The 401(k) Dilemma

Where’s the Hedge?

Mon, Nov 16, 2009 - 12:00am

Dilemma

Every day that you walk into a store, you know that prices are continuing to surge. If you don’t, then your wife certainly does. Those who still have jobs know that they are being pushed to do more, for less remuneration as the surge for increased productivity is unabated. Now with the US Dollar being trashed as an essential part of the US Government’s recovery plan, the cost of that component of your life that uses imported goods is going to soar as well. This chart of the US Dollar index, a good proxy for purchasing power has been published in my Financial Sense articles since February 2008. It called the 2008 low and the 2009 top. A monthly close below the DC black line at 72.78, forebodes a further drop to around 60c. And that’s going to hurt US consumers.

So under these continuing pressures, the chances of your being able to afford a comfortable retirement are for most, less certain than ever. The term “401(k)” comes from the section of the tax code that describes the tax breaks given to employee retirement savings plans. About 60 million Americans currently have a 401 (k) plan, and according to the NY Times, this represents about 40% of US Non Farm workers. The average Fidelity 401(k) balance in the second quarter was $53,900-and that’s a long way from comfortable retirement.

Indeed the whole 401(k) story, beloved and continually espoused by those who collect the fees for handling your money is largely just another Wall Street con job, supported by marketing and spin and not much substance. Bear with me as I put this story into perspective, and then I will show you the answer to this dilemma.

Tens of millions of Americans are enrolled in private employer-sponsored retirement plans-the great majority of them in 401(k) plans, which long ago replaced traditional pension benefits. These plans are easy to participate in with payroll deduction, and most people-once signed up- don’t spend much time thinking about the investments they’ve chosen.

All that has changed in recent months. The huge loss of value in those accounts, caused by the stock market decline, has imperilled retirements for older workers and caused younger workers to wonder whether they should have participated at all.

Given the wipe-out of years of savings, are there ways to make retirement nest eggs safer? NY Times

And from Alicia Mundell:

Even before the financial crisis, I was concerned about the ability of 401(k) plans to provide secure retirement income. They were not designed for that role. When 401(k) plans came on the scene in the early 1980s, they were viewed mainly as supplements to employer-funded pension and profit-sharing plans. Since 401(k) participants were presumed to have their basic retirement income security needs covered by an employer-funded plan and Social Security, they were given substantial discretion over 401(k) choices.
We need a new tier of retirement income that would allow 401(k)s to return to their original role as a supplementary savings plan. Today most workers with pension coverage have a 401(k) as their primary or only plan. Yet 401(k)s still operate under the old rules and the balances in these plans will likely be insufficient as the sole supplement to Social Security.

, a director of the Private Enterprise Research Center and professor of economics at Texas A&M University has this to say:

So your 401(k) has tanked, what do you do now? There is little doubt that the majority of us had a significant portion of our 401(k) invested in equity markets and most of us have experienced a loss of nearly 50 percent in the value of that investment over the past year. While this inverse financial tsunami is a rare event, rare events happen. The essential question is, would you have been better off if your 401(k) was invested entirely in U.S. Treasuries?
Your future is still more secure if you own it rather than someone else.
There is no doubt that the world is risky and rare events happen. But what is the alternative? Assuming that the current value of equities represents the future earnings of the underlying corporations, then unless you believe that something fundamental has changed so that the long-term future of the economic system is one of stagnation, you should continue to invest in your 401(k) and maintain an age-adjusted equity share.
The one fundamental that has changed, at least in the short run, is the market’s perception of the “rare event” risk. It is common for our perception of the likelihood of a rare event to rise immediately following that event. In the investment world, the consequence of this perception is an increase in the compensation investors require for assuming market risk, the “equity premium.” Thus, even if the market expects firms to return to their former profitability, the current value of these equities will be below pre-rare-event level. As time passes, the “equity premium” required to account for market risk falls, allowing the market value of equities to return to pre-rare-event levels.
The real question is whether there exists a superior instrument, in this case meaning an instrument with less risk and an acceptable rate of return? Essentially, what is the alternative to the individually-owned 401(k) system?

