Row Your Boat

August 17, 2006 by  


By Bob Wood

As readers of this space know by now, I remain as firmly in the bear camp as ever when it comes to the domestic stock markets. I just don’t see how a tradition relative return oriented investor can hope to make a reasonable risk-adjusted profit given the economic fundamentals and average valuations on the shares that make up the major averages. But there are always options and for those of you who find yourselves in the midst of your prime earning and savings years. Consider rowing instead of sailing your way to better returns.

I steal this analogy from a new book on investing by Ed Easterling, called Unexpected Returns. He is, as I am, a believer in absolute return methods the power of secular trends. Those longer term trends are the golden opportunities for investors. Since most savers are at their peak earnings years for a relatively short span of 20 or so years, finding a bull market in one asset class or another at the right time is vitally important.

As seen on page 206 of this book, “Absolute return managers want to make profits not only when the wind is at their back but also when it changes and becomes a headwind. Absolute return managers will therefore use risk management and hedging techniques. From the point of view of absolute return managers, relative return managers do not use risk management, and do not manage assets as they follow benchmarks.”

The saver who began in earnest in 2000 might become frustrated at the sight of his or her monthly brokerage statements, showing so little gained for so much effort. What happens to the hopes for financial security should this saver endure a bear market of several years, like the three secular bear markets seen in domestic stocks in the past century?

And as history clearly shows, investors are anything but rational during times of duress, as is common when returns do not match with expectations. So what options exist for the frustrated investor here, especially when the domestic markets head lower in what stock market veterans like Richard Russell and others are sure is the beginning of the “next leg down” or the resumption of the secular bear market begun in 2000?

The idea alluded to is that longer term trends have typically played out in three stages. The secular bull market, like the one that investors enjoyed here from 1982 to early 2000 is usually followed by a cyclical bear market, lasting from a few months to a few years. At some point, stock valuations become more compelling than they have been in several years, tempting investors to go bottom fishing. I did a lot of bottom fishing myself in the summer of 2002.

The problem with this scenario is that at the end of long term bull markets, valuations get so extended that even after a bear market cycle, valuations are still far above those typically found at the beginning of secular bull markets. At the start of the three secular bull markets of the past century, the average stock sold for less than 10 times earnings. That has yet to be the case here, but relative to the end of the bull market in 2000 when the S&P 500 sold for close to 30 times earnings, stocks appeared cheap to some.

But past secular bull markets have always ended with the major averages selling at or above 20 times earnings, where the Dow Industrials now sit, and slightly above where the S&P 500 sits. As for the Nasdaq 100, who knows what the average valuation is since their accounting methods are so suspect?

So the second leg of the bear market begins, followed by another failed attempt at a meaningful rally, whereupon the third and last leg of the secular bear market begins and takes most investors out of the stock markets for good.

So it is rather easy to see where the difficulty lies for investors now. And Mr. Easterling describes the dilemma with the sailing analogy. During those secular bull markets, all that is required is patience. The markets are headed higher due to investor confidence, followed by investor greed. All that is needed is for savers to plow as much money into stocks and mutual funds as possible and ride the wave. It is like sailing when the winds are up.

But secular bear markets are akin to sailing when the winds are calm or in your face. Without an inboard motor of some kind, you’ll either sit there for as long as it takes the winds to freshen, or go back in time, technologically speaking, and start “putting your backs into it” and begin rowing. And these are the times when rowing is the only way to make a reasonable return on your savings, put at risk in the hopes of outpacing inflation. But with a headwind, even rowing becomes a labor of dubious value.

So Mr. Easterling advises that you all consider something else that I have harped on ad nauseum in this space for the past 3+ years, that of thinking in terms of using an absolute return strategy as opposed to trying to beat a more typical benchmark such as the S&P 500. After all, what do you care if you beat the market in a down year if you lost money doing it?

This involves a different strategy than you are used to, and maybe a lot different than your broker or advisor is used to, or comfortable with using. In the simplest terms, it involves ignoring all that “stocks for the long run” nonsense and keeping a larger than normal portion of your portfolio in cash, reducing risk and downside potential.

Another method and one that I continue to use with great success is hedging. Since we don’t know for sure which way the markets will go in the next few months or years, why not own things that will benefit either way? After all, Greenspan used the term “irrational exuberance” in 1996, which may have spooked investors out of stocks three years before the bull market ended. A hedging strategy would have kept those investors involved, if only to a lesser, but safer extent.

I have covered some hedging strategies here before and won’t repeat those ideas again for this installment. But Mr. Easterling is sure that the investor who is rowing now, making the effort required that is not needed in a bull market are the ones who will enjoy earning returns that more closely meet with expectations, while of course, reducing downside risk that traditional sailing investors accept in full.

Of course, I always look to go my own way since running with the crowd never seems to work well. And how many investors are hedging, or buying shares in hedge funds, or funds of funds peddled by their brokers? Too many, I am sure.

But there is another way. And while it involves hedging, the method I use involves hedging in asset classes that are all in the midst of their own secular bull markets. So for the holdings on the long side of my portfolios, the wind is at the back of the investor. But the same thing can be said of those options used as hedges!

While I am now net short in all accounts, the hedges being employed all look to be moving with the wind, riding the waves as it were. Has anyone noticed that as of today, August 12, some of those bear market mutual funds recommended here like the Prudent Bear fund or the Rydex OTC Short fund are up double digits, or about 14%?

In a secular bear market, the wind is at the back of those funds as they ride the next leg down. Stocks sold short in my model accounts are also enjoying a return to valuations that more closely resemble reality. All I have to do is sit and wait patiently. The market is coming my way there.

As for the long side, those sectors that dominate include energy, and sectors that look better from a fundamental supply and demand standpoint. Of course, the winds do not blow at a steady pace. Too many investors get spooked out of their best holdings at the first sign of weakening, not appreciating the nature of favorable breezes.

Given the precarious nature of our collective finances, and the recent article in the USA Today about the federal government’s use of two sets of books showing the size of the federal budget deficit, it is becoming obvious that America is essentially bankrupt, not having anywhere near the resources needed to properly service our debts and retirement obligations.

So massive money printing is the obvious solution since our elected leaders always seem to opt for the easy, quick fix. So the winds behind investors in commodities like gold and other mined materials looks to be among the strongest. And with our largest corporations and employers of labor fleeing to lower cost locales like India, China and Eastern Europe, don’t those economies look to be in the early stages of economic strength?

So my own version of managing risk and looking for market beating returns simply involves finding better markets to work with. And in each sector or asset class, the basic fundamentals, on both the long and the short side look as compelling as any I can find, looking the world over, or as chess players put it, “seeing the whole board” of investing opportunities.

The wind is at the back of each stock or mutual fund I hold, or why else bother with them? Hey, I’m just like you or anyone else. Why work harder than is needed? And who really wants to head out onto the lake and spend the day rowing? Sailing is supposed to be just that, riding along and letting nature do the work. It’s supposed to be fun even. But rowing into a head wind is another story, and one I’d rather not spend my time trying to explain the merits of as more traditional managers have to now.

Have a great week,
Bob
Bob Wood ChFC, CLU Yusuf Kadiwala. Registered Investment Advisors, KMA, Inc., bwood44@tampabay.rr.com. •

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