Let the Big Horse Run

MJG

Hi Guys,

A few days ago, MFOer Mark posted about possibly holding a down investment until it recovered to its purchase price. As part of his closure on the topic he said: “Then I thought of some other fairly noteworthy melt downs involving esteemed managers: Bill Miller (LMVTX), Bill Nygren (OAKLX) and Ken Heebner (CGMFX) who I thought at one time or the other were the sharper tools in the box.”

These are excellent examples of why and how we decide on a particular fund, and the difficulties associated with performance persistency or lack thereof after we choose them.

General George Patton expressed some aspects of our decision policy with the following pity observation: “Never tell people how to do things. Tell them what to do and they will surprise you with their ingenuity.”

We hire a fund manager to do our investing; we don’t tell him which investments to trade or how to do it. We trust them to do it prudently and wisely. In essence, as John Stewart sang, we “Let the Big Horse Run”. For your entertainment, here is a Link to Stewart’s song:



But persistency is an illusive parameter in the investment world. There is much uncertainty, and consequently, many faulty decisions. We are too often fooled by randomness. Our patience levels melt after a bad year or two.

Yet, in many instances, all this is likely a regression-to-the-mean. How often after discarding a fund, its returns escalate while the recently purchased replacement returns are mediocre? Statistically, it happens frequently. We are slaves to rash decisions that are harmful to end wealth.

The universe of mutual fund managers is populated by far too many marginal managers who struggle to achieve benchmark returns. Study after study demonstrates that challenge. This group of guys don’t deserve their top heavy salaries. But there are exceptions. When you identify such a superior performer, cut him a little slack. Everyone suffers a sub-par year or two. Even Babe Ruth and Warren Buffett have endured slumps. Your patience will be rewarded. Stay the course is not a bad rule.

As Stewart says, “Let the Big Horse Run”.

Best Regards.

heezsafe

On the other hand, big horses with broken leg(s) are usually put down. Not doing so ASAP can lead to much bigger regrets later.

@Mark It took me a while to find this. Thought you and others might find it amusing, as well as humbling; I can't imagine anyone who invests for a significant period of time being able to avoid the psychology of a major market correction, who doesn't later reflect back on how pathetically they handled most all of it. Gotta have a plan, gotta have clarity, gotta execute it.

This is commentary from a weekly posting done by a MF portfolio manager (known to the MFO board, liked by some, disliked by others), at another time when people were wondering if we were entering a bear market/recession and wondering whether they should hold or sell. It describes the mentality of an investor in the midst of a bear market correction, who has never before had his/her general plan to be a "long-term buy-and-hold investor" challenged (or maybe has experienced it before but didn't learn anything from it):

Feb 11, 2008
Again, my guess, and it's just a guess, is that a sustained rally – if only a sustained bear market rally – will be more likely a) at the point that investors fully accept recession as common knowledge, so they can start putting “recession” behind them without fear that it's still ahead, or b) at the point the S&P 500 declines a full 20% from its high (anywhere below 1250) – again, so they can start putting “bear market” behind them without fear that it's still ahead. Strangely, the market often responds well when investors recognize that their fears have become reality, because at that point investors can at least begin to believe that the worst is behind them.

That doesn't mean that things won't, in fact, deteriorate beyond a 20% market decline or a shallow and well-recognized recession. But as I've frequently noted, most bear markets are not simply one-way movements. Bear markets typically comprise two, three or more separate 10-20% declines, punctuated by fast, furious rallies. It's easy to forget that the 2000-2002 bear included three bear market advances of 20% from intra-day low to intra-day high, as well as numerous smaller advances, all of which were surrendered in subsequent plunges to new lows.

This is a good time to review what bear markets look like, because even though our own focus is always on the prevailing Market Climate, an understanding of how such market periods evolve can be helpful in riding one out. As I wrote in April 2000, bear market psychology typically evolves something like this:

"This is my retirement money. I can't afford to be out of the market anymore!"

"I don't care about the price, just get me in!!"

"It's a healthy correction"

"See, it's already coming back, better buy more before the new highs"

"Alright, a retest. Add to the position - buy the dip"

"What a great move! Am I a genius or what?"

"Uh oh, another selloff. Well, we're probably close to a bottom"

"New low? What's going on?!!"

"Alright, it's too late to sell here, I'll get out on the next rally"

"Hey!! It's coming back. Glad that's over!"

"Another new low. But how much lower can it go?"

"No, really, how much lower can it go?"

"Good Grief! How much lower can it go?!?"

"There's no way I'll ever make this back!"

"This is my retirement money. I can't afford to be in the market anymore!"

"I don't care about the price, just get me out!!"

The following are actual figures and headlines from the 1973-74 bear market. At the January 1973 market peak, earnings had hit a new high, and stock prices were selling at a P/E multiple of 20, which is extreme on the basis of record earnings. Over the next 2 years, corporate earnings grew by 56%, yet the market fell by half. The 73-74 bear market teaches that stock prices can decline from rich valuations even if earnings grow dramatically:

Suppose you own stock. You have decided to be a "long term investor." Stock prices rise to a new all-time high. You feel vindicated. The economy looks great. Although market breadth has deteriorated, your commitment is firm. "I can't afford to keep my life savings out of the stock market." “Buy-and-hold” is your motto.

