Stop-Loss Orders Can Lose Money Quickly (2010-05-17)

Stop-Loss Orders Can Lose Money Quickly

(2010-05-17) by David John Marotta

After investors and their advisors experienced the precipitous market drop during the fall of 2008, many people searched for ways to protect their assets. After a year-long review of possible ideas, I decided to stay the course and not change our investment strategy. Every technique I reviewed would have put such a drag on portfolios as to erase gains over the last 10 years.

Although the S&P 500 had a flat or down decade, even my simple gone-fishing portfolio had satisfying gains over that same time period. I write every year or so about how this diversified portfolio is doing. Although they aren't even the best funds to select today, they remain popular funds with low expense ratios.

The portfolio consists of 20% Vanguard Total Bond Index (VBMFX), 21% Vanguard 500 Index (VFINX), 10% Vanguard Small Cap Index (NAESX), 21% Vanguard Total International Stock (VGTSX), 10% Vanguard Emerging Market Index (VEIEX) and the final 18% in T. Rowe Price New Era Fund (PRNEX).

Through the end of April 2010, that portfolio has a 6.05% 10-year annual return versus 0.19% for the S&P 500 alone. Over 10 years, that's the difference between being up 79.93% and down 1.88%. Diversification over the last decade boosted returns significantly. It doesn't always safeguard you from market losses, but as I said, anything you do to protect yourself from losses can weigh down portfolio returns significantly.

My favorite quote last year was from former Fed chairman Paul Volcker: "You can't hedge the world." If you try too hard to avoid volatility, you will probably just dampen your returns and may still experience some other unexpected event (the so-called black swan), like the defaulting of municipal bonds you thought were secured.

One strategy we rejected as a hedge against a precipitous market drop is a technique called a stop-loss order. After purchasing a stock or exchange-traded fund (ETF), an investor can place an additional order with instructions on when to stop holding the security and sell it. Stop orders are triggered when the security reaches a specific price.

Sell limit orders are placed above the current market and execute when the security reaches that price. Sell stop orders are placed below the current market with the objective of limiting losses if the market value drops.

We recommend avoiding these types of orders for downside protection. Getting out of the markets at a 15% loss doesn't help you know when to get back in. Most investors who get out remain there until the markets rise well above the triggering values. Getting out is also the exact opposite of rebalancing. When the market drops, rebalancing your portfolio would mean selling bonds and investing more in the markets, not getting out of the market.

We think these are good reasons to avoid stop-loss orders, but many others disagreed. Thousands of investment advisors recommended this technique to their clients. Now it looks like this advice may have been the cause of the market plummet.

For example, take Vanguard Value ETF (VTV), which was trading at around $50 per share on May 6. Investors or advisors who wanted to protect their investment from a catastrophic drop in the markets may have wanted to sell if the markets dropped by 15%. This would mean placing a stop-loss order that would be triggered at $42.50.

Just because a market move sets off a stop-loss order doesn't mean the investor will get the trigger price. The trigger submits the sell order as a market order, meaning it gets whatever the next market price is. Under normal conditions this might mean the stock would be sold at most for a nickel below the trigger price (i.e., $42.45).

Unfortunately, May 6 wasn't normal conditions.

Possibly some large sale of Procter & Gamble caused a drop in the Dow. That may have triggered some automatic stop-loss orders in Dow index funds, which may then have caused other Dow stocks to drop in value.

The drop in Dow stocks could easily have triggered additional stop-loss orders. Each sell pushed stock values lower, triggering more stop-loss orders set at even lower levels. This cascade of stop-loss orders caused the May 6 free fall.

But it gets worse. The stock exchange has speed bumps in place to slow the market when it appears to be moving too fast. These curbs limited transactions from market makers at exactly the time when higher liquidity was needed. A market maker is a firm that stands ready to buy or sell a particular stock on a regular and continuous basis at a publicly quoted price. Market makers move that price gradually, which keeps the market orderly.

Without market makers, when there are more sellers than buyers, a stock has no price. Some of these market orders got picked up by exchanges linked to the New York Stock Exchange. Others got picked up by stub orders for a penny a share.

