Wednesday, August 24, 2011

MPT Is Still Just A Theory

Most investors are basing their investment strategy on an oversimplified theory of investing that is better suited to writing dissertations than it is to managing an investment portfolio.

The tools most advisors use to build portfolios are based on Modern Portfolio Theory (MPT), which is the idea of creating a portfolio that balances risk and return using a computer-generated distribution of holdings designed to maximize return achieved per amount of risk taken. MPT works in theory, only because of the unrealistic assumptions made in constructing the theory.

MPT assumes that the future unfolds in a random fashion. In reality, future returns are much more likely to fall – from high valuation levels and when economic fundamentals weaken – and rise when the opposite is true. In statistical jargon, the distribution of returns are not in a normal bell-shaped curve. Returns are skewed by price levels and economic fundamentals. As a result of MPT, most investors keep the same (static) portfolio construction through good times and bad, rather than ramping up risk and return during the good times, and taking less risk when the outlook is less favorable. Taking the same amount of risk, in both good times and bad, reduces optimal return during good times and produces more painful losses in down markets. Ideally, portfolio Beta (the sensitivity to market risk) should be flexible, depending on where you are in the market and economic cycles.

MPT also assumes that probabilities don’t change and that investors don’t make mistakes. While not all investors admit their mistakes, or learn from them, all experienced investors have made them. MPT assumes that everyone has good data, can reasonably calculate the probability of future events, in a rational and error-free decision process. These assumptions pretty much rule out anyone and everyone who has experience investing in the market.

Finally, MPT is typically a backward-looking method. In theory, it should look forward. In practice, however, it uses historical returns as an input. So even in a world where long-term bonds pay only about 2.2 percent and are likely to decline in price in the future, your advisor’s computer will likely estimate a 5 percent return on bonds looking into the future. The entire investment industry, it seems, is dependent on a classic garbage-in/garbage-out process for constructing portfolios.

To do a better job, computers need accurate future return numbers as input, but crystal balls are in short supply. At the very least, “efficient frontier” simulations should be based on forward-looking estimates, but I know of no brokerage or advisory firms that are prepared to take on the liability of customizing those inputs.

May-Investments solution is to admit mistakes, adjust portfolio risk based on the current market environment and economic fundamentals, and to try to stay in the way of what’s working in the market – and get out of the way of what isn’t, allowing current market action and industry-specific economic fundamentals (rather than a computer simulation) to drive our portfolio construction process.

By proactively managing portfolio risk throughout the market cycle, we hope to be able to take the most risk only when risk-taking is being rewarded, and more effectively preserve wealth when markets turn down.

Plasma ray guns are great weapons, in theory. Hollywood used them in Star Wars, The Terminator, StarTrek and dozens of lesser known works of fiction. Like MPT, plasma guns are theoretically possible. In reality, however, plasma torches which have existed for some years can project plasma streams only about a foot. If an intruder breaks into your home, common sense says that an old-fashioned colt revolver would be a better choice.

The markets turned ugly in August. Are you still relying on Modern Portfolio Theory to protect your financial house?
 
Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

Monday, August 8, 2011

S&P Downgrade Sends Volatility Higher

As if today’s 634-point stock market sell-off after the S&P downgrade of U.S. government debt wasn’t bad enough, the path taken by the sell-off was even worse. Because of how the sell-off unfolded throughout the day, we decided to reduce risk in the model portfolio, selling an exchange-traded fund mid-day and an industrials sector mutual fund at day’s end.

The key to the decision to reduce portfolio risk was the steadily increasing volatility (VIX) index throughout the day. An early morning spike in the index suggested that the market would be able to handle the ratings downgrade with only modest damage; eventually the market stabilized at around -300 points. But then the volatility index rose to new highs as the market struggled to hold its ground. When the VIX index approached its old spike level, we executed trades to sell our exchange-traded fund holding, the only intra-day sale that was possible in the model portfolio. Even worse, as the afternoon progressed, the VIX index climbed to even higher levels, suggesting that there is a significant risk of another sell-off tomorrow morning.

With the market moving so quickly down, we felt the need to protect assets and increase the amount of cash on the sidelines.

So, if the market falls another 1,000 points from here – what is that, two days trading? – there will be enough money on the sidelines, in cash equivalents or in gold, to buy a meaningful position of stocks at the lower price levels. We’ve always said that falling stock prices feel a lot worse if you don’t have any cash on the sidelines with which to take advantage of the new, lower prices. We haven’t had enough on the sidelines, thus far. With the rising volatility statistics, it was time to have some dry powder on the side.

If the market rises 1,000 point tomorrow morning, the decision of when and how to reinvest actually gets much more difficult.

