Saturday, October 18, 2008

Buy High & Sell Low /Retrospective on the Good & Bad

The general thrust of individual behavior is to buy high, when it appears to be safe, and sell low when panic sweeps the market. It is very hard to keep emotion out of investing decisions. Trim Tabs reported 75 billion was pulled out of mutual funds in September. Seeking Alpha Hedge fund redemptions hit 31 billion during the last quarter, with assets under management falling 210 billion. MarketWatch One would reasonably expect an acceleration of redemptions for October, when volatility has spiked and the losses have accelerated with some of the largest daily moves in stock market history, both up and down. I did a fair amount of mutual fund selling last year and early this year. You sell into strength, not weakness. You accelerate buying in bear markets and sell when it is frothy. 

Somehow the common sense approach of selling into strength and buying into weakness is just impossible for individual to implement as shown in the anecdotal reporting from this weekend. I do believe that the losses suffered this year will convince many to avoid the market and that is understandable, but I am a player and will always be one.  

One way that I have survived is simply to avoid making big allocation decisions all at once. I will invest the cash raised over the past year and half  only in incremental amounts, picking and choosing my spots as carefully as possible, realizing that I have no idea how deep the recession will be or how long it will take to restore confidence, which is in very short supply. I suspect the market will turn up strongly even when the news remains troubling. People will forget or push the memories of the last few months to the back of their minds, and that will help to start the process of buying stocks again. As Buffett said, if you wait for the Robins to start singing in spring time, it is too late. 

One modification that I will make to my historical approach is to wait until volatility simmers down before making a serious re-entry, possibly waiting until the VIX returns to less than 20 from its current level.  The use of this indicator was refined mid-year. Unfortunately, my model did not give me a clear signal to buy back the double short for the S & P 500 (SDS), missing the buy point by 1. With several months of the VIX below 20, I might even consider buying the double long ETF (SSO) for the S & P 500 to give me more potential upside, but that is only for those with a very high risk tolerance. Normally, in the past, I would dump all bond investments and re-allocate those funds to stocks. I will try to refrain from doing that this time, since I am running out of years to recover from these meltdowns. I will keep some individual bonds in my portfolio at all times from now on.

Part of the strategy will require that the short term notes which mature next year will not be re-invested in bonds but will be re-deployed into stocks. These notes are arranged in a ladder out to 2015 so I would anticipate buying stocks or stock ETFs will all of the funds generated from these short term notes coming due only in 2009 and 2010, unless there is a catastrophic external event that causes me to develop serious and new concerns which can not now be predicted or even contemplated now with a hyperactive imagination.  

The bubble mania in 1999 was a clear get out of the way indicator. It was not just internet and tech stocks. Stocks like GE were selling at one point at over 40 times earnings for example. Prior to the current meltdown, the market was not over valued like it was in the 1999-2000 period. This recession is caused by the most serious  credit crunch since the Great Depression that has its origins the creation of a hyper state of leverage, particularly by investment banks reaching 40 to 1 debt to equity in some cases, and the careless, irresponsible and incompetent way that leverage was used to create and inflate a housing bubble, with housing prices rising to levels that could not be sustained by growth in income. A related problem, and of equal importance, is that the instruments created by Wall Street are so complex that they can not be valued and are not understood by the very people that created them.  This causes all financial institutions to cease trusting the balance sheets of all other institutions. This is discussed cogently by the 92 old economist Anna Schwartz in this weekends WSJ. WSJ.com

When housing prices increased at 20% compounded,  which happened in numerous markets from 2002 to 2006, with wage growth barely keeping up with a rise in inflation, reality had to set in eventually, though it always seems like a long time in real time living it, and  thereafter bring prices back down to the level of affordability. The parabolic price rises in home prices in places like California, Florida, and Nevada were caused by the expansionary money policy of the Federal Reserve under Greenspan and the easy credit facilitated by the banks, with the investment banks playing the critical role in financing the expansion and eventual destruction of the non-bank mortgage lenders.  Ms. Schwartz is very critical of Greenspan and deservedly so.

The mutual funds that I wanted to keep long term were sold down to 100 shares when the value of those shares exceeded $3,000 or to $3,000. Most of this selling was done when the Dow was between 12 to 14 thousand, with several total eliminations during the summer and fall of last year. I will now start to buy again shares of some mutual funds  with the minimum allowed for purchase, and buying slowing, with no more than two or three adds per months, usually only on down days. I also substantially cut my individual stock position prior to the meltdown. Instead of relying on mutual funds for broad stock exposure, I will park most of my new money in individual stock selections and low cost stock ETFs. I am not impressed with these highly paid managers losing 40 to 50% this year. The S & P is down 35%.  I will buy within the next six months two Vanguard ETFs that I sold last year- the Vanguard Large Cap ETF (VV) and the Vanguard World ex US (VEU), both are very low cost ways to get broad exposure to the markets. The Ishares ETF  for the total stock market (IYY) will also be bought back at some point.   

It is time for a retrospective on where I went wrong after having summarized what I did right. 


 In retrospect, I made  at least four mistakes, with the fourth one being the largest. 

