Who Said It Was Going to Be Easy? Keep It Simple

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The stock market has not had a negative year-to-date return at any point this year! This is the first time that has happened since 1979. If you were to go through the financial news headlines for the year and then guess how the market has performed you would've likely come up with a number far below the actual performance of the market in 2012. Why have we been so bearish this year? Why has every pullback in the market been met with, “Oh no, here comes 2008 all over again”?

I am not sure. Certainly I have my theories. Everything I read lately makes a mention of how tough it is to make money in this market. Really? Is it tougher than in the past? Are we making it more difficult than it needs to be? Are we just all worn out from the downturn in 2008 to make rational decisions? Have many of us forgotten what it is we are supposed to be doing? 

Why is it that people think it is harder to make money in the market? One of the things that I see making it more difficult is that stocks are not leading for as long as they have in the past. Leadership takes place in a span of just over 20 weeks now. Many industry groups roar ahead and take a leadership position in the market only to see those gains quickly reversed. Does this make things more difficult or is it just a fact? Perhaps we need to take this fact and trade a little differently. You buy stocks to make money. You can’t be afraid to make money (still the greatest piece of advice a boss ever gave to me). So, if our internal playbook says we should buy stocks and hold them for a few years and then take away a nice profit, perhaps we need to make an adjustment to the realities of the current market.

In case it's not clear, the market doesn’t give a darn about our internal playbook. With everyone looking at the same fundamental and technical indicators, maybe we just need to make an adjustment to our long held beliefs on the life cycle of a winning stock. If winners begin to break down technically and do not hold key technical levels maybe it is just wiser to take our gains and move on to the next opportunity. If some names in our portfolios make the slow steady grind higher. then it's hold on and prosper. The takeaway is when there is a divergence between the fundamental and technical picture, the technical view is more often than not the correct vantage point. The entire market knows all there is to know—the technical picture, our insights, are never deeper than the entire market. So, maybe it would be easier to instill some discipline and hold stocks that continue to rise or come into support levels in an orderly fashion and sell the names that breakdown technically? Maybe if we use that discipline on every trade we can make some money in this tough market? I say this because you would be amazed at how many deft money managers are at coming up with “reasons” to hold a stock after it breaks down technically. Just punt the thing. When they go up you are right when they go down you are wrong. When you are wrong have the discipline to admit it and move on. When you do this you will be amazed at how infrequently you have large losers your portfolio. 

When I started in the industry a 5% pullback was a huge catalyst to buy. A 10% pullback led to more than a few migraines, but was also viewed as a buying opportunity. Most of the people that were influential in the industry when I started were managing money in the 1987 crash. The market went down 22% in a day. In retrospect it was just a huge buying opportunity. That mentality sunk in. If you missed some names you liked you waited for the next 5% pullback and started your position. Now as soon as we get anything looking like a pullback the comparisons to 2008 begin and clients, financial news talking heads, and, worst of all, portfolio managers, start to panic. It is probably best not to compare most time frames to the rally in 1999 or the crushing down drafts in 2000-2001 or 2008. Look at the market and evaluate information real time and react accordingly. If individual names in your portfolio begin to decline and enter their own private bear markets make sure they are sold. The names that continue to buck the trend and perform should be held. When the markets bottom out at moving averages or the decline becomes exhausted, use the cash you have raised to make some timely purchases. The people that were most bearish and ran for the hills and called everyone else a fool for not following suit over the past decade have received the most attention. Perhaps their time in the driver’s seat is waning. I am sure getting tired of their predictions of the European Union dissolving or Greece simply evaporating or the dollar going to zero or the fiscal cliff creating a depression beginning the day after tomorrow

When I started in the olden days of the markets there were certain principles held onto that were simply true. You didn’t fight it and you used these guidelines to make money for clients. The last thing you ever wanted to be was an economist or a strategist. Those were the guys that couldn’t make it as a portfolio manager so they drifted to jobs where they simply gave an opinion and didn’t put any money to work. For example, if the Fed cut rates then you became more bullish on stocks. Lower rates were good for the economy and stocks were helped. Maybe that was a simplistic approach but a profitable one. Now everyone comes out of the woodwork to tell us why this is a good or bad move and why the Fed is wrong or why the dollar is going to go to nothing or why someone is going to completely change the rules or some other nonsense. "Don’t fight the Fed" was typically the way to go. Now people come on TV to tell you their thoughts on the Fed action and why it really means this or that and it can never mean the other. The question I have for these “experts” is when was the last time you bought a stock? If the answer is not recently, then who cares what you think? Great your ravings got you a few blog hits or some subscribers to your newsletter but you are the only guy getting paid. All portfolio managers start off with a blank sheet of paper and have to construct a portfolio using all the information they have access to.

“We buy stocks that have good fundamental characteristics and are gaining market share against their competitors. We hold them as long as they continue to perform. We boot them when they break below key moving averages.” Sadly to say that doesn’t sell. I will show you the description of a “model” that unfortunately works. I have added my translation of what this means in parentheses. “We screen 5000 stocks through our proprietary model (it’s so proprietary we’ll never tell you what it is and it is the model I stole from my last firm). We then perform more screens to further distinguish the winners from the losers (shouldn’t every worthy screen go into your proprietary model)? We then perform this great feat of financial wizardry that generates a buy list of stocks. More smart guys then come in and do some really cool things and then the super duper smart guys that comprise our 'committee' (I simply despise that word) determine what stocks should be bought. Then traders that have absolutely no insight into any of this step in and determine when the stocks should be bought. If the thing breaks down we come up with a tweak to our valuation model that justifies the stock’s valuation and we continue to hold it. We then pray the thing turns around and gets above break-even because it will only be considered a 'value' for so long."

People eat this stuff up. When I tell people about owning basing or advancing stocks and then selling them when they begin to go down I am often met with a blank look. I translate the look into “well can’t you come up with something more complicated? Why yes I can. I won’t but I definitely could. It won’t help your portfolio and it is just a bunch of nonsense. We can all come up with decent criteria to buy stocks. What we do when we are wrong in the long run will determine our fates. Don’t rationalize and sell the losers when they break down technically. Don’t bother scrubbing it through a proprietary sell template matrix. Don’t bother because if you want to you can rationalize holding any name if you come up with enough valuation screens that will make the name “attractive at these levels.”

The existence of issues is not a reason for the market to go higher or lower. If we keep our eyes and ears open we can always come up with a long laundry list of potential issues with the market. What are the chances these issues will derail the market? If you want an accurate picture of the chances look to the market itself. The most powerful fundamental is always price. The market is well aware of the fiscal cliff. The market has zero vested interests in the resolution of the fiscal cliff. The market never makes a “call”. The market told you a few weeks back the fiscal cliff was a big deal and the powers that be were going to figure out a way to foul things up. With the advance today the market is telling you there will be some sort of resolution. 

Get up early, eat a good breakfast and get some exercise. Spend less than you make. Buy stocks that are going up and sell them when they breakdown below moving averages. Talk to your kids and go throw a ball with them a few times a week. They all fall in the category of common sense. Keep the committees, elite coaches, consultants, and “experts” to a minimum.

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About Thomas J Smith CFA

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