The easiest way to explain this market, which is selling off much faster than the economic fundamentals would seem to justify, is that the market is factoring in a new recession that isn’t yet evident in the economic indicators. Today’s updated May-Investments Leading Economic Indicator is, once again, pretty flat. Neither is the Conference Board’s LEI warning about an upcoming downturn. But the falling stock market and rising bond prices are typical of what happens during an economic recession.

The stock market looks very reasonably valued – unless a recession causes earnings estimates to dramatically decline. One thing we don’t want to do is sit still and watch the market decline 50%, as it did in the 2008 sell-off, and do nothing to protect portfolios.

The risk that the shattering of consumer confidence will result in lower consumer spending and a new recession cannot be ignored simply because the traditional Leading Indicators, nor the May-Investments indicators, are confirming the risk. We all know that the effective monetary policy for small businesses is tight. There is no more room for fiscal policy to stimulate. More off balance sheet borrowing by the Federal Reserve may just lead to more credit downgrades. Given the lack of stimulus options available, it wouldn’t be shocking for the economy to turn down and if profit margins get squeezed, then valuations can easily come down also.

As I’ve heard people say several times in the past few years, “hope” is not a strategy. “Stubborn-ness" is not a strategy. Our strategy is to “get out of the way of where it’s not working.” At market extremes, it makes sense to go contrarian. At this point, however, it seems to make more sense to follow our discipline, have some cash on the sidelines, and reduce risk while this credit market disruption plays itself out.

I still don’t think that the U.S. is the big problem. But the Asian and European markets closed before the worst of the selling hit the U.S. market, so they are likely to be selling off tomorrow and wondering which European sovereign debt rating (e.g. France’s Aaa-rating) gets lowered next. Also, most individuals own mutual funds, not stocks or exchange-traded funds, and Monday’s market close will be their first opportunity to sell out. Those trades will hit the market Tuesday morning and may explain the big sell-off late in the afternoon on Monday.

Reducing risk in the portfolio enables us to reduce the amount of “fear” in our own thinking about the portfolios. With money on the sidelines, falling prices become an opportunity to buy instead of just a painful reality. We can focus forward, on the recovery to come, instead of just looking backward and regretting missed opportunities to sell.

This is all part of investing in stocks. It is why stock returns, going forward, will likely be higher than those available to bond or cash investors. This is why we don’t want short-term money invested in stocks, and why we’ve been encouraging people to make certain that only “risk” money is invested in stocks. Sometimes, like today, having a discipline forces us to make decisions that we begin second-guessing the moment we execute the trade. Having a process reduces the impact of emotions on strategy, but it doesn’t eliminate the feelings of emotion – the responsibility for making buy and sell decisions about other people’s money. That’s all part of managing money.

But it would be much more difficult, and emotional, if we had no discipline at all.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

Thursday, August 4, 2011

What next after 512-point sell-off?

Today’s 512-point drop in the Dow left investors frightened about the future, disgusted with the Congressional folly that has brought us to this point, and wondering what action to take next. Although I am not as anxious about “the future” as others, the question of what to do next weighs heavy on investors’ minds, including mine.

Before I make a decision, some perspective is in order. Since July 22, the S&P 500 stock index has fallen -10.8%, including today’s jaw-dropping plunge. We finally achieved what many market historians consider “a correction.” Corrections happen, fairly often. The magnitude of the drop was not as frightening as how quickly it happened.

To put this drop in perspective, keep in mind that in spite of this today’s drop, the market is still up 6.5% from a year ago. To be hiding in cash in order to avoid this most recent bout of normal market volatility, at current interest rates, a bank certificate of deposit owner would have to hold their CD for 13 years or more to make up for the return on stocks over the past year.

To give more perspective, the “standard deviation” for the stock market is typically around 15%. This means “15 percent, plus or minus.” In essence, occasional 30 percent market declines are all well within the “normal” market environment.

The 2007-2009 decline of more than 50 percent is considered a “black swan” because it’s almost never supposed to happen. With that black swan event in our recent past, investor memories naturally jump to fears of another market rout, when in fact we’ve just barely reached the point where we’d call this a “correction” at all.

This sell-off feels bad, but not because of the severity of the decline. As market corrections go, thus far this has been relatively modest. The sell-off feels horrendous partly because we have short memories. Let’s be honest, tell me what “correction” you remember that didn’t feel awful! It feels even worse now because it happened after the debt ceiling fiasco which has left investors afraid of how our overly large government is bereft of credibility, impotent and incompetent, unable to address the very real challenges we face.

In fact, however, the U.S. economy continues to muddle through, lurching forward in much the same fashion as it has been all year. In April, while spirits ran high and the market reached new heights, weekly jobless claims languished around 400,000 per week. Today’s number, while called “disappointing” by the media, was right at 400,000. What has changed is not the absolute number, but rather the lack of confidence in our ability to turn the tide.