First, I thought that I was being conservative by switching some funds from a growth fund into a balanced fund. If it has stocks, even a 60% allocation to stocks and 40% to bonds, it will be hit hard during a bear market for stocks, so I have still lost by switching from Janus Contrarian (down 44%)  to Janus Balanced (down 18%), though the loss in the balanced fund was less than 1/2 as much. Many 60/40 balanced funds are down 20% to 30% so far this year and many growth funds like Fidelity Magellan are down close to 50%. The Fidelity Balanced fund is down 30% this year which is awful and I do not own that one. I will keep the Janus Balanced fund and add to it now. But, in the future, when I get as worried as I was last year, I will not look for safety in a balanced fund, but will simply move that money to cash and keep it there until the issues causing me concern are resolved.

Second,  I switched some funds from a growth stock fund to a bond fund, particularly two from Loomis Sayles that were rated five stars by Morningstar. For comparison purposes, I would note that the Vanguard Total Bond market index fund is down 1%. For safety, I placed close to equal amounts in the Loomis Sayles Retail Bond (down a pathetic 26%) and their Global Bond fund (down a less pathetic 13% but still bad). I pay them for those returns.  I have positive returns picking my own bonds this year.

From now on, I will go with bond ETFs for broad coverage, particularly in areas where I do not buy individual bonds like inflation protected bonds (TIP) and (WIP) and foreign government bonds (BWX) and from now on I will rely on myself to make individual bond selections since I am doing far  better with my choices operating out of a home in the SUV capital of the world than these so-called highly paid experts. I will therefore not dive for cover into a bond mutual fund or a balanced fund in the future. Losing a little less money is not the option that I was looking for this year. 

Third,  after becoming concerned, as it turned out rightly so,  I started to  invest and kept investing  in one of those funds that change the investment allocations based on a selected year for retirement, and then changing the investment mix as years go by to become more conservative. I thought that I was being conservative by selecting one with a retirement in 2010 which was the most conservative choice.

I dumped some of the funds raised by selling other mutual funds into that one rather than into cash and have suffered  to date a 25% decline. If I could do it again, I would not have started any new mutual fund investments until a bear market was close to a year old, as is the case now and then I might add to it monthly, and then stop two years after the next bull starts. I will keep the fund and hope for better results down the road.     

Fourth, I call this one the biggest mistake this year. I did not make any adjustments in my holdings of closed end investment companies which is one of my top 10 categories of investments when I soured on the market. Now, I have to adjust my strategy to dig myself out of this hole. I will reinvest dividends from most of the closed end investment companies presently owned  during the remainder of this bear market, and I will stop doing that after the second full year after the commencement of the next bull market, reverting to cash dividends at that time.

When it is obvious to me that the bull is extended or on its last leg,  I will sell them all, every last share, and this will probably be  signaled by a signal from the VIX that trouble lies ahead, as noted in my previous very extended discussion of this signal in prior emails.  That would occur after a prolonged   bull market pattern in the VIX which breaks to the upside as it did in 2007. It clearly gave two warning shots before the onset of the current bear market in October 2007. 

 I kept my closed end funds this time, which was a major mistake in retrospect causing much of the losses suffered this year as a result of a double whammy, the fall in the market plus a widening of the discounts to NAV. Discounts to NAV hit unprecedented levels earlier in October 2008, with closed ends routinely selling at more than 30%  discounts to asset values. That is part of the opportunity and the risk with this asset class.

Eventually, the discounts will narrow to more normal levels, but that phenomenon, caused by widespread individual investor panic, and individuals are the main holders of these funds, has accelerated my losses in this category of investments this year.  My thinking was that the ones selected, which paid large monthly or quarterly dividends, would actually provide me with downside protection.

In fact all them actually contributed significantly to my downside this year. My strategy now with them is to reinvest the dividends to buy additional shares during this bear market and then sell them all when I receive another signal from the VIX of a transition from a bull to bear market. I will just call this strategy a closed end fund bear market accumulation phase with total liquidation when a transition signal is first given by VIX  during what I have previously called the Transition Phase to a bear market.

In other words, I will not hold one share when the VIX signals an approaching bear market but will buy them back slowly when there has been at least a 20% correction or more. Their discounts to NAV are appealing now so I may selectively add to them in addition to reinvesting the dividends. The ones currently owned include several that sell call options and/or broad based indices to hedge downside risk including ETW, EOI, IRR, IAE and BCF. I thought the call option strategy would give me more protection but this proved not to be the case. I also own a fund devoted to stocks based in Switzerland like Roche, Nestle and Novartis (NVS), called the Swiss Helvetia fund (SWZ). SWZ.com - Swiss Helvetia Fund 

I took a starter position in JQC, as mentioned in a prior post, and traded in and out quickly on two others, FAX and AGC. One that has been good until this year is the Royce Value Trust (RVT), for small cap exposure. Royce Value Trust I have been using Evergreen International Balanced for exposure to international stocks and bonds, and this one pays a monthly dividend. International Balanced Income Fund - Fund Holdings Most of these funds are high yielding and that was part of a strategy to generate income and hopefully manage the investment by buying at large discounts and then selling when the discount to NAV narrowed, generally to less than 10% or near zero in some cases, thereby making a profit on the shares and keeping the large dividends. It worked until this year so I changed the strategy as outlined above. You have to be flexible and to learn from the past, being rigid, inattentive and careless are not prescriptions for success in this often treacherous field.  

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