The January Massacre, The Duke Of Wellington, And The Value Of Reserves

Includes: DIA, IWM, QQQ, SPY
by: Jim Sloan


I have not written in the area of market macro or offered stock selections for over a year because I have felt my opinions would not be helpful.

While studying the life of Wellington, who defeated Napoleon, I have found a metaphor - maybe more than a metaphor - about the value of reserves.

Whether one should hold reserves at times or be always fully invested may be argued by intelligent market analysts; human frailty, if nothing else, may argue for cash reserves.

Nobody really knows what will happen next in the market, but we must make estimates.

In turbulent markets the right balance of cash and equities exists at an "efficient frontier of indifference," where the investor is indifferent to major market action.

analysis For over a year I have had little to say either in the macro area or on the particular virtues of individual stocks. As for the likely action in the market overall, I have an opinion, of course, but there is no shortage of articles expressing market opinions, and mine are so provisional, so couched in probabilities, and so driven by my own idiosyncratic weighting of many factors as to seem not very useful for most market participants. Silence has seemed best.

As for individual stocks, I also hold quite a few opinions, but I have restrained myself from sharing them because the truth is that over the short to intermediate term the action of the broader market tends to overwhelm the relative performance of individual stocks. This is especially true at moments like the present. At least three quarters of individual stocks move in the same general direction as the market, and if you take the wrong side of the market's movement in individual positions - well, I wish you the best.

Instead of adding one more piece expressing a broad market opinion I have written pieces which nibbled around the edge of things - a look at some aspects of the KMI debacle, a suggestion for arbitraging the Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B)/Precision Castparts (NYSE:PCP) deal (a suggestion which I feel is still valid), and some strategic think pieces on retirement planning, pensions, and Social Security - useful, I hope, but not very sexy.

Meanwhile I have been reading up on the Duke of Wellington.

Wellington And The Value Of Reserves

For a lifelong student of military history I came late to studying the Iron Duke - the conqueror of Napoleon and of much of the Indian sub-continent. Wellington never lost a battle. Think of it. In widely varying circumstances and often with indifferent troops drawn from several nations he prevailed wherever he commanded. He overcame all comers from India to the Peninsula Campaign in Portugal and Spain to, finally, Waterloo. I commend him to all who have the slightest interest in military history and strategy and suggest that you might start with the Wellington section of John Keegan's fine study The Mask of Command. Wellington was a superb battlefield leader and a man's man of the first order, but he was also a cool strategist - and a deeply conservative one - whose principles of warfare seem to me to have application when it comes to markets like the present.

Wellington once stated that the presence of Napoleon on a battlefield had a value equal to an extra 40,000 troops (a generous compliment to a defeated foe who failed to reciprocate by saying that Wellington roaming the front lines at Waterloo was probably worth at least as many). Later, however, Wellington refined his statement by saying that he had spoken loosely, and that while Napoleon was worth 40,000 men when comparing the size of two armies, that was not at all the same thing as having 40,000 fresh troops in reserve.

Having troops held in reserve was a lifelong obsession of Wellington, and it never served him better than at Waterloo. In the middle stages of the battle he had troops in reserve to shore up places where his line was failing and to recapture lost strong points. At the end of the day he went all in, committing everything he had. "In for a penny, in for a pound," he shouted while waving the last of his reserves forward. Napoleon's never-before-defeated imperial guard faltered and broke, and Wellington's army conducted a devastating pursuit which put a permanent end to Napoleon and French dreams of empire. Wellington's use of reserves at Waterloo is a consummate study of skill and timing in the use of reserves, and it contains a powerful suggestion for participants in the financial markets.

Should One Almost Always Hold A Cash Reserve?

Some strategists argue that it is a long term mistake to hold any reserves at all. There is no knowing what is about to happen on the battlefield of the market, and therefore no rational way to decide how much to hold as a cash reserve. The greatest risk, they say, is of being underinvested while the market is doing well. I acknowledge that point of view, but I disagree with it. Although my approach must inevitably admit to some element of market timing, I do not think it is the sort of market timing which has become a swear word in some sophisticated market circles. It has nothing to do with trying to call tops or bottoms in the market. What it does have to do with is the fact that different market conditions suggest different levels of cash reserve.

What I try to do is what a successful battlefield commander does: assess the overall situation. What are the goals? What are the risks? What do I stand to gain if I succeed? What do I stand to lose if I am wrong? What are the probabilities? What can I estimate about intangibles and incalculables which may affect the outcome?

