Perspective may be the only true value left when fear runs amuck.
There’s a blizzard of reports swirling about and it’s easy to get confused. One need only review the headlines for a few minutes to feel dizzy. But while the red ink flows like rivers in a hurricane, the first step in assessing what’s happening is stepping back and looking at the big picture. With that in mind, here’s a whirlwind tour of where we stand as of last night:
First, demand for safety has surged–to extraordinary levels. One need only look at the collapsed yield on 3-month Treasury bills for evidence. It’s a rare event when money managers willingly accept a guarantee of no return, perhaps even a slight loss in exchange for assurance that principal will be returned. Welcome to the new age.
The annualized yield on the popular benchmark of a “risk-free” asset closed at 0.03% last night, a sea change from just three days earlier, when the security closed at a 1.49% yield. Reportedly, some investors yesterday at one point were gladly buying 3-month T-bills at negative nominal yields! The rush to safety was so strong that the hope of turning a profit could wait for another day (or year?). The same motivation drove up the price of gold by one of the biggest single-day gains ever for the precious metal. The rise had nothing to do with inflation worries, which are effectively dead for the moment. Rather, it’s all about finding a port that’s sure to weather the financial storm blowing through global markets. A few thousand years of encouraging history in the metal’s ability to preserve wealth aren’t easily ignored these days.
Where does that leave the major asset classes? Battered and bruised, to be sure. With the exception of commodities and bonds–short-term investment grade bonds–there was red ink everywhere yesterday. There’s no shortage of minus signs so far this month either. All the major asset classes are down in September through last night, with the exception of U.S. investment grade bonds as per the Lehman Aggregate Bond Index. As a result, our CS Global Market Portfolio Index (GMP) has slumped 8.5% so far this month, based on our preliminary estimates. That’s better than the S&P 500’s 9.9% drop this month through yesterday, although it’s cold comfort given what’s going on in the world. (We’ll analyze GMP and the implications for portfolio strategy in more detail in the coming days and weeks. As a preview, this isn’t entirely unexpected although it’s clearly painful.)
The biggest fear is now fear itself. Perhaps that’s rational, perhaps not. Lending has dried up, cash is king and everyone’s wondering where the next shoe will drop. That’s hardly a surprise, but strategic-minded investors must keep the big picture in perspective.
For several years we counseled that long-term investors should have been increasingly cautious as bull markets bloomed in everything. By the time the correction finally hit a year or so ago, prudent investors should have held above-average levels of cash. For those who’ve followed that advice, they’re halfway home. But now comes the real work, i.e., redeploying the cash.
Given the current climate, talking about buying is about as popular as sticking needles in your eye. We’ve been counseling nibbling in the recent past, and with the benefit of hindsight that looks like bad advice. If only we knew what was coming in more detail, and when, we’d have advised 100% cash. Alas, we don’t have any greater insight into the future today than we did last year, or yesterday for that matter. We’ve been sufficiently suspicious, however, to recommend no more than modest forays into seemingly bargain priced asset classes. A year later, we now know that was premature.
So it goes in trying to maximize return and minimize risk over a business cycle, or two or three. No one rings a bell at the bottom or the top. The next best thing is to manage a multi-asset class portfolio dynamically, favoring those corners where value and prospective returns are highest while shunning those at the opposite extreme. And, as per Tobin, one needs to think how much cash to hold in relation to the risk portfolio. Some call it asset allocation for short.
Rebalancing along the way is essential and in order to be effective it must be ongoing. In the short term it’s almost doomed to look ugly at times, but hopefully less ugly than picking one or two asset classes. The payoff will only come over the long run, perhaps as early as 5 years or so although 10-years-plus is probably a more realistic time horizon.
In the short run, there’s always a more alluring alternative. If we knew which one would stand up to the test of time, that’d be the way to go. But we don’t, and so the next-best strategy is the only game in town.
For the moment, cash is king; in early 2007, cash was trash. Round and round we go.
But we digress. For those with a larger weighting in cash than is strategically prudent, you’re only halfway home. Sitting in cash, or going overboard by shunning risk will eventually take a heavy toll, especially after subtracting future inflation, which we expect will be hefty as we look backwards sometime in 2018 or so. No one’s all that worried about the mounting liabilities on the government’s books today, nor should they be. It’s all about injecting liquidity. But those chickens will one day come home to roost.
That leaves us with the decision of when and where to nibble. No doubt we’ll have to continue nibbling far into the future, assuming we’re not willing to redeploy everything on a given day.
Risk management is still essential, but it’s also frightening. But this too shall past. The only question: are you of a mind to take advantage of the future? If so, how? The answer, it seems to this editor, is the same as always: slowly, methodically and carefully. In short, the strategy’s the same, and so are the expectations. It’s only the prices that have changed. In the long run, that’s the good news, even if it seems otherwise in the here and now.