Stop Loss Trades Entered

Update – since the market has kept going up, none of these stop / loss orders has been triggered. This is a good thing. We will leave the orders out there and may re-calibrate them based on the new highs. We only put stop losses on stocks where we thought that either they were near a top or a stock that we’ve had a long term issue with and I wasn’t going to sink all the way back down once it had gotten to break even.

The market has been on a nice rally. Some of the stocks that we’ve held on to for years we’ve given up on (Alcoa, and Exelon a while back) while others we are now putting on “watch” and have a “stop loss” price where they will automatically be sold when the market hits a certain price.

In general, these portfolios are managed as if they have a long time horizon. We will stay invested in the stock market over the entire haul. However, we will watch for stocks that have either stagnated for a long time or may be entering a period of secular decline. Finally, some stocks we’ve nurtured back from earlier lows and I won’t be able to take watching them fall back again.

The last time we put this strategy in play was before the stock crash in 2007-8. We did sell some high flying Chinese stocks that never recovered those high prices again. However, you have to re-invest the money so even selling at a high doesn’t mean that you won’t necessarily lose money; it means you took the gain off the table (or avoided the loss) and then started with a NEW stock that was possibly over-valued at the time of your initial purchase. There is no free lunch, and that is why we employ this strategy sparingly.

How a “stop loss” works is that if a stock hits a certain price, a sell order is immediately issued. It doesn’t mean that it will sell exactly at that price (for instance if your stop loss is at $34 then that is when the order is triggered but it could get filled at $33 or any other price in that range depending on how quickly it is moving down). There is a variant with a “limit”, where you stop at $34 but say something like you don’t want it selling below $33. In that case, if the stock plunges on past your stop and the only offers are at $32, nothing at all happens. In my case I went for the simpler “stop loss” order.

These orders are outstanding for 60 days. After that time they expire, unless renewed. The hope is that the stock market continues to rise and we never trigger ANY of these orders. At that point I will review the market again and determine if I want new stop loss orders for these or different stocks and how to proceed next based on conditions and my specific stocks.

Stop Loss Trades Entered

Portfolio 1

URBN 28 shares at $34 good til December 6

Portfolio 2

ORCL 30 shares at $30 good til Dec 6

WYNN 6 shares at $150 good til Dec 6

URBN 23 shares at $34 good til Dec 6

Portfolio 3

WYNN 6 shares at $150 good til Dec 6

URBN 28 shares at $34 good til Dec 6

CLF 44 shares at $17 good til Dec 6 (updated)

Portfolio 4

ORCL 26 shares at $30 good til Dec 6

NUE 14 shares at $45 good til Dec 6

Portfolio 5

RVBD 30 shares at $13 good til Dec 6

No stop loss orders were entered for Portfolio 6

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Customer Protection in Brokerage Accounts

The Wall Street Journal has an article in their November 24, 2012 issue titled “Protecting a Small Account” with the tagline “What the Spate of Brokerage Blowups Means for Investors”.

The article discussed some recent events where brokerages went bankrupt or ran into financial troubles, specifically smaller or regional firms. They give some generic advice, such as research your firm or and carefully check your brokerage statements each month for evidence of unauthorized trades.

The overall risk is that if a firm goes bankrupt while holding your money, The Federal Securities Investor Protection Corporation (SIPC) provides the following guarantees:

The Securities Investor Protection Corporation protects customers against the loss of missing cash and/or securities in their customer accounts when a SIPC member broker-dealer fails financially. SIPC either acts as a trustee or works with an independent court-appointed trustee in a brokerage insolvency case to recover funds.

The statute that created SIPC provides that customers of a failed brokerage firm receive all non-negotiable securities – such as stocks or bonds – that are already registered in their names or in the process of being registered. At the same time, funds from the SIPC reserve are available to satisfy the remaining claims for customer cash and/or securities custodied with the broker for up to a maximum of $500,000 per customer. This figure includes a maximum of $250,000 on claims for cash.

