Bullish Backdrop Continues But Signs Of Stress Appear

My colleague, Mark Yusko, just recently penned his 4th-quarter market review which is well worth reading in its entirety. However, buried inside of it was this terrific bit of insight from Roger Babson.

“Roger Babson’s success as an investor, and in running his investment research firm was, to some large degree, based on his unique (some might say unorthodox) beliefs in how markets functioned. Babson was quoted as saying, “Don’t look for society to give you permission to be yourself,” and his willingness to start an investment business based on a theory that many dismissed as something akin to astrology was notable (particularly because it ended up working).

During his time at M.I.T., Babson became interested in Newton’s third law and posited a theory that the business cycle was driven in part by the interplay between human participants and gravity. Over the course of his career Babson researched and developed Newton’s theory and came to the conclusion that economic variables (and even the stock market itself) could be explained by the gravitational forces of the earth. Working with M.I.T. Professor of Engineering George F. Swain, Babson applied the concept of actions and reactions to classical economics, which led to the development of the Babsonchart of Economic Indicators. The Babsonchart was designed to not only assess current economic, business and investment conditions, but to predict future conditions as well. Having amassed a meaningful fortune himself, Babson expanded his business information business into wealth management after the Financial Panic of 1907 and utilized the Babsonchart to counsel on when it was wise to be in the markets or out of the markets (one of the first tactical allocation services). Babson had concluded that there was a better way to manage wealth, saying,

“More people should learn to tell their dollars where to go instead of asking them where they went.”

Babson thought it was important to just begin his wealth management effort with his own capital because he believed that, “people would rather be shown how valuable you are, not told.” Actions always speak louder than words, and Roger Babson was always a man of action. As a disciple of Newton, Babson drew strength from the construct of “actions and reactions,” so whenever an endeavor in Babson’s life ended, a new one immediately began to take its place. Babson had an amazing ability to never be discouraged by setbacks. One of his mantras was, “When we are flat on our backs there is no way to look but up.” Perhaps his greatest strength, however, was his willingness to take chances and to rebound when the risks at the time perceived by others seemed to overwhelm the likelihood of a successful outcome.”

Babson developed his own list of “Ten Commandments of Investing” that he encouraged his readers and clients to follow:

1. Keep speculation and investments separate. This is a very important concept that is often lost on market participants. We describe it as the Three Bucket Rule. Everyone should have three buckets in their portfolio:
   1. The Liquidity Bucket (10% to 15% to cover lifestyle costs),
   2. The Stay Rich Bucket (70% to 80% that is diversified, long-term investments,) and;
   3. The Get Rich Bucket (10% to 15% for speculation, we joke this is for the stock tips and friends & family deals, unfortunately, you will likely lose it all, so keep it small).
2. Don’t be fooled by a name. Make sure you know what you are buying as names can be deceiving. For example, the Blue Chip Growth Fund in my 401(k) that turned out to be “the Blue Chips of the future” and was actually small-cap growth instead of large-cap core.
3. Be wary of new promotions. If a financial services firm is selling you something new, it is likely that they have figured out how to package up an old idea with higher fees for themselves.
4. Give due consideration to market ability. Be honest with yourself about how much time you are willing to commit to investing and whether you have the knowledge, temperament and discipline to be an effective investor.
5. Don’t buy without proper facts. Do your homework and never (ever) buy a stock tip. Always remember there is someone on the other side of every transaction who has done at least as much diligence and research as you have.
6. Safeguard purchases through diversification. Concentrated portfolios make you rich (or poor) and diversified portfolios keep you rich. How do you create a small fortune? Start with a large fortune and stay concentrated.
7. Don’t try to diversify by buying different securities of the same company. Single company risk is a very dangerous game (that said, over the past 80 years there have been some developments in capital structure arbitrage which make this rule a little less absolute).
8. Small companies should be carefully scrutinized. Back in Babson’s time this was a really big deal as the small companies that went public were dicey at best, and fraudulent at worst. With the increased regulatory burden placed on public companies today, there is somewhat less risk, but small-caps are still very volatile and should be handled with extra care.
9. Buy adequate security, not super abundance. Investing is about taking intelligent risks. You must take risk in order to make an adequate return, but you only want to take the risks where you are adequately compensated.
10. Choose your dealer and buy outright (i.e., don’t buy on margin.) Leverage is a tool. It can be used to amplify the returns of any assets, but the danger of margin is you are leveraging leveraged assets, which can lead to problems. The real danger is leverage can’t make a bad investment good, but it can make a good investment bad through forced selling at inopportune times

“I repeat what I said at this time last year and the year before, that sooner or later a crash is coming which will take down the leading stocks and cause a decline of 60 to 80 points in the Dow Jones Barometer. Fair weather cannot always continue. The Economic Cycle is in progress today as it was in the past. The Federal Reserve System has put the banks in a strong position, but it has not changed human nature. More people are borrowing and speculating today than ever in our history. Sooner or later a crash is coming and it may be terrific. Wise are those investors who now get out of debt and reef their sails. This does not mean selling all you have, but it does mean paying up your loans and avoiding margin speculation. Sooner or later the stock market boom will collapse like the Florida boom. Some day the time is coming when the market will begin to slide off, sellers will exceed buyers, and paper profits will begin to disappear. Then there will immediately be a stampede to save what paper profits then exist.” – Roger Babson, September 5th, 1929.

The crash began just a few weeks later…on October 29th, 1929.

Make no mistake. The bulls clearly remain in charge of the market currently. Just don’t fall into the “complacency trap” that such will always be the case. This is why having some method of managing risk is critical to long-term investment success.

Data Analysis Of The Market & Sectors For Traders

S&P 500 Tear Sheet

The “Tear Sheet” below is a “reference sheet” provide some historical context to markets, sectors, etc. and looking for deviations from historical extremes. If you have any suggestions or additions you would like to see, send me an emai l.