Jeff Saut's Morning Column: "MIM2"
"We're back from Santa Barbara, where we gave the keynote address at the second annual Minyans in the Mountains (MIM2) conference. In attendance were such notables as Michael Santoli, Steve Shobin, Bernie Schaeffer, and Tony Dwyer, to name but a few. As reprised on Minyanville's market-savvy Web site (www.minyanville.com), the theme of this year's conference was, "Managing risk and staying in the game."
Clearly that is a topic many stock market participants wish they had considered six years ago. Nevertheless, we began our speech with a quote often used in these missives, but whose message is always worth repeating. To wit:
"Most people acknowledge that losses will happen regardless of the type of business venture. A light bulb manufacturer knows that two out of three hundred bulbs will break. A fruit dealer knows that two out of one hundred apples will rot. Losses per se don't bother them; unexpected losses and losing on balance does. Acknowledging that losses are part of business is one thing; taking and accepting those losses in the markets is something else entirely. In the markets, people tend to have difficulty actively taking losses. This is because all losses are treated as failure; in every other area of our lives, the word loss has negative connotations. People tend to regard the words loss, wrong, bad, and failure as the same, and win, right, good and success as the same. For instance, we lose points for wrong answers on tests in school. Likewise, when we lose money in the market we think we must have been wrong."
. . . What I Learned Losing a Million Dollars, by Jim Paul and Brendan Moynihan. Ladies and Gentlemen, everyone knows how to win. Few know how to lose. Yet the secret to making money in the markets is knowing how to lose, or how to control your losses. Listen to the pros:
"I'm always thinking about losing money as opposed to making money. Don't focus on making money; focus on protecting what you have." - Paul Tudor Jones
"The majority of unskilled investors stubbornly hold onto their losses when the losses are small and reasonable. They could get out cheaply, but being emotionally involved and human, they keep waiting and hoping until their loss gets much bigger and costs then dearly." - William O'Neil
"One investor's two rules of investing:
1. Never lose money
2. Never forget rule No. 1" - Warren Buffett
All of those pros have different market philosophies. They have contradictory strategies for making money.
Some are traders; some are value players; some are growth-stock advocates; others are emerging-growth seekers; etc., etc., etc. But the message is clear - "Learning how not to lose money is more important than learning how to make money!" Now consider another quote from the brilliant Peter Bernstein (author of "Against the Gods"):
"After 28 years at this post and 22 years before this in money management, I can sum up whatever wisdom I have accumulated this way: The trick is not to be the hottest stock picker, the winning forecaster, or the developer of the neatest model; such victories are transient. The trick is to survive. Performing that trick requires a strong stomach for being wrong, because we are all going to be wrong more often than we expect. The future is not ours to know. But it helps to know that being wrong is inevitable and normal, not some terrible tragedy, not some awful failing in reasoning, not even bad luck in most instances. Being wrong comes with the franchise of an activity whose outcome depends on an unknown future. Look around at the long-term survivors at this business and think of the much larger number of colorful characters who were once in the headlines, but who have disappeared from the scene."
I don't know how much of a "colorful character" I am, but I am a survivor because I learned to manage the risk of being "wrong" during the 1972 to 1975 bear market. Manifestly, managing losses has been a lesson that has served me well over the years. It has been particularly helpful over the past six years. Indeed, since the Dow Theory "sell signal" of September 1999 we have managed the risk in keeping with our mantra, "Don't let ANYTHING go more than 15% to 20% against you." In conjunction with that mantra we have also employed asset allocation, as well as a strategy of rebalancing investment positions in an attempt to manage the risk.