The simplest answer to this potential risk is to split up your assets so that you don’t have more than $500,000 with a single brokerage firm.

However, there are downsides to doing this. For one thing, larger firms give bigger discounts as you consolidate assets. Vanguard, for example, gives a large number of free trades and provides lower cost mutual funds, along with other services. In order to get certain types of brokerage services at other firms it helps to be a larger scale customer, as well.

Based on a review of Vanguard, Fidelity and eTrade, the major firms also take out insurance with Lloyds of London for additional coverage beyond the SIPC minimums. Per Vanguard’s web site:

To offer greater protection and security, Vanguard Marketing Corporation has secured additional coverage from certain insurers at Lloyd’s of London and London Company Insurers for eligible customers with an aggregate limit of $250 million, incorporating a customer limit of $49.5 million for securities and $1.75 million for cash. Coverage provided by SIPC and certain Lloyd’s of London and London Company Insurers does not protect against loss of market value of securities. The policy provided by certain Lloyd’s of London and London Company Insurers is subject to its own terms and conditions.

In addition to a Lloyds policy, Fidelity describes additional protections available to investors at their site here. Key additional items:

Broker CDs, which are issued by an FDIC-insured institution and held in Fidelity brokerage accounts, are also eligible for FDIC insurance. The coverage maximum for IRAs and brokerage accounts is $250,000 per bank. All FDIC insurance coverage is in accordance with FDIC rules.

I inadvertently tested this over and over during the 2008-9 crash as CD’s I bought from high yielding bank through my brokerage account repeatedly failed and the cash investment, plus accrued interest to date, was transferred back into my cash account with every failure. I certainly wish that I had those high yielding CD’s back today, since interest rates are now below 2% even for 5 year CD’s, but I digress…

There are important exceptions to the coverage, including stocks bought on margin and futures contracts. If you are using these sorts of instruments then you need to do additional research.

Cross posted at Chicago Boyz

Market Timing on Debt

The historical “rule of thumb” is that markets are rational. This is likely true over some period of time, but not in the short run.

A recent article in the WSJ (more like a blurb, on the back page) called “The Big Number” described the current situation with junk bonds.

Yield hungry investors are making the bond market a welcoming place for even the lowest rated borrowers. The average yield paid by new triple-C rated issuers (i.e. “junk”) of corporate bonds in the third quarter hit a record low.

The current yield on new CCC bonds is 9.05%, down from 10.65% in the second quarter of last year. This is a decline of 18% in about a year, which is a giant decrease for a company considering re-financing.

In addition to being able to sell debt at the lowest rates in years, these highly leveraged firms are also able to find buyers for their debt (i.e. the market is liquid).

When the market freezes up, as it did in 2008, there are two main impacts – 1) the rates that everyone pays for financing in the short term move up sharply 2) there is little financing available for those that don’t have the strongest credit. In practical terms, #2 means that if you need money, it will cost you very dearly such as when Goldman Sachs had to borrow from Warren Buffet at a 10% preferred stock issuance.

While it is very difficult to determine the right time to buy and sell, there is no doubt that “market timing” is of incredible importance. If you have a highly leveraged company, these low rates and many yield hungry buyers willing to lend to you means that you can retire very high cost debt, load up on lower cost debt, and roll out maturities for many years, buying your company valuable time in case there is a recession or business downturn.

Today is literally the opposite point of time in terms of market timing from when Goldman Sachs was forced to pay 10% rates to Buffett; today even the lousiest company (in terms of credit ratings) can get funding cheaper than that (9.05%, per this article). This doesn’t mean that rates won’t still fall – if I could predict that I’d be on an island somewhere – but it does show the amazing difference in market conditions that just a few years made, without the economy itself changing in any substantive manner.