The total number of people receiving unemployment is still at nearly an all-time low since February 2009, when it skyrocketed after the 2008 financial panic. Housing affordability is near an all-time high. Today’s chain store sales met expectations, and are up +4.6% from year-ago levels. Auto sales weren’t booming, but haven’t weakened much except that Honda and Toyota still don’t have much product to sell because of the tsunami. The Institute for Supply Management numbers were weaker than expected, but still indicate growth. Factory orders were down, but not as much as expected. Construction spending is weak, but still up. Falling oil prices, while painful to the portfolio, may prove to be a welcome relief to U.S. consumers.

For the most part, the economic reports announced this week were either neutral or only slightly weaker. There has been little in the U.S. to justify this correction except that consumer and investor sentiment is awful. But therein lays an important clue as to where investors should be looking. Don’t look in the U.S. For all of our warts, and for all of the tragedy playing out in U.S. economic policy, the U.S. economy is limping forward like the cowboy in the old John Wayne movie that just won’t die, no matter how many arrows Washington’s progressive bureaucrats shoot in his direction.

The economic problem is primarily overseas. The debt ceiling fiasco appeared to be causing the market sell-off but when our self-made problem was finally resolved, the markets continued to go in the wrong direction. As bad headlines in Europe continued to get ink, investors have realized that the real problem isn’t with our own governmental incompetence, but rather the natural result of socialist policies in southern Europe.

But, even here perspective is in order. The Greece problem, though not quite resolved, seems to be inching toward a temporary solution. The bad press arrived when the bond prices of Italy and Spain began falling, especially versus German bond prices. Falling bond prices preceeded the meltdown in Greece, too, and the media has begun to paint all of Obama’s progressive partners in Europe as a collection of fiscal basket cases one step away from default.

While I’m no long-term fan of Italy’s fiscal rectitude or Spain’s entrepreneurial zeal, these nations are much more than a hop, skip and a jump from the mess in Greece, which was the poster-child for Enron-style sovereign bookkeeping. When Greece blew itself up, short-term interest rates rose to above 20% as Greece’s sovereign debt fell to cents on the dollar. With Spain and Italy, their interest rates have soared…to about 6.5%. While it’s true that Greece’s rates did go up above 6% on the road to oblivion, it is truly a leap of logic to assume that because Italy’s rates are now above 6%, that they won’t stop until their bonds, too, are selling for cents on the dollar.

Hey, let’s face it. Given the left-wing orientation of the political establishment in much of southern Europe, their interest rates ought to be at least 6%! Perhaps investors across the globe are finally realizing that these socialist welfare states really are much more risky than Germany. I am not going to conclude that disaster is around the bend, simply because Italians are finally paying an honest rate for the lira they borrow.

The fact of the matter is that Europe has some very real problems to resolve, and that paying for these past mistakes will be quite costly. I can only hope that the U.S. Congress is paying attention (although I seriously doubt it). Moreover, China has been working hard to reduce its growth rate from “on fire” to merely “breathtaking.” The end result of these terrible twin trends might very well be a global recession. And given our weak recovery, the U.S. economy might get dragged down in a global soft patch.

So, the investors’ dilemma is this. Should investors sell because the debt-ceiling compromise is a disaster and the U.S. economy is collapsing? I don’t think so.

However, in my view the issue is really whether the rest of the world is falling into a new global recession that threatens the U.S. recovery as well. This is the risk facing our portfolio. The mutual fund model portfolio sold its last (explicitly) international funds in mid-February, when we got rid of our Latin America and Asia investments. Our only international stock holdings are owned as part of a sector portfolio, and (mostly) as holdings in our gold and precious metals fund, which (most days) has been helping to hedge the decline in stocks.

Based on the facts, alone, I would have no trouble standing up to this sell-off. As uncomfortable as it is to own stocks in this environment…or maybe even because it is so uncomfortable to own them, intellectually I think that is the right call.

However, our discipline requires stepping to the side if the market enters bear market territory, which is right around the corner. We are probably a day or so from beginning to take money off the table. The gold position, alone, not only didn’t protect us much (today), it was actually part of the problem.

We often acknowledge our lack of a crystal ball. On days like today, in particular, it would sure come in handy. If we'd had it ten days ago - even better.  In its absence, we have a discipline that requires moving money off to the side in a down market. If this sell-off continues, we will have passed “correction” territory and be squarely in the midst of another bear market. If that happens, we have little recourse but to yield to the momentum of the market until more is known about the magnitude of the global slump.
 
Everyone wants to sell at the top. We’ve never even pretended that is our discipline. We’ve always promised to try to get out of the way of what’s not working. Unless today was capitulation day and the market recovers tomorrow or Monday, then we will move assets out of the way until things stabilize. Remember, we would likely never move all to cash. However, what looks to me like an over-reaction to a more rationally priced Italian bond might be much more serious, so we will follow the discipline and the next two days will determine what we do next. 
 
Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .