Truth Or Consequences?

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“I have opted for more conservative ideas and not aggressive ones.”

After 28 years at this post, and 22 years before this in money management, I can sum up whatever wisdom I have accumulated this way: The trick is not to be the hottest stock-picker, the winning forecaster, or the developer of the neatest model; such victories are transient. The trick is to survive. Performing that trick requires a strong stomach for being wrong, because we are all going to be wrong more often than we expect. The future is not ours to know. But it helps to know that being wrong is inevitable and normal, not some terrible tragedy, not some awful failing in reasoning, not even bad luck in most instances. Being wrong comes with the franchise of an activity whose outcome depends on an unknown future (maybe the real trick is persuading clients of that inexorable truth). Look around at the long-term survivors at this business and think of the much larger number of colorful characters who were once in the headlines, but who have since disappeared from the scene.

The aforementioned quote, from the brilliant Peter Bernstein (author, historian, economist, and investor), hangs on the wall of my office, for in this business one is often wrong. But, as Bernstein notes, “Being wrong comes with the franchise of an activity whose outcome depends on an unknown future.” My redeeming feature is that when I am wrong, I tend to be wrong quickly. Or as stated by William O'Neil, “The majority of unskilled investors stubbornly hold onto their losses when the losses are small and reasonable. They could get out cheaply, but being emotionally involved and human, they keep waiting and hoping until their loss gets much bigger and [that] costs them dearly.”

Indeed, we are always trying to manage the “risks&rdquo inherent with investing (or trading), for as Benjamin Graham wrote, “The essence of investment management is the management of risks, not the management of returns.” And that, ladies and gentlemen, is why we often “wait” on an investment until its share price is at a point where if we are wrong, we will be wrong quickly, and hopefully the incidence of “loss” will be small and manageable. To be sure, we always consider the consequences of being wrong. This is when risk management lives up to its real meaning. Again as Peter Bernstein wrote in a New York Times article:

The key word is ‘consequences.’ I learned this lesson many years ago from studying Blaise Pascal, a French mathematical genius in the 17th century who spelled out the laws of probability more clearly than anyone before him. This was a thunderclap of an insight that, for the first time, gave humanity a systematic way of thinking about the future. Pascal was both a gambler and a religious zealot. One day he asked himself how he would handle a bet on whether ‘God is or God is not.’ Reason could not answer. But, he said, we can choose between acting as though God is or acting as though God is not. Suppose we bet that God is, and we lead a life of virtue and abstinence, and then the day of reckoning comes and we discover that there is no God. Well, life was still tolerable even if less fun than we might have liked. Here, the consequences of being wrong would be acceptable to most people. Suppose, however, we bet that God is not, and lead a life of lust and sin, and then it turns out that God is. Now being wrong has put us into big trouble.

RISK management, then, should be a process of dealing with the consequences of being wrong. Sometimes, these consequences are minimal – encountering rain after leaving home without an umbrella, for example. But betting the ranch on the assumption that home prices can only go up should tell you the consequences would be much more than minimal if home prices started to fall.

To this “truth or consequences” point, after being wildly bullish at the October 4, 2011 “undercut low” I turned cautious on the equity markets in late January when the “buying stampede” ended. Since then I have been waiting for a price decline that would produce another good risk-adjusted “buy point” like the ones identified on August 8th and 9th of last year, as well as the aforementioned “undercut low.” That does not mean I have not been featuring certain investments when the risk/reward metrics were deemed as being tipped decidedly in our favor. Rather, I have opted for more conservative ideas and not aggressive ones. Case in point, in last week’s verbal strategy comments 3.5%-yielding Rayonier (RYN/$45.51/Strong Buy) was again featured with these comments from our fundamental analyst:

We are upgrading REIT Priority List member Rayonier to Strong Buy (from Outperform) as we believe RYN shares currently offer one of the most compelling risk/reward profiles in our REIT coverage universe. In our view, the underperformance of RYN shares year-to date (RYN shares are down 1%, while the RMZ and S&P 500 are both up 10%) present an attractive entry-point for investors ahead of the company’s highly accretive cellulose specialties expansion project, which is on track to come online in mid-2013.

