Some thoughts about the market

[SaulR80683]

The year started terribly and bottomed on Feb 11th. On that day, my personal bottom, I was at 80.5% of what I started with. I’m now at 100.2% of what I started with, having risen 24.5%. That’s my whole portfolio! Up 24.5% in two months and a week or so, from that very scary time when a bunch of TA advocates and Market Timers suddenly appeared on our board, all screaming “Sell! sell! sell! Get into Cash or Gold!” and saying that all their indicators were that we were going into a Crash! The next time we have a scary correction and it feels like the sky is falling, and the TA and Market Timers arrive to scare you, keep that in mind. Don’t forget how scared you were at the bottom, and how disastrous it would have been if you sold at the bottom. Just saying…

Saul

For Knowledgebase for this board,
please go to Post #17774, 17775 and 17776.
We had to post it in three parts this time.

A link to the Knowledgebase is also at the top of the Announcements column
on the right side of every page on this board

[captainccs]

Saul, I’m very glad you posted those numbers. Let me add mine:

 **Date     Saul%    Denny%**
12/31/2015   100.0    100.00
 2/11/2016    80.5     92.50 approx
 4/23/2016   100.2     99.25

The Science of Complexity holds that life happens on the edge of order and chaos. Our job, the job of all life forms, is to remain alive and thrive on that knife edge. In my view, investors live on the right edge of the price chart, we see all the past to the left and none of the future to the right. How much would we give for a time machine that came back from the future to tell us what will go up?

There is a story about a man whose wish was fulfilled. The paper that arrived on his doorstep was tomorrow’s! He immediately went to the financial pages and picked some winning stocks to buy. As he read on he saw his own obituary! Careful with what you wish!

Investor have to realize and accept that the future is uncertain and invest accordingly. It’s very much like a casino but the casino has much better defined odds to work with. Each game has a known vigorish which, over the long run, tells the house how much it is going to take from the bets. Much like insurance, the casino relies on the law of large numbers. Investing has much more uncertainty than the casino and it is expressed as volatility. The numbers I posted above show that your portfolio has a lot more volatility than mine. Your additional risk should be rewarded, in the long run, by greater returns at the expense of more nail biting.

So, ¿what’s my point? Don’t change horses in midstream! One has to be prepared in two ways, 1) stock by stock, and 2) on a portfolio wide basis.

1. I like the way Peter Lynch puts it. Find a good stock and write down its story on a 3 by 5 card. Sell when the story changes. The random fluctuations in price don’t matter as long as the story is intact.

2. I don’t recall the author but his thesis was that there are efficient portfolios and there are sturdy portfolios. An efficient portfolio typically uses leverage but the risk of having the loan called makes it more dangerous. This is what played out in 2008. As prices dropped, assets backing loans fell in value and loans got called forcing more sales and creating a chain reaction that culminated around mid March 2009. Debt is a good indicator of riskiness. On the other hand, a sturdy portfolio, for the same author, is one backed by cash, sufficient cash to weather a catastrophic collapse. The objection usually is that you want all your money to work for you and with ZIRP cash it’s a deadweight. But think about how much you could have bought after March 2009. If this idea needs reinforcement, read Gerald Loeb’s The Battle for Investment Survival. In truth sometimes he sounds more like a trader than an investor but his rationale for holding cash is quite convincing. In deflationary times cash in the piggy back increases in purchasing power.

To conclude, if you are certain about each one of your stocks and you are certain that you can withstand a market collapse, then you need not fear it, instead, prepare to make the most of it.

One additional comment, the less volatile a portfolio is the less scary it is in a market downdraft.

Denny Schlesinger

[SaulR80683]

Saul, I’m very glad you posted those numbers. Let me add mine:

Hi Denny, that was very interesting. You went down a great deal less (7.5% compared to my 19.5%), but then went up a great deal less as well (only 7.3% where my portfolio went up 24.5%), and you ended up almost equal (just 1% behind).

There must be an explanation for that. Were you mostly in cash? Or in very conservative large-cap stocks? But they were down a bunch too…

Can you explain it?

Saul

[JLodie]

Not sure what Denny’s methods are, but the premise of timing strategies are not to pick absolute tops or bottoms. The timers (I am not one yet, but the concept is enticing and I’m still in research mode) you mentioned in your OP were out long before the market bottomed. They got out sometime after the market topped (many were out in Dec or earlier) and got back in sometime after the market bottomed. While many of these strategies don’t convincingly appear to improve overall gains, they do reduce draw downs while maintaining market average gains. So if Denny’s port didn’t drop as much as yours, but didn’t go up as much from the bottom either, that would be the point (assuming he’s using some type of timing system).

I’ve been investing for the past 16 years, but still feel I lack a definable strategy. I’ve always felt wanting more cash during downturns, so the idea of having some (using timing methods) is obviously attractive. The trick now is to figure out how to use it to reliably improve one’s gains. The IBD/CANSLIM concept is rather attractive as it combines some timing with many of Saul’s ideas for choosing growth stocks.

The quest continues. Thank you Saul and everyone else on this board for all the enlightening discussions and education.

Cheers,

Jeff

[othalan]

This whole year, I’ve been totally baffled at the “official word” on the stock market, the economy, and what “experts” recommend for investors. Looking at all the companies I was researching I couldn’t find anything in the earnings reports to justify what was being said about the market in general and the economy. I admit I normally ignore news media and “experts” anyway and thus always start out from a point of distrust for what they say. But still, this year has been baffling to me listening to what the talking heads have been saying.

Not that I’m going to argue. I am now invested in some great companies at extremely attractive entry points. I am already up significantly for the year.

I’m not claiming success. Not until I find out how well I can hold onto those gains next time the market plunges. But so far I am quite satisfied.

captainccs (AKA Denny Schlesinger ): The numbers I posted above show that your portfolio has a lot more volatility than mine. Your additional risk should be rewarded, in the long run, by greater returns at the expense of more nail biting.

Denny, this is a reply to the above comment, but really is for everyone: Have you considered that volatility does not necessarily need to equate to fear? My portfolio shows significantly higher volatility than yours yet I have felt very little uncertainty or fear; never once felt any desire for nail biting!

It is all in risk management, which for me largely boils down to education and patience. If I know the company well enough (thank you Saul), I can estimate some interesting price points. For example, a price below which I might be interested in buying shares, a price below which I am definitely interested in buying shares, and (possibly most importantly) a price the stock is unlikely to fall below barring major catastrophe. If I have the patience to wait for good entry points, the primary risks are then only my own level of education (easy to manage with study), how well I trust the company’s management (easy to manage as I learn more about the company over time) and the chance of unforeseeable catastrophe (an educated guess).

LGIH has been a hot topic of discussion periodically, so let me use it as an example. Here are my notes for how I evaluated the company in January before I made my first purchase:

**2016-01-15 - LGIH - P/E 10.4 - Price 21.74**

Above $25 - Too expensive given my uncertainties about the company
Below $23 - Expensive but consider a small position
Below $22 - Very good deal, buy a larger position
Below $20 - Unlikely to fall much lower than this at current P/E
Below $18 - Catastrophe Line
Above $30 - Probably too big of portfolio % for the risks, decrease position size?

NOTE: That is one snapshot in time. All the above I adjust constantly based on my knowledge of the company, the current adjusted P/E ratio, etc.

Today the above numbers have changed significantly because TTM earnings are higher and I have spent more time researching the company. I have an average entry price of $21.30. I think it unlikely the stock will reach that price again barring a truly horrendous catastrophe no matter how volatile the stock price. That means the nail-biting factor is really very low in spite of the fact that this is a big position for me. LGIH could drop 20% and I would still be making a very nice amount of money. No worries.

Do your research, ignore the talking heads who are trying to make money from your panic, and don’t worry so much!

[captainccs]

Not sure what Denny’s methods are, but the premise of timing strategies are not to pick absolute tops or bottoms.

Jeff, this is not the place to explain what I do but, in general terms, I’m a long term growth investor, I sell covered calls for income and to lower the average cost of positions, and I don’t think I share a single stock pick with Saul. I have no use for “absolute tops or bottoms” but there are elements of timing in my approach that is not really timing but simply sell high, buy low that happens to coincide with accurate market timing. If you wonder why I turned around the usual order of “buy low, sell high” it’s because it applies mostly to selling covered calls where you sell first when the premium is right and you close the position when sufficient premium has been extracted.

There must be an explanation for that. Were you mostly in cash? Or in very conservative large-cap stocks? But they were down a bunch too…

Can you explain it?

Saul

The above is also part of the answer to Saul. Selling covered calls acts to reduce portfolio volatility. You have a stock at $100, you sell a call at $10 making the net position $90. The stock goes up to $120, the call goes up to $15 (the option’s delta, 5::20 = .25). Net position $105. Volatility without options 20%. With options 16.7%.

The calls generated cash (included in total portfolio value) which means that the stocks fell more that 0.75% vs. your gain of 0.2%. Now, had I bought the same stocks with the cash then my number of shares would be higher and their average unit cost lower that when I started.

