Newsletter Article 2nd Quarter 2009
As the head of Redwood’s Investment Policy Committee, I am often asked about our investment strategy during these volatile times. The same questions regarding our methods keep coming up so I want to address some of them in this newsletter.
Should I cash out and wait for the market to turn around?
This is the most common question we get from clients and might appear to be a very smart, simple strategy. All you do is sell all the positions in your portfolio, keep it in cash, and reinvest when the market turns around. Simple, right?
Let’s go back to November 20, 2008 when the Dow closed at 7552 – a time when many people employing the “simple” strategy were selling all their holdings and going to cash.
By January 2, 2009 the Dow was up 20% to 9034. Those employing the aforementioned strategy would buy in here because this is a recovery, correct? Maybe time to get back in?
However, from January 2 to February 31, the Dow was down about 18%.
Thus, you would have lost another 18% by unsuccessfully trying to “time the market”, (i.e. getting out when the market is going down, waiting for a recovery, and buying back in when the market is up).
The simple strategy sounds easy but it’s virtually impossible to time the market correctly. When the recovery does happen most of the return occurs over a 2- 3 month time frame. By the time you realize a recovery has occurred, it is too late. You have missed the positive returns generated by the recovery because you were holding cash.
The conclusion is the “cash out and wait” strategy almost never works even though you repeatedly see individuals going to cash during volatile markets and professionals touting it in the press.
The new regime in the White House is turning us into a socialististic society
The implication here is that if the new regime pushes us toward socialism or a more European–like system, our GDP will drop and U.S. stock returns will be lower.
I do not wish to make any sort of political comment. My only interest is evaluating the political landscape as it relates to potential returns for our client portfolios. Based on the evidence, the belief that socialist regimes impede their country’s stock market return appears faulty.
So what are good examples of socialist countries? Maybe France? Germany? Sweden?
Well, our friends at Dimensional Fund Advisors (DFA) ran an interesting analysis about the returns generated by these countries over the last 39 years.
All these countries have significantly outperformed the US in the past 10 years and even in the past 39 years.
|*In US dollars|
Again, I have no political point to make. I just want to set aside the notion that our stock market returns will necessarily be substandard if the current political regime implements their policies.
Should I increase my bond allocation?
It seems natural to want to increase your holdings in more stable assets and decrease your holdings in assets that have declined in value during times when the economy is volatile.
Using this logic it would make sense for a person who started out with an allocation of 60% stocks and 40% bonds to increase their bond percentage to 50% bonds and 50% stocks after suffering a significant drop in the value of their stock holdings.
However, history shows us we profit by doing the opposite– maintaining our original allocation of 60% stocks and 40% bonds by periodically rebalancing the account
For example, if you have a 60% stock /40% bond allocation and stocks drop 20% in value while bonds hold their value, the allocation actually changes to 48% stocks and 52% bonds without doing anything in the portfolio.
When we rebalance, we sell bonds (the “High” assets that have maintained their value) and buy stocks (the “Low” assets that have dropped in value). Rebalancing forces us into a discipline of selling high and buying low. Wavering from your assigned allocation by buying more of the “High” and selling the “Low” assets may feel good in the short term but takes you off this discipline.
This strategy can significantly increase the return of your portfolio especially in times like this where the stock market has dropped almost 50% and bonds have increased 5%.
This time it’s different?
In the 1990s, investors piled into technology stocks with the expectation that skyrocketing demand for computer hardware and software would change the paradigm of the “New Economy”. In mid-2000s, it was all about China, India, and Brazil and how they were going to provide new opportunities for American companies. Commodity speculators drove the price of oil to $140 along with other precious metals on the expectation that demand from these countries would escalate.
Today is no different, instead of over-buying, people are over-selling with an expectation of a stock market panic and Great Depression II. This crisis has its own characteristics but we have seen banking crises before in US history. They all have unique circumstances but share a common ultimate outcome–the United States economy bounces back.
I have never seen the economy or stock market this bad
I hear this often, especially among our older clients. While I don’t want to downplay the pain of this economic cycle, let me remind you that the 1970s were a dismal period in U.S. history. We did not have the banking issues we see today but unemployment skyrocketed, GDP dropped, and the stock market dipped over 40%. Most clients living today do not remember or were not as concerned with the stock market at that time but there were significant, national problems. Eventually the economy and the stock market rebounded robustly.
I have gone on record before stating I do not believe this current situation will lead to anything close to what happened in the Great Depression when the stock market was down over 80%. I expect more of a 1970’s scenario, whereby it takes 2-3 years for things to turn around. GDP dropped 30% back then (our most recent report showed a drop of 6%) and unemployment reached 25% of the nation (currently at around 8%).
Should we increase our allocation to defensive industries like consumer goods or health care?
Taking bets on sectors typically does not payoff. Even though these sectors have done well recently, once the market turns around, you will see a different story. As we have stated before, taking bets on sectors or stocks almost never pays off.
Should we buy beaten down individual stocks like General Electric or Bank of America?
Taking bets on individual stocks is effectively gambling. Even though these stocks are probably cheap and have the potential for substantial appreciation we still need to stick to our plan. We still believe individual stocks offer no more upside than the market as a whole and much more down side, as the holders of AIG, Lehman Brothers, and Countrywide stocks have experienced.
Keep in mind, even after the run in March, the S&P 500 is still down 45% from its peak. Also, we are effectively buying these undervalued stocks via the value equity funds (targeted value, large cap value, international value) you see in your portfolio. By the nature of their mandates, these funds invest in undervalued securities. However, instead of a handful of stocks they own thousands. In this way we participate in the upside and minimize our downside.
What changes are we making to our portfolio?
In general, we are sticking with our original strategies depending on the risk tolerance of our clients. However, we have taken advantage of some glaring opportunities like high yield bonds, investment grade corporate bonds, treasury inflation protected securities, and international stocks. However, keep in mind we are buying these assets through very diversified funds not individual holdings. Thus, you will see these asset classes in your portfolio but are not exposed to the kinds of risk involved in holding a single stock or bond.
Should we invest in gold?
Gold tends to be a popular investment during distressed economic times and inflationary periods. Unfortunately, gold is purely a speculative bet and has never proven to be a good long term investment. Of all the assets out there, gold has probably the longest period of price data available to analysts and the conclusion is always the same. In inflation adjusted terms, the long term return is zero. As Gary Brinson points out, an ounce of gold bought a fine men’s suit in the time of Shakespeare and so it does today