Raymond James' Jeffrey D. Saut: The game of risk

The following is an investment strategy column by Jeffrey D. Saut, managing director at Raymond James & Associates Inc.

“To be sure, there is no exact definition of what ‘calling' a market top or bottom involves. In the case of the March 2009 bear market bottom, for example, does ‘calling' 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 can be drawn from this week's market anniversaries: Predicting turns in the market is incredibly difficult to do consistently well. That means that, if your investment strategy going forward is dependent on your anticipating major market turning points, your chances of success are extremely low.” —Mark Hulbert, MarketWatch (3/10/10)

The above excerpt was penned by the esteemed Mark Hulbert in an article titled “Fools R Us.” Appropriately, that article ran in a MarketWatch column on the 10-year anniversary of the NASDAQ Composite's peak of March 10, 2000. Ten years ago the COMP was changing hands around 5050. At last Wednesday's anniversary date it closed at 2358.95, for a 10-year loss of some 53%. Meanwhile, since that peak, the S&P 500's earnings are up approximately 48%, real GDP is better by more than 20%, and interest rates are substantially below where they were back then. If you are a college professor such statistics do not “foot” with your teachings because professors tend to believe stock returns are all about earnings and interest rates. We concur, but would add the caveat, “That is if you live long enough.” As money manager Greg Evans, eponymous captain of Millstone Evans in Boulder, Colorado writes us:

“Hey Jeff, I enjoyed your missive on Mr. Market last week. 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 – 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 $54, and they earned $3.05 last year. That's a 10.8% annualized growth rate on the stock price; and, a 10.6% growth rate on earnings – QED.”

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 shareholder actually lost money! The reason was “Mr. Market” was unwilling to capitalize that improvement in earnings anywhere near the P/E multiple of 1972. Regrettably, “Mr. Market” is indeed a 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, “The essence of investment management is the management of RISKS, not the management of RETURNS. Well-managed portfolios start with this precept.” Clearly, Warren Buffet understands this “management of risk” concept for he too has learned when to “play hard” and when not to “play.” Decidedly, his insight to hoard cash, and shun Internet stocks, in the late 1990s was brilliant, yet it was greeted with catcalls that “the old man has lost his touch and just doesn't get the Internet age.” However, investors benefitted handsomely if they heeded his advice. Enter the aforementioned quote from Mark Hulbert, who essentially is espousing the old market axiom, “It's TIME in the market, not TIMING the market.” Typically such comments are accompanied by the verbiage, “If you missed the 10 best stock market sessions of the year it kills your returns.” To be sure, over the past 81 years (1928 – 2009) if you missed the 10 best sessions a $1 dollar investment grows to only $15, while staying fully invested returns a little over $45 on that same invested dollar. However, that is only half of the story. To wit, if a prescient investor could miss the 10 worst sessions that same dollar grows to $143.47 – proving the management of “risks” is more important than the management of “returns;” or, that you can make numbers do anything! That said, while we too don't believe anyone can consistently “time” the stock market, we do believe in Dow Theory. To us, Dow Theory is like a roadmap for the “primary trend” of the stock market. Recall, Dow Theory gave you a “sell signal” in September 1999 (albeit three quarters too soon), a “buy signal” in June 2003 (a few months too late), and again a “sell signal” in November 2007. Note, it is not Jeff Saut “calling” the stock market, but Dow Theory. More importantly, the Dow Theory “buy signal” of last year currently remains in force. Accordingly, last week we attended this year's Raymond James Institutional Investors Conference with an “ear” for good risk-adjusted stock ideas. A few names we heard that are also favorably rated by our fundamental analysts include: NII Holdings (NIHD); Eclipsys (ECLP); Alliance Data Systems (ADS); Nuance Communications (NUAN); Polycom (PLCM); Micron Technology (MU); Brunswick (BC); Occidental Petroleum (OXY); Corporate Office Properties (OFC); and Unum Group (UNM), to name but a few. Obviously, there were other interesting presenting companies, but due to time constraints we don't have time to list them. Also of interest is that some names have yield-oriented convertible preferreds, and/or convertible bonds, worthy of your consideration. The call for this week: Nassim Taleb (trader extraordinaire) has 10 rules. Rule number 8 reads: “No matter how confident, always protect the downside.” We agree and therefore always try to “look” down before looking up in an attempt to manage the risk. As for the “here and now,” the broadest index them of all, the Wilshire 5000, has strung together 11 consecutive higher sessions, a feat not seen since the mid-1990s. Accordingly, it is pretty over-bought on a short-term basis. That upside skein can be seen in the candlestick charts, which have not experienced a downside “red candlestick” session since the upside reversal of February 25, 2010 (see www.stockcharts.com). We are therefore turning cautious, but not bearish, on a trading basis. That strategy suggests a shortterm correction is potentially due, but NOT an intermediate-term bearish decline. Indeed, since the end of the envisioned January/February “selling stampede,” we have been constructive on stocks. However, we currently think pairing some trading positions, and/or raising stop-loss points, is warranted. Meanwhile, a number of our Japanese recommendations broke-out to the upside in the charts last week, the Reuters/Jefferies CRB Index (commodities) broke below its rising trendline, the 10-Year Treasury Yield Index (TNX/3.71) broke above its 50-day moving average (read: higher rates), the Volatility Index (VIX/17.58) continued to trade below 18 (read: too much complacency), mutual fund cash positions are at historic lows of 3.6%, and the NYSE overbought/oversold indicator tagged a rare overbought reading above 90 last week. Ergo, color us cautious in the very short-term. For more investment strategies by Mr. Saut, go to raymondjames.com/inv_strat.htm.