The Go Broke More Slowly Plan
Board: Macro Economics
(At the suggestion of 00jane, I am cross-posting this from the MF Pro boards.)
Well, everybody has to have a plan, even people who really do not have a clue.
So, with that clarion call to action, here is my 40-point plan, which I call the Go Broke More Slowly Plan (GBMSP). I wrote it up for my kids (who help manage my portfolio and are undoubtedly thinking, “Is he kidding? FORTY points?!?!), but am sharing in the twin hopes of learning something and maybe helping others.
The GBMSP sits on top of and controls the BITB Stock Rejection machine (http://boards.fool.com/1228/the-bitb-stock-rejection-machine...... --post available to MF Pro members; let me know if you want it cross-posted here), which is still my core operating manual, subject to the overrides of the GBMSP.
I hope that the GBMSP is a reaction to today’s market conditions (it is drawn pretty carefully from the ideas of a number of smart people, including Jeremy Grantham and Seth Klarman), but recognize a strong possibility that it is also a reaction to the late 2008/early 2009 market, which is no longer with us. Have I learned lessons from that market, or have I merely been cowed by it?
I. NEAR TERM
A. Background Ideas: Near Term
1. The apparent extent of the economic recovery is misleading. The economy is being falsely propped up by Fed actions; it is not as good as it seems and will decline toward reduced “New Normal” levels once Fed support is withdrawn.
2. Quantitative easing will probably go away this summer.
3. It appears unlikely that inflation will be a real problem for a while. Current headline inflation (food and energy) seems to be the result of transient factors, e.g.: floods; possible interruptions in oil production due to turmoil in Africa and the Mideast; and high China demand that may now be slowing. Idle labor and unused capacity should dampen core inflation for a while, at least.
4. The Fed rate is likely to remain low for a fairly long time – possibly well past the end of 2011.
5. Stock prices are sharply higher due to (a) good – but misleading and propped up – economic results and (b) vast amounts of liquidity, partly from Fed policies and partly from pent-up investor demand. Risk premiums are low and stocks are at least fairly valued and most likely significantly above fair value.
6. Commodity prices are very high, possibly nearing a near-term top (depending on the Mideast turmoil). As with stocks, these inflated commodity prices are probably at least in part due to Fed actions.
I went to the bank and asked to borrow a cup of money. They said, "What for?" I said, "I'm going to buy some sugar." -- Steven Wright
B. Near-Term Conclusions
7. The near-term effects of the Mideast/African crisis are difficult to predict. Leaving them aside -- and assuming that they will in any event be fairly transient -- it seems quite possible that the stock market will continue to rise for a while. Eventually, however, it is my guess (consistent with the views of Grantham, Klarman and many others) that any increases from here – and probably a lot of today’s value – will be given back in the near- to medium-term future, possibly very sharply, as the market corrects and resets.
8. Thus, although significant near-term dips in high-quality stock prices could provide an entry point for a short-term trade, that is not our game; this is probably a time to be selling rather than buying.
9. Am I whistling at the moon? No, I think not – but I do see a bad moon risin’:
And I am not the only one:
-- [C]ash has a virtue that people don't appreciate fully. . . . it buys you the right to buy the U.S. market if the S&P drops from 1,220 today to 900, which is what we think is fair value. . . . in the not too distant future, stocks will be too expensive and they'll crack again. —Jeremy Grantham
-- It is clear, both in the financial markets and in government policy, that no long-term lessons have been drawn from the events of 2008. . . . By late 2010, froth had returned to the markets . . . . Exuberant buying had replaced frenzied selling, as investors purchased securities offering limited returns even on far rosier economic assumptions. – Seth Klarman
-- While we are not forecasting renewed market dislocation, this possibility cannot be dismissed. Given the rapid market run-up over the past 2 years and our ongoing concerns about the economic outlook . . . I do not wish to be responsible to limited partners through another possible market crisis. -- Carl Icahn
