March 24, 2011 By dduane in Analyzing performance, Current Market Thoughts, Fixing mistakes, Portfolio management, Technical Analysis, Trading, Why measure performance? Tags: business, Current Market Tactics, finance, investing, investment strategy, market tactics, money, performance attribution, Portfolio management, stock market, Technical Analysis, Trading
A correction is the signature countertrend movement of a bull market.
It’s normally short–lasting two or three weeks. It’s also shallow, although psychologically it may not seem like it at the time. Typically, the decline will be more than 3% but fall considerably short of 10%.
trigger vs. cause
I think it’s important to distinguish between the trigger for a correction and its cause.
The cause, which is always valuation, is usually easier to see.
Stock markets are ultimately driven by the economic performance of the companies whose stocks are publicly traded. Bull markets occur during periods when corporate profits are not only expanding now but are also expected by investors to continue to do so for an extended period. During times like this, investors can easily become overenthusiastic and bid stock prices up to levels that are too high too soon, given consensus expectations for profit growth. In fact, they tend to do so repeatedly.
Actual earnings expansion may eventually show–and it often does, in bull markets–that the consensus is too conservative. But the market rarely stands still for an extended periods of time. It either goes up, or it goes down (don’t ask me why, that’s just the way it is). So if the justification for the price you’re paying in February for a stock will only come through an earnings report that will be made in October or in the following January, your stock probably isn’t going to sit there and wait. If there’s no way it can go up for now, you can be very sure it’s going to start to go down.
Put a slightly different way, if the consensus thinks that S&P 500 earnings will be at best $100 for 2011 and that investors will be paying 14x for those profits, the consensus target for the S&P–until the market begins to factor in 2012 earnings–is 1400. At 1350, this implies only about 3% upside for the market for, say, the next six months. That isn’t enough financial incentive to choose stocks over some other, less risky investment, in my opinion.
It isn’t that the market thinks bad things will happen in the economy. It’s a question of the odds of making a satisfactory return. Sooner or later, this fact dawns on investors. They slow down their buying to a trickle.
This is the position we were in a week ago.
What must–and always does–happen in this situation is that the market has to decline enough to restore favorable odds. Last year the magic number for “favorable” seemed to me to be more than 10% but less than 15%. My guess is that this year the number is lower,because investors are more confident, maybe 10% or so.
The trigger for a correction can be anything. Many times it comes out of the blue. You should also note that the trigger doesn’t necessarily have to make any sense. In 2010, for example, INTC reported the first of a series of stunningly good profit results early in the year. The consensus concluded (incorrectly, as it turns out) that this was the high point for tech earnings in the current business cycle. So the entire market, which had been a bit frothy, sold off.
This year the trigger is unrest in the Middle East. My guess is that if equity markets had been 10% lower, stocks would have shrugged off events in Libya.
where are we now?
Proceeding in logical order, the first question to answer is whether we are still in a bull market or whether what we are seeing now is not a correction, but evidence of a reversal of the markets from bull to bear.
True, market tops are notoriously difficult to recognize–more so for always-bullish growth stock investors like me. But we’ve just begun to see economic recovery take hold in developed markets. Corporate profits seem to me to be very likely to continue to expand. Valuations aren’t crazy high. Interest rate hikes are a long way away. Therefore, I interpret what we’re in now as a correction. (Also, as it turns out, I’ve been writing that one is due for some time.)
Applying the rules of thumb I outlined above, stocks in the S&P 500 should be weak for another 5-10 trading days and bottom somewhere around 1250.
On the other hand, there seems to have been a mini-panic in New York trading around midday last Thursday that may have taken a lot of the negative sentiment out of the market. From intraday high the previous Friday to intraday low on Thursday, the S&P fell around 4%, which would just barely qualify for the depth of a decline.
I think trading in the next few days will be interesting to watch. Last week’s decline really wasn’t deep enough or long enough to qualify as a correction, no matter what happened on Thursday. So there should be more weakness to come, unless underlying sentiment is super-bullish.
what to do in a correction
As I’ve mentioned a number of times in other posts, stocks that have gone up a lot usually suffer the worst in a correction. “Clunker” stocks (and everyone holds one or two), on the other hand, don’t decline much because they’ve never gone up. The most useful thing to do when the market is declining is not to hide under the bed, but to upgrade your holdings. Sell the clunkers at relatively attractive prices and buy healthier stocks at a discount. You should make gains from doing this. At the very least, you’ll have gotten rid of securities that would have continued to subtract from performance.
