Concentrated Stock—The Marriage Decision That Could Ruin Your Retirement, And Seasonal Weakness Ahead
From time to time, we come across client situations where a significant portion of their liquid net worth (and total net worth) is tied up in either one stock or in just a handful of them. This can be a challenging problem, because often there are company ties, inheritances from family members, and often, very large tax bills that would be created if one sold a good portion of the stock.
In some of these instances, common sense is thrown out the window because of an unwillingness to diversify and pay taxes, or perhaps because one thinks the disasters will only happen to someone else.
In this month’s update, we’ll tackle this issue, and also touch on Market Seasonality, as stocks have just entered the worst six-month period of the year, from May to October. It does not always pay to SELL in this time period, but on average, the data for doing so since 1950 has been rather compelling. We’ll view this in light of how the markets are acting right now.
Concentrated Stock—The Agony and The Ecstasy
The genesis of this story came to me just a few weeks ago, from a Wall Street Journal piece entitled “Retired from GE, Now Pinching Pennies.” But, it has been percolating in my mind for many months, as we encounter a variety of client situations where they either have worked for a company for a long time, (such as one of the subjects of the WSJ story) or as in other cases, they have inherited stocks from family and held them for 20 or more years where the unrealized gains are literally in the hundreds of thousands of dollars.
This is not a story about General Electric, or Merck, or Comerica Bank. All of which we will touch on here. And, I’m not even mentioning Bear Stearns, Enron or Lehman Brothers. Rather, this is a story about owning too much General Electric (or whatever name you want to plug in). For the most part, all of the examples have been great companies at one point. But, nothing grows forever, and the best of blue chips regularly do self-destruct. In fact, according to a white paper published by American Funds, only 54% of companies in the Fortune 500 in 2000 are still on the list today. The rest have either gone bankrupt, merged with another company or simply dropped out of the rankings.
The core message you should take from this analysis of equity investing was best described by financial writer Nick Murray, who said, “One can become wealthy by underdiversifying. But it is almost inexpressibly harder to stay wealthy by underdiversifying.”
General Electric
Growing up in the 70s and 80s, I still think of that funky logo on all the lightbulb boxes and major appliances. But, the reality is, the company changed dramatically, becoming heavily focused on finance and communications. Like many other stocks, GE fell apart in the 2008-09 stock market decline, dropping from $28 to about $5 per share (see the charts below, courtesy of www.stockcharts.com). It then took over 8 years to recover to $30, and now sits about $14.60.
One of the people featured in the WSJ article, Gary Zabroski, worked for GE for 40 years, retiring in 2016 with an $85,000 annual pension and GE stock valued at $280,000 (the article does not offer if he had any other savings). His stock is now worth $110,000, and he’s looking to go back to work. “I never planned on retiring and having to go back to work,” said Mr. Zabroski.
A couple of points here. It is pretty clear to me he didn’t have a plan, period, because there was no selling strategy in place, and second, it seems clear he didn’t have an advisor either. He had the luck of retiring when the stock was at its highest level in 7 years. Not everybody will have that luck, but it is about having a prudent, structured plan.
There is no mention in the article as to whether the stock Mr. Zabroski owns is in a retirement account (where there would be no tax consequences for selling) or in an after-tax account, where unrealized capital gains can be an impediment to many. But, candidly, it doesn’t matter. In our book, if you have more than 30% of your invested net worth in company stock, you are playing Russian roulette and better be prepared to live with the negative consequences of such a choice.
Since we don’t know if taxes were a consideration in the above case, let’s touch on that. In the vast majority of cases we come across, taxes are a big deal, because stock options and restricted stock are usually involved, and these are not in retirement accounts. But, they cannot be the focus and the driver of decisions. In many situations, clients will have to write (or pay) a six-figure tax check to the government.
I don’t know anyone who LIKES doing that, but it means that one has significantly increased their liquid net worth and removed a lot of money from overconcentration. That’s a lot better than blowing oneself up, because you picked the chamber with the bullet in it.
What If The Stock’s In An Uptrend?
This is a fair question, as not every company stock is automatically going to go down shortly after one retires. You’ll see an example of this shortly with Comerica. This ultimately gets back, though, to having a game plan and one, in my view, really needs to know technical analysis. See the point and figure chart below of General Electric, courtesy of www.dorseywright.com.
As I’ve illustrated on the chart, GE gave a Point and Figure SELL signal in May 2017 when the stock traded down at 28, breaking below the previous column low at 29 which was made in October 2016. In addition, not shown on the chart, the Technical Attributes for GE fell to 2 (out of a possible 5) on February 3, 2017. Using this process in an unemotional quantitative way, no stock should be held with only 2 Technical Attributes. The stock was 29.70 at the time. It is now 50% lower.
