Dalton — Bitcoin has been up nearly 20% year-to-date. Tesla is up almost 40% year-to-date. Even big-cap blue chips like Intel are up about 5% year-to-date. A quick search on a screening website found 572 other stocks that were up more than Intel year-to-date. A lot of them, of course, are crazy-tiny volatile small-cap stocks, but many of those names I’d feel OK putting in my mother’s portfolio, if I bought individual stocks. As a general rule, I don’t buy a lot of individual stocks for myself or for clients of my firm, Berkshire Money Management. Our clients happen to be more interested in not losing money than in hitting home runs. However, I hear from our six advisors that clients have been calling asking us to buy them some of those individual stocks that have been on a tear.
What does it mean when people who are generally more interested in not losing money suddenly want to get more aggressive? First, let me say there is nothing wrong with that. I work with fellow business owners all the time and we are much more likely to make business decisions when we feel more confident about the outcome. Investors want to buy stocks when they go up because they feel more confident that they will continue to go up. I can respect that. I have targeted investments I’ve considered buying, but I don’t ever feel compelled to be the first person to put in a dollar. Even if my research is solid, it doesn’t mean that the price of something must reflect that. My research can be right on the fundamentals, but the technical part, the price, can say, “Hold on! We’re still going down!” So, yeah, I like to see things go up before I start investing in something.
But the vibe now is a bit different. And it’s not just my clients. According to data from Lipper for the week ending Jan. 22, for the fifth week running, investors were overall net purchasers of equity funds. That may not sound too impressive, but even with double-digit gains for the stock market in 2019, investors poured a record amount of new cash into taxable-bond funds while net redemptions of U.S. equity mutual funds reached $41.3 billion. (There were $204.1 billion of net withdrawals from actively managed U.S. mutual funds, while passive funds, such as most ETFs, had net inflows of $162.7 billion). If you are wondering why stocks went up in 2019 as investors sold them, corporate buybacks totaling about $700 billion helped (corporate buybacks are predicted, by some, to be around $675 billion in 2020).
The vibe, after a decade of stock market gains, feels less like technical confirmation of fundamental research and more like that melt-up I’ve been talking about. The factor pushing up stocks has recently been, well, that everybody wants to buy stocks. In many ways, that’s good news for the intermediate and long-term health of the stock market — we want people interested in buying stocks to help keep up the prices. But short term, it’s unsustainable. Vastly overbought markets such as this one are highly vulnerable to a pullback. The start of the first correction of 2020 is virtually at our doorstep, if not already here.
Those returns I cited at the start of this column are examples of what you see during melt-ups, which are dramatic and unexpected rises in stock prices, driven partly by a stampede of investors who are buying things not because of a change in fundamental performance, but rather because they don’t want to miss out on price appreciation. When everyone who has wanted to buy stocks has bought stocks, the demand dries up and the price of those stocks suffer — the same is true for all goods and services. Melt-ups don’t necessarily have to resolve themselves with a crash, but they do have to be resolved — and often they are resolved by a correction.
I’ve argued over the last couple weeks that a retrenchment of the S&P 500 back to its 50-day moving average would be a reasonable resolution to this melt-up. Given the dramatic and unexpected rise in stock prices, a drop to the index’s 50-day moving average from its recent top would be about a 10% correction. Yikes. I mean, like most other 10% corrections, it’ll probably be forgotten as if it never happened. But it’s going to hurt going through it, if it is that big And if pain is coming, you probably want to know when. What will cause the correction and the corresponding pain? If you ask Ms. Market, she’s gonna tell you, “Just give me a reason.” She wants to go down. She’s ready.
And when she does go down, I’m going to be annoyed that whatever happens to be in the headlines at the time will be blamed as the reason why prices are dropping. Ugh. Correlation, my good friends, is not causation. However, the media and the narrative always treat it as such. Whether it’s WWIII trending on Twitter or the coronavirus or because “Bad Boys for Life” bombed at the box office, whatever is happening at the time the market goes down, the media will blame that. My annoyance aside, the point is the market doesn’t need a reason like that. We humans need a narrative to make sense of things because that gives us comfort. But the truth is the market is right on the edge of something we don’t want to be part of, but we’ll totally forget shortly after it happens. The solution isn’t to take drastic defensive measures, because volatility is simply the cost of being in the market. It’s natural. If you’re not used to playing in this sandbox by now, grab your shovel and pail and head back over to — well, nothing works with that metaphor, because the sandbox is the safe place for tots in a playground. Even kids can handle the volatility of the teeter totter or the monkey bars. A correction is just part of the game, and you can’t win if you’re not playing the game. So, keep playing.
That certainly doesn’t mean you stay on the playground if there are killer bees or creepy clowns buzzing about. Sometimes you do grab your shovel and pail and head to the comfort of home. Also, that doesn’t mean you can’t play it safe. And it’s time to play it safe. How? Rebalance! It’s one of the most underused tactical investment tools in the business, mostly because people don’t have a real plan; they just keep buying investments and holding onto them until they go down enough that it hurts too much to keep holding onto the declining investment. Instead of that strategy, take the time to sell and buy to adjust the allocation of your portfolio back into some semblance of what your plan would call for. There are most likely some riskier stocks or funds that have accelerated in price to the point where you own more of it than you should. Address this by selling those and reallocating the proceeds to the parts that have proven to be more stable. This will allow you to manage some of that downside volatility without taking you out of the long-term game, because it’s still time to play.
There is nothing contradictory in your plan by becoming increasingly more defensively oriented while keeping a claim on the upside, especially because I’ve got no idea on the timing. An overbought market can become more overbought. There is no way to determine when buyers will cease to step in. And I am reluctant to raise large amounts of cash when the Fed is currently being so accommodative to the stock market. Small steps here. Continue to ride this wave, but do so in a continuously defensive manner.
Regarding when you might need to take much bigger steps to secure the value of your portfolio, I have a few things on my radar: first, if there is a change in the White House that leads to an attack on capitalism. Feb. 3 kicks off the 2020 Democratic Party presidential primaries with the Iowa caucus, the first major contest of the U.S. presidential primary. Real Clear Politics has Bernie Sanders surging the last week over Joe Biden (Biden was up by a whisker a week ago). I think if the White House went Democratic, the stock market would digest Biden much better than most of his opponents. The stock market probably won’t like Sanders or Elizabeth Warren.
The second event that would accelerate our defensive measures would be if inflation got high enough to trigger the Fed to raise rates to battle it. We’re not there yet, and the good news is that there would be money to be made on the way to getting to that point. The third event isn’t as exact: I’m concerned about some sort of credit event. Interest rates are low enough to mask the sins of some consumers and corporations.
Today, we just trim the risk back a bit and get your portfolio to the allocations that fit your long-term plan. I’ll keep my eye out for you when we should change your long-term plan in favor of some much-needed short-term protection.
Allen Harris, the author of ‘Build It, Sell It, Profit: Taking Care of Business Today to Get Top Dollar When You Retire,’ is a Certified Value Growth Advisor and Certified Exit Planning Advisor for business owners. He is the owner of Berkshire Money Management in Dalton, managing investments of more than $400 million. His forecasts and opinions are purely his own. None of the information presented here should be construed as individualized investment advice, an endorsement of Berkshire Money Management or a solicitation to become a client of Berkshire Money Management. Direct inquiries to firstname.lastname@example.org.