The Rules, Grand Finale: Every Rule Has Exceptions

By David Merkel, CFA of alephblog

Rule: every rule has exceptions, including this one

In the long-run, and with hindsight, most actions of the market make sense.  Sadly, we live in the short run, and our lives may only see one to 1.5 full macro-cycles of the market in our lives.  We live in a haze, and wonder what useful economic and financial rules are persistently valid?

We live in a tension between imitation and thought, between momentum and valuation, between crowds and lonely reasoning, between short-term thinking and long-term thinking.

It would be nice to be like Buffett, who has no constraint on his time horizon, managing to the infinite horizon, because he has so much that setbacks would mean little to him.  But most of us have retirements to fund, college expenses, a mortgage, and many other things that make us far more subject to risk.

Does valuation matter?  You bet it does.  When will it matter next?  Uh, we can’t answer that.  When we come up with a good measure of that, people begin using it, and the system changes.

My personal asset allocation for most of my life has been 75% risk assets/25% cash.  Especially now, when bond yields are so low, I don’t see a lot of reason to extend the maturities of my bond portfolio, aside from a small position in ultra-long Treasuries, which is a hedge against deflation.

Investment reasoning is a struggle between the short-term and the long-term.  The short-term gets the news day-by-day.  The long term silently gains value.

If you invest long enough, you will have more than your share of situations where you say, “I don’t get this.”  It can happen on the bull or bear sides of the market, and you may eventually be proved right, but how did you do while you were waiting?

Thus, uncertainty.

Is there a permanent return premium to investing in equities?  I think so, but it is smaller than most imagine, particularly if compared against BBB/Baa bonds.

I’m not saying there are no rules.  Far from it, why did I write this series?!  What I am saying is that we have to have a firm understanding of the time horizon over which the “rules” will work, and an understanding of market valuations, sensing when valuations are high amid a surging market, and when valuations are low amid a plunging market.  There are times to resist the trends, and times to embrace the trends.

The rules that I embrace and write about are useful.  They reduce risk and enhance return.  I once said to Jim Cramer before I started writing at RealMoney that the rules work 65% of the time, they don’t work 30% of the time, and 5% of the time, the opposite of the rules works.  This is important to grasp, because any set of tools used to analyze the market will be limited — there is no perfect set of rules that can anticipate everything.  You should expect disappointment, and even embarrassment with some degree of frequency.  That’s the way of the market even for the best of us.

Hey, Buffett bought investment banks, textiles, shoes and airlines at the wrong times.  But we remember the baseball players who had seasons that were better than .400, and Buffett is an example of that.  In general, he made errors, but he rarely compounded them.  His successes he compounded, and then some.

The rule I stated above is meant to be a paradox.  In general, I am a long-term oriented, valuation-driven investor who seeks to maximize total return over the long haul, with significant efforts to avoid risk.  Do I always succeed?  No.  Do I make significant mistakes?  Yes.  Have my winners more than paid for my losers over the 20+ years I have been an active investor? Yes, yes, and then some.

But this isn’t about me.  Every investor will have days where they will have their head in their hands, like I did managing the huge corporate bond portfolio in September 2002, where I said to the high yield manager one evening as we were leaving work, “This can’t keep going on like like this, right?  We’re close to this burning out, no?

He was a great aid to my learning, an optimist who embraced risk when it paid to do so.  At the time, he agreed with me, but told me that you can never tell how bad it could get.

As it was, that was near the bottom, and the pains that we felt were those of the market shaking out the crud to reveal what had long lasting value.  Or at least, value for a time, because the modus operandi of the Fed became inflating a financial/housing bubble.  That would not work in the long run, but it would work for a time.  After that, I worked at a place that assumed that it would fail very soon, and was shocked at how far the financial excesses would eventually run.  I was the one reluctant semi-bull in a bear shop that would eventually be right, but we had to survive through 4+ years of increasing leverage, waiting for the moment when the leverage had gone too far, and then some.

Being a moderate risk-taker who respects risk is a good way to approach the markets.  I have learned from such men, and that is what I aim for in my investing.  That means I lag when things are crazy, and that is fine with me.  I don’t play for the last nickel — that nickel may cost many bucks.  Respect the markets, and realize that they aren’t here to serve you; they exist to allocate capital to the wise over the long run.  In the process, some will try to profit via imitation — it’s a simple strategy, and time honored, but when too many people imitate, rather than think, bad things happen.

The End, for Now

This post is the end of a long series, and I thank those who have read me through the series.  I think there is a lot of wisdom here, but markets play havoc  with wisdom in the short run, even if it wins in the long run.  If I find something particularly profound, I will add to this series, but aside from one or two posts, all of the “rules” were generated prior to 2003.  Thus, this is the end of the series.

 



About the Author

David Merkel
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.