Pitfalls in Today’s US Stock Market – Part 3

Friday, May 28, 2010

Given Wall Street’s disruptive game playing described in Parts 1 and 2, what’s an investor to do? Today, I address “III. How we can invest and protect ourselves.”

Personal note: At the beginning of “Part 1” I explained my negative emotions about what has been going on, particularly from the regulators’ standpoint. Those feelings come from over 45 years of active stock investing and a 30-year career in fund management, working with top Wall Street firms (and competing with others). That experience, combined with historical reading, research and analysis, produces this conclusion: This is the least friendly, supportive and protective environment for individual investors since the 1930’s investing regulations were enacted.

Most of the Wall Street people I have worked with have been upstanding, ethical and desirous of producing sound products and good performance for their investors. My concern and frustration with today’s regulatory laxity is that it allows the ethically-challenged to profit legally at our expense.

I know my explanations and conclusion might be disturbing, but my purpose is absolutely not to frighten. In fact, until now, I have hesitated writing about my overall evaluation and feelings. I know how easy it is to scare investors out of their stock holdings – especially in this market environment.

So, why now? May 6 exposed the dangerous weaknesses in the US stock market’s functioning, and investors need to understand what’s going on and why. From that knowledge comes the ability and confidence to invest using – and even taking advantage of – the market’s current operating structure.

Why not just avoid stocks? The US stock market currently offers some of the best opportunities for long-term returns – returns that could be far superior to other investments, including bonds.

So, now let’s shift gears and discuss the components of a wise investment strategy for today’s US stock market.

Goal: Avoid pitfalls and pursue opportunities

The “new” Wall Street combines danger and opportunity to investors:

  • A danger because manipulated price movements, combined with potentially false (or, at least, hyped) information, can diminish our understanding of what is really happening in the market and to our investments. Worse, our emotions can be roused, resulting in actions from being enticed or frightened.
  • An opportunity because periodic bursts of added volatility can produce abnormal prices that we can take advantage of

Here are the ways we can keep our cool, sticking to our investment plans, avoiding getting caught by a pitfall and, perhaps, capturing some additional return.

1. Control news intake

Tracking the markets and our investments too frequently can be problematic (see “Watching Investments Closely Can Blur Understanding and Increase Sense of Risk” – May 3).

This long-time observation now has new meaning. Although May 6’s extent was likely an aberration, other similar events can occur. While watching a near-miss auto accident can be titillating, it’s unnerving when it’s our car. It’s much, much better to view May 6 (or any of the recent, flip-flop trading days) after the close, when the wildness and day-trading, game-playing volatility has washed out.

Even better is maintaining a focus on weekly closes. Rarely are weeks made up of days that all move in the same direction. Plus, short-term traders usually close out their positions by Friday’s close to avoid the potential surprise “adverse” news over a weekend. So, the trend of Friday closes tends to be more informative than the daily ones.

2. Place orders wisely

I covered order placement recently in “Trading Strategies for Today’s Markets” (May 13). The primary steps we can take are:

  • Do not place stop orders – they can fall prey to price manipulation
  • Do place limits on market orders – using limits above the ask (on buys) and below the bid (on sales) ensures that your trade cannot be hit by a sudden, adverse price move
  • Do consider scattering about a few opportunistic limit buy orders – most will go unfilled, but if there is a sudden price drop, you could acquire a low-cost position. (The same applies to selling, but not now – this market is too skittish to produce any wild run-ups.)

3. Select investments carefully – blend opportunity with the investment’s characteristics

Funds: Use active (not passive) management

In March 2009 I switched from passive (index) funds to actively managed funds. Why? I felt that the market and companies were in such disarray that values and opportunities were scattered throughout the stock market. A passive approach indiscriminately picks up all issues that fit certain criteria and then weights each holding without regard to potential return.

But don’t index funds outperform? No. I know that data was being used last year to “prove” they do, but that process of using past performance results in a cycle of “Index is best!” then “Active is best!” and back again.

Since early last year, active managers have been doing better, and I expect they will continue to do so. We have an environment in which stocks rise and fall somewhat in unison, producing good opportunities in the better stocks.

I particularly like actively managed funds for smaller companies, lower-priced stocks, high growth companies and less-diversified companies. There will be outstanding performers from these areas, and selecting them today requires skill and analytical resources.

Examples of skilled fund management groups are American Funds, Fidelity, T. Rowe Price and Vanguard (the actively managed funds).

Funds: Consider selected closed-end funds

I covered closed-end funds earlier (see “Closed-End Funds – Structure and Price Discount Add to Potential Returns” – March 12). The discounts remain, so there is the potential of added return (see “Closed-End Funds Selling at Discounts Offer Bonus Returns” – April 21). Examples of established, well-managed funds are Adams Express (ADX), Central Securities (CET), General American (GAM) and Tri-Continental (TY).

Funds: Be wary of ETFs (Exchange Traded Funds)

There are four items that, to me, currently make ETFs less desirable:

  1. ETFs are mainly index funds – The potential added returns from actively managed mutual funds can overwhelm ETFs’ supposed tax and day-trading benefits
  2. To many investors, name and holdings can differ – Wall Street is producing new ETFs daily and there are now some with “indexes” that are simply mini-groups of stocks. By looking at the holdings, you can determine if they match the ETFs’ name – and your expectations (e.g., see “Want To Buy A Sector Fund? Ignore the Label; Examine the Contents” – February 25)
  3. Trading support is added unknown – To keep the price near the net asset value, ETFs use a complicated structure that allows institutions to trade large blocks of ETF shares. They willingly do so in normal markets, using arbitrage to pocket the tiny differences between the ETF’s price and its index value. This trading support disappeared in May 6’s crazy moments, causing many ETFs to plummet. So, it is important to understand how it works.
  4. Avoid leveraged ETFs – These hyperactive funds convert investing to gambling. If there isn’t enough return potential from an investment, move on. Don’t borrow to “enhance” your return, even if the borrowing is done inside the fund. Remember, this leverage isn’t being managed, like at a professional trading firm. As with the index-based portfolio, the leverage is untouched by human hands (or minds)

Stocks: Focus on large, sound, well-managed companies

I believe most investors should hold at least a couple of individual stocks, particularly in this market. Doing so moves the mind from amorphous, global issues (like Greek contagion) to understandable, focused company activities.

Here are companies that I have previously written about: Alcoa (AA), Boeing (BA), Caterpillar (CAT), Coca-Cola (KO), Exxon-Mobil (XOM), Intel (INTC), Merck (MRK), NVR (NVR) and Wal-Mart (WMT).

Stocks: Only use margin borrowing if you can meet a margin call

Like with stop-loss orders, if a stock falls enough, margin calls can be triggered. If new funds aren’t then put into the account, the position can be lost. We want to be an “advantage-taker” on a price drop, not an “advantage-giver.”

So… I hope you have gained an understanding of the pitfalls in today’s US stock market, but retained an interest in US stock investing. I believe it’s a great time to own a portfolio of attractively priced US stocks, through actively managed funds and individual stock holdings.

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John Tobey on Seeking Alpha

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May 2010