Introduction
Almost
all investment advice is framed primarily as buy recommendations and to a
lesser extent sell recommendations. For the sake of brevity and complexity
these recommendations are at best incomplete and in many cases misleading. Even
when we start with cash and expect our estates to be settled in cash, we are dealing
with at least with a two-step process.
Cash
Nothing
can be simpler than cash or it may seem so on the surface, but it is actually a
series of decisions that can be a major influence on the ultimate performance
of any other investment. The single most important characteristic of cash is
that it has the burden of opportunity cost. The decisions to accept or reject
the opportunity to make or lose nominal amounts of money is borne by one’s cash
pile. In an inflationary environment any uninvested cash will see its
purchasing power decline. If the central bank’s desire for 2% inflation is
achieved on average for ten years, most of the current purchasing power of cash
is wiped out. While there is a low probability that our custodians will
disappear with our money, a few have done so in the past, thus there is risk entrusting our cash pile to any single custodian (and some may say in any
one currency or location).
Asset
Allocation Switches
Most
asset allocation, after costs of the transaction including taxes, produces
dollars that are moved from one asset to another. Even a move into or out of
cash could be viewed as a time or possibly price allocation when one side is
immediately executed and the other side is delayed until perceived conditions
change. The opportunity cost of the delay should be assessed. Perhaps a long-term
reasonable approach to this assessment is a figure between the inflation rate
and a generalized accrual pension target of seven to eight percent. Bear in
mind that the current fifty two week gain for the average general equity fund
is 20% which is highly unlikely to continue. However, it does show that the
size of opportunity cost is variable as well as cyclical.
Motivated
Switches
Most
switches are motivated by either a strong desire to buy or sell an investment
and almost all the emotional attention is spent on that motivation. I want to
own “X” or I must get out of “Y.” Far less attention is spent on the other side
of the transaction, the funding vehicle or the receiver of the proceeds. When
one thinks of the longer term impact of the transaction there is some chance
that the less-desired part of the equation will be more important than the
initiating desire. Remember any decision
could be wrong both in terms order of magnitude and direction of any swap. This
is not a clarion call to be passive and let market, economic, and political
events dictate results. Just consider both sides of any transaction in making
one’s decisions. One approach is a quote from my old data and consulting client
Sir John Templeton when he said his transactions were motivated by choosing
“better bargains.” This suggests a reasoned analysis of both what one owns and
what one may want to own.
Portfolio
Driven Switches
In
truth most individuals and some institutions actually own a collection of
investments that were chosen only for the attractions of the individual
investments. One of the reasons that I use mutual funds for clients is that
they get judged on how well the entire fund performs not any individual
investments. The long-term compensation of the portfolio management team and
the owners of the management company is based on how well they perform compared
to their peers.
For
the managers of portfolios, the weighted mix of investments is critical to the
ultimate results. Today I see too many portfolios of institutions and
individuals owning some or all of the ten most popular stocks. Unfortunately
while they own the names of currently winning stocks, they own less of these
names than they occupy in the popular market indices. Thus when the indices
rise they are underweighted in the winners and so lose out to the market, which
can be costly in terms of marketing to outer-directed investors. They get some
relative benefit when the market goes down, but probably lose absolutely.
I am
attracted to portfolios that pay attention to their total opportunity and
risks. Many of these use cash or equivalents to partially de-risk portfolios.
At times it may be difficult to assign all of the cash to de-risking as many
funds that have an easily stampeded audience carry redemption reserves.
(Unfortunately in rising markets reserves of all types hurt near-term
performance.)
Another
important factor to me is how much investment sensitivity to long-term currency
risks is in my clients’ base currency (which is currently in US dollars). As
there is practically no US investment that is not directly or indirectly at
risk or benefit from the movement of the US dollar, this is an important
consideration for me and my clients. There are numerous ways to address this
opportunity and risk. One can own foreign currencies, own foreign securities
that are primarily owned by local investors and multinationals that are
themselves operating globally and measuring currency and other risks. The funds
to avoid are those that are not paying attention to both the risks and
opportunities.
Are
We Approaching a Tipping Point?
Almost all professional investors and many sophisticated individual investors are thinking or obsessing about the next major decline that could begin in a day, by year-end, after the 2018 Congressional elections or the 2020 Presidential election. I will let others focus on the timing of a major decline. I have suggested that unless we see a great deal more enthusiasm for equities, the next decline looks to be in the “normal” variety of around 25%. A review of fund history and those of many individuals, shows there are very few investors that can sidestep a normal decline and recommit at lower prices and deliver an investment performance better than the majority that held through the round trip.
However,
with this week’s focus on the 22.6% decline on October 19th 1987, it reminds me
that thirty years has passed and beyond the normal decline there is a once in a
generation (which is normally about twenty five years) a 50% market decline.
Some may feel the 2007-2009 decline represents the needed 50% decline. Perhaps
they are right, but I see enough similarities in both declines to put me on my
watch.
My
Watchlist
1. Both declines started with fixed income
markets weakening due to excess speculation. I am wondering whether we are
seeing that in both the US Treasury market and the number of new credit funds
being established.
2. The infamous South Sea Bubble was created by
almost universal belief in the forthcoming riches from Latin America. Today the
fast growing asset classes are Emerging Equity and Emerging Debt Funds. Bear in
mind some concerns about the existing Chinese debt structure and probable
expansion as it attempts to build its “One Belt One Road Initiative.”
3. Not the cause, but a primary accelerator of
the 1987 collapse was the regulatory mismatch between Chicago and New York
stock futures markets. Is there a potentially similar accelerator in ETFs and
ETNs?
4. There are twenty mutual fund investment
objectives tracking the diversified, general equity market. On a year-to-date
basis, five are performing better than the S&P500 funds, but in the last
four weeks eight are performing better, with three of the Small Cap investment
objective joining the leaders. Until very recently, the NASDAQ composite has
been out-performing the larger cap markets. One can’t help to question whether
this is a late stage speculative surge.
Bottom
Line
Think
through your allocation switches as to what you are buying and selling and also
pay attention to parallels with history.
__________
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A. Michael Lipper, CFA
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