Another name featured was 7%-yielding LINN Energy (LINE/$39.86/Strong Buy). As stated by our fundamental analyst:

The partnership delivered another strong quarter beating our EBITDA and distribution coverage forecast, proving that not only does it know how to buy assets but it does a good job of operating them too. Speaking of operations, lightning has now struck twice in the Granite Wash with the partnership’s horizontal Hogshooter play having the potential to be one of the highest rate of return oil plays in the country. Based on our continued bullish outlook for the acquisition market, our forecasted distribution growth (5%+), and its solid hedge book, we reiterate our Strong Buy rating.

Last week this conservative strategy looked somewhat foolish (again) with the D-J Industrials (INDU/13228.31) up 1.53% and the S&P SmallCap 600 Index (SML/462.02) better by 2.58%. The real weekly winner, however, was Natural Gas’ 9.67% sprint. The best performing macro sectors were: Financials (+2.21%); Technology (+2.56%); Energy (+2.67%); and Consumer Discretionary (+2.76%). The Consumer Discretionary performance is interesting because last week’s economic reports continue to soften as of the 15 reports released only six were above estimates. Also disappointing were earnings reports with 65.6% of reporting companies beating earnings estimates and 65.1% bettering revenue estimates. This was a pretty big drop from the previous week’s ratio. Even more troubling is that forward earnings guidance turned negative, which was a decided negative swing week over week. The two sectors that have telegraphed the best forward earnings guidance are Healthcare and Industrials. Meanwhile, many of the indices I follow are breaking down from what a technical analyst would term a rising wedge chart pattern (read: negatively), the D-J Transportation Average (TRAN/5267.39) continues to struggle with its double-top often referenced in these comments (that would be negated by a move above ~5390), the NYSE McClellan Oscillator is back in overbought territory (see the chart on page 3), the Buying Power/ Selling Pressure Indicator suggests the rally from the April 10th low has been more about reduced selling pressure rather than increased demand, the Operating Company Only Advance/Decline has never confirmed the upside, and my weekly internal energy indicator still does not have enough energy to support a new leg to the upside. Regrettably, all of this continues to leave me in cautious mode.

The call for this week: In this business when you’re wrong you say you’re wrong; at least that’s what the pros do. Clearly, I have been somewhat wrong by being conservative, but not wrong by much because the INDU is actually 70 points lower than where it was at the April 2, 2012 intraday high. Given the aforementioned litany of cautionary indicators, my sense remains the S&P 500 (SPX/1403.36) will spend some more time below 1425 while the short-term overbought condition is alleviated and the stock market’s internal energy is rebuilt. Friday’s market action only reinforced that belief with the indices gapping higher and then closing well below those highs on lower volume.

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“The absolute price of a stock is unimportant. It is the direction of price movement which counts.”

During major sustained advances in stock prices, which usually occupy from five to seven years of each decade, the investor can complacently hold a list of stocks which are currently unpredictable. He doesn’t worry about the top because he knows he is never going to sell at the top. He knows that the chances are overwhelming in favor of the assumption that he will get far better prices by waiting until after the top is passed and a probable reversal in trend can be identified than he will ever get by attempting to anticipate the top, and get out on the nose.

In my own experience the largest profits we have ever taken have come from stocks purchased while they were making a new high in a market which was also momentarily expecting the top. As I have already pointed out the absolute price of a stock is unimportant. It is the direction of the price movement that counts. It is always probable, but never certain, that the direction of the price movement will continue. Soon after it reverses is time enough to sell. You should sell when you wish you had sold sooner, never when you think the top has arrived. That way you will never get the very best price—by hindsight your individual transactions will never look daring. But some of your profits will be large; and your losses should be quite small. That is all that is necessary for a satisfactory, enriching investment performance.

Stock Profits Without Forecasting – by Edgar S. Genstein

These are two of the most important paragraphs I have encountered in 45 years of studying markets. DO NOT read them just once. Go off to a quiet spot that invites contemplation and READ THEM SEVERAL TIMES. Then reflect on all of the mistakes you have made in trading and investing. Bells will ring, and curses will be uttered, if you are truly honest with yourself. My advice is to keep this quote handy, read it over, and study it every time you get ready to make an important buy or sell decision; especially if your emotions reign.