You can find these and a hundred similar stories from apparently respected members of the savings industry, and they all have the same theme that something better is required. All too, acknowledge that historically stock market returns beat Bonds and other conservative investments by a wide margin. But there are many pitfalls in the system including employer contributions or the lack thereof, portability and most of all timing. By the end of last year, the average 401(k) balance dropped to $57,200, down 28 percent from $79,600 in 2007, according to consulting firm Hewitt Associates. Forty-four percent of workers lost at least 30 percent. But the most damning indictment and one which the whole industry ignores, comes from the Detroit News:

Another danger in relying on 401(k) plans is simple bad luck: Workers who have the misfortune to retire at the wrong time in a business cycle can lose as much as three-quarters of their account value by retiring in the wrong year. A study from the Brookings Institute found that a worker who saved for 40 years in stocks could have retired and replaced 90 percent of his income-if he quit in 1999. But another 40-year hand retiring in 2008 would barely replace 25 percent of his pre-retirement income.

Of course the universal assumption that being caught in an Equities down draft is “bad luck”, is at the root of savers’ dilemma. For it isn’t “bad luck” at all, but at best bad management, and at worst, sheer incompetence.

Scandal

The failure to adequately protect investments basically comes from mistaken belief systems. First comes the belief that diversification across asset classes will remove the risk. For this assumption to be true, markets would need to be a net aggregate of constant value so that a fall in one class of asset is correspondingly matched by a rise in another. Others believe that so long as fundamentals in the earning entity remain constant, so will its future value. And that’s not true either, as valuations vary with perception and available liquidity. As we step out onto the ledge of financial experimentation, which is being imposed by well meaning bureaucrats who hope to restore the status quo ante, there is simply no precedent for the experiment of substituting the public balance sheet for that of the selected “too big to fail” institutions.

What we can be sure of is that systemic risk merely moves from one sector of the markets to another.

That Mutual Funds, 401(k) funds, pensions or any stock market investments are not adequately hedged is a scandal. The plethora of strategies available to all, from sophisticated to plain vanilla instruments makes a sensible hedging strategy simple and within your grasp. The legion of advisers know well the strategies available, and reams of material are available on the various stock hedging options, so why is it that the vast majority of these investments are un-hedged?

It’s not for lack of the availability of tools.

The answer is that the vast majority of savers are content to leave their affairs to others, which seems a strange indictment of Americans, the most fiscally savvy and independent people on the planet, and the mistaken belief by sophisticated money managers that their asset allocation strategy is spread across uncorrelated asset classes. The lesson from the recent bout of market indigestion (or wholesale disaster if you or your advisers played it wrong) is that liquidity or lack thereof attacks all asset classes simultaneously. The degree may differ, but the downward trajectory is the same.

This is the Australian SPI chart which is the broad index that tracks the top 200 stocks on the Australian Stock Exchange. Now this is a country that didn’t go into recession, saw no appreciable rise in long term unemployment ratios and that still has house prices running in the major cities at North of 8 times earnings:

Despite all the riches that the lands Down Under certainly enjoy, its major market suffered the same fate as China and others as the Danielcode black line cast its spell.

The corollary is that the “buy and hold” mantra is so deeply imbedded in the investing public’s psyche that they see market collapses as an unavoidable part of the game, and something to be accepted as part and parcel of the investment game. And that too is just not true.

My observation is that hedging, deleverage or portfolio rebalancing as defensive strategies have costs. And the returns on stocks are likely enough over a longer term to bear the rapacious fees that are so irritating to investors, but insufficient to justify a perpetual hedge. And that is particularly true if the question of systemically mispriced options is raised. There are much better ways.

We can take as our guide to solving this dilemma, words from an old master WD Gann who averred that the most expensive part of stock trading was the first and last eighth of a move, meaning that being a top and bottom picker was fraught with difficulty and therefore cost; and a modern master of the investment game Warren Buffett who has sagely observed that the best way to make money in investing is not to lose any! Couple these words of wisdom with the availability of highly effective hedging tools, and weigh this against the undoubted cost of accessing and implementing those tools, and the answer resolves itself as being “Time”. And not just time, but market time.

We know from old, the importance of time. Solomon, the wisest man who ever lived was also the richest. He is famed in history as the builder of Solomon’s Temple, also called the First Temple, completed in 960 BC, and famed in fiction with such masterpieces as H Rider Haggard’s 1885 novel “King Solomon’s Mines”.

And Solomon wrote the epic definition of the importance of time in Ecclesiastes “Ecc 3:1 To every thing there is a season, and a time to every purpose under the heaven.”

