The Band Travels Up

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The Band Travels Up
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Three months ago, I bumped against my upper cash limit.  After that, I put an additional 6% of funds into the market.  Now cash is up to 18%, near my cash limit of 20%.  As I look at my portfolio now, most of the portfolio is above the central band.  I may buy another stock to bring cash levels down, but I am going to use a different tool because everything has moved up.  I’m moving the band itself up.  (Last time, if I had moved the band up, there were a lot of stocks near the lower edge of the band, and I don’t like moving the band when results are dispersed.  I don’t want to buy or sell as a result of moving the band.)

I don’t adjust the trading bands often — maybe once a year or so.  I leave them fixed in nominal dollar terms, adjusting for when clients add or remove assets.  When the market has moved so much that almost every stock is above or below the central line of the band, rather than add or sell a stock, I adjust the height of the band.  I moved my band up 6%, which puts half of my stocks above and below the central line of band, from which if a stock is 20% over the central line, I sell down to the central line, and if a stock is 20% under the central line, I buy up to the central line if I still believe that the stock is a good one to own.  This is the way that Portfolio Rule Seven works.

This makes the sell points further away and makes the buy points nearer, which in turn makes it incrementally more likely that cash will be dispersed, not accumulated.  Now, if the market keeps running up, particularly for value stocks, cash will still accumulate, but it will take more to make that happen.

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Why do I do it this way?  In this environment, I look at the height of the market, which is considerable, but I also look at the momentum, and conclude that I ought to let things run more, if they will.  In my opinion, the stocks that I own for clients are undervalued, even if the market is not undervalued.  Old economy stocks have lagged for years behind new economy stocks, and valuation differences are pronounced.  I experienced much the same thing in 2000-2001 when growth got whacked, and value kept performing until everything went through the wringer in 2002.

Now, I’m hoping, but not saying that value is coming back, but it is certainly overdue. If this period is anything like the beginning of the 2000s, it will be very good for value investors.  The challenge will be managing high absolute market valuations versus favorable relative valuations.  It makes for a bumpy ride, but I like the stocks that I own, and will keep adjusting through all of the bumps.

Now, I’m hoping, but not saying that value is coming back, but it is certainly overdue.

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

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