Obviously, I agree with Mr. Genstein’s advice, but over the years have added a “twist” to his sage strategy. That twist has been to be a scale-up seller in select stocks that have appreciated when I think I should raise some cash. This does not mean I sell the entire position if I continue to find the fundamentals to be favorable. But, scale selling partial positions accomplishes a number of things. Firstly, it allows capital gains to accrue to the portfolio (sometimes long-term capital gains and sometimes not). Secondly, it rebalances said stock position back towards the original portfolio weighting intended. Thirdly, it tends to give me the “margin of safety” mentioned in Benjamin Graham’s book “The Intelligent Investor.” To wit, this strategy allows me to hold some of my original investment positions until I “wish I would have sold them sooner.”

I revisit this topic this morning after spending last week in Colorado speaking at several events and seeing institutional accounts. Unsurprisingly, most of the institutions have had a difficult time over the past few months. As one portfolio manager put it, “While we make money in one position we give more than that back in another.” Indeed, since the “buying stampede” ended on January 26th it has been a market in which it has been pretty easy to lose money. For example, at the intraday high of January 26th the D-J Industrial Average (INDU/13029.26) traded at ~12842. Last Friday the senior index closed at ~13029 for a 12-week gain of 0.015%. Meanwhile, many individual stocks have fared far worse. As for retail investors, my presentations to them last week found most frozen like a deer in the headlights of a car buffeted by the recent decline and the negative “spin” from the media; so let me address the recent action.

Recall that we advised raising some cash following the cessation of the “buying stampede” in anticipation of a 5% - 8% pullback in the major averages. That said, our mantra was, “You can be cautious, but do not get bearish.” Some took that “raise cash” advice, but most did not, imbibed by the Dow’s 14.3% rally from mid-December, and its 23.4% rally since the October 4, 2011 “undercut low” that we actually recommended buying. Now, however, the Dow’s 4.4% decline from its April 2nd peak into its April 10th reaction low has brought back memories of last year’s May to August angst, which lopped 17.6% off the Industrials. While the recent news backdrop is less appealing than that of October – February, it is still not a reason to believe we are going to see another May through June swoon of over 17%. Let’s examine why.

In the last tactical bull market of October 2002 through October 2007 (60 months) there were nine such 4% or greater pullbacks, yet stocks traded higher after each correction. In the current tactical bull market of March 2009 to present (37 months) there have already been eleven 4% or greater pullbacks and each time stocks have also subsequently traded higher. Clearly the frequency of corrections/pullbacks has increased in the current cycle likely driven by memories of the Dow’s 54.4% massacre between October 2007 into the March 2009 bottom that at the time we deemed would be similar to the “nominal” price-low of December 1974 (that was the “nominal” price low of that wide-swinging, trading-range 1965 – 1982 affair). More recently, we have likened last year’s October 4th “undercut low” to the valuation-low that occurred in August 1982 since valuations last October were at levels not seen in decades. Whether we have begun a secular bull market like that of August 1982 – January 2000 is debatable, but we doubt last October’s low will be violated.

Nevertheless, since the beginning of February there have been a number of gleanings that left us in cautious mode. The parade looks like this: an upside non-confirmation by the D-J Transports (TRAN/5234.25), the small-caps also failed to confirm the upside with the Russell 2000 (RUT/804.05) subsequently experiencing a 7.5% decline, weakness in the market-leading Financial SPDR Fund (XLF/$15.18), worsening Advance/Decline and New High/New Low figures, a 90% Downside Day on April 10th, waning Buying Power, an exhaustion of the stock market’s weekly internal energy, softening economic reports, and the list goes on. On the positive side: the stock market’s daily internal energy has a full charge of energy, an 8.53% drop in the price of gasoline last week, an earnings reporting season that has so far seen 72% of companies beating estimates and 70% beating revenue estimates (more importantly, after two quarters of reducing guidance companies are now raising future earnings guidance), late Friday the IMF announced it has raised another $430 billion to be used if Euroquake worsens, a U.S. dollar that looks like it is breaking down (read: a positive for stocks), and hereto the list goes on. All of this continues to leave us chanting, “You can be cautious, but do not get bearish!”

