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Jeff Saut Presents: Don't Bet The Farm!


...each time we won two chips we would put one of them into our pocket, not to be used again that night.


"In 1965 Steve McQueen starred in The Cincinnati Kid, the classic poker movie of all time. This movie has so far saved me from becoming ultrabroke or ultrarich. The climactic scene in the movie involves a showdown hand of five-card stud between Steve McQueen ("the Kid") and Edward G. Robinson ("The Man"). This scene made an indelible impression on me during my school years. With three cards dealt, Robinson bets heavily on a possible flush, a stupid bet if there ever were one, particularly since McQueen has a pair showing. The pot gets bigger and bigger. McQueen ends up with a full house - aces over tens, which loses to Robinson's straight flush. When Robinson turns his hole card, the jack of diamonds, McQueen looks as though he is going to throw up. He has been wiped out. The movie's soundtrack is throbbing. Sweat is dripping down McQueen's face, as he stares at Robinson's hand in disbelief."...Frederick E. Rowe Jr., Forbes

We are familiar with cards, dice, and betting in general. While in college we supplemented the monthly stipend from our parents with the winnings from playing cards. The bluffing, the betting, the showdown was all great drama to us. Back then we learned the "one chip" rule. To wit, each time we won two chips we would put one of them into our pocket, not to be used again that night.

When we entered this business in 1971 we found that same kind of strategy useful in managing risk. In the stock market's case, while the human natures of fear, hope, and greed still play a large roll, we tended to substitute card players with the personalities of stocks, the market makers, the Fed, Washington, and the politicians. Using such strategies we found that if you do your homework, and manage the risk, the odds of success in the markets are much better than a card game. When you lose in the markets at least you get back most of your money (if you manage the risk) and the government shares in a portion of your losses via the capital gains/capital losses tax system. In a card game it tends to be basically all or nothing with each hand.

Subsequently, we practiced and honed our market skills in the early 1970s on a trading desk, chalking up our early "lumps" to learning the game and paying our dues. Later on we started winning fairly consistently by sticking with well-defined rules to guide our decisions and by managing the downside risk. Indeed, managing the risk is crucial, for like Mr. Rowe we too remember "The Cincinnati Kid" and while Steve McQueen made the "intelligent" bet (consistent with the odds), "The Kid" made one big error . . . you do not bet the farm no matter how good the hand looks. Or as one savvy seer suggests, "If you're going to bet the farm, you had better have two farms!" Manifestly, in life, in cards, in the markets, anything can happen and you never take that "bet the farm" kind of chance because occasionally "The Man" hits the long-shot and you're busted.

We reflected on mathematics, probabilities, and odds over the weekend after finishing the book "Fortune's Formula: The Untold Story of the Scientific Betting System That Beat the Casinos and Wall Street" by William Poundstone. The book centers on Claude Shannon, who in the late 1940s had the idea that computers should compute using the now familiar binary digits 0s and 1s such that 1 means "on" and 0 means "off." Shannon's information theory is what lies behind computers, the Internet, and all digital media. As the book notes - when asked to characterize Shannon's achievement, USC's Solomon Golomb said, "It's like saying how much influence the inventor of the alphabet has had on literature." In 1956 Claude Shannon and John L. Kelly turned their skills on how to mathematically "win" at the casinos and eventually on how to "win" in the stock market. Those mathematical insights were subsequently employed by the phenomenally successful hedge fund Princeton-Newport Partners. While there were many formulas for their success (edge/odds; Gmax = R; etc), the manner in which Shannon rebalanced portfolios was elegantly simple. To reprise some lines from the book:

"Consider a stock whose price jitters up and down randomly, with no overall upward or downward trend. Put half of your capital into the stock and half into a "cash" account. Each day, the price of the stock changes. At noon each day, you "rebalance" the portfolio. . . . To make this clear: Imagine you start with $1000, $500 in stock and $500 in cash. Suppose the stocks halves in price the first day. This gives you a $750 portfolio with $250 in stock and $500 in cash. That is now lopsided in favor of cash. You rebalance by withdrawing $125 from the cash account to buy stock. This leaves you with a newly balanced mix of $375 in stock and $375 in cash. The next day, let's say the stock doubles in price. The $375 in stock jumps to $750. With the $375 in the cash account, you have $1,125. This time you sell some stock, ending up with $562.50 in stock and cash. Look at what Shannon's scheme has achieved so far. After a dramatic plunge, the stock's price is back to where it began. A buy-and-hold investor would have no profit at all. Shannon's investor has made $125."

We have often written about portfolio rebalancing as one of the keys to successful portfolio management. And, while Shannon's simplistic example is too short-term oriented (aka, day-to-day), we are intrigued with it. For example, say you put $100,000 into a cash account and $100,000 into Raymond James' "Analysts' Best Picks" (ABPs) and then rebalanced every other month, or at the end each quarter, using Shannon's methodology. Another approach we have recommended for the ABPs is to scale buy them purchasing one third when they are released in December, one-third sometime in January, and the final one-third in February. This strategy seems sensible since history shows that the ABPs can most of the time be purchased below their original prices sometime during the first quarter of the new year. As a sidebar, Shannon's rebalancing methodology could also be employed with this scale-in buying approach. We think these types of strategies can improve the odds of success for investors.

Speaking of odds, what are the "odds" as far as the stock market goes? Well, by most measurements the cyclical bull market that began in October 2002 is now very long-of-tooth at 39 months. Moreover, equity markets tend to have at least a 10% correction roughly every 19 months. Currently, we have not seen such a correction since October 2002. Also worth consideration is the fact that earnings have grown at a double-digit rate for a long time and stocks, as measured by the major averages, have gone nowhere. Additionally, that earnings growth has been driven by aggregate profit margins for the S&P 500 that are near 40-year highs, leaving the "odds" of them expanding further not a good bet. Accordingly, Ned Davis notes, "When margins get up to these levels the market typically goes nowhere." This is consistent with our investment strategy, as well as our sense that earnings are regressing to their historical single-digit growth rate (6% - 7%) and that P/E ratios are compressing. Combine this with the high price of oil, flattening yield curves, a weakening housing market, our feeling that the undersaved/overspent consumer has reached a "tipping point," and is it any wonder we continue to think the economy remains on a glide-path to muddle?

Consistent with these views, we remain steadfast in thinking that sector, and stock, selection will be the key to investment returns rather than just indexing. We favor dividend-paying stocks, and large capitalization stocks over small/mid-caps (although we still will "mine" these sectors since they afford the best earnings growth and capital appreciation prospects). We remain "value investors," although our guess is that in the low-return environment we envision, Wall Street will pay-up for "real" growth situations.

In conclusion, since our mid-October buy 'em "call" we have suggested that the S&P 500's trading target was 1280 - 1300, which should occur in late January. Well, here we are. We think the stock market by most measurements has already made a big bet. To expect much more from here would be a long-odds play. We would rather make the "intelligent" bet and not risk the farm.

The call for this week: Place your bets!

P.S. - We are in Vancouver all week and this will be the only strategy report for the week.

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