Entering The Most Dangerous Market Phase: In Three Parts

Entering the Most Dangerous Market Phase: In Three Parts by A. Michael Lipper, CFA.

Many years ago I heard an unoriginal line in the elevator (the “lift,” for my British friends) coming down from the New York Stock Exchange Luncheon Club. “Do you know how to make a small fortune?” the old floor broker asked — then he quickly supplied the answer. “Start with a large one.”

There are two important axioms about a major stock (and bond) market decline.

Big losses are only possible after big gains. This is not quite as earth-shattering as Sir Isaac Newton’s discoveries. But the result to one’s portfolio is indeed grave.
Historically, by far the biggest loss suffered by investors is not the decline from the peak to the bottom. A much larger loss over time is sustained by the disheartened investors who feel foolish or embarrassed by the loss and withdraw from participating in future markets. One of the reasons that those of us who entered the US market in the mid to late 1950s did so well was that many of the more senior investors were concerned about another Roosevelt 1937–38 type collapse and as such were sellers and not buyers.

Part 1: The Market Can Go Higher

My last several posts focused on some of the pre-conditions present in past peaks. I am not flashing red lights for investors to stop what they are doing. I am stressing that I perceive the need for additional caution. I fully recognize that the stock markets in many countries can get further extended by those who are focusing on the upside by touting the following points:

According to a chart supplied by Strategas Research Partners and T. Rowe Price Group, Inc. (NASDAQ:TROW), after 57 months of expansion of the last 13 bull markets, the average gain was 165%, which compares with our present rise through mid November of 164%. Thus we are on track in terms of up phases. There were four bull markets that showed further upside. In terms of greater S&P 500 (INDEXSP:.INX) advances, the 1990–2000, 1932–37, 1949–56 and the 1982–87 Bull Markets performed greater than we have achieved in this phase. The first two on the list had gains of about twice to three times what we have gained so far, so there is potential for more upside. Morgan Stanley (NYSE:MS) is leading the cheering section with a published view that we will see 2014 on the S&P 500 in the year of same number.
The financial conditions in Europe are not only not getting worse, but Moody’s Corporation (NYSE:MCO) is selectively raising up various low sovereign debt ratings. (In the end, if he could have held on, Jon Corzine would have made money on MF Global’s leveraged bet on the euro.)
Surprising to some, the US domestic economy is showing a pickup in growth. One might wonder whether what we need are more bouts of government shutdowns to help productivity?

Part 2: Deep Structural Problems Are Not Being Addressed

All is not well or improving in our world with some very serious structural problems not being part of current proposals.

We live in a paradoxical world where there is substantial unemployment and under-employment at the very same time that businesses cannot find qualified applicants to fill job openings. The missing elements for the employers are not just a mismatch of training skills. Employers say that what are missing are basic academic skills, work and discipline attributes, and work-oriented integrity. Even with an expanding economy, many may not find work. In effect, we have structural unemployment.
Around the world, the size of individuals’ retirement capital is significantly insufficient. To the extent that this lack of retirement funding is going to be addressed by individuals, the only place that they can get the money is by spending less and saving more, which will hurt our consumption models.
As a nation, there is every chance that in aggregate, US health care costs will go up beyond various budget assumptions. The strong odds are that society will pay more with less-strong odds that the quality and efficacy of health will improve to the same degree as costs will rise.

Part 3: The Trap is Being Set

There is nothing that I have laid out in this post that is startlingly new. Most investors will focus on Part 1, the upside. With the rising momentum, people will not be overly concerned about Part 2, the problems not being addressed. This behavior is similar to the aforementioned Sir Isaac Newton, who bought and then sold out of the parabolic rise in the South Sea Bubble caper only to be sucked back into re-purchasing out of envy and then again lost all that he had committed in the subsequent collapse. He fulfilled the same role that my professor friends at Caltech have demonstrated in the brain study that focuses on past successes or pleasures. As junior securities analysts we quickly learned of the power of the greater fool theory. For a long time fools have more buying power than prudent investors.

What to Do?

I have five suggestions:

Be careful — it is easy to get sucked in and many bright people will.
Focus on investment with well-financed companies that have quality products and services that remain essential in the future. You probably will earn less but probably will also lose less.
Reduce the ratio of your net purchases to your net sells. While cash is the equivalent of trash in today’s low-interest-rate markets, Warren Buffett has amply demonstrated his acumen at Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B), emphasizing the value of cash during periods of stress and accepting under-performance until the rising cash pile can be used dynamically.
Remember that future opportunities will occur and in the long run that will be good for you.
Use the time horizon strategy I have previously suggested, separating your intermediate time horizon investments from your longer-term investments. (Please contact me if you would like these posts emailed to you.) The intermediate investments should be current price–oriented. When the bidding for these good companies gets excessive on a historic basis, be a supplier (seller) into the market. Ride out your long time horizon investments, and when they periodically decline due to short term factors, buy more.

Do you disagree? Please let me know; I am always anxious to learn from wise people.

*Stocks of the companies mentioned are either owned in my private fund or are in my personal portfolio or both.

This was previously published on Inside Investing at the CFA Institute.

A. Michael Lipper is a CFA charterholder and the president of Lipper Advisory Services, Inc., a firm providing money management services for wealthy families, retirement plans and charitable organizations. A former president of the New York Society of Security Analysts, Mike Lipper created the Lipper Growth Fund Index, the first of today’s global array of Lipper Indexes, Averages and performance analyses for mutual funds. After selling his company to Reuters in 1998, Mike has focused his energies on managing the investments of his clients and his family. His first book, MONEY WISE: How to Create, Grow and Preserve Your Wealth was published by St. Martin’s Press. Mike’s unique perspectives on world markets and their implications have been posted weekly at Mike Lipper’s Blog since August, 2008.

Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.