Who is buying all of this? Right now your bank account and CD’s effectively pay almost zero, and US government debt 10 years out is 1.6%. Thus for someone who wants income, an investment that pays 9.05% LOOKS a lot better than under 2%.

The flip side of loaning to the most highly leveraged, lowest rated companies, is risk. Risk can be business risk or their continued ability to find low rate financing (liquidity).

On a market timing basis, this is the best time for these sorts of companies.

Cross posted at Chicago Boyz

Faith vs. Experience and the Young

A recent Wall Street Journal titled “The Young and the Riskless” details how “twentysomethings” are not investing in stocks, but instead are putting their savings into less risky investments.  The tag line on the article is:

Twentysomethings are seeking safety from market volatility at precisely the wrong moment in their investing lives.  Here’s how to get back on track.

From the outset I was struck by the author’s presumptuous and scolding tone. I also like their strategic use of the word “volatility” instead of the more appropriate term of “losses” when describing market events over the twentysomething’s financially sentient lifetime, which would be something like the last 10-15 years.

Per the charts in the article

The percentage of young investors who say they’re willing to take above-average or substantial risk has declined from 52% in 1998 to 31% in 2011. 52% of investors in their 20’s who say they will “never feel comfortable in the stock market”. 33% of 20-somethings’ non-401(k) portfolios held in cash, versus 27% for all investors.

It is important to understand how “faith” in the market is typically defined in the popular financial press. Faith usually means putting your money in an index fund (or ETF), with low fees, continuing to do so regardless of market conditions, and relying on the belief that “in the long run” it will all turn out alright and you will be able to retire rich. The “financial calculators” have an assumed rate of return that you receive on your money, similar to the same calculators that public pension funds use, and they are typically “set” between 6% and 10%. Due to the “miracle of compounding returns” you can amass large sums of money in the future.

The problem with this mantra is that NO ONE has been winning with this strategy for a LONG time. What you see, instead, is that money put into the market is often battered immediately by volatility and is worth a fraction of what you put in only months prior. If you change jobs regularly (once every 2-3 years, as younger people often do) and are an avid 401(k) saver (which is recommended), many times when you pull out your money it will be valued far less than what you put in, or about even when the company match is taken into effect (depending on vesting). This can be demoralizing. I know that when I left companies in the late nineties and after the dot-com collapse I started putting more of my money into cash-like investment selections (despite warnings from my employers’ 401(k) educational materials) just because I hated moving balances worth a fraction of what I held back out of my pay when I left to start with a new company.

Also, in order to win “in the long run”, you have to stay with it in the short run. This means that when stocks plummet, you need to stay in the market and keep investing. If you decide to cut your losses and run, or stop putting new money in during market troughs, you don’t get the same benefits when the stocks rise later. This post I wrote basically said that no matter what you did in 2007, it turned out to be a loser, but if you bought during the trough in 2008 (or held throughout) you saw big gains later as the market turned back around (to where it was before). BUT if you didn’t stick with the markets, you didn’t benefit from these gains and ended up as a net loser. It is VERY HARD mentally to keep investing when markets are going down, but if you don’t buy low there is no way you can even conceptually win in the “long run”. If you bail, for sure you are going to fail, assuming you are following the mantra (which is what the WSJ article’s author was lamenting).

Kids see their parents’ struggles. Their parents have been believers in the markets, since the bear markets of the 70’s were replaced by the bull markets of the 80’s and 90’s. If you retired in the 90’s, after years of investing in the doldrums, you not only benefited from high interest rates which appeared to “goose” the compounding effect, but you also essentially did some great “market timing”, buying low and selling high. But the parents of today’s twentysomethings didn’t retire in the early 90’s, they kept working, and watched their investments suffer along. Now the parents’ are in a bind.

