Lessons From a Brutal Bear Market

By on June 3, 2007

Originally published in May 2003:

INDEXES ON 5/29/03

DJIA 8,711.18
S&P 500 949.64
NASDAQ 1,574.95

Lessons From a Brutal Bear Market

Describing this as a newsletter is a bit of misnomer. This really can’t be called a newsletter since the news isn’t being reported here. It’s more of an idea letter and sometimes the ideas are good and sometimes they’re not so good.

The past 3 years was an inevitable, brutal experience, but can provide valuable lessons for the future. A traumatic bear market causes one to question investment theses developed over the years and seek ways to improve returns while mitigating risks. There is no way to achieve consistently high returns without making what appear to be very risky moves at critical junctures. Anyone who says they can completely mitigate risk while beating the market is selling snake oil. There are lots of charlatans on the loose in the investment world who try to convince their followers that they can do the impossible; which is to predict the future with any consistency.

One important lesson learned over not just the past year, but over the past 3 years is that screening for what appear to be cheap stocks is a way to set oneself up for fraud and deception by management. I won’t go into the tedious specifics, but several positions purchased in the aggressive portfolio have been unmitigated disasters because management was lining their pockets while disclosing completely false and deceptive financial information. How do you protect yourself from this kind of fraud? One seems to require more diversification than most academics have implied is minimal to avoid portfolio devastation. It has been claimed by the proponents of Modern Portfolio Theory that, based on an efficient market, 15 randomly chosen stocks will tend, as a portfolio, to have only about 5% more risk than a randomly selected portfolio of 100 stocks. The theory appears to be anchored in an ideal world where management is not working entirely in its own interest through any deceptive means possible. My belief now is that it is better to have over 40 positions to protect against blatant management misdeeds. In order to achieve this increased level of diversification Exchange Traded Funds (ETFs) and Closed-End Funds trading at large discounts to Net Asset Value (NAV) will be utilized to a greater degree when buy signals are triggered. Screening for cheap stocks based on PE, book value or yield as a practice of stock selection will be discarded since this often leads one to stocks where there is some unexposed fraud waiting to be unleashed after a position is taken.
In keeping with this alteration of investment philosophy on diversification the position of Town and Country Trust (NYSE: TCT), held in the conservative portfolio, was recently liquidated and will be replaced by the iShares Cohen and Steers Realty Majors Index (AMEX: ICF) at some point in the future when a buy signal is provided by the system. This does not mean to imply that the management of TCT is anything other than honest, but having one position to represent an entire sector, that being Real Estate Investment Trusts (REITs), is simply not prudent given what has occurred with the likes of Worldcom, Bristol Myers Squibb, Elan and Mirant.

The market currently is giving the bears fits because it is on the verge of breaking out to the upside into a new bull market. My best guess is that the market will trend higher from here based on a couple of factors; 1) measuring the earnings yield of equities against 10 year treasury yields shows stocks are undervalued historically by a substantial degree (by as much as 50%), 2) The 3rd year of the presidential cycle is strongly biased to the upside for stocks. Of course, there are all sorts of things that could go wrong, but I don’t know of any time when this wasn’t the case. Deflation has been the buzzword used lately, and if it gets out of control and actually has an impact on consumer’s purchasing behavior we could see a major setback for economic progress and the stock market. Falling prices can impact decisions on whether people purchase items in the immediate future or delay purchases expecting prices to fall further. This could cause a disastrous feedback loop in an economy experiencing high debt levels by consumers and corporations. Hopefully, the Federal Reserve and government can stave off this possibility through stimulative means. The recent tax cut was a good step in this direction, but my feeling is that it will take more than that to get the economy out of the doldrums.

In keeping with the adage, “sell in May and go away,” the allocation to stocks in the aggressive portfolio will be reduced by approximately 15 percentage points today. As mentioned in the past here, the May through October period is historically weak. This tendency of the market is definitely not foolproof, but given the unusually high allocation of the portfolio to equities, it would appear to be a prudent move to reduce positions at this time. Therefore, Elan (NYSE: ELN), Advanced Micro Devices (NYSe: AMD) and Bristol Myers Squibb (NYSE: BMY) will be sold. A reciprocal buy signal will provided sometime in October to raise the allocation by 15 percentage points.

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