Our Thoughts on the Market - A Normal Market

A "NORMAL" MARKET?

Excerpted with permission from Dorsey Wright and Associates

One of our long-time clients sent us an article from the Wall Street Journal that was written by a Staff Reporter and titled, "A Normal Market? There's No Such Thing." It immediately made me think about how investors long for the good ol' days of Red hat (referred to as 'Red Hot' back in the day) appreciating in value from $100 to $280 without a downtick, and the years of the Dow Jones producing back-to-back 20% gains; because those were "normal" days, right? It's like the classic novella, "Who Moved My Cheese," where Hem and Haw keep going back to the same place they remembered their cheese being located. Each time they carry the same expectation that their cheese will be right where they left it, and each time they find themselves in utter shock that it has been moved. They continued to return back to the same place each day, expecting the cheese to miraculously appear, while taking no action of their own to facilitate the discovery of new cheese. As it turns out, the cheese never did miraculously appear and eventually they were faced with the grave reality that the cheese had been moved and wasn't coming back, at least not while they were still around.

Hem and Haw learned that cheese can remain gone far longer than they could remain vital, just as investors learned in recent years that the markets can remain "irrational" far longer than they could remain solvent. Investors, similar to Hem and Haw, got used to a certain "if then" relationship from the late-90's and expected it to continue year in, and year out. If we bought tech stocks, then they would go up . . . if not in a few hours, then most certainly in a few days or weeks. And on a far greater scale, we had virtually a 20-year bull market where anyone could have made money just buying stocks like Coca-Cola (KO) or an index for that matter. As long as you didn't get shaken or stirred from the righteous path of "buying and holding," or dissuaded into any risky "market timing," your investments would survive any near-term blip on the radar screen and move to new highs. Then, all of a sudden, the cheese was moved.

A bear market set in and most brokers and investors had never seen this happen before, they knew nothing of the bear market people kept talking about. Sure, we'd been through recessions in the 80's and 90’s that was nothing to even raise an eyebrow about and certainly didn't mean the market had to stay down for any length of time. The new-fangled bear market was confusing at best. Most brokers continued with the buy and hold mantra they had grown up with, and the only real difference was that this time it didn't work.

For anyone who has read even the Cliff's Notes version of stock market history, you know this isn't the first and won't be the last major blindsiding for investors. In fact, this was no different than the time when the only time to buy a dividend yielding stock was when the yield rose above that of bonds. This was the status quo for investing back in the mid-1950's. It seemed pretty simple back then, I would imagine, you simply bought stocks when their yield rose above that of bonds. When their yield declined below that of bonds, stocks were considered expensive so you sold them and bought bonds instead.

That is what you did because that is what worked. Bonds to stock, stock to bonds, and so on, back and forth. That worked right up until it didn't, when the cheese was moved. The Wall Street Journal did not herald this change, there was no committee assigned to determine the validity of this relationship between stocks and bonds, there was no OJ Simpson-like trial to determine if the glove fit or not, it just happened.

As time went on, investors began to evaluate stocks on a total return basis, dividends and appreciation rather than just dividend yield. Those still adhering to the old mantra of selling stocks and buying bonds when bond yields surpassed that of stocks got hammered. They learned the ability of the stock market to be irrational, and also the ability to stay that way.

Even some of the smartest people in the world were caught waiting on cheese that wasn't coming back; the Yale University Endowment fund is a great case in point. They sold stocks that continued to go straight up and bought bonds that did nothing. Their cheese had been moved and the investment world had changed, those still adhering to the old way of thinking lost out for their inability to adapt. For years a set of outcomes had become truth to investors, ingrained in their minds before being proven invalid by a free and open market. Change is difficult, but imperative for anyone who invests across multiple paradigms.

Today Mr. Jones is still looking for the good ol' days I think. Why not? After a few killer years we had a strong rally in 2003, why not just keep the spirits up and the bets on the table? Heck, we feel the same strain of human emotion here; after all we were there for the whole ride and still have some of the T-shirts to prove it. Mr. Jones now looks at his 401K and sees that it's basically where it was back in 1998, give or take a good or bad decision along the way. Mr. Jones knows he's not Warren Buffett by now, but he doesn't really consider that he has actually lost ground. The market went up, the market went down, it then went up again and here we are back where we were in 1998. Of course he has been putting money in steadily, as has his employer and he fails to see that the gain in his portfolio from its lows is generally due more to his own deposits rather than appreciation. Be that as it may, his cheese has been moved and some will probably never accept or admit that.

The WSJ article makes a lot of sense when it suggests that for many of us accumulation of assets in a stock account only come after age 50. This is because of the demands of buying a house and providing for college education of our children. This is probably why 75% of all wealth in America is in the hands of those 50 or older. Two decades after we turn 50, or even 1 1/2 decades, we begin to take money out and cease putting it in. So how the market reacts over this ensuing 1 1/2 to 2 decades is critical to our retirement. "Hope Springs Eternal," but reality is what is. A bad 20 year stretch where the reality of stock market returns are more like 1.5% annually, like it was in 1929-1949, is devastating to Mr. Jones's one shot in this life at a comfortable retirement. At least it is when your asset allocation advisor told you to sit back and wait for your 10% a year check to come in the mail.

I urge investors to ask themselves "What if?" What if it just doesn't pan out to be a 10% return over the next 15-20 years? How will you deal with that? Maybe being proactive is the answer. Perhaps you can't send in any more money than you do. You still have two kids in college, bills to pay, you can only send in what you originally planned for each year. On top of that, you may not feel particularly lucky these days, so raising the volatility in the account to compensate for lost time is not appealing either. So let's look at an alternative method of trying to attain that 10% return while managing risk. It's called covered call writing.

This strategy helps to manage risk in your stock portfolio as it provides some downside protection. It offers money upfront, as well. 

For those of you that have heard my real estate analogy, this will ring a bell.  As an example, you purchase a home for $200,000 and over time watch its value rise to $300,000.  You are concerned about protecting the value in your investment, but don't want to sell just yet.  One day, someone comes along and makes you an offer. For the next 4 months, they would like the right (not the obligation) to buy your house for $325,000.  In return for this “option”, they will hand you a check for $15,000.

There are 3 possible outcomes: 1) Over the next 4 months ,the home prices in your neighborhood stay flat,  your buyer declines to purchase your home for $325,000 and you keep the $15,000. 2) Home prices in your neighborhood actually go down a bit.  Your buyer again declines to purchase your home for $325,000 and you again keep the $15,000.  You have protected the value of your investment against a price decline down to $285,000.  3)  Home prices continue to move higher.  Your buyer exercises his right and purchases your home for $325,000.  These dollars combined with the $15,000 check gives you a total value of $340,000 for a home you paid $200,000. Covered writing is a way to earn extra income and hedge your stock portfolio in a down to sideways market.  It is not for everyone, but it is a strategy to consider while managing your risk and trying to attain that 10% return...

One of the many services we offer at Garretson Financial is helping our clients manage risk in their portfolios.

Please give us a call if you would like to learn more about how we can help you.

Options involve risk and are not suitable for all investors.  Prior to buying or selling an option a person must receive a copy of the Characteristics and Risks of Standardized Options (ODD).  Copies of the ODD are available from your Broker, by calling 1-888-OPTIONS, or on the web at http://www.options clearing.com/publications/risks/riskchap1.jsp. The information in this article is provided solely for general education and informational purposes and therefore should not be considered complete, precise or current.  No statement within this article should be construed as a solicitation for or a recommendation of the purchase or sale of any security.