Monday, February 28, 2011

Another Opportunity to Hedge

Last week's late rebound in stock prices provides another opportunity to hedge against significant declines. I wrote last week about why stock prices are vulnerable to declines, particularly small-capitalization stocks relative to large-capitalization stocks. An important reason is the high level of bullishness that sentiment surveys reflect.

Today's report on short selling provides further evidence. Short sales as a percent of all stocks fell to the lowest level, 3.3%, in three years. Though the level of shorting is higher than it was in much of the 1990's, the recent decline in reported shorting corroborates the growing anecdotal sense that the shorts have capitulated and covered their positions during the powerful rally in stock prices since last August.

In addition, individual investors have reversed course after many months of net selling and have been buying equity mutual funds in recent weeks. Though this new buying could drive equity prices higher in the short run, it still seems prudent to hedge portfolios now with put options on stock indexes, or alternatively, to raise cash reserves.

Steve Lehman

S & P 500: 1320
Russell 2000: 822

Thursday, February 24, 2011

How to Invest in a High-Risk Stock Market

How should an investor respond to today’s high stock-market risks? Those who feel compelled to remain fully invested should seek to minimize potential damage by rotating away from the areas with the greatest price appreciation off the March, 2009 lows toward areas that are relatively undervalued.

Large capitalization stocks with attractive dividend yields are still undervalued. Their price performance has lagged that of small company stocks in particular, and their valuations are extraordinarily attractive in RELATIVE terms. (Stocks overall are, of course, historically quite OVERVALUED). These large-capitalization companies often have strong cash flows, dominant competitive positions, and international operations with better growth prospects than those of small-capitalization companies that operate only in the U.S. In addition, international operations would provide a hedge against potential further declines in the U.S. dollar.

Examples of attractive large-capitalization stocks are Abbott Laboratories (ABT) and Microsoft (MSFT). Abbott currently sells for 10 times estimated 2011 earnings per share, has a dividend yield of 4.1%, and just raised its dividend for the 39th consecutive year. (Disclosure: I own shares of Abbott.) Microsoft sells for nine times estimated current-year earnings, after making an adjustment for its large cash holdings. Microsoft also generates substantial cash flow in excess of its normal business needs, which facilitates dividend increases and share repurchases.

When one can buy shares in outstanding businesses at approximately ten times earnings, especially when there is significant excess cash flow and current (and rising) dividend income, one should do it. If there are macro concerns, then one can hedge the overall portfolio against declines by purchasing inexpensive put options on market indexes that would rise in value if stock indexes decline.

Investors who do not feel compelled to remain fully invested have a key advantage over fully-invested investors. They don’t HAVE to be in the market all of the time. They can take a patient approach that Warren Buffett likened to a baseball player batting without strikes being called. (As a baseball fan, I can relate to that. And as a mediocre baseball player in my youth, I can REALLY relate to that!) They can wait for a “fat pitch” before swinging. With stock-market risks currently at a high level, having to stay fully invested today would be like standing at the plate facing ace pitcher Cliff Lee and having balls and strikes called.

So now is an ideal time to hold cash despite earning no yield in the short term. That way, there will be resources available to scoop up bargains after the next major market decline. Alternatively, maintaining a portfolio of undervalued large-capitalization stocks and hedging with index put options would also provide desired resources after a market decline, as the options could be sold at a profit and reinvested in newly-depressed common stocks.

Thus, for either category of investor, now is definitely not the time to be complacent about equity prices. But with straightforward strategies for protecting capital in the next decline and being poised for the next major rise in equity prices, one could have a deserved sense of equanimity.

Steve Lehman

S & P 500: 1305
Russell 2000: 803

Tuesday, February 22, 2011

A High-Risk Time for Stocks

There is extraordinary risk in the stock market now. Expectations are high, which leaves the market vulnerable to disappointment. Sentiment measures are at historic high levels of bullishness, and the put/call ratio is back to where it was last spring before the 15-20% drop in stock prices.