C. Near-Term Action Items and Motivational Ideas:
10. Do not be a stock-picker if a Macro truck is bearing down on you – start by getting out of the way of the truck!
I'll always remember the last words of my grandfather, who said "A truck!” -- Emo Phillips
[W]aiting on the railroad tracks as the “Bubble Express” comes barreling toward you is a very painful way to show your disdain for macro concepts and a blind devotion to your central skill of stock picking. The really major bubbles will wash away big slices of even the best Graham and Dodd portfolios. Ignoring them is not a good idea. – Jeremy Grantham
11. As Grantham suggests, when we see a pretty obvious macroscopic situation (e.g., a bubble or a burst bubble), we should react strongly to that macro condition -- do not be a stock picker at such times (when correlations all seem to go to one in any event).
12. Stocks are overvalued today. They will come down at some time; when they do, how will we feel? Think about how great it felt to own MON at $70 – then remember how it felt when it hit $45! Do not fall in love with stocks when they are over-priced, when a correction is coming, clear as a bell. It may take a year or two, and there may be a lot more gains between here and there, but it is coming . . . .
13. We should not conclude today that stocks are heading for a sharp decline sometime soon and then, in a few months or a year or two, look at a large decline in our portfolio and curse ourselves for not heeding our instincts.
I live on a one-way street that's also a dead end. I'm not sure how I got there. -- Steven Wright.
14. Do not buy U.S. or developed market company stocks now, because there will most likely be better buying opportunities fairly soon.
15. Despite our long term plan to accumulate commodities (discussed below), now is the time to start selling near-bubble commodity stocks and assets. Start easing out now; in any event, do not buy commodities and commodity stocks now. Do not sell entire commodity-related positions, however – keep a core position.
16. Also start easing out of stock positions, especially those that are not defensive. Accumulate cash, moving toward minimum core positions in equities. Above all, now is the time to eject any stocks we do not really want to own.
17. Continue a reduced, low-level program of generating dividend and option income through the sale of puts and covered calls on blue chip, wide moat, dividend-paying stocks that fit our BITB Stock Rejection machine criteria.
18. Continue to hold:
-- Reasonably valued acceptable dividend stocks;
-- Small “marker” positions to keep our attention on a stock;
-- Core positions in our wide (non-brand) moat core stocks, including those based on great management; and
-- Property-ownership REIT positions.
19. If we encounter a deep-value position at this time, we should pass, buy just a small “marker” position, or sell put options at an additional discount. These stocks will not be immune to the coming dip.
20. Do not sell stocks in our China small cap basket, because those stocks have been hammered recently by bogus short sellers and seem not to be subject to the concerns described above for US companies. (They are, however, subject to their own concerns, which is why we should wait for a serious dip before filling out the rest of those positions.)
21. Consider “pair trades” such as buying LLL (or selling puts on LLL) and selling SPY short (or buying puts on SPY) – but remember that correlations go to one in a sharp correction. Still, this may be a low-risk way to try to eke out stock picker gains until the market corrects, without getting killed by a sudden sharp correction.
22. We can also consider shorting stocks once the market seems to be turning. Here, the idea would be to short high momentum, high volatility stocks (e.g., CMG, LNN, GMCR) as a hedge. We need to think further about this idea.
23. As we raise cash, do not risk it in bonds for a few extra dollars of return. Current low interest rates and no signs of inflation make the opportunity cost of holding cash as low as it has ever been.
D. Summary of Near-Term Actions
24. The BITB Stock Rejection Machine is an approach to a muddle-through, New Normal, flat market. That is not our market today, so we need to revise our procedures.
25. In general, we should ratchet down our option activity and become a significant net seller of equities (do not rely on covered calls to effect our sales – just sell).
26. Our goal is to raise cash, and to do so carefully but fairly quickly (I want to go from our current levels of about 70% cash to more than 90% cash by June).
27. If there is a sharp immediate dip (e.g., due to Africa), do not panic; we are already well-positioned for such an event. But, do not sell into such a dip; we will reevaluate things if that happens.