So it is in markets. For investors, there is a time to be long and a time to be short, or a time to stand aside. Knowledge of these “times” will go a long way to satisfying Mr Buffet’s axiom of avoiding losses.

Solution

I want to show you in the simplest terms, how you can stay invested in the market but protect yourselves from the wildest market gyrations. Those that destroy your hard won savings. There are layers of sophistication that can be matched to this approach but today I am just going to show you the first two building blocks. If there is sufficient interest from Mom and Pop investors, admittedly not my usual clientele, I will develop this theme for you in subsequent Financial Sense articles, and it may be possible to incorporate this strategy into the Danielcode web site.

Let’s start with some basic assumptions:

  • Average investors want their market analysis in a short digestible form
  • Acres of newsprint are destroyed by analysts and economists who scour statistics, reports and market intelligence, in the hope that they can discern future market directions. We know that analysts start off behind the eight ball because the material that they work from (balance sheets, financial reports, company guidance etc) are at best incomplete and at worst blatantly false. For economists, their fate is even more hazardous. Aussie Rupert Murdoch’s throw away line that “Economists were invented to make weather forecasters look good”, is likely complimentary to most.
  • The aim of the navel gazing and reading of the chicken entrails are solely for the purpose of divining whether to be “long, short or flat”. We can do all of that in a simpler, more compelling way.
  • And we can do it using just a few analytical tools with just a handful of rules.
  • And we can make it mechanical. An absolute imperative when dealing with the endless opinions and assertions that modern communication has imposed on us all. If it is not mechanical we will be buffeted by the swings and arrows of outrageous fortune, not to mention those habitual self promoters intent on impressing us with their pseudo knowledge of future market directions. It ain’t so Sport!

So if we can replace endless columns of comment and wish fulfilment, not to mention the abuses of spin, marketing and product pushing that are largely enmeshed in market thought today, we will truly be delivering some uncommon views for wise investors, the professed purpose of this august publication, for whom I am so privileged to write.

So cutting to the chase, our search for investing nirvana boils down to a reliable trend indicator. Something stable enough that long term investors are not compelled to review their position more than once a month, and something that markets know and recognise but that is unknown to others. That is always the way of the Danielcode.

Trend

To talk about market trend we have also to talk about time. Gann stated that at any time there are always two different trends in the market. In fact there are many more. A bull market in a weekly chart may well be a bear market in a quarterly chart. So the time that we choose for our base is important. For the purpose of this article, I have chosen the Danielcode monthly charts (24 trading days, see “Master Class” for rationale), my assumption being that for most private investors, a monthly review of their portfolio and the broad market’s trend is not unduly onerous. Put simply, if you are not prepared to pay attention to your financial future at least once a month, you likely deserve the fate that has already befallen so many. Losses and plenty of them.

Here are just a few snapshots of historical moves in markets to reinforce Solomon’s message that there is nothing new under the sun: Ecc 3:15 “That which hath been is now; and that which is to be hath already been; and God requireth that which is past. “

Here is the Dow in 1929:

And the S&P index in 1973:

And our current markets:

An alarmist might say that instability in markets is getting more frequent. Certainly the degrees of leverage and black ops derivatives have increased at a rate totally incomprehensible to most. And that trend is certain to accelerate. Nothing remotely approaching reform is going to happen in global financial markets. With the same rogues still in charge, courtesy of their respective governments’ bailouts, a reasonable man (he of the Clapham Omnibus), will expect more of the same. So at the least, we can see that the necessity for prudence is more pressing every day.

This will all happen again some day, and likely sooner than you think!

Here is our base chart showing the output of the Danielcode monthly trend indicator, a proprietary but unsophisticated mix of largely traditional market studies:

In this chart we can see a whipsaw in the trend in 1994; thereafter it stayed on a buy signal (blue) until November 2000; switched to a Sell signal at that time and remained on the bear side until September 2003. From there it signalled a resumption of the bull market until February 2008, when it again alerted us to the impending bear market about 90 days after the market top in October.

The notable feature of this chart (24 trading days is a Danielcode “month) is the stability in its signals. The indicator showed one dominant trend for long periods of time, with no whipsawing since December 1994.

