Kenneth Kaszak

One of my favorite words is ‘epiphany.’  It means the sudden realization or comprehension of the essence or meaning of something.  The term is used in a philosophical or literal sense to signify that an individual has obtained illumination and insight into a problem, skill set, process or experience.  Epiphanies usually arrive suddenly after a prolonged learning curve and often times after an internal struggle.

I recently had an epiphany.  It arrived suddenly but was the result of a journey that started in late 2008.  As a way of introduction, I’m an investment advisor.  The foundation of my practice is to teach investors the inner workings of the investment business and how to protect themselves from the industry.  My investment portfolios consist mainly of low-fee, dividend-oriented mutual funds with some access to developing markets and oil and gas-related investments known as Master Limited Partnerships.

In the fall of 2008 my sky was falling. The stock market was under intense pressure.  After topping out over 14,000  in October of 2007 the Dow Jones Industrial Average began a slow but steady decline throughout 2008.  While there were signs of the market stabilizing during the year, usually after Hank Paulson or Ben Bernanke announced the latest market Band-Aid, the market continued downward when it was collectively decided that that Band-Aid wasn’t going to keep the market elevated.  The downward pressure culminated in a 18.4% decline during the week of October 4 through October 10.  The dividend-paying portfolios I had in place didn’t hold up to the pressure like they needed to.  “If only I knew which variables to study to let me know when to be in the stock market and which variables to track to let me know when to be out of the market,” I thought to myself many times, “ I would be the best investment advisor ever.”  In essence, I wanted to learn how to become a market timer.

And so the journey that lead to my unique epiphany began.

What was the key…or the keys… to timing success?  Was it monitoring the Volatility Index (VIX), the Elliot Wave Principle, the MACD (Moving Average Convergence Divergence) or maybe using the Halloween Strategy (sell out of stock positions on May 1 and reinvest on October 31)?  The Kondratieff Long Wave Cycle may hold the answer I was searching for (I can proudly introduce the Russian economist’s theory because I wrote a paper about it in college).

How about measuring investor sentiment through Short Margin Interest, Stock Market Value as a Percentage of GDP, or the Relation between the Yield on 10-Year Treasuries vs. that of the Dividend Yield of the S&P 500?  The ten Leading Economic Indicators and the seven Lagging Indicators would seem to provide insight on when to enter or leave the stock market.

Maybe I could become a chartist and study the Japanese Candlestick formation, the Head and Shoulders Top formation, the Ascending and Descending Triangles, Wedges and the uniquely named Cup and Handle formation.  Maybe formations would be my key.  Or Resistance levels.

I could sell when the market was about to break through a downward resistance level and buy when the resistance level was about to be breached on the upside.

Or I could follow guidance issued by the Federal Reserve’s Beige Book, the Economic Cycle Research Institute’s U.S. Weekly Leading Index, the University of Michigan’s Conference Board’s Consumer Confidence Index, the Philadelphia Manufacturing Index, or indices released by the ISM (Institute of Supply Management) or the PMI (Purchasing Managers Index).  The subjective dissertations may be the key to my market timing mission.

I will insert here that I ruled out moving out and in of the market based on news events.  In a previously compiled study, I tracked the movement of the S&P 500 Index after ten negative  world events ranging from the Cuban Missile Crisis up to September 11, 2001.  The result was that the market went down on the news but tended to trade sharply higher six months, one year and five years later. (see “Sorry Potsie, But I Just Don’t See It”).  Bad news didn’t stop the market;it only temporarily slowed it down.

As a fan of thought-provoking quotes, maybe I could just do my trading by following these three quotes:

“Be fearful when others are greedy, and be greedy when others are fearful.”

–Warren Buffett

“Buy when there’s blood in the streets.”

–Baron Rothschild

“Buy when the cannons boom, sell when the trumpets sound.”

–Nathan Rothschild

As unpleasant as it would be to see blood in the streets, or as pleasant as it would be to hear the sound of trumpets, the main point here is that the Rothschild family evidently had the ability to deliver colorful quotes.

