The strong half of the year for the stock market has historically been the end of October through the end of April. The vast majority of the gains in the S&P 500 and Dow Jones Industrials* have been made in this period since 1950. While this pattern doesn’t always play out - notable exceptions were 1973-1974 and 2000-2001 – and past performance is not a predictor of future returns, the trend gives us hope for a strong close to what has been one of the more volatile years on record.
Source: Chart of the Day, www.chartoftheday.com.
*Past performance is no guarnatee of future results. The S&P 500 and DJIA are indices and as such cannot be invested in directly.
When Good Stocks Go Bad
One of the most frustrating aspects of a market downturn can be watching stocks that you hold, which have nothing to do with the crisis of the day, drop precipitously in value. The company’s attractiveness hasn’t changed. It may still pay a great dividend. But its value is significantly less.
The reason for your stock’s fall is the reason diversification has limited value in protecting a portfolio in a major downturn. All too often, it’s the good positions that are sold first in a market downturn, fueling the fall of key indices and the spread of fear in the market.
In the current sub-prime situation, mortgage lenders and home buyers began to rely too heavily on steadily increasing home prices to bail them out of bad loans. Income and asset documentation requirements were dropped for many loan originations and speculation abounded in hot markets. We are now seeing the effects with respect to the housing market.
What is a little less obvious is its impact on major institutional investors with leveraged portfolios that included mortgage-backed securities in their many derivative forms..
When the banks noticed the quality of these investors’ portfolios declining with the increase in defaulting loans, they increased their margin requirements on the monies these investors had borrowed to achieve their leverage. Since the banks had no way of knowing which investors held the most endangered securities, the margin calls impacted a broad range of institutional investors.
These investors had to come up with sometimes millions to meet their margin calls at a time when the value of the mortgage-backed securities was in question. The problem with selling an asset when no one is exactly sure of its value is that you are going to get a minimal offer. If the underlying asset still has value, the investor may be better off to hold on until the market regains its perspective, and avoid selling the security for a fraction of its real value.
As a result, many investors opt to instead sell their “good” stocks where they can lock in gains. Unfortunately, good stocks sold into an uncertain market are still going to fetch a lower price than they might have two months ago. In addition to depressing market demand, the sale of good stocks can actually trigger a downward cycle where other investors, seeing values dropping, opt to sell the stock as well.
It’s basically momentum investing in reverse. Any asset which gets priced in a free market will be impacted by variations in other assets in that market. Good stocks are not immune.
Ideally, the good stocks are the first to bounce back and regain their former value when the correction ends. This is the hope of the buy-and-hold investor.
The active investor takes a different approach and views a declining value as reason to exit a position regardless of the value of the underlying stock, adhering to the old market truism, “Don’t fight the tape.”
The goal of the active investor is to have funds when the decline ends to buy back into good stocks at a discount. When the stock begins to bounce back, the investor’s objective is to gain real value, rather than simply hope to get back to break even. Whether or not the plan works depends in part on when the position is sold, how low it subsequently drops, whether the investor is able to buy back in below the price at which the security was sold and whether or not the stock regains its value as anticipated.
Remember all investing has risks. There is always the potential for loss as well as gain. What is important is that you have a plan and rationale for how you invest and that your plan has an exit strategy.
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Hyman Minsky Was Right
An economist who died in 1996 at the age of 77, Hyman Minsky believed that financial systems are inherently susceptible to bouts of speculation that, if they last long enough, end in crises. Rather than efficient, he maintained that financial markets have a tendency toward excess and upheaval.
The Wall Street Journal explains that:
“At its core, the Minsky view was straightforward: When times are good, investors take on risk; the longer times stay good, the more risk they take on, until they've taken on too much. Eventually, they reach a point where the cash generated by their assets no longer is sufficient to pay off the mountains of debt they took on to acquire them. Losses on such speculative assets prompt lenders to call in their loans. ‘This is likely to lead to a collapse of asset values,’ Mr. Minsky wrote.
“When investors are forced to sell even their less-speculative positions to make good on their loans, markets spiral lower and create a severe demand for cash. At that point, the Minsky moment has arrived.”
While we have a ways to go to see how the current credit crisis finally ends up, the good news is that in every crisis is an opportunity, provided you don’t have a mountain of debt to prevent you from capitalizing on the opportunity. In an “efficient market” there is little leeway for investors to outperform the indices. In Minsky’s market with bouts of speculation and crisis, investing is a lot more interesting.
* “Mr. Minsky Long Argued Markets Were Crisis Prone; His 'Moment' Has Arrived,” Justin Lahart, Wall Street Journal, August 18, 2007.
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Two Vital Documents – A Living Will and a Power of Attorney
The following is a true story related by an associate that points out the importance of planning for the worst .Bad things can happen to good people, but they don’t have to be made worse by a failure to plan.
Two years ago, a good friend suffered a severe stroke that left him with extensive brain damage, dependent on a ventilator and feeding tube to survive. He had lived a long, successful life and accumulated a sizeable retirement portfolio that would leave his wife in comfort for the remainder of her life. After consulting with his doctors, she asked that they discontinue medical treatment and allow her husband to pass away.
