Sunday, June 23, 2013

Losses Lead to Profits, but Will the Fed Learn?

Losses are inevitable in all of life, including your investment portfolio. As a matter of fact, the only thing I promise to those whose portfolios I manage is that I will make mistakes for them, but hopefully they will be relatively small and quick, and that we learn from them.

There are four kinds of losses. The first is that the selection failed to deliver the expected result because the choice was fundamentally flawed. The second is a faulty understanding of how the particular investment actually works. The third is the right idea, but the wrong timing. The fourth and the most dangerous to the future of the people involved is not to learn from the losses. One of the few things I did not learn from my experiences in the US Marine Corps is my motto of “Blunder Forth,” but the key is to learn from past blunders and not to repeat them.

Diversification losses

Since few, if any of us know with certainty what either the markets or the economy are going to do, it is traditionally wise to hedge our bets. (This is why at the racetrack an occasional bet on second place or even third makes more sense than only betting to win, particularly in each race.) There are two active ways to hedge our bets. One is to sell something short. The second is to buy something which is likely to move in the opposite direction than the bulk of the portfolio is expected to go.

Many institutional and individual investors are hesitant to sell short because to be successful one needs to get one’s timing right. Too few have a good history of this skill. Many more investors look for contrary plays. Two of these are gold and TIPS (Treasury Inflation Protected Securities). The owners of these are betting that the current manipulation by the major central banks of the world will produce a decline in the value of major currencies or create a large bout of inflation. In the first half of 2013 neither of these calamities have occurred, therefore these bets are considered by many to be losers. In most institutionally managed portfolios the actual or paper gold (futures or gold mining shares), the gold holding is less than 10% and in many cases below 5%. The purpose of the holding is to act as a ‘canary in a mineto signal an abrupt change of conditions which has not yet happened. TIPS are typically held in a portfolio that also owns other bonds or bond funds. The combination of the bond holdings is meant to insure that when the bonds mature they will produce dollars that are equal in spending power to the level of the dollars invested initially. For most of this year TIPS have not been returning a real (inflation adjusted) return.

Are the investment in gold and TIPS losers? I would say no. Because of some investment in TIPS, a number of investors were able to have enough courage to own much larger investment positions that had a more positive outlook than if they had not owned TIPS.  I would go further by saying that a well-balanced portfolio could well be at its maximum risk of large losses when all of its investments are showing significantly positive results. It is unprepared for abrupt changes which have been known to happen.

However, there is a risk which overtook investors in 2007-2009. The risk is that the protective diversification schedule was trashed by the correlations (particularly on the downside) among supposedly uncorrelated assets. I am not at all suggesting that one should abandon diversification as a practice, but to be aware that there will be times that supposedly uncorrelated prices will move together and only a reasonable amount of cash or very short-term treasuries will supply some ballast to a rapidly sinking portfolio.

Will the Fed learn?

The two losing diversification investments mentioned above were meant to be good diversifiers against the actions of the US Federal Reserve Board (the Fed) and a number of other national Central Banks in attempting to stimulate their economies by depressing the natural risk-oriented interest rate levels. Perhaps it is coincidence, but this week I have become conscious of four separate but different comments that suggest that we are approaching a time when the structure of the Fed may be changing. In order of their first appearance to me the four are as follows:

1.   As mentioned in last week’s post I chaired a panel presentation on the impact of the media on the nature of “bubbles” with Bill Cohan and Jason Zweig at the Columbia Club in New York. As is often the case in these public sessions, the audience was less interested in history and more interested in what to do now. One of the speakers who is a good historian stated that the Fed is not very good about predictions. They have not done a good job of predicting the economy and worse, they have been poor on predicting what they would do in the future.

2.   A “Hindsight” column in the  New York Times, included an article by Roger Lowenstein entitled “The Fed Framers Would Be Shocked.” Roger is someone who has written widely on the economy and the market, he is the independent chair of the Sequoia Fund, a sound fund that comes out of the heritage of Warren Buffett’s original hedge fund. He focuses on the concerns of many involved with the passage of the act that created the Fed; that it would become too powerful and would drive the economy. The authorization of the second Bank of the United States was allowed to lapse because many feared control of our economic interests by a powerful unelected body which would likely to be heavily vested by the ‘money trustbankers. In some ways this was a replay of the battle between local control and national control, a battle that is still raging in education, medicine, and other arenas that people care about.

3.   The Bank for International Settlements (BIS) functions as the central bank for the world’s central banks. In a report released over the weekend, they urged the central banks to withdraw from the stimulus business. The BIS felt that the proper function of the central banks was inflation control not to provide growth impetus for their economies, which is a function of the governments and their fiscal policies. An interesting article was published Sunday by the Telegraph, entitled:
BIS Fears Fresh Bank Crisis from Global Bond Spike.” 

4.   There is a bill in Congress which removes the double standard for the Fed by eliminating the responsibility to aid the growth in the economy other than by attempting to control inflation.

I found it interesting that all seem to be forgetting that the original purpose of the Fed was to substitute a public source of capital to troubled banks replacing JP Morgan’s policy of forced cooperation. (Morgan once locked the participants of a key meeting in his library to force agreement among the solvent banks to provide bailouts to the distressed banks.)

Quite possibly these and additional drumbeats may hasten changes in the proper use of the Fed. Others are learning from the recent past, it will be interesting to see whether the momentum for change will come from within the Fed or from external forces.

All of us, including the Fed can learn from our past losers or mistakes.

From what losers have you learned? Please share publicly or privately.       
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