I found myself doing this on Thursday. That’s pretty early in a correction to be acting. I’ll be interested to see how this works out.
One of my first bosses used to say that it takes three good stocks to offset the negative effects of one clunker. Today, I’m not sure that’s the right ratio–a lot depends on investment style. Also, I think the number is bigger than that in bear markets, where bad news is discounted heavily and good news is ignored, and smaller in bull markets. But the ratio is certainly greater than 1 at all times. That’s why it’s catching mistakes early is crucial to investment success.
Recently I’ve been reading books on decision-making. I got the first, Jonah Lehrer’s How We Decide, from one of my sons. I saw a review of the second, The Art of Choosing, by Sheena Iyengar, and bought it myself. Both cover a lot of the same material, and in the same order. This may be due to the Columbia connection between the authors. Lehrer was an undergraduate there; Iyengar teaches there. How We Decide is more readable and refers to a much larger number of experimental results. The Art of Choosing focuses more on research Ms. Iyengar has done herself, and emphasizes that the psychological picture we create of ourselves for ourselves will be internally consistent–but won’t always correspond with reality.
Both books highlight the fact that we all tend to hold beliefs that we come to on a non-scientific basis. For example, we all tend to think that we’re above average at just about everything we do. Once we’ve made a decision, we tend to defend it by searching only for information that reinforces our opinion. We also tend to ignore or screen out any data that calls our initial decision into question. In fact, if we have believed something different in the past, we also gradually rewrite our memories (shades of Orwell) so that we come to believe we’ve always thought what we think now.
Even worse than all this, the more important the initial belief, the more likely we are to do this.
While this tendency may be relatively harmless if I think I’m handsome or witty or a good dancer, it’s an absolute disaster for an investor. It’s a very great difficulty for professionals, who need very strong egos to withstand two aspects of the job: many of the economic factors that influence the portfolio are outside the manager’s control, and at least 40% of the decisions managers make turn out to be wrong.
The professional manager has to keep his confidence from shattering, but at the same time be open enough to reality to stop his mistakes from destroying his portfolio performance.
How do you do this?
You have to be aware of the tendency to need to be right all the time, and resist it. You have to actively scan news sources to look for negative information about your investment ideas. A professional has to make it clear to sellers of research that you don’t regard a negative opinion or negative information as insulting or a reason to stop associating with them.
In my experience, every portfolio has its dark corners where underperforming stocks fester. Periodic performance measurement and stock-by-stock attribution analysis are the only cures.
Some investors–I’m not one of them–will also have mechanical rules that compel them to immediately sell a stock if, for example, it drops by 15% from its purchase price or earnings results fall short of internal/external analysts’ estimates. The first rule seems to me to work better for value investors than their growth counterparts. The second appeals to me more, but–at the risk of succumbing to the self-deception I’m writing about–I don’t subscribe to it. My issue: the risk of missing an AAPL or a MON or a COH because of a temporary earnings disappointment is too high.
It’s much easier to write about how professionals deal with the size and number of positions they hold in their portfolios. That’s because money management firms create products that have certain risk parameters and leave it to customers to decide whether they want the product or not. It’s impossible, however, to write very specifically for individuals without knowing anything about their financial circumstances and psychological makeup. So you should take what follows as general thoughts rather than specific advice.
two issues to figure out
I think there are two aspects to the question of position size for non-professionals. Both stem from the fact that stocks are risky investments. One is objective, the other subjective. They are:
–Your own objective financial situation, given your age, income and accumulated wealth. The question is how much risk–and the associated possibility of loss–can you afford to take. Determining this is what financial planning, whether you do it yourself (probably using the tools on a discount broker’s website) or hire a professional to help you, is for.
For a twenty-something, having 90% of savings in stocks and having one or two positions that are each 5% of equity holdings is probably ok–assuming you’ve done appropriate research. The two big equity positions amount to 9% of the person’s accumulated wealth. By far his largest asset, however, is probably his human capital–his lifelong earning potential–rather than savings. He has plenty of time for a risky investment to work out or to recover from even a large mistake.
For a sixty-something, on the other hand, having two 5% positions is probably also ok–relative to one’s overall equity holdings. But that’s assuming the person in question has an age appropriate asset allocation. In most circumstances going into retirement with as much as 90% of your savings in equities is crazy.
