Making money in a bull market is not a difficult thing. Knowing what to do when the direction turns is what separates the wheat from the chaff. Markets have indeed turned over and the long-awaited correction seems to be in place. So what should one do? What are we doing?

First things first:  never panic. The end of the world has a funny way of never turning out that way. There is indeed life after Lehmann Brothers; Enron and WorldCom did not forecast that all corporations were really frauds; and the stock market has survived recessions, depressions, world wars and terrorist attacks. Not once was panicking a wise decision.

This is much easier said than done, so there are some things that we can do to help – the most important of which is knowing what we own. There are two basic world views on stocks: Some people see them as pieces of paper which are traded the way children trade baseball cards. We see them as what they are, partial ownership in companies. I have no idea how scared people in the first camp must be when the Dow Jones opens for trading down more than 1,000 points. That must be terrifying.

We, however, know what we own. Apple’s business did not collapse Monday morning at 9:30 am Eastern Daylight Time. We realize that this is just a big mistake on the part of irrational traders, many of whom are no longer human beings but computer programs, and this overreaction will be corrected shortly. Having this faith is much easier done when one knows what she owns.

It also helps to have a plan – knowing that there are risk controls in place in your portfolio and professionals ready to act when necessary. This is why we discuss with our clients how much pain they can tolerate. It is much better to focus on risk when things are going well and we are not caught up in the emotion of the moment.

Not panicking is of utmost importance, but it is not the only important issue. Secondly, one must understand that not all losses are created equal. There are short-term trading losses, in which the market moves down because the mood has turned negative. Nothing has changed in the underlying businesses of companies whose stocks are being beaten up; it is just the mood of the market. This is the classic opportunity for long-term investors. The prudent thing to do is wait for some sign of a bottom, then add to the position.

Then there are mistakes. Of course mistakes can happen in any market environment, but they are often easier to see in a downturn. Here one must again fight irrational thought. Tax law in our country says that one cannot write off an investment loss on his taxes unless he has realized the loss: in other words, sold the investment. Many people, including several financial advisers, believe this means that one has not lost anything unless he sells. That is simply not true.

A loss is a loss. If the investment in question is sound, then one can expect to gain it back, and usually much faster than people appreciate. However, as Warren Buffett learned early in his investing career, one does not have to make it back in the same way he lost it. Many times investors are better off realizing the loss so that they can rebalance and better take advantage of the next leg up.

In summary, the steps of navigating a downturn are: Don’t panic. Know what you own and have a risk control plan. Then, be honest about the loss. Where your investments remain strong, use it as an opportunity; where there is weakness, cut losses and look for new opportunities made possible by lower prices. Remember the words of Benjamin Graham, and be greedy when others are fearful.

Chuck Osborne, CFA
Managing Director

~Navigating a Correction

A few years back I was playing golf with my minister. We teed off on the first hole and his drive went straight down the middle, while mine went to the right in long rough and behind a tree. I chopped my ball out of the rough and short of the green, while he hit a nice second shot just ten to twelve feet to the left of the hole. I chipped up to about eight feet from the hole. He made a good birdie putt that just missed and then tapped in for par. I sank my putt for par. We walked off with the same score, but he had hit three good shots and I had hit only one good shot. He put his arm around me and said, “You know, sinking eight foot putts will forgive a lot of sins.”

The market over the last year or so has reminded me of that moment. If one only follows the headlines and sees the returns of the large market indices, such as the S&P 500, then one thinks the market is doing fine. If on the other hand one looks below the surface, she will find that the market return has been bolstered by a few darling companies. Further, most of these companies are making little or no money, but they are hot growers with popular products. The two that really stand out are Amazon and Netflix.

Before I go further let me first say that as a customer of both I am a big fan. Over the last year I have gotten everything from books to underwear on Amazon. Their distinctive boxes sit in front of our house more days than not. We also have Netflix steaming service, which my children can operate all by themselves. They have discovered that the cartoons that were around when their parents were young were far less educational and far more entertaining. My wife and I also maintain the now-old fashioned DVD service, because Netflix is smart enough not to stream the movies we really want to see.

