When It Comes To Defining Safe Assets, Timing Is Everything

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.

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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.

This CTA Is The Best-Performing Hedge Fund This Year

InvestAs equity long/short hedge funds have struggled this year, managed futures funds have been able to capitalize on market volatility and generate some of the best returns in the hedge fund industry. The managed futures sector refers to funds known as commodity trading advisors, or CTAs, which generally use a proprietary trading system to trade Read More

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

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.
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