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A Little Advice: Don’t Go Without an Exit Plan

When do you sell?

Many individuals who have come to swear by the buy-and-hold investment philosophy would say the answer is “never"--at least, in terms of their diversified stock portfolios (i.e., mutual funds).

And that has been the correct answer for most investors in the 1990s. Just let it ride. Every market dip has been relatively short in duration, and--for the market overall, though certainly not for all stocks--relatively insignificant in magnitude.

Hence, last week’s stock tumble probably failed to rile many Americans. So what if the Dow Jones industrial average slid 404 points, or 4.3%, in the four sessions through Thursday, weighed down by worries about weakening corporate earnings growth? On Friday the Dow inched up 4.38 points to 8,937.36. Crisis over!

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The average general stock mutual fund, a better proxy for the typical American’s equity stake, slumped nearly 4% for the week, cutting the year-to-date gain to 11%, according to Lipper Analytical Services.

That’s still a great return, to be sure. But what if that gain were to evaporate in a selling wave over the next few weeks? Worse, what if the stock market overall were to do something it hasn’t done since 1990--fall more than 20% from its recent highs?

Many investors still would say, “Let it ride.” Of course, it’s easy to say that before the fact. In the heat of the moment such steadfast views tend to become more wobbly.

What’s the alternative to letting it ride? Having an exit plan. That means leaving the buy-and-hold camp for the market-timing camp--not an easy transition for many investors because it goes against everything they’ve been taught in this long bull market.

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Does market timing make sense? No and yes.

No, because over the very long run, the odds are stacked heavily against people who try to move in and out of the market versus those who simply hold a diversified portfolio of stocks.

It’s not just that it’s extraordinarily difficult for most investors to consistently identify the market’s lows and highs. (Remember, you have to do both.) You also have to factor in trading costs and the scourge of capital gains taxes.

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On the other hand, market timing does work--or can work--on one important level: A good timing system can limit your losses when the next major market downturn arrives.

Mark Hulbert, whose Hulbert Financial Digest in Alexandria, Va., tracks investment newsletters--many of which use some kind of timing system--says his research has shown that only about 10% of market-timers have beaten the buy-and-hold market return over an extended period.

But that isn’t the key issue, Hulbert says. “I wouldn’t ask [a market-timer] to increase my return. I would ask them to reduce my risk,” he says.

The math gets interesting, and downright scary, when you start talking about bear-market losses.

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Say the market were to plunge 30%. Just to get back to even, stocks would have to rise 43% after bottoming.

A 40% market decline would require a subsequent rebound of 67% just to get you back to even.

That may not be a problem for investors who can wait 10 or 20 years before they need to tap their stock nest egg. But what about retirees or pre-retirees, who perhaps don’t have that kind of time horizon?

Investor Warren Buffett, one of the greatest proponents of buy-and-hold investing, also credits his massive wealth to something else: He’s never had a huge loss, he’ll tell you. That’s paramount, because once your capital is severely depleted, the challenge is that much greater to restore it, let alone to make it grow again.

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How does market-timing work, in practice?

Some investors have a simple rule: If they lose a certain amount in an investment--say, 10%--they figure they’ve made a mistake, and they sell.

That’s an insurance system, but it isn’t a timing system per se.

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A good timing system should get you out of the market when some mix of time-tested indicators suggests a meaningful decline is at hand.

The system also should, without the baggage of emotion, get you back into the market when those indicators suggest the market’s general trend is up again.

We’re not talking about getting in, then out, then in again on a weekly or monthly basis. That’s for speculators, not investors.

One of the best timers over the last 15 years, according to Hulbert, has been Dan Sullivan, editor of the Chartist investment letters in Seal Beach.

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Hulbert’s figures show that, through May, Sullivan ranked second of 29 letters tracked in terms of his stock picking and market timing over the prior 15 years.

Sullivan’s average annual return in that period: 16.1%, versus 16% for the Wilshire 5,000 index, the broadest U.S. market index.

Sullivan, now 64, began writing his newsletter in 1969, after teaching himself about the market while running a liquor store in Whittier.

He was heavily influenced, he says, by a book called “The Battle for Investment Survival,” written by Gerald M. Loeb, a former stock broker and financial journalist.

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Sullivan says two main points stayed with him after reading Loeb: “What I learned is that you want to be with the market leaders, and that you want to limit your losses.”

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Sullivan’s timing model, revised a couple of years ago, now is based on three indicators: the stock market’s momentum, which factors in the number of stocks rising versus the number falling over short periods; the market’s trend, as measured by the movement of key stock indexes; and monetary conditions in the economy--that is, whether money is tight or loose.

Two of the three indicators must be positive for his model to generate, and maintain, a buy signal, Sullivan says.

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When the signal is on buy, Sullivan’s subscribers--about 10,000 of whom take his stock letter and 6,000 of whom take his mutual fund letter--also get his recommended list of stocks and funds to own, respectively.

In practice, Sullivan says, his system has kept investors in the market about 60% of the time over the last 10 years.

He concedes that the model has whiplashed subscribers on occasion, meaning a sell signal was quickly followed by a buy signal.

In fact, that happened just recently: Sullivan’s system, which had been on buy since May 5, 1997, flashed a sell signal on June 11 of this year as the market’s spring downturn accelerated.

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On July 1, with stocks rallying again, the system flashed a buy signal, which remains in place.

Sullivan, whose own money rides with his system, concedes that the recent whiplash upset some subscribers. Although they took away a handsome gain over the May ’97 to June ’98 period, those holding stocks or funds in taxable accounts also incurred a capital gains tax bill--only to be put back into the market a few weeks later.

“One subscriber said to me, ‘This whole thing is foolish!’ ” Sullivan said.

But the soft-spoken Sullivan is unapologetic. He says he has seen enough bear market declines in his lifetime to know that it’s better to be safe than sorry when the market begins to turn against you, especially after a long bull run.

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Today, although his model is back on buy, Sullivan reminds his subscribers that stocks have rarely if ever been this richly priced relative to underlying earnings.

“If valuations just went back to normal, it would mean a huge drop” in the market, he says.

He isn’t predicting that, he adds. But he wants to have his money following a discipline that, he hopes, will get him out of the market long before the losses become extreme.

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Does Dan Sullivan believe he’s smarter than the market? No way.

“We have no argument with a buy-and-hold strategy if you have the psychological strength to withstand the inevitable nerve-racking bear markets, and the time to repair the damage, which can be measured in years,” he says.

Most investors may not need someone like Dan Sullivan, or a formal timing system. But every investor should consider whether he or she needs some plan in place for the day when buy-and-hold no longer feels so comfortable.

(The Chartist newsletters can be reached at (562) 596-2385; or write P.O. Box 758, Seal Beach, CA 90740.)

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Tom Petruno can be reached by e-mail at tom.petruno@latimes.com.


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