However, as an investor I am not a big fan of paying $276 for $1 in earnings for Netflix, nor do I wish to pay much more for a company that never seems to have earnings at all, even if it is Amazon. The stock of those two companies are up 90 percent and 69 percent respectively over the last year.

Meanwhile stocks of companies that not only earn money but that also pay a portion of that money back to shareholders in the way of dividends have been getting killed. We recently ran some numbers, and it turns out the top ten dividend-paying stocks in the S&P 500 are down more than 18 percent over the last year. None of those companies has a positive return. The top 50 dividend- paying stocks are down 15 percent, and only 11 of those companies have a positive return on their stock.

Sinking eight foot putts may forgive some sins. A few star performers may create the illusion of positive markets, but ultimately all one is doing is trying to keep up appearances and put off reality. My minister and I had the same score on that hole but eventually the player hitting more solid shots is the one who will prevail, and he beat me by more than 10 strokes. A market can only hide behind a few stars for so long.

It appears we may have finally started to see some cracks in this façade:  We could be due for a correction. Corrections are always painful, but they are necessary. There is a reason they are called corrections. Some stocks have already been overly beaten down, while others overly inflated. That needs to be corrected so that we can then re-start this bull market with most stocks participating. Good putting can hide a lot of flaws, but ultimately if one wants the good scoring to continue then he has to hit fairways and greens. Likewise, for the bull market to continue we have to see more companies participating. Correcting these flaws may be painful in the short run, but it does pay off in the end.

Chuck Osborne, CFA
Managing Director

~Keeping Up Appearances

“Sell in May and go away.” That used to be the motto on Wall Street – just cash in and go on vacation for the summer. Of course that is not the best long-term retirement strategy, and for taxable accounts that could increase the tax bill quite a bit. But there is something strange in the water this summer that is almost making us take that silly advice seriously. My children have a case of the summer sillies, and the market seems to, too.

We had the Greece scare earlier this summer. I’m always fascinated with the news coverage of such events. Every investor, fund manager, Wall Street executive, etc., who could be found to do an interview pretty much said the same thing: Greece isn’t the story, it is China. Yet the media outlets sent their roaming reporters to Athens, not Beijing. It bordered on the surreal – Greece voting “no” to get a better deal, only to learn that no such deal existed.

To the extent that China has been discussed it is described as a market meltdown, yet it is seldom noted that the domestic stock market in China was up more than 160 percent before this “meltdown” occurred. I used to joke about no client ever complaining about upside volatility, but it really is true. People do not seem to understand that rapid movements up are just as abnormal and usually just as temporary as rapid movements down. China’s government has stepped in to stop the carnage; anyone found selling short will be placed in jail. That will put a stop to a free fall.

Now the focus is back home and on earnings. Last week Netflix reported:  huge customer growth, still can’t make money but no one seems to care, stock went up over 16 percent. Google reported the next day: beat expectations on earnings but missed expectations on revenues, stock went up more than 16 percent. Apple reports, beats all the way around; stock goes down. Microsoft reports, beats all the way around; stock goes down. Oil supplies are down by 1.5 million barrels over the last two weeks as gasoline demand is “unusually high,” according to the EIA. So the price of oil is again in free fall.

So let’s sum up:  If you are a company with a really cool product that you have yet to figure out how to make profitable, or if you are a cool Internet name with less-than-expected revenues, your stock is up dramatically. If you’re a commodity whose supply is down and demand is up, your price is down dramatically. If you are a company with real tangible products that are insanely profitable, and you do better financially then anyone thought possible, then your stock price is down dramatically. What is wrong with this picture?

