-->Portfolio Predicament
The Daily Reckoning
Paris, France
Monday, 10 February 2003
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*** The winter of investors' discontent is upon us...or the
late autumn, anyway...
*** Gold and oil fill the news...who cares about coffee
and propane?
*** While commodity bulls cheer, consumers
lament...investor portfolios remain under Wall Street
misguidance...and more!
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It's a gloomy winter day here in the Daily Reckoning Paris
HQ, not least of all as your editors are elsewhere.
Bill is on a plane bound for Nicaragua...and Addison is
snow-bound in New Hampshire. But our faithful man-on-the-
scene in Manhattan, Eric Fry, is here with the latest news
from Wall Street for you...
Eric?
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Eric Fry, reporting from New York:
- The"sandpaper" bear market keeps grinding away. 189 Dow
points turned to sawdust last week, as the blue chips
dropped to 7,864 - the index's lowest level since early
October. The Nasdaq fell 3% to 1,282.
-"The poor start to the year might be a harbinger," USA
Today points out."Of the 19 times since 1950 when the
market fell in January, stocks finished up for the year
only seven times, the Stock Trader's Almanac says."
- We shudder to think what a losing January AND a losing
February might portend...A fourth straight losing year
perhaps? Of course, Mr. Market does not observe the
Gregorian calendar...or any other calendar, for that
matter. He observes only the seasons of investor emotions,
and now is the winter of their discontent...or at least the
late autumn.
-"Wall Street today is in one of its recurrent sinking
spells," writes James Grant, editor of Grant's Interest
Rate Observer."Many call it a crisis of confidence, by
which they mean under-confidence. Less attention is given
to the preceding crisis of overconfidence...Markets are
cyclical. First, investors trust too much. They believe
that no price is too high to pay for a stock or a bond,
then they doubt that any price is too low. So credulity is
followed by cynicism, unreasonably high prices by
ridiculously low ones."
- To be sure, stock prices are no longer"unreasonably
high," but neither have they become"ridiculously low". At
least, not as most might define"ridiculous" - the sort of
valuations that typified the stock market in 1982, when
stocks sold for eight times earnings and yielded 6%...Now,
THAT was ridiculous!
- The seasonality of investor sentiment manifests itself in
all financial markets, commodities as well as stocks. Prior
to 2001, two decades of falling commodity values had driven
the price of most commodities to ridiculously low levels,
in many cases below the cost of production. Even today,
after a two-year rally, commodity prices are still low.
- Curiously, despite the rallying commodity markets, long-
term bond yields remain below 4%. Normally, bond yields
rise when commodities are rallying. One of these two
markets would appear to have it wrong.
-"The deflationists own Treasurys," Jim Grant observed
recently,"while the inflationists own oil, gold, nickel,
natural gas, soybeans etc. For now, everybody - temporarily
- is happy. The question before the house is which
constituency is more likely to become unhappy?"
- Bridgewater Associates - like the New York-based editor
of the Daily Reckoning - unapologetically, albeit humbly,
predicts that bonds will become less happy as time goes on.
"Arguably, we are in the midst of the most powerful
commodity move in the last 22 years, and this will now
start hitting the CPI," Bridgewater Associates asserts.
"One of the major global themes in 2002 was the powerful
surge in commodity prices. So far, 2003 has seen the move
continue...[Therefore], our estimates suggest overall
inflation will jump well above 3% in the coming
months...Given the commodity move, this is pretty much
baked in the cake.
-"Prices are rising across all major commodities,"
Bridgewater continues."96% of all major commodities are up
since January 2002 [lean hogs being the one exception...But
who would want a 'lean' hog anyway?]."
- Standout performers since January 2002 include coffee,
which is up 130%, and propane and natural gas, which have
more than doubled. But who cares about coffee or propane
when gold and oil are capturing all the headlines? Gold and
oil are the Taylor and Burton of the commodity markets -
glamorous, volatile and prone to making front-page news.
- Last week, gold soared to nearly $390 an ounce before
retreating to finish the week at $370. The energy complex
put on an even more dramatic performance, as crude oil,
heating oil and natural gas all soared to multi-year highs.
- Crude for March delivery rallied nearly $2.00 to $35.12 a
barrel, its highest level since November 2000. Next up,
natural gas jumped 8% to $6.043 per million BTUs. Not to be
outdone, heating oil gushed an incredible 17% last week,
from 93.2 cents a gallon to $1.10...Time to shut off the
furnace and start foraging for firewood.
- Commodity bulls may be enjoying the rallying energy
markets, but the rising cost of driving a car and heating a
home will bring no smiles to the faces of consumers.
The Daily Reckoning PRESENTS: Diversification is the key to
minimizing risk, maintains Nobel prize-winner Dr. Harry
Markowitz. But, as John Mauldin points out below, with a
few important caveats...which Wall Street seems to be
ignoring.
PORTFOLIO PREDICAMENT
by John Mauldin
In 1952, Dr. Harry Markowitz received a Nobel prize for an
essay outlining the tenets of 'Modern Portfolio Theory'. In
very simple terms, Markowitz' theory posits that an
investor can reduce the overall volatility of his portfolio
by diversifying his investments among a group of non-
correlating asset classes. In other words, when one asset
class - stocks, for example - goes down, a savvy investor's
diversification into bonds and real estate will help hold
the value of his portfolio steady.
