Is There Enough Left on the Upside? by A. Michael Lipper, CFA
One of the many necessary elements for a peak to occur is the belief that the current market rise will continue. This belief is nurtured by cheerleaders and there were two highly respected ones sharing their views with us this week. The first was in Mark Hulbert’s column, where Sam Eisenstadt, the former statistical genius of Value Line, stated that he believes in the next six months the stock market will rise 8% as the leadership will shift to higher-quality companies rather than the lower-quality ones that have been the leaders.
The second was an observation from US Global Investors’ Investor Alert which quoted a study by BCA Research which examined the 30 years since 1870 when the market was up 25% or more. They found that in 23 years following the big gain, the market had an average gain of 12%. A number of Wall Street types are now hoping to split the difference and are looking for a 10% gain.
Is 8%, 10%, or 12% good enough?
On the one hand (as the economist would say), these gains are 2–4 times the recovery high on the US Treasury 10-year note at just over the 3% yield achieved this Friday. On the other hand, someone trained on using the odds of meaningful success would start to get cautious. Just five years ago the percentage decline in the market offered a potential recovery to the prior peak of 2–3 times what is now being offered. This is not counting on going on to new highs. The question now is, are we about to enter Sir Isaac Newton’s “greater fool theory” trap? Remember he participated early in the run-up to the infamous South Sea Bubble. He got out early but got sucked back in when his friends were making more money faster than he did. When the bubble did break, he lost all of his gains and more. What we have learned from the recent studies at Caltech is that some people don’t retreat when they sense danger, but stay involved believing that their sense of timing will take them out of danger. As I mentioned in prior posts, I learned about this as a junior analyst and it was called the greater fool theory. To believe that future big gains are possible after large gains are achieved does not show the level of caution that many successful long-term investors use.
I used to question why we researched bonds when I was studying security snalysis at Columbia with Professor David Dodd. The name of the class was the same as the title of the book that he co-wrote with Ben Graham. What became clear to them, and what was reinforced in the recent mortgage market collapse beginning in 2005 and culminating in 2008, was that at times the fixed-income markets are much more sensitive to credit conditions, and therefore to the eventual health of the economy, than my fellow stock jockeys realize.
As mentioned above, on Friday the 10-year US Treasury bond’s yield rose to a psychologically important 3% from a low of 1.63%. This, in turn, caused bond prices to decline in absolute terms. I look at historic 10-year yields the following way:
- I view the normal yield for the 10 year to be about 4%.
- During abnormal times, rates would be in the 6–8% range, which should meet the relatively few defined benefit pension funds’ actuarial requirements.
- During economically stressed periods, one could see yields in the 9–12% range, if not higher.
The higher current yields would occur when there is greater demand for capital than what is immediately available, usually with both the private and public sectors needing money to meet their immediate and longer-term needs. We are currently far from these conditions now, but sound equity investors should be alert to credit conditions as both the private and public sectors are short of capital for long-term productive investments.
Is there too much asset allocation?
For far too long, investment pundits and those who direct the construction of long-term portfolios have found comfort in diversification into many different asset classes — domestic stocks, international stocks, emerging market stocks and bonds, and now stocks from frontier countries as well as similar fixed-income asset classes (going from the most to the least secure). To these lists add private equity, commodities of different types, real estate, timber, and elements from the art worlds, plus intellectual property. While not a separate asset class, hedge funds owning one or multiples of these classes are included in the array for diversified investing. Many of these types of investments have badly trailed the simple stock market and some for 2013 are likely to show negative results, such as commodities and volatility measures. I would suggest there are three lessons one should consider before deploying asset allocation.
The first is that in declining markets, and particularly in sharply declining markets, correlations will increase. Wherever there are pools of liquidity they will be drawn down. Assets that can be sold quickly will be sold. Second, when there are choices to be made, particularly in the early phases of a rally, selectivity will be important. Along with the skills of the selector, it is important to understand the relative sizes of compensation of the intermediaries. Isn’t it strange the highly compensated products and intermediaries get the first mover advantage? The third clue (the most difficult one for those of us who are trained in complexity) is to keep the strategy simple where most of the time is spent on selectivity. In his weekend column in The Wall Street Journal, Brent Arends quoted a study by Andrew Smithers, a well-known and highly respected British investment thinker, who in a study for the investment committee of a college at Cambridge University recommended that it should have only two asset classes, stocks and cash. Stocks could range from 60% to 100% based on the level of the market, utilizing some long-term ratios. In today’s world this simple but effective approach is making a lot of sense, at least until reset approaches coming off the next major bottom.
What is increasingly missing from our command structure?
As a US Marine Corps officer, I never really retire, I just change uniforms. Over the weekend I enjoyed an interview with Camille Paglia in which she is quoted as saying, “The entire elite class, now in finance, in politics and so on, none of them have military service, hardly anyone. These people don’t think in military ways. The politicians lack practical skills of analysis and construction.” She finds “no models of manhood except on Sports Radio.” (My friends at the National Football League and the NFL Players’ Association will be glad to hear that they are her models of manhood.) However, she is not alone seeing the benefits of military thinking, conditioning, focus, and street smarts for returning service men and women. Prudential Insurance and JP Morgan Chase are among the leaders in seeking out these returning heroes and heroines and presenting them with job opportunities. I am guessing some of these people will rise to the top of our leading organizations. On a global basis, the benefits of a well-spent military life could, and I