Monday, September 8, 2014

Expecting Trouble? Here Are Investments to Ponder

Another interesting article in the Wall Street Journal today arguing for "safe haven" investments because of global conflicts and the Fed exiting QE.

Of course we are in a bubble, and of course there is some risk with what is going on with the Fed and Ukraine.  But, that doesn't change the fact that nobody can predict the market.  This bubble will eventually burst, but it could be tomorrow or it could be five years from now.  Trying to time it and go into "safe haven" investments now could turn out to be a great decision or a horrible mistake.

A better approach of course is to be tactical and stay in harmony with market trends.  Then it doesn't matter when the bubble bursts, you can shift to "safe haven" investments before bad turns into really bad.

Of course, there is also no such thing as a "safe haven" investment but that is a post for another day.

Mutual Funds Five Star Curse

There was an article in the Wall Street Journal this morning on how most funds that achieve a five star Morningstar rating don't eventually lose it:

This makes perfect sense for a number of reasons:

1. Morningstar ratings reflect past performance
2. Most mutual funds are style box investors, meaning they stick to a specific style like large cap value, small cap growth, etc.
3. When their style is in favor they will typically do well
4. When their style is out of favor it is hard for them to do well
5. Styles don't stay in favor forever

So you would actually expect a five star mutual fund today probably won't be a five star fund tomorrow.

Instead of using past performance, like a star rating, to judge whether you should buy a fund or not, you should be trying to figure out if the performance is sustainable.  How did the manager get a five star rating?  Is that something that can be continued?  For example, if large cap value stocks have just had a historic 10 year run and a large cap value manager has a five star rating, how likely is is that the next 10 years would be as good as the past 10 years?  Probably not that likely.

Friday, September 5, 2014

A Rising Tide Doesn't Lift All Boats

Goldman Sachs: Why Stock Pickers Have Suffered a Really Bad Year

Just saw this article this morning on how only 23% of large cap managers have outperformed the S&P 500 this year and how the average hedge fund is up only 2%.  There are a couple of things that investors should read into this:

1. This year is different than last year.  Last year was pretty much straight up, at least in the US, so anyone US focused had a good year.  This year is different as there has been so much going on beneath the surface---small and mid cap under performance, momentum stocks getting killed, etc.

2. Because we are seeing so many divergences this year and so much going on beneath the surface, buy and hold investors should be real nervous as this could be a signal a top is near.  Tactical investors have no reason to fear tops.

3. Comparing a money manager to the S&P 500 is only valid if that money manager invests like the S&P 500.  There are a bunch of money managers who are closet indexers who pretty much try to track the S&P 500, for those guys comparing them to the S&P is valid.  Hedge Funds and other flexible managers can't be compared to the S&P because they have the ability to pursue absolute returns (unlike the closet indexers who ride the market up and down).  These guys will usually under perform at time of high risk and at speculative tops because they will take some money off the table.  This is ok because they will tend to make it back, and then some,  when the market crashes.

Thursday, September 4, 2014

Is Morgan Stanley Advocating Tactical?

Morgan Stanley Braces for Seven Years of Bond Losses

According to this article in Bloomberg yesterday:

Morgan Stanley (MS) Wealth Management’s Jonathan Mackay predicts the securities will post annual returns of between 1 percent and 2 percent for the next seven years -- which means you’ll lose money after accounting for inflation. That’s a big shift considering the debt gained 8.7 percent annually on average in the 30 years through 2012.

 Investors should “have a lower average allocation to bonds than you would have in the previous cycle because they just don’t provide the income and return,” said Mackay, senior market strategist at Morgan Stanley’s $2 trillion wealth management unit. While central-bank stimulus is supporting bond values, “the collateral damage is going to be lower portfolio returns.”
For a moment it almost seemed like Morgan Stanley was advising clients to take a tactical approach to their portfolio instead of the stick your head in the sand and have an allocation to bonds based on how conservative you are because bonds always make money (even though it is mathematically impossible for bonds to have the kind of run they have had over the past 30 years).  But then he ruined it by saying:

 The way to get around this is to buy higher-yielding assets, he said. While higher-rated bonds have been outperforming their riskier counterparts in 2014, that may be poised to reverse.
So still somewhat of a tactical approach since he is advocating moving out of lower yielding bonds into higher yielding but instead of reacting to the market (like buying low yielding Treasuries now because they are in an uptrend) he is advocating blind faith that higher yielding bonds will do better than lower yielding.  Maybe, maybe not.

Tuesday, August 5, 2014

You Can't Have it All So What is Most Important?

There are basically three types of years in the market:

1. Years that basically go straight up---2013 is a good example
2. Years that basically go straight down--2008 is a good example
3. Years that could be up or down but are really choppy--so far 2014 is a good example

No investment strategy can do well in all types of markets, every strategy has its kryptonite.

A buy and hold or asset allocation strategy that has a meaningful allocation to stocks should do well in an up market, awful in a down market, and probably ok in a choppy market.  That means that you can make some good upside in an upmarket but will give it all back, and then some perhaps, in a down market.  That doesn't sound like a great trade off to me.

A tactical strategy should do well in an up market and a down market and will struggle in a choppy market.  That means that a tactical strategy can make money in an up market, make money, or at least not lose money, in a down market, and make a little or lose a little in a choppy market.  This seems like a much better trade off to me.  You have the potential to avoid the large losses and just have to experience some frustration in a choppy market that has no real lasting trend.

Of course what you do year by year doesn't matter that much in the overall picture, the most important thing is how you do over time.  If you can avoid the large losses in the down market then you should be much better off over time than the people who ride the market up and ride the market down.

Friday, August 1, 2014

Support And Resistance

We talk a lot about support and resistance areas in the market but what we would do if the market breaks through these important areas.  Support and resistance levels are psychologically important areas in the market that act as a magnet as markets get  close to them and are typically difficult for markets to break through.  As a market goes up or down it usually hits an area where it stalls before breaking through and continuing the trend.  These areas become support on the downside and resistance on the upside.  For example, as I write this the S&P 500 had a major decline yesterday and closed at 1930.  If you look at a chart of the S&P you can clearly see a number of times the market tried to break through 1919 and failed.  Therefore, 1919 becomes the next big support level which you would expect the market to test because it is so close and you would expect some problems breaking through it.  Support and resistance can also tell you other things about the market.  Murray Ruggiero, our chief systems analyst predicted in early 2008 that the Dow Jones Industrial Average would ultimately go to 7700 (he was off by a bit as it hit 6600 but still a great call).  This wasn't based on a crystal ball it was based on how markets work around support and resistance areas.  Typically when a market hits a low it tests and retests that level before rallying.  In 2002 the Dow hit 7700 and never looked back, meaning it was likely that at some point we would retest that level which we did.   So the main benefit of looking at support and resistance levels is to get a feel for what markets are likely to do and to help explain market movements.

Unless you are a day trader support and resistance levels don't help much.  We will use them when we are already trading to decide where to place our limit orders but we won't get out of a market just because it breaks through support or get in because it breaks through resistance.  Down moves in any bull market are normal and healthy but typically they just end up being noise and are retraced back to the upside.  Down moves that are just noise are great buying opportunities, panic sellers usually end up regretting it. True trend changes however are significant as they can result in double digit losses that are hard to come back from.    Our goal when the market goes down is to try to judge whether the move is just noise or a true change in trend.  We will never be 100% right, sometimes we will get out of a market and it will snap back up, but if we put the odds in our favor we can do everything possible to avoid the large long term loss.

The last true trend change I remember was August 2011, that was the month that the wheels almost came off the global economy.  Central banks where able to act and stem disaster but it was a period where it made sense to exit the market as the risk of being invested outweighed the rewards.  The last time we got out of the market was February of this year as the down move we had in January looked like a change of trend but at least in the short term it turned out to be noise and we got back in.

Sunday, July 27, 2014

Investors and Financial Professionals Think About Risk Differently

A colleague just forwarded me an article about how Investors and Financial Professionals both think about risk differently:

This is something we see every day and it manifests itself in  two main areas:

1. Financial professionals think of risk in terms of standard deviation while investors think of risk in terms of drawdown and loss.  

So when financial professionals look to reduce the risk of portfolios they look for non correlated asset classes to reduce portfolio volatility.  This creates a portfolio that appears to diversified but often does nothing to reduce drawdowns or losses as having asset classes like commodities and different stock sectors offers little, if any, protection during a crisis.

Investors always remember their high water mark.  No matter how much money they have made, if they are under their high water mark they will not be happy.    Portfolios should be designed that keep drawdowns to absolute minimums.

2. Financial professionals assume that risk tolerances are static but investor risk tolerances seem to change based on the current market.

So when financial professionals attempt to deduce a client's tolerance for risk, little if any emphasis is placed on the current environment.  In real life though, when you ask an investor how comfortable he is with loss in March of 2009 when the market has just gone down 60% you are very likely to get a different answer than if you asked that same client today.  

In reality, most investors want absolute returns in a down market and relative returns in an up market. Any approach to minimizing drawdowns needs to take this into account.  For example, you could potentially minimize drawdowns in a stock portfolio by adding bonds.  This can reduce drawdowns in a crisis but it usually also reduces the upside in a bull market.