Paranoid? Compartmentalize.

Introduction

If you don’t know how to get some place, it is useful to know where you are. To be a successful investor over time, it is wise to guess whether you are early or late and which cycle are you playing.

Various commentators have described the current market in terms of “risk on.” The preponderance of those who are active participants are accepting more market risk as indicated through their buy orders.  There is substantial data to broadly support this view. While the popular stock market indices have been rising on relatively light reported volume, elements of both the bond markets and the commodity markets are showing significant strength. Non-energy related commodity prices are now showing mid single digit gains on a year to date basis which is also being translated into gains for many emerging market stocks. Commodities and emerging market stocks are normally viewed as more risky than general stock markets.

If one believes that in today’s environment institutional traders of all sorts see investing in high quality bonds in some form of a “carry trade” is another way to play a “risk on” game. In the past week an usually large amount of money has been invested through mutual funds and more significantly ETFs in high grade fixed income pools. This was not the case in high yield, lower quality securities as can be seen in the changes in their weekly yields. According to Barron’s, an index of high quality bond yields dropped to 3.42% from 3.58% the week before as distinct from intermediate quality bond yields slightly rising to 5.12% from 5.10%. The magazine believes the ratio between the best bond yields and the intermediate bonds is a good predictor of future stock market progress. This week the ratio was 66.8 vs. 70.2 last week and 75 a year before. Most of the time this confidence index moves less than one percentage point per week. A move of 3.4 is a dramatic indication of surging demand pushing high quality yields lower. A symptom of taking on more risk for investors is that Ireland can sell a century bond that follows a similar Mexican 100 year bond.

Clearly we have entered a “risk on” stage. The critical question for both the participants and those on the sidelines but with cash to spend is, “Does this move make me early or late?”  I am aware that my old friend Ralph Acampora, who worked with me on the board of the New York Society of Security Analysts, and who is the father of modern market analysis, has told clients that the correction phase is over. He believes that we have started a new market cycle. Thus he is in the camp of analysts who believe the current move is early in the cycle. He may be right as he has a good batting average on market calls.

One of my concerns is that many companies have become much more efficient in their human capital deployment. They have hired slowly and have used both technology and their external supply chains to keep their active employment costs low, particularly now in the face of rising healthcare costs. This works well in a flat to rising economy. This does not work well even in a modestly declining economy. 

I study the financial services business more intently than other businesses. One of the reasons many of these stocks did poorly in the first six weeks of 2016 was when revenues fell a little they did not have enough people to lay off to keep operating income flat. In one case the quarterly revenues of an important component of a financial services firm fell 3% and operating income fell 21%. In another case revenues fell one tenth of one percent and operating margins fell one percentage point. My concern is if we go into a stagnation phase, many managements will need to make draconian moves to generate cash to meet domestic debt service requirements. The current “risk on” attitude is not reflected in the stock prices of some managements that are unprepared for stagnation.

What to Do?

I rely on my approach of timespan diversification as captured in the Timespan L Portfolios^®. The biggest risk of not producing sufficient funding for current spending is in the shortest term Operational Portfolio. In this case if we see a quick reversal to a “risk off” attitude there can be a significant loss in prices before the next up cycle. Thus, as I have written previously, the operator of a short-term portfolio (and that includes many managers who can not tolerate under-performance for a single or even two years) should set up scaled orders to reduce the risk of disappointment on the way up.

Currently I do not see a significant risk in the longer term portfolios in the Timespan suite, now. The key word in the last sentence is “now.” At the moment most of the “risk on” players are confining their trades to the high quality portions of the market. Based on over fifty years of experience following the various markets I am on the alert for a switch in momentum from high quality to low quality in stocks, bonds, and commodities. Experience shows at sometime, (usually after a significant price rise) high quality issues disappoint and momentum shifts to lower quality. At that point some will remind us that over many long periods, low quality securities have better long-term performance than high quality. Not that they are superior vehicles, but that their entry points are significantly lower than when most investors invest in high quality paper.

The Key to Long-Term Investment Success

The critical key to long-term investment success is not primarily in security selection. The key is how to manage the investor. My approach is to break down or sub-divide  problems into bite size pieces. In effect what I am suggesting is to use compartmentalization to control the natural paranoia facing declining markets. Under this approach instead of using an overall asset allocation schedule, I let the assignment of funding needs dictate individual timespan portfolio compositions, accepting that most of the time the longer maturity portfolios will be consigned to “risk on” structures.

There may be help coming along the way. A recent paper produced by post doctoral students at Caltech and the University of Melbourne is studying contagion or the tendency of people to stampede into making hasty and often unhappy decisions. What they found was people are more likely to become victims of contagion if they have recently (directly or perhaps indirectly) experienced similar contagions in the past.

We should equip people with enough historical knowledge to know that those who participate in a stampede are likely to be trampled and investors improve their odds of survival with a more patient attitude on picking when to dismount the tiger that they are riding.

Question of the week: Where are we? 

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