If moving in and out of the market based on those quotes wasn’t the answer, maybe I could monitor the “investment media’ and act upon what the talking heads on CNBC, MSNBC, Fox Business, Tech Ticker, et. al, were saying.  Maybe there would be something in their messages that would lead me to the decision to enter the market, stay in the market or leave.   I could monitor the investment media to know when to reverse my position and do the opposite.  These individuals have to be experts.  After all, they’re on TV and radio.  They should know how to time the market better than anybody not on TV or radio.

I identified at least one calendar year when I should be in the market.  The Third Year of a Presidential term.  The evidence was strong.  Beginning with the third year of Calvin Coolidge’s term in the White House up through George W. Bush’s second term, the market has averaged 19.4% over the 21 periods under study.  Only two of those Third Years (1931 & 1939) out of 21 were negative for the year.  I’ll take those odds.

Or I could turn to the world of sports to help guide my timing decisions.  I could make my choice depending on who won the World Series and the Super Bowl.  Sounds odd, right?  It is.  But if an investor had been invested in the stock market the year after the previous ten times the St. Louis Cardinals won the World Series, their Average Annual Return would have been 18.5%.  Nine of those ten years would have been positive.  If you don’t believe the numbers you can, as  Casey Stengel used to say, look it up.

The fortunes of the Pittsburgh Steelers may provide some insight into when to be in the market.  In the year following the six seasons the Steelers won their six Super Bowls (the year after the season would be the same year that each Super Bowl was played), the market has an AAR of 25.66%.  Coincidental?  Totally.  But in a really cool way.

I made note cards with all the possible links to the movement of the stock market and posted them on my office wall.  I would look at these cards, sometimes changing the order of importance.  I emptied a new Highlighter pen marking up my cards, then ripping up those cards, posting new cards and highlighting those cards.  What were the most relevant and valid criterion to be used in my quest to be a great market timer?  Where were they hiding on the cards right in front of my face?

And then my epiphany arrived.  It arrived in the realization that my practice of low-fee, high diversified stocks, bonds and MLPs was the best way to structure clients’ portfolios. My knowledge of the history and mechanics of the capital markets from a total return basis, percentage of positive years vs. negative years, impact of dividends, performance of the markets after negative years, importance of diversifying into high-yielding investments with low correlation to the stock market was the best roadmap (now GPS) to follow in investing money for my clients trying to “grow” their asset base (as opposed to investors taking monthly or quarterly distributions for their portfolios).  As Elliot Gue, one of the MLP analysts I follow, stated in the summer of this year:

The truth is that out of the thousands of economic data points released every month, you can always find some number to back up almost any economic or market view, no matter how off the wall it may seem.  These conflicting signals are confusing and quickly lead to information paralysis and an inability to react to changes in the outlook. (Personal Finance Weekly;June 18, 2011)

By holding myself out as the man who can move in and out of the markets I would be consistently subjecting myself to decisions of whether to buy or sell. If I was wrong one time in either direction I would have subjected my clients to a decrease in their value (this conversation isn’t taking into consideration the tax consequences for moving in and out of non-deferred accounts).

When it comes to the stock market (as defined by the S&P 500 Index), we are talking about an exchange whereby hundreds of thousands of entities, from an individual with one share of one company to an institutional investor with hundreds of thousands of shares of numerous market members are motivated by different factors, have different knowledge bases and different time horizons making decisions to buy, hold or sell. One of those investors….the one with hundreds of thousands of shares has the ability to move the market with a decision that may be unfounded based on data that is irrelevant or invalid. It doesn’t take a high percentage of any one company’s shares outstanding being sold to move the price of that one company lower. Companies, and markets, are priced daily based on the last trade. I couldn’t put myself…or my clients’ money….in a position where I’m forecasting investor sentiment of the total market (I would also have to be extremely careful when returning to the market after a period of decline. The Falling Knife I was trying to catch may end up in the Cat….the Dead One that Bounced).