This week we will see more major companies reporting earnings. From our research universe, stocks that are favorably rated by our fundamental analysts and appear positive on our proprietary algorithms are: Brinker (EAT/$27.90/Strong Buy); Baidu (BIDU/$144.91/Strong Buy); Pultegroup (PHM/$8.37/Outperform); and Caterpillar (CAT/$107.73/Outperform – covered by Raymond James Ltd.).

The call for this week: For the past few weeks I have wrongly suggested that my sense is the S&P 500 (SPX/1378.53) will remain mired in the 1385 – 1425 consolidation zone. As paraphrased:

I think the SPX needs to convalesce in the 1385 – 1425 zone while the short-term overbought condition is alleviated and the market’s internal energy is rebuilt. Interestingly, while my daily internal energy indicator now has more than a full charge of energy, the weekly energy indicator is nowhere near being fully recharged. The implication is that the downside should be contained, but the SPX is also not likely to breakout above 1425 without spending more time consolidating. ... Importantly, all of the pullbacks in the SPX this year have been between 25 and 35 points. Accordingly, measuring from the recent reaction high of ~1419 produces a level of 1394 for a 25-point correction, and 1384 for a 35-pointer. Hence, anything more than a 45-point pullback would put the SPX below the bottom of our 1375 – 1385 support zone and suggest something has changed, potentially bringing into view the 1320 – 1340 zone.

Subsequently, the SPX dropped below that envisioned zone, yet has rallied back into the 1375 – 1385 zone, which has now become an overhead resistance level. And for these reasons we counseled for caution before leaving for Colorado last week. Our advice was not to sell short, not to add to existing long positions, not to raise cash since we have already raised cash, but rather to sit tight because the downside should be contained in the 1320 – 1340 zone. Confidence that downside objective will be achieved grows if the April 10th intraday low of 1357.38 is violated. And this morning that pivot point looks like it is going to be tested with the preopening futures off some 14 points. Indeed, “The absolute price of a stock is unimportant. It is the direction of price movement which counts.”

Here’s the paradox: the odds are overwhelming I will end up richer by aiming for a good return rather than a brilliant return – and sleep better en route. Folks who seek a killing usually get killed. Gunslingers get shot, and often in the foot, with their own guns. While there is always some guy around on a red-hot streak, his main function is to tempt the rest of us into becoming fools and paupers. A return of 15% to 20% annually is a lot more than most folks realize, or need. If a 30-year old with $10,000 in an IRA gets 15% annually, he’ll be a millionaire before normal retirement. That’s the power of compound interest. If that same 30-year old were to sock away another $2,000 per year at 15%, he would end up as a 65-year old $3 million fat cat. At 20%, it’s an incredible $13 million. That’s a lot, but it’s not too much to ask. The two most definitive studies ever on long-term returns, the Ibbotson/Sinquefield and Fisher/Lorie studies, both point to average annual returns for stocks of 9% plus per year going back to the mid-1920s. So 15% to 20% per year is really 66% to 100% better than the market as a whole. That’s tough but doable. Consistency is the key. It is close to impossible to get a good, long-term, rate of return if you suffer serious negative numbers en route. It’s the math. A single year that is down 30% means you have to get 30% per year positive returns for the next four years to get back on track for a 15% annual average. Or, if you score 20% annually for four years, and then suffer a 30% decline, your five-year average return is only 7%.

... Ken Fisher, Forbes, 1989

I have often republished Ken Fisher’s sage advice ever since first reading it in 1989 because it speaks to the centerpiece of my investment philosophy. To wit, “The odds are overwhelming I will end up richer by aiming for a good return rather than a brilliant return – and sleep better en route.” Or as Benjamin Graham wrote, “The essence of investment management is the management of RISKS, not the management of RETURNS.” Indeed, if you manage the downside the upside will take care of itself. Avoiding the big loss is, and always has been, the key to investment success. Accordingly, when the odds are not tipped in my favor I tend to not be very aggressive, a stance I took a few months ago.