Not only did the markets get hit, but there isn’t really an underlying foundation of belief in WHY the market should do so great “in the long term”. In the past you could look at the track record of the US and show how we weathered recessions, panics and depressions, wars whether declared or un-declared, and always came out ahead. But today everything seems to be static or declining; our unemployment rate is high, we have high “real” inflation from commodity price increases (oil, food), and the cost of services like a college education or health care (if you can get insurance at all) is very difficult to bear. In order for the market to rise, the country needs to be productive, well run, and growing – does this seem to be today’s perception of American performance? This lack of an underlying narrative in why markets should rise of the long term (other than it has happened in the past), combined with the miserable ACTUAL performance during the last decade and a half, is killing confidence in the “long run” hypothesis that markets go up.

Another element of caution is that not only did stocks crater (or stay flat), but everything else fell apart too, in defiance of what the typical financial media said would occur. Housing became a miserable investment, rather than the guaranteed path to wealth that was painted in the press. Can’t you remember people saying that renting was “throwing your money away”? I remember having many, many people look at me in a dumbfounded fashion when I told them that I rented for over a decade when I could have easily bought. This thinking has obviously changed radically, despite record low interest rates (high rates would have made the housing problems unimaginably worse, at least in the short and medium term).

If kids travel, they can see how the “US Peso” doesn’t go far overseas. The dollars is worth a fraction of what it used to buy vs. the Euro, the Canadian dollar, the Australian dollar, or the Japanese Yen. The devaluation of the US dollar is another signal of our relative decline, along with our equity markets and housing markets.

The popular press’ scolding is going to fall on deaf ears until young adults see something out of their own experience that would convince them that stock investing is a winning strategy. The lack of anything except (comparatively) ancient charts of a world before the cell phone and the internet won’t sway them.

It really comes down to faith vs. experience. And among the young, experience is winning.

Generation X Addendum

This wasn’t mentioned in the article but a parallel trend I personally have noticed is that people of my generation (Gen X) are taking charge of their finances in their own way. Those with means tend to personally select stocks and get involved directly in their investing rather than “passively” investing through indexes (although ETF’s are part of their portfolio). While I am in the finance industry, many of my friends and acquaintances are not, but they have grown tired of bad and counter-intuitive advice and are taking matters into their own hands, in a variety of ways. Their particular strategies aren’t important – what is important is that they don’t believe the common wisdom and are taking responsibility for their own investment outcomes. In my opinion this is another manifestation of what the twentysomethings are doing, except by people with more assets to invest in the first place.

Cross posted at Chicago Boyz

The Long Run

The portfolios that we run on this site coincide with a market that effectively is a “do nothing” market.  We are basically flat over the last 13 years, meaning that there hasn’t been growth in the indexes since 1998.

The money that an index investor would have earned (i.e. if you put $100,000 in the SPY ETF or a mutual fund such as Vanguard’s VFINX) would have come through dividends, which averaged about 2% / year during the period.  Thus every year you received $2,000 in dividends (taxable each year) which means over the 13 year period you made roughly $30,000 (adding in compounding of interest) before taxes or maybe $24,000 after taxes depending on your bracket (and whether or not the 15% dividend received deduction applied during the period).

This is reflected in our results; while valuations fluctuate about 1/2 the total return of portfolio one, our longest lasting portfolio at over 10 years, is due to dividends.  When we look to select stocks a strong (and sustainable) dividend yield is an important, although not the only factor we look for in the “list of six stocks” that we pick from each year.

In the October 24, 2011 issue of Barron’s there is an article titled “It’s Cheaper the Second Time Around” that discusses the fact that indexes have been flat for the last 13 years.

The fact that we are struggling daily to hold above a level first reached nearly 13 years ago is both sobering and, viewed in the proper light, profoundly encouraging for true long-term investors… we are finally returning to a time of ‘stocks for the long run’… anyone who believes in mean-reversion investing has to consider the current starting point for equities at least somewhat attractive…

Jim Paulsen of Wells Capital was kind enough to calculate the 10-year forward return from all points in historry when the market was flat or down over the priod 12 yars.  The result: a 7.2% annual gain, versus 4.7% for all other times, not including dividends.

