A Response To Chuck Carnevale

by: Roger Nusbaum

An advisor/blogger named Chuck Carnevale wrote a post called "Volatility Is Not Risk" which he said was "inspired" by my post from last Sunday. Here is a link to the Seeking Alpha version which drew a lot of comments as of the last time I looked. Chuck was kind enough to let me know ahead of time about his post and I believe he invited me to respond. He said he generally views many aspects of portfolio management differently than I do. It appears as though he focuses on dividend stocks but I do not know if he does so exclusively.

There are countless ways to have success in markets both in nominal terms and risk adjusted terms so different approaches are of course valid. No single approach can be best for all times and all market conditions (a point I have made many times), all approaches have flaws and attributes and ultimately each end user must settle on what is best for them.

In my post on Sunday I talked about complacent attitudes toward risk that develop after something has been working for a while and I talked about strong holders of a stock versus weak holders and that weak holders are the ones who typically panic sell. I used the example of client holding Philip Morris Intl (NYSE:PM) and its 32% drop into the 2009 low as an example of weak hands selling.

Early in his post Chuck said he took "exception" to a couple of points that I made. He said my "assumption that a bear market will provide a tragic outcome because dismayed investors will panic is more assumption than fact." He took further "exception" to what he believes is my insinuation "that dividend paying stocks are not safe investments." Finally he thought my example with PM was misleading.

Before responding I should note that the article is very long and I may have missed some of Chuck's contextual points.

He starts out making his argument by acknowledging that weak holders do exist but I think he then goes on to say that if they do exist it is because of "the preponderance of negatively biased information that is promulgated upon the general public, especially regarding equities and how risky they are. In other words, if people were offered a more reasoned perspective, then perhaps much of the irrational and catastrophic panic selling that Roger alludes to could be avoided."

If Chuck is calling for more reason during times of large and fast market declines then (shameless self promotion alert) I would point him to this blog starting long before the 2008 bear market and then all the way through it in terms of pre-planning a defensive strategy ahead of time while still in a rational state of mind and then sticking to it. If anything, the time to worry (not the best word because of the emotion implied) is right here right now while things are going well in the market.

Frankly as I read that part of Chucks article I don't think it had much to do with my post. Yes, there should not be a lot of articles that engender fear after the market has dropped a lot but there are. Putting aside that I have a track record for writing keep your emotion in check articles after the market has gone down a lot the fact remains that many market participants react badly in the face of large and fast declines (otherwise there would never be any large and fast declines) and anyone not realizing this ahead of time (this is the context of my posts before the crisis) will be shocked. Human behavior is such that we tend to make poor decisions when we are shocked or in some other heightened emotional state. This is my "assumption" based on first hand observations going back to 1984 and also based on talking to clients in the various roles I have had in the industry over that time.

The "tragic outcome" occurs when people have not prepared mentally for a large decline. There will be another nasty bear market, people will panic sell because they did not prepare and somehow forgot what the last one felt like. I have seen this repeat cycle after cycle and I would think Chuck has too, having been in the industry longer than I have. People should not panic but they do. Realizing ahead of time that others will panic can help you prevent your own panic--again this is the context of my thread.

As far as insinuating that dividend stocks are not safe, he outlined his belief that bonds are currently more expensive. They probably are more expensive. I have been writing for several years the extent to which we have been keeping maturities very short because of what I believe are persistently unattractive risk reward trade-offs going further out on the curve.

"Dividend stocks not safe" is pretty vague as many banks with great dividend histories proved out to not be safe. The full context of this idea is that for investors or advisors who don't know better, a 32% decline in PM (sticking with the same example) is not "safe" if they were expecting a bond substitute which is how dividend stocks have been portrayed in many places. We have owned PM for many years (started the position as Altria) and did not sell it as part of our defensive strategy because of the yield, the elasticity of demand for the product and history of doing relatively well during bear markets/recessions. A 32% decline in a down 56% world is a great result for a stock in my opinion but I think it is terrible for someone who was expecting no decline (no decline is of course irrational perception not potential reality).

Chuck made the fundamental case for why PM should have been held onto and while the business did just fine the stock did drop 32%. If in a couple of years (or sooner) there is a 30-40% bear market decline I would expect PM to drop 15-20% regardless of whether it was justified and would be thrilled with that result in the context of it being an equity holding. If I explain the holding to any clients as a bond substitute and it dropped that much I would expect my phone to blow up and if the bond portion of client portfolios were heavy in stocks like this I would expect to lose clients.

Part of what I try to do as a portfolio manager (my perception of how to do the job) is to let client assets grow when conditions are favorable and protect client assets when conditions aren't so favorable. Part of this process then is understanding/remembering how people and markets react under stress and often people and markets react poorly under stress (repeated for emphasis). They shouldn't but they do.

As I say early on above (and throughout the life of this site for that matter) Chuck makes a point about what is best for him (and his clients have to buy into that to be happy) and I make a point about what is best for me (and our firm's clients have to buy into that to be happy) and if you are a do-it-yourselfer then you might find bits of process to take from each, one or neither to create your own process.

On an exciting personal note, today is the Prescott Basin Ops Drill, which is annual inter-agency training drill with two components; a simulation of a Type 3 Incident (which is pretty big but not Wallow Fire size) and some form of training for the boots on the ground firefighters. I have been part of the group that organized the event for the last two years, which is a new role for our department, and we have always participated in the boots on the ground training but this year I'm going to have a chance to be involved with the simulated incident as the deputy incident commander, which is great for our department and recognition that a Type 3 Incident could easily start in Walker and having us involved might make sense-at least that is how I am taking it and am very excited for the learning opportunity.