Knowing when to hold 'em

Recently, a client expressed his concerns about the equity markets to me. He felt skittish and worried that a correction could be imminent. He asked me, "What do you make of it when the S&P 500 fails to break through a key resistance level after four attempts?" As I thought about his question, the words to an old Kenny Rogers song started going through my head.

You gotta know when to hold 'em,

know when to fold 'em,

know when to walk away,

know when to run.

Please don't confuse me for a Kenny Rogers fan, but there is some folksy wisdom in those lyrics and I think it applies to the investment process. If you run for cover every time there is a moment of concern in the market, you will never be successful. Investors need to learn to be patient. They need to learn to discern between real concerns and made-for-TV economic drama. Sometimes--in fact, most of the time (assuming the underlying investment is sound and the portfolio is properly structured)--investors need to learn to just hold 'em.

A word about technical indicators

First of all, to my client's point about the market's inability to break through key resistance levels: I have learned to not put much value on technical market indicators like resistance levels and support levels, etc. unless I am dealing with very  short time horizons.

Early in my career, I worked as a bond trader for a primary dealer in Los Angeles and then later as a futures broker in London. Both jobs required me to work with very short horizons--sometimes measured in minutes. In those cases, I found technical indicators to be helpful. However, as I started managing large institutional portfolios with time horizons measured in months and years, the value of technical indicators evaporated. They seem to do well explaining what happened yesterday, but they do a miserable job predicting what is going to happen tomorrow. Consequently, I don't really care that the market has failed four times to breach a key resistance level. 

Focus on the fundamentals

As an investor, I focus on the following four areas, listed in order of greatest importance.

1. How is the portfolio structured?

  • Am I properly diversified?

  • Do I have the correct asset allocation?

  • Have I minimized the risk in the portfolio for the level of return I am trying to achieve?

2. Are the underlying investments sound?

  • How disciplined is the manager in terms of staying with his or her portfolio mandate?

  • How well are companies performing?

3. How is the economy doing relative to general expectation? 

  • Are there severe imbalances brewing?

  • Are underlying trends supportive of economic expansion and corporate profitability?

4. How is investor sentiment?

  • Are investors overly pessimistic?

  • Are investors fully invested or are they sitting on large cash positions?

Though it is less important than the others in determining the success of the portfolio, the final point on the list is perhaps the most important when it comes to judging the future direction of the market. Sir John Templeton, one of history's legendary investors, summed it up this way:

"Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria."

Recent history corroborates Templeton's rule of thumb. The despairing pessimism of 2008/2009 helped launch one of the great bull markets in history, with pessimists fighting it all the way up. We now appear to be in a transition phase from skepticism (though we still hear plenty of that!) to optimism. I am keeping my eyes open for signs of euphoria.

I recognize that some might point to the huge market rally in 2013 as a sign of euphoria, but that isn't how I experienced it. That rally was more like the continuation of the "wall-of-worry" rally we have been experiencing since March 2009. In a euphoric market, I would expect to see a reversal of the massive exodus from stocks to bonds that started in 2007. No sign of that, yet. And, though real yields on cash are still significantly negative, investors have been slow to move their cash into stocks. This definitely feels like a "hold 'em" market to me.