It Isn’t How Much You Make… It’s How Much You Keep
It is the most important, and the most difficult, quality investors need to acquire in order to be successful. And understanding the difference between patience – required to keep one’s focus on the primary current trend – and stubbornness – the market “should” do x or y – may be the second most important.
I’ve been in this business a very long time. At our firm, we are often early, sometimes wrong, and always human. But preserving capital is always uppermost in our minds, even if that approach is unfashionable for a year or two. Humility is important when dealing with a system with as many moving parts, all fueled by emotion, as the stock market. We (I) well recognize that we (I) can make mistakes! But doing so and dealing with those mistakes is far more intelligent than trying to walk some tightrope of alleged perfection or divine good fortune (or selective memory in reporting…)
An example: We acquired one client in mid-2011 who saw our writing and philosophy and knew, in his head, that our long-term, ratchet-gains, conserve-capital approach would be perfect for him. The problem is… that may have been what he needed, and he realized it, but it isn’t what he wanted. What he wanted was “to beat the market.” It quickly became obvious that he wanted to be able to brag about his stock selection and market timing prowess to friends or self. So at the end of the first quarter of 2012, with the Dow up 8.1% and his portfolio up a mere 4.8%, he decided to switch horses. When I asked why he was moving on, he said, “You didn’t even beat the Dow this quarter.”
I wish this gentleman much luck. I imagine he immediately sought an adviser or a subscription service or a guru who enjoyed a “better performance” in the preceding 12 weeks, without once asking what level of risk that guru employed to enjoy that short-term burst. And of course if he did every bit as well as the Dow in the next six weeks – he saw that entire 8.1% evaporate completely. Impatience is expensive.
Our more conservative approach and willingness to hedge meteoric (and thus, by definition, usually short-lived) gains retained that 4.8%, but did lose 0.8% sine, for a 4% gain thus far this year. It isn’t what you make in the short term; it’s what you keep — and steadily add to — in the long term.
Paradoxically, “The Dow” or “the S&P 500” or “the market” is a terrible way to measure your progress toward your goals, how well you preserve capital, or what you will have in your nest egg in 5 years, 10 years or 25 years. The reason is that it engenders and reinforces short-term thinking. In ebullient markets, it also fires the imagination to believe that what goes up must keep going up and is not to be missed. In a bad market, it is seen as a cruel taskmaster intent on taking everything from us and something to be avoided forever. What an emotional roller-coaster!
What if, instead, we simply tried to enjoy a good portion of each secular (long-term, big-cycle) bull market, while never throwing caution to the winds, and we avoided the worst of every secular (long-term, big-cycle) bear market by keeping the bulk of our nest egg intact to be able to buy the stellar bargains that accompany the end of the secular bear?
Many people, like our above client of nine months, say they can handle a 15% drawdown. They say they are in it for the long term, and they say capital preservation is the most important thing to them. But their actions say: I have to beat the market every year or change strategy/horses! So they keep searching and keep changing horses and keep just behind the curve, and at the end they have exhausted themselves and the horses with their impatience.
I prefer to think in terms of where we are in these long-term secular cycles and act accordingly. Using history as my guide, I recognize that most of us have at best four, and in many cases only three, such secular markets in our entire lifetime. Taking my own lifetime as an example, I was too young to enjoy the great 1949-1968 generational bull market when Americans returned from war ready to work hard and build the greatest agricultural and industrial powerhouse the world had ever known.
That was 20 years of bull market during which time the market rose more than 400%. Of course there were corrections within that secular bull – what we call “cyclical” bear interregnums. That’s how markets work; nothing goes straight up or straight down and the more parabolic the rise the more likely a decline is in the wings.
By the time I was 21 and able to afford to invest even 100 shares of a $10 stock, we were descending into the next secular move of my lifetime – into a sideways-to-down bear market. My first impressions of “investing” were: “Whoa! Whoever said this was easy lied big-time.” That generational bear lasted from October 1968 to August 1982, when the market began to anticipate the election of President Reagan and the return to American growth. So my first generational secular market was 14 years of mostly down but, of course, with bull interregnums that were long enough to be valuable if one were willing to reallocate at moments of great pessimism.
It isn’t that bear markets only go down – viewed with the lens of history, they really go as much sideways as down. One need not simply hunker down for 14 years, but we must not buy with impatience. We have to pick our battles. It was this early experience that prepared me to handle bears better than someone who had come of investing age in the 1950s, when it was all so much easier. I realize that capital preservation is far more important in the tough times than merely making money one year (or, in the case of 2012, one quarter!) and giving it all back the next.
My second secular market is shared by most, if not all, readers of these columns. That was the magnificent bull market from the autumn of 1982 to the end of 1999. Those 17 or more years were nothing short of phenomenal. During that time, it was hard to make a bad decision. Great companies went up, good companies went up, and junk companies went up — toward the end of the Internet silliness, far more than the great companies. For too many people whose seminal experience in the stock market began from 1983 to 1999, they did not realize this was not only a secular bull, but it was an outlier of a secular bull, climbing 1000%. Nor did they understand that when the riskiest stocks move up the most, we are near the end of the drunken bacchanalia, not near the beginning. We stuck with the great companies and were able to sidestep the carnage that ensued.