II. LONG TERM
A. Background Ideas: Long Term
28. Over time, the federal deficit will either be reduced or it will not. Either way, there is pain ahead for the US economy and the US stock market, although the magnitude and timing of that pain is hard to predict. The more likely result is large but long-deferred pain as we keep pushing the deficit problem into the future.
29. It seems likely that the long-term market picture will be a muted, muddle-through, New Normal following a correction of today’s (and tomorrow’s?) exuberant valuations.
30. But there is another risk – in addition to the likely coming correction -- that we dare not ignore. Seth Klarman said it best:
[T]he government's fiscal and monetary experiments may go awry, resulting in runaway inflation or currency collapse . . . as this insight is not unique to us, the cost of insurance is high. There are no easy ways to navigate these turbulent waters. But because the greatest risks are of currency debasement and runaway inflation, protection against a currency collapse – such as exposure to gold – and against much higher interest rates seem like necessary hedges to maintain.
31. TIPS are a standard inflation hedge, but (i) they are very expensive right now, and (ii) they protect against inflation but not against rising interest rates absent inflation, which is actually possible, at least given the extraordinarily low existing rates. So, no TIPS, at least for now.
32. And of course no bonds.
33. We must also realize that bond-like stocks (e.g., regulated utilities paying a healthy dividend) face many of the same loss-of-principal risks as bonds.
So, what do we do as a long-term plan?
B. Long-Term Action Items and Motivational Ideas:
34. First, we accumulate cash and wait for a correction. This may take a long time; in fact, we may look like idiots!
There's a fine line between fishing and standing on the shore looking like an idiot. -- Steven Wright
35. But, eventually, a correction will come, a sharp, breathtaking, scary downturn. When we feel sick at the idea of investing, when all we want to do is bury our cash in the back yard and think about something else (say, at S&P 900) – that is exactly when we will deploy about 2/3 of our cash in a flash, in big, bold, daring buys.
36. And here is how we will deploy that cash. We will raise each of the following baskets to the listed percentage of total equity investments, excluding (i) our remaining 1/3 of accumulated investable cash and (ii) our emergency cash hoard:
-- Small Cap China Basket -- to 6%: basket consists of up to 11 stocks.
-- Commodity Basket – to 30% (this is an inflation hedge, and follows Grantham’s stern advice): basket consists of up to 25 stocks – note that, per Andrew Sullivan’s thoughts, we seek to own producers of non-precious-metal commodities.
-- Dividend/Option Basket – to 30% (many of these stocks are non-brand wide moat firms that have pricing power, another inflation hedge): basket consists of up to 43 stocks.
-- Real Estate Basket – to 20% (another inflation hedge): basket consists of up to 7 stocks.
-- Primo Value Basket – to 4%: basket consists of up to 12 stocks.
-- Primo Small Cap Basket – to 5%: basket consists of up to 20 stocks.
-- Small Cap Templeton Basket – to 5%, basket consists of 58 stocks so far.
37. I have tweaked the composition of our Dividend/Option Basket because I fear that many brand-based wide moats may not survive the types of huge problems we are hedging against – runaway inflation or currency collapse. In such circumstances, consumers may well trade down and brand-based moats may disappear.
38. On the other hand, moats based on other characteristics will be very valuable in a Klarman disaster scenario by creating pricing power. Consider:
-- Pipeline MLPs have irreplaceable physical monopolies, and in addition regulated pipeline rates typically allow for inflation adjustments);
-- Railroads – who is going to build a new railroad?
-- One-of-a-kind properties (e.g., ISCA, MSG); and
-- Sticky customer experiences (e.g., ATVI, PAYX);.
39. We will also consider, at the “blood in the streets” time, letting some expert managers invest our remaining 1/3 cash, making sure that redemption issues are not affecting their funds. The list includes SEQUX, DODFX, JENSX, HSGFX, OAKMX, FAIRX, OAKIX, TWVLX, and YACKX.
40. Note that many of our basket holdings are either foreign companies or US companies with significant activities in emerging markets – again, placing us in compliance with Grantham’s recommendation to mildly overweight emerging market stocks.
There will be a test on Friday.