To handle situations like this, though, one is going to need a competent advisor with knowledge in technical analysis. Unfortunately, they’re not found on every street corner. Having said that, had Mr. Zabroski simply followed the common sense we outlined above (no more than 30% in concentrated stock), he’d be fine today.
The stock was about $30 in the first quarter of 2016 (we don’t know when he retired). Had he sold 70% of the holdings and simply replaced that amount (about $200,000) into an S&P 500 Index fund, he’d still have almost his entire $280,000 today, even with GE plunging over 50% from that time. That is not to say he should have had all his funds in stocks—that is another essay, since we don’t know his total picture other than he has an $85,000 annual pension. After all, the S&P 500 has gone down more than -40% twice in the past 18 years. However, the odds of an individual company going down more than 50% is much greater than the entire index. The average stock in the S&P 500 is twice as volatile as the index itself.
Merck—The Wonder Drug Company
No doubt there may be a number of Mr. Zabroski’s employed at Merck, the 7th largest pharmaceutical company in the world, who employs over 55,000 people and also has a defined benefit pension plan similar to GE. If you retired from Merck after 20 or 30 years, look at the chart below which goes back to 1999, and illustrates how important it is WHEN you retire.
Adjusted for dividends, the stock made an all-time high (at that time) in May 2000 at 37.21. It then preceded to fall -59% to November 2004 at 15.29. It then more than doubled to 40.86 in December 2007 (again dividend adjusted), before plunging -61% to 15.81 in March 2009. Should you have had the misfortune of retiring from Merck in 2000 with $1 million of stock that you planned to live off in retirement, and done nothing but hold on (the mantra of Wall Street), nearly 9 years later, you would have less than $400,000 left. It would likely be much less, because during those 9 years, you would have been taking an income from the money to supplant Social Security and a pension.
Keep in mind that today, fewer and fewer employees at large publicly traded companies have access to a pension plan, which means it is even more important to manage the stock. According to a Willis Towers Watson P.L.C. analysis, just 99, or about 20% of Fortune 500 companies offered a defined benefit pension plan to new employees in 2015. This was down from 248, or almost 50% of the firms, back in 2005.
By the way, please don’t give me the argument that if you just hold on long enough, you’ll eventually be OK. Yes, today, Merck stock is over $59 on a dividend adjusted basis, and has now gained about 59% since May 2000. But, it took almost 13 years to get back to even, and that was after two separate losses of basically -60%. You can’t argue that you didn’t lose anything. I’d say you lost 13 years, and were likely now 78 years old (if you retired at 65), and frankly, might be lucky to be alive after suffering so much. And that assumes one didn’t sell in a panic, near the bottom. If you’re such a person that could deal with that, you don’t need us.
Comerica Bank—A Different Tale
Just so you can see the other side of the coin, I wanted to show a real-life example of a situation that has turned out pretty well thus far. Much of this is due to the coincident timing of retirement combined with having the company stock in an uptrend. Maybe some of this has simply been luck, but there is a way to manage it in your favor. See the chart below of Comerica, a regional bank headquartered in Dallas, Texas.
Our client had been an officer at the bank for many years, and retired in January 2017. You can see that during the 2008 decline, the stock plunged from 50 to about 12 at the March 2009 low. For any employees retiring in that time period, it would have been quite difficult. Just think if you would have had 50% or more of your invested net worth in company stock. For many officers, when combining stock options, restricted stock and performance shares, that could easily be the case unless they take it upon themselves to systematically reduce exposure.
In addition, some companies require officers to always own a minimum amount of stock. I don’t know what that figure might be, as I’m sure it varies by company, but these are some of the things that employees have to deal with.
In this case, the stock went from the 12 area to 50 by 2014, but then dropped to 30 in early 2016. By the time our client retired in January 2017, the stock had moved up to the 70-75 zone. The technical attributes of the stock when looking at relative strength and trends turned bullish in May 2016 and went to maximum bullish in November 2016, where it still is today, and is trading around 95. Our client used this opportunity in the past 15 months to sell significant portions of their holdings in order to begin diversifying.
The technical attributes changed dramatically in just 11 months. In January 2016, the stock was a 1 on a 1 to 5 scale. If at all possible, one does not want to sell stock when it’s ranked 1. And, fortunately, our client didn’t need to sell any stock at that point since he was one year from retirement and still collecting his salary. A year later, though, the stock was ranked a 5, had hit 75, and it was a matter of when to begin taking chips off the table.
I must admit, I thought selling Comerica around 75 was a good deal. And then the stock kept going, and going, and even recently hit 100. Who wouldn’t want an extra 33% on their stock? Nothing goes up forever, though.
