March 16, 2009
A FRESH LOOK AT AN OLD IDEA: THE FUTURE'S COMING (STILL)
What if the apocalypse is delayed once again? What if the depression turns out to be a nasty recession? We don't have the definitive answers, but we know how to ask the questions and consider the odds.
When the last investor has sold, when the appetite for risk has completely vanished, the markets will bottom and the cycle will turn in earnest. Deciding in advance when that moment arrives is an inescapably speculative venture, and investors with weak constitutions will want to avert their eyes, and portfolios. For everyone else, it's time to go to work.
That starts by recognizing that waiting for a clear confirmation that the turning point is here is likely to miss the big gains that typically come in the early weeks and months of the eventual rebound. Navigating those two extremes is a big fat slice of risk. Finding a reasonable balance, which differs for every investor, is the core of the investment challenge at the moment.
The generic solution is to keep the risk allocation of the portfolio fully invested, through thick and thin, boom and bust, while keeping a stash of cash. Of course, that doesn't feel so good when the bust actually arrives. Looking at long-term numbers is easy; weathering the day-to-day pain of a bear market, especially one as deep and devastating as this one, is sheer torture for all but the most disciplined of investors.
It's a safe bet that the bears now outnumber the bulls by a wide margin. In fact, unless you look real hard, you might assume that bulls have gone the way of the dodo and the prospect of having a satisfying career on Wall Street—or Detroit. Just thinking about adding risk exposure to portfolios these days is like sticking needles in your eyes. That's just one reason why you should consider it.
The unwinding, intellectually and otherwise, is now in full swing. Today's news that Barclays is discussing a possible sale of its iShares ETF unit is a sign of the times. As recently as 2007, the financial industry was falling over itself in trying to launch new ETFs, with increasingly speculative reasoning, as we reported in those halcyon days. Barclays, one of the original firms that helped spark the exchange-traded fund revolution, is now having second thoughts. The urgent need to raise capital among companies near and far is part of the reason.
Have we come full circle? It sure looks that way, or at least pretty close to full circle. We won't know—can't know for sure until after the fact, of course. As such, there's always reason to sleep with one eye open and to question pundits and analysts, including yours truly. Accordingly, keeping a portion of your asset allocation firmly focused on the long term, which is to say shunning short-term tactical adjustments, is prudent. But it shouldn't dominate every last bit of your investing decisions. Some portion—and reasonable minds can debate how big, or small a portion—should be dedicated to tactical asset allocation. Invariably, each investor's personal circumstances, including risk tolerance, investment objectives and time horizon, are crucial variables.
Generally, the financial literature, and a fair amount of real-world investment results, makes a compelling case for recognizing that asset class returns are partially predictable. But only partially, and even then there's no guarantee. Still, the implication is that investors—even so-called conservative, long-term investors should avail themselves of the opportunities, to a degree. Yes, we must be cautious, wary and otherwise suspicious of thinking (dreaming) that there's easy money in attempting to forecast the future. But if you're looking out at least three years—five or 10 is even better—Mr. Market drops a number of clues about what may be coming.
Ideally, you were doing no less in 2005-2007, when the bull market looked increasingly extended. For those who ignored the signs, it's going to be tough to take advantage of expected risk premia now. But for those who are still standing, the future now looks bright, or at least brighter than it has in quite some time. Yes, that's a contrarian view, but that's the only way to fly in the money game.
Summarizing the details takes time, of course. A fair amount of The Beta Investment Report is focused on just that: Analyzing the clues in the context of dynamic asset allocation for strategic-minded investing. In addition, we're finishing up a book on asset allocation for Bloomberg Press. Meanwhile, let's say that the collective evidence in the here and now suggests reason to raise risk allocations. Not aggressively—yet—nor with the expectation that it offers a quick buck. By our reckoning, we're still early, perhaps very early in the market rebound that awaits. Suffice to say, we're far from betting the farm on any one scenario, or asset class.
That said, we have a bit more confidence that the hour is late for severe and crushing bear market debacles. Yes, the markets could tread water for quite a long stretch. They could also prove us wrong and take another sharp leg down. We simply don't know. But not knowing also includes being clueless about a future that's surprises everyone on the upside. We're reluctant to bet heavily either way at this point.
The financial markets usually begin recovering well ahead of the economy, and so looking for convincing signs that the recession (depression?) has passed harbors quite a bit of timing risk. And as we discussed earlier this month, there's still plenty of reasons to wonder when the economic contraction will cease.
We do know that this bear market is now the steepest in the post-World War II era in terms of percentage loss for the S&P 500. In terms of its duration, on the other hand, the current correction is still middling. At the moment, the selling is in its 17th month since the October 2007 stock market highs. That puts us currently at just under the average length of bear markets since 1945. The longest one lasted 3 years, so one has to stay mindful of the malicious possibilities.
Nonetheless, if we look at the full range of clues, everything from volatility to fundamental valuation, from the term structure of interest rates to monetary policy, along with other metrics, strategic-minded investors should be increasingly focused on taking advantage of the alluring price of risk in the capital and commodity markets. Do so cautiously, and by using broad index funds and ETFs. In any case, do so.
Yes, that's advice with an embedded forecast, which is primarily one of betting that we'll sidestep the apocalypse after all. No guarantees, of course. If you need to be absolutely, positively sure, we've got the perfect investment for you: 3-month T-bills. Otherwise, history reminds that the recession beta, if you will, is the primary driver of risk premia. We're supremely confident that history will repeat itself on this point. As always, the timing is the great question.
Posted by jp at March 16, 2009 9:59 AM