This optimism also is evident in expectations for earnings growth. Earnings growth of 19% expected over the next twelve months for the median S & P 500 company is among the highest levels since 1980. This also occurred at the major market tops of 1973 and 2008. Recent reports from the Producer Price Index input costs and the Philadelphia Fed show input prices rising at an unusually rapid rate. When that has happened historically, margins have been squeezed and earnings have fallen short of expectations. After a doubling—or more—in stock prices since the low of March, 2009; sentiment at high levels; and cyclically-adjusted earnings that place valuations at historically high levels, a cautious strategy makes sense. Tomorrow I’ll discuss some appropriate strategies.

Steve Lehman

Monday, February 21, 2011


Welcome to my new blog. For those not familiar with me, I've been a money manager for the last 25 years, including ten as a mutual-fund manager. I have experience across asset classes, including equities, fixed income, currencies, commodities, precious metals, and REITs.

I believe that investing is as much art, or behavioral study, as it is science. Investing is essentially the combination of valuation and contrarian psychology. Investing in asset classes that are historically undervalued offers a margin for error (or “margin of safety,” as Seth Klarman so eloquently explained in his book of the same title). This is related to contrarian psychology. Asset classes that are undervalued are so because they have become depressed in price. These assets are unpopular among investors, who have a strong herding instinct toward areas that have done well already and whose attributes have become obvious to even casual observers. It follows that an asset’s starting price greatly affects one’s likely return.

A contrarian value approach is easy to aspire to, since it makes so much sense. Buy assets that are selling for less than their true worth, and sell when they are selling for more than their true worth. (Ascertaining their true worth is a question for another day.) That is why many market participants claim to be contrarians, but a far smaller number have the necessary disposition to actually behave like one. Being a contrarian requires defying the conventional wisdom, especially of the supposed experts. Experts--especially economists and market strategists—tend merely to extrapolate recent trends into the future. If they make a bold stand or forecast that is markedly different from their peers, they take a big personal risk. The cost to them of being wrong in such a case is often the loss of employment. So it is much safer for their careers to be in the mainstream, even if it means going over the cliff with almost everyone else, as happened in 2000-2002 and 2008. This is nothing new. As the esteemed British economist (and market speculator) John Maynard Keynes wrote decades ago, "Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally." So be skeptical of forecasts, especially when they include the implied precision of decimal points!

Another aspect of a contrarian approach is the notion of risk. Conventional finance theory and institutional-investor practice define risk as an investment's volatility (and unpredictability). In response, Wall Street firms have devised exceedingly elaborate quantitative techniques to measure and purportedly control risk. Such models, devised by mathematical geniuses, appeal to clients who want the latest (and supposedly most sophisticated) approach. In 2008, we learned the limits of these arcane risk-modeling approaches, as they failed to anticipate market breaks, largely because of the assumption that the future would be similar to the relatively recent past. That also is why the record of forecasting is so abysmal, and why Nassim Taleb became a celebrity in pointing out the limits of conventional, linear thinking that fails to anticipate "bolts from the sky (my term)". Those supposedly sophisticated approaches to protecting capital largely failed in 2008 for the second time in less than a decade, as they did in the crash of 1987 when using the technique of "portfolio insurance."

Instead of adopting the conventional view of risk, I view risk simply as the probability of a permanent loss of capital. Buying undervalued assets reduces one’s chances of incurring such a permanent loss, as opposed to buying into a good “story” (at a high price) and hoping to sell at a higher price to another (the Greater Fool Theory). Yes, when asset prices swing sharply it is worrisome, but volatility often presents opportunities, specifically when markets are not in established, long-term trends. Furthermore, the conventional wisdom and conventional finance theory hold that high risk (volatility) leads to high returns, because investors demand a higher return to accept more volatile, uncertain returns. It sounds good in theory. But the wise strategist and behavioral-finance proponent James Montier cited evidence that in the stock market, low risk (volatility or beta) stocks with high dividend yields actually produced higher returns than high risk (beta) stocks. So much for conventional finance theory!

So with this blog, you will not get conventional thinking about investing. Instead, I hope you will get a fresh perspective--and I hope--profitable investment ideas. Stay tuned!

Steve Lehman