It is good that this analysis disclaimed the impact of dividends and yet noted that they are important, although if the yield is relatively consistent over time (which isn’t true, since yields go down when stocks go up, and vice versa) the analysis should hold true.

This type of investing approach is also a version of “market timing” – you should buy when items are cheap, and sell when they are expensive.  The most obvious example of this is housing; if you bought in 2007-8 you probably are regretting it right now – that same house probably would cost you a lot less to buy in 2011 then it did back then, for the same exact house.  It isn’t obvious HOW to do market timing, but the effects are real for anyone struggling to pay on an underwater mortgage today.

Like every good investment analogy, there is a counterpoint – Japan.  Japan peaked long ago, in 1989, and still hasn’t recovered to the highs.  In order to be a long-run investor in Japan you apparently have to be very patient, indeed.  Of course at some point investors are entering the market and they don’t care about recovering 1989 highs anyways.

For our portfolios here at the site flat returns mean a few things:

1) we don’t feel so bad at our struggles to raise values since the market has been poised against us

2) we have been right to focus on dividends, since they have been the only reliable source of cash over the period (relative to stock values)

3) while the analysis is more complex many of the overseas indexes weren’t flat over the same time frame; we have been putting up almost 1/2 our picks from overseas companies (US based ADR’s to keep it simple) in that same time frame

4) there is some hope that our patience will be rewarded if values increase in the next decade

It is All Market Timing

When I first started in investing one of the cardinal rules (for the general public) was “don’t try to time the market”.  From a practical perspective this meant that you were supposed to continue putting money in the market whether it went up or down and then hold for the long term.

Everyone knew that the market does move in cycles, such as the giant bust at the time of the great depression in the 20’s and the 30’s when stocks crashed, wiping out many investors.  Another classic example is the Japanese stock market which peaked in 1989 at around 39,000 before falling to a low of 7000 in 2009, over 80% below its high (today it is around 10,000).  Even the most cursory review of the chart shows that if you sold at the peak and / or bought at the trough (this hasn’t worked yet in Japan because the market hasn’t moved back up yet) you’d make a tremendous amount of money; but the popular wisdom is that it was “too hard” for an individual investor to determine when to enter and exit the market so don’t try at all.

To some extent “re-balancing” is a form of market timing, because as stocks rise in value if you practice the model you are supposed to sell off some stocks and buy bonds (or whatever else is in your portfolio, could be commodities or real estate) which accomplishes much of what market timing is supposed to do.  Re-balancing is more complex because it involves multiple asset classes which each have their own valuations but you could say that re-balancing is at least a “cousin” of market timing.

While everyone’s situation is different this graph shows Portfolio One, the longest of the portfolios that I run at “Trust Funds for Kids” for my nieces and nephews.   This graph neatly shows the immense power of market timing during the critical period 2007-2010.
Portfolio One History December 2010
In order to understand this graph, you need to know that we invest $1500 / year in each portfolio (I put in $500, the beneficiary puts in $500, and I match $500) so this is a classic “dollar cost averaging” model where we put in money at fixed intervals regardless of the markets’ performance.

In 2007, the market was mostly flat, and we made an investment of $1500 late in Q3 2007, right when the market took a punishing drop.  As you can see the value of this incremental investment was immediately devoured by a drop across all the stocks in the portfolio.  From a high of $14,000 when the investment was made in Q3 2007 (the scale on the right is in dollars) the portfolio skidded to a sickening drop of around $9500 in a matter of months, or a loss of over 30% by early 2008.

Since that nadir in 2008 at $9500 we have invested $3000 more in the portfolio ($1500 in Q3 2009 and $1500 in Q3 2010) so the “base” value ignoring any gains in the interim would be $9500 + $3000 = $12,500.  And now the portfolio is worth over $20,000!  Thus the portfolio gained $20,000 – $12,500 in value or $7500, a gain of 60% (calculated by dividing the gain of $7500 vs. the base of $12,500).

