By: Chuck Carnevale, F.A.S.T. Graphs, Inc.
Early in their careers investment professionals are taught the importance and benefit of properly diversifying their client’s portfolios. Modern Portfolio Theory (MPT), which was developed and promoted by academia, has taken diversification to the extreme. According to Modern Portfolio Theory, asset allocation is the primary determinant of future returns and in the reduction of overall portfolio risk. Asset allocation is in effect a term suggesting that portfolios need always be diversified across numerous asset classes. In order to accomplish the proper balance, Modern Portfolio Theorists rely on sophisticated mathematical formulas.
Unfortunately, for these formulas to work the modern portfolio theorists had to conjure up the theory of efficient markets based on the premise that investors are rational and markets are efficient. This notion once led Warren Buffett to quip: “if the markets were efficient, I would be a bum on the street with a tin cup.” In truth, there is growing evidence that investors are not always rational and markets (the stock market) are neither efficient nor always rational. We believe that now represents one of those times where several markets are not only behaving very irrationally, but also very inefficiently.
Consequently, although we generally believe in the soundness of the principle of diversification, we also believe that extraordinary times require extraordinary measures. Any historian of markets or economies would acknowledge and agree that many of our financial markets are currently far from behaving ordinarily. With this article we intend to point out several markets that are behaving both inefficiently and completely out-of-sync from sound and prudent economic principles. Therefore, we will argue that certain sacred cows that would and should apply during normal circumstances need to be questioned and challenged in these very uncertain times.
Speaking for myself personally, I have managed assets for individuals for more than 40 years. During the vast majority of this tenure, I have adhered to the principles of a diversified portfolio comprised of a mix of equity and debt (stocks and bonds). Although I have not personally utilized commodities or hard assets, I did not strenuously object to their inclusion into a client’s portfolio at an appropriate level. However, for the first time in more than four decades I have altered my traditional position. What follows next articulates the reasons why, and provides supporting evidence behind my current position. It’s up to the reader to evaluate the information and decide for themselves whether they agree or disagree.
The Problem with Bonds Today
One of the most important changes in my attitude regarding a client’s proper portfolio mix is my current eschewing of bonds and other debt instruments. If the client currently holds a properly constructed portfolio of bonds with laddered maturities, I would suggest holding maturities that make sense, and selling those that don’t. In order to make sense, the profit received minus taxes would have to allow the owner to harvest their gains and reinvest without sacrificing current yield. However, consideration needs to also be given to the reality that any current price appreciation on their bonds will disappear in the future as the bonds move closer to majority.
Next, let me present why I feel as strongly as I do. The following Bloomberg’s Chart of the Day published last November compares the 10-year treasury yield versus the S&P 500 dividend yield since the 1950s. This chart clearly provides evidence of why bonds have historically made sense for investors to own. In addition to safety, the big reason was a yield significantly greater than the one offered from equities. Consequently, investors needing income looked to bonds simply because equities did not offer enough income to meet their needs. Clearly, this graph now shows how that differential, or gap, has not only been closed, but is actually close to reversing.
This next Bloomberg chart published on August 12, 2011 looks at 10-year treasuries versus the S&P 500 since 2007. Note from the commentary that the closing of this yield gap is attributed to plunging share prices which could simultaneously imply low stock valuation generating the higher yield. But most importantly, note that the author, David Wilson, suggests that these days U.S. investors looking for income might be better off with stocks than bonds. Although we generally agree with Mr. Wilson’s opinion, we would recommend looking more specifically at individual stocks rather than the S&P 500 index. Later in this article we will elaborate more on this point.
The Problem with Gold Today
The use of gold as a medium of monetary exchange spans the entire history of mankind and is even prominently mentioned in the Bible. Consequently, there is no question that mankind has always valued gold. However, the real question is what is the proper intrinsic value of this coveted element? When attempting to answer this question, consideration needs to be given to the fact that gold, unlike a stock or bond, does not pay income. Therefore, gold’s future value and return potential must come from appreciation in its price. Of course, this implies the need to buy low in order to sell high.
The following graph, once again courtesy of Bloomberg, published on August 4, 2011 shows that gold is currently the most expensive it has ever been relative to global equities. If the reader focuses on the timeframe 2008 through 2010, the potential volatility of holding gold today can be vividly seen. This graph certainly makes a case for taking some profits off the table if not coming out of gold altogether. This is not to imply that gold cannot go higher than it already is, because there is no way to precisely quantify how irrational a market can be. But even the most fervent gold bug must acknowledge that this precious metal is not cheap today.
This next chart going back to 1975, courtesy of Kitco, illustrates that gold has historically been priced at around $200-$400 per ounce during strong economic times. However, after the recession of 2001 the price of gold has been on an undeniable and powerful advance. Also, notice the similar price action of gold from 1975 to 1980 where gold peaked at around $850 per ounce.
This next chart shows how precipitously gold can fall after it reaches aberrant and lofty levels. This is a risk that owners of gold should at least acknowledge and be aware of. From 1982 to year-end 1984, the price of gold fell from approximately $850 an ounce to $300 an ounce. That’s more than a 65% loss, and notwithstanding the occasional rally, gold more or less traded in a narrow range until the recession of 2001. Gold is clearly a great hedge during weak economic times, and a very poor investment that offers little growth and no income during strong economic times.