Between 2:40 pm and 3:00 pm, at some points no one knew what certain stocks or ETFs were worth. Consequently, the value of many ETFs hit virtual zero. Stop-loss orders for VTV set at $42.50 got executed for $0.10 a share. Then after every stop-loss order was finally triggered, the plunge came to a halt.

After the last of the stop-loss orders was cleared for pennies a share, the automatic selling stopped. At that point many institutional investors or their automated systems stepped in to bargain hunt and pick up shares for fractions of what they were worth. The market quickly rebounded, recovering most of its value in the next 20 minutes.

You can see this effect on Google finance, where it looks like the stock price for VTV bounces off zero that day at 2:52 pm. These trades were not an isolated event. Many stocks sold for just a penny per share. These trades show a market in free fall with a snowball of cascading stop orders and no market makers stepping in to set a reasonable price.

The statistics are already being cleaned up to erase this trading anomaly. Some sites still show the year low of these ETFs as $0.10 or even $0.00. But other sites now have the edited low of VTV as $18.58 or $19.32 that day.

After the close of trading on May 6 and numerous investor and advisor inquiries, the NASDAQ mandated canceling these clearly erroneous trades. But they insisted these were legitimate market orders executed in a reasonable manner and were not aberrations or mistakes in the system. In other words, you have been warned that the events of May 6 were a natural consequence of using stop-loss orders during a market free fall.

Thus the stop-loss order technique failed at the very moment it was supposed to save the average investor. It tried to sell in a free-falling market and only succeeded in dumping valuable stocks on a dime and for a dime. Even after adjustment, some investors lost 63% on a day where the stock market only closed down 3.62%. I doubt investors or financial advisors will be advocating the widespread use of stop-loss orders again in the near future.

But if they do, I suggest putting in a series of limit orders to buy stocks or ETFs at half their current value. If investors ever want to dump their shares for half their value, I'm more than willing to buy at that price.

Be a contrarian. Buy when people are selling. Especially when they have automated their panic with stop-loss orders.

from http://www.emarotta.com/article.php?ID=390

Now's Still the Time to Buy a House (2010-05-10)

Now's Still the Time to Buy a House

(2010-05-10) by David John Marotta

Between 2005 and 2009 I annoyed local realtors by claiming that real estate values were headed lower. Then in a column in July 2009, I said it was the time to buy a house. And now in the spring of 2010, it is still the time to buy a house.

Early in 2005 my father George Marotta and I explained the coming subprime debacle and predicted "the bubble, if it is a bubble, could pop as late as 2006 or 2007." Our projection was accurate. Real estate continued to rise that year. But it was relatively flat in 2006, underperforming the markets that appreciated over 15%.

Two years later, I wrote, "Many homeowners with adjustable rate mortgages have seen their monthly payments increase 50%, due to the higher rates. With the sudden jump in monthly mortgage payments, many are finding they can no longer afford to stay in their homes. The rate of late payments and foreclosures has continued to rise, leaving many lenders on the brink of bankruptcy themselves."

Again, the prediction was accurate. In 2007 the Cohen & Steers Realty Majors Index turned negative, losing 18.03%. Residential real estate did even worse. Apartments suffered one of the largest declines, down 25.4%. In February 2008 in my column "For Now, Avoid Real Estate Investment Trusts," I warned again to stay out.

It wasn't until well after the financial implosion that I suggested to readers it was the time to buy a house. I said, "Nathan Rothschild offered the contrarian advice to 'Buy when there's blood in the streets and sell to the sound of trumpets.' It is time to consider buying residential real estate. The bottom is forming, although it may continue to do so through early 2011."

I believe that advice will also prove accurate. Comparing last month's statistics from the Charlottesville Area Association of Realtors, the median home price has dropped from $247,000 last July to $238,000, but the rate of decline has slowed. The average days on the market have risen from 125 to 153. And although the number of active listings is still high at 3,312, the number of houses actually selling has started to pick up.

Home prices are well below 2005 averages, and time on the market is well above the healthy market average of 90 days. Sellers have been slow to realize that their home isn't necessarily worth the appraised value or what they paid for it or even what they owe. Houses are simply worth whatever the market will bear, which is a lot less than it was at the peak of the market three years ago. National trends have followed a similar cycle.