Some might say it is the direction of these movements. Companies who do not make money are not supposed to have stocks that go up in value and vice versa. However, Wall Street has always been a little silly this way in the short term. A company is a darling and no matter the reality traders and analysts find something to like, or a company goes out of favor and they find something to hate. That has always happened and always will. The real, long-term issue with what is happening now is the word dramatically. Individual stocks are moving huge amounts on a daily basis.

Happy Birthday Dodd-Frank. Five years ago the massive regulatory pile-on was passed. Proprietary trading of Wall Street firms was a bee in the bonnet of Paul Volcker so he got a rule named after him. No more trading for Wall Street firms. Forget that this had nothing to do with the financial crisis, or that much of the proprietary trading that happened was to serve clients. If one wishes to buy, someone has to sell, and Wall Street firms often would just do it themselves and look for someone on the other side later. That made implementing the rule a little difficult. But this summer it is finally here and in full effect.

Those proprietary trading desks added a lot of liquidity to the market and smoothed out a few rough days. Yes the big firms often made money off their trading desks, but they also made the markets work more efficiently by adding volume and liquidity. It is very difficult to quantify the exact impact, but my experience over the last few years as firms one by one got out of the trading business is that volatility has increased. It is not necessarily higher in the aggregate, as losers and winners still cancel one another out, but the individual movement is much different.

Summertime has always been slow, which means less liquidity and therefore bigger daily price movements. More volatility. It has gotten worse and will likely continue to do so. All the more reason for a prudent investing approach, patience and the understanding that as with our children, so goes the market – summertime is often silly time.

Chuck Osborne, CFA
Managing Director

~The Summer Sillies

There is nothing more frustrating in our automated world than dealing with a computer system issue. You are working away then all of a sudden, nothing. You reboot because you know that is what the IT people will tell you. Then you get the blue screen of death and call IT. “Have you tried rebooting?” Yes. “Are you sure it is plugged in?” Yes. “Okay I’ll be right there.” He comes, he reboots and it works again. “I swear I did that,” you say. “Sure you did,” he says as he walks away.

It is so frustrating, but it is part of our lives today. At some point we just have to understand that it is largely out of our control. In his book “The 7 Habits of Highly Successful People,” Stephen Covey states habit one as being proactive. Part of living a proactive life is understanding what is in your control and what is not. He referred to items that one can control as one’s circle of influence.

Covey is not alone. In “Golf is not a Game of Perfect,” sports psychologist Bob Rotella implores golfers to focus on process, because once the ball leaves the club face, everything that happens is out of their control. John Wooden, the legendary basketball coach, spoke about this in his books, too. Wooden focused on teaching and on his players’ execution of what they were taught, not on winning and losing, because he understood that the outcome is often impacted by luck, good or bad, and is therefore out of his control. The interesting thing is that Bob Rotella’s clients have won a lot of golf tournaments, and John Wooden’s teams won a lot of championships. That is what happens when one focuses on the things that are within his control.

In the investment world we often refer to the rate of return on an investment as performance. I once had a senior portfolio manager tell me that we should ban such talk. Performance is something that happens on a stage, he would say. We deliver investment results. When I first heard this I didn’t think much about it; I thought it was just an old man splitting hairs. Now, I’m a lot older and have begun to understand what a difference hair splitting can make.

First, it puts one in the correct mindset for making investment decisions. We can discuss yesterday’s performance, but it seems silly to discuss yesterday’s investment results. The word investment itself connotes a longer, more meaningful time period, while the word results connotes some sense of finality. The investment result cannot truly be known until it has fully run its course. The day we sell a stock is the first day that we truly know the end result. This puts us in a much better mindset for making prudent decisions.

Secondly, day-to-day performance of an investment is not something one can control. We cannot control, or even know in advance, that the New York Stock Exchange (NYSE) will suffer a technical glitch that will halt trading. We cannot control what happens in Greece. We cannot control the short-term volatility of China’s equity markets. The list of things that have short-term influence on performance which we cannot control could go on forever.