The tops in 2000 and 2008 were signalled nice and early and before much damage was done to an investment portfolio. But the signal for the lows in 2002 and March 2009 was late. This is a natural function of mechanical indicators. The stability in the signals is caused in part by the proprietary studies running over relatively long time periods. Hence at gentle roll over type turns like the 2000 and 2007 tops, the studies give us a nice early signal. In contrast, the step declines and fast rebound at the March 2009 low leave the indicators way behind. I know that there were many who got so bitten by the Bear bug that they insisted on staying short after the March low this year. Even more fulminate and rage over the quality of the present stock market rally. It is as Myron Scholes (Nobel Laureate in Economics and developer of the Scholes-Black model for pricing options) pointed out today, largely a rally in junk stocks which he simply calls a junk rally. That may be, but market price is reality whether deserved or not. The tape is the truth for the present and markets could care less about how it happens. The price is always right.

Shortly after the Danielcode publicly called the March low in the S&P at 666 to the day and a few points, one of my clients, a charming and talented young man from Northern California, who is an S&P sell side plunger rather than a serious trader, earnestly told me that his then guru (they are apparently “legion”, as was the demon in the Gadarene Swine; multiple and interchangeable, and wholly deserving of the same fate-they drowned) insisted that on his Elliott Wave count, the market had much further to go down the numbers. He insisted that regardless of what the market did, another massive down leg in Equities would unwind. And for all I know, he may be right. In the meantime this particular individual’s dedication to a highly suspect cause has wiped out his trading bank and apparently much more.

Being safe in the markets means sticking closely to the trend. Leave the hypothesising to those who claim foreknowledge. That’s their whole game. We mere mortals know that such a gift is forever beyond our grasp. So let’s look at another trend defining technique. For this we revisit the earlier examples of market turbulence that I used as examples above. We take the same charts but convert them to our standard Danielcode monthly charts, that is 24 trading days (see my “Master Class” articles in Financial Sense archives, or at the Danielcode website).
Here’s the 1929 Dow example to which I have added a Regression Channel. You see that the 2 definitive trends in this market are clearly identified by the monthly close outside the respective channels.

And here’s the 1973 jolly in the S&P with the same treatment:

And the recent and current market in the S&P index. The one that crushed many of you:

And here’s the fun part. The drawing of these channels is entirely mechanical and consistent on all the charts we have examined from 1929 to date. It is still a lagging indicator, and working off a monthly chart, the lag times are significant. But not as significant as not having knowledge of a clearly defined trend.

Let’s add the Regression Channels to our earlier trend chart, so that you can see the completed chart below. The additional technique introduced here is 1 period later in its Bear signal from the 2000 top; 2 periods (DC months) earlier with its Bull signal at the 2002 low; exactly the same at the 2008 top and it has the added virtue of switching back to the long side in August 2009, which the proprietary trend signal which creates the coloured chart channels failed to do.

Since 1994, these simple tools have garnered 2059 points on the S&P index on a long and short basis. We can start with our base price in this index, which for the purposes of this article was 449 in 1994. On this basis, our points tally now returns 458% over the 15 year period, or about 30% per annum.

And as rough and unscholarly as those estimates are, it does make the point that knowing some of the secrets of market “time” bears out Mr Buffett’s comments that once you eliminate the draw downs, the market is the place to be. It sure is hard to get with a pick and shovel.

Making it Better

For those who like their market action closer to the bone, and who are prepared to review the status of their investments more frequently, we can speed up the signals by shortening the time period. In so doing we will get more false signals, but with a simply defined failure point (all market signals must always have a pre-defined “failure” point and that’s where your initial stop on entry goes), losses on fake outs are minimised. Just to illustrate this point, we slide the time period of the chart to a 2 DC week or 12 trading day period.

Without changing the look back period for our proprietary indicators that are running these charts, we have by halving the bar time, effectively doubled the speed of the indicators. We now get some whipsawing in the signals for the 2002-2007 Bull market, but precious few considering the time span, and the regression channels are barely changed. We can continue this process right down to the 3 day cycles at which stage we bump heads with the Danielcode T.03 signals that called the March low in this market, to the day and a few ticks. But that’s “trading” and this article is written for our cousins, the market investors.

If you have noticed that the definitive trend changes that these methods identify are usually accompanied by an outsized bar signaling an acceleration of the trend, then you are on to something. The market is talking to you. And that makes you a member of a very exclusive club.

Is it True?