Regarding the media: there has been an explosion in the number of television, radio, and print media outlets devoted to investing and the markets. These sources need a constant source of information to package around the advertisements they sell. These ads are the real source of the media outlets;not the information the talking heads (or writers) or presenting to you. As an occasional talking head I know that often the squeaky wheel—the person with an extreme message one way or the other—gets the air time. To follow these individuals when making timing decisions would be as relevant as hoping the St. Louis Cardinals and Pittsburgh Steelers win their respective championships each year.

The proliferation of investment newsletters is also a factor to contend with. Each day in my inbox there are at least two offers for investment newsletters. Some of the newsletters ‘tease’ with a headline that a certain company is about to pop for a 300% return but I must sign up for a two-year subscription in order to get the company name. Other newsletters promise to share with me the secrets to popular investing and stock selection…..but I must share my credit card information first. In the newsletter world, I wonder if the authors are making more money from the sale of the subscription or their positions in the stock. Or, as Jim Cramer used to do, were the publishers taking a position in a stock, promoting it through the newsletters and internet and selling their position when others bought in and increased the price (but not the value)?

After my “Uh huh” moment, a study came across my desk. Author and investment manager Michael Dever in “Jackass Investing” revealed a study on “Buy & Hold vs. Buy Low, Sell High.” Mr. Dever’s parameters were the S&P 500 Index over a 29-year period. Buy & Hold bought the market and held it for 29 years. “Buy Low,Sell High” bought the market but sold it each time there was a 20% increase and didn’t buy back in until there was a 10% decrease. This study would have been absent any sales commissions or annual asset management fees.

The results: the AAR of “Buy and Hold” was 9.09%. The AAR of the “Buy Low, Sell High” was 4.69%, almost half as much. In the 29-year period in the study, the market timer would have lost tremendous amounts of money because they would have not taken advantage of the Power of Compounded Growth. “Buy and Hold” would have grown $100,000 into $1,243,394. “Buy Low, Sell High” would have turned $100,000 into $377,790.

The interesting numbers from this study are 53.29% and 53.28%. These are the number of positive trading days each portfolio was subjected to over the 29-years of the study. This percentage compares well to the number of positive trading days (53%) over the 50-year period ending in 2009. From a previous project completed this year, it was determined that over the 139 trading months between January 2000 and July 2011, the percentage of months that were positive was 62%.

Speaking of percentages here are the numbers I stay on top of: the S&P Index has a 31-year AAR of 12.93% and a CAGR of 11.39% (period ending 12/31/10). There were six negative calendar years in the 31-year period and 5 in the 21-year period. The 21-year AAR and CAGR are 10.36% and 8.51%. The Power of Compounding would have turned a $100,000 investment (net of commissions and fees) into $2,832,907 after 31-years and $555,731 after 21 years.

The “Buy Low, Sell High” audience may want to use the 11-year period ending 2010 as a failure of “Buy and Hold.” The AAR for that period was 2.40% and the CAGR was 0.31%. In an environment where the market was negative 19.53% of the time over 31-years, the recent decade had negative years 36.36% of the time.

That 36.36% negative experience in the last 11 years, coupled with the AAR of 2.40%, is not contrary to “Buy and Hold” but a testament for low-fee active management. The American Funds portfolio (heavy on dividends and developing markets) I utilize for my growth-oriented clients had an AAR of 7.75% over the same time period.

Many advisors who charge “wrap” fees on top of the fees charged by the mutual funds their clients are invested in are under some pressure to justify those fees. They tend to try to outthink the market during times of decline and reallocate their portfolios. They end up hurting their clients’ account values because they make the change too late in the process on the way out and on the way back in. Here’s proof:

The Capital Group, parent of the American Funds mutual fund family, released a study detailing the performance of the S&P 500 Index in each five-year period after significant market declines. The declines range from a 19.41% drop (from 09/21/76 through 03/06/78) to 86.22% (from 09/07/29 to 06/01/32). For the purposes of this study we’re going to use the market declines from 09/76 through 03/00 through 10/02). Here are the declines and the AAR return for the 5-year period after the decline (there are not calendar years but the actual 5-year trading periods).