Half the advisors at our firm have purchased real estate in the last year, and I'm personally still looking for investment opportunities. It isn't too late because the recession has been prolonged and the recovery delayed.

Investment real estate isn't for everyone. You shouldn't have more than a third of your net worth bound up in real estate. For many families the home they live in provides them with more than enough real estate exposure.

Also, you don't need to buy and manage individual properties to get an exposure to real estate. Publicly priced and traded real estate investment trusts (REITs) offer an easy way to get in and out of real estate for the average investor. In a favorable climate, up to 8% of your portfolio might be invested in REITs this way.

We got out of REITs entirely and are only looking to get back in recently. My father would always say, "Make half a mistake," which suggests putting perhaps 4% of your portfolio back in REITs now and waiting until early 2011 for the other half.

If you are looking for an easy recommendation for an investment vehicle, try the Vanguard REIT exchange-traded fund (symbol is VNQ). The expense ratio is only 0.15%, and the yield is 7.8%. This is by far the simplest way to take advantage of this trend.

Specific individual real estate holdings offer investors the opportunity to leverage their investments by holding a mortgage on the property. Lending requirements are very tight right now, so for investors who can still get credit, there is real opportunity.

Investors could invest $1 million in appreciating securities, or they could invest $700,000 in appreciating securities and put $300,000 down on a $1 million commercial real estate holding. Assuming normal conditions, the second arrangement will produce a better return. The danger is that you do not want to be highly leveraged in a falling real estate market. Borrowing the money you are investing amplifies the gains, but it also amplifies the losses.

I've heard a number of bleak predictions for the housing market recently. Everyone is expecting real estate to underperform the stock market for many years going forward. Maybe they are right.

With the $8,000 first-time homebuyer tax credit expiring, demand may shrink. Starting your search now may be the perfect time. And there will be another opportunity at the end of the summer when buyers shrink even further. But maybe they are wrong. By this time next year, I expect the markets to turn positive. And I think it is time to make half a mistake and invest a little back into real estate.

It was only a few years ago that everyone was boasting about how real estate was appreciating by 1% every month. They made us feel like fools to be out of the market. With only a handful of listings out there, we were told that even if a glut of houses came on the market it would take years to satisfy the demand. But markets can turn quickly. Now we are contrarians again, looking at the trends and trying to gauge if there will be a second precipitous drop before the bottom. I don't think so. I think that we are near the bottom and brighter days lie ahead.

In the meantime, there's still blood in the street. Don't miss this opportunity to look for a great real estate deal.

from http://www.emarotta.com/article.php?ID=389

Should You "Sell in May and Stay Away"? (2010-05-03)

Should You "Sell in May and Stay Away"?

(2010-05-03) by David John Marotta

The old stock market adage "Sell in May and stay away" suggests you can avoid risk and increase return by getting out of the markets during the summer.

This advice appears this time of year whenever the markets have appreciated over the previous six months. Sometimes it's right, adding anecdotal evidence that you ignore the advice only at the risk of your equity.

But it's a slippery claim to evaluate and consequently a difficult trend to capitalize on. Let's begin by pinning down the exact days you would exit and then reenter the market.

The saying originated in Britain as "Sell in May and go away, stay away till St. Leger Day." The final horse race of the British equivalent of the Triple Crown takes place on St. Leger Day, in the second week of September. In the United States, September and October historically are considered dangerous months to invest. In addition, St. Leger Day is unknown here. So the date of reentering the markets has been pushed to the end of October, causing the rule to also be known as the "Halloween indicator."

Buying in mid-September or at the end of October is a significant choice. Since 1950, September has been the only month averaging a negative return. The S&P 500 has appreciated an average of 0.97% each month. But the September average is -0.37%, due to severe losses in 1974 and 2002.

October, contrary to popular opinion, is a typical month with an average return of +0.82%, despite the 21.5% loss in 1987 (Black Friday) and the 16.8% loss in 2008. Prior to two years ago, the average for October was 1.17, well above the 0.97% monthly average.

Mark Twain commented wryly on October, saying, "This is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August and February."

For the purposes of our analysis, I will use October 31, Halloween, as the day we would buy back into the markets.

