixes of investment offerings for each with different return, volatility and expiration.  They give you a feeling that you actually are in control of your financial future and that, when you achieve the goals you have set for each bucket, you have performed well even if those results are significantly less than the most common benchmark, the S&P 500 Index, over the same period.

Obvious from the quotes above is the fact that most professional managers believe their chances of holding on to customers improve if they can encourage their clients to focus on the risks of losing principal rather than opportunities for portfolio growth. Individuals can anticipate how much and when they might need to withdraw sums of money in the future than it is for them to figure out how much profit a company will earn in future years, what the risk is that the company will miss those projections and whether domestic and international economics will put the projections in jeopardy.

Investors have seen and, perhaps, experienced the financial pain and wealth destruction that bear markets and crashes have caused and are afraid of becoming victims themselves. So “investment advisory” firms help them anticipate what amounts they’ll need for certain in 2, 5 or 10 years for such expenses as college tuition, wedding, house or retirement – expenses that may exceed income at the time and will need to be funded by savings.  Advisors will then match those future financial demands with various funds they suggest which they believe will minimize the risk of not having the full amount when needed.  The more chucks of “capital expenditures” you identify in your personal financial plan, the greater the number of segregated funds you’ll set aside today.

Your projecting your future financial needs, income and assets may be financial planning but is it “portfolio management”?  Having someone tell you what asset classes and individual securities give the adequate returns with acceptable risk may satisfy your financial needs but does it provide the best management of your portfolio?  Should we attempt to insulate our portfolios against risks determined from our projected expenditure needs or from economic, industry and company risks?  Can individuals manage their portfolios in such a way that they contain portfolio risk yet still achieve better than adequate returns?

In the remaining articles in this series I’ll describe a portfolio management style that has worked for me and, perhaps, can work for you.

Technorati Tags:

July 9th, 2013

Portfolio Management – Part 1

Portfolio Management Puzzle

Portfolio Management Puzzle

A good place as any for jump-starting the blog after an extended absence is with a question I recently received from a new Instant Alerts Member.  It’s a vexing question for which there really is no easy or objective answer.  It’s a question I continually think about and search for answers to.  The question was:

If you where starting now, what number of stocks would feel is manageable and comfortable for starting a $50K or $100k portfolio?”

Those who’ve read my book know that I omitted the topic of portfolio management … the omission was not an oversight but intentional.  As a matter of fact, I had even considered the topic to be a follow-up second volume. Since the question was asked, however, I’ll begin answering it over the next several articles, comprehensive but not overly exhausting or esoteric.

Those who’ve searched for an answer on their own have discovered that there are hundreds of thousands of academic books and articles available on the subject of “stock portfolio management”.  The introductory paragraph of one such academic articles entitled “How Many Stocks Make a Diversified Portfolio?” in the The Journal of Financial and Quantitative Analysis of Sept, 1987 is typical of what you might find if you were to accumulate a couple of hundred such articles [my emphasis added]:

“How many stocks make a diversified portfolio? Evans and Archer concluded that approximately ten stocks will do …. rais[ing] doubts concerning the economic justification of increasing portfolio sizes beyond 10 or so securities ….. The primary purpose of this paper is to show that no less than 30 stocks are needed for a well-diversified portfolio.”

In the next section, the authors add [my emphasis added]:

“The risk of a stock portfolio depends on the proportions of the individual stocks, their variances and their covariances.  A change in any of these variables will change the risk of the portfolio.  Still, it is generally true that when stocks are randomly selected and combined in equal proportions into a portfolio, the risk of the portfolio declines as the number of different stocks in it increases.”

In the end, like most research in financial and investment management is constructed in a fantasy world with unrealistic or incomplete assumptions. For example, another textbook on the subject focuses on the process involved in managing the risk of a portfolio as contrasted with determining the criteria for portfolio management success.  The article summaries the process into the following steps:

“Portfolio management is a process encompassing many activities aimed at optimizing the investment of one’s funds.  Five phases can be identified in the process:

  • Security analysis
  • Portfolio analysis
  • Portfolio selection
  • Portfolio revision
  • Portfolio evaluation”

In short, most of the literature aims at identifying the ideal combination of various assets to construct a portfolio that offers the required trade-off between risk and return.  The approaches used, however, are complex, they assume that the state of the market at the time the analysis is irrelevant, they are indifferent as to the source of those investment funds (i.e., whether reallocated or new cash infusion) and often ignore the unique characteristics of the specific individual investor and assume they will balance risk against desired risk themselves.

In the next several posts I’ll give you my view of the best way for individual investors to manage their portfolios based on my own personal experience.  Rather than assuming from the start, as do the academicians, that the market is perfectly efficient and the future is known and measurable with near certainty, I start with a different set of assumptions:

  • Market timing is possible and an integral part of portfolio management
  • In some ways, stock selection is like buying a lottery ticket since no one can know with certainty what is the future of any individual stock
  • Because of the risks and uncertainties inherent in investing, we seek to optimize rather than maximize performance by continually comparing our performance against external benchmarks.

As this discussion of portfolio management unfolds, more basic assumptions will be added.  But for the time being it’s a beginning that underscores the difference in this approach to the classical academic one, a foundation for beginning to build a different approach to portfolio management for individual investors.

A member’s question launched this discussion so other topics that might be of interest or are puzzling you are welcomed.  They might include such topics as (not necessarily in this order):

  • How many stocks should be in your portfolio?
  • What is the nature of risk and can you actually inoculate yourself from it?
  • Is portfolio management different for a young investor adding new funds to their portfolio than a retiree with a stable portfolio?
  • Is portfolio management different if you’re investing in mutual funds, fixed income, individual stocks or ETFs?
  • How should a person’s investment horizon preference (for example, several months vs. several years) factor into their portfolio management practices?

Technorati Tags: