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.

Washington & the Necessary, But Insufficient, Signs of a Market Bottom

Feeding the optimist can be a long and frustrating task, but a necessary one. I am taking on this task to help others as well as to reinforce my upside bias. This bias is based on the old US Marine Corps belief that the best defense is an offense. Like most analysts, I am a reviewer of history; and I believe that even in history’s darkest moments, the human condition has been on the rise.

In the midst of our deep financial problems, we may be in the best position ever to deal with solutions. The current mood of investors is shifting to the view that the light at the end of the tunnel is not a way out, but rather an oncoming train. Historically this feeling of hopelessness is a required backdrop for the scene at the bottom. With that thought in mind, I was thrilled to see a story entitled “Bear Market’s Bite Could Go Deeper” in the online version of The Washington Post. “It is unlikely the market has hit bottom,” the article begins, continuing with the opinion of a chief technical analyst at S&P, “The current market environment is showing few signs that have characterized previous lows—high price volatility, high volume of trading and even higher levels of fear.” “Bear market bottoms tend to be violent affairs.”

Why am I thrilled with this article? First, the Washington Post is the single most respected source of perceived wisdom, therefore it must be politically correct in the Washington Beltway. Second, based on the high regard the American investing public has for the media in general, people now search for truth in the opposite direction of media pronouncements. Third, the S & P analyst is accurate only if one is dealing with a cyclical bear market where the search is for a violent bottom to wipe out the weak holders as a precursor to a sharp rise. This kind of bottom is not logical if one believes, as I do, that this bottom is the terminal set of points at the close of one era. The most logical type of bottom after the damage of the corrective phase is a dull exhaustion bottom, created by the absence of buyers at any price. The pessimists are exhausted and possibly sold out; and the optimists, like me, feel the prices are fine, but the time may not be quite right.

One of the many signs of a tectonic shift in the structure of our investment markets crossed my desk late this week, driving home the impact on our conservative and senior population. I received a notice from the American Funds Group announcing that their Balanced Fund was reducing the dividend to its fund holders. The explanation for the cut was the curtailment of dividends from the high quality stocks they own, as well as the current low interest rates on high quality fixed income securities in their portfolio. As many of you know, the American Funds are managed by Capital Research one of the largest investment management groups, with a long history of distinguished results.

A word about the origins of Balanced funds. This type of fund was an extension of the trust accounts used in both the UK and the US, comprised of both stocks and bonds. In Boston, these were the types of accounts that Clipper Ship Captains left with their lawyers to manage while they were away. The income off the trust was to provide for the current needs of the family, and the stocks for growth of assets. In many ways balanced funds act more like fiduciary accounts than the single asset class type funds.

There are a number of important observations from this action to reduce the dividend:

1. The current market decline is now going to be felt by those who can least afford a change to their income level.


2. Many high quality stocks have cut or omitted their dividends. These are the very same corporations that were considered among the most reliable of our corporate citizens as recently as one year ago. Something fundamental has changed for the worse among our best.


3. The original investment concept of a Balanced fund was that stocks and bond prices would move inverse to each other. Bond prices would rise when stocks declined. Currently in the high quality corporate bond market this is not happening in a significant way. This is another example of the tectonic shifts in our marketplaces. The term tectonic is an apt geological term that that defines when the great plates that make up the earths’ crust move, which happens extremely rarely. We are now into something new and maybe for the first time in our investment lifetimes, something “completely different.”

In some ways we may be in a Revolutionary period similar to the French or scientific revolutions or even closer to home, the American Revolution. I am writing this blog on February 22nd, George Washington’s birthday. As my wife Ruth serves as a “Lifeguard,” a group devoted to fund-raising and introductions to the wonders of Mount Vernon, we often go there to celebrate the memory of our first President, the only one not to serve in the city named after him. For the moment I want to focus on this man, often called “the indispensible Washington.”

If we are truly in a revolutionary period, where are our leaders like Washington, Hamilton and the others? The politicians and most of the patriots turned to General Washington for the leadership of what could be laughingly called our army. It was a bold step to choose a military leader who had been defeated in the last war, but he was possibly the richest man in the colonies. His fortune was earned by brilliant land speculation in many of the thirteen colonies and other nearby regions. During the Revolution we had better tactical generals, but none better on a strategic level. Interestingly, Washington was constantly out of sorts with Congress, and threatened to resign on numerous occasions if provision was not made for the meager funds to pay his troops.

The war was won largely due to the quality of Washington’s leadership, a fortunate break in the weather and the threatened presence of the French fleet. Washington’s leadership created trust on the part of his soldiers and perhaps the one-third of the population that supported the cause. At the moment what we are missing is faith, or if you will, trust in our institutions, media, economy and markets. Each day many of us start the day with low trust in that list, and the actions of the day lowers the trust even further. What we need now during what appears to be a revolutionary period, is faith that things will get better. Let us hope so. History suggests that eventually the optimists win.