Portfolio rebalancing, when done correctly, is an art form. Simply stated, portfolio rebalancing is the strategic redistribution of asset classes within a portfolio to keep said portfolio's objectives in-line with its original objective. As John Valentine of Valentine Capital notes:
"To provide a simplified allegory, think of investment planning for the future as an automobile, conveying an investor to his or her financial goals. The investment portfolio is its motor, the asset allocation model is the fuel mixture, and the assets invested are the fuel. The more efficiently the motor runs, the greater the speed with which the whole vehicle travels toward the destination. Should the fuel mixture, or asset allocation, run too rich, the motor wastes precious fuel. Should it run too thin, the car has trouble achieving enough forward momentum. ...Many individuals on the road to their financial goals fail to make these periodic adjustments and still eventually arrive. Not surprisingly, the investor who rebalances his portfolio at regular intervals may arrive sooner and with more fuel in his tank. ...Rebalancing a portfolio is crucial to the investor seeking to reduce the volatility in a portfolio and increase cash flow simultaneously... The longer a portfolio is left unbalanced, the more compromised its asset allocation may become. There are two potentially negative repercussions associated with a compromised allocation: being overexposed to the downside and underexposed to the upside. Don't let this happen to you!"
Over the past few weeks we have been recommending employing such a rebalancing strategy with some of our energy stock positions since our sense is that crude oil was/is searching for a short/intermediate parabolic peak. Verily, many of our energy stock investment positions have grown into well oversized "bets" given their price appreciation over the last few years. Consequently, they should be rebalanced. As stated in last week's letter:
"We think oil prices are searching for a short- to intermediate-term 'pig peak' provided someone isn't about to blow up the Mideast oil fields. . . . With many of the energy stocks three-to-four standard deviations overbought, any pullback in oil prices could cause an outsized decline in energy stocks. Therefore, we think it is only prudent portfolio management to rebalance some of your energy positions. That can be accomplished either by selling 20% - 30% of your most technically vulnerable energy stocks, or hedging the downside through the use of put options."
Longer-term we remain an energy bull, near-term we are a chicken.
On a trading basis, at least so far, that rebalancing of energy "call" has been generally correct, for using the intraday highs to the intraday lows of the Oil Index (XOI/964.84) and the Oil Service Index (OSX/162.25) shows that they have surrendered 7% and 7.6%, respectively, since their recent price-highs. However, our buying-stampede "call" in precious metals did not fare so well. Indeed, gold was down on the week, yet merely closed some of the upside breakaway price-gaps in the charts. Much of this "golden weakness" is likely attributable to the dollar's rebound, which as measured by the Dollar Index has rallied from roughly 87 back to its 50-DMA at 88.86; and, in the process tagged overhead resistance. Long term, we think the dollar goes lower and gold goes higher, a view we have held since 2001 (with gold at $260/ounce) and when we embraced a "stuff stock" positive-stance (timber, agriculture, energy, precious/base metals, etc.). We remain buyers of "stuff stocks," preferably those with yields on price declines, as a long-term theme.
As for the equity markets, we think that the "highs" are IN . . . of course we said the same thing back in mid-June at DJIA 10650. Yet as the astute Minyan John Roque noted in Barron's over the weekend, "Without the lift provided by the highflying energy stocks, the (S&P) 500-stock benchmark has made little progress over the past 22 months, is well off its December 2004 high and remains below its 50-day and 200-day moving averages. We believe there is important technical deterioration occurring below the surface of the otherwise placid S&P 500." Ned Davis goes John one step better when he opines in the same article, "Compounding the bull case is the difficulty in making an argument for stocks being undervalued. According to Ned Davis Research, the S&P 500 would have to retreat 22% for its price-earnings ratio to reach the median of the last 34 years." We agree and continue to argue for a trading-range environment for the major market indices; as well as out-performance for the "stuff stocks," and the small-to-mid-cap universe of stocks.
The call for this week: Ned Davis research also noted in Barron's - (oil's) sentiment polls show that 81.3% of pollsters show that they are bullish as they have been in the past decade and Davis believes (that) signals a potential top in crude oil's surge - we continue to trade, and invest, accordingly in keeping with Warren Buffett's recent comment, "The Noah rule: Predicting rain doesn't count; building the ark does!"
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