Our Timely Transition Continues

Includes: DIA, QQQ, SPY
by: Income Surfer

This post comes to you from central Indiana. It's my first time in the Hoosier state, and I am surprised by the mix of rolling hills, forest, and legitimate moisture. While spring had clearly emerged in Kansas and Missouri, it still looks like winter over here. The great plains were plenty dry, and the moisture in Indiana is a welcome relief. We are looking forward to exploring the state parks over the coming days, and poking around a few cities also. Learning about new parts of the US, and revisiting some of our favorites, is what our Extended Roadtrip is all about. So we'll keep traveling and being grateful that our work saving/investing has allowed us the flexibility to enjoy several months without a day job. We have been truly blessed and it feels great. Roll On!

Long time readers know that at IncomeSurfer.com, we aren't chartists. For us, the businesses behind the stock certificates tell 90% of the story we care about. Sure, prices and valuation matter, but we typically bottom up investors. Our process is to dig into the companies, then look at the valuation and price of each company measured against itself. We don't typically spend much time paying attention to charts and indicators, but we also know that investing doesn't occur in a vacuum. So when I see charts like the one below... it gives me pause.

First up is a two-year chart of the S&P 500 (using SPY as a market proxy). Take a look at the lower highs and lower lows in the chart below. I'm sure there is some fancy name for this chart pattern, but I don't really care. What I know intuitively is that this chart is suspect. If this chart was spread over a month or two, I wouldn't even give it a look, but this is a two-year chart, taken after 7 years of economic expansion.

Courtesy of Yahoo Finance

Much has also been said about the net level of margin debt outstanding on the NYSE. (The NYSE regularly publishes data of the margin debt levels.) David Stockman and other perma bears have been talking about the high levels of margin debt outstanding since at least late 2013. So why haven't equity markets collapsed over the last 2.5 years? Are things different this time? Maybe, maybe not, but honestly I doubt it. When these "experts" look at statistics and past indicators, they really seem to struggle to discern if those indicators were "causative" or just a symptom of a broken system. Many such indicators, such as the Margin Debt charts below, are a combination of the two in my opinion. Take a look at the two charts below.

I have always been skeptical of statistics, because they are so easily manipulated to produce a technician's desired outcome. In my former professional life as an engineer, you would never believe the number of times I have seen colleagues manipulate empirical formulas to produce desired results. Hell, I've even done it myself, with an eye if on what happens if I am wrong. Clearly, all such formulas require professional judgment, but the idea of "garbage in, garbage out" applies universally. So I always try to think for myself, and draw my own conclusions, while asking a lot of questions of the assumptions that others have made.

Where am I going with all of this dribble?! I admit that the two margin data charts have an impressive correlation with the S&P 500 results. I contend however, that those charts are only a starting point for your thought process if you seek to draw your own conclusions about what they mean. If you give a skilled statistician enough data, they can draw a correlation between ANYTHING. I really mean anything. Between the number of monarch butterflies migrating to Mexico and volcanic eruptions in southeast Asia. Anything! Some seemingly correlated factors do matter, but not all. To be significant to me, there needs to be clear causation. Show me that X happened BECAUSE of Y. Otherwise, they are just mildly interesting statistical facts.

Which brings me back to the 2nd and 3rd graphics above. Much has been said about the levels of margin debt, but in my opinion, the levels aren't nearly as important as the rate of change (think derivative or steepness of slope) of those levels. Yes, high levels of margin debt mean that the process of unwinding that debt will be longer and more painful, but it gives ZERO indication of WHEN that debt would be unwound.

In my own line of thinking, I can see how a rapid reduction in the outstanding margin balance would affect share prices. As the securities that were bought on margin are sold, and the margin loans repaid. I can also see how the prices of most securities would be adversely affected if the financial institutions that issued those margin loans suddenly called them in, also resulting in forced sales. So the question then would be whether the change in the rate of the outstanding margin balances is the RESULT of declining securities prices (i.e. scaring leveraged investors to take risk off the table BECAUSE of a reduction in prices), or if the reduction in margin balances CAUSES lower prices. For that critically important question, I have no answer. My belief is that it's a combination of the two, and that causation is possible in extreme events (like a global banking crisis), but not terribly likely at this moment in time.

That being said, I am paying attention and am glad that we are transitioning our accounts at the current time. So what are we doing to our portfolio? I can tell you that there will be no changes with regard to our Long-Term Holdings. These are companies that we intend to hold through thick and thin, for the coming decades. Already our largest positions, we have set aside $50k to purchase additional shares as the opportunity presents itself.

We are also in the process of selling positions in companies that we don't consider long-term holdings, with the idea of freeing up capital to invest in the four broad-based Vanguard indexed ETFs that we have written about so many times.

We don't mind taking some profits off the table at this point, but don't see any reason to panic or dump all of our positions. We have actually been systematically taking profits for some time. I personally think we are very late in this bull market, so I will leave you with a sage comment from my investing buddy Jay. It echos a comment Nathaniel Rothschild made in the 19th century.

"why risk 30% of my capital trying to squeeze another 5% out of the current stock market" ~Jay

As for us, we’re off to hike a state park. It’s a beautiful day up here in Indiana. Wishing each of you a great day!

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