The best investors are like socialites. They always know where the next party is going to be held. They arrive early and make sure that they depart well before the end, leaving the mob to swill the last tasteless dregs.
The Economist, 1986
2009…What A Ride
This was one of those years that reminded us what a roller coaster the stock market can be, and also of the dangers of conventional thinking.
After the collapse in global financial markets in the fall of 2008 and the resulting battering taken by stock markets around the world, the consensus in January ’09 was that the worst was behind us. That was a reminder of the danger of conventional thinking. By early March, ’09, the market represented by the DJIA and the S & P 500 was down by 25%.
At that point, the consensus shifted and there was growing sentiment that we might be entering a long period of economic stagnation; that’s when we heard respected economic forecasters talk about a one-in-five chance of another depression. It was precisely at this point that the coordinated stimulus spending by governments around the world finally had an impact, and we began seeing signs of an economic recovery.
2009 reminded us that it is impossible to predict short-term market movements. The noted British historian Paul Johnson has written that at every given point in time you can always point to good news and bad news – the only difference is the balance between the two and what gets the media’s attention.
We at L & S try to follow The Economist’s thought process. You may recall that we avoided the financial stocks and REITs in late 2007 and all of 2008. We held very large amounts of cash at the end of 2008 and in the first quarter of 2009 and re-entered the market late in March and early in April as we started to see equities begin to appreciate from very depressed levels.
Risk Management Transcends Everything
Despite the recovery in the global economy and markets since the first quarter of 2009 the general sentiment and confidence level among many people today is quite negative. There are certainly lots of things to worry about in the U.S. – stubbornly high unemployment, a housing market that is still depressed (although no longer in decline), and huge government deficits.
This past year we have heard some interesting things about portfolio strategies driven by the ongoing financial crises. Some clients new to our strategy have told us that their previous advisor had them well diversified, but their portfolio still lost a significant percentage of its value. Unfortunately, during a systemic breakdown like the global financial crisis we have recently experienced, diversification may not be enough to insulate investors from heavy losses and in our view, may even contribute to increasing them.
We believe that when there is a systemic problem affecting the entire market—the recent global financial crisis is a perfect example—diversification can be worthless. It’s like bringing a
knife to a gun fight.
“The New Normal” is a future world of slower growth and lower returns, but in a recent interview Mohamed El-Erian, co-CEO of PIMCO, said, “There are three things that every investor needs to get right, the first thing is a forward-looking asset allocation—not a backward-looking asset allocation, but an asset allocation that makes sense in ‘The New Normal.’ Secondly, finding the vehicles that are stable enough to express that allocation. And, thirdly, risk-management.”
El-Erian further went on to say that it is not enough to be diversified. While he believes diversification is absolutely necessary, it is not sufficient as a stand alone strategy. He believes investors must look at other elements of risk management in order to navigate in times of lower returns and potentially higher volatility. We at L & S Advisors believe that “risk management transcends everything”, and, therefore, we start our analysis by making judgments about the risk the market presents at any given moment.
Are We Out Of The Woods?
One of the most important jobs we do that you never see, is read. As you know, our lives are awash in a constant flood of information, and even we professionals sometimes struggle to make sense out of it. To make matters worse, the headlines often don’t help us figure out what’s going on.
For instance, is there still a threat of deflation, which was in the headlines at this time last year? Since May, the CPI has been +.1% (May), +.7% (June), flat (July), +.4% (August) +.2% (September), +.3% (October) and +.4% (November, the most recent statistic we have). For the most recent 12 months, consumer prices have risen 1.8%. This is in contrast to the 1.4% drop in consumer prices reported by the Bureau of Labor Statistics over the second half of 2008 when a lot of economists were talking nervously about a deflationary spiral. We have not read any headlines to declare this, but the deflation threat appears to be over; the question now is whether inflation will remain as mild as it has been, or, as the economy recovers, will it take off?
Since you always hope to get more return on your investments than the inflation rate, are there any investments that look especially weak if indeed the threat of deflation is over? In an effort to avoid any losses, a lot of investors and institutions have parked their money in short-term investments. By one estimate, there is currently about 90% as much money ($11.7 trillion) in money market accounts and short-term Treasuries, than in the Wilshire 5000 stocks ($13.1 trillion).
But is this really avoiding losses? 3-month Treasuries are paying about 0.3%, 6-month issues now pay .16% and 12-month T-bonds are yielding .37% which is well below the inflation rate. Every rise in the CPI means the value of their money is going down which is something else we aren’t reading about in the headlines. Money market fund yields are at record lows.
Meanwhile, we’ve all been reading screaming headlines about debt problems in Dubai, one of the oil-rich Emirates in the Persian Gulf, but Dubai makes up just 0.1% of the global economy. What hasn’t been widely reported is that very quietly the sovereign wealth funds in Qatar and Kuwait have been selling their stakes in U.S. companies and raising capital. More recently, Saudi Arabia, Kuwait, Bahrain and Qatar are now creating their own petro-currency, which will be called the “Gulfo,” and are in the process of creating a regional central bank along the lines of Europe’s monetary union.
