Raymond James’ Jeffrey Saut: ‘Manage the risks – not the returns’

“Most traders (investors) seem to become convinced of the genuineness of a movement in either direction only when it approaches a culmination . . . one reliable indication of the start of an upward swing is afforded when, after a period of declining prices or, less frequently, dullness, THE MARKET ADVANCES OR REFUSES TO GO DOWN FOLLOWING THE RECEIPT OF BAD NEWS.
News can seldom be utilized by the public for market purposes, even when its authenticity is beyond question. For instance, if tomorrow morning’s newspaper should announce the death of the President, the failure of a great ‘corner house,’ or the complete destruction of Gary, Indiana, it is more than likely that stocks sold on the news would bring the lowest prices of the day, for the very good reason that each seller would be competing with thousands of other sellers who would have learned the news at the same time.” . . . “One-Way Pockets,” by Don Guyon (first published 1917)
“Shrugs off bad news” indeed, for at the beginning of July the headline news was pretty bleak. 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 “upswing” for the envisioned May – June decline. My mantra last summer was, “Despite the headlines, and rants of ‘death crosses,’ Hindenburg Omens, Roubini revelation, Prechter predicted plunges, et al, the equity markets refused to go down. When markets don’t ‘listen’ to bad news that’s 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 see-saw, back-and-forth, trading-range environment and no runaway bull. Indeed, the S&P 500 (SPX/1165.15) fell from 1150 in January to 1044 in February before rallying to 1220 in April. From there we got the May Mauling that ended with a June Swoon, leaving the SPX at 1011. From those lows the SPX tagged an intra-day high last week of ~1168. Summing all of those point moves shows the SPX traveling 648 points (both up and down) between January’s highs into last week’s intra-day high. Confounding, those trading range “swings” have started and ended abruptly without much warning, 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 scientist-based program/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 of 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 he 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 – 1927 advances correctly. In 1929 he 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.” Livermore listed three major points for his success:
1. Sensitivity to mob psychology
2. Willingness to take a loss
3. Liquidity, meaning that stock positions should not be taken that cannot 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,” he said, “you might as well be wrong by two points as ten.” He followed this method successfully and was one of the few bears to make a fortune on Wall Street and keep it . . .
Interestingly, all of 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 unpracticed by many investors. To be sure, 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 not a tactical strategy.” Such mantras cost S&P 500 index 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 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 of a mindset that you can’t make money in the stock market anymore. My response is “hogwash!” Forgetting the various mutual funds and ETFs mentioned in these billet 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.” Expanding on that thought, one savvy seer comments that since 1929 the October – January stock market return, after a positive September, has averaged 7% versus only 2% following a down September. David Bianco goes on to state, “Not only that, Oct-Jan performance during mid-term election years has never been negative, with the average return of 13%.” While markets can certainly do anything, I have argued 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 (PM) the stock market’s action over the past few months is a nightmare. Accordingly, with year-end approaching not only do underinvested PMs have performance anxiety, but bonus risk and ultimately job risk. Granted, the equity markets are currently somewhat overbought. But, in a powerful “up move” they can stay overbought. Further, my proprietary intermediate-term trading indicator turned positive (green bars) four weeks ago after being negative (red bars) since the first week of May (see the nearby chart). Also, studying the attendant SPX chart, 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. And, except for the Long Term Capital Management debacle of 1998, has tended to contain price declines.
The call for this week: Well, I’m on the road again this week speaking to PMs and conducting retail investor seminars. My message remains pretty simple. With more quantitative easing (QE2) 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, QE2 should spur more M&A 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 SPX is up roughly 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 the inflation, which unless the laws of economics have been repealed is surely coming.
P.S. – Have I got you thinking about what trading strategy to follow? Well, I’ve been holding the best system for last. Here is the one sure-fire formula for success. “Don’t gamble, take all your savings and buy some good stocks. If they go up, sell them; if they don’t go up, don’t buy them!” – Will Rogers
Like what you’ve read? Subscribe to Market INtelligence »

Related Topics: Investment Gurus