Catching Stocks Is Like Catching Fish

by Wendell Cayton

Plop! There, got another one! Fishing? No, I was catching stocks. Only instead of the high stress method of thrashing around on the Internet and day trading, I was practicing the low-stress, low-IQ, method of adding to portfolios by using simple limit orders to buy the stock.

I find a bit of similarity between ‘catching’ stocks and ‘catching’ fish. I grew up in Central Washington. The Ahtanum Creek came down from the Cascades not far from our home. On hot summer afternoons my brothers and I could often be found reclining in the shade along its banks, with our fishing poles, a worm swimming on the end of the line, propped up on a forked stick. With little effort we could usually catch enough trout for dinner.

We preferred this laid back approach to catching fish as opposed to flailing our poles back and forth, in a more typical Type A manner. The latter method required more worms, and often caught more snags than fish. It was much more relaxing to put out our bait, enjoy the day, and pull in the fish that picked our worm.
Stock can be ‘caught’ the same way. The procedure is simple . . . just use limit orders. A limit order is an order placed through a broker to buy or sell a stock when it hits a certain price. These instructions are transmitted to the floor specialist at the stock exchange who will hold them as an open order to buy or sell at that price.

Your target price to buy must be below the current trading price, or above if your order is to sell, otherwise your order will be immediately executed as a market order.

When placing the order, you can either leave it in place for that day, or until you chose to cancel, known as “Good Till Cancelled.” You can also instruct the broker that you will—or will not—accept a partial execution of the order.

Buying stocks in this manner works well for stocks that you intend to buy and hold and that are trading within a somewhat definable price range. Setting the price target is like picking a fishing hole. Some places in a stream are not likely fish habitat. If you set the price too low, the price may not come back to that level, leaving your order unfilled

When stock prices are rapidly moving up, as they did last fall after the September/October correction, limit orders to buy do not work well. Reminds me of spring along the Ahtanum when mountain runoff would swell the creek with swift flowing rapids. The water was going much too fast for the fish to find our bait. Neither is the market going to look back for a price set too low.

There are several ways to arrive at your target price. Using fundamentals such as earnings, ratio of price to book value, sales volume, etc. you can calculate your ‘fair value.’ This is the price you would be willing to pay to own a piece of that business. Above that price, you would not be interested.

If you are satisfied that the stock is trading within a range that you consider fairly valued, you can watch daily trading activity, noting the high and low prices occurring during the day. Put your target at the low point within that range.

There are a number of sites on the Internet where you can see charts depicting the trading range for the day or other periods. I find the Yahoo’s financial section works well. There I can find charts for the day, 5 days and 3 months, all of which depict the ranges for the day. This site also provides historical pricing for any date(s) showing the open, high, low, and close.

Mortgages and Retirement

The decision whether to retire with or without a primary residence mortgage is a key planning issue for most retirees. This has become even more of an issue as housing values rise and mortgages grow bigger, often making the house the most valuable asset on the retiree’s balance sheet.

Prevailing logic holds that one should pay off the mortgage prior to retirement. Grounded by the experiences of the Great Depression when people did lose mortgaged homes, this wisdom runs contrary to our current tax code, potential returns from alternative investments and the need for liquidity.

Today’s tax code allows a tax deduction for mortgage interest paid on a principal or second home. To understand the true, after-tax cost of this benefit, subtract your marginal tax rate from 1 and multiply the result by the current interest rate charged for the mortgage. This is the after-tax cost of borrowing the money. For example, a borrower in a 28% tax bracket with an 8% mortgage is paying (1-.28) x 8% = 5.76% after-tax interest for that mortgage.

To put it another way, if the borrower were to pay off the mortgage, he would be investing in a tax-free, risk-free investment yielding 5.76%.

Paying interest for the sake of a tax deduction does not make sense. However, if the alternative is to keep the principal sum that would be used to pay the mortgage invested, earning an after-tax return greater than 5.76%, plus 3-6% margin for risk, then there is a valid reason for not paying the mortgage.

Finding the money to pay off the mortgage can be a tax issue as well. If the principal sum required must come from either selling investments which will generate a taxable gain, or withdrawing a lump sum from a retirement account—all of which will be taxed at ordinary income rates—it might be better to continue mortgage payments and avoid the higher tax bill. This spreads the taxes over a much longer period.

Conventional wisdom encourages those wishing to pay off their mortgage to do so by making additional monthly payments. However, if that same money were invested in an alternative investment, earning the equivalent after-tax return as the interest payment saved by paying off the mortgage early, the homeowner is faced with an interesting choice.

Which would he prefer, a paid for house at the end of the accelerated payment period or a continuing mortgage and a liquid investment amount equal to the interest he would have saved, had he paid off the mortgage early? When the tax consequences are factored into this equation, plus the investment return potential, paying off the mortgage early has little advantage other than peace of mind.

Finally, the need for liquidity in the retirement plan must be considered. A paid for home is an illiquid asset. It is easy to refinance when one is working and can show the ability to repay the loan from earnings. Lenders aren’t quite so anxious to lend money when there are no wage earnings.

Capital required for repairs, replacement of capital item such as appliances, automobiles, etc. and potential medical expenses are reasons enough to maintain liquidity. If all available capital is tied up in the house, a retiree is short on options when it comes time to pay such expenses.

A possible solution to this liquidity problem is to refinance just prior to retirement. If the existing mortgage has been paid down, the principal sum to be refinanced will be smaller, allowing for lower payments. Of course these payments will be stretched out over a longer term, implying that the house might never be entirely paid for, but by keeping liquidity intact, the retiree might have a sounder financial situation.

Consumer Confidence

by Bruce Fenton

Since consumer spending makes up about two-thirds of overall spending, consumer attitudes are an important part of the investment landscape. Intuitively, if consumers are confident about the future, they are prone to continue spending and make long-term financial commitments to purchase “big ticket” items like homes or automobiles. Conversely, if they are not confident about the future, they are likely to hold back on major purchases.

Consumer confidence is generally reflective of the economic environment, not necessarily predictive of the future. But consumers don’t always walk their talk, although the idea behind confidence surveys is sound.

Despite the intuitive sense that a slowing or dropping level of consumer confidence should foretell a recession, that doesn't always happen. As a matter of fact, at times consumers have kept our economy afloat. Despite wars, pestilence, stock market bubbles, a dearth of capital spending by business, corporate governance scandals, slipping consumer confidence—you name it—at times consumers have continued to spend.

A better way to understand consumer behavior might be to look at long-term trends in consumer spending patterns. Students of consumer behavior like Harry S. Dent, author of The Roaring 2000s Investor, point out the simple fact that consumer spending has more to do with the age of the consumer than the condition of the economy.

For example, a younger population in their late 20s and early 30s are more likely to spend on family formation goods and services as they have babies, buy their first homes and begin raising families. As they age, they trade in smaller homes for bigger homes. Eventually, they sell their big homes and move to retirement communities. Throughout their lives, their spending patterns change in a very predictable fashion. Dent argues that peak spending per household occurs when the head of the household is age 46-47.

So when baby boomers have bought their last big homes and spent all they’re going to spend on furnishings and toys, our economy is likely to come up short. At that time, consumer confidence levels are likely to be high, reflective of the good life, not necessarily reflective of their future spending patterns.

That’s when we have to be careful.

Bruce Fenton is a financial consultant, a writer, and the Managing Director of Atlantic Financial Inc. Bruce welcomes inquiries, comments, and questions. He can be reached by contacting The Fenton Report.