When It Comes To Defining Safe Assets, Timing Is Everything

When I was young, my paternal grandfather retired, and made my Dad and my Uncle, who worked for him,  buy him out of his firm.  They did so, and laid out a lot of cash to do it, which my grandfather invested in certificates of deposit at various banks.  In the ’70s, he looked like a genius, while my mother, who was beating the market with her half Growth At a Reasonable Price, half utilities strategy, still lagged behind CD returns.

When It Comes To Defining Safe Assets, Timing Is Everything

But when the ’80s came, there was no contest.  CD yields fell, fell, and fell.  Stocks gave high returns, and the returns more than outpaced CDs over the two decades combined.

So what are safe assets?  Part of it depends on time horizons.  If you have a short time horizon for when you will need to use the money, then you have to only look at money market funds, and high-quality short-term debt.

If the time horizon is long, it becomes a question of margin of safety.  What is the worst outcome reasonably possible?  Assets that are risky are at their safest point at the bottom of a bear market, and their riskiest point at the top of a bull market.  The difference is margin of safety.  But it doesn’t feel that way.

For those with a long time horizon, the safest assets are those that are misunderstood and hated, with low prices relative to intrinsic value.  The downside is clipped, and the upside could be considerable, with decent probability.

That is one reason why I think that for those with long time horizons risk and return are negatively correlated.  Take less risk, get more return, within reason.  There are times when the market is irrationally bearish.  That is the best time to invest, but wait until things stop getting worse before investing.

Moderate risk-taking tends to win in the long run. If markets mean-revert, a 50-50 mix of stocks and bonds will beat a 100% stock portfolio.

Beyond that, in an environment like this, where there is more capital than there are good places to deploy it, we should see a lot of IPOs to absorb excess capital into mostly unprofitable ideas.  Much as I like Twitter as a service, I don’t see how it grows into its current valuation.  This feels a little like 1998-2000, but only a little.  We need more of a frenzy of IPOs offering dubious value to suck up the capital of those who are foolish.

What does make this situation more like 1998-2000 is the Q-ratio, which is at its highest point since 1998-2000.  This is the second-highest peak for the Q-ratio, which measures the value of stocks versus their replacement cost.  This means that equity returns are likely to be negative/low for the next 5-10 years.

So at a time like this, where can your assets be safe?  Bond interest rates are low, and don’t reflect the risks. Stocks have high valuations, and I invest in the few stocks with low valuations.  The alternative is to earn nothing in cash.  At present, that is the safest option, and may return the best over the next year.

I know, no one can do market timing well, but at present, the odds are tilted against risk.  I’m thinking of buying a hedge against my taxable brokerage account.

Safe assets are those that avoid loss, and behold, safe assets often offer better returns as well, if purchased during a time of fear.

By David Merkel, CFA of alephblog