I’m not sure how cash affected the results. I came into a nice chunk of cash mid 2015 from the sale of a property and a large part of it was to be added to the portfolio when the time was right. I had been thinking that a usable market correction was due sooner or later since the bull was a bit long on the horn. I found a buyer in late 2014 and closed the deal mid 2015. I didn’t touch the cash until January 2016.

I bought stocks in the first quarter using 14% of the cash in January, 55% in February, and 31% in March. Maybe I lucked out.

In January I closed a losing position and opened two new ones selling covered calls.

In February I added to three positions and sold covered calls. One will be called in June for a CAGR of 34%, the second I bought back in April for a small profit, and the third I bought back in April so I could close a position I had lost confidence in*.

In March I opened one new position and added to another, again selling covered calls.

I don’t think you can make truly meaningful comparisons between portfolios with different strategies over a short timespan like a quarter or even year. Nevertheless, mine, being a bit more conservative, might well underperform yours while both beat the market. Time will tell.

Denny Schlesinger

• I don’t share a single position with Saul but I like this board. The April sale of the positions I lost confidence in could well be a reaction to a post on this board – something about rabbits?.

[captainccs]

captainccs (AKA Denny Schlesinger ): The numbers I posted above show that your portfolio has a lot more volatility than mine. Your additional risk should be rewarded, in the long run, by greater returns at the expense of more nail biting.

Denny, this is a reply to the above comment, but really is for everyone: Have you considered that volatility does not necessarily need to equate to fear? My portfolio shows significantly higher volatility than yours yet I have felt very little uncertainty or fear; never once felt any desire for nail biting!

It is all in risk management, which for me largely boils down to education and patience. If I know the company well enough (thank you Saul), I can estimate some interesting price points. For example, a price below which I might be interested in buying shares, a price below which I am definitely interested in buying shares, and (possibly most importantly) a price the stock is unlikely to fall below barring major catastrophe. If I have the patience to wait for good entry points, the primary risks are then only my own level of education (easy to manage with study), how well I trust the company’s management (easy to manage as I learn more about the company over time) and the chance of unforeseeable catastrophe (an educated guess).

Great question othalan!

First of all, “nail biting” and “fear” are being used as metaphors for “risk.” Risk proper (unlike uncertainty) is something that can be calculated and using techniques like “risk management” can be mitigated as you state. This is why you don’t bite your nails and sleep soundly.

As far as I know, volatility was first considered risk in Modern Portfolio Theory (MPT) whose objective is to create a low volatility portfolio even at the expense of yield. I’ve spent a considerable amount of time pondering why volatility should equate to risk because it was not obvious to me that it should be so. Instead of trying to find the answer in finance I used real world examples. One that helped a lot was considering a caravan in the desert that could not carry enough water for the whole trip and depended on a wadi to provide water on route. The wadi would only have water if rains came on time. The volatility of the rains indeed was risk for the caravan! Or the caravan might be delayed overlong and the volatility of the ETA was also risk for the caravan. At the cost of reduced profits the caravan might add a few water carrying camels (risk management) adding not just to the water supply buy also to the food supply. They eat camels. But they would need food for the camels, more profits lost.

Volatility as risk as used in MPT does not make sense because the same level of volatility represents different levels of risk for different portfolios and for investors with different circumstances.

To answer your question, for you volatility might not be risky. For a leveraged investor it would be.

Denny Schlesinger

[othalan]

captainccs (AKA Denny Schlesinger ): To answer your question, for you volatility might not be risky. For a leveraged investor it would be.

Actually, I do use leverage and consider there to be almost no risk to it. I do not recommend investing with borrowed money to most people as the risks are (as you note) extremely high without careful risk management. But as with all risks, leveraged investing risks can be managed, even with high volatility.

My overall leverage is relatively low because most of my investments are in retirement accounts. However, my non-retirement account has quite high leverage. Quite volatile too. But not very risky.

All risks can be mitigated, including leverage+volatility. But as I said, I actually suggest most people do not follow my example in this as it takes a great deal of knowledge and preparation.

I had not heard the term “Modern Portfolio Theory (MPT)”, but looking it up I am familiar with the concept. I am opposed to the entire concept. (Saul’s Knowledgebase is the best argument I can think of for why I am opposed to MPT) I also place absolutely no credence in equating volatility with risk. Sure, some types of volatility are extremely risky, but it is a logical fallacy to say that all volatility is risky just because one type of volatility is risk.

[haywool]

Hey there !

In a recent thread, othalan reminded me of something making the statement “Have you considered that volatility does not necessarily need to equate to fear?”

Indeed !