Then life became difficult. One of the couple’s sons sued to force the hospital to continue treatment. My friend had left behind no living will setting limits on how long he wished life-supporting medical treatments to continue. Nor had he established a power of attorney to allow another to make decisions on his behalf should he become incapacitated. Without that level of instruction, there was little the doctors could do.
In two years, a significant portion of the comfortable retirement portfolio has been eaten away by medical and legal costs and unprofitable investments that cannot be sold without my friend’s authority. The family has been shattered, the wife’s serenity destroyed, and my friend still lies unresponsive in a hospital bed.
Improved medical technologies have brought with them the ability to prolong life, but the decision of whether or not to do so typically rests on the individual once they reach the age of legal consent. When that individual is unable to make decisions and has left no instructions, his or her care can fall into a medical limbo. Regardless of your age, health or family status, you should have a Living Will and a Power of Attorney agreement.
A Living Will is a legal document that sets out guidelines for dealing with life-sustaining medical procedures in the eventuality of the signor’s incapacitation. It can be very general or very specific.
A Power of Attorney is a legal instrument that is used to delegate legal authority to another to make property, financial and other legal decisions for the principal (the individual who executes the instrument). It can give broad or very limited authority and specifies in what circumstances the “agent” is to have this power and when it terminates. The Power of Attorney is frequently used to help in the event of the principal's illness or disability or in legal transactions where the principal cannot be present to sign necessary legal documents.
Most states have statutory forms, i.e. written model forms for Living Wills and Powers of Attorney that residents can rely on as being legal. Depending upon the complexity of your situation, you may want to consult with your legal advisor to develop these forms.
A living will and power of attorney are not giving away control, but rather taking control of your life. Everyone over the age of legal consent should have one.
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The importance of an exit strategy
There is a point in all aspects of life when an exit strategy is a very good idea. It may be when the weather turns against you, or the highway comes to a complete stop with news that an accident will close the road for hours. You may want an exit strategy in terms of a living will that says when further medical intervention is not wanted. Or even a pre-nuptial agreement that spells out how assets will be divided in the event of a divorce.
Exit strategies acknowledge risk. In investing, your exit strategy should revolve around protecting the value of your assets. Buy-and-hold investing relies too heavily on diversification to minimize losses to your portfolio. There’s no exit strategy that says enough is enough. Good stocks have risks. A rising tide may raise all boats, but the reverse is also true.
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Is Buy-And-Hold Really the Answer to Successful Investing?
Market downturns inevitably seem to lead to a resurgence of articles supporting buy-and-hold investing, complete with back tested studies of fictional investors proving that trying to “time” the market doesn’t work. But before you opt for a passive approach to your investments, take another look at the studies and ask these questions:
(1) What is the length of the study?
Most studies supporting buy-and-hold investing use periods of 20 years or greater. Given the market’s historical upward bias, over longer time periods, the impact of down markets is reduced.
Investors who are looking at a shorter investment span, where they will need to withdraw assets not in 20 years, but in 5 or 10 years, or perhaps are withdrawing funds now, could face a very different scenario. Based on historical data, it takes 3-8 years to recover from a bear market. If you need your money during that time it doesn’t matter that the long term trend is up.
(2) Do the studies look at the value of missing down markets?
There’s two sides to taking a more active approach to investing. One is obviously to be invested when the market is going up. The flip side is to move out of vulnerable investments when a downtrend appears to be taking shape.
This is risk management at its most basic. Many studies supporting buy-and-hold investing are full of the risk of missing up days, but light on the value of preserving capital when the market drops.
(3) Are the assumptions reasonable?
One of the statistically “impossible” arguments against active management is the impact on performance of missing the best days or months of the time period. Whenever you encounter this argument, you can be virtually sure the flip side – which is also statistically impossible – missing just the worst days or months – is omitted.
Before you take the buy-and-hold argument to heart, look at the assumptions of the study and ask yourself if they ring true for your situation.
(4) If mention is made of moving in and out of the market in response to market trends, what are the criteria used for moving out and back into equities?
Good active management is based on carefully developed and back tested principles of market behavior. The investment manager looks for relationships and trends that recur over time and indicate a likelihood that the market will move in a similar fashion this time. Emotions and media coverage have no place in the criteria.
(5) Do you have the temperament to endure sustained losses?
Buy-and-hold investing can work for investors over longer time periods. But it goes counter to human nature. Studies supporting buy-and-hold investing typically deal with smaller account values. If an account of $10,000 loses 25% of its value, i.e. $2,500, it doesn’t sound so bad. If your $500,000 account loses $125,000, it sounds a lot more like real money. Which is why few investors truly buy and hold. When the pain gets too great, they sell. And, without a plan to reenter equities, they lose opportunity when the markets recover.
Investing is a risky way to make money. It only makes sense to look at ways you can control some of those risks. Looking back at market history and saying "Well, the market has always recovered so it will this time as well," is taking a lot for granted. With each market decline, the circumstances change. Different investments tend to move to the forefront, risk return ratios shift.
Our goal in managing client assets is to always take a thinking approach to where you should be invested and why. We believe buy-and-hold investing is far too risky for most portfolios and we welcome the opportunity to show you why.
