Construct a portfolio in this environment?

If speaking to an audience of experienced investors, I would have a detailed series of metrics that one might consider when stock picking.  But given that the average person is simply trying to find their way to an informed investment strategy without being a professional, the answer lies in pragmatism, which is far more clever than having a mnemonic for insightful stock picking.

Stock picking for the individual investor is folly: The average investor does not have a multi-million dollar large nest egg, so diversification is difficult.  For the average person I recommend top-down analysis such as sector etfs.  Here is why:

Suppose you want to buy a diversified portfolio of attractive stocks.  A diversified portfolio is attractive because the more stocks you have in your portfolio the less susceptible it is to the change in value of any one particular company.  And it is known that in general a diversified portfolio over time will outperform a concentrated portfolio.  The problem is that a truly diversified portfolio requires a lot of money, and is out of reach for the average investor.

For example, the average price of a NYSE stock is about $40.  If you wanted to buy a portfolio of 50 stocks and 100 shares of each stock, that would require $200,000 cash minimum.  That is well beyond the cash availability for most people.

ETFs give the average investor the chance to invest smaller sums of money while still achieving a diversified portfolio.  Since ETFs have no real minimums and invest themselves in diversified pools of high quality equities, even $5,000 could “participate” in the performance of a portfolio costing many times more.  The ETF is a convenient way to give the smaller investor access to multiple stock positions and, for that matter, the benefit of a professional money manager.

For active ‘traders’ ETFs make intraday trading possible which is an advantage over mutual funds.  If you are looking for short term exposure intra-day you can do it.  Also investors can short ETFs if they seek to take advantage of sectors or stocks that they believe will be out of favor.

The head fake

I had excellent open-field instincts when playing football.   The term was to “juke” the defense with the head fake.  I also had speed (4.49 40-yard dash) but it was the open field head fakes that opened the way.

Similarly, in basketball, the quick crossover dribble can leave the opponent’s body tragically conflicted, not knowing in which direction to defend.  The nickname for the crossover dribble, another type of head fake, is the ”ankle breaker” because the defender’s simultaneous movement in opposite directions is likened to breaking his ankles.

The market has rallied magnificently in the last several weeks.  Since its March 9 low of 676.83 the SP500 has surged impressively to 907.24, yielding a 34% return in less than two months.

Is it real or is it a head fake?

While there are glimmers of hope for the economy the stock market has gotten ahead of itself in my opinion.  Structural problems in the economy do not revert so quickly.  Every trader would like to be the one who times the market recovery, thus it becomes a self fulfilling prophecy.  Every slight upward trend gains rapid momentum as no one wants to be the fool who misses the rally — least of all those professional managers hanging on to their clients by a thin thread.  No manager wants to explain why their fund performed less than the market.

Moreover, the potential loss on a short sale position is unlimited:  short sellers must constantly adjust their positions, and they are occasionally forced to close them out, resulting in huge market up-days….  which in turn feeds the notion that a recovery rally is upon us…. and so on, and so on.  The market continues to advance in a pseudo-bullish feedback loop.

I too have had to capitulate occasionally.  I have participated in approximately 25% of the up-trend, attributable mostly to those days where I just gave up, reversed my short equity market positions (globally), closed my eyes and went long.

But do not become complacent.  This rally may be one of the cruelest ankle breakers of all.

– Wayne Weddington