frozen by the screen: a portfolio manager’s ailment

frozen by the screen

Every seasoned professional investor I’ve sat down and compared notes about the profession with has experienced this phenomenon.  Usually it happens when the market is declining and you’re underperforming–sometimes badly.  You turn on your computer or your trading machine to see what prices are doing.  Your stocks are doing poorly again.  But instead of either turning to another page or going back to work, you sit and watch the flow of trading in your stocks and worry.  You may be mesmerized or horrified.  You’re using up a lot of emotional energy.  You know this isn’t helpful, but you just sit and watch–and maybe perspire heavily.  You can’t tear your eyes away from the screen.

This isn’t good.  For one thing, you’re not doing anything productive.  You’re not thinking about how you can tweak your holdings to achieve even higher levels of outperformance.  In a deeper sense, though, this behavior is a sign that you’re either about to lose your confidence or have lost it already.  You’re focusing on failure, not success.

for professionals

This happens to every professional now and again.  It’s the equivalent of a hitter going up to the plate worrying about being hit by a hundred mile an hour fastball and breaking his ribs, rather than visualizing how he’s going to hit a double off an accomplished pitcher.  You’re setting yourself up for failure.And the cold reality is that if you can’t get into a positive frame of mind, then you may not be cut out for this line of work.

For a portfolio manager, there are several obvious steps to take to restore a positive mood:

1.  Turn off the price screen and don’t turn it back on.

2.  Take out your analysis of the stocks you hold that are performing the worst, rethink and rework your assumptions, and come to some conclusion.  The result will probably be that you believe the stock is as cheap as you thought.  Even if you spot some fatal flaw, you’ll have some reason other than fear for making a change.

3.  Rethink your portfolio structure and whether it’s still appropriate.

4.  Look for depressed stocks that you always wanted to own but thought they were too expensive.  Consider whether a market downdraft has made them more attractive.

5.  Look for long-term weak performers in your present portfolio (you know they must be there, because everyone has them).   They’re probably not going down much (because they never went up).  Think about using them as a source of funds for any new additions.

6.  You can always take some risk out of the portfolio by making it look more like the index.  In my case, however, every time I’d done this it’s been a mistake.

7.  If you’re going to do something stupid, like selling a perfectly good stock while its price is down, do it in a very small amount.

8.  If nothing else works, go to the gym  …or read a book.  Just don’t turn the screen back on.

Of course, there’s an underlying assumption I’m making–that what’s going on is a moment of mental weakness, a temporary loss of focus.  It’s also at least possible that your unconscious is telling you that you have deep fundamental flaws in your portfolio that you need to fix as fast as possible.  But if you know yourself well enough psychologically, you should be able to tell the difference.

for regular people investing their own money

Funnily enough, these are much harder cases to diagnose.  Good professional investors are highly trained in what is an often counter-intuitive way of thinking about the world.  So the pitfalls they encounter are usually well understood, because they’re the ones every other manager has encountered as he tries to master his craft.

For regular investors experiencing angst at declines in their holdings, I’d have three basic questions:

1.  Do you know how the companies whose stocks you hold earn their money?  Have you read quarterly/annual reports and 10Q/10K filings?  Have you formed an expectation about potential returns for each holding?  If you haven’t, you’re not investing, you’re buying lottery tickets.

2. Do you have an overall financial planning strategy?  Is the risk in the stocks you hold appropriate for your economic circumstances?

3.  Are you willing to devote the time needed to develop investing skills, or would you be better off finding a financial planner to help?  (Finding a competent adviser is a whole other can of worms, however.)

why am I writing this today?

My personal stock portfolio had been holding up relatively well during the correction–until yesterday.  I did end the day with two green lights on the screen, DKS (who knows why) and 1128:hk, where the market was closed while New York was falling sharply.  But my other stocks really got clunked.  That’s just life.   But I noticed that I was starting to stare at my screen in an unhealthy fashion.  So I ran for about a half-hour and read a couple of chapters in a book about web design. 

For what it’s worth, my take on the sharp reversal in my portfolio’s relative fortune signals that the correction has entered a new phase.  The tendency in downdrafts in the market is for investors to begin by selling stocks they don’t care much about.  As the correction progresses, the selling reaches closer and closer to what people consider their crown jewels.  If the decline ends in a mini-panic, even parts of core holdings get shown to the door.  I’m not saying this last happened yesterday, but I do think the correction took another step closer to completion.

I’ve updated Current Market Tactics–Are we in a correction?

I’ve just updated Current Market Tactics.  If you’re on the blog, you can also click the tab at the top of the page.

bear market rallies

bear market rallies

Bear market rallies are counter-trend movements in downtrending markets.

In one sense, they’re analogous to corrections, only occurring in bear markets rather than in uptrending ones (which is why I’m writing about them the day after my post about corrections).

There are several big differences, though.

Corrections tend to be relatively short in their duration and in the extent of their decline.  They also tend to occur frequently and irregularly in any bull market.  Their major cause, as I see it, is overenthusiastic valuation of stocks in an environment where the underlying economic fundamentals are relatively well understood.