I strongly believe that “fear” is a personal perspective. Some girls (and some guys too) are afraid of snakes. Some are not. My wife is in the not category … when in college she would walk around the dorm hallways with a garter snake draped over her arm just to watch the reactions of the other girls. Spiders and wasps can have the same affect. I think market fear is the same way. Some won’t “take a chance” with stocks because they are afraid that they will end up in the poor house. While others invest, if you want to call it that, with gay abandon because they just like the name or whatever.
As othalan stated, It is all in risk management, which for me largely boils down to education and patience. Fear, then, seems to be a product of education and patience. And I believe therein lies the answer.

Thanx,
Rich (haywool)

[mauser96]

i don’t know which “market timers” you say showed up at the bottom.

Because my timing related posts date back to mid September 2015, well before the bottom. I should say “this bottom”

And I certainly did not “scream” or try to panic anyone. In fact I said timing does not always work.

post 11983 date 9/18/15

Me, I have been mostly but not entirely out of stocks since early August. Based entirely on data driven algorithms . But my data is based on stock prices and it is hard, no data revisions on the way. Even that does not mean that it always works. But even error type sells are followed by buys so I won’t lose much.

post 15438 dated 1/13/16

The majority of my indicators of the general market have been saying for a while that a bear market is more likely than not, i.e. the odds are somewhat in the bear camp. But unlike bear market bottoms indicators, these are almost all momentum based, and thus miss most other market forces…

Daily systems are the most sensitive but have lots of false readings, weekly ones less sensitive and monthly ones even less sensitive . The monthly ones are the most reliable but slow to register and I don’t have the end of January readings yet.

This is not a matter of predictions but of keeping the odds in your favor, being the Blackjack “house” not the player whenever possible.

As I posted previously I am more I’m in the “keep what I have” mode than “make more” mode, and over the last month or two that has worked out well.

while from a long term basis the longer term signals appear at this time to have whip saw failure, not so the mid term signals which allowed me a few buys very close to the bottom .

As I have posted before this is a form of strategic diversification balancing out buy and hold. It is not either/or.

While there is fairly massive evidence that momentum works ,I use it only for a part of my portfolio That part of the portfolio did not suffer a 25% loss, it about broke even. The main reason for timing is smaller draw down, less risk, having some cash available for those rare bear market bottoms.

After the reception my posts got,I decided to keep future signals to myself.

I don’t consider losing 1/4 of your money only to get it back to be a huge success. Of course it’s more of a success than losing 1/4 and not getting it back. Buy and hold certainly beats emotional panic selling . That is assuming your stocks are quality stocks.

I do not need a fire in my home to regard the money I paid for fire insurance as a success.

[captainccs]

Actually, I do use leverage and consider there to be almost no risk to it. I do not recommend investing with borrowed money to most people as the risks are (as you note) extremely high without careful risk management. But as with all risks, leveraged investing risks can be managed, even with high volatility.

My overall leverage is relatively low because most of my investments are in retirement accounts. However, my non-retirement account has quite high leverage. Quite volatile too. But not very risky.

All risks can be mitigated, including leverage+volatility. But as I said, I actually suggest most people do not follow my example in this as it takes a great deal of knowledge and preparation.

Ten or fifteen years ago I would have agreed with you but no longer. It could be I’m getting older.

Denny Schlesinger

[IanERichards]

I had not heard the term “Modern Portfolio Theory (MPT)”, but looking it up I am familiar with the concept. I am opposed to the entire concept.

The best quote I have seen on this comes from ‘Free Capital’

Learning modern portfolio theory to become an investor is like learning physics in order to play snooker

… Or words to that effect. I guess pool instead of snooker for you guys over the pond. Snooker in vogue in the UK at the moment as half the country watching the world championships on the BBC.

[strelna]

‘Risk… is something that can be calculated and… mitigated…’

Not easy. Central bankers have led us into a world where global debt is 3 x global GDP (and as such, can never be repaid. Their actions in the future must now be coercive (negative interest rates, capital controls, attempts to abolish cash transactions and ultimately cash itself).

Secondly, the global situation, mainly China’s effect on recession elsewhere, are too complex to understand. I mean for anybody to understand. There are too many ‘unknown unknowns’. Black swans will be seen.

So the current situation, where recession is overdue and (for example) the PE of blue-chip consumer staples could quite plausibly be half what it is now, is worth, if not biting your nails about, giving serious attention to. It cannot be said too often: we are living in financial times which are artificial and bear no resemblance to the free market America was once famous for, and which assured her prosperity.

I suppose the practical investing side of this rumination is to look for value, pricing-power and low debt. In addition, my own inclination is to not even look at any company with a ROIC under 16. Unlike Saul, I also love cash. It’s what stops me biting my nails.