Putting it this way seems almost pedestrian, but I read many articles here and elsewhere which do not incorporate enough elements of the above battlefield assessment. An example common in income and retirement investing is excessive focus on pressing personal goals -- "what I stand to gain," or more often, "what I need to gain." A part of the reason has to do with the times. Two major market crackups in fifteen years and the very low risk-free rate engendered by the Fed's effort to fix things have left many people badly short of income needed for retirement.

Two very dubious approaches get applied to this income problem. One is the advice that to make up the shortfall, investors have to undertake more risk. This approach treats "risk" as if it were the kind of nominal boilerplate disclaimer we all tend to ignore. But risk is nothing of the kind. Risk is risk. The last thing a person under financial duress needs is more losses.

The other dubious approach is recommendation of a particular stock or investment vehicle out of context - without considering overall market environment. I see a lot of that right now. I keep a back-of-envelope list of stocks (often including stocks recommended on SA) which would be pretty interesting with the market currents at my back, but which face pretty heavy pulling with the overall trend negative or in serious doubt.

(The converse error, of course, is an obsession with "what I stand to lose if I am wrong." This was the error of George McClellan, the general who most often disappointed Abraham Lincoln by inaction. He drilled up a great army but couldn't bring himself to commit it to battles because, hey, terrible things often happen in battles. This is the definition of the stopped-clock bear.)

How then might one approach the question of correct balance between aggressive risk-taking and excessive reserves in a turbulent market like the present one?

The Other Side Of The Hill

Wellington famously said: "The whole art of war is getting at what is on the other side of the hill." He himself often concealed his forces in that way, behind a ridge where they could jump up with volley fire to surprise opponents disdainful of risks. He used this concealment brilliantly at Waterloo.

Nobody really knows what is waiting on the other side of the hill - a plague, maybe, a terrorist event, alien invaders, hyperinflation. We just don't know. All we can do is sort out things that are improbable from things that are fairly likely. We must ask: how much can we know, and how can we come to know it?

The answer for me is to use all the tools I possess as well as a few shortcuts and guesstimating tricks. I know both anecdotally and from published statistics that the economy has been growing relatively poorly since the 2008 crack-up. That's enough to know on that subject.

I also know that earnings growth of U.S. corporations has depended significantly on share buybacks, and that despite continuing buybacks earnings growth appears to have gone negative over the last year. I know that this is in part due to poor translations of profits earned in other currencies (the strength of the dollar) and in part due to the breakdown of the oil sector, but I suspect that neither of these is the whole story.

I know that the stocks I own in less cyclical industries have done reasonably well over the last year while those I own or have owned in cyclical areas have done much less well, especially in the last few months. This is information I know intimately and securely. I also know that this sort of market action often (but not always) precedes broad market declines and suggests caution about the economy.

I watch market action and market technicals, less systematically than most technicians but drawing upon more than fifty years of anecdotal observation. Recent market action has been bad and has gone from bad to worse - poor action in the broader market, and more recently inability to rally strongly when oversold, leading to a series of lower highs and lower lows.

I use an informal Bayesian approach, checking the ongoing progress of my own observations. I ask if events are unfolding in a manner which tends to validate or invalidate my original working assumptions?

Here's a quirky example. Sometime in the summer of 2015 a very brief glance at the daily charts of the major averages produced a mental picture resembling sketches of fully opened parachutes (or umbrellas, or inverted saucers). A glance was all it took. The sketches were incomplete at that point. I formed a mental picture of how these parachute sketches would need to unfold if they were to complete the rounding tops they had started to resemble. Then I waited, making occasional brief checks on the charts.

What happened over several months was that the images of a market rolling over developed just as I would have expected. Markets that look like that at a casual glance are a technician's version of a Malcolm Gladwell "blink" - the second or two of first impression which leads physicians to better diagnoses than dozens of careful tests.

In my experience stock charts that look like parachutes often end in significant corrections, with the size of the correction roughly correlating to the scale of the parachute. In this case the rolling over took about a year to complete - a relatively long process. The January massacre we are currently experiencing looks - again at a brief glimpse - a lot like the beginning of the major correction one might expect.

Of course I don't stop with brief, personal, anecdotal observation. I pay close attention to writers I have learned to respect, including several on SA. Sometimes their views conflict. Jeffrey Gundlach, who represents the best current wisdom from the bond crowd, has a well articulated bearish view. Jeff Miller, a stalwart of SA, appears to have a cautious but bullish view. Where does one go with opposing opinions by smart and serious people? I try to consider their arguments without trying to decide exactly which one is right. Instead I ask if there might be some sort of synthesis in which their apparently opposite views might be reconciled.

I also look at the views of mainstream technicians, including subscription sources John Murphy and Charles Kirk. Both have reinforced my anecdotal caution about market price action. But remember: technicians think market action is everything. Fundamental analysts like Gundlach and Miller think fundamentals are everything. Neither is everything. Both are everything.