To Sum Up
To be clear, concentrated stock is not limited to owning just one company. For instance, a $1 million portfolio with 20 stocks at $50,000 each is absolutely fine, but the same $1 million portfolio with 3 stocks worth $340,000 is not.
I’d mentioned writer Nick Murray above. He wrote a great piece on this subject 8 years ago. I’m humble enough to admit that I don’t think I could improve on how he summed up his thoughts on this topic, so below is a direct quote from the end of his article.
“The holder of an overconcentrated stock position isn’t even an investor anymore. He’s a bettor, and he’s betting on a very long shot: the thesis that the iron law of creative destruction does not apply to him, because his blue chip is so blue that it’s exempt. Worse, he is betting the preponderance—if not all—of his fortune on this wildly improbable thesis.
“His philosophy, if we can dignify it by calling it that, is summed up in the motto that Joseph Hazelwood, the captain of the ill-fated Exxon Valdez, chose to have printed under his yearbook picture when he graduated from the Merchant Marine Academy: ‘It can’t happen to me.’
“It could. And it did. Resist the impulse ever to fall in love with one great stock.”
Hey, Hey, Hey, Time To Sell In May?
They say a picture is worth a 1000 words, so take a look at the graph below showing U.S. Market Seasonality of the Dow Jones Industrial Average back to 1950, courtesy of my friends at www.dorseywright.com.
The premise of this strategy is to be invested in the broad stock market from November to April (the best six months) and to be out of the market from May to October (the worst six months). Virtually the entire gain from stock indexes since 1950 has come during the seasonally strong period. Yet, it obviously does not work every year. According to Ned Davis Research, the S&P 500 Index has had a positive return from April 30 to October 31 in 31 of the last 46 cases (67%). Over the last six years, the S&P 500 has gained on average close to 5% over the May/October period.
Even so, when you look at the data over longer periods, it is still working. According to Dorsey Wright, since April 2000, the Dow Jones Industrial Average has gained 134% during the strong six months and lost just under 4% during the weakest six months. Below is a custom chart we keep up (thanks to Ned Davis Research) using a MACD signal to enhance the trades.
As you can see in the mode box in the middle right section of the chart, since 1985, the S&P 500 Index has compounded at over 15% annually during the favorable periods, and only just over 1% during the unfavorable period. When coupled with the Presidential Cycle this year with it being a mid-term election year, the odds appear to be in favor of seasonality providing a headwind. According to the study below from Ned Davis Research, the S&P 500 has been essentially flat during mid-term years during the worst six months, but has rebounded strongly beginning in November.
Our Models Remain Defensive
Of our 8 stock market risk models, only 3 are currently bullish, so our tactical equity exposure is running around 38%. I can’t say I have a lot of conviction about the outcome, but I do have conviction in following our process. Keep in mind our risk models were 100% invested in late January, so one can see the flexibility in our approach. We are simply responding to changes in our indicators, and right now our work is suggesting that preservation of capital is preferred over a big bet on the upside.
Nothing has changed on the bond market side. Our risk model for high yield bonds remains on the SELL signal from February 12, and those funds are sitting in a variety of short term bond funds. Though the stock market has reached new recovery highs the past few days (not new all-time highs), high yield bonds have barely budged. The yield on the 10-year Treasury Note is now above the 3% level. If it stays above this level and continues to rise, it is likely that stocks will react in a negative fashion. We’ll just have to see.
On the positive side, the daily advance/decline line reached another new high last week, even though prices have not. As we’ve written about in the past, this is normally a leading indicator and typically indicates higher prices until a negative divergence forms. Could this time be different? Yes, it could be, but I have no idea if it will be. We’ll let the market tell us the story.
Material Of A Less Serious Nature
A curious-looking funeral procession pulled into the cemetery. A few dozen cars followed a dark truck towing a boat which held a coffin.
As the mourners exited their vehicles a passer-by nodded to the truck and boat and said, “That guy must have been an avid fisherman.”
“Oh, he still is,” said one of the mourners.
“You think he’s still fishing in heaven?” asked the passer-by.
“No, he’s headed off to the lake as soon as we bury his wife.”
Though markets aren’t exactly exciting right now, there is some pretty good baseball being played by the Angels, right down the street from our office. Here’s hoping it continues, but I just heard that the rock band TRAIN has come out with a revised new single. It’s called Falling All Angels. Another Angels pitcher (I’m losing track of how many), Kenyan Middleton, just hit the shelf with an elbow injury. Geez!
Thanks for your continued trust and confidence in all of us at TABR.
Sincerely,
Bob Kargenian, CMT
President
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