Then, after a modest rise in interest rates, the market sells off -12.3% in just over 2 months time. Ouch. A correction. Buy on the dip. These things happen from time to time. You're a long term investor. Buy-and-hold is your motto.

Sure enough, prices recover. Somewhat. A 4.8% advance, but already, you think, you're on your way to new highs again. Then, you lose it all in a -10.2% decline. Two months later, you've given back your advance, and you're at a lower low. Alright, another correction. Maybe you buy on the dip. Bargain prices. Buy-and-hold is your motto.

And it's already paying off. A month later, you're up 7.8% from the low. But then a -9.1% selloff takes your portfolio even lower than the first two drops. The market is down -19% overall. You start to question the amount of risk you're taking, but how much lower can it go?

Thank goodness. 15.8% advance over the next few months! Should have bought more on the last decline. Earnings are still growing strongly. You decide not to wait. You buy more on the advance, confident that you'll be rewarded by new highs. Then the market plunges -20% over the following 4 weeks. You stare at your statement and feel sick. You've held on for a year and your reward is a new low in your portfolio. This really is a bear market.

Now some volatility. Up 12% over a few months. Then you lose it all a few months later in another decline. Then another 11% advance, followed by a -12% plunge to a new low. Seven times now, you've seen your portfolio collapse by more than -10%. With every recovery, a fresh disappointment. And the months march on. It's a year and a half since the peak. You've lost nearly 30% of your wealth. Price/earnings ratios look low, but they looked low before the last decline, too. But maybe it's the bottom. After all, the average bear market takes stocks down about 30%. Holding your calculator, you realize how that works. A -30% decline wipes out a 43% gain. Didn't really consider that at the top.

Stocks rebound a little over the next month. Just 6%. You're still clinging to the bottom. Then, the bottom drops out. Not just 10%, or 15%, but a real free-fall. Over the next 6 weeks your portfolio plunges by -27%. You're another -23% down from the previous low! Almost 2 years of nothing but losses! Major ones. You've lost almost half your retirement, now. Half your life savings! And the economy has turned bad. Everybody knows that stocks were overpriced at the top! It was so obvious! Greed. Valuations were so high. Everyone was so optimistic. Why didn't you see it at the time? You decide you can't afford the risk. Sell half. See if things recover, then get back in.

Well, prices do recover. More than 15%. But then you lose it all in another selloff! Another new low! The market has lost half its value! Nine major plunges. Nearly every one to a lower low, and getting worse. This market has no support. Where are the buyers going to come from in an economy like this? People are unemployed. They don't have the income to invest! And certainly not in the stock market. The financial headlines trumpet "The Real Recession is Yet to Come", and "The Coming Dividend Crisis." Some of the less diversified mutual funds are down as much as -80% from their highs! 80%! Every $100 has collapsed to $20. If it could happen to them, it could still happen to you. This is too risky. After all, you think, "I can't afford to keep my life savings in the stock market."

"Better safe than sorry" is your motto.

That's what a bear market feels like, but we all have a tendency to forget

John Hussman
from Watching for Audit Delays and "Qualified" Opinions
http://www.hussmanfunds.com/wmc/wmc080211.htm

Over the next six months or so, any MFOer who simply cannot reach decisions now about particular investments.... can play along if they'd like.

Old_Skeet

Old_Skeet went through this and even got married in 1974 during the bear market I was telling my wife investing is the next best thing to sliced bread. Sure ... sure, she'd say. We are still married and been through a bear market or two ... now, perhaps we hear another one growling. With this, I plan to be mindful of my asset allocation and be more conserative and taking less risk than I have in the past. Seems, some made money in these bear markets by playing the rebound ... I know my family did ... and, I am still invested and I have been for all these years (sometimes more so than others).

linter

no matter what you think of hussman, that's a brilliant analysis of what the typical investor -- ie, me -- goes through and has gone through. i think i'll print it out and staple it to my forehead, so i can reread it each time i look in the mirror.

Mark

@heezsafe - Oh, that's good. I'll have to bookmark that puppy. One of my kids could stand to read that now as he's ready to rip off my head. Fortunately he's in a foreign land for the moment. My advice to him basically "Don't be rash but do measure and calculate. Work your plan and don't look back." We'll see.

@MJG - You noted: "Yet, in many instances, all this is likely a regression-to-the-mean. How often after discarding a fund, its returns escalate while the recently purchased replacement returns are mediocre? Statistically, it happens frequently. We are slaves to rash decisions that are harmful to end wealth."

Intuitively that's what I was thinking but I can't verify it at all. Yet it looks right. My plan allows for a certain loss before pulling the plug measured by the context in which the loss happens to be occurring. Heck, we reward .350 average hitters with outrageous contracts and they are only successful 3-4 times in every 10 attempts. Indeed, some players (managers) are cut a little more slack than others.

vkt

Hilarious writeup by Hussman, although I couldn't help thinking that is exactly the mirror image of his own investing behavior when markets are going up!

A problem for Hussman is that the bear markets don't last long enough for him to make back all the money he loses waiting for one.