Bear market rallies are none of these.  Here’s how/why:

Bear markets themselves are often described as playing out in three phases, in the following order:

hope, where investors are either in denial or radically misunderstand the deteriorating economic fundamentals,

boredom, where investors understand that economies are in recession, (correctly) believe that an upturn is not likely for a considerable period of time and become reconciled to relatively poor times, and

despair, when investors, after waiting in vain for signs that economies are turning up,  give up all hope of ever seeing any improvement.  Their negative emotional state sometimes causes them to sell their stocks across the board and at foolishly low prices.  This sort of final selloff, if one happens, typically marks both the bottom of the market, the lowest point of recession and the beginning of recovery.

Significant bear market rallies typically happen only twice in a bear market.  They mark the transitions between phase one and two, as well as between phase two and three.  They can easily produce a 10% rise in the index and can last for a month or more.  Unlike bull market corrections, bear market rallies are based on a mistaken reading of the economic fundamentals.  They fail as investors work out that the view they have of the economy is too rosy.  In so doing, they usher in the next down phase.

Market tops are notoriously difficult to detect.  So many investors incorrectly regard the first leg down in a bear market as just a big correction, which they diagnose as providing a super-good buying opportunity.  That belief is what starts the first bear market rally.

As the “boredom” phase of the bear market  stretches out, investors try to anticipate the beginning of the next bull phase.  They know that bull markets typically start when sentiment is at its lowest ebb and that the first movement upward tends to be explosive.  So they begin to argue (incorrectly, for a second time) that downside is limited and upside is significant.  They also think they can see early signs of economic recovery.  These sentiments are the tinder that sparks the second bear market rally.  It, too, fails as new economic developments throw cold water on these beliefs.

What is a “correction,” exactly? Is one going on now?

corrections

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.

investor shift away from emerging equity markets is picking up steam

Recent reports from consultants like Cambridge, MA-based EPFR indicate that the large allocation shift  retail equity investors in developed countries have made in the past two years away from their home markets and toward emerging economies has begun to reverse itself.   From early January onward, individuals have been taking money out of emerging markets funds and plowing it into developed markets equities.

What does this mean?  What should we do, if anything, in response?

a look at the performance numbers

To put the current asset allocation shift into context, let’s take a look at three equity areas:

–the S&P 500, as representative of US large capitalization stocks,

–the MSCI EAFE (Europe, Australia and the Far East) index as a proxy for stocks in other developed markets, and

–the MSCI Emerging Markets index.

Just so I can get the numbers easily, I’m going to use the appropriate ETFs as proxies for the indices themselves.  All returns are in US$.  Here goes:

last 10 years

EM     +321%

EAFE     +96%

S&P     +53%

from March 2009 (the bear market bottom)

EM     +119%

S&P     +94%

EAFE     +77%

from Sept 2010

S&P     +23%

EAFE     +19%

EM     +12%

year to date

EAFE     +5.4%

S&P     +5.3%

EM     -2.2%

one month

EAFE     +7.0%

S&P     +4.2%

EM     -1.4%

What does this show us?

…several things:

–If we look at the last ten years,  US stocks have had only half the return that developed markets outside the US have enjoyed and 1/6th the performance of emerging markets equities.

–The asset allocation away from the US in 2009-2010 didn’t affect the relative performance of the S&P vs. emerging markets that much.  You have to remember that the earnings of publicly traded US companies have a healthy dose of emerging markets results in them.  Still, I think the resilience of the US in the face of investor neglect is remarkable.

–The relative performance of the S&P vs. EM begins last September.  In other words, it leads the asset allocation shift by four months.  I think this means investors are reacting to the relative performance numbers, not causing them.  That’s not so surprising.  It suggests, though, that such allocation shifts are lagging indicators, not leading ones.

flows can have asymmetrical effects

Sorry about the less-than-clear title.

There’s a wide and deep pool of investors in many developed countries.  Residents are wealthy enough to own stocks themselves.  They also typically have pension plans that invest for them.  And, of course, there are private equity funds and the big investment banks with their proprietary trading desks.  Adjustments to changing prices by all these agencies tend to mitigate the effects of money flowing in and out of the developed equity markets.

In emerging markets, in contrast, many of these stabilizing factors–notably, the existence of pension plans or of individuals able to afford the risk of owning stocks–aren’t present.  So flows of funds from developed countries in and out of emerging stock markets can have relatively large effects on prices.

my thoughts

Of course, your personal risk tolerances and your financial situation will be the primary drivers of your investment decisions.  But I don’t think the asset allocation shift is important enough to make you rethink a sound asset allocation plan.

As for myself, I expect the flow of individual investor money back into developed markets means that smaller capitalization stocks there will do a bit better than they otherwise would, and that periodic market corrections will be shorter and shallower than we have seen during 2010.

Professional emerging markets investors, facing customer withdrawals, will likely emphasize larger stocks in more liquid markets.  So “frontier” markets–which none of us have any business being in–will likely languish for a while.  

The way I read the performance figures for the past year or two (over the past 12 months, EM and the S&P are about neck and neck), a lot of discounting of the need of emerging country governments to cool down overheating economies is already reflected in stock prices.  The withdrawal of foreign “hot” money will speed the cooling down process along a bit, although the repatriation of funds may cause price weakness.  I see this as a potential buying opportunity.  Although I think it’s still too soon to act, the main message of the asset flow reversal is probably to set practical investors to thinking about when to increase emerging markets exposure.