One thing that has been constant during this time is my “strategy”, which consists of picking from a list of (mostly) large capitalization stocks that is split roughly 2/3 US and 1/3 international in this portfolio.  Thus swings weren’t caused by a change in strategy or an improvement in my stock-picking capabilities (a topic of much amusement for Dan) – these changes were solely caused by a move in the aggregate market.

Thus what can I conclude based upon this experience – that market timing is pretty much everything.  ANY STOCK you bought in 2007-8 appeared to be a tremendous LOSER when the market fell out in late 2008-9, and ANY STOCK you bought at the nadir in 2009 is a WINNER today.  I am obviously exaggerating a bit here because some stocks rose or fell based on their own particular circumstance (think BP) but this rule cuts across the vast majority (90%+) of the total stocks in the market, especially if you have a relatively diversified portfolio like Portfolio One.

I’m not telling anyone anything that isn’t obvious to many people, especially professional investors or technical analysts.  There still is a large population of the general public, however, that are starting to wake up to this (they know their stocks got killed all at once and then rose) but in general they don’t know what to do with these hard-won insights.

For the portfolios I run for my nieces and nephews I am not going to a market timing method although I do try to sell off stocks I viewed as over-valued or stocks I think aren’t going anywhere.  Since I re-invest the proceeds into other stocks, however, the portfolios are still just as exposed to the overall market.  There are a lot of reasons for this but the main one is consistency, this model has generally worked and it is understandable to them (you work over the summer and we make regular investments) and these funds are supposed to be a help not their entire source of income and support.

If you did want to “time the market” there are a vast number of tools and indicators that you can use.  Pick up any trading or professional investment journal and there are myriad software applications and methodologies to choose from starting with the classic price / earnings ratio on to super complex methods that are way over my head.  I am not advocating any of this do your own research and your own planning but the performance of this portfolio neatly shows the impact of the overall market and how it generally dwarfs the impact of individual stock selections.

Cross posted at Chicago Boyz

Market Timing

In the past I, like many general investors, shied away from the concept of market timing. It was viewed as too difficult, and many investors left the markets when stocks went down and then missed the rally on the way up, essentially “buying high and selling low”. Instead, investors were advised to “stay the course” and keep investing, assuming that, over time, the rising markets would reward continuous faith with high returns.

An article in Sunday’s Chicago Tribune showed in a crystal clear fashion that, in fact, market timing is the ONLY issue for stocks, at least nowadays. This article shows stock performance for the top 50 stocks by market capitalization based in the Chicago region.

EVERY SINGLE STOCK is showing positive performance over the last 12 months! What are the odds of that, assuming that the stock market has its ebbs and flows? Very remote. The ONLY issue in the market over the last few years has been timing; everyone lost in late 2008 when the market cratered, and everyone who bought in at the trough made a lot of money. Likely to see this same article in late 2008 virtually 100% of the top 50 firms would be in negative territory over the prior year.

While I can’t say for certain what is driving stock performance UP (now) or DOWN (2008), I can say that virtually the entire market is extremely correlated with this phenomenon, as indicated by the top 50 stocks all being in positive territory.

Recent articles I have seen point to returns as being closely tied to the P/E level; when you buy into a “cheap” P/E market, you do well; when you buy into an “expensive” P/E market, you do poorly. While no one can say for certain what cheap or expensive really means, that broad theory is one that might be crucial to stock investing post 2000. In modern history (the last 30 years) there hasn’t been a long period where stocks traded in such a narrow range (around the Dow 10,000 level); but we need to decide how to weight the last few decades against the entire history of the stock market.

While I am not a professional stock adviser, the fact that 50 out of 50 of the top Chicago stocks (by market capitalization) are all up has to be a signal of some sort.

Cross posted at Chicago Boyz and LITGM