Your editor has been absent from these digital pages for just 11 days, but a lot can happen in 11 days.
Consider the table below, which summarizes the performance of the major asset classes of late. In particular, note the prevalence of red under the 4-weeks column. Risk has been showing its other face to investors, many of whom formerly thought that there was but one outcome to embracing the four-letter word.
The fact that markets have retreated in earnest should come as no surprise. After a multi-year run of dispensing mostly gains, the major asset classes have reintroduced the notion of humility to the masses. As readers of this site will recall, we’ve been expecting no less for some time. Granted, even a broken clock is right twice a day, and so we’re vulnerable to criticism that our warnings were early. True, although we’ve advised all along that our preferred strategy has been one of raising cash methodically as markets continued moving higher.
As a result, our own personal allocation to cash is well above levels we’re comfortable with as a long-term proposition. The idea of continuing to elevate the cash weighting was always with an eye toward redeploying it when prospects looked more attractive elsewhere. Now that red ink has arrived, is it time to redeploy? Yes, sort of. But in addition to diversifying across asset classes, we’re of a mind to diversify across time as well, for both buying and selling. The reason: we can’t see the future. Yes, we can make some educated guesses, in part driven by quantitative clues handed down by the markets. Those clues, however, aren’t foolproof.
Meantime, let’s be clear: the correction so far, painful as it seems, hardly amounts to an earth-shattering buy signal across the board. Blood is starting to trickle, but it’s still not running in the streets.
Take a look at REITs, which are the hardest hit among the major asset classes. Surely, this is where value bursts loud and clear. Yes and no. Having shed nearly 12% so far this year, REITs are clearly battered but the selling still looks modest in context with history. Indeed, REITs have only returned to price levels of mid-2006. Meanwhile, the current trailing yield on VNQ (our proxy for REITs) is a modest 3.84%, according to Morningstar. That’s nearly 100 basis points below the yield on the benchmark 10-year Treasury. For our money, we’d prefer to see REITs yielding a premium over the 10 year before we go rolling back into the asset class with any searing conviction. Although it’s still somewhat out of favor, ours is a philosophy of requiring compensation for assuming risk. Crazy, perhaps, but that’s our story and we’re sticking to it.
Yes, the prospective capital gains for REITs may ultimately combine with the yield to outperform the 10 year. But at this stage, when the markets are anxious and just beginning to become reacquainted with the fuller persona that is risk, we’re inclined to wait a bit more. At the same time, with cash at the ready, we’d start nibbling at REITs if a further dip of some magnitude arrives in the coming weeks and months.
All of which reminds that our strategy of slowly but consistently raising cash as markets climbed will be mirrored with a strategy of slowly but consistently redeploying cash as markets fall. This carries no appeal to short-term traders, but for our strategic-minded focus, it suits us just fine. The degree and focus of the future redeployments will depend on where the red ink burns the brightest.
For now, though, we’re still content to watch and wait, nibbling here and there but making no major buys. Indeed, some markets have barely corrected at all, the recent selloff notwithstanding. The S&P 500, for instance, despite its sharp decline in recent weeks, has retreated only to levels considered healthy back in April. We don’t recall many bulls worrying that 1400 or so on the S&P was the end of the world in the spring. Meanwhile, the ~1460 level on the index currently elicits fear that equities are weak. Same price, different emotions.
Perhaps the only refreshing exercise in times like these is to remind oneself of the iron law of investing: lower prices equate to higher expected returns while higher prices imply lower expected returns. That principle can either work for or against investors, and the outcome resides completely within. We’re of a mind to make it work for us, which requires a commitment to the ancient wisdom of buying low and selling high. Everything else is noise.