Almost out of
nowhere, the markets are looking more and more imposing, and less attractive,
to professional and non-professional investors.
The reasons lie less in the analysis of fundamentals but more in a
deteriorating trust of systems, players, and motives in the financial
community.
Natural risk
takers, and the risk averse, are leaning more towards “stuffing money in the
mattress” than they are towards complicated derivatives. Wild gyrations in stocks and bonds heightens
the fear and skepticism within investors that this is a game they wish to play.
A majority of poll services indicate that many
think investing is “not fair.”
In a climate in
which concern is growing about performance and ethics in financial matters how,
and why, does confidence dissipate so rapidly?
Markets.
The
psychological shift has been imperceptible to some, tectonic to others. My data indicates that despite rising prices
during the last decade, relative strength integers (a measure of velocity,
momentum, and magnitude) were declining as far back as 2006. Thus, equity valuation increases were being
built upon false bases. Indeed, when the
credit crisis hit in 2008, money was already looking for safe-haven escape
routes. Unfortunately, even bonds failed
to offer the requisite alternative investment scenario.
During the next
two years, cash was seeking a safe place to park.
Although
wealthier investors were “less affected” by portfolio declines, high-net-worth
players were, in part, more responsible for the permutations in product
construction and use than the less affluent, thus the perception that markets were “unfair.”
Downside collapses are “bothersome” to the
wealthy, catastrophic to the poor.
As I have
stated before, one’s tolerance for risk is mirrored in their asset
allocation. And asset allocation,
itself, plays a greater role in the probability of portfolio capital gains than
any individual security within that portfolio.
Thus, heavily concentrated portfolios, such as real estate portfolios or
technology-only portfolios for example, showed poorer performance than more-diversified portfolios during the same
period.
One’s
willingness to absorb risk, and expose assets to specific sector volatility, is
the great conundrum of investing.
But risk-taking
is not only about objective data and portfolio modeling. It is also about perception. If the perception is that all risks are
equal, or none are fair, then investors will be unwilling to balance risk
against risk-tolerance. Such is the case
today. The markets are delivering the
opposite of what is expected (based upon theories of standard risk evaluation)
and, thus, no one perceives a fair opportunity to win.
It is extremely
difficult to keep from getting negative.
Markets are cyclical. In fact,
this period is not the most egregiously woeful period in the market’s
history. We have been here before (1929,
1987, 1993, 1999, etc.). Fear is not an effective portfolio management tool.
In the long run, an effective discipline and methodology is preferred
to an emotional or irrational response.
Strategy.
The most
remarkable thing about my proprietary Arlington Econometrics methodology is how
quantitative statistics can improve upon intuitive return expectations by
focusing upon correlated and volatility variances between asset
categories. The extent to which we can measure performance and location of a
financial security helps us to identify the magnitude, velocity, and direction
of its trend and to offer probabilities of its risk-adjusted return.
This is lofty
stuff for many investors and often eschewed in favor of hot trends or
recommendations from television personalities.
Unfortunately, these people are no different than you and sometimes have
difficulty quantifying their own hunches within a global spectrum. Most importantly, hunches tend to be quite
volatile (beta), indeed just what the aggressive investor is looking for!!
Incorporating
stochastic integers, analogous to a GPS system, into investing diminishes beta
while enhancing return probabilities (alpha).
During the pre-crash period, most investors lost their focus about risk
management, instead focusing upon less
diversification and lower correlated
probabilities to generate alpha. Thus,
crashes and mini-crises affected them more severely than most.
Diversification
and asset allocation also exposes an investor to a global panoply of assets and
potential for capital gain from a variety of geographies, capitalizations and
sectors. Indeed, my client’s accounts
have shifted from high concentrations in equities, to sector rebalancing
globally, and ultimately to cash and yield during the past three years. As a result, our drawdown has been smaller,
while our returns have been superior.
Conclusion.
Real or
perceived, we are in a new dynamic of financial fundamentalism: Earnings around the globe are shrinking as
consumer demand declines; stochastic measurements are less aggressive than the
previous decade; the secular bull is now a secular bear; capital formation is
less aggressive and more biased towards traditional products; global employment
patterns are reconfiguring towards energy, technology, bio-sciences and away
from traditional retail, consumer-led brands; politics and terrorism are
upfront and real in our internet-connected universe.
It would be
disingenuous to deny the macro patterns described above. It would also be calamitous to ascribe these
trends as anything more than a general pattern of
reshifting fundamentals that occurs on the “back-leg” of any market’s parabolic
duration. Simply, we are in a normal, albeit painful, response to the previous
generational cornucopia, and a requisite recalibration of policies, data, and
psychology.
I believe that we
are also experiencing an excess of “manual stimulation” to, what should be, a
normal measured time series during which (as has happened historically) there
is a gradual shift from boom to bust, then boom again. All
the stimuli, all the political rhetoric, all the sustained partisanship is
indicative of another type of fundamental dialogue, but not necessarily the
science of economics and market statistics.
To that extent, the global financial markets are disassociated from
politics and influenced only at arm’s-length from what occurs in political
capitals around the world.
The markets
tell us something when they react “positively” to negative political or
economic data. In some cases, unrealistic expectations about the relationship
between data and market performance can send investor psychology sky-high or
down-in-the-depths on an hourly basis.
Such is the impact of expectations
and internet upon market volatility over a 24 hour cycle.
Imagine, if you
will, that you wake up one year from today to review market performance, the
political landscape, and your portfolio.
How much, based upon what you know today, would have changed? Then, do it again one more year later. Now you can begin to understand how trends
develop and how one either becomes right or wrong in the long run. Those are
the bets that real investors make.
My commitment
is to quantify those bets, and to allocate client’s resources so as to mitigate
downside risk and to maximize sector opportunity. Within that context I see several categories
of opportunity, irrespective of 24-7 internet proponents who proclaim
otherwise. I see significant quantifiable momentum in agriculture (foodstuffs,
grains, arable land); biosciences; biopharmaceuticals; alternative
(replenishable) energy; technology; industrial infrastructure (rail, highway,
air); basic materials (tangible assets); and consumer cyclicals (innovative product
development).
Interest rates
cannot stay this low indefinitely, nor can global treasuries continue to be as
accommodative as they have been since the credit slide began. I believe we are likely to enter a period of
tighter money and higher inflation in the next decade, particularly if a
hoped-for economic recovery is to succeed.
Every
investor’s dream is for 20% returns with no risk…at least that’s what is
frequently requested of me. But our emphasis
should be on maintaining a prudent discipline about investing, and mitigating
any turbulence whose volatility might cause significant risk.
While it
appears as if the “little things” are of greater significance, my belief is
that we can improve performance by focusing upon those activities that generate
positive macro performance for the duration.
As the title
infers, “Take two aspirin and call back next
October.”
Asset
Allocation:
Equity 28%/Fixed
Income 42%/Cash 30%
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