Flat Lining

May 4, 2008 by  


By Bob Wood, MMNS

Anyone who reads this column regularly knows that I have recommended a basket of holdings, which, I believe, will perform well for investors including them in their portfolios. With “perform well,” I don’t mean to imply an every day occurrence! The holdings I recommend as “best investments” should increase in value over time — but not at all times.

Occasionally, I take calls from clients about some investment, asset class or fund held in my managed accounts. Some will invariably notice that one or more of their holdings is not rising higher — as they expected. What I preach to the impatient is — patience. Lack of patience may have much to do with how few investors actually earn returns that match their expectations.

To explain, I’ll begin with one of my current favorite asset classes, one that I have included in managed portfolios for the past six or seven years — precious metals. I often ask investors how they would like to own an asset that has increased from just over $70 to more than $200 in just under five years. Sounds great, doesn’t it?

This performance describes the Philadelphia gold and silver index, symbol XAU. To review it, you can run charts on most financial web sites to produce the same chart I am looking at right now. Keep in mind that, over that period of time, the S&P 500 index has risen by about 50%, which is not a bad return, though well behind gains seen in precious metals shares.

What I want you to focus on now is looking closely at the chart for the gold stock index. You will see a noticeable pattern. Those shares rarely move in a nice, steady rise higher; instead they tend to move in fits and starts. This, I think, is the pattern that often hurts investors. They expect whatever they buy to move consistently higher. If it fails to do so, they dump the shares and go in search of something that is moving higher.

At the start of the five-year period for XAU, this index rose from 60 to about 110. That’s a nice move, which no doubt got many investors’ attention, especially from those who had yet to allocate money into the sector. Market trends tend to show that, once the crowd of latecomers rush to get involved, the holding reacts. In this case, the index fell — down to about 75. What a bummer!

Yes, this is a rather typical occurrence. Early money sees an opportunity missed by the crowd, buys into it, and enjoys a nice run up as the latecomer crowd pushes it even higher. The early (smart) money sees solid gains and begins to scale back — or take profits, as the financial media describes this process.

Often, latecomers become discouraged when whatever they just bought falls in price and produces losses. Then, many latecomers sell in frustration, which pushes prices even lower. Meanwhile, early investors watch with delight as their former holdings are again priced low enough to produce more solid gains, so they re-invest.

That new flood of money pushes prices higher, and the previous cycle repeats again. From our starting point at 60 in early 2003, gold ran to its first peak of 110 in about one year. From there, it went to a low of 75 in mid-2004 and then rallied back to the previous peak in late 2004. But then it fell back again, testing the previous low of about 75, in mid-2005. Those shares again hit the previous high of about 75 near the end of 2005, after almost two years going nowhere!

Imagine the distaste for this sector by investors who rode its shares up and down over that two-year period when other asset classes were going higher. Imagine how many investors became discouraged with the precious metals sector while they were undoubtedly hearing stock market promoters in the financial media explaining that gold and silver do not pay dividends or produce profits. They called them ‘’barbarous relics,’’ or other names they gives those things that do not sell.

Imagine the horror now of those investors who sold their precious metals in the summer of 2005, when the outlook was bleak with shares riding a flat line to nowhere. About one year later, those same shares have rocketed higher to the 165 level, trouncing nearly every other asset class in their portfolios!

Isn’t that always the way? Of course, as the gold index was hitting a new high level in mid-2006 and the crowd was hearing anew about the great rise in precious metals shares, in they came again. So profit takers sold their shares to the latecomers, and, once again, the index fell — to about the 120 level. It then stayed, until mid-2007, trading in a range from about 120 to above 150, then going down, and then shooting up again, frustrating investors again and again.

Do you see a pattern developing? Precious metals shares tend to run higher for about a year, much higher in each case, only to spend the following 18 to 24 months moving sideways in a price channel. When the crowd loses patience and sells, with the hope of finding a faster-moving investment — something with price momentum, metal shares again run higher.

The gold index hit bottom again and again, finally bottoming out again at the 125 level in late summer of 2007. From there the index has raced higher for about half a year, topping out at about the 210 level.

Would anyone be surprised to see this index trade in this range for the next year or two, only to shoot higher after the crowd loses patience again? I certainly expect that to happen and have, accordingly, reduced my precious metals allocation by a small amount. But when stepping back to review the past — in calmer moments, we see that, over the past five years, this index has been a huge winner.

As with any secular, long-term bull market, I expect advances in the precious metals index to run higher for the next several years. Just that like anything else in the markets, it will never go straight up — or down. The markets have an amazing way of spooking investors out of their best holdings — at the worst possible time.

But we do it to ourselves, don’t we? Too many investors fail to take the longer view with their holdings. I chose to invest in precious metals while thinking they would enjoy a long-term bull market, based on fundamentals that are only getting better with time.

And yes, I see the same pattern for some other asset classes that I have recommended over the past few years. Look at patterns for energy shares and international and emerging markets stocks and bonds. I had been a big fan of the Indian market until the start of this year, when I judged that investor enthusiasm for that country’s shares had become too high and valuations looked too rich. So, aside from the one stock I still hold in that market, Tata Motors, I have left it.

But that doesn’t mean I won’t buy there again someday. Unlike the precious metals sector, current fundamentals for the Indian market are not as robust and durable. With the Financial Times newspaper now quoting the Indian market as selling for about 22 times earnings, the time for moving out was right.

Along with that high valuation came last year’s fad for mutual companies to take advantage of whatever had done well. So mutual funds focused on the “BRIC countries.” That trend led me to scale out of holdings in those places (Brazil, Russia, India, China) and look to European markets as alternatives.

Someday, with current losses seen in the Indian and Chinese stock markets, investors will again lose patience, and those prices will revert back to favorable levels of valuation, when, once again, I’ll invest there.

Of course, what unfolds there may well look much like what we’ve seen with precious metals shares, with sideways trading for a year or two. Then those markets will find favor with bargain hunters, after the crowd has fled to better performing sectors.

I could very well have stayed invested in BRIC countries, and, over time, they may all move much higher. I anticipate the day when I will load up there again. The power of secular, long-term trends is the stuff of investor dreams. But many lack the required patience to ride those 15-to-20 year rallies to greater heights. Bouncing from one hot sector or country to another almost never works as hoped.

Find one or two sectors or asset classes that look best, based solely on the fundamental stories behind them, take your positions and ignore the markets for another 10 years. It might be the easiest and most profitable time in the markets for you in a long while. Look for those formerly “hot” sectors that have flat-lined for a few months as opportunities to prosper. They are not signs of pending death!

Have a great week.
Bob

Bob Wood ChFC, CLU Yusuf Kadiwala. Registered Investment Advisors, KMA, Inc., invest@muslimobserver.com.

10-19

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