With numbers like this, we of course have to ask “Is this method either sustainable or true?” And the answer is Yes. And No.

You may not think so with recent events and the likely carnage to your investments so fresh and raw, but the period from 2002 to 2007 was one of benign calm for the major US indices. Volatility as measured by the VIX or “Fear” index declined to a decided snooze with just a brief eruption in 2006:

In this environment, we had a long drawn out channel without a single event outside the 2 standard deviations that the regression channel uses for this market. But it was not always so and extreme volatility will defeat even the most methodical approach. Let’s have a look at some more difficult market periods. They will likely come again.

We start with a look at the SPX chart from 1968 to 1978. The first thing you notice about this chart is the two swooping pullbacks into June 1970 and October 1974. The first was a 37% decline followed by a 50% decline. Then a lower high into the end of 1976, followed by another 20% pullback.

The net effect of this conspicuous volatility was that from March 1968 to March 1978, the market was flat. Here’s another “lost decade” for investors. And who’s to say it won’t happen again. Or worse. For this period of chart you certainly needed a proactive hedging strategy. I have put the usual Buy/Sell signals on the chart so you can see the savings that a cohesive strategy would have shown you, not to mention the wear and tear on your nerves, heart, and likely the pacemaker! Heart stopping stuff indeed.

Moving on to the mid 80s and the run up to the 1987 crash, you can see that hedging in the lazy market conditions of 1984/85 actually returned a loss on the hedge, but more ominously our indicators failed to give a Sell signal, at least on this time frame for the ‘87 crash. We can surmise that markets cannot maintain momentum once they break above our regression channel for an appreciable time, and uber bulls may even be pleased that no Sell signal was issued at the 1987 peak as the market was back at those highs within 2 years.

But does it really make any sense to attempt to withstand an event that on a shorter time frame looks like this, below:

In fact, the crash of ’87 merely returned this market to its long term trend lines, where it stayed with just a single signal requiring hedging action until the start of 1995 from where the great bull market that culminated in the 2000 top was launched.

The answer to this problem and all others related to market trends is again “Time”. As Gann so presciently observed almost 80 years ago, no discussion of market trends is possible without defining the time frame. So to get earlier signals we slide to a shorter time frame. I have found the 9 day chart (1.5 Danielcode weeks, see “Master Class” in my FSO archives or at the DC website) to be the most efficacious for my needs, and to bring this article up to date, here is the current chart of the S&P index:

At the end of August, in my article “Mariners and Markets”, I told you that 1125 was one of two high probability targets for this rally. We are just 20 points from that number now with no sell signal apparent on our proprietary trend indicator, and the S&P happily journeying along its regression channel. All that can change. But unlike economists’ opinions, which seemingly change with each new doctored government statistic, markets can’t change direction without creating a readable signal on the price chart. How quickly that signal is apparent is just a function of the market time frame in which you choose to live.

So our journey through the travails and triumphs of the S&P has now covered 40 years. In that time we can see periods of zero growth for long periods of time and at the 2009 low we had to go back 13 years to find any net growth. Yet if we eliminate even 40% of the most savage declines we have a vastly profitable compounding machine.

The real cost of household inflation is never recognized by official statistics. But you know as well as I, that a much better solution is required for the average working man’s savings to ever become a serious retirement plan. The ever present conundrum is that to make the myriad of underfunded pension schemes and private retirement plans worthy of their aim, something different is required. Broadly speaking, the average wage doesn’t leave much, if any, to invest in retirement plans. And the contributing companies who are overly generous (contribute one penny more than the parsimonious minimum) may not be around when you need them. The standard political solutions of adding years to your working life or reducing entitlements are just sop. Neither solution has enough horse power to make a significant difference absent draconian and wholly unacceptable changes, and both are still subject to that awful vagary of markets; Time.

As usual my advice is keep your money close. Learn how to manage your investments and you will truly have a future to look forward to. If you would like to know more about this simple market strategy, I invite you to register at the Danielcode website (it’s free) and that will ensure that you are alerted to our upcoming series of free webinars that will explore the Danielcode trend indicators in exquisite detail.

Eph 3:19 And to know the love of Christ, which passeth knowledge, that ye might be filled with all the fullness of God.

Copyright © 2009 John Needham

About the Author

Lawyer and Financial Consultant
jneedham [at] thedanielcode [dot] com ()