‘Manage the risks – not the returns,’ he says

For example, U.S. manufacturing and initial employment claims were pointing to an economic slowdown, private-payroll growth was below forecasts, and legendary investor Barton Biggs recommended “selling stocks” on concerns the economy was weakening. Yet stocks just wouldn’t go down. At the time, I was cautiously bullish, having sold all of the downside hedges recommended in the March/April “up-swing” for the envisioned May/June decline.

My mantra last summer was: “Despite the headlines, and rants of death crosses, Hindenburg omens, Roubini revelations, Prechter-predicted plunges, etc., the equity markets refused to go down. When markets don’t listen to bad news, that is good news.”

Nevertheless, I only got it half right because while I have done pretty well for the investing side of portfolios, I have clearly underplayed the trading side.

Still, most of this year’s action has been a seesaw, back-and-forth, trading-range environment, and no runaway bull.

Indeed, the S&P 500 fell from 1,150 in January to 1,044 in February before rallying to 1,220 in April. From there, we got the May mauling that ended with a June swoon, leaving the S&P 500 at 1,011.

From those lows, the index tagged an intraday high two weeks ago of 1,168. (The index closed even higher last Wednesday, at 1178.10)

Summing all of those point moves shows the S&P 500 traveling 648 points (both up and down) between January’s highs into that intraday high. Confounding matters, those trading-range swings have started and ended abruptly, begging the question, “How is the average investor to compete with the Wall Street giants who seem to make or break markets according to fickle sentiment, superior research, rocket science programming, high-frequency trading, etc.?”

Well, perhaps the best way is to emulate some of the trading principles used by the pundits of yesteryear who beat the stock market no matter the emotions and mechanics that drove the institutional herd.

For instance:

Bernard Baruch: Some 70 years ago, he would research a stock, buy it and then each time the stock rose 10% from his purchase price, buy an additional amount equal to his first purchase. If the stock began declining, Mr. Baruch would sell everything he had bought when the drop equaled 10% of its top price.

Baron Rothschild: His success formula was centered on the famous quote attributed to him: “I never buy at the bottom, and I always sell too soon.”

Jesse Livermore: This legendary speculator profited enormously by calling the various 1921-27 advances correctly. In 1929, Mr. Livermore reasoned that the market was overvalued but finally gave up and became bullish near the top in the fall of that infamous year.

He quickly cut his losses, however, and switched to the short side. Mr. Livermore listed three major points for his success: sensitivity to mob psychology, willingness to take a loss and liquidity (meaning that stock positions shouldn’t be taken that can’t be sold in 15 minutes “at the market”).

Addison Cammack: A stockbroker from Kentucky who swore by the two-point stop-loss rule.

“If you’re wrong,” Mr. Cammack said, “you might as well be wrong by two points as 10.”

He followed this method successfully and was one of the few bears to make a fortune on Wall Street and keep it.

Interestingly, all these disciplines have one thing in common. They all adhere to Benjamin -Graham’s mantra, “The essence of portfolio management is the management of risks, not the management of returns. Well-managed portfolios start with this precept.”

Managing the risk — what a novel concept, but one that is not practiced by many investors.

Typically, when portfolio values start to erode, investors seem to chant, “It’s time in the market, not timing the market,” or, “It’s a strategic strategy, not a tactical strategy.” That cost S&P 500 investors more than 50% in portfolio value from the October 2007 high into the March 2009 low.

However, if that same index investor listened to the cautionary signals that the stock market was flashing in November 2007, and hedged that long index portfolio for the downside, the loss would have been less than 10%.

Unfortunately, many investors continue to shun stocks, having not managed the downside risk, leaving them with a mindset that you can’t make money in the stock market anymore. My response is, “Hogwash!”

Forgetting the various mutual funds and exchange-traded funds mentioned in these billets-doux since the end of June, I have offered some 30 stocks for investors’ consideration. Four of them are down marginally, the rest are up.

Moreover, as we entered the dreaded month of September, I wrote, “Over the last 16 midterm elections, the stock market has never made a new reaction low post-election day.”

LAST TWO MONTHS

Although markets can certainly do anything, I have argued that if we can get through October without some downside plunge, you are going to start hearing about the strong upside seasonality of the November/December time period.

Ladies and gentlemen, to an underinvested portfolio manager, the stock market’s action over the past few months is a nightmare. Accordingly, with year-end approaching, not only do underinvested portfolio managers have performance anxiety, but bonus risk and ultimately job risk.

Granted, the equity markets are somewhat overbought. But in a powerful “up move,” they can stay overbought.

Further, my proprietary intermediate-term trading indicator turned positive four weeks ago after being negative since the first week of May. Studying the attendant S&P 500 and its 70-week moving average shows that the 70-week moving average has tended to call the stock market’s direction when it has turned up and turned down.

My message remains simple.

With more quantitative easing on the way, the risk of another downdraft in housing has been taken off of the table. It has also boosted commodities, which is plainly good for our “stuff stocks.”

Additionally, quantitative easing should spur more mergers-and-acquisitions activity, increase share repurchases and lower the U.S. dollar (good for export companies), all of which is positive for the S&P 500. Speaking to the weaker dollar, since the rally began in July, the index is up about 13%.

Meanwhile, the Dollar Index is down 13%, causing one old Wall Street wag to lament, “Is the stock market going up or is the “measuring stick’ (aka the dollar) going down?” And this is why you want to have your depreciating dollars in productive asset classes that throw off cash flows, and hopefully keep up with inflation, which unless the laws of economics have been repealed, is surely coming.

Jeffrey D. Saut is chief investment strategist at Raymond James & Associates Inc.

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