After market declines lasting from 3 months to 2 years and 3 months, the 5-year AAR of the market averaged 20.16%. Of course this study could not include the 5-year AAR for the 10/09/07 to 03/09/09 decline of 56.78%. That 5-Year AAR remains to be determined (but the period got off to a great start—the AAR for calendar 2009 and 2010 was 20.72%).

The above study reminds me of a smaller epiphany I had in 2009. The stock market decline of 2008 and 2009 was brutal and seemingly never ended. But when the market turned and started its recovery, my new fear was that the market was coming back too fast. But it wasn’t. The market was recovering from the excess selling that had taken place. Point is: a market decline is part bursting of a bubble/correction and part overselling. And many of the same sellers who were part of the overselling crowd were the same people who put a different hat on and become buyers.

Large Epiphanies sometimes come with a series of small epiphanies. My financial epiphany was no exception. In addition to the low fee, dividend/distribution portfolios I structure for my growth-oriented clients, I have to be more aware of is the “entry point” for making the initial investment. This “entry point” revolves around buying the investment at a prudent time.

The portfolios for my growth-oriented clients consist of low-fee, high yielding equity-income and developing market mutual funds along with energy-sector Master Limited Partnerships (MLPs). The funds and MLPs I invest in have to be making money in order to be able to make their quarterly distributions (The financial bookshelf is full of stories of companies who tried to keep making dividend payments without earning money. These companies used a combination of stock offerings, borrowings, asset sales, etc. to maintain a dividend. All these mechanisms dilute or decrease the value of the stockholders’ value. Those companies are not in my portfolios.)

I could have a “non-entry point.” That would be a point when the market is priced too high according to the Price-Earnings Ratio. The value of the market divided by the earnings of the companies in the S&P Index provide a P-E ratio. If that ratio is too high, that would be a time not to buy into the market. Here’s textbook evidence: the average P-E Ratio of the Index measured over any statistically significant period is around 17 times. The Ratio was 28.9 as of March 30, 1999 during the lofty days of the internet bubble. Over the next 5 years the Index had an AAR of (1.41%) and a ten year AAR of (3.24%). The P/E Ratio was 20.33 on 12/31/03. The next five years saw an AAR of (2.19%).

This review of P-E Ratios and the market results in a new way to invest: “Buy Low and Hold” (credited to Morgan Housel of The Motley Fool.com). It would be of value to my clients and myself to monitor the value of the market as measured by the earnings before making an investment decision (Master Limited Partnerships have their own unique set of entry points. This discussion is focused on the general stock market as measured by the S&P 500). The evidence is strong. Buy when the market is not overpriced, keep asset management fees low, accumulate and reinvest dividends and stay diversified.

That, in one sentence, was my epiphany. My Big Epiphany.

In closing, this article is being prepared as November 2011 comes to a close. New clients and new money need to be allocated. Go in the market or stay out? I have the experience and knowledge cited in this article and the other unique insight I’ve gained over the years to guide me. But I also have the knowledge of this fact: 18 of the last 21 Decembers have produced a positive total return for the S&P 500 Index. The average December performance since 1990 is a gain of 2.1%, the best of any month over that time period.

And if you don’t believe me, follow Casey Stengel’s advice and look it up.

Notes: AAR and CAGR were used throughout this article. Average Annual Return is the mathematical mean of the market. Compound Annual Growth Rate is the geometric mean. If an investment had a 100% increase in Year One and a 50% decrease in Year 2, the AAR is 25% . However, your investment is back to its starting point. The more reflective number is the CAGR, which in this case is a 2-Year Return of 0. Over periods of time, the CAGR is lower than the AAR and more reflective of what happens to your money.

The S&P 500 Index, unmanaged listing of 500 companies meant to reflect the economy, was used to define the term: “the market.” The Index has no sales charges and no annual management or advisory fees and is used as a benchmark to compare the performance of equities and specific stock issues and mutual funds against that benchmark. The results of the Index w/ Dividends was used for return information.

Sources: Yahoo Finance, moneychimp.com, The Motley Fool.com, Absolute Wisdom, The Capital Group Companies, Personal Finance Weekly, previous articles written by the author.