Now What?

By Bob Wood, MMNS

By now, you are probably in the midst of figuring out what recent stock market volatility means for your portfolio — and what you should be doing in response. The Dow’s losing over 400 points in one day tends to have that effect on investors!

The ensuing weakness in stocks has many wondering which strategies to adopt now, considering how formerly calm, steady market rises have now become rather unsteady and nervous. Perhaps you are wondering if “staying the course” may be your best option, since, if given enough time, the market may again steady itself, and the upward trend will resume.

Of course, with my bearish outlook on the domestic economy and stock markets for the past couple years, the recent losses came as no real shock. The only surprise to me is that the recent drops in stocks took so long to occur, given the weakness of the economy’s underlying fundamentals. And it’s about time that reckless U.S. fiscal and foreign policies were factored into investor thinking.

But the offsetting optimism continues in the financial media, and the Bush administration has no shortage of spokespersons explaining how wonderful our economy is. I find their credibility on the economy about as good as with most everything else they manage and report. And I wonder why it has taken so long for investors to realize that the same people directing our foreign policy are managing our economy, too. From my perspective, they are no better at one than the other!

In past articles, I have offered for your consideration strategic options for your investment portfolios. Yes, I have been bearish on domestic markets and differed with promoters in government and the media regarding the health of our economy. But I also have suggested alternatives to the traditional diversification methods touted by big brokers and academics who focus on the U.S. economy and investing in risky assets.

Joining me in this distaste for traditional investing strategies that revolve around the Efficient Market Theory (EMT), diversification and asset allocation is none other than the greatest investor of our time, Warren Buffett. In his most recent letter to shareholders of his company, Berkshire Hathaway, he again credits his investing success to avoiding the most commonly accepted methods of building an investment portfolio.

Buffet says that “to expect a soft landing seems like wishful thinking,” which is opposite to what we commonly hear from the media. He also relates a short story about an investor whose long-term track record is among the best he’s ever seen. That record was achieved by 90-year-old Walter Schloss, who is now retired. According to Buffett, Walter’s track record showed performance results ‘’that dramatically surpassed those of the S&P 500,’’ which the academics still teach as always properly priced, based on all information known to investors, who are, at all times, responding rationally to that information. Do you think that all, most, or any investors are rational at all times? Take your pick on that one.

Both Buffett and Schloss did what the academics call “virtually impossible,” except when experiencing luck in extreme amounts. And Buffett, who has always been kind enough to share his investing philosophy with anyone willing to listen, began speaking about his friend’s performance in 1984. He explains his confusion at the lack of reaction to his and his friend’s awesome performance:

‘’To my knowledge, no business school teaching EMT made any attempt to study Walter’s performance and what it meant for the school’s cherished theory. Instead, the faculties of the schools went merrily on their way presenting EMT as having the certainty of scripture.

‘’Typically, a finance instructor who had the nerve to question EMT had about as much chance of major promotion as Galileo had of being named Pope. Tens of thousands of students were therefore sent out into life believing that on every day the price of every stock was ‘right’ (or more accurately, not demonstrably wrong) and that attempts to evaluate businesses – that is, stocks – were useless. Walter meanwhile went on overperforming, his job made easier by the misguided instructions that had been given to those young minds.

‘’After all, if you are in the shipping business, it’s helpful to have all of your competitors be taught that the earth is flat. Maybe it’s a good thing for his investors that Walter didn’t go to college.’’

So what does this mean for you, considering the erratic performance of the major domestic averages? Well, under the best of circumstances and even in the best investing environments, Buffett is suggesting that your portfolios may be poorly constructed. Even in good markets, with a portfolio built and managed according to the most widely accepted methods taught in business schools, you probably still had it all wrong!

So what would he think of your classically built portfolio during these uncertain times? If it was wrong during good times, how does it look when investing gets really shaky, like now?