Will the Gulf States Union (or whatever it is called) need to pump more oil in order to balance its fiscal ledgers and support their new currency? Does that mean oil prices will drop further, at least temporarily, as all these issues get sorted out?
There is another subject that is getting a lot of headlines lately: unemployment. Recently, we’ve heard some rare good news, that fewer jobs are being lost now than a year or six months ago. What we have not seen reported is that every month that jobs are lost puts America deeper into a hole that it will need to climb out of eventually.
How big is this hole? Has anybody tried to calculate it? Economist Paul Krugman recently suggested that with eight million jobs lost since the start of the recession plus 100,000 new Americans moving into the work force every month, the economy would need to create an average of 300,000 new jobs a month in order to get to something close to full employment five years down the road. So, using Mr. Krugman’s data, if you see any number lower than 300,000 new jobs created, you’ll know that this particular hole is getting deeper.
This makes it easier to interpret some of the forecasts that you may be reading, such as the recent study by the Bureau of Labor Statistics, which estimates that the economy will create 15.3 million new jobs in the next ten years. Do the math and that comes out to about 125,000 a month.
None of this helps us predict the future, of course. It does show that much of the information that we receive, and the way the information is presented, can be disinforming (at worst) or (more often) take our attention off what’s really going on in the world. There’s a lot more to know than what the headlines are telling us.
With all of these cross currents, we continue to focus on making choices that seek to enhance our investment return while concentrating on making wise investment decisions.
The Secret Sauce
Today, as never before, the world's capital markets are interrelated and interdependent. Political and social events play as significant a role in financial markets as economic factors. As a result, we believe that success in something as difficult as the stock market rarely comes by chance. It is almost always the result of hard work combined with experience and adherence to a sound investment strategy. Our investment approach seeks to identify the most attractive sectors for investments and serves as a risk management tool. We believe that successful risk management investing depends on what type of investments you hold, investment techniques, and the duration of the investment.
It is our job to digest a multitude of facts and opinions and to take action based on the judgments we make. L&S Advisors believes superior risk adjusted returns are achieved by protecting against the downside. Our emphasis on risk management when analyzing a potential investment is a key component of our strategy. We believe evaluating the tradeoffs between potential risk and return when analyzing investment opportunities has helped contribute to our superior investment performance vs. the market averages across several different market cycles.
Our philosophy is that attractive returns can be achieved by structuring portfolios that are distinct from the market indices. We believe that when active management strategies are too constrained by benchmarks they will not produce significant alpha or satisfactory risk adjusted returns over the long-term.
We recognize the importance of diversification but do not stay diversified across all asset classes at all times. Our portfolios have no constraints with regard to capitalization, foreign/domestic designation, or growth/value label beyond those specifically requested by individual clients. If economic conditions suggest to us a move to all cash, we have no systemic limitations preventing us from doing so. If we believe we need to remove a sector completely from your portfolio, we immediately act on that decision. If economic conditions suggest to us that the market will trade sideways, we may write covered calls to seek additional income where appropriate for approved clients. Further, we have the ability to act quickly, because our investment process does not rely on large bureaucratic committees. We believe actively managed portfolios can quickly take advantage of current investment opportunities.
Advisors Are Not All Created Equal
In any discussion about the financial crisis and its effect on investors, you can be sure that someone will lament, “Everyone got killed. There was no place to hide.” What they really should be saying is, “My investment process was inadequate. I had no place to hide because I was not prepared for this kind of systemic risk.”
There were places to hide during the crisis. Cash performed well and so did bonds. Gold and other precious metals, while not completely immune, performed well during the fourth quarter of 2008 and first quarter of 2009 as stocks fell another 30%.
Students of market history understand the potential for systemic failure. They know that financial crises happen. Markets have crashed before and they will crash again (no matter what politicians say). Such is the nature of cycles.
We believe that successful investors understand cycles and plan for unknown and unexpected events while average investors suffer from average thinking and crowd behavior. Average investors were not prepared for the recent financial crisis, and they will likely be ill prepared for the next one. It makes sense that they think there was no place to hide. Successful investors, on the other hand, may not have foreseen the crisis, but they were prepared for it. Their investment process included cash, alternatives, and crisis-avoidance techniques. Their planning was grounded in economic and market history.
We believe that it is wise to continue to favor MLPs. Although the sector has had a considerable run-up, we believe long term MLPs are still attractive if only as a yield investment. As investors’ appetite for yield and risk tolerance evolves, MLPs should continue to benefit. We have developed an information booklet on MLPs which we will be happy to send you on request.
Best wishes for a Healthy, Happy and Prosperous 2010.
Past performance is no guarantee of future results. The information contained herein is based on internal research derived from various sources and does not purport to be statements of all material facts relating to the securities mentioned. The information contained herein, while not guaranteed as to accuracy or completeness, has been obtained from sources we believe to be reliable. Opinions expressed herein are subject to change without notice.
The performance of DJIA and S & P 500 is shown as a general market indicator only and should not be considered an appropriate benchmark for individual account performance; the management style for client accounts may utilize positions and strategies, such as covered calls, that are not reflected in the index. Indexes are calculated on a total return basis with dividends reinvested and are not available for direct investment.
