Long-Term Investing In The Age Of Black Swans

by: AlanHHI

I've always thought of myself as a long term investor. When I started investing in the mid-1990's I thought that I would own the same stocks for years, if not decades, and I could ride the ups and downs. Not only that, but a large part of my portfolio was in tech (much too large, but that's another article), and that was a great place to be at the time.

These days I've still got a concentrated portfolio, but it is more balanced. I have many energy MLPs [including Breitburn Energy (BBEP), Linn Energy (LINE), and Vanguard Natural Resources (NYSE:VNR)]. I've still got tech [including Apple (NASDAQ:AAPL) and Google (NASDAQ:GOOG)], and I've got some consumer discretionary [including McDonald's (NYSE:MCD), Panera Bread (NASDAQ:PNRA), and Home Depot (NYSE:HD)]. In addition, half the portfolio is in financial preferred stocks paying about 7% interest.

Most of the portfolio is in IRAs, so I have flexibility to sell positions and buy them back without major tax consequences. I still like to hold positions for a long time (years), but the "Black Swans" of the last few years have affected my general approach to investing. In the past I could not imagine selling my entire portfolio at once. These days, I'm willing to "sell everything" under the right conditions.

A Black Swan is an event that causes a steep drop in the market, usually over a sustained period of time. The one that's usually cited is the crash of 2008. This crash happened when Lehman Bros. was allowed to go bankrupt, and the stock market dropped by nearly 50%.

I never did sell out during this 2008 Black Swan, but I did reduce my positions during most of it. Fortunately, I was lucky enough to get back in during April of 2009 and I was back to even by the end of 2010.

That experience, together with the debt ceiling fiasco I describe below, has changed my thinking about keeping positions in a time of major market stress. This is especially true when the market stress is purposely caused by politicians.

Potential Black Swans that might make me sell all of my common stocks include:

  • The debt ceiling fiasco -- From time to time Congress must increase the debt ceiling to allow the United States to keep paying its bills. In the past Congress has occasionally refused to increase the debt ceiling until the White House would agree to relatively minor unrelated changes. However, in August of 2011, Congress threatened to use this debt ceiling tactic unless the White House went along with major changes. The crisis was finally averted, but only about 12 hours before the deadline.
  • Even though the debt ceiling was raised in time, the length and uncertainty of the process caused a market crisis with the S&P 500 dropping 18.5% from 1,350 to 1,100.

  • The most frightening thing about the debt ceiling fiasco is that we are subject to another one as soon as January, 2013. Either a majority of the House or 41 senators can cause it. Thus, it is very possible that another debt ceiling threat will be made regardless of who is elected president. Perhaps our "leaders" have learned their lesson, but I an not at all sure; especially since soon after the debt ceiling compromise last year the congressional leaders promised to try it again.
  • The "fiscal cliff" -- Unless the Congress and the president act, a combination of tax increases and spending cuts will shrink the ecomony by 1.3% in the first half on 2013. This will likely cause a recession and a significant drop in the stock market. I do not believe the danger to the market from the fiscal cliff is as serious as a debt ceiling fiasco, but I am afraid that the timing of the fiscal cliff may make a January 2013 debt fiasco more likely.
  • The euro collapse - Every few months we are reminded that the debt of many European countries is out of control. The mechanisms available to deal with this debt are both difficult and time consuming. There is fear that a "Lehman event" will arise in Europe and the European countries will not be able to fix it even if they want to.
  • A collapse of the euro could be even uglier that the Lehman bankruptcy. This fear surfaced (or perhaps resurfaced) shortly after the debt ceiling fiasco last year. As shown below, the market didn't recover from the 1-2 punch of the debt ceiling fiasco/ euro crisis until February 2012

It should be noted that the debt ceiling crisis and fiscal cliff are known events and can be stopped or fixed by the idiots in Washington (with apologies to idiots for the comparison). The timing of a euro collapse is uncertain, and it may not be able to be fixed when it does occur.

With all of this hanging over our heads, I intend to take the following approach to the threat of a debt ceiling fiasco/ fiscal cliff at the beginning of 2013:

  • I will watch carefully after the election to see whether partisan comprise is likely or even possible.
  • I intend to publish another article next month reviewing my thinking once we know who will be occupying the White House and Congress next year.
  • I will be seriously considering selling all of my common stock and sitting in cash and preferred stock by the end of 2012.
  • Once we are past the debt ceiling and fiscal cliff I plan to buy back everything and get back to the same position I am in right now.

By taking this approach to the debt ceiling/ fiscal cliff, I understand that I may be foregoing a lot of gains if the politicians behave responsibly after the election. I will be very pleased if this happens in spite of the forgone gains. Sadly, I believe the chances that our leaders will behave in both a timely and responsible manner are small, so I'm willing to forgo those gains to avoid the downside that may occur it our politicians disappoint me again.

Even though the euro collapse may be more dangerous than the debt ceiling/ fiscal cliff, the timing is uncertain so I don't feel I can sell in front of it. When and if the euro collapses I'm prepared to sell all my common stocks as soon as it looks to be ugly. There were several weeks to sell after the 2008 Lehman crash and still preserve most of the portfolio. I plan to take the same approach for a euro collapse and hope to preserve most of my gains.

In addition, my whole long term investment approach has changed in these ways:

  • I used to consider how a stock would perform over several years before I purchased it. These days I worry much less about performance after a year or two. With all of the Black Swans out there it is likely I will be selling everything before the out years come up.
  • A large part of my portfolio is in high dividend common stocks and MLPs. The Fed has promised to keep interest rates extremely low until 2015. Normally, I would very concerned about what would happened to these stocks and MLPs after interest rates begin to rise. I am still concerned about rates rising, but much less than I used to be since the politicians may well have me selling everything before then.

Disclosure: I am long AAPL, BBEP, GOOG, HD, LINE, MCD, PNRA, VNR. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.