To me each piece of evidence, fundamental or technical, is part of a whole picture which almost always contains contradictions.

The Efficient Frontier of Indifference

So what should you do? I think you must come to a best provisional judgment, first about the market, then, equally important, about yourself. What is the value in your life of pressing for small gains? What is the damage that would be done to your life by a large drawdown? What are the scale and probability of each?

As far back as late 2013 I personally began to scale up my cash reserves. I didn't miss the up move into the middle of 2014 - my portfolio went up with the market, my stock positions in aggregate outperforming the S&P (slightly), but my equity "bucket" underperforming when including cash reserves. That was fine with me. My feeling then was that the other side of the hill might contain modest gains for quite a while but might also contain a serious enough drawdown at some point to warrant holding a fair amount of cash.

How would I behave in the event of a serious drawdown? I wasn't sure then, am not sure now, but I know that if fully invested I wouldn't like it much. I would have no positive action to take and might feel great pressure toward exactly the wrong action at the worst moment.

There have been two major crackups in the past twenty years. I did very well during the first - the dotcom crash - in part because the market offered alternatives, small caps (then greatly undervalued) and certain sectors (including housing stocks which were then early in the build toward their own bubble). I did less well (though luckily not disastrously) in the 2007-2009 crackup mainly because the value-investing metrics I have always believed in did not perform in the usual way.

Do I expect a crash like the ones that began in 2000 and 2007? No.

Do I think the major drawdown has begun? I'm not sure.

What I do think is that the next big drawdown will be characterized by a situation in which there is no place to hide. There is just cash, or a very close equivalent, which I wrote about in this article back in 2013.

But how much cash?

I can't answer that question for anyone but myself, but I will repeat a view of cash from that earlier article. Cash and equities sit on opposite sides of a seesaw. When equities get clobbered, cash effectively rallies. The price of a dollar bill doesn't go up, but its value does. If it sits in your equity bucket, it rallies in terms of the stocks it will buy.

I want to wake up every morning feeling indifferent to what the market does. The trick is to keep the equity/cash allocation in my portfolio at the efficient frontier of indifference. It's the allocation level which equalizes my expectation of future opportunities if the market declines with the satisfaction I will have if my stock portfolio continues to rise modestly. If the market seemed outrageously cheap I would feel differently, but this is how I want to feel in a turbulent and somewhat overpriced market.

No two people will come at this question with exactly the same assumptions - the same time frame, the same assessment of the financial world, the same attitude toward risk. I have asked myself if my looking at the markets this way is a luxury which derives from having a pension which enables me to worry less about income. I don't think this is the case. A pension which relieves the pressure to produce immediate income shifts the curve, but does not change the basic framework.

Should you assume my market view? No.

Should you consider the process? Maybe.

I do have one suggestion for turbulent markets.

Attention To Small Creatures And Small Duties

My own daily rituals include several tasks which take the edge off of market concerns. I make my wife a breakfast of fruits and yogurt and a lunch salad of kale, quinoa, tomatoes, etc, which I hope will prevent her from eating junk foods during the day. I also attend my cat and honor his requirement of being petted while he eats. I tell him that I continue to like him a lot and thank him for the added two years of life expectancy that actuaries say he provides.

I also try to think of one or two people who are not currently enjoying the exceptional good luck I have had in most areas of my life. A couple of SA writers are among them, having shared with readers the fact that they or their loved ones have serious illnesses. I send my best hopes their way and remind myself that many of the best things in my life are random and unearned. Every now and then I come across a small thing I can do for a less fortunate person - not a cause, a person. What the market does that day seems less important.

As for the Duke of Wellington, conqueror of Napoleon, he served twice as British Prime Minister and served as commander-in-chief of the British army until his death at the age of 83. He did not entirely dismiss small things, however. I can't leave a piece invoking the Iron Duke, conqueror of Napoleon, without repeating an anecdote from his later years that shows a more human side which perhaps tangentially contributed to his success:

The Duke once met a little boy, crying by the road. "Come now, that's no way for a young gentleman to behave. What's the matter?" he asked.
"I have to go away to school tomorrow," sobbed the child, "and I'm worried about my pet toad. There's no-one else to care for it and I shan't know how it is."
Keen to ease the little chap's discomfort, the Duke promised to attend to the matter personally.

After the boy had been at school for just over a week, he received a note: "Field Marshall the Duke of Wellington presents his compliments to Master ---- and has the pleasure to inform him that his toad is well."

Disclosure: I am/we are long BRK.B, PCP.

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.