Recall, it was around the end of January that, at least by my work, the “buying stampede” ended when the D-J Industrial Average (INDU/12849.59) closed lower for four consecutive sessions. Interestingly, at the “buying stampede’s” intraday peak of January 26th the senior index changed hands at ~12842. At last week’s intraday low it was some 131 points below that level, consistent with my statement, “Except for a few stocks, I don’t see where a whole lot of money has been made since the end of January.” Given that strategy, I have preferred to focus on select mutual funds and exchange-traded products with “conservative not conventional” investment styles. One such mutual fund is Goldman Sachs’ Rising Dividend Growth Fund (GSRAX/$14.85), whose investment style is to invest in companies that increase their dividends by 10% per year on average for 10 years in a row. Accordingly, the fund seeks capital appreciation and current income. Another investment idea is the Yorkville High Income MLP ETF (YMLP/$19.53). YMLP is structured for an outsized current yield by investing in master limited partnerships. Yet because of that structure no tax-cumbersome K-1 is issued since the dividend distributions are classified as return of principal. Granted, my conservative stance looked pretty foolish when the INDU tagged ~13265 on April 2nd, but has not looked as foolish since then with the Dow surrendering roughly 4% into last week’s lows. That declined sparked the question, “Hey Jeff, is the correction over?”

Well, as repeatedly chronicled in these comments, all of the pullbacks in the S&P 500 (SPX/1370.26) this year have been between 25 and 35 points. Accordingly, measuring from the recent closing reaction high of 1419.04 produces a level of 1394 for a 25-point correction, and 1384 for a 35-pointer. Importantly, anything more than a 45-point pullback would put the SPX below the bottom of our 1375 – 1385 support zone and thus would suggest something has changed. It would also represent a breakdown below a spread triple-bottom for most of the major averages. While there is minor support around 1360 – 1365, my hunch is that breaking below 1375 brings into view the 1320 – 1340 level. Nevertheless, coming into last week I thought the SPX would remain mired in the 1385 – 1425 consolidation zone while the short-term overbought condition was alleviated and the stock market’s internal energy was rebuilt. And at last week’s low the NYSE McClellan Oscillator was indeed back in a fully oversold position. Moreover, my daily internal energy indicator also had more than a full charge of energy. Therefore, at Tuesday’s lows one should have expected some kind of “throwback rally,” and that’s exactly what we got. Unfortunately, Friday’s Fade left the SPX back below the aforementioned 1375 – 1385 zone and consequently still vulnerable. This would be especially true if last week’s lows at ~1358 are breached this week.

Since the SPX’s April 2nd peak the two worst performing sectors have been Energy and Financials, which have fallen more than 5%. While this is not surprising for Energy, because that group did not act well during the entire 1Q12 rally, Financials was one of the best performing sectors of the quarter, suggesting their weakness since early April may be telegraphing a change in the investment environment. Also concerning was last week’s 17% leap in the Financials’ Credit Default Risk Index. Then there was market-leading Apple’s (AAPL/$605.23) weakness over the past four sessions, a four-day downside skein not seen since last year. With such “tells,” and given the fact that the INDU and SPX have fallen below not only their envisioned support zones, but their respective 50-DMAs, we continue to counsel for caution, believing early this week should provide better clarity on the near term directionality of stock prices. Verily, “Be Conservative Not Conventional!”

The call for this week: Earnings season commenced last week with 75% of the reporting companies beating estimates. This week will show increased earnings reports with many of the major companies reporting. Our sense is the earnings environment will continue to be pretty good, which should limit the stock market’s downside to the 1320 – 1340 level. Moreover, the SPX held above its weekly uptrend chart line at 1358 last week, leaving the technical setup not as vulnerable as it was in May 2011. However, the December to late January upside runaway appears to be over until the stock market’s weekly internal energy is rebuilt. Unfortunately, the weekly internal energy indicator is nowhere near being fully recharged. The implication is that the downside should be contained, but the SPX is also not likely to break out above 1425 without spending some more time consolidating.

P.S. – I am in Colorado this week and will return next week.

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