Since I was a child, I always found enjoyment in solving riddles. Looking at obscure facts, massive information with no value and contrasting opinions, I would attempt to derive a clear answer to any problem. In today's markets, these skilled are much needed. If anything, the past few months have served as one giant riddle with massive volatility swinging stock prices higher and lower on a daily basis.
In order to grasp the volatility we have witnessed, look at yesterday's activity. The markets opened higher and stayed at elevated levels. With the Federal Reserve (Fed) announcing their interest rate decision at 2:15pm, a reasonable expectation would have been for the pre-announcement rally to act as a typical run-up that would be followed by profit taking. Instead, the market stayed elevated after the interest rate decision and then sprinted higher into the close. For a market that often failed to maintain bullish momentum, one could argue that the Dow Jones Industrial Average (DJIA) closing 331 points higher (2.94%) on a day when up volume represented 90% of total volume is a sign that we have bottomed and will head higher. However, when you consider that the DJIA has moved up or down greater than 2% 19 times in 2008(as opposed to large swings 14 times in all of 2007) it becomes clearer that today is an environment where large price changes do not yield immediate trends. Further with 11 of this year's 19 large moves being down days, one could argue that yesterday's 300 point gain was just a blip in a longer term downtrend.
As one who studied literature during college, I have always felt I have a grasp over how small subtleties lead to big results. There is no magic formula that yields consistently strong investment results. If we have learned anything from the credit crisis, overreliance on black box models leads to disaster. Initially the outcomes are favorable, but as people put more reliance into methods they cannot fully comprehend, disaster occurs. From CDOs to various quantitative hedge funds, black box models fail. The true believers will spin the outcome with the explanation that a billion year event occurred to cause the loss. In reality, we seemingly experience these statistically impossible events much too frequently for my liking. Instead of attributing the outcome to a random, unforeseeable event, I find the answer lies in the investment approach. For me, investing has always been as much art as science. Granted, hard math is needed to determine how cash flows will develop and what the outcome yields. However, the choice of growth rates and discount rates has a much larger effect on the ultimate outcome. By artfully considering multiple scenarios and a range of outcomes, an investor will yield better results than someone who plugs numbers into a model and hopes for the best.
Considering the need to look at a wide range of outcomes, what thinking can be applied to the current market? Are the large move of bank stocks and a 3% rally in the DJIA indicative of a major bottom or just another trap being set by the bears? With the market, the definitive answers to these questions can only be achieved in hindsight. The post mortem can be handled by the academics in the years to come. However, as investors we must act today and use those actions to grow our wealth.
The DJIA began its most recent decent on May 20th. The prior day the DJIA had battled its way back to 13,028. While this represented a slight loss on the year and a 10% drop from the all-time high, the May 19th close was an 11% rally from the low of the year recorded only two months earlier. As the current decline in the DJIA pushed prices lower and into bear market territory, I was looking to my timing model and various other indicators to see if we had reached an oversold bottom. My timing model became oversold on June 23rd and quickly reached an extreme oversold scenario on June 26th. History had taught me that anytime my model became severely oversold, quick, material gains followed. Based on this logic, I went very long of the market and awaited the rebound. That decision turned out to be correct as my portfolio performed well and added a fair amount of alpha over the following month. However, this high level view obscures what truly happened and following it blindly would lead to poor decision making.
While performance was strong since I made the decision to go aggressively long, little of the performance is attributed to the market itself. When I received the extremely oversold reading, the S&P 500 closed at 1,283. By the moment my timing model had returned to a normal reading, the S&P 500 was trading at 1,260. For an investors who saw the oversold reading and went long the broad market, a loss of 2% occurred. This is the first time an extremely oversold market delivered losses to a bullish investor. As of yesterday, my timing model is now 67% long and on the verge of becoming overbought. The price of the S&P 500 - 1,286. Basically, we have gone from oversold to overbought with no movement in the broad market. Considering that many stocks would need to drop 5-7% in order to return the market to a neutral reading, extreme caution is advised.
So if the market was flat, how was I up? The simple answer is stock selection. In today's environment, solid proprietary research has more value than ever. Investors are taking a shoot first; ask questions later approach to investing. The large price swings are selling off good and bad companies alike. For someone with patience, discipline and faith in their work, you could buy assets at bargain levels and wait for a quick rebound in price.
As an example, consider Motorola (MOT). As has been well publicized, their handset business has been weak as new product development stalled. However, their balance sheet is strong and their other operating businesses have good margins and wide economic moats. On July 15th, MOT closed at $6.76. Knowing they have over $2 of net cash on the balance sheet, I bought the shares understanding that I was getting their operating businesses for just over $4 per share. This price was incredibly cheap and would eventually reward patient investors. Luckily, I did not have to wait very long. Better than expected earnings and new management has allowed the stock to rally 44% in three weeks. An investor who had done their homework and had the courage to stand by their conviction realized a large gain very quickly.
Recognizing today's environment as a stock picker's market has large implications for portfolio construction. To realize gains in the future, less reliance should be placed upon index funds and sector rotation. Instead, the focus should be on specific, value-added ideas. By focusing on core research and risk management, we can build a portfolio that is skewed for long term performance while controlling risk. The opportunities will always exist to find the next Motorola. Patience and discipline is the recipe needed to search out good ideas while courage and faith in your work is needed to buy those stocks when everyone else says sell.