Monday, February 7, 2011

Is your investment policy ready for market trauma?

Cullen Roche at Pragmatic Capitalism posted a chart from Pring Turner Capital comparing the current stock market to previous secular bear markets in the past. They go on to state that the current secular bear could last until the 2016-2020 timeframe.

I wrote about this back in July 2010 (see Wait 8 years for a new bull?) and pointed to a study by John Geanakoplos et al as they related demography to long-term stock returns, with the conclusion that a new secular bull is likely to begin 2018.

A series of rolling booms and busts
In such an environment, maintaining a buy-and-hold investment approach will result in sub-par returns, as Barry Ritholz points out. We are destined for a series of booms and busts, as the market oscillates between an inflation psychology one minute and a deflationary one the next. John Mauldin and I are on the same page on market volatility:
Investors are good at absorbing short-term information, but they are much less successful at absorbing bigger structural trends and understanding when secular breaks have occurred. Perhaps investors are like the proverbial frogs in the frying pan and do not notice long, slow changes around them. There are three large structural changes that have happened slowly over time that we expect to continue going forward. The U.S. economy will have:

1. Higher volatility
2. Lower trend growth
3. Higher structural levels of unemployment (The United States here is a proxy for many developed countries with similar problems, so much of this chapter applies elsewhere.)
Even David Rosenberg has grudgingly agreed with my viewpoint in his Breakfast with Dave (registration required) on February 3, 2011 (emphasis added):
Everyone should be made aware of the insanity of it all, and that preserving their capital and growing it slowly and prudently is a totally appropriate strategy for this radical money easing environment. This type of policy breeds speculative and dubious rallies, but what they inevitably trigger are boom-bust cycles such as the ones we saw in 1999-2002, 2006-2009, and the current one we are in today. This is no time for short memories.

Rosenberg writes that market perception will oscillate between commodity inflation and deflation:
The Fed has created an "inflation" mentality in commodities, foodstuffs and stocks ― aided and abetted from a U.S. dollar that has sunk back to two-month lows. At the same time there is still a "deflation" mentality for many final consumer goods, which is unlikely to change until the employment picture improves further.

Be tactical & stay liquid to be opportunistic
I agree that preserving capital is of utmost importance in such an environment, but then we also need to earn a reasonable rate of return. My advice:
  • Stay liquid and keep your powder dry for investment opportunities. Capital preservation is going to a key consideration in such a volatile environment.
  • Be more tactical and use models such as my Inflation-Deflation Timer Model to preserve capital and benefit from any intermediate term volatility.
  • Be aware of the risks in allocating funds to value oriented strategies (e.g. high quality stocks, as per Jeremy Grantham) or income oriented strategies (e.g. high dividend yield or SIRP as per David Rosenberg). While such buy-and-hold approaches are likely to outperform the market over the longer term, investors will have to be prepared to withstand periods of high drawdowns, i.e. losses, such as the episodes seen during the Lehman Crisis of 2008.
Today, we have the cross-currents between a powerful Fed injecting liquidity into the markets (see my post on Bernanke preparing the grounds for QE3) and an overvalued equity market. Comstock Partners believe that the current stock market looks like 2000 and 2007. I would agree that current conditions feel like late 2007 and early 2008. We have commodity prices on a tear, which is bullish, but evidence of systemic failures (subprime and CDS/CDOs then, Europe and the muni market now), which is bearish. Such situations do not resolve themselves well but the timing of the failure is anyone's guess.

Bottom line: get ready for volatility and make sure that you have right investment policy and risk controls in place to deal with market trauma.


walt said...

Too bad SA comments deteriorated into babble.

Please elaborate on "stay liquid." Pay-nothing money markets? Short-term (2-3 year) bonds?

Cam Hui, CFA said...

Cash - focus on return OF capital and opportunities instead of return ON capital.