–Your temperament, your tolerance for risk and–a factor I didn’t really understand until I stopped being a full-time money manager–the amount of time and effort you’re willing to devote to studying the companies whose stock you hold and following corporate developments.
I’ve often listened to casino company CEOs trying to position their gambling services as entertainment. They joke that if you spend $500 on opera tickets you get a few hours of music but, unlike a casino jaunt, you have absolutely no chance of leaving the performance with any of the money you came in with.
As far as the stock market is concerned, this is a “Know thyself.” issue. If you’re going to act on “hot tips” from a friend or from some guy on TV whose background and track record you know nothing about, you’re entertaining yourself, not investing. You’ll probably lose your shirt. So keep positions to negligible amounts.
One other editorial comment: there’s a whole generation of Americans on the verge of retirement, whose pension savings are in IRAs or 401ks or other defined contribution pools of money. We’ll likely live for thirty more years. But there’s no monthly check in the mail from the company we worked for, like our parents had. Our lifestyle will depend on the investment results from savings we’re responsible for managing. Not taking much time or interest in doing so is probably not the greatest option.
let’s say you want to invest, not just entertain yourself
1. Investing is a craft skill–like being a baseball player or a carpenter. It doesn’t require you to be an Einstein. It is experience-intensive, though. This means you have to do your homework and serve an apprenticeship. You start by investing small amounts, keeping records of your decisions, analyzing your results and thereby figuring out what you’re good at and what you’re not. Even the best professional investors aren’t good at everything. But they know they do a few things very well and stick to them.
2. I’m not a fan of paper portfolios. I don’t think they have enough meaning. If you wanted to be a professional baseball manager, better to manage a high school team than to be in a bunch of fantasy leagues. Start with tiny amounts of money.
3. Over years of training portfolio managers, I’ve found that inexperienced managers always have great difficulty in making position sizes large enough to make a difference to performance. As I mentioned in my post yesterday, a 50 basis point (.5%) position is probably not going to affect overall portfolio results one way or another. It’s a waste of time. In addition, if you have nothing but 50 basis point positions, you have to watch 200 stocks. That’s an impossible task–and you’ll probably be killed by not catching your mistakes in time (that’s another topic, but trust me, it’s true).
For most seasoned professionals–growth investors, anyway–their top 10 positions make up around a quarter of their portfolios. If you were to analyze it, the rest would probably look a lot like the manager’s benchmark index. So the portfolio will likely rise or fall on the ten stocks big positions. The task of monitoring them is manageable. And if two outperform the benchmark by 20% each in a year, the manager will have about a 100 basis point gain vs. the index (it probably won’t be exactly 100 bp–it’ll depend on whether the market is going up or going down). For US managers, that’s usually enough to put you in the top quartile.
4. I think individual investors, once they’ve gotten enough experience to make intelligent judgments, should consider taking a (modified) page from the professional’s book. This means:
–invest most of your equity allocation passively, through index funds or index ETFs
–complete your equity holdings with a small number of individual stocks (I have around a half-dozen, but I’m willing to spend a lot of time monitoring them)
–determine a maximum position size. Consider both the possible impact of a losing position on your equity holdings and on your overall savings. If you’re, say, fifty years old and subscribe to the rule that your equity holdings should be the same percentage of your total savings as 100 – your age (which I think is a reasonable first approximation), then you have 50% of your holdings in stocks.
Suppose the individual stock you have the most confidence in were to be 5% of your equity holdings. If that stock went to zero, you’d lose 2.5% of your wealth. Is that acceptable? If that is, then I think a reasonable approach to active management would be to establish three 3% positions and have the remainder of your equity holdings passive.
You should, of course, have a plan for what happens if your stocks go up, as well as for what you’ll do if they go down. But the action you derive from determining a maximum position size is that you begin to trim the position if you’re fortunate enough to have it reach 5% of the equity total. You don;t just let it grow.
–determine a minimum active position size, as well. This is a much trickier topic than it appears on the surface. I think positions below 1% of your equity holdings are a waste of precious analytical resources. Let’s say you set that as a minimum size.
The complexity arises this way: suppose you start out with a 1% position and the stock drops by 20%. Do you average down and restore the position to 1%? …or do you say you’ve made a mistake and sell? A lot depends on your own level of self-awareness and your tolerance for risk.
As for myself, for example, bitter experience has taught me that if I have a large position that goes against me and I average down, disaster quickly follows. So when a large position performs poorly nowadays, I either decide to hold on or to sell. I never add.
