June 5, 2007
RISK IS STILL A FOUR-LETTER WORD
Rarely have so many earned so much for so long.
That sums up the performance record for the broad asset classes. By almost any measure, the past five years have been extraordinary. Rarely has everything run higher, year after year, and posted robust gains in the process.
One might think that the party would be showing signs of age after such an astonishing track record. But as our table below suggests, momentum in its upward form remains the dominant force in the markets this year--again. Indeed, red ink has been banished from the list.
Debating how long red will continue to be conspicuous in its absence from the performance tally should be topic number one for strategic-minded investors. By extension, one can reasonably question how long the mother's milk of this bull era will last, namely, liquidity, which has been exploding globally for some time now.
Of course, such topics have proven to be losers in recent history for the simple reason that taking on more risk has proven to be the winning concoction. Staying the course and committing more money to markets around the globe promises to remain the winning strategy, we're told by more than a few bulls. Perhaps they're right. We certainly continue to own a diversified portfolio, albeit one that's continually biased toward less rather than more risk as time goes by.
Nonetheless, full-blown discussions of risk are rare. Such is the power of bull markets, especially those that have been around for a while. Risk, by contrast, couldn't get arrested if it tried.
But as students of market history know, there is no return without risk, no bull without bear. The great unknown, as always, is the timing. On that we can offer no insight other than to opine that the cycle will one day turn and that the peak is closer today than it was yesterday, and will be closer tomorrow than it was today.
With that in mind, there are two basic paths one could choose. The first, which we wholeheartedly renounce, is declaring that a new era has dawned and that corrections of any magnitude or length are the stuff of history. The alternative is assuming that cycles remain intact, however much the past few years appear to contradict such thinking.
We offer no proof in defense of the latter except to point to the repeated rise and fall of markets over the course of time. That, of course, opens us to the charge of using history as a guide to the future. As such, we confess our guilt on that score. Our only explanation is that we are otherwise blind. Flawed though the past is for reading the future, it's all we have.
For those who agree, and are inclined to act accordingly, we point you to recent research by one Mebane Faber, currently managing director and portfolio manager at Cambria Investment Management in Los Angeles. Mr. Faber has crunched a considerable amount of market history for a paper titled "A Quantitative Approach to Tactical Asset Allocation," which can be read here and also in the Spring issue of The Journal of Wealth Management.
Among the paper's insights is the familiar counsel that diversifying across asset classes, selling in bull markets and buying in bear markets enhances risk-adjusted returns. The result comes primarily by reducing risk rather than elevating return, the research finds, echoing what others have said over the years.
If nothing else, the paper adds to the growing body of literature that argues for owning a mix of assets and rebalancing when the respective weights of those assets move to extremes. Alas, everything now seems engulfed in one of those extreme moments. History offers precious little context for navigating in these waters. Perhaps then it's time to reconsider the original zero-correlation asset class: cash. No, it won't make you rich, but its prospects for risk reduction are looking more alluring with each passing day.
Posted by jp at June 5, 2007 9:47 AM
Greenspan nailed it recently with the observation that what we are witnessing is a one-time event, wherein a population bloc the size of China/India combined cannot "join the open world economy" more than once, and he could have added SouthAmerica into that idea as well. As to risk, all we need is another global war on the scale of WWI or WWII, and given homo sapiens proclivity to repeat the mistakes of the past, the war event is only a matter of time.
Posted by: franko at June 5, 2007 12:57 PM