What we can learn by listening to the greatest investor of our time is that in good times and bad, in bull and bear markets, you are best served by going your own way and paying the utmost attention to valuations. And that certainly means not committing cash to businesses priced at premium levels. When the Dow 30 Industrials sell for more than 20 times earnings, as they do now, we realize why Buffett prefers sitting on a mountain of cash and buying very selectively.

Staying away from stocks selling at premium prices is as important as buying stocks that sell for the right prices. Your profits are assured based on what you paid — not what you sell them for later.

So here we are in a market environment that has become uncertain, at best, and even dangerous to investors who may have ridden the recent bull market cycle to new portfolio highs. Since you may have had it wrong during that nice bull phase, can you imagine what the great investors of our time would think of your portfolio now? So, what should you do?

I think the most important thing you can do is to dare to look stupid when it comes to your investments! You must dare to be wrong or, at least, appear wrong. And since Buffett’s method differs markedly from those most widely accepted, as did his friend Schloss’ methods, many apparently believe that Buffett has been wrong for his entire career! And since it seems that no business schools have ever studied his friend’s performance, it becomes apparent that Schloss built an enviable record over a very long time by looking wrong to the “experts.”

Now that I may have pried open a few minds and possibly inserted thoughts about doing things differently, how does this thinking apply to the sudden changes in domestic markets? All I can suggest is what I have been doing — and which changes I am now making. (And please remember that this column does not offer individual advice; if you make portfolio changes based on these suggestions, you’re on your own!)

As long-time readers of this column know, I, too, adhere to the idea that going your own way is best. I have been avoiding domestic stock markets and advocating hedging — owning shares of mutual funds called “bear funds,” which are designed to do well in “down” markets. I am sure that other financial professionals, with whom I have discussed my methods openly, consider them wrong, especially my allocation of virtually all long-side exposure to foreign and emerging market stocks and funds with smaller allocations in commodity-type investments in energy and gold. None have been eager to follow my lead. That I have allocated nothing to domestic large caps, mid-caps or small caps strikes others as wrong and, yes, even stupid!

But, hey, the strategy has worked! And it has worked because this method evolves from my belief in valuations and search for economies better managed than ours. I also avoid popular methods of investing as espoused by publications like Investors Business Daily, neatly captured in recent advertisements for Jim Cramer’s show, where he advises to ‘’buy high and sell higher.’’ Ouch!

As for now, I am still convinced that the bull market run enjoyed by investors in the domestic stock markets was of the cyclical kind, meaning short-term in nature and bound to fail at some point when the stronger, secular bear market resumed. I think that turning point may be upon us. (But then, I had that same thought last May, too!)

For now, I am adding to hedges in the form of ‘bear funds’, and those “different looking” options are growing larger by the week in my clients’ managed accounts. I have shared the names of some of these selections in the past, and several fund families offer them, from the Prudent Bear Fund to an array of options offered by Rydex, ProFunds and others.

If you are philosophically opposed to shorting stocks or owning bonds, you will not hold either option now growing in my clients’ accounts. But you could follow Buffett – by holding bundles of cash while waiting for real opportunities to appear. You don’t have to accept every risk to prosper in the markets. It’s much better to pick and choose your opportunities rather than rely on the “stocks for the long run” strategy — that hasn’t worked for anyone else in the past.

This approach will undoubtedly cause discomfort when you tell friends how you’ve built your portfolio, but daring to be wrong or daring to look stupid seems to have worked very nicely for those two great investors mentioned earlier. And in times like this, the crowd is bound to have it wrong, as they usually do, according to Buffett. Think about the idea of building a “bear market portfolio,” or, at least, a portfolio that should weather stormy times in stocks, should recent selling become more pronounced.

Take a look at bear market fund options, or, at least, think about holding a lot of cash. The worst that can happen is that you’ll miss another “leg up” in the stock market, but at least you’ll still have your money and will live to fight another day!

Have a great week.

Bob Wood ChFC, CLU Yusuf Kadiwala. Registered Investment Advisors, KMA, Inc.,