In recent days, I have come across a couple of articles on Seeking Alpha debating whether or not the broad-based indices are in a secular bull or secular bear market. I spent some time thinking about which case I agree with more before concluding that the entire debate is rather pointless. It certainly can make for entertaining reading, and the Comments sections of the articles can add some food for thought. But what concerns me more than debating whether we are in a secular bull or secular bear market is understanding what is driving asset prices up and down and positioning my portfolio accordingly.
My portfolio is quite diverse in terms of the number of different assets and securities owned. The list includes numerous individual stocks, numerous individual corporate bonds, several individual Treasury bonds, gold, silver, platinum, and a small number of ETFs. Each asset class and each security plays a particular role in helping me work toward my financial goals. In today's article, I'd like to provide readers some insight into how I manage the equities portion of my portfolio.
I realize that each of us has different financial goals we would like to achieve, and our methods for doing so may be quite different. I would like to share the manner in which I manage my equities portfolio not only to provide food for thought for those readers who might be looking for new ideas, but also to illustrate that regardless of the type of market we are in (secular bull, cyclical bull, secular bear, cyclical bear), there are people who will get along just fine buying and selling stocks throughout as part of a larger portfolio plan.
Before sharing the three parts of my equities portfolio, I would like to briefly provide a high-level synopsis of my view on what has been driving equities higher in recent years. In short, I am of the opinion that the Fed's actions are the main driver (in several ways) of the rising stock market. Things such as an improving housing market, rising corporate earnings, and even the incredibly large deficits the U.S. government is able to run are, in my opinion, by-products of Fed actions (some more direct than others). The supposed "fix" in Europe is, in my opinion, solely the result of ECB actions and not the result of structural changes that addressed the root cause of the problems. The ECB is therefore a secondary driver of rising U.S. equities (yes, the ECB actions positively affect U.S. equities).
I could write an entire essay explaining why I am confident the Fed and the ECB are the two main drivers of rising equity prices, but for the purposes of this article, I would simply like to share my overarching view of the main reason stocks are rising. In many articles I've read and interviews I've seen in the financial media, I have come across financial pundits who assume that people who share my viewpoint are simply sitting in cash or are shorting the market. I am an example of someone who believes the Fed and ECB have played major roles (to different degrees) in pushing equity markets higher but is also long many stocks. Over the years, I've learned not to let personal political or economic beliefs get in the way of making money in the financial markets. The markets don't care about my personal beliefs, and they don't care about yours either. Despite the fact that I am not a fan of QE-forever, I cannot stop it and therefore must learn to live and invest in a QE-world.
With that in mind, let me share the three parts of my equity portfolio:
1. Multi-Cycle - The multi-cycle portion of my equity portfolio consists of numerous individual stocks and ETFs that I plan to hold through multiple economic cycles (expansions and contractions). In other words, during the multiple economic cycles, I anticipate riding out bull and bear markets with these stocks, assuming the businesses continue to perform as I expect them to. If something changes in terms of a company's business, and I believe a stock can no longer serve the functions I intended it to serve for my portfolio, then the stock will be sold. Examples of such stocks that currently reside in my portfolio include Wal-Mart (WMT), Johnson & Johnson (JNJ), Siemens (SI), and Royal Dutch Shell (RDS.A). These are companies that I believe have business models that will survive and thrive over time and are stocks that I purchased at prices low enough that I am confident the principal investment is relatively safe.
2. Single-Cycle - The single-cycle portion of my equity portfolio consists of stocks I am willing to hold during an economic expansion. My goal is to purchase these during periods of extreme market weakness and hold them until such a time that I believe the stocks themselves have had the majority of their run higher and the market as a whole has had the majority of its run higher (from a cyclical standpoint). Two such examples from my portfolio are Medtronic (MDT) and Paychex (PAYX). I have now completely sold out of those two positions and have also almost completely sold out of the single-cycle portion of my portfolio.
3. Trading - The trading portion of my equity portfolio consists of positions that I hold for less than a day to positions I may hold for several weeks. They can be single-stock positions, ETF positions, or even options positions (both calls and puts, both long and short). My intention when trading is to make what I consider a respectable return in a somewhat defined short period of time. For example, in recent weeks, I have been trading in-the-money puts on the iShares Russell 2000 ETF (IWM) from the long side. I have bought puts on IWM eight times since late January, day trading them six times and holding them overnight twice, with profits on each of the eight trades ranging from 0.50% to 2.25%. Why am I telling you this? The reason is that some of those trades occurred on days IWM closed higher, and I want to illustrate the fact that traders can make money shorting even on up days, just as traders can make money being long on down days. Timing, among other things, matters tremendously when trading. When you see an up day in the market, don't assume that everyone who was short that day lost money, just as when you see a down day, do not assume that everyone who was long that day lost money.
Trading is a different animal from the more traditional buy-and-hold investing, and it requires a completely different skill set. Despite the fact that I have been trading from the short side in recent weeks, I do not recommend that any readers put on trades similar to mine without being comfortable with the risks associated with short selling and options. Investors putting on such trades should also have the capital to withstand significant volatility and potentially even losses.
Let me continue by addressing one question I think some readers may have about my take on rising stock prices relative to my recently selling down the single-cycle portion of my equity portfolio. If I think QE is the predominant driver of equity prices, and the Fed is in the midst of QE-forever, why would I sell my single-cycle equities? In a nutshell, I think the Fed and the U.S. equity market indices have reached the point that the Fed, going forward, will struggle to print enough electronic money to satisfy the demands of those equity participants who have the largest influence on equity prices. And given that struggle, the net benefit from QE on equity prices will slowly diminish. It wouldn't surprise me if the Fed does enough to keep the stock market inching along at low single-digit annualized gains (relative to the recent highs) for a period of time. But those types of returns, combined with the very real risk of something worse than that happening, are simply not enough for me to hold onto the single-cycle equities at this point in the economic and stock market cycles.
Despite the fact that I think the more recent rounds of QE could prove to do more long-run damage than good to the U.S. economy, it doesn't stop me from owning stocks. We live in a QE world. That is a world dominated by cheap money flooding the financial system. That is a world in which confidence in fiat currencies is slowly being eroded. And that is a world in which many financial, business, and investment decisions are being made solely because of the excess liquidity floating around and because of the confidence that the Fed (and even politicians) will be there to save the day should asset prices begin to fall. That is not a situation that I envision surviving over the long-run. The problem is that I cannot define with precise accuracy when the long-run becomes the short-run.
Therefore, I own stocks as a form of protection (along with precious metals) against currency debasement and as protection against the possibility that the Fed defeats the strong deflationary forces that lurk beneath the surface in the global economy. And I do my best to manage my equity portfolio in a way that both respects the power the Fed has over financial markets but also recognizes that the party will end at some point. Whether or not you agree with my method of managing stocks in a QE world, I hope I've at least provided you some solid food for thought.
Good luck and happy investing!
Additional disclosure: I am also long JNJ and WMT bonds.