Sunday, April 12, 2009

Relations and Correlations

At this time of year people of many faiths hold family gatherings. At the same time, those who are not physically near their biological families often group together for a meal. In the current era, some of us define our families through various types of electronic media. All of these relationships bring people together that have some common directions that keep these individuals glued together, at least for awhile. In a similar fashion, at times security prices moves in the same direction, and often in similar magnitude. The year 2008 saw almost all stocks, bonds, commodities, and even currencies and interest rates drop. There were very, very, few price series that rose. A number of observers commented that the only thing that went up was the correlations of prices to one another. This being the case, there were very few price trends that were reliably going up. Thus, with the exception of successful short selling, most natural hedges did not work at all or did not work well enough to totally offset declining prices.

Even before last Thursday’s price spike (April 9), we started to see various commentators issuing views as to what investors should do when, not if, the next upward phase begins. These pundits are savvy enough not to issue a declarative statement that they had seen the bottom point, (even though I believe many common stocks have seen their bottom prices). Few, if any commentators see an immediate sustained rise in prices, and almost none are firmly predicting new record prices. Also, they are not predicting when the upsurge will begin. Nevertheless, they believe that there will be a meaningful rise.

The interesting, and much more difficult job is to define a winning strategy to take advantage of the force of the animal spirits which will drive the market higher. Some investors rely on the historical patterns of certain types of stocks, bonds and commodities leading the way, e.g. large cap growth stocks, high yield bonds, commodities in short supply, etc. A second group focuses on the expected human reactions to the drubbing that portfolios have sustained in a very rapid manner. They also hold the knowledge that the last ten years have yielded little or no positive results, particularly on an after-inflation basis, and where needed, on an after-tax basis. The third and much smaller group, to which I am a member, believes that the future will be shaped more by the future structure of the players and events, rather than by dogma.

The U.S. Congress and other political organizations are currently in the “blame and punishment” mode, trying to ensure that the problems that have been created will never happen again. This is an impossible task for several reasons. The first is that they have forgotten that it takes “two to tango” (or to do other dangerous and competitive contact sports). None of the imprudent paper would have been sold if it were not for the greed and ignorance of buyers of all sizes and sophistication levels. The second barrier to ensuring a solution is that we are in the process of creating new and different investment organizations, with talent freed from the government-mandated bureaucracies of today’s large financial institutions. The third barrier is that the globalization of the world’s commerce is keeping some of the world’s brightest students from studying and eventually settling in the United States.

I am convinced that new types of investment organizations have been and will be formed. I hope that new and refined financial contracts and instruments will be created. As both natural resources and technology will find more immediate payoffs overseas, the financial community and many of us as customers will follow with our dollars. Increasingly it will become clear that national governments are important part of the problem. But even a larger part of the problem is a lack of awareness; we must teach people of all levels of economic knowledge that they are primarily responsible for what happens to them.

How does this translate into a portfolio selection process? First one should deal with a multiplicity of forward looking managers who combine “beyond- the-horizon” awareness with an intimate knowledge of the details of the tactical exploitation of events. Second, in order to be able to avoid the liquidity problems of rapid purchases, an “opportunity reserve” is a good idea. The opportunity reserve should be made up of two elements, short term cash or money market funds, as well as the most liquid index funds. The mix should be dictated by a general market view. Note that this reserve is quite low cost. Opportunistic investments should be few in number. Even for the ultra high net worth individual/family or a large institution, no more than ten probes into the future should be undertaken.

I have a personal bias toward specialist managers whose skills are more focused on future developments. I also suggest that portfolio components should not be well correlated to each other in terms of performance. If and when they become too correlated, it may be time to rebuild the opportunity reserve with particular emphasis on the cash side.

This Easter Sunday finds me pro families however they are related, but I am anti correlations in the long run.

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