On the other hand, averaging down is a standard tool of most value investors.
So alhtough it’s important to have worked out a plan, though, it will depend a lot on you as to what the plan actually is.
a portfolio review
I’ve been doing a general review of my portfolio over the past few days. It might not be a bad idea for you to do something similar–assuming that like me, you haven’t done something formal recently.
The “official” reason is that we’re more than a year–and a doubling in the S&P–away from the lows of last March. A lot has changed since then. Also, from trying to observe my own quirks over the years, I know that when I start to become too interested in the day-to-day movements in the actively managed part of my holdings (confusing brains and a bull market, as they say) stocks are at a near-term top. I also think there’s a reasonable argument to be made that, entering year two of the bull market, we should take a more selective approach to active management than simply noting that the elevator is going up and making sure we’re on it.
I’m not advocating a change in overall strategy. Recovery has barely begun, so it’s much too soon to think about becoming defensive, in my view. But the investing landscape has changed a lot in the past twelve months. I don’t think of this so much as spring cleaning, but rather pruning back the bushes and pulling out the weeds.
I’m looking at four things:
overall asset allocation
Suppose you think you should be holding 60% stocks and 40% fixed income, including cash. (The traditional rule is that your stock allocation should be 100 minus your age–40% for a sixty-something–with the rest in bonds/cash. This rule was made up before many people started living into their eighties and nineties, so I think it shortchanges stocks. But that’s an issue for another day.)
Suppose also that you were too stunned to rebalance a year ago and were holding 50%/50% at the bottom. If the fixed income half didn’t include a large chunk of junk bonds, which really have a lot of the risk characteristics of equities and arguably shouldn’t be counted as “safe” investments, you’re probably now holding 75% stocks and 25% bonds.
As a stock guy, I hate to say it, but that’s probably too big a deviation from your target asset allocation. Rebalancing is in order. You can console yourself with the thought that in the coming year the difference in returns between stocks and fixed income likely won’t be anything nearly as dramatic.
It seems to me that any deviation from index funds in the stock portion of your holdings has to be large enough to make a meaningful difference to your wealth if you are correct, but not so large that it blows a huge hole in the bottom of the boat if you’re wrong. For me, that translates into an individual stock or specialized mutual fund/ETF holding being at least 1% of the total but no more than 5%.
An aside: Just as a fact of arithmetic, it’s hard for a position that starts out as 2.5% of a portfolio to become a 5% position. To get there, the stock/fund/ETF has to achieve the return on the portfolio plus 100%. Unless the other 95% has been an unmitigated train wreck–and with mostly passive investments it shouldn’t be–this is a real feat.
Reaching, or exceeding, your maximum position size should mean automatic pruning. In my case, I have a couple of stocks that I added to last March-April that I feel I have to cut back.
Not every stock is an AAPL, offering the possibility of above-average growth for a far as the eye can see. Many companies, in contrast, are relatively mature. Their profits rise and fall with the economy, and their stocks trade in predictable patterns relative to their prospects during a business cycle. For such stocks, investors normally set target prices, at which they intend to sell the stock, before they buy.
A given issue may trade at, say, 10x peak earnings for the cycle, and may reach that level a year before the peak earnings period. In that case, your plan is to forecast peak cycle earnings and sell the stock when it reaches the 10x price.
For each actively-managed position you have, it’s important to have a plan. This is a good time for seeing where cyclical stocks you own stand vs. your selling target.
clunkers and small change
Every portfolio has its dirty secrets, the stocks your eye jumps over rather than take a good look at how it has performed.
There may also be positions that you started to build but never completed for one reason or another. These ones are too small to make a positive contribution, so the only thing they can do is make trouble–sort of like weeds.
Entering year two of an up market, every stock has had its chance to show how it can perform. If it hasn’t done what you’ve expected, there are two questions you should ask yourself: do I still believe in this stock? and…is there something better I can do with the money?
For small positions, an investor should make them bigger or make them go away. You may hold onto them for some other reason–just recognize that these may be indulgences to your vanity, not investments.
There can also be small positions that started out as big positions. Everyone has them. The investment calculation–where do we go from here?–doesn’t really change because of the stock’s cost basis. The only way in which the analysis differs is making sure you use the value of the tax loss in a taxable account.
Look at your actual asset allocation vs. your target. Prune back your large positions, as needed. Pull out the inevitable weeds.