I am now in my third generational market — the bear market which began in the winter of 2000 and has yet to run its course. If history is our guide, and it is, secular bulls tend to last something like 16 to 20 years on average and secular bears last somewhere around 13 to 17 years. The current bear is in its 13th year. Will this be its last gasp this time around? We can certainly hope so, but as Jesse Livermore said, “When I have to depend on hope in a trade, I get out.” Time will tell.
The astute reader of the chart above will notice that we are actually up 9% from the highs of early 2000. Other analysts therefore considered the bull market to extend to October of 2007 and believe we are only in the early innings of this bear. I disagree for the following reasons:
(1) Historically, bulls grow tired before 20 years. To imagine a 27-year bull market would make it quite the outlier!
(2) Anyone who lived through the dot-com dot-bom would be hard-pressed to agree there was anything bullish about the fallout from that era. Fortunes were lost. That's a bear market. Remember, I am showing the blue-chip Dow 30 only because other benchmarks don’t provide sufficient time yet to see the broad sweep of history. Very few investors own only these 30 stocks. The actual carnage has been much worse in the S&P, the Nasdaq, the Russell 2000, etc.
(3) Bear markets are as much sideways as they are down. It isn’t unusual to see wonderful relief rallies after sickening slides in a bear market.
(4) This time around, the bear was interrupted – and possibly extended – by the misguided decision by the national government, acting through the Treasury, the Fed, and the regulatory organs, to juice the market, arrogantly believing it could kill the bear. The Fed’s charter is to ensure employment and prevent inflation. Somewhere along the way, it was decided that juicing the economy with low home interest rates and reducing loan quality by insisting upon “equality” in lending, no matter how creditworthy the borrower, would ensure endless economic boom times and an ever-rising market.
A lot of people were fooled by this and last massively in 2008 and early 2009. I see the run-up as just a failed attempt by those in power to believe they could overwhelm common sense with taxpayer dollars. Sooner or later, the piper must be paid.
I believe, however, that in spite of an over-reaching, self-important and condescending national government, I will have the good fortune to see a fourth secular market in my lifetime – and just when I need it most, as I enter those years when I must think about taking care of increasing medical expenses, and I can think about philanthropic activities. Whether this big bear ends in 2012, 2014 or 2016, it is nearer its expiration date than its freshness date. Just getting the “big” secular decision correct places an investor light-years ahead of most of their peers for whom six months is an eternity
Of course, the great thing about this investing business is that we don’t have to wait for the next generational bull to make money. First of all, there are numerous counter-moves within the primary trend that last for a couple years. Second, there are now instruments available that allow us to rather more safely hedge our investments and benefit from the primary down trend. And finally even “bear” markets aren’t steadily down markets, but rather “resting zones” where the market goes nowhere but has, in addition to those countertrends, long periods where it moves more sideways than down.
Each of these cycles, up, down and sideways, have investment vehicles that allow us to profit during those times. Clearly, during the up cycles we can buy stocks. But during the sideways cycles, we can collect dividends and write options. And during the down moves, we can hedge and use ETFs and mutual funds that enter into both long and short positions or which short the market in a well-diversified manner. The key is to get The Big Move right. Even if we then get only four out of seven of the cyclical moves right, we have still preserved all our capital and even made some money during the bad times.
Too many investors (and portfolio managers) talk about their “style” of investing as a fixed star no matter what the external market is doing. I think this is a huge mistake. In a secular bull market, patience is rewarded but even impatience is not overly punished as the market makes higher highs and higher lows. In a secular bear market, one must, however, engage in the occasional reallocation to take advantage of cyclical bulls. Patience is rewarded while waiting for these. And wait we must – impatience and presuming every up move is the beginning of a new bull we mustn’t miss leads to abject failure. The flexibility of a different "style" is called for in such markets!
What is likely to happen next? Well, the market has lost more in six weeks than it gained in the previous 12. Our admonition to sell in May (this year!) seems to have been fortuitous. But nothing goes straight up or straight down. So there will likely be a counter-move up, which we will mostly ignore. On the other hand, when the politicians decide it’s time to prime the pump via QEIII, we will unwind our hedges.
Mr. Bernanke seems to like his job. If he wants to keep it, impoverishing the next generation of American citizens may seem a small price to pay today. Enjoy it for the short burst it will provide. But as I wrote in a recent comment, just because we're going to get another fix from our current dealer of street drugs, the Fed, doesn’t mean that we are off these mean streets. Getting a cheap high for a few minutes or even a few months is not the same as getting clean. Our nation needs to get clean. Our markets will follow.
For now, we are long the Swiss franc currency ETF (FXF) believing that the Swiss National Bank cannot forever hold their current peg to the euro and a run to Swiss francs is inevitable, short the market via the Active Bear ETF (HDGE), long a few core positions like Johnson & Johnson (JNJ), and hedged via a number of long/short mutual funds.
Disclosure: We are long JNJ, FXF and HDGE (which is, however, an inverseETF).
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