The Game of Risk
by Jeffrey Saut, Chief Investment Strategist, Raymond James
June 17, 2013
âTo be sure, there is no exact definition of what âcallingâ a market top or bottom involves. In the case of the March 2009 bear market bottom, for example, does âcallingâ it mean the adviser's portfolio needs to have moved from being all cash to 100% invested in stocks on the exact day of the bottom? If my analysis had relied on a definition as demanding as this, then it wouldn't be surprising that no timers called recent market turning points. But my analysis actually relied on a far more relaxed definition: Instead of moving 100% from cash to stocks in the case of a bottom, or 100% the other way in the case of a top, I allowed exposure changes of just ten percentage points to qualify. Furthermore, rather than requiring the change in exposure to occur on the exact day of the market's top or bottom, I looked at a month-long trading window that began before the market's juncture and extending a couple of weeks thereafter. Even with these relaxed criteria, however, none of the market timers that the Hulbert Financial Digest has tracked over the last decade were able to call the market tops and bottoms since March 2000. These results add up to perhaps the most important investment lesson of all that: predicting turns in the market is incredibly difficult to do consistently well.â
... Mark Hulbert, MarketWatch (3/10/10)
The above excerpt was penned by Mark Hulbert in an article titled âFools R Us.â Appropriately, that article ran in a MarketWatch column on the 10-year anniversary of the NASDAQ Compositeâs peak of March 10, 2000. Ten years ago the COMP was changing hands around 5132. It is now trading at 3423 for a 13-year loss of some 33.3%. Meanwhile, over that same timeframe, the earnings of the S&P 500 are up 83%, nominal GDP is better by some 57.6%, and interest rates are substantially below where they were back then. If you are a college professor such statistics do not âfootâ with your teachings because professors tend to believe stock returns are all about earnings and interest rates. I concur, but would add the caveat, âThat is if you live long enough.â As money manager Greg Evans, eponymous captain of Millstone Evans in Boulder Colorado, writes:
âHey Jeff, I enjoyed your missive on Mr. Market. I use that Warren Buffet allegory quite a bit with clients. One interesting statistic on Berkshire is that its stock price was $38 in 1968 and 8 years later, after trading higher and lower, ended up (again) at $38. Most clients would look at that (performance) and say â it hasn't done anything for 8 years so I am going to sell. But an astute investor, looking at the underlying growth in book value, would see an average annual growth rate of 14.6% over those 8 years and conclude they should buy more. As to your point that over the long-term stock prices are ultimately determined by their book value, earnings and cash flows, I have often run numbers on stocks over a 25-year time frame to show to clients. For example, Coca-Cola's stock price in 1983 was $5.10 (midpoint); and, Coke earned $0.30 per share that year. The stock price today is ~$40, and they earned $1.97 last year. Thatâs about a 15% annualized growth rate on the stock price; and, a ~15% growth rate on earnings â QED.â
Surprisingly, however, if an investor bought Coke shares at their peak price in 1972, over the next 12 years the company compounded earnings at nearly double-digit rates (with only four down quarters), yet said shareholders actually lost money. The reason was âMr. Marketâ was unwilling to capitalize that improvement in earnings anywhere near the P/E multiple of 1972. Regrettably, âMr. Marketâ is indeed manic depressive, which is why the stock market is truly fear, hope and greed only loosely connected to the business cycle. And that, ladies and gentlemen, is why the successful investor needs to learn how to manage risk. As Benjamin Graham wrote, âThe essence of investment management is the management of RISKS, not the management of RETURNS. Well-managed portfolios start with this precept.â
Clearly, Warren Buffet understands this âmanagement of riskâ concept for he too has learned when to âplay hardâ and when not to âplay.â Decidedly, his insight to hoard cash, and shun internet stocks, in the late 1990s was brilliant, yet it was greeted with catcalls that âthe old man has lost his touch and just doesnât understand the Internet age.â However, investors benefitted handsomely if they heeded his advice. Enter the aforementioned quote from Mark Hulbert espousing the old market axiom, âItâs TIME in the market, not TIMING the market.â Typically such comments are accompanied with the verbiage, âIf you missed the 10 best stock market sessions of the year it kills your returns.â To be sure, over the 25-year period ending on 12/31/2011 the buy and hold investor saw returns of 6.81% per year. But, if you missed the 10 best sessions your annualized return falls to 3.67%. Miss the 20 best and you experienced only a 1.65% yearly gain, and missing the 40 best yields a negative 1.62% return. However, miss the 10 worst days and a prescient investor realized a 10.89% per annum gain, while missing the 40 worst shows annualized returns leaping to a 17.74% â according to a study from Hepburn Capital Management â thus proving the management of ârisksâ is more important than the management of âreturnsâ (see chart on page 3).
That said, while I too donât believe anyone can consistently âtimeâ the stock market, I do believe in Dow Theory. Dow Theory is like a roadmap for the âprimary trendâ of the stock market. Recall, Dow Theory gave you a âsell signalâ in September 1999 (albeit three quarters too soon), a âbuy signalâ in June 2003 (a few months too late), and again a âsell signalâ in November 2007 (note, it is not Jeff Saut âcallingâ the stock market, but Dow Theory). More importantly, the Dow Theory âbuy signalâ of earlier this year remains in force. Nevertheless, I continue to think we are in a short/intermediate âtoppingâ process. The timing models that have worked so well year to date targeted June 11/12th as the days that a feint to the downside would start. While I had thought the convening of the German Constitutional Court would be the causa proxima, it turned out to be Japan and its statement that it would not increase the monetary stimulus operations. Subsequently, in Friday morningâs verbal strategy comments, I said:
âI think we are going to limp around and then try for the reaction high of 1687. If we donât make a higher high on that attempt, and turn down from there, then the mid-July swoon I have been targeting will arrive prematurely. However, if we do make a higher high it probably means we are still going up to make a new high into the first or second week of July and then start the swoon. Indeed, I have mixed signals into the end of this week (meaning last week), as well as mixed signals into the beginning of next week (meaning this week). So, it would not surprise me to see the upside action fizzle today (last Friday) and have the market limp around with attempts to sell off into early next week. However, there are much more positive timing point signals coming next week (aka, this week), so my hunch is that the SPX limps for a few sessions and then starts to push higher.â
And while Fridayâs Fade (-106 points) wasnât much of a âlimp,â Thursdayâs upside action surely fizzled.
The call for this week: Nassim Taleb (trader extraordinaire) has 10 rules. Rule number 8 reads: âAlways protect the downside. As pointed out ad nauseum, Black Swans do occur. No matter how much you test, there will be a âthis time is differentâ moment forcing your bank account into oblivion. No matter how confident, always protect the downside.â I agree with Talebâs comments and therefore always try to âlookâ down before looking up in an attempt to manage the risk. As for the here and now, as I said on Friday, âIt would not surprise me to see the upside action fizzle today (last Friday) and have the market limp around with attempts to sell off into early next week. However, there are much more positive timing point signals coming next week (aka, this week), so my hunch is that the SPX limps for a few sessions and then starts to push higher.â And this morning âhigherâ is the watchword as last weekâs âtaper tantrumâ is fading on rumors of a softer Fed at this weekâs meeting, leaving the preopening S&P 500 futures up about 12 points.
Copyright © Raymond James