So let’s focus on what we can control. We can control what custodians we recommend for use to our clients. We are not short-term traders, so rare temporary technical issues that halt trading are not really of concern. What is of concern is making sure that good records are kept of what our clients’ actually own. We also keep our own redundant system. Prices change, and pricing errors can be fixed – this is the NYSE’s role. Having proper documentation of what one owns is of most importance, and that is the role of the custodian.

We can control what we own. We can know the balance sheet, the income statement. We can have an understanding of the products they make. We can judge the quality of their management. We can have reasonable certainty that cash will be there for dividend payments, and that the company has intrinsic value. We can diversify knowing that we won’t always be right. In other words, we can do the fundamental things that prudent investors do, which we know bring long-term success. That is what we can do, and what we will continue to do every day for our clients.

Warm Regards,
Chuck Osborne, CFA
Managing Director

~Control

“Nip it in the bud!” That is what Grandma would have said. If one wishes to put an end to certain behavior, then she had better make that clear as soon as possible. If one allows small transgressions, then slowly over time the transgressions will grow and grow until all authority to stop any transgression is depleted.

This timeless wisdom – the phrase dates back to the 16th century – is easy to understand, but hard to actually implement. Short-term ramifications always get in the way: the fear of being seen as over-reacting; the rationalization that this current transgression is really not that big of a deal; the fear of potentially negative consequences to making an early stand. Doing what is right is always so hard. Every parent understands this.

Now the EU understands it as well. In childrearing we call it spoiling the child; in economic terms it is known as moral hazard. Once one starts forgiving debts it becomes very difficult to convince a debtor that he really does need to live within his means. The ongoing saga of Greece’s indebtedness has finally come to a head. After kicking the can down the road for the last five years the EU has come to the same conclusion of many parents before them: We have let this go as long as we are going to and it is now time to get serious.

Polls in Greece indicate that the people there are reacting much like a child unaccustomed to discipline. They blame the creditors. How dare they expect us to actually pay what we owe? That is somewhat understandable, after all it was the Greek government not the Greek people that got the country into this mess. Many citizens whose taxes must be raised and pensions cut are rightfully upset as the politicians who got them into this mess are in much better condition than the people they claimed to care about. Of course that is often the downside to democracy; people vote for those who promise the most and then don’t really pay attention. That happens in lots of places. Everywhere one looks today one sees governments awash with debt. Are we all on the road to being the next Greece?

Those who profit from others’ fear will likely pronounce such. However, I’m an optimist. In the long run this tough stance by the EU is a good thing. Governments must take their debts seriously, and every now and then it is healthy to have that reminder, especially within the EU. If the folks in Brussels really want Italy, Ireland, Portugal and yes, even France, to get serious about being fiscally sound, then they need to show them that there are ramifications for not doing so. In other words, nip it in the bud. End this while it is still just Greece, which is so far gone.

On our side of the pond Puerto Rico is suddenly in the news as they are about to default. Of course we have seen it happen to cities in California, and the state of Illinois is the leading candidate for our own internal debt crisis. Maybe the U.S. will finally get serious about fiscal responsibility.

In the meantime, how do we invest with all of this happening? We addressed that in our last Insight, and nothing has happened over the last two weeks to alter our comments. We don’t see Greece having a significant impact. Of course there is always the knee-jerk reaction that leads to a couple of down days, but year-to-date – and even last week – international stocks have been the best place to be, so the markets don’t seem too concerned about Greece. But, even if we are wrong about that, we know what we own and we still like it for the long term. We have our risk controls in place for portfolio security and if need be we will take action.

There is no great cause for concern for your portfolio. The concern should be for the people of Greece, and over the hope that the political leaders in other countries are watching this and beginning to understand that fiscal irresponsibility needs to be nipped in the bud.

Chuck Osborne, CFA
Managing Director

~“Nip It in the Bud!”