The date to sell stocks is equally challenging. The traditional wisdom suggests selling May 1. But since 1950, May has performed well with an average return of 0.80%.

The problem with the data is what time period you use to back-test it. My data are from 1950 through the end of last month. But when the saying first circulated, May was flat. Since 1987, however, May has done phenomenally well, averaging 2.11%. May's recent streak of luck has raised its average substantially.

Yale Hirsch popularized this approach of investing in his "Stock Trader's Almanac" starting in 1986. He found that investing in November through April produced better returns than May through October.

Mark Vakkur refined Hirsch's approach to cherry-pick the best months. He suggested alternating between being fully invested, half invested, and out of the markets entirely depending on the month. September has the worst returns, but February has the second worst.

Historical patterns can be correlated to an infinite number of future predictions. Others would suggest that price per earnings ratios or the yield spread between long- and short-term bonds are a better indicator of stock returns. To suggest that each month is a reliable indicator of future results requires more than past statistical anomalies. Even if those statistics are taken from 60 years, they still represent a limited data sample.

I tried a simple thought experiment taking 720 imaginary pennies and flipping groups of 60 in 12 different categories, each labeled with a different month. In total I flipped 40 more tails than heads. But one month alone contributed 24 of the extra tails. Flipping 42 tails and only 18 heads in one month certainly seems meaningful. Simulating penny flips with a spreadsheet, I repeated the experiment multiple times. Each time at least one random month produced an anomalous result.

Here's another saying I like better: "Stocks go up and stocks go down." The markets are inherently volatile. Sometimes most of the tails can land in one month over a 60-year sample.

Seasonal investing hit the height of its support in Sven Bouman and Ben Jacobsen's 2002 study. The drop in the markets that summer heavily contributed to the trend. Between 1950 and 2002, returns for November through March averaged 9.06% versus only 3.18% between May and October.

Since 2002, however, the trend has been much more muted. The recent difference between these numbers is statistically small for the wide range of returns.

In 2009 May through October went against the trend and was up 20.10%. But in 2008 that same time period was down 25.84%. The past five months, November through March, are following the trend and up 13.87. But a year ago, November through April was down 8.53%.

Even in the last two years, this volatility can be made to fit the trend. Adding the two years together, November through April was more up, and May through October was more down. Although the markets have gone nowhere, blindly following the strategy would have produced a 5.74% gain.

As this column has repeatedly advised, rebalancing and diversification are clearly a better long-term approach.

Larry Swedroe of Bogleheads.org, an indexing discussion site, did an analysis starting in 1926 that switched to U.S. Treasuries every May 1 and moved back into the S&P 500 on November 1. The strategy produced an annualized return of 8.3% versus 10.25% for just holding the S&P 500.

By cherry-picking the right years, he found periods when the strategy might outperform a buy-and-hold strategy. This held true specifically for 1987 through 2002, the very period in which the saying received national attention.

Given the volatility of the markets and the strength of seasonal psychology, there may be a period of months when markets will perform better. But that doesn't mean Treasuries can outperform May through October.

My own study shows that since 1950, May through October has contributed a 3.16% return; November through April has contributed 8.44% for an annual return of 11.60%. If you sell in May, you have to be able to get a six-month Treasury return better than 3.16%. Considering trading costs and capital gains taxes, that's difficult.

If a seasonal ebb and flow to market returns really exists, it may be as simple as observing when cash is tight and not flowing into the markets. In February bills from the holidays arrive, and many people are gathering cash to pay their taxes. Summer vacations strap many families, resulting in high expenses in September. Only after bills are paid can money flow back into the markets.

In contrast, December sees large profit-sharing bonuses put into the markets, and pension funds are often invested in January. In the early spring, people are funding their retirement accounts.

These are just speculations. It could just as easily be the amount of sun in the Northern Hemisphere affecting people's emotions. Or it could just be that a lot of random tails fell in the September portion of the carpet.

Thus we provide a thoughtful compromise between jumping in and out of the markets and ignoring the seasonal effect entirely. If the markets are up, as they are now, and we are approaching the summer months, it is a good time to take some profits off the table. I'd like to replace the adage with the following advice: "Rebalance in May and call it a day."

from http://www.emarotta.com/article.php?ID=388