At this year's Global Alternative Investment Management
(GAIM) conference, Harry Markowitz impressed two critical
insights upon me...and an important conclusion.
The first insight came during Markowitz' presentation.
Reprising a speech he gave last year on the 50th
anniversary of the publication of his paper, Markowitz went
through the history of how Modern Portfolio Theory came to
be. Buried in a slide discussing the non-correlation
between asset classes was the point that in the 1980's, the
world assumed there was no correlation between the U.S. and
international stock markets. International stock markets
were considered a separate asset class and were marketed as
such.
Today, we know that the correlation between the"U.S." and
"international" stock market classes is quite high. The
diversification"protection" an investor got from investing
offshore in 1980 has disappeared, as world markets have all
tanked at the same time in the past few years. Markowitz's
point was that if you attempt to diversify, it is important
that the markets you diversify into don't actually move
together.
This same oversight caused the spectacular failure of Long
Term Capital Management in 1998. That fund, led by Nobel
prize-winning economists, profited for years by making a
highly leveraged bet that the interest rates on bonds would
converge. In 99 out of 100 years, that is the case. They
believed they were diversified because they held bonds in
scores of different nations. Their theory was that even if
the 100-year flood happened in Norway, if you only had a
small amount of your capital in Norway, you were protected.
What they discovered too late was that in times of stress,
the world had become so connected that there was no benefit
to diversifying among countries. LTCM went down in flames,
drowning in the flood in Norway and the rest of the world.
Markowitz, in his work, allowed for correlations to change
over time. When Wall Street uses his theory, it does not;
it does not want to be involved in"market timing".
Instead, analysts tell their clients to use such-and-such a
fixed correlation portfolio, and that over time, things
will even out. They wait for their correlation studies to
become fatally flawed, and then change them after the fact.
By then, customers have lost their shirts.
In a GAIM keynote luncheon address last year, I argued that
Modern Portfolio Theory has been misused by Wall Street to
persuade retail investors and large institutions alike to
remain in poorly performing assets. The argument that you
must always stay invested in stocks because they always go
up in the long run is a demonstrably false premise. It is
one of those economic arguments that work fine in theory,
but in practice, are a prescription for disaster for
investors.
When I took the opportunity to ask Markowitz about his
views on how Wall Street has used (or misused) his theory,
the second insight presented itself. In the lobby of the
PGA National Resort, there was more than one eye raised as
the charming elder statesman and educator, deprived of his
chalkboard, enthusiastically began to draw graphs in the
air to illustrate his answers. He was kind enough to draw
the graphs backwards, so that they could be"viewed"
correctly from my position. I would have loved to have sat
in his class in college.
At first, Markowitz replied that he thought Wall Street had
done a reasonable job in helping institutions to diversify.
At some point, however, I brought up the point that Wall
Street has used his work to justify 'buy and hold'
policies, which were not helping small investors.
"Aahh," he replied."It all depends upon which assumptions
about future returns you use."
And therein lies the rub. Wall Street and mutual funds use
various studies to show rather large returns for the stock
market. Stay fully invested, they say, and you can
eventually grow rich. Many pension funds assume 9% to 10%
returns on their total investment portfolios. Since 30% or
more of their funds are in bonds, this means they assume
they will be getting at least 12% or more each year from
stocks.
As the saying goes, there are lies, damned lies and
statistics. Using past performance as a guide, what your
return over the next decade will be all depends upon when
you start and when you end your study. Using a 70-year
study to predict future returns, as Yale's Roger Ibbotson
has done, is worthless, as none of us will ever invest in
an index fund for 70 years. Further, it is misleading to
suggest such a statistical relationship between a 70-year
period and any given 10-year future period.
But even comparing 'apples to apples' has its problems. For
example, take any two dates for the Dow, 20 or more years
apart, from the last 100 years, on which the Dow P/E ratios
are similar - and then look at the annual returns. The
results show numbers that are all over the board, and
nothing ever approaches 10%. If you start in 1908, when P/E
ratios are 12.5, and then go to 1986, when P/E ratios are
12.38, the returns over that period average about 4.75%.
Multi-decade periods within that time, but with the same
P/E ratio at the beginning and end of the period, produce a
range of returns from 5.5% to 3.29%.
As you look at the data, the overwhelming fact that jumps
out is that the most important single factor that
determines your future investment returns is the point from
which you start calculating. If you start during a period
when P/E ratios are dropping (secular bear markets), your
return for at least the next decade is going to be flat at
best. If you start when P/E ratios are rising, your returns
are going to be very good. They can very well be in the 10%
plus range for long periods of time.
Sadly, we are now in a period of where P/E ratios are going
to go down. This is a process that will take many years to
finally complete. That means investors cannot use the
investment strategies which worked during the last two
decades. They cannot use relative-return 'buy and hold'
index funds, or even most stock mutual funds, and expect to
make progress. Instead, they must seek absolute return
investments.
What does this mean? Well, it implies that your investment
portfolios are going to grow slower than most of you would
like. The era of 12-15% is over. Done. Gone. To try and
grow them faster implies you will be taking more risk. But
this is a perilous decade for risk-taking. Rather, it is a
decade for risk avoidance